Hello, dear friend, you can consult us at any time if you have any questions, add WeChat: THEend8_
ACCT2511
Financial Accounting Fundamentals Lecture learning objectives 1. Know and be able to apply the definition and recognition criteria of liabilities 2. Be able to account for current liabilities 3. Be able to account for non-current liabilities: borrowings and bonds 4. Understand the difference between provisions and contingent liabilities. What part of a Company Annual Report are we looking at today? • • Liabilities: Definition • “A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits” (AASB Framework, paragraph 49) • Essential characteristics: – The existence of a present obligation arising from a past event – results in an outflow of economic benefits 4 LO 1 More on Definition criteria (1): Present obligation • An obligation is a duty or responsibility to act or perform in a certain way. • Legally enforceable obligations: consequence of a binding contract or statutory requirement. – e.g. amounts payable for goods and services received • Constructive obligations: arising from normal business practice, custom and/or a desire to maintain good business relations or act in an equitable manner. – e.g. a policy to rectify product defects even after the warranty period has expired. 5 Past Events Liabilities result from past transactions or other past events. • Somewhat redundant because in order to have a present obligation there would need to be a past obligating event. For example: • Acquisition of goods => Accounts payable • Sales => warranty • Receipt of a bank loan => borrowings •You can think of present obligation and past event as one characteristic: Present obligation (because that must arise from a past obligating event) Outflow of economic benefits Settlement of a present obligation usually involves the entity giving up resources embodying economic benefits. For example: – transfer of other assets – payment of cash – provision of services – replacement of that obligation with another obligation – conversion of the obligation to equity. Recall from last week: Reporting Assets & Liabilities • Not all assets & liabilities are on the balance sheet • Assets and liabilities have to: (1) Meet essential definition criteria (from previous two slides) And THEN (2) Meet recognition criteria (defined on the next slide) To be recognised (reported) on the Balance Sheet. If they meet (1) but not (2), they are disclosed in the notes Recognition of Liabilities Recognition is the process of incorporating assets and liabilities that meet the definitions into the Balance Sheet. An item that meets the definition of a liability should be recognised if: a) It is probable that any future economic benefit associated with the item will flow from the entity; and b) The item has a cost or value that can be measured with reliability. AASB Framework, Paragraph 83 a)Probability of outflow of Future Economic Benefit • Probable if the event is more likely than not to occur • Where there are a number of similar obligations, need to consider the class of obligations as a whole. • E.g., Smoove Ltd sold 50,000 blenders in 2022 – Each blender comes with a 1 year warranty – In previous years 2% of customers made warranty claims – If considering each single blender by itself: no provision for the warranty could be recognised (2% chance of outflow of FEB is not probable) – However, if considering all of the blenders together (as a class of obligations): a provision can be recognised as it is now probable that at least some of blenders will result in a warranty claim b) Reliable measurement • The cost or value of the liability needs to be measured with reliability • The use of estimates does not undermine reliability. • A range of possible outcomes is enough to make an estimate that is sufficiently reliable to use. Decision path for liability recognition Does the item have all two essential characteristics of a liability? Does the liability meet both the recognition criteria? Does not appear in the balance sheet but may appear in a note Liability recognised in the entity’s balance sheet Separately disclosed in the notes No NoYes Yes Current vs. Non-Current Liabilities A liability shall be classified as current when it satisfies any of the following criteria (AASB101, para 60): – It is expected to be settled in the entity’s normal operating cycle. – It is due to be settled within twelve months after the reporting date. All other liabilities shall be classified as non-current. 13 LO 2 An aside: Working Capital • WC ($) = Current Assets - Current Liabilities Low or negative working capital can be an indication of short-term financial difficulties. • Current ratio = Current Assets/Current Liabilities This gives an indication of the magnitude of working capital (rather than a $ value). Current Liabilities • Usually recorded at full maturity value • Due to the short time frame involved • Difference between maturity value and present value is usually small and immaterial. E.g., • Accruals for goods/services received but not paid for/earned such as accounts payable, notes payable, accrued expenses, unearned revenue • Interest bearing liabilities that are due within 12 months • Formal debt instrument to pay specified amount at specified time • Tax liabilities • Dividends Payable • Provisions…. 15 An aside about terminology • Classify the following accounts as Asset, Liability, Revenue or Expense: – Rent Payable – Rent Receivable – Rent Revenue – Rent Expense – Accrued Rent Revenue – Unearned Rent Revenue – Accrued Rent Expense – Prepaid Rent Expense Notes Payable • May be interest bearing or non-interest bearing. • For interest bearing notes, the accounting treatment is straight forward. • Non-interest bearing notes will be covered in advanced courses • E.g., on 30 June 2022, Apple Pie Ltd. signed a three-month 10 per cent annum note payable to purchase a new truck costing $40,000. Interest and principal are paid at maturity. What is the journal entry on June 30 2022? 17 Dr Motor Vehicle 40,000 Cr Note Payable 40,000 Current Maturities of Long Term Debt • The portion of long term debt maturing within the next 12 months is reported as a current liability. • E.g., At financial year end Banana Bread Ltd is holding a mortgage of $850 000 that requires payments of $10 000 each month. Next year the interest component of the payments will equal $70 000. • What is the current liability that would be reported? • (10 000 x 12) – 70 000 = $50 000 • What is the non-current liability that would be reported? • 850 000 – 50 000 = $800 000 • What is the interest expense for next year? • $70 000 18 Non-Current Liabilities • Obligations that are not expected to be paid within the next 12 months / operating cycle • Arising from specific financing situations • E.g., borrowings, bonds • Arising from ordinary business operations • E.g., superannuation and other obligations to employees, deferred income tax obligations, provisions 19 LO 3 Long Term Debt: Accounting for Borrowings Recognising borrowing: Dr Cash XXX Cr Borrowings XXX Recognition and payment of Interest: Dr Interest Expense XXX Cr Interest Payable XXX Dr Interest Payable XXX Cr Cash XXX Repayment of principal: Dr Borrowings XXX Cr Cash XXX 20 Recall Banana Bread Ltd Banana Bread Ltd is holding a mortgage of $850 000 that requires payments of $10 000 each month. Next year the interest component of the payments will equal $70 000. (1) Write a summary transaction to record the interest payments for the year (assume interest is paid as incurred) Dr interest expense 70 000 Cr Cash 70 000 (2) Write a summary transaction to record the principal repayments for the year Dr Borrowings/mortgage 50 000 Cr Cash 50 000 21 Accounting for Bonds • Bonds are issued by companies, and are a promise to pay interest and return the investor's capital on a specified date (“maturity” date). • i.e., A bond is a promise to pay something in the future in exchange for receiving something today. • The seller/issuer of a bond is a borrower • The buyer of a bond is a lender • Why issue bonds instead of borrowing from a bank? • Borrowing directly from a bank can be more restrictive and expensive • Access to more lenders Some more terminology relating to Bonds • The amount to be repaid to the bond buyer (lender) at maturity is known as the face value • The explicit interest rate being offered by the bond seller (borrower) is known as the coupon rate • E.g., Bircher Ltd issues 100 bonds with a face value of $1 000, with the principal to be paid at maturity in 2 years. The coupon rate is 5% per annum and paid annually. • Bircher Ltd is the borrower. The people buying the bonds from Bircher are the lenders. • Bircher will pay out $5 000 ($1 000 x 0.05 x 100) in coupon payments each year, for two years • At the end of two years, Bircher will also pay $100 000 ($1 000 x 100) to the lenders to clear its debt. Bircher Seller/Borrower Muesli Buyer/Lender 2-year Bond with FV = $1000, coupon 5% Cash At issue date Year 1 Bircher Seller/Borrower Muesli Buyer/Lender $50 cash coupon payment Year 2 (at maturity) Bircher Seller/Borrower Muesli Buyer/Lender $1050 cash ($50 coupon payment + $1000 FV) Coupon rate vs Market rate • Recall: the explicit interest rate being offered by the bond seller (borrower) is known as the coupon rate • Today we will call the rate that the market requires to lend to this borrower the market rate • Differences in the coupon rate and the market rate will impact how the bond is valued/priced at the time of issue • (1) Coupon rate = market rate – issued at face value • (2) Coupon rate < market rate – issued at discount • (3) Coupon rate > market rate – issued at premium (1) Coupon rate = Market rate (bonds at face value) • If the coupon rate and the market rate are equal, bonds are said to be issued at their face value • i.e., the amount received by the borrower at the time of issue is the same as the face value that will be paid to the lender at maturity • Recall: Bircher issues 100 bonds with $1 000 face value, with the principal to be paid at maturity in 2 years. The coupon rate is 5% per annum and paid annually. • Imagine the market rate is also 5% The journal entry to recognise the issue: • Dr Cash 100 000 Cr Bonds Payable 100 000 Recall: Bircher issues 100 bonds with $1 000 face value, maturity in 2 years, coupon rate is 5% p.a. and paid annually, market rate is also 5% • End of year 1: Recognise the coupon payment Dr Interest Expense 5 000 Cr Cash 5 000 • Note: coupon payment equals recorded interest expense • End of year 2: Repay the principal and recognise the 2nd coupon payment: Dr Interest Expense 5,000 Dr Bonds payable 100,000 Cr Cash 105,000 Journal entry is almost the same as when you have a loan! (2) Coupon rate < Market rate (bonds at discount) • If the coupon rate is lower than the market rate, the bonds are issued at a discount • This is because the present value of the bond is less than the face value of the bond • Bonds discount = the difference between the face value and market value. It is a contra-liability account. Journal entry when bonds are issued: Dr Cash Dr Bonds Discount Cr Bonds Payable (2) Coupon rate < Market rate (bonds at discount) • Recall: Bircher issues 100 bonds with $1 000 face value, with the principal to be paid at maturity in 2 years. The coupon rate is 5% per annum and paid annually. • Imagine the market rate is 7% • What does this mean for bond valuation by the market? For each bond: Present value = $963.84 =
(+.) +
(+.) +
+. This means that Bircher will only receive $96 383.96 for 100 bonds, even though it will have to pay back the face value of $100 000 at maturity You will find a simple explanation regarding present value at the very end of these lecture slides (2) Coupon rate < Market rate (bonds at discount) The journal entry to recognise the issue is: Dr Cash 96 383.96 (2) next! Dr Bonds Discount 3 616.03 (3) last step Cr Bonds Payable 100 000 (1) start here! The discount represents implicit additional interest of $36.16 per bond. The journal entry above is recording all of this interest at the time of issue, even though the debt will not be paid for two years. We will need to amortise this discount amount. Bonds Discount