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