SESSION: 9

Liabilities

9-1
Learning objectives

1. Overview of major liabilities

2. Learn the basic terminology and features of bonds
3. Understand basics of accounting for bonds
4. Learn basic terminology relating to leases
5. Understand basics of accounting for leases

9-2
Overview of liabilities

A liability must meet three essential conditions:

1. The future transfer or sacrifice of economic benefits is probable.
2. The obligation of the future sacrifice of economic benefits is present, known,
3. The present obligation is based on transactions or other events that have already
happened.

• Classification based on credit period / maturity

• Current liabilities are due within one year – e.g. wages payable
• Long-term liabilities due beyond one year – e.g. post retirement benefits

• Classification based on requirement to pay interest

• Interest bearing liabilities – e.g. bank loan
• Non interest bearing liabilities e.g. accounts payables

9-3
Current Liabilities Liabilities that need to be settled within one year

Accounts payable Amounts owed to suppliers for goods and services purchased on credit.
It is normally noninterest-bearing unless it is not paid within the
specified duration.

Accrued expenses Obligations for expenses that have been incurred but not yet paid that
include - wages, rent, utilities, insurance, or other dues. They are
recorded as debits to the relevant expense and credits to an accrued
liability account to correctly include all the expenses owed at the end
of the reporting period. These are normally interest-free.

Deferred revenue Obligations created when the company accepts payment in advance for
good and services it will deliver in the future; also called unearned
revenues

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Short term Short-term loans taken by the company. Eg. Commercial paper, line of
borrowings credit or revolving bank loans etc. These borrowings are normally
interest bearing and are due to the lenders on demand

Current portion of When companies have long-term debt, they must reclassify the portion
long term debt that has to be repaid within the next year as the current portion and
remove it from the long-term debt category.

Income taxes Income taxes due to the federal, state, and/or local government
authorities within a year

Others Miscellaneous and infrequently occurring current liability is shown in

an “other” category.

9-5
Non Current Obligations that are not expected to be settled within one
Liabilities year.
Discounting future payments to their present value [ TIME VALUE OF
MONEY] is an important part of valuing long-term liabilities.

Bank borrowings Installment loan or term loan - Each installment payment equals the
portion of the principal that is due plus the interest accrued on the loan.
Often, the company secures the borrowed funds using some specified
assets as collateral

Bonds Borrowings from the capital market. Because bonds are liquid and
lenders can limit their risk to a particular company, traded bonds are a
cost-effective way for investors to participate in debt markets and for
companies to borrow money.

Others Long-term liabilities may include other obligations such as those

incurred for leases, pension obligations, deferred taxes etc

9-6
Bonds

Repayment date

Face value

Coupon rate

Coupons (Interest payments)

9-7
 Basic terms
• Face value – the amount that the company must repay
• Maturity – the date when the company repays the bond in full (face value)
• Stated rate or coupon rate – the rate of interest that the company must pay
• Market rate - the rate of interest demanded in the market place given the risk
characteristics of a bond. This rate can be different from the coupon rate.
• Frequency of interest payment
• Paid periodically typically semi-annually
• Paid cumulatively at the end of the bond’s life, called a zero-coupon bond

9-8
Features
• Covenants – a provision stated in a bond, usually to protect bondholders interest. If these
conditions are violated the bondholders have a right to demand repayment of the loan principal.
Examples of covenants include
• Restriction on sale of certain property
• Restriction on payment of dividends
• Requirement to maintain certain level of retained earnings

• Preference in liquidation -
• Mortgage bonds are secured by the pledge of a specific property. In case of default, these
bondholders have the first right to proceeds from the sale of that property
• Debentures have a general claim against all assets, instead of a specific claim against
particular assets
• Subordinated debenture holders have claims against assets that remain after satisfying the
claims of other general creditors

• Sinking fund – the company is required to put cash aside to repay the bond
• Callable – the firm has the option to prepay the bond (before maturity)
•
9-9 Convertible – the bond holder has the option to convert the bond to equity
Determining bond proceeds

 Every bond has a coupon rate that is promised by the company at the time of filing
prospectus

 On the day when the bond is actually issued in the market, the prevailing interest
rates might be different

 The bond proceeds depend on the market rate of return that prevails for an
investment of like risk, on the issuance day.

 Basic demand and supply economics determines bond proceeds. Bonds are sold for
cash and are issued at:
 Par if coupon rate = market rate
 Premium if coupon rate > market rate
 Discount if coupon rate < market rate

9-10
 Illustration# 9.1 Consider a 10%, 3-year bond with a face value of 1,000, issued
1/1/20X1. Assume that the prevailing market rate is 10% the day the bond is issued.
What much will be received in cash when this bond is issued.

Principal repayment of
1000

Interest payment of =
Face value*coupon rate
= 1000*10%
100 100
= 100

0 1 2 3

9-11
 Calculation of bond proceeds

Face value 1000

Coupon rate 10%
Discount rate 10%

Year 1 2 3
CF
PV Factor
PV
∑PV

9-12
 Illustration# 9.2. Consider a 10%, 3-year bond with a face value of 1,000, issued
1/1/20X1. Assume that the prevailing market rate is 9% the day the bond is issued.
What much will be received in cash when this bond is issued.

Principal repayment of
1000

Interest payment of =
Face value*coupon rate
= 1000*10%
100 100
= 100

0 1 2 3

Note that there is no change in cash outflows of the company since it is promised. The only change
is the rate used in the PV calculations since market rate on date of issuance is now different.

9-13
 Calculation of bond proceeds

Face value 1000

Coupon rate 10%
Discount rate 9%

Year 1 2 3
CF
PV Factor
PV
∑PV

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 Illustration# 9.3. Consider a 10%, 3-year bond with a face value of 1,000, issued
1/1/20X1. Assume that the prevailing market rate is 11% the day the bond is issued.
What much will be received in cash when this bond is issued.

Principal repayment of
1000

Interest payment of =
Face value*coupon rate
= 1000*10%
100 100
= 100

0 1 2 3

Note that there is no change in cash outflows of the company since it is promised. The only change
is the rate used in the PV calculations since market rate on date of issuance is now different.

9-15
 Calculation of bond proceeds

Face value 1000

Coupon rate 10%
Discount rate 11%

Year 1 2 3
CF
PV Factor
PV

∑PV

9-16
 Accounting for bonds
• Because market rate and coupon rate are different, there is likely to be a discount or premium when
a bond is issued.
• When and how much should such discount / premium be recognized
• At the time of issuance
• Over the life of the bond
• At the time when bonds are retired

• Effective interest rate method is used to amortize bond discount or premium

• The effective interest rate (market rate at the time bonds were issued) is multiplied times the bond's
book value at the start of the accounting period to arrive at each period's interest expense.

• The difference between coupon payment and the interest expense will be the amount of amortization
Effective interest rate method
Year Beginning Coupon Interest Amortization Ending Ending net
net liability payment expense of bond unamortized liability
discount discount
0 24 976
1 976 100 107 7 17 983
2 983 100 108 8 9 991
3 991 100 109 9 0 1,000
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 1. The journal entry to record the bond issuance:

2. The journal entry to record the interest payment in year 1 is:

Interest expense is calculated using the market rate at the time of bond issuance.
The market rate will subsequently change but for accounting purposes we continue
to use the market rate at the time of bond issuance.

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3. The journal entry to record the interest payment in year 2 is:

4. The journal entry to record the interest payment in year 3 is:

5. The journal entry to record the repayment of bond in year 3:

9-19
Retiring bonds before maturity

Illustration # 9.4. Assume that the company repurchases the bonds on the open market at the
end of year 2 when the current price of the bond is 971. What are the financial statement
effects?
Effective interest rate method
Year Beginning Coupon Interest Amortization Ending Ending
net payment expense of bond unamortized net
liability discount discount liability
0 24 976
1 976 100 107 7 17 983
2 983 100 108 8 9 991
3 991 100 109 9 0 1,000

9-20
Leases

Lease is a contract that conveys the right of one party to control the use of an asset owned by
another, for a specified period of time in exchange for consideration.
• Lessee – party using the asset
• Lessor – owner of the asset
• Periodic rental payments called minimum lease payments (MLP)

Commonly leased assets - – Airplanes, buildings, equipment, vehicles

Advantage of lease - Many companies use leases to obtain easier access to assets, to finance
assets, and/or to limit risk ( such as obsolescence) associated with the outright purchase of
assets.

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 Classification of leases

Finance lease : Leases that transfer substantially all benefits and risks of ownership. One
of these 5 conditions have to be met -
i. lease transfers ownership of property to lessee by end of the lease term
ii. lease contains an option to purchase the property at a bargain price
iii. lease term is 75% or more of estimated economic life of the property
iv. present value of rentals and other minimum lease payments at beginning of lease
term is 90% or more of the fair value of leased property less any related
investment tax credit retained by lessor
v. The asset being leased is of a specialized nature and is expected to have no
alternative use to the lessor at the end of the lease term.

Operating Lease: Leases other than finance leases

9-22
Accounting by Operating Lease Finance Lease
LESSEE

Balance • All leases are recognized on the balance sheet (except leases with a term of less
than 12 months).
sheet
• Lease asset is reported as either PPE or a “right-of-use” asset that is amortized
over the lease life.
• Lease liability is reduced by principal payments each period, like a mortgage.
• Accounting treatment is similar to recording a PPE asset that is purchased and
financed with borrowed money (both the asset and liability are reported on the
balance sheet).

Income Rent expense is recognized for the • Straight-line amortization expense of

straight-line amortization of the total the right-of-use asset
statement
lease payments plus up-front costs. • Interest expense is recognized on the
lease liability.

9-23
 Illustration # 9.5.
HM Co leases an asset on January 1, 20X1
• Lease has a 3 years with annual MLPs of $10,000, $15,000 and $20,000 to be paid at the
end of year 1, 2, and 3 , respectively.
• Assume an interest rate of 8% p.a. for the lease and the PV of MLP is $38,000. The

Is this an operating lease or a finance lease under the following conditions –

(i) Estimated useful life of the asset = 3 years
(ii) Estimated useful life of the asset = 10 years

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 Calculation of ∑PV of MLP
Discount rate 8%

Year 1 2 3
CF 10,000 15,000 20,000
PV Factor 0.9260 0.8574 0.7939
PV 9,260 12,861 15,879
∑PV 38,000

Dividing MLP as interest espense and reduction in lease liability

Year Beginning MLP Interest Reduction in Closing
lease liability expense lease liability lease liability

1 38,000 10,000 3,038 6,962 31,038

2 31,038 15,000 2,481 12,519 18,519
3 18,519 20,000 1,481 18,519 0

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 Accounting for finance lease

Balance sheet impact

Capitalize the asset as ∑ PV of lease payments and record corresponding liability

Income statement impact (JE 1 and 2 repeated every year)

1. Recognize depreciation of ROU asset

2. Record MLP as reduction in liability and payment of interest

9-26
 Accounting for operating lease

Balance sheet impact

Capitalize the asset as ∑ PV of lease payments and record corresponding liability (same as
finance lease)

Income statement impact (JE repeated every year)

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Next session
• FSA – part 3

9-28