B215 Financial Accounting

AC10 Need to Pay

Specific Learning Outcomes
• Demonstrate understanding of liabilities – current and non-current
liabilities.
• Define and record common types of current and non-current
liabilities
• Outline the differences of raising finance by borrowing and by the
issue of shares.
• Prepare an amortization schedule for interest charges and principal
repayments.
• Demonstrate understanding of contingent liabilities.
• Explain and account for contingent liabilities.
• Examine the different ways of accounting for contingent liabilities
according to their degree of probability.
• Outline the differences between liabilities and contingent liabilities
and their impact to the financial statements.
Problem Analysis
KP Power Pte Ltd
evaluate and present
the financial impact

Taking the Issuing

bank loan new shares

Purchase of Warranties
What are the inventory on
costs with regards credit terms
to each method? Prepayment Probable loss
Preparation
by customer
of financial
statements
How to record
Preparation of journal
journal entries for
entries, T-accounts and
these transactions?
adjusted trial balance
What is a liability?
Definition (FRS 37 Paragraph 10)
A present obligation of the enterprise arising from past events,
the settlement of which is expected to result in an outflow from the
enterprise of resources embodying economic benefits.

Liabilities: => Credit

=> Debit
Current and Non-current
Liabilities
Current Liabilities Non-current Liabilities
• Obligations requiring • Obligations not requiring
payment within one year payment within one
or within the operating year or operating cycle.
cycle, whichever is
longer. • Alternative to owner’s
equity as a source of
• Expectation that the financing.
obligations (debts) would
be paid from current
assets.
 Common Types of Current
Liabilities
• Trade Payables
(a.k.a. Trade creditors / Accounts Payable)
- Oral or implied promise to pay off debts arising from credit
purchases of inventory and other goods

• Unearned revenue
(Revenue that has yet to be earned)
- Arises when customers pay in advance
- The liability is normally satisfied by rendering services to
the creditor, rather than making cash payments
 Common Types of Current
Liabilities – cont’d
• Accrued liabilities
(a.k.a. called Accrued expenses)
- Liability for an expense that has not been paid.
- Examples are Accrued Interest expense, Accrued Salary
expense

• Current portion of long-term debt

- Some long-term debts are payable in a series of monthly
or quarterly installments (e.g. mortgage loans).
- Principal amount due within one year is classified as a
current liability and the remainder of the debt is classified
as long-term liability.
 Common Types of Non-current
Liabilities
• Long-term debt
- Debt due to be paid at a date more than one year in the future.

• Deferred income taxes

- From income already earned and recognized for accounting, but
not taxed

• Notes payable
- Notes promising to pay a certain amount of money at a certain
time

• Bonds payable
- A long term liability account for bonds issued by a company that
are outstanding as of the balance sheet date
 Difference between payables and
accruals - Recap
• Trade payables are liabilities to pay for goods or
services that have been received or supplied
and have been invoiced or formally agreed
with the supplier.

• Accruals are liabilities to pay for goods or

services that have been received or supplied but
have not been paid, invoiced or formally
agreed with the supplier, including amounts due
to employees (for example, amounts relating to
accrued vacation pay).
Provisions

A liability of uncertain timing and amount.

They are distinguished from other liabilities such as trade payables

and accruals because there is uncertainty about the timing and
amount of the future expenditure required in settlement.

Reported separately from payables.

Different from Contingent Liabilities.

Examples are:-
 Provision for warranty expenses

 Provision for bonus

FRS37 on Provisions
Paragraph 36
The amount recognized as a provision should be the best estimate of the
expenditure required to settle the present obligation at the balance sheet
date.

Paragraph 37
The best estimate…….. is the amount that an enterprise would rationally
pay to settle the obligation at the balance sheet date or to transfer it to a
third party at that time.

Paragraph 38
The estimates…. and financial effect are determined by judgment of the
management of the enterprise……
 Example of Provision: Warranties
• Liabilities that appear in the Financial Statements as an
estimated amount. (Eg. MP3 player warranties provided by
manufacturers).

• Matching principle requires the expense of performing the

warranty work to be recognized in the period that the products
were sold in order to offset against the related revenue from the
sales of the products.

• Warranty may extend over several years (eg. warranty on cars),

therefore the liability has to be estimated.

• Uncertainty regarding when warranty work will be performed,

therefore accountants traditionally classified the liability for
warranty claims as a current liability.

• Journal entry for making a provision for warranties

• Dr Warranty Expense (P/L);
Cr Provision for Warranty Exp (B/S)
(Being a provision for warranty)
Difference between accrual and
provision
• Provisions can be distinguished from other liabilities such as trade payables
and accruals because of the uncertainty about the timing or amount of
the future expenditure required in settlement.

• Although it is sometimes necessary to estimate the amount or timing of

accruals, the uncertainty is generally much less than for provisions.

• Example 1: In Bob’s work agreement with XX Pte Ltd, he will be paid one
month’s bonus at the end of the year. As such, XX will accrue one month
of his salary as at year-end.

• Example 2: Management thinks the company has done well this year and
has approved the bonus to be paid out. Management has informed the staff
informally. This is provided as a provision instead of accrual as the
certainty in amount and timing of payment is less certain compared to
example 1.
Contingent Liabilities
(Commitments)
• Commitments are contracts for future transactions.

• Commitments are NOT liabilities, as there is no obligation

to make payment until the services are received.

• If commitments are material, they should be disclosed in

the Notes to Financial Statements.

• Eg. A long-term employment contract with key officer or a

contract to buy or sell inventory at future dates.
FRS37 on Contingent Liabilities
Definition (FRS 37 Paragraph 10)
(a) a possible obligation that arises from past events and whose
existence will be confirmed only by the occurrence or non-
occurrence of one or more uncertain future events not wholly
within the control of the enterprise; or

(b) a present obligation that arises from past events but is not
recognized because:
(i) it is not probable that an outflow of resources
embodying economic benefits will be required to
settle the obligation; or
(ii) the amount of the obligation cannot be measured with
sufficient reliability.

Examples:
• Outstanding lawsuits/litigation claims
• Obligations for environmental cleanup
 Contingent Liabilities
- An example

SembCorp Industries
Annual Report for the year ended
31 December 2007

D:\Documents\
My Notes\LEO\B215 (C151) - F
Difference between Provisions and
Contingent Liabilities

In general, provisions are contingent in nature.

Difference between provisions and contingent liabilities is whether
such liabilities can be recognised.

Criteria to recognise:-
(a) an enterprise has a present obligation (legal or constructive)
as a result of a past event;
(b) it is probable that an outflow of resources embodying
economic benefits will be required to settle the obligation;
and
(c) a reliable estimate can be made of the amount of the
obligation.

If the above conditions are not met, no provision is recorded.

FRS 37 – Decision Tree for
Contingent Liabilities
Start

Present
obligation as No Possible No
a result of an obligation
obligating ?
event?
Yes

Probable No Yes
Remote?
outflow?

No (rare) No
Reliable
estimate?

Disclose contingent
Provide Do Nothing
liability
FRS 37 – Decision Tree for
Contingent Liabilities (*Summarised)
 Overview of Liabilities
Current/ Types of Timing Amount To be
Non-current Liabilities recorded

Current Payables, Fairly certain Fairly certain Yes

Deferred
Revenues, Loan
Non-current Payables, Loans Fairly certain Fairly certain Yes
Either, Accruals Not very Not very Yes
usually certain certain
current
Either Provisions Not certain Not certain Yes
Either Contingent Least amount Least amount No, but
Liabilities of certainty of certainty disclosed if
necessary

Note: The liabilities are arranged such that they decrease with the
certainty in timing and amount.
Application to Problem
Statement
Accounting for the additional events & transactions
Events & transactions Journal Entries
Purchased 28 units of “Mini Wave” Dr Inventory/Purchases $25,200
laptops at $900 each. The Cr Accounts Payable $25,200
transaction was made fully on
credit term of 30 days and the (Being purchase of 28 Mini Wave Laptop
goods have since been delivered. from Wavey Pte Ltd as inventory.)
Company will make payment on
last day of credit term.

Customer paid $8,800 for 220 Dr Cash and bank balance $8,800
pieces of laptop batteries, delivery Cr Unearned revenue $8,800
will be made later.
(Being payment of cash by customer
before delivery of goods.)
Application to Problem
Statement
Accounting for the additional events & transactions

Events & transactions Journal Entries

Replaced $2,700 for faulty Dr Provision for warranty expense $2,700
laptops sold last year. Cr Inventory $2,700
(Being warranty repairs for faulty laptops.)
Estimated 2% of sales in 2008 Dr Warranty expense $3,100
will require replacement. Cr Provision for warranty expense $3,100
(Being Provision for warranty.)
Highly probably that company Dr Fine $2,500
will be found guilty and the Cr Provision for fine $2,500
fine amount can be
reasonably estimated to be (Being provision for fine.)
$2,500.
Application to
Problem Statement

Financial Statements for

KP Power Pte Ltd

Microsoft Office
Excel 97-2003 Worksheet
Managing Capital
Debt Financing
• Usually entails borrowing
of considerable sums of
money from one or more
financial institutions
• Through taking up loan or
issuing bonds
Issuing Equity
• Offer of shares to general
public through a stock
exchange, or to a select
group through a private
placement.
Associated Costs
• Debt financing costs
- Increased monitoring costs due to increased
probability of bankruptcy caused by debt
obligations
- Interest expense

• Costs of issuing equity*

- Flotation Costs
- Underwriting costs

* To be covered more in-depth in subsequent week

More on Impact of Bank Loan

To understand the impact of the bank loan, it is

necessary to prepare an amortization schedule.

An amortization schedule can allow you to keep

track of the amount of interest paid every month as
well as the amount owing on the loan at any point
in time and present the correct amounts in the
Financial Statements.
Bank Loan Repayment
First - you have to first work out the loan repayments. This is easily
done so using the PMT function in EXCEL to calculate the payment for
a loan based on constant payments and a constant interest rate.

Application to Problem Statement:

A loan of $400,000 at a 4.5% interest rate compounded monthly to be
repaid in 3 years in equal instalments is made. The loan is to be
repaid on a yearly basis.

Semi annual repayment

= $72,013.98
Application to problem Statement
Amortization Schedule
Principal $ 400,000.00
Interest 4.50% compounded semi-annually
Loan period 3 years

Payment $ 72,013.98 (Using PMT function)

Principal +
Period Principal
Interest Int erest PMT Balance
1 $ 400,000.00 $ 9,000.00 $ 409,000.00 $ 72,013.98 $ 336,986.02
2 $ 336,986.02 $ 7,582.19 $ 344,568.20 $ 72,013.98 $ 272,554.22
3 $ 272,554.22 $ 6,132.47 $ 278,686.69 $ 72,013.98 $ 206,672.71
4 $ 206,672.71 $ 4,650.14 $ 211,322.84 $ 72,013.98 $ 139,308.86
5 $ 139,308.86 $ 3,134.45 $ 142,443.31 $ 72,013.98 $ 70,429.32
6 $ 70,429.32 $ 1,584.66 $ 72,013.98 $ 72,013.98 $ -

$ 32,083.90 $ 432,083.90
Impact of taking a loan
Taking a loan

Statement of Statement of
Comprehensive Financial
Income Position

Expense Asset may increase resulting from

incurred expansion into China market
(interest)
Reduce Net Liability
income before increase since
taxes loan increased

Tax reduced
Conclusion

 The company needs to compare the costs of raising

capital through debt financing and issuing new equity.
 Businesses need to keep track of their liabilities if they
are to be successful.
 The correct presentation of the company’s position
may help management to make better decision.
 The crucial task of measuring and monitoring liabilities
is a must so that the financial status of the company is
presented accurately and fairly.
 Mindmap
Liabilities

Contingent
liabilities Definition

Classification

Recognition Measurement
Current

Non-current
Present Amount can
obligation that be reasonably
probably Common examples
estimated
requires an
outflow of Presentation in
resources balance sheet
References
Websites
1. Financial Reporting Standard FRS 37,
http://www.ccdg.gov.sg/frs/attachments/2004/FRS_37_2006.pdf, Retrieved on 1
Feb 2009
2. Liabilities, http://www.referenceforbusiness.com/small/Inc-Mail/Liabilities.html;
retrieved on 1 Feb 2009
3. "Amortization", http://banking.about.com/od/loans/g/amortization.htm?p=1,
Retrieved on 1 Feb 2009
Textbooks
1. Libby, Libby and Short; Financial Accounting, Fifth edition; McGraw Hill; 2007;
Chapter 9
2. Larson, Wild and Chiappetta; Principles of Financial Accounting, 17th Edition;
McGraw-Hill Irwin; 2005; Chapter 11
3. Edmonds, Edmonds, Olds, McNair, Tsay, Schneider; Fundamental Financial &
Managerial Accounting Concepts, McGraw-Hill Irwin; 2007 edition; Chapter 8&9