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Chapter 10
An overview of accounting
for liabilities

10-1

Learning objectives
Know the definition of a liability and understand how
to apply the recognition criteria provided in the
AASBs Conceptual Framework.
Understand what a contingent liability represents and
understand how it should be disclosed within the
notes to a reporting entitys financial statements.
Understand which provisions should be treated as
liabilities.

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Learning objectives (cont.)

Understand why, with certain transactions,
professional judgment is required to determine
whether the transaction gives rise to a liability or an
item of owners equity.
Understand how to calculate the issue price of
securities such as debentures.
Know how to account for any premium or discount
that arises on the issue of debentures.

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Relevant standards and guidance

AASB 137 Provisions, Contingent Liabilities and
Contingent Assets
AASB 101 Presentation of Financial Statements
AASB 132 Financial Instruments: Presentation
AASB 139 Financial Instruments: Recognition and
Measurement
The AASBs Conceptual Framework

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Liabilities defined

AASB 137 defines a liability as

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.

Three components of the liability definition

1. There must be a future disposition of economic benefits to
other entities.
2. There must be a present obligation.
3. A past transaction or other event must have created the
obligation.

10-5

Liabilities defined (cont.)

Present obligation:
a duty or responsibility to act in a certain way.
might be legally enforceable, e.g. binding contracts or
statutory requirements.
might also arise from normal business practice, custom and
a desire to maintain good relations or act equitably, e.g.
repairing faulty goods outside of warranty periods.

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Liabilities defined (cont.)

For a liability to be recognised and disclosed in the
balance sheet (the AASB Framework):
it must be probable that a sacrifice of economic benefits will be
required; and
the amount of the liability must be able to be reliably measured

Where the entity retains discretion to avoid making any

future sacrifice of economic benefits:
a liability does not exist and is not recognised

Some professional judgment might be required to

determine if a liability should be recognised (possible
constructive or equitable obligation).
.

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Contingent liabilities
AASB 137 para. 10: Contingent liability arises when there is:
A possible obligation that arises from past events and whose
existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly
within the control of the entity; or
A present obligation that arises from past events but is not
recognised because:
It is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation; or
The amount of the obligation cannot be measured with sufficient reliability.

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Contingent liabilities
So, Contingent liabilities are:
obligations only payable contingent upon a future event; or
present obligations not currently deemed to be probable or not
measurable with sufficient reliability.

Examples include guarantees to cover another

organisations debts or potential obligations from legal
actions.
It would be inappropriate to recognise them on the
statement of financial position (balance sheet) but to
disclose them in the notes to financial statements.
Refer to Worked example 10.1 page 336.

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Liability provisions
Defined as a liability of uncertain timing or amount (AASB
137).
Traditionally, a number of provisions were included as
liabilities on balance sheets:
for example, provisions for employee entitlements and
maintenance and warranty repairs.
Now, if amounts are provided for future expenditure (e.g.
future repairs and maintenance) but there is no obligation
to an external party:
they may not be recognised as liabilities.

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Liability provisions
AASB 137, para 14:
A provision shall be recognised when:
An entity has a present obligation (legal or constructive) as a result of a
past event;
It is probable that an outflow of resources embodying economic benefits
will be required to settle the obligation; and
A reliable estimate can be made of the amount of the obligation.

Only obligations arising from past events existing independently of an

entitys future actions may be recognised as provisions:
for example, penalties for unlawful environmental damage

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Liability provisions (cont.)

Measurement of provisions (AASB 137):
the best estimate of the expenditure required to settle the present obligation
at the reporting date.
if materially different from its undiscounted value, the provision must be
recognised at its present value.

Provisions must be reviewed at each reporting date (AASB 137 Para

59). If an outflow of economic benefits are no longer required to settle
the obligation, the provisions shall be reversed.
Where change in carrying amount of a provision is due to the impact of
using present values, AASB 137 requires the change to be recognised
as a borrowing cost specifically, paragraph 60 states:
where discounting is used, the carrying amount of a provision increases in
each period to reflect the passing of time. This increase is recognised as a
borrowing cost.

Refer to Worked Example 10.2 (p. 342)

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Debtequity debate
All things being equal, firms typically prefer to disclose low
levels of debt.
When faced with a need for additional funds, firms might
issue debt-like securities labelled as equity:
for example, redeemable preference shares,

If securities are defined as equity:

associated distributions are termed dividends (i.e. distributions of
profits), not expenses.

If securities are defined as debt:

associated payments are treated as interest, therefore occasioning
a reduction in profits.

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Debtequity debate (cont.)

AASB 132 Financial Instruments: Presentation
the substance rather than the legal form of a financial instrument
governs its classification on the balance sheet.
therefore some preference shares are financial liabilities.

Requirement to treat preference shares as debt can have

significant implications for debt-to-assets ratio.
Refer to Worked Example 10.3 (p. 346)

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Accounting for debentures

Debentures
a written promise to pay a principal amount at a specified time in
the future, as well as interest calculated at a specified rate.
also referred to as bonds.
typically secured over the assets of the entity issuing the
debenture.
may be issued at par, at a discount or at a premium.

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Debentures issued at par

Par (or face) value
the amount that the debenture holders will receive on maturity of
the debentures.

Investors will pay par if the interest rate offered (coupon

rate) accurately reflects what they believe the interest rate
should be.
Refer to Worked Example 10.4 (p. 348)

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Debentures issued at par (cont.)

Issue of debentures:
Debit
Credit

Cash trust
Applicationdebentures

Debit

Cash at bank

Credit
Debit
Credit

Cash trust
Applicationdebentures
Debentures

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Debentures issued at par (cont.)

Payment of interest
Debit
Credit

Interest expense
Cash at bank

Redemption of debentures
Debit
Credit

Debentures
Cash at bank

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Debentures issued at a discount

If the market requires a rate of return in excess of the
coupon rate:
the issue price must be discounted to a price at which the cash
flows to the investor represent the rate of return required by the
market, i.e. debentures issued at a discount.

The present value of the future receipts, discounted to the

markets required rate of return, needs to be calculated.
Refer to Worked Example 10.5 (p. 349)

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Debentures issued at a discount (cont.)

Issue of debentures (assume direct private
placement)
Debit
Credit

Cash at bank
Debentures

FV of
security

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Effective-interest method
What does the discount represent in Ex. 10.5?
The discount represents the difference between the face value of
the debentures (in this case $10,000,000) and the amount actually
received from the issue.

How should we account for it in subsequent periods?

The discount is not separately shown. The liability is disclosed at
its present value. In accordance with the requirements of AASB
139 we use the effective interest method which means that at the
end of the debenture term the present value of the debentures will
equal the face value.

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Effective-interest method
Using the effective-interest method, the interest expense for a period will
equal the present value of the liability at the beginning of the period multiplied by
the market rate of interest.
9,263,991 x 6%

555,839.50

The accounting entries to recognise the payment of interest would be:

December 31, 2015
Dr Interest expense

555,839

Cr Debentures
Cr Cash

55,839
500,000

30 June 2016
Dr Interest expense

559,190

Cr Debentures
Cr Cash

59,190
500,000

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Debentures issued at a premium

Premium
amount paid for a security in excess of its par/face value.

Investors are prepared to pay a premium if

debentures are issued that provide a coupon rate in excess of that
demanded by the market.
the issue price will rise to the point where the effective rate of
return will equal the markets required rate of return.

Again, we need to calculate the present value of the future cash

flows discounted at the markets required rate of return.
Refer to Worked Example 10.6 (p. 351).

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Effective-interest method for debentures issued

at premium
Example 10.6
Again, using the effective-interest method, the interest expense will equal the
present value of the liability at the beginning of the period multiplied by the
market rate of interest.
10,811,089 x 4% =

432,444

The accounting entries to recognise the payment of interest would be:

December 31, 2015
Dr Interest expense
Dr Debentures
Cr Cash

432,444
67,556
500,000

30 June 2016
Dr Interest expense
Cr Debentures
Cr Cash

429,741
70,259
500,000

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Hybrid securities
Exhibit characteristics of both debt and equity.
Convertible notes:
is debt that allows conversion, at the debt holders option,
into shares of the issuing company.
would, if conversion is probable, have an equity component.
would also have a liability component for payment
obligations prior to conversion.
Should be represented partially as debt and partially as
equity.

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Summary
The chapter addresses the general issues pertaining to
liabilities.
Liabilities can be classified as current or non-current.
How preference shares and convertible notes are
disclosed depends on whether they are of the substance of
debt or equity.
For provisions to be liabilities there must be a present
obligation to other entities.
Debentures can be issued at par, at a premium or at a
discount and any associated discount or premium can be
accounted for by use of the effective interest method.

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