School of Accounting

ACCT 1511: Accounting and Financial Management 1B

Topic 2

Liabilities

Student Handout

Content:
1. Learning objectives
2. Readings
3. Seminar Preparation Qs List/PASS Qs list
4. Topic 2, part 1, slides
5. Lecture Workshop questions
6. Topic 2, part 2, slides
7. Lecture Workshop questions
8. Topic 2 Tutorial questions.

Website: http://moodle.telt.unsw.edu.au
 Introduction and Learning Objectives

At the end of this topic, you should:

LO1. Understand the definition and recognition of liabilities as set out in the
Framework.
LO2. Internalise the various types of liabilities, current, non-current, provisions and
contingent, and off-balance sheet items, and the basic accounting principles
and assumptions that apply.
LO3. Consider the position of liabilities within the context of the balance sheet and
the A = L + E equation.
LO4. Be technically competent in journal entries and T-accounts relevant to liability
recognition for different types of liabilities.
LO5. Be able to apply accounting principles to Liability items and appreciate the
limitations of Balance Sheet information.

Required Readings

Required Readings

Trotman, Gibbins & Carson (TGC) 6th edition Chapter 11.1-11.9 (inclusive)
Amortisation of bond premiums and bond discounts posted on Moodle.

Additional References
http://www.aasb.com.au

1
 PASS Questions for Topic 2

Trotman and Gibbins & Carson 6th ed.: Problem 11.3

Problem 11.7
Problem 11.14
Problem 11.17

Tutorial Preparation Questions for Topic 2

Trotman and Gibbins & Carson 6th ed.: Practice Problem A

Problem 11.11
Problem 11.12
Problem 11.15
Problem 11.16
Problem 11.20
Problem 11.21
Problem 11.22

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Australian Australian
School of School of
Australian School of Business Business Definition Business

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)
ACCT1511
Essential characteristics:
Topic 2 1. The existence of a present obligation arising from a past event
Cannot have a present obligation without an obligating event. For

Liabilities (1) example, the obligation to pay suppliers only occurred because the
company purchased goods in the past. The obligation to rectify
goods under warranty only happened because of sales in the past.
Tutorials this week
No tutorials next week
The obligation to repay a bank loan only arose because the
company received a bank loan in the past.
2. Potential to result in an outflow of economic benefits

Australian Australian
School of School of
Present obligation Business Present obligation Business

An obligation is a duty or responsibility to act or perform in a certain A distinction needs to be drawn between a present
way. An obligation might arise in two ways: obligation and a future commitment.
legally enforceable obligations as a consequence of a binding
Example: a decision by the management of an entity to acquire assets
contract or statutory requirement.
in the future does not, of itself, give rise to a present obligation. An
e.g. amounts payable for goods and services received.
obligation normally arises only when the asset is delivered or the entity
enters into an irrevocable agreement to acquire the asset.
Constructive obligations arising from normal business practice,
custom and a desire to maintain good business relations or act in an
irrevocable nature of an agreement means that the economic
equitable manner.
consequences of failing to honour the obligation, leave the entity
e.g. a company policy to rectify a product even after the warranty
with little, if any, discretion to avoid the outflow of resources.
period has expired.

Australian Australian
School of School of
Outflow of economic benefits Business Recognition criteria Business

The settlement of a present obligation usually involves the entity giving Recognition only when the item meets two recognition
up resources embodying economic benefits. criteria (AASB Framework, paragraph 83):
For example:
transfer of other assets; 1. It is probable that any future economic benefit
payment of cash; associated with the item will flow from the entity;
transfer of other assets; and,
provision of services;
replacement of that obligation with another obligation;
conversion of the obligation to equity.
2. The item has a cost or value that can be measured
with reliability.

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Australian Australian
School of School of
Probability of outflow of FEB Business Reliable measurement Business

It is probable if the event is more likely than not to occur. The cost or value of the liability needs to be measured with reliability
i.e. greater than a 50% chance.
The use of estimates is an essential part financial reporting and
Where there are a number of similar obligations the probability that an
outflow will be required in settlement is determined by considering the class does not undermine reliability.
of obligations as a whole.
In other words, although the probability of outflow for anyone item may Except in extremely rare cases, a range of possible outcomes is
be small, it may well be probable that some outflow of resources will be enough to make an estimate that is sufficiently reliable to use.
needed to settle the class of obligations as a whole.
Example: Company A sold 45,000 waffle makers that comes with a 1 year warranty. In In extremely rare cases, where no reliable estimate can be made, a
the past, the company has experienced that around 3% of its customers make a claim on liability exists that cannot be recognised.
the warranty. The manufacturing process has not changed, so Company A expect a
similar percentage to be lodging claims under the warranty going forward. If one
considers each single waffle maker by itself, no provision for the warranty could be
recognised because if viewed in isolation there is only a 3% chance of outflow of FEB
associated with the obligation, and therefore not probable. But when considering all of the
45,000 waffle makers together (as a class of obligations) then it is probable that at least
some, although we do not know which of them, will claim on the warranty and therefore a
provision can be recognised for the class of obligations as a whole.

Australian Australian
School of School of
Diversion: A note on contracts. Business Decision path for liability recognition Business

A note on contracts: in practice, obligations under contracts that are

equally proportionately underperformed are generally not recognised as
liabilities in the financial statements. Does the item have the two essential
Example: Company A enters into a contract with Company B to purchase some characteristics of a liability?
goods to be delivered in 2 weeks time and with payment to be received in 4
weeks time. At this stage, Company B has not done their part of the contract Yes No
that is, delivered the goods and Company A has not done their part either
payed for the goods. That is, the contract is equally and proportionately Does the liability meet Does not appear
underperformed. Therefore, and at the time the contract is signed, neither of
both the recognition in the balance sheet but
the two companies recognise anything. However, when Company B delivers
the goods in 2 weeks time, the contract is no longer equally and proportionately criteria? may appear in a note.
underperformed and Company B will record a sale, and company A will record
the receipt of the goods along with an accounts payable. Yes No
Liability recognised
However, such obligations may meet the definition of liabilities and, provided
Separately disclosed
the recognition criteria are met in the particular circumstances, may qualify for in the entitys
in the notes.
recognition.
balance sheet.

Australian Australian
School of School of
Current vs. Non-Current Liabilities Business Current liabilities Business

A liability shall be classified as current when it satisfies any of the Accruals:

following criteria (AASB101, para 60): For goods/services received or supplied but have not
It is expected to be settled in the entitys normal operating cycle.
It is due to be settled within twelve months after the reporting
been paid. Examples:
date. - Accounts payable
- Accrued expenses
All other liabilities shall be classified as non-current. - Unearned revenue
Interest bearing liabilities:
Note payables, bank loans and credit facilities:
supported by formal debt instrument to pay specified
amount at specified time.
Current tax liabilities
Dividends payable

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Australian Australian
Short Term Payables and Accruals School of
Business Illustration- Accounts Payable School of
Business

Account payables are the amounts owed to suppliers of goods and Example 1: Inventory for $40,000 is purchased on credit and payed 30
services to the company, such as inventory, electricity, phone services days later (ignore GST).
etc. When purchased:
Dr Inventory $40,000
Cr Accounts Payable $40,000
The goods and services are usually purchased on credit and payment When paid (30 days later):
is made within a short period of time. Dr Accounts Payable $40,000
Cr Cash $40,000

Sometimes Account Payables are just referred to as Payables. Example 2: The company receives an invoice of $5,000 for the use of
electricity. The invoice is to be paid within 30 days (ignore GST).
When invoice is received:
Dr Electricity Expense $30,000
Cr Utilities Payable $30,000
When paid (30 days later):
Dr Utilities Payable $30,000
Cr Cash $30,000

Australian Australian
School of School of
Accruals Business Accruals Business

Accruals are obligations to pay for goods and services that have been Example 2: A company receives a cash deposit for the purchase price
received or supplied but have not been invoiced or formally agreed on, in full, $20,000, for some goods that are to be custom made. The goods
such as wages, interest and cash deposits from customers. where finished and delivered to the customer 20 days later, and it had
cost the company a total of $10,000 to make the goods (ignore GST).
Example 1: Suppose that that company pays $100,000 a fortnight (i.e. 10
working days) in wages. The companies year end is 30 June which in this year When receiving the deposit:
falls on a Friday. Last payment to employees before year took place on the 23 Dr Cash 20,000
June (i.e. last Friday) and covered the fortnightly period from 9 June to 23
Cr Unearned Revenue 20,000
June. The journal entry to recognise the wages owed to employees at year end
for the five working days between 23 June and 30 June is (ignoring tax and on-
costs): When delivering the goods:
Dr Unearned Revenue 20,000
Dr Wages expense $50,000 Cr Revenue 20,000
Cr Wages payable $50,000
Dr COGS 10,000
Cr Inventory 10,000

Australian Australian
School of School of
Short term - Interest Bearing Liabilities Business Non-Current Liabilities Business

Short term interest bearing liabilities are obligations to pay an amount Non-current liabilities typically arise from:
in the future but have interest-bearing characteristics. This interest- 1) specific financing situations. Examples:
bearing characteristics distinguishes these obligations from accounts - Borrowings (such as direct borrowing from banks).
payable. - Bonds (such selling debt on the open market)
- Different types and different names (e.g. Bonds, Debentures,
Example 1: A motor vehicle was purchased on 1 August by issuing a Unsecured note) and there is some differences in the extent to, and
60-day, 9 per cent note for $20,000. whether or not, they are secured with a charge over the companys
assets. But they are similar in format and for the purpose of this
The entry to record the issuance of the note: course we do not distinguish between them. Note the textbook call
Dr Mother Vehicles 20,000 them debentures, whereas I have stuck with the term bonds.
Cr Notes Payable 20,000 More complex than bank borrowings as time value must be
When the notes mature: explicitly considered.
Dr Notes Payable 20,000 2) ordinary business operations. Examples:
Dr Interest Expense 300*
superannuation obligations,
Cr Cash 20,300
deferred income tax obligations
*(300=20,000*9%*(60/360) long service leave

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Australian Australian
School of School of
Accounting for Borrowings - Illustration Business Accounting for Bonds Business
Pretty straight forward to account for. Example 1: Company A borrows 200,000 Bonds are issued by companies and is a promise to pay interest,
on 1 January 2012 to be repaid on the 31 December 2013. The interest on the usually a fixed amount at set intervals, and to pay the bondholder a
loan is 10% per annum and is to be repaid together with the principal on the 31 specified amount on a specified date in the future.
December 2013. Year end for Company A is 31 December 2013.
1 Jan 2012 (Recognising the borrowing): A bond is a promise to pay fixed amounts in the future in exchange for
Dr Cash 200,000 receiving something today.
Cr Borrowings 200,000
31 Dec 2012 (Recognising the interest expense): Promisesthat is, bondscan be bought and sold. The buyer of a bond is
Dr Interest Expense 20,000 a lender. The seller of a bond is a borrower.
Cr Interest Payable 20,000 So if a company issues bonds, the company is borrowing money from
31 Dec 2013 (Repayment of principal and interest): whoever is purchasing the bonds.
Dr Interest Expense 20,000
Cr Interest Payable 20,000 Why issue bonds, instead of borrowing from the bank?
Dr Borrowings 200,000
Cr Cash 200,000
Direct borrowing from a bank can be more restrictive and expensive
Dr Interest Payable 40,000 than selling debt on the open market through a bond issue.
Cr Cash 40,000 Access to more lenders than just banks.
*Note that before 31 Dec 2012 the borrowings will be classified as a non-current liability, Access to more risk friendly lenders.
but after 31 Dec 2012 the borrowings will be classified as a current liability. Possible less collateral needed to be put up in comparison to bank
loans

Australian Australian
School of School of
Accounting for Bonds - Terminology Business Accounting for bonds Business

Face value The amount printed on the instruments face, to be
repaid by the seller (borrower) at the maturity date.
Maturity date is simply the date when company that issued the bond
must pay the bondholder the face value of the bond.
For example, a company issues a bond on 1 July 2010 with a face value
of $1000, which will mature on 30 June 2012. That means the company
will pay the bondholder $1000 on 30 June 2012.
Coupon rate The percentage applied to the instruments face value
to determine periodic payments of interest.
For example, a company issues a bond on 1 July 2010 with a face value
of $1000 and which will mature on 30 June 2012, with a coupon rate of
7% paid annually. That means that after each year, the company has to
make coupon payments to the bondholder of $70.
(The coupon rate is not always the same as the current market rate of
interest for valuing the bond as we shall see and that creates a little
bit of complexity).
Bonds are issued at either:
face value
Amount received for the bond is equal the face value
below face value (discount)
Amount received for the bond is less than the face value
above face value (premium).
Amount received for the bond is more than the face value
Why premium/ discount?
Because the coupon rate is NOT equal to the market interest rate. That is,
the interest payments on the bond that is payed to the lender does not
equal the interest payments that the bondholder requires to purchase the
bond. The result is an adjustment in the purchase price of the bond (i.e.
the cash the company initially get when issuing the bonds). This
adjustment purchase price ensures that the total money the bondholder
actually earn over the life of the bond is equal to the market rate when the
bond was issued.

Australian Australian
School of School of
Bonds issued at face value. Business Bonds issued at discounts Business

This is the case where coupon rate is equal to market rates. To understand why bonds are issued at a discount, it is often helpful to
Example: On 1 July Company issued 1,000, $100 bonds with the think of a bond without any interest payments. These are sometimes
principal to be repaid at maturity in 2 years. The coupon rate is 7% per referred to as zero coupon bonds. That is, the bond has a face value to
annum and paid annually. be repaid to the bondholder on maturity, but there are no coupon
payments.
On issue date: Recognising the issuance of the bond.
Dr Cash 100,000 If offered a choice between $100 today or $100 in one year (assuming a
Cr Bonds Payable 100,000 positive real interest rate), a rational person will choose $100 today. Somewhat
End of first year: Recognising the coupon payment: simplified, the reason for this is that todays money can be put in a bank
Dr Interest Expense 7,000 account or any other (safe) investment that will return interest in the future and
Cr Cash 7,000 therefore increase the value of that money in the future. That is the same as
saying that money received in the future is worth less in todays money.
End of second year: Repayment of principal and the coupon payment:
Dr Interest Expense 7,000 Consequently, any rational lender will charge an interest on the amount that is
Dr Borrowings 100,000 lent.
Cr Cash 107,000 So if a company is to issue a bond with a face value of $1000 with maturity in 2
So when bonds are issued at face value, the accounting is pretty much similar years time, and the bond has a zero coupon rate. Nobody would be willing to
to the accounting for normal borrowings. A little bit more complex for bonds purchase that bond for $1000, as that would mean no return to the lender. So
issued at premiums and discounts. what will happen? next slide.

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Australian Australian
School of School of
Bonds issued at discounts Business Bonds issued at discounts Business

One way to ensure that the lender gets a return on its money is to offer
less than the face value of the bond. So in this case, where the bond
has a face value of $1000 with maturity in 2 years time and a zero
coupon rate, if the bondholder purchase that bond for, say, $900, then
the bondholder would have had a return of $100 on their money ($900)
over the two year life of the bond. Since the bond was issued for less
than the face value, the bond is issued at a discount.
How much is will the discount be? That depends on the how much
return on money the bondholder require to purchase the bond. The
bondholders required return for the specific bond (at the time it is
issued) we call the market interest rate.
The specific amount a company receives for a bond is dependent on the market
interest rate. In this case, where the bond has a face value of $1000 with maturity in 2
years time and a zero coupon rate, the only cash the bondholder is going to receive is
the $1000 after two years. The amount the bondholder is willing to pay for the bond, is
determined by the market rate. Let us say the market rate is 10%. Then the
bondholder would be willing to pay $826 for the promise to receive $1000 in two years.
The $826 is simply the present value of the 1000 in two years. (Appendix to chapter 11
explains time value of money. We will not examine you on time value of money
calculations, but it will help you with understanding why we account for bonds the way
we do). The discount of $174 ($1000-$826) is a reflection of the implied interest the
company must pay the bondholder. The discount of $174 is needed so the bondholder
can get the 10% per annum return on their money.
Cash the company receives Cash paid to the
when bond is issued: bondholder on maturity:
$826* $1000

*$1000/(1.10)2=$826.45 Yr 0 Yr 1 Yr 2

Australian
School of
Bonds issued at discounts Business
So far we have considered zero coupon bonds, but there is really no difference when it
comes to bonds with coupon payments. Let us expand on the previous example. A company
is going to issue a bond that has a face value of $1000 with maturity in 2 years time, and a
coupon rate of 8% paid annually. However, the market rate when the bond is issued is 10%.
Again, the bondholder will not pay a $1000 for this bond as the interest payments provided
on the bond of 8% is less than the 10% interest required by bondholder. How does the
bondholder make up for the difference? Again, the bondholder will pay less than $1000.
Specifically, the bondholder would be willing to pay $965, and the discount of $35 ensures
that the bondholder get a 10% per annum return on the money over the life of the bond
instead of 8% return if the bond was issued at face value. Whenever a bond has a coupon
rate lower than the market interest rate, the bond will be issued at a discount.
Australian
School of
Bond issued at premiums. Business
So far we have considered bonds where the coupon rate is lower than market rate and the
bonds are issued at discounts, but there is really no difference when it comes to bonds with
coupon payments higher than market rates. It works the opposite way. A company is going to
issue a bond that has a face value of $1000 with maturity in 2 years time, and a coupon rate of
8% paid annually. However, the market rate when the bond is issued is 6%. The bondholder
will be willing to pay more than $1000 for this bond as the interest payments provided on the
bond of 8% is more than the 6% interest required by bondholder. Specifically, the bondholder
would be willing to pay $1037, and the premium of $37 ensures that the bondholder only get a
6% per annum return on the money over the life of the bond instead of 8% return if the bond
was issued at face value. Whenever a bond has a coupon rate higher than the market interest
rate, the bond will be issued at a premium.

Cash the company receives Cash paid to the bondholder Cash the company receives Cash paid to the bondholder
Cash paid to bondholder on maturity (face value + Cash paid to bondholder on maturity (face value +
when bond is issued: when bond is issued:
(coupon payment): coupon payment): (coupon payment): coupon payment):
$965.28* $1036.67*
$80 $1080 $80 $1080

Yr 0 Yr 1 Yr 2 Yr 0 Yr 1 Yr 2
*$80/(1.10)+ 1080/(1.10)2 =$965.28 *$80/(1.06)+ 1080/(1.06)2 =$1036.67

Australian Australian
Accounting for Bonds at Discounts and Premiums School of Accounting for Bonds at Discounts and Premiums School of
Business Business

When bonds are issued at a premium or a discount, the premium and Example 1. Company A issues 100 bonds with a maturity date in 2
discount are recognised in a different account from the bond payable. years. The bonds has a face value of $1000and the coupon rate is 7%.
The market rate is 9% so the company only received $965* per bond.
The bond payable is always recognised at face value, and the Journal entries when the bond was issued:
difference between the cash received and the face value of the bonds
is recognised in a contra-liability account. Dr Cash 96500
Dr Bond Discount 3500
Cr Bonds Payable 100,000
A bond discount account will have a debit balance and therefore
reduce the carrying amount of bond payables. Example 2. Company A issues 100 bonds with a maturity date in 2
years. The bonds has a face value of $1000and the coupon rate is 5%.
A bond premium account will have a credit balance and therefore The market rate 3% so the company received $1038* per bond.
increase the carrying amount of bond payables. Journal entries when the bond was issued:
- (Technically, this should not be called a contra-account because it has a credit balance
just the same way as bond payables do. Technically, this is called an adjunct account. Dr Cash 103800
But that is possible only of interest to bookkeeping nerds like myself. You are more than Cr Bond Premium 3800
welcome to think of it as a special kind of contra-liability account that increases the Cr Bonds Payable 100,000
carrying amount of bond payables.).
*Rounded to nearest dollar.

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Australian Australian
Amortisation of Bond Discounts and Premiums School of Amortisation of Bond Discounts and Premiums School of
Business Business

The discount or premium is amortised over the accounting periods until Bond premiums and bond discounts are amortised using the effective
the bonds are due on maturity. interest method. This is a bit different from using the straight line
The accounting periods amortisation is included with the interest approach, and requires a few simple calculations.
expenses. This should make sense, because the reason the discount
and premium was recorded in the first place is because the coupon rate The textbook stops short of how to actually amortise bond premiums
was not equal to the market interest rate. As such, the bond premium and bond discounts, so we have provided some additional material on
and the bond discount is an implicit adjustment to interest expense of moodle.
company.
For a bond discount since it has a debit balance, amortising this account would
require a credit entry, and it would add to the interest expense for the period,
making the interest expense higher than the coupon payment.

For a bond premium since it has a credit balance, amortising this account
would require a debit entry, and it would subtract from the interest expense for
the period, making the interest expense lower than the coupon payment.

Australian Australian
Amortisation of Bond Discounts School of Amortisation of Bond Discounts School of
Business Example 1. Company A issues 100 bonds on 1 July 2009 with a maturity Business
In case of a bond discount, the total interest expense on bond from it date on 30 June 2011. The bonds has a face value of $1000and the coupon rate is
7%. The market rate is 9% so the company only received $964.81 per bond. To find
was issued to its maturity is the sum of coupon interest payments plus
the interest expense for each period, we must multiply the market rate with carrying
the difference between the proceeds received on issue and the amount. A table like the one below will help us keep track of things:
principal repaid (the face value).

The annual interest expense is measured by multiplying the effective

interest rate by the amount of the liability at the beginning of each
period. Any excess of interest costs over the amount of interest paid in
cash (i.e. coupon interest payment) is accounted for as an increase in
the carrying amount of the liability.

By maturity date, the carrying amount of the bond liability will be

increased to an amount equal to the principal, as the discount reduces
to zero.

* Rounding error. Include with the interest expense and the amortisation of bond discount in the last period.

Australian Australian
Journal Entries: Amortisation of Bond Discounts School of School of
Business Amortisation of Bond Premiums Business

When the bond was issued (1 July 2009): Exactly the same as bond discounts, just the other way around.
Dr Cash 96,481.00
Dr Bond Discount 3,519.00 In case of a bond premium, the total interest expense on bond from it
Cr Bond Payables 100,000.00 was issued to its maturity is the sum of coupon interest payments less
Interest Expense (30 June 2010): the difference between the proceeds received on issue and the
Dr Interest expense 8,683.29 principal repaid (the face value).
Cr Bond Discount 1,683.29
Cr Cash 7,000.00 The annual interest expense is measured by multiplying the effective
Interest Expense and Repayment of Principal (30 June 2011): interest rate by the carrying amount of the liability at the beginning of
Dr Interest Expense* 8,835.71 each period. Any excess of the interest paid in cash (i.e. coupon
Cr Bond Discount* 1,835.71 interest payment) over the interest expense is accounted for as a
Cr Cash 7,000.00 decrease in the carrying amount of the liability.
Dr Bond Payable 100,000.00
Cr Cash 100,000.00 By maturity date, the carrying amount of the bond liability will be
decreased to an amount equal to the principal, as the premium reduces
*The rounding error of .92 is included in these amounts. to zero.

Dr Per Tronnes 36

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Australian Australian
Amortisation of Bond Premiums School of Journal Entries: Amortisation of Bond Premiums School of
Example 1. Company A issues 100 bonds on 1 July 2009 with a maturity Business Business
date on 30 June 2011. The bonds has a face value of $1000 and the coupon rate is When the bond was issued (1 July 2009):
5%. The market rate is 3% so the company received $1038.27 per bond. To find the Dr Cash 103,826.94
interest expense for each period, we must multiply the market rate with carrying Cr Bond Premium 3,826.94
amount. A table like the one below will help us keep track of things: Cr Bond Payables 100,000.00
Interest Expense (30 June 2010):
Dr Interest expense 3114.81
Dr Bond Premium 1885.19
Cr Cash 5,000.00
Interest Expense and Repayment of Principal (30 June 2011):
Dr Interest Expense 3058.25
Cr Bond Premium 1941.75
Cr Cash 5,000.00
Dr Bond Payable 100,000.00
Cr Cash 100,000.00

Dr Per Tronnes 37 Dr Per Tronnes 38

Australian
Amortisation of Bond Premiums and Discounts Simplified School of
Business
1. Bond premiums happens when the effective interest rate is lower than coupon rate.
a) It makes the interest expense lower than coupon payments.
i) Yearly interest expense = o/b of the carrying amount*effective interest rate
ii) Yearly coupon payment = face value of bond * coupon rate
iii) Difference is the yearly amortisation of the bond premium
b) Over the life of the bond: total interest expense is total coupon payments less
bond premium.

2. Bond discounts happens when the effective interest rate is higher than coupon rate.
a) It makes the interest expense lower than coupon payments.
i) Yearly interest expense = o/b of the carrying amount*effective interest rate
ii) Yearly coupon payment = face value of bond * coupon rate
iii) Difference is the yearly amortisation of the bond discount
b) Over the life of the bond: total interest expense is total coupon payments plus
bond premium.

Dr Per Tronnes 7
 Lecture Workshop Questions for Topic 2.1

In the very beginning of the financial year 2008, Swing Ltd issued 100 five-year bonds with
face value of $100 and a coupon interest rate of 8 per cent per annum, payable annually in
arrears at the end of the financial year. The bonds were well received in the market, and the
issue price for each bonds 102. Consequently, the market rate was 7.51% at the time the
bonds were issued. Swing Ltds financial year ends on 31 December.

Complete the following table:

Yearly Coupon

Bond Premium
amortisation of
Yearly Interest
Bond Payable

Bond Payable
o/b Carrying

c/b Carrying
Year ended

Amount of

Amount of
o/b Bond

o/b Bond
Premium

Premium
c/b Bond
Payment

Expense
Payable

Yearly
31/12/08 10,000 200 10,200
31/12/09
31/12/10
31/12/11
31/12/12

What will be the journal entry when the bonds were first issued:

DO NOT WRITE OUTSIDE THE BOX

What will be the journal entry for recording the coupon payments at 31 Dec 2008:

DO NOT WRITE OUTSIDE THE BOX

What will be the journal entry for recording the coupon payments at 31 Dec 2009:

DO NOT WRITE OUTSIDE THE BOX

What will be the journal entry for recording the coupon payments at 31 Dec 2010:

DO NOT WRITE OUTSIDE THE BOX

What will be the journal entry for recording the coupon payments at 31 Dec 2011:

DO NOT WRITE OUTSIDE THE BOX

What will be the journal entry for recording the coupon payments and payments of the
principal at maturity on the 31 Dec 2012:

DO NOT WRITE OUTSIDE THE BOX

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Australian Australian
School of School of
Australian School of Business Business Definition Business

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)
ACCT1511
Essential characteristics:
Topic 2 1. The existence of a present obligation arising from a past event

Liabilities (2) 2. Potential to result in an outflow of economic benefits

No Tutorials this week

Tutorials next week

Australian Australian
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Recognition criteria Business Provisions and contingent liabilities Business

Recognition only when the item meets two recognition Provisions are liabilities that are either:
1) uncertain in timing
criteria (AASB Framework, paragraph 83): 2) uncertain in amount.

1. It is probable that any future economic benefit
associated with the item will flow from the entity;
and,
2. The item has a cost or value that can be measured
with reliability.
That does not mean we cannot measure them reliably.
Contingent liabilities are either:
1) a possible obligation arising from past events but whose existence
depends on future events;
2) are liabilities that do not meet the recognition criteria.
Important! Provisions are recognised on the balance sheet. Contingent
liabilities are not recognised on the balance sheet but are disclosed in
the notes.

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Provisions Business Provisions Business

May be current or non-current. Provisions are reported separately from payables and
May arise from either a legal or constructive obligation. accruals in the balance sheet.
Remember, if no present obligation, then no provision.
Provisions are estimates due to uncertainty in: e.g., no provision for (future) maintenance.
Timing and/or
Amount. Journal entries when creating a provision (normally):
That does not prevent us from making reliable estimates so
Dr . Expense
that they may be recognised.
Cr Provision for
Examples:
-warranties Journal entries when provisions are settled:
- uncertainty in how many is going to claim on the warranty so
Dr Provision for
the amount is uncertain, and uncertain about the specific timing
when a customer may claim on the warranty.
Cr Cash
-employee benefits (e.g. annual leave).
- uncertainty about the timing when employees take annual
leave in the future.

Dr Per Tronnes 1
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Australian Australian
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Provisions - Illustration Business Provisions - Illustration Business
Example 1: Arrow Flex Ltd. sells gym equipment which comes with a 1
Example 2: Ninja Ltd. just started to sell replicas of samurai swords which
year warranty, that if there is a default in the equipment the customer will
comes with a 1 year warranty, that if there is a default the customer will
get their purchase price refunded in full. The warranty plan is set up
get their swords replaced. The company believes that a reasonable
based on the prior experience: that is, 5% of Revenue. This year,
estimate of the rate of default products is 3% of cost of goods sold
revenue was $100,000. At the end of the year, Arrow flex has paid out
(COGS). This year, COGS was $50,000. (As Ninja Ltd. just started to sell
$4800 in actual warranty claims:
these swords, this is the first time a provision for warranty is provided for).
However, due to a manufacturing error, the percentage of goods that were
Journal entries to create the provision:
claimed to be default by customers in the end was actually 15%.
Dr Warranty Expense 5,000
Cr Provision for Warranty 5,000 Journal entries to create the provision:
Dr Warranty Expense 1,500
Journal entries to record actual warranty claims: Cr Provision for Warranty 1,500
Dr Provision for Warranty 4,800 Journal entries to record the actual warranty claims:
Cr Cash 4,800 Dr Provision for Warranty 1,500
Dr Warranty Expense 6,000
Cr Inventory 7,500

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Provision for Employee benefits Business Business

Some examples: Let us assume that annual leave is a short-term employee benefit
Annual leave where the annual leave is expected to be taken within the same
Long Service Leave accounting period where the employee earns the annual leave. (somewhat
Sick Leave unrealistic, but it means we dont have to calculate the net present value of these benefits)

Rostered Days
In periods where employee works and earn the annual leave:
Retirement benefits: Pension (defined benefits)
Dr Wages Expense
For some of these, there are many assumptions that need to be made Cr Cash
in determining the dollar amount of the liability, including estimates of
future of staff turnover, future salaries, discount rates etc. These Dr Annual Leave Expense
complications are better left for a future course. Cr Provision for Annual Leave

In periods where employee takes annual leave:

Dr Provision for Annual Leave

Cr Cash

Australian Australian
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Why do firms want their staff to take leave Business Contingent Liabilities Business

Leave is usually earned in days/hours. As employees get promoted
and earning more money, each of those hours will cost the company
more to pay out.
There is another reason as well. When a person takes annual leave,
liability decreases and cash decreases. If a person did not take
annual leave, then the normal way of recording their salary would
take place: increase in an expenses and decreases in cash. So the
net effect when people take annual leave, compared to people not
taking annual leave is a reduction in liabilities and reduction in
expenses.
Two types of contingent liabilities:
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 entity; or
A present obligation that arises from past events but
is not recognised because:
It is not probably 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.

Dr Per Tronnes 2

Australian
School of
Contingent Liabilities Business
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 entity.
In this case, there is a past event. However, it is uncertain whether
this event gave rise to an obligation or not. Currently, there might be
a present obligation, or there might not be a present obligation.
Whether there is a present obligation or not, will only become clear
when some other future events take place.
This is somewhat rare. In most cases it will be clear whether a
present obligation exists or not. But in some cases, for example in
law suits, it may be unclear.
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Contingent Liabilities Business
In cases where there is uncertainty whether a past event gave rise to a
present obligation or not, so that only a possible obligation exists at
reporting date, an entity determines whether a present obligation exists
at the reporting date by taking into account all available evidence,
including that of experts. On the basis of such evidence (AASB 137,
para 16):
(a) where it is more likely than not that a present obligation exists at
the end of the reporting period, the entity recognises a provision
(if the recognition criteria are met); and
(b) where it is more likely that no present obligation exists at the
end of the reporting period, the entity discloses a contingent
liability, unless the possibility of an outflow of resources
embodying economic benefits is remote.
Australian
School of
Summary of contingent liabilities Business
Dr Per Tronnes
5/08/2016
Australian
School of
Contingent Liabilities Business
Example: Ten people die after attending a wedding. Company A
provided the food served at that wedding. Some of the family members
of the people who died, are currently instituting legal proceedings
against Company A claiming that the people died of food poisoning
from the food Company A provided at the wedding. They are seeking
compensation $1,000,000. Company A denies that the food it served
caused food poisoning. At the date of authorisation of the balance
sheet, the court has not reached a decision yet.
- Here there is a past event. Namely, ten people dying at the wedding.
At this stage, however, it is not clear whether this past event result in a
present obligation existing or not. This will only become clear after the
court reaches it conclusion. Consequently, there is only a possible
obligation whose existence will be confirmed only by decision of the
court in the future, and the decision is uncertain and not wholly within
the control of the entity.
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Contingent Liabilities Business
A present obligation that arises from past events but is
not recognised because:
It is not probably 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.
In other words, if a liability exists, but fails the recognition criteria, a
contingent liability is disclosed in the notes to the financial statements.
In cases, where there is only a remote chance (i.e. very unlikely) that
there will be an outflow of resources embodying, the entity do not even
need to disclose the contingent liability.
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Professional Judgment Business
Some situation involving decisions on contingent liabilities may require
discussion with outside experts and definitely requires the application of
your professional judgment. Some contingent liabilities will be
addressed in prior years files. After all, lawsuits can drag on forever.
But facts may change. A contingent liability that was remote in prior
years may now be probable. Something that was remote, might
become reasonable possible although not quite probable.
3
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Australian Australian
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Business Financing Options and classification Business
Recall
A balance sheet is a snapshot of resources the company has available Both liabilities and equity details how our assets have been funded.
and where sourced. That is: Assets = Liabilities + Equity.

It may often be quite obvious how to classify those funding sources into either
Liabilities that come out of legal or constructive obligations (e.g.
borrowings, bonds, unsecured notes, leases); or
Equity capital (e.g. ordinary shares, preferred shares)

Resources Sources

LIABILITIES
ASSETS
EQUITY

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Classification Business Business
The key feature of debt is that the issuer is obliged to deliver either cash or But with the complexity of some financial instruments, it may not always
another financial asset to the holder. The contractual obligation may arise be so easy to classify them as either equity or liabilities because they
from a requirement to repay principal or interest or dividends. Such a are:
contractual obligation may be established explicitly or indirectly but through
Hybrid Instruments: Financing forms that exhibit both debt and
the terms of the agreement. For example, a bond that requires the issuer to
make interest payments and redeem the bond for cash is classified as debt.
equity characteristics (e.g. convertible notes, and convertible
preference shares)
Equity is any contract that evidences a residual interest in the entitys
assets after deducting all of its liabilities. For instance, ordinary shares,
where all the payments are at the discretion of the issuer, are classified as
equity of the issuer.

The critical feature that distinguishes a liability from an equity instrument is

the fact that the issuer does not have an unconditional right to avoid
delivering cash or another financial asset to settle a contractual obligation.
But there are other considerations as well.

Dr Per Tronnes 4
 Lecture Workshop Questions for Topic 2.2

On 15 May 2011, five of RockOils workers died, possible as a result of food poisoning from
the cantina that the company operates on site. Legal proceedings are started by workers
relatives seeking damages from RockOil, but RockOil disputes liability. Up to the date of
authorisation of the financial report for the year to 30 June 2011, RockOils lawyers advice
that it is not probable that RockOil will be found liable, although they cannot rule out the
possibility completely.

a) As at 30 June 2011, will this be recognised on the face of the balance sheet or in a note or
neither? Justify your answer with reference to a key characteristic of a liability (1 mark):

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During the 2012 financial year, the legal proceedings between the workers and RockOil drag
on. RockOil still disputes liability. Up to the date of authorisation of the financial report for
the year to 30 June 2012, RockOils lawyers advice that it is now probable that RockOil will
be found liable due to new developments in the case. However, they cannot rule out the
possibility that they will not be found liable either. The lawyers advice RockOil that the
damages awarded to the families, if RockOil is found liabile, could be in the range of 10
million to 30 million, but the expected amount is 25m.

b) As at 30 June 2012, will this be recognised on the face of the balance sheet or in a note or
neither? If it is recognised on the balance sheet, what will be the dollar figure recognised.
Justify your answer with reference to a key characteristic of a liability (1 mark):

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Hoyt Axton Pty Ltd. does not provide an explicit warranty on its product, but is aware that in order to
be successful it must maintain good customer relationships. Consequently, Hoyt Axton Pty Ltd. has a
policy of replacing any faulty product with new ones or to return the purchase price in cash to the
customer even if it is under no legal obligation to do so. This policy is publicly disclosed on the
company website and customers are generally well aware of this policy. Prior experience suggests that
about 4% of the products Hoyt Axton Pty Ltd sell is faulty and returned by the customers. Of those
that return their goods, about a fifth want their purchase price returned, and the rest want their faulty
product replaced with a new guitar. As such, Hoyt Axton Pty Ltd. has already recognised a provision
of $12,000 in relation to this policy at the end of this period. At the end of the period, Hoyt Axton Pty
Ltd have received 355 of faulty goods and returned $3,500 cash to customers and $10,500 worth of
products.

(c) Write the journal entry for refunding cash and replacing the faulty products (1 mark) (ignore any
tax implications):

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 Tutorial Questions for Topic 2
Q1: Accounting for bonds

At the very beginning of 2008, Heatseaker Ltd issued 200, $1,000 bonds with a coupon rate
of 7.3 percent which is paid annually in arrears to bond holders. The bonds have a 4 year
maturity. The bonds were very well received by the market, so Heatseaker Ltd received
$1045 for each of the bonds. This suggests an effective interest rate (market rate at time when
the bonds were issued) of about 6 per cent.

(Hint: the interest expense for a period is the market rate multiplied with the carrying amount
of the bonds payable (periods opening balance). The amortisation of either premium or
discount for the period is the different between the periods coupon payment and the periods
interest expense. Any rounding error is adjusted for in the last period)

a) Write down the journal entries to record the bond issue at the very beginning of 2008.

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b) For the year ending 2008, what will be the journal entry?

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c) For the year ending 2009, what will be the journal entry?

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d) For the year ending 2010, what will be the journal entry?

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e) For the year ending 2011, what will be the journal entry?

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f) Is the periodic interest expense higher or lower than the coupon rate?

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g) Over the life of the bond, how much will Heatseaker Ltd pay in coupon payments?

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h) Over the life of the bond, how much will Heatseaker Ltd record as interest expense?

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Q2: Mid-Session Supplementary Exam 2011, Semester 2: Question 5 (Adapted)

Dig Hard Pty Ltd. is a mining company and has since 2000 conducted mining operations
across two developing countries that are lacking environmental laws. Dig Hard Pty Ltd.s
mining operations cause severe contamination at local production sites. Although there is no
readily available published environmental policy, Dig Hard Pty Ltds CEO, David Kerr, has
in an interview stated that [Dig Hard] always considers the environment.

After significant pressure from Environment groups, one of the countries in which Dig Hard
Pty Ltd. has operations passed a new environmental act on the 1 March 2008 that requires
Dig Hard Pty Ltd. to clean its mining sites when it is finished mining. Expert advice obtained
by Dig Hard Pty Ltd. estimate that the fair value of costs to clean up its mining sites when
production is finished is $3,400,000, where 47% is related to the mining operations in the
country that has not yet passed any environmental laws.

a) As of 30 June 2007, did Dig Hard Pty Ltd.s have a present obligation (justify your
answer) and if yes, what would be the amount of that obligation (1 mark):

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b) As of 30 June 2008, did Dig Hard Pty Ltd.s have a present obligation (justify your
answer) and if yes, what would be the amount of that obligation (1 mark):

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At 20 June 2010, Dig Fast one of Dig Hard Pty Ltd.s subsidiaries obtains a loan from a
creditor. Dig Hard officially guarantee for the borrowings of Dig Fast in the case default. Dig
Fast financial condition at that time is sound. However, during the financial year ending 30
June 2011, the financial condition of Dig Fast Pty Ltd. deteriorates and it looks unlikely that
Dig Fast Pty Ltd will continue as a going concern. Dig Fast Pty Ltd. files for bankruptcy on 5
September 2011.

c) At 30 June 2010, will this information be mentioned in Dig Hards annual report? If yes,
where? Justify your answer.

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d) At 30 June 2011, will this information be mentioned in Dig Hards annual report? If yes,
where? Justify your answer.

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Q3: Final Exam 2012, Semester 2: Question 8 (Adapted)

Metal Fuzz Pty Ltd. produces and sells a particular model of electric guitars. You have just
taken up the position as the chief accounting for Metal Fuzz Pty Ltd. but the auditors have
questioned the previous accounting treatment of Metal Fuzz Pty Ltd.s return policy.

Metal Fuzz Pty Ltd. does not provide a warranty on its product, but is aware that in order to
be successful it must maintain good customer relationships. Consequently, Metal Fuzz Pty
Ltd. has a policy of replacing any faulty product with new ones or to return the purchase price
in cash to the customer even if it is under no legal obligation to do so. This policy is publicly
disclosed on the company website and customers within the electric guitar community are
well aware of this policy. Prior experience suggests that about 3% of the guitars Metal Fuzz
Pty Ltd sell is faulty. Prior experience also suggest that about half of those that return their
faulty guitars to Metal Fuzz Pty Ltd want their purchase price returned and the other half
would like it replaced with a new guitar.

During the financial year ending 30 June 2013, Metal Fuzz Pty Ltd. had incurred revenue of
$500,000 and cost of goods sold of $250,000, and it had replaced faulty products worth
$5,000 and also returned $5,000 cash for faulty products. Metal Fuzz Pty Ltd. has previously
not recognised anything in their accounting records in relations to their return policy.

(a) Does Metal Fuzz have a present obligation (justify your answer):

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(b) Write down all journal entries (if any) in relation to Metal Fuzz Pty Ltd recognising a
liability in relation to its policy:

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(c) Write down all journal entries (if any) in relation to Metal Fuzz Pty Ltd replacement of
faulty products or returning cash to customers (given what you have done in part b):
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Q4: Dentro Retail Group

Dentro Retail Group specialises in the ownership and management of shopping centres. The
following events unfolded for the Dentro Retail Group in the late 2007.

Dentros 2007 financial year ended 30 June. On 6 September the board approved and signed
off on the financial statement. And the audited full financial statements were lodged with
ASIC 18 September. It turned out, however, that the figures reported in the financial
statements lodged was not entirely correct, and on the 20 December the Dentro Retail Group
publically acknowledged these errors.

Timeline:

Extracts from Dentros 2007 Financial Statements, are disclosed below. The first column
details the incorrect figures reported in the financial statements lodged on 18 September, the
second column details the figured that should have been reported, and that was released 20
December.

Financial Statement Extract

($'000) ($'000)
Balance Sheet 2007 Reported 2007 Corrected
Current Assets 1,337,991 1,821,976
Non-Current Assets 6,827,065 6,827,065
Total Assets 8,165,056 8,649,041

Current Liabilities 1,753,499 3,751,581

Non-Current Liabilities 2,846,434 1,332,337
Total Liabilities 4,599,933 5,083,918

Total Equity 3,565,123 3,565,123

Income Statement
Revenue 795,166 795,166
Expenses 324,933 324,933
Net Income 470,233 470,233
The following chart details the share price movement of Dentro Retail Group:

Required:
a) list three differences between the reported and the corrected 2007 figures:
1.

2.

3.

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b) Calculate the current ratio (current assets/current liabilities) for both the reported and
corrected 2007 figures:
Calculation for 2007 reported figures:

Calculation for 2007 corrected figures:

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c) To the current ratios calculated in part (b), do you think the shareholders reaction to
the corrected 2007 numbers is justified? Justify your answer.

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