Liabilities

Definition:
• present obligations based on past transactions or events that require
either future payment or future performance of services
A liability is 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. [IASB Framework, paragraph 4.4 (b)]
• Liabilities are also captured by IFRS 9: Financial Instruments:

A financial instrument is any contract that gives rise to a financial

asset of one entity and a financial liability or equity instrument of
another entity [ IAS 32, paragraph 11]

−Most relevant standards:

IFRS 9 (Financial Instruments), IAS 37 (Provisions, Contingent Liabilities
and Contingent Assets)
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Liabilities

− Recognized when incurred; end-of-period adjustments may be

necessary
− classified as current or long-term; determinable or contingent

• Initial valuation at fair value minus transaction costs that are

directly attributable to the issue of the financial liability if classified as
measured at amortized costs (IFRS 9, 5.1.1)
• A liability needs to be classified as either
– Subsequently measured at amortized costs
– Or at fair value through profit and loss (Fair value option)
• Subsequent measurement
– According to classification
• Amortized costs: The amount at which the financial liability is measured at
initial recognition minus the principal repayments, plus or minus the
cumulative amortization using the effective interest method of any
difference between the initial amount and the maturity amount. (IFRS 9,
2
Appendix A)
Long-term / current

• Long-term Liability
– due beyond the current period or the normal operating cycle, whichever
is longer
– used to cover long-term financing needs

• Current Liability
– due within one year or within the normal operating cycle, whichever is
longer
– incurred in connection with operating process
– long-term liabilities may contain a current portion according to the lapse
of time
• to be shown separately

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Part I: Current Liabilities

– Accounts Payable
• sometimes called trade accounts payable
• balances owed to others for goods and services purchased on open
account
– Short-Term Loans
• „line of credit“ – short-term borrowing when needed
– Current Maturities of Long-Term Debt
• portions of long-term debt maturing within the next year are
classified as current liabilities
• e.g. installment due on a long-term liability, i.e. a loan
– Dividends Payable
• liability is incurred after the board‘s decision to pay out dividends
• liability exists until dividends are paid
• Subsequent valuation:
– Current liabilities are valued at the amount due, time value of money is
not material
– Exception: current portion of long term debt 4
Unearned Revenues
• examples:
– sale of season tickets for a sports club
– subscription of magazines
– gift certificates
– meal tickets
• accounting treatment
– when payment is received: debit cash, and credit unearned revenue
account
– when revenue is earned: debit unearned revenue, and credit an earned
revenue account

Type of Account Title

Business Unearned Revenue Earned Revenue

Airline Unearned Passenger Ticket Revenue Passenger Revenue

Restaurant Unearned Meal Revenue Meal Revenue
Magazine Publisher Unearned Subscription Revenue Subscription Revenue
Sports Club Unearned Ticket Revenue Ticket Revenue
5 5
Economic function of unearned revenue

• recognize unearned revenue when customers are entitled to receive

future service for their present payment with certainty
– to be distinguished from warranty reserves

Example – Microsoft
¾ unearned revenue increased year after year
¾ u.r. arise from sale of Windows and Office
you do not buy just the current version but future
improvements as well
¾ if sales are growing so is unearned revenue

Increases in unearned revenues may signal favorable future

development!

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Part II: Long-term liabilities -Bonds

Some Background information on bonds:

• securities issued by, e.g. corporations or governmental agencies, to

obtain large-sum long-term financing
• normally due ten to fifty years after issue
• various covenants and restrictions for protection of both lenders and
borrowers
• small denominations allow collection of large sums of money
• interest payment
– annually or semiannually
– zero bonds
• „bond issue“ refers to total number of bonds issued at one time

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Why issue bonds?

• to obtain large sums of money for long time that cannot be collected
otherwise e.g. from banks
• debt financing has some advantages over equity financing
– stockholder control remains unaffected
– tax savings: interest expense is tax deductible
– leverage effect: spread between return on assets and interest cost is
usually positive and increases return on equity
• Stock financing vs. bond financing – an example
– € 2 million needed to fund a project
– alternative I – issues 100.000 shares at current price of € 20 per share
– alternative II – issuance of € 2 million, 9% bonds at face value

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Funds obtained by ... issuance of ... issuance of
additional shares bonds
(250.000 shares (150.000 shares
outstanding) outstanding)

Earnings before interest

and income taxes € 700.000 € 180.000 € 700.000 € 180.000
Interest 0 0 180.000 180.000

Earnings before income taxes € 700.000 € 180.000 € 520.000 €0

Income taxes at 35% 245.000 63.000 182.000 0

Net income € 455.000 € 117.000 € 338.000 0

Earnings per share € 1,82 € 0,47 € 2,25 0

RoE 9.1% 2.34% 11.27% 0%

Note: Net income under bond financing is lower than under stock financing, but return
on equity may be higher.
Note that interest cost will increase with leverage because of an increasing default
risk.
Volatility of earning increases. 9
How to issue bonds ?

• usually, approval by board of directors and general meeting of

shareholders necessary; authorized:
– number of bonds
– total face value and nominal interest rate
• face value: amount of principal the issuer must repay at maturity
• nominal interest rate determines amount of cash interest the issuer
has to pay (also stated rate of interest)
– bonds are taken by investment banks („underwriters“) and sold to the
public
– underwriters buy bonds for resale or on a commission basis
– bondholders are represented by a trustee, typically a large bank
– contract between company and bank is called bond indenture
– specifies terms of the bond, rights, privileges, and limitations of
bondholders
• bondholders receive bond certificates as evidence of the company‘s
debt to the bondholder; bondholders are creditors !
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Types of Bonds

• Secured and Unsecured Bonds

– secured bonds: bondholders have a claim to certain assets of the
company upon default, e.g. mortgage bond
– unsecured bonds: issued against general credit of borrower (debenture
bonds)
• Term and Serial Bonds
– term bonds: all bonds of an issue mature on the same date
– serial bonds: bonds mature over several maturity dates
• Registered and Coupon Bonds
– registered bonds: corporation maintains record of all bondholders
– coupon bonds: bond not recorded in the name of the owner;
transferable by delivery
cont‘d next page

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Types of Bonds, cont‘d

• Convertible and Callable Bonds

– convertible bonds: bonds that can be converted into common stock at
the option of the holder
• bonds furnished with a stock option to reduce coupon
– callable bonds: bonds that can be retired before maturity at the issuer‘s
option

• Income and Revenue Bonds

– income bonds: interest payment only if company is profitable
– revenue bonds: interest on the bonds is paid from specific revenue
sources

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Valuation of Bonds Payable

• bonds are traded in the capital market

– market rate (effective yield) of interest and (current) bond prices are
inversely related
• yield rate: the virtual interest rate r a bond purchased at the current
price in the market yields to the owner
• Let c denote the coupon, B the bond price, T the maturity (time to
repayment), face value = F.
• Then r is the solution to the following equation:

⎛ T c ⎞ F
⎜⎜ ∑ ⎟⎟ + =B
⎝ t =1 (1 + r )t
⎠ (1 + r )
T

• The yield for longer term debt uses to be higher than for shorter
term debt (normal term structure of interest rates)
• yield rate (bond price) depend on credit rating

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 Valuation of Bonds Payable

face value € 300.000

stated rate of interest 7%
market rate of interest 10% 12%

schedule of payments year 1 year 2 year 3 year 4 year 1 year 2 year 3 year 4

interest € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000

principal € 300.000 € 300.000

present value of interest € 66.567 € 63.784

present value of principal € 204.904 € 190.655

present value (selling price) of the bond € 271.471 € 254.440

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 Inverse relation between interest rates
and bond prices

B bond #1 – stated
rate of interest of c1
= 5% and term to
maturity of T1= 10
bond #2 - stated
rate of interest of
c2 > c1 and term to
maturity of T2=T1
bond #3 - stated
rate of interest of
c3=c1 and time to
maturity T3 = 5 < T1

%r

assumption: bonds 1-3 have the same face value = 100 15

Stated rate of interest, market rate of interest,
effective rate of interest, and bond issue prices:

• The stated rate of interest i = c/F may differ from the market rate of
interest
– since the yield must be equal to the market rate the issue price must be
adapted accordingly:
• If the stated rate is
– lower than the market rate: issue price lower than face value, bond sells
at a discount
– higher than the market rate: issue price exceeds face value, bond sells
at a premium
⎛ T c ⎞ F
⎜⎜ ∑ ⎟⎟ + =B
• at the date of issue (
⎝ t =1 1 + r )t
⎠ (1 + r )
T

must hold with a given market rate r

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Accounting for bonds payable

• Bonds are long term financial instruments to be valued at

– fair value (minus transaction costs) at initial recognition
– Typically they need to be classified as subsequently measured
at amortized costs

Definition:
• Amortized costs: The amount at which the financial liability is
measured at initial recognition minus the principal repayments, plus
or minus the cumulative amortization using the effective interest
method of any difference between the initial amount and the
maturity amount. (IFRS 9, Appendix A)

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Issuing bonds at Face Value (“at par”)

• stated rate of interest i = r market rate of interest

• accounting entry: cash proceeds = face value of the bonds
– Example: 5-year term bonds, face value of € 900.000, dated January 1,
2009, interest rate 8%, annual interest payments on January 1.

To record issuance of bonds on January 1

Cash 900.000
Bonds Payable 900.000

To record accrued interest expense at year end

(December 31)
Bond interest expense 72.000
Bond interest payable 72.000
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Issuing Bonds at Discount

• stated rate of interest i < r market rate of interest

– Example: as before, but market rate of interest now 10% (stated rate of
interest 8%).
5
72.000 900.000
∑
t =1 1,1t
+
1,1
5 = 831.766

– discount is 68.234
– has to be amortized over the time to maturity
– Effective interest rate method has to be applied

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Issuing Bonds at Discount

To record issuance of bonds on January 1

Cash 831.766
Discount on Bonds Payable 68.234
Bonds payable 900.000
To record accrued interest expense and accrued amortization at
year-end (December 31)
Bond interest expense 83.177
Discount on Bonds Payable 11.177
Interest Payable 72.000

Balance sheet presentation: Long-term liabilities

Bonds Payable € €900
900.000
000
Less: Discount on Bonds Payable 112.159 € 831.766
68.234 € 787.841
20 20
Issuing bonds at a premium

• stated rate of interest i > r market rate of interest

– Example: as before, but market rate of interest now 6%
To record issuance of bonds on January 1
Cash 975.823
Premium on Bonds Payable 75.823
Bonds payable 900.000
To record accrued interest expense and accrued amortization at year-end
(December 31)
Bond interest expense 58.549
Premium on Bonds Payable 13.451
Interest Payable 72.000
Long-term liabilities
Balance sheet presentation Bonds Payable € 900€000
900.000
Add: Premium on Bonds Payable 75.823 €21
133.901 21
975.823
€ 1.033.901
Effective interest method

• The effective interest method is to be applied to amortize discounts

and premiums over the lifetime of the bond

• interest expense = bond carrying value × effective rate of interest

– discount amortization = interest expense – interest to be paid
– premium amortization = interest to be paid – interest expense

– increasing amounts are amortized in each period

• interest expense is equal to a constant percentage of the
carrying value of the bonds
• interest expense recorded is, thus, increasing under discount
and decreasing under premium amortization

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Effective interest discount amortization
schedule for an 8% bond sold to yield 10%

Annual interest paid interest discount unamortized bond carrying

period expense amortization discount value
issue date 68.234 831.766
1 72.000 83.177 11.177 57.057 842.943
2 72.000 84.294 12.294 44.763 855.237
3 72.000 85.524 13.524 31.239 868.761
4 72.000 86.876 14.876 16.363 883.637
5 72.000 88.364 16.364 0 900.000

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Effective interest premium amortization
schedule for 8% bonds sold to yield 6%

Annual interest paid interest premium unamortized bond carrying

period expense amortization premium value
issue date 75.823 975.823
1 72.000 58.549 13.451 62.372 962.372
2 72.000 57.742 14.258 48.115 948.115
3 72.000 56.887 15.113 33.002 933.002
4 72.000 55.980 16.020 16.982 916.982
5 72.000 55.019 16.981 1 900.001

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Zero Bonds

• bonds that bear no interest (explicitly) and are issued solely for cash
• also called deep discount bonds
– Example: An 8-year zero bond with face value of € 10 million (10.000 x
€ 1.000 each) is issued and sold at a price of € 3.270.000.
• What is the implicit interest rate ?

€3.270.000 = €10.000.000 ⋅ (1 + i ) −8
10.000.000
i= 8 − 1 = 0,14999
3.270.000

• The implicit interest rate is 15%. It is the interest rate that equates
(in present value terms) the cash received with the amounts to be
paid in the future.

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Disclosure Requirements for
Long-Term Debt

• composition of long-term debt

• long-term debt maturing within one year should be reported as a
current liability
• maturities of long-term debt during each of the next five years
• any special arrangements, e.g. refinancing, conversion into stock,
„off-balance-sheet financing“

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Provisions and Contingent Liabilities

• Provisions:
– A provision is a liability of uncertain timing or amount (IAS 37, 10)
– IAS 37 contains general regulations, rules for specific types of
provisions are found in several standards
• E.g. IAS 19 Employee Benefits or IAS 17 Leases
• A provision should be recognized when, and only when:
– An entity has a present obligation as a result of a past event (legally or
constructive)
• The obligation needs to involve another party to whom the
obligation is owed
– It is probable (ie more likely than not) that an outflow of resources
embodying economic benefits will be required to settle the obligation
– A reliable estimate can be made of the amount of the obligation.
(The standard notes that it is only in extremely rare cases that a reliable
estimate will not be possible)
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Provisions and Contingent Liabilities

• Contingent Liability:
• 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
recognized 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
• An entity should not recognize a contingent liability. It should be
disclosed in the notes unless the probability of an outflow of
resources is remote

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Example

• Dream Cars Inc., a car dealer, offers various specialties to its

customers:
– Free repair of newly bought cars in case of defect within the next two
years
– Free inspection on request by new customers within the next six months
with purchase of 4 new tires before Christmas (as a Christmas customer
appreciation special)
• No definite liability incurred; Uncertain:
– payee
– time
– amount.
• Nevertheless
– An obligation as a result of a past event (car sales) is present
– An outflow of resources is probable, and
– the amount can reasonably be estimated.
Ö Record the estimated amount as a provision!
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Common instances of contingent liabilities:

• Litigation, claims, and assessments

– the cause for legal action occurred in the past
– probability of unfavorable outcome hard to assess
– estimate of expected loss: legal action is decided but number of
claimants uncertain
– pending litigation vs. actual/possible claims and assessments: no exact
amounts disclosed due to influence on position before the court

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Warranty costs

• Warranty: guarantee to repair or replace defective goods during a

predetermined period following the sale
– Amount and timing is uncertain
• A provision needs to be recognized:
– An obligation as a result of a past event (car sales) is present
– An outflow of resources is probable*, and
– the amount can reasonably be estimated

* If there is a number of similar obligations the probability that an outflow will

be required is determined by considering the class of obligations as a
whole
• Matching argument:
– Cash Basis – warranty costs charged to period in which
company complies with the warranty
– Accrual Basis – warranty costs charged to period of sale as
operating expense 31
Example

• Michael Drums sells music instruments. Per 100 units sold, 2 require
warranty service. The cost per service is estimated at € 70. In 2002,
he sold 800 units. Five warranty services have already been
performed at costs totaling € 430.

– Obligation as a result of a past event: sales of music instruments

– Outflow of resources probable:

Prob(at least one unit out of 800 is defect) =1-Prob(zero units are
defect) =1- ((800-16)/800)800=1-0>0.5

– Amount can reasonably be estimated:

E(C)=0.02*800*€70= €1.120
€1.120-€430= € 690

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Journal entries for the example:

1. Sale of 800 units at average price of € 100

Cash or Accounts Receivable 80.000

Sales 80.000

2. Recognition of warranty expense

Warranty Expense 430

Cash, Inventory, or Accrued Payroll 430
(warranty costs incurred)

Warranty Expense 690

Provision for warranty services 690

3. In 2003 warranty costs of 700 arise related to 2002 sales

Provision for warranty expense 690

Warranty expense 10
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Cash, Inventory, or Accrued Payroll 700
Environmental liabilities

• result from obligation to clean up, say, toxic waste or to landscape

sites no longer used for business
– sometimes very hard to estimate the liability
– indemnity claims after environmental catastrophes
• For example: Bayer AG
“[28 ] Other provisions
Other provisions are valued in accordance with IAS 37 (Provisions,
Contingent Liabilities and Contingent Assets) using the best
estimate of the extent of the obligation. Interest-bearing provisions
are discounted to present value. Personnel commitments mainly
include annual bonus payments, long service awards and other
personnel costs. The miscellaneous provisions include € 131 million
for restructuring. Provisions for environmental protection relate to
future relandscaping, landfill modernization and the remediation of
land contaminated by past industrial operations. Sufficient
provisions have been established for such commitments.” [Bayer
AG, Annual Report 2000, notes to financial statements.]
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