Financial Liability

Definition and Nature of Liabilities

• According to IASB, liability is a present obligation of an enterprise arising from past
event, the settlement of which is expected to result in an outflow from the enterprise
of resources embodying economic benefits.
• From the definitions given, a liability possess the following essential characteristics:
1. present obligation
2. past event
3. transfer of an economic resource
• An obligation is a duty or responsibility to act or perform in a certain way which may
be legally enforceable as a consequence of a binding contract or statutory
requirement.
• A legal obligation is one that derives from a contract (through its explicit or implicit
terms), legislation, or other operation of law.
• A constructive obligation is one that derives from an enterprise's actions whereby an
established pattern of past practice, published policies or a sufficiently specific
current statement, the enterprise has indicated to other parties that it will accept
certain responsibilities, and as a result, the enterprise has created a valid expectation
on the part of those other parties that it will discharge those responsibilities.
• The settlement of a present obligation involves the enterprise
giving up economic resources.
• Such settlement of a present obligation may occur in a number of
ways, such as by
a. payment of cash
b. transfer of other assets
c. provision of services
d. replacement of an obligation with another obligation; and
e. e. conversion of the obligation to equity
• An obligation always involves another party to whom the obligation
is owned. However, it is not necessary to know the identity of the
party to whom the obligation is owed for it to quality as a liability.
Financial Liabilities
• As defined in International Accounting Standards 32 a
financial liability is any liability that is a contractual
obligation.
a. to deliver cash or another financial asset to another entity, or
b. to exchange financial assets or financial liabilities to another entity
under conditions that are potentially unfavorable to the entity, or
c. that will or may be settles in the entity's own equity instruments
and is a non-derivative for which the entity may be obliged to
deliver a variable number of the entity's own equity instrument, or
d. that will or may be settled in the entity's own equity instruments
and is a derivative that will or may be settled other than by
exchange of a fixed amount of cash or a financial asset for a fixed
number of the entity's own equity instruments.
• Based on the above definition, a financial liability arises
from a contract to pay cash, or exchange financial asset
or financial liability.
• Examples of this nature are accounts payable, notes
payable and bonds and mortgage payable.
• Financial liabilities also include those contractual
obligation that will or may be settled by issuing equity
instrument (e.g. convertible bonds).
Initial Recognition
• An entity shall recognize its financial liability when and
only when it becomes a party to the contractual
provisions of the instrument; that is, when the entity
issues the financial instrument or acknowledge in
whatever form its obligation as s result of the
contractual provisions of a contract.
• A financial liability is initially recognized at fair value,
which is the transaction price.
• For financial liabilities that are measured at amortized
cost, the transactions costs directly attributable to the
issuance of the financial instrument is considered in the
initial measurement.
Measurement Subsequent to Initial
Recognition
• Except for financial liabilities that are measured at fair
value, financial liabilities are subsequent measured at
amortized cost.
Accounting for Specific Financial
Liabilities
• Accounts payable, or trade accounts payable are
liabilities arising from the purchase of goods, materials,
supplies, or services on an open charge-account basis.
• The credit time period generally varies (e.g. from 30 to
120 days) without any interest being charged on the
deferred payment.
Methods of Accounting for Cash
• The agreement for the purchase of goods usually includes incentives for
early payment of accounts; thus, cash discounts are offered.
• The purchase transaction may be recorded using either the gross methods
or the net method.
• Under the gross method and when the entity adopts the periodic inventory
system, the Purchases accounts and the Accounts Payable are recorded at
the gross invoice price. A cash discount taken on purchases is recorded
upon payment as a credit to Purchases Discounts. Any balance of Purchase
Discounts is reported in profit or loss as a deduction from gross purchases.
• Under the net method and when the entity adopts the periodic inventory
system, both Purchases and Accounts Payable are initially recorded at
invoice price less the cash discounts available. A cash discount not taken is
recorded as a Purchase Discounts Lost, which is reported in profit or loss as
part of finance cost.
Notes Payable
• A promissory note is a written promise to pay a certain
sum of money to the bearer at a designated future time.
• The promissory notes may arise out of either a trade
situation (purchase of goods or services on credit) or
the borrowing of money from a bank, or other
transactions.
Note Bearing a Realistic Interest
Rate
• Accounting for the issuance of interest-bearing note is
relatively straightforward.
• Since the note is interest bearing (and assuming that
the stated rate approximates the prevailing market rate
for similar obligations), the fair value (and also the
present value) of the note at the time of its issuance is
equal to its face value.
Note Bearing an Unrealistic Interest
Rate
• A note bears an unrealistic interest rate when any one or both of these two
situations exist:
a. the interest rate appearing on the face of the note is significantly different from
the market rate similar notes; and
b. the consideration received on account of the note issued has a fair value that is
significantly different from the face value of the note.
• In such cases, the note and the interest to be paid based on the stated rate
are discounted at the market rate of interest on the date of the issuance.
• If the rate stated on the face of the note is higher than the market rate of
interest, the discounted amount is higher than the face value of the note,
resulting in premium on notes payable.
• If the rate stated on the face of the note is lower than the market rate of
interest, the discounted amount is lower than the face value of the note,
resulting in discount on notes payable.
Non-Interest Bearing Note
• Accounting for a non-interest-bearing note is slightly more
complex and applies the same principle for notes carrying an
interest rate lower than the market rate of interest.
• A non-interest-bearing note does not explicitly state an
interest rate on the face of the note.
• It does not mean, however, that there is no interest imputed
on the original obligation.
• A non-interest bearing note is simply written in a form where
the interest is imputed on the face value of the note.
• Thus, the face value represents the present value of the
obligation plus the imputed interest for the term of the note.
Sample Problem
Bonds Payable
• A bond is a certificate of indebtedness whereby the borrower agrees to pay
a sum of money at a specified future date plus periodic interest payments
at the stated rate.
• They are commonly issued in denominations of P1,000, P5,000, or
P10,000, referred to as face value or par value.
• Normally, a corporation sells all of its bonds to an investment firm, referred
to as an underwriter, which resells the bonds to the investing public.
• In some instances, bonds are sold directly to investors.
• The contact between the issuing corporation and the bondholder is known
as bond indenture.
• The bond indenture specifies the terms of the bonds, rights and duties of
both parties, restrictions on the issuing corporation and all other important
details affecting the contracting parties.
Types of Bonds
• The more common types of bonds are
1. term bonds,
2. serial bonds,
3. secured bonds,
4. unsecured bonds,
5. registered bonds,
6. bearer bonds,
7. convertible bonds and
8. callable or redeemable bonds
Term Bonds and Serial Bonds
• Bonds that mature on a single date are called term
bonds while bonds that mature in installments are
called serial bonds.
Secured Bonds and Unsecured
Bonds
• Secured bonds provide security and protection to investors in the
form of specific assets of the issuer, such as real estate or other
collateral.
• A real estate mortgage bond is secured by a lien against real
estate;
• A collateral trust bond is secured by shares of stocks and bonds
held by the issuer as investment;
• A chattel mortgage bond is secured by a lien against movable
property like motor vehicles.
• On the other hand, unsecured bonds, frequently termed as
debentures are not protected by the pledge of any specific asset
of the issuing corporation.
Registered Bonds and Bearer (or
Coupon) Bonds
• Registered bonds are bonds whose owners' names are registered
in the books of the issuing corporation. When these bonds are
sold, the transfer agent cancels the original certificate
surrendered by the seller, and a new certificate is issued and
registered in the name of the new bondholder. Interest checks are
mailed periodically to the bondholders of record.
• Bearer bonds or coupon bonds are not recorded in the name of
the owner. Each bond is accompanied by coupons representing
periodic interest payments, covering the life of the issue. The
issue of bearer bonds eliminates the need for recording changes
in the ownership as well as preparing and mailing periodic
interest checks.
Callable Bonds and Convertible
Bonds
• Callable or redeemable bonds are those that give the
issuing company the right to call or retire the bonds
before maturity date, usually specified on the bond
indenture.
• The issuing company pays the bondholder an amount in
accordance with the call provisions.
• Convertible bonds are those that give the bondholders
the right to exchange their bond holdings into a
specified or predetermined number of the issuing
corporation's of stock.
Zero-Interest Bonds
• Zero-interest bonds, also known as deep-discount
bonds, are issued at significantly lower than their face
value.
• Total interest on these bonds during their entire term is
paid together with the principal amount on maturity
date.
Issuance of Bonds
• An entity shall recognize financial liability in its
statement of financial position when, and only when,
the entity becomes a party to the contractual provisions
of the instrument.
• Thus, bonds payable are initially recognized at the date
of the actual issue of the bonds.
• Bond liabilities are initially recognized at their
discounted value, which equals the net proceeds from
their issuance.
• The issue price of the bonds is the market price of the
bond, which varies with the safety of the investment
and the prevailing market rate of interest for similar
Accrued Interest on Bonds Issued
• Bonds are often issued at any date between the interest
payment dates.
• Since the issuing corporation will pay the full periodic
interest on all bonds outstanding at an interest date, the
bondholder is usually required to purchase the interest
that has accrued interest is added to the issue price of
bonds to determinate the total cash proceeds from the
bond issuance.
Transaction Costs on Issue of Bonds
• Bond issue costs are expenditures incurred by the issuing company
for legal fees, printing and engraving of bond certificates, taxes,
commissions and similar charges.
• When a financial liability is recognized initially, an entity shall
measure it at its fair value (issue price) and considering transactions
costs that are directly attributable to the issue of the financial liability.
• This means that bond issue costs form part of the initial carrying
amount of the bond liability.
• In effect, the net proceeds are reduced by incurrence of bond issue
cost.
• The determination of the initial amount of the premium or discount on
bonds payable is based on the difference between the face value and
the net proceeds.
Premium and Discount Amortization
• Bonds are financial liabilities that are subsequently measured at amortized cost.
• The amortized cost of a financial liability is the amount at which it is measured at
initial recognition minus the principal repayments plus or minus the cumulative
amortization using the effective interest method.
• When bonds are issued at a premium or discount, the periodic interest payments
made by the issuer to the investors over bond life do not represent the complete
interest expense for the periods involved.
• In order to reflect the total interest cost of the bonds, bond premium or discount
should be allocated over the life of the bonds using the effective interest
method.
• This allocation, called amortization, is a deduction from or addition to the interest
expense.
• The amortization of premium or discount results in a gradual adjustment of the
bond's carrying amount toward the bond's face value and adjustment of the
nominal interest to the effective interest.
Effective Interest Method
• Under the effective interest method, a constant interest rate
based on the beginning of period carrying amount of the bonds is
recognized as interest expense each period, resulting in unequal
recorded amounts of interest expense.
• The effective interest methods provides an increasing premium or
discount amortization each period.
• To obtain a period's interest expense under this method, the
bond's carrying amount at the beginning of each interest period is
multiplied by the effective interest rate.
• The difference between this amount and the amount of interest
paid or accrued (nominal interest rate x face value of the bonds)
is the amount of discount or premium amortization.
Sample Problems on Bonds Payable
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