FA3Lesson 2. Liabilities

1. Definition

2. Contingencies and estimated liabilities

3. Long-term debt and bonds payable

4. Debt retirement

5. Defeasance

6. Cash flow statement aspects

1. Definition

Liabilities are obligations of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future.

- CICA Handbook, 1000.32

2. Contingencies and estimated liabilities

Examples:

A13-1, A13-3

Measurable Not measurable

Likely Accrue, and disclose if amount is uncertain

Disclose in notes

Undeterminable Disclose in notes Disclose in notes

Not likely Neither record nor disclose unless material

Neither record nor disclose unless material

3. Long term debt and bonds payable

• Bonds typically offer interest payments annually or, more commonly, semi-annually, and repayment of the principal when the bond matures

• Bond valuation is a present value exercise, where the interest payments are an annuity and the principal repayment is a lump sum; the discount rate is determined by the market as function of the risk-free rate and risk

Key bond data

1. Face value (or par value, principal value): amount payable when bond is due

2. Maturity date: end of bond term and due date for the face value

3. Stated interest rate (or coupon rate, nominal rate): rate that determines periodic interest payments

4. Interest payment dates: dates at which periodic interest payments are due

5. Bond date: Earliest date bond can be issued

Bond characteristics determined by market

1. Market rate of interest (or bond yield): return required by investors, function of prevailing interest rates and bond risk

2. Market value: present value of cash flows implied by coupon rate and principal repayment, discounted at market rate

3. Bond discount/premium: difference between bond face value and market value, at date of issue

Bookkeeping for bond issueDr. Cash Mkt

Cr. Bonds payable FaceDr. Discount on bonds payable Face-Mkt

orCr. Premium on bonds payable Mkt-Face

Mkt = market value of bond at date of issueFace = face value of bondDiscount or premium arises if market interest rate (yield) at date of issue differs from stated interest rate. Example: A13-10

Amortization of discount/premiumEffective interest methodInterest paid = face value X (stated interest

rate / # of interest payments per year)Interest expense = market interest rate at date of

bond issue X opening net book value of bond (i. e., after last payment)

Adjustment to discount/premium = difference between interest expense and interest paid (i. e., is a plug)

Example: A13-10

Amortization of discount/premium

Straight-line method

Interest paid = face value X (stated interest rate / # of interest payments per year)

Adjustment to discount/premium based on straight-line allocation (same every period)

Interest expense is a plug = interest paid

+ amortization of discount (if any)

- amortization of premium (if any)

Example: A13-14

Issuing bonds between interest dates

• Investor pays for interest accrued since last interest date, and then receives full regular interest payment on the next payment date (investor pays present value of bond cash flows PLUS accrued interest)

• Using PV tables for valuation, must calculate bond value at interest date prior to issue and at interest date after issue; difference is prorated for time elapsed

• Discount/premium amortized only over period during which bond is outstanding (A13-17)

4. Debt retirement

1. Record interest expense (including amortization of any discount or premium) up to date of retirement

2. Remove bond and any associated discount/premium and/or issue cost accounts

3. Credit cash for amount paid

4. Any balancing amount is a gain or loss on redemption

Example: A13-21

5. Defeasance

Debt is defeased when its future funding requirements are provided for by (presumably low-risk) assets segregated in a trust account.The debt and assets are removed from the balance sheet and any gain/loss recognized.In-substance defeasance is defeasance wherein the bond issuer retains final responsibility for the debt.Example: A13-23

6. Cash flow aspects• Financing activities: Cash received from debt

issues are inflows; cash paid to repay or retire debt are outflows

• Operating activities: Gains/losses on debt retirement and amortization of discount/premium are non-cash income statement items – they are added back to income (indirect method) or ignored (direct method)

• Operating activities: Cash paid for interest must be separately disclosed (Ex.: A13-34)