Intermediate Accounting
Thomas H. Beechy
Schulich School of
Business,
York University
Joan E. D. Conrod
Faculty of Management
Dalhousie University
Powerpoint slides by:
Michael L. Hockenstein  Commerce Department • Vanier College
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
Liabilities
Chapter 13
13-2
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

What is a Liability?
 A liability is defined in the CICA Handbook as
having three essential characteristics:
 it embodies a duty or responsibility to others that
entails settlement by future transfer or use of
assets, provision of services, or other yielding of
economic benefits, at a specified or determinable
date, on occurrence of a specified event, or on
demand
 the duty or responsibility obligates the entity, leaving
it little or no discretion to avoid it
 the transaction or event obligating the entity has
already occurred
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
What is a Liability? (cont.)
 These characteristics can be simplified for
practical purposes by remembering that a
liability is:
a highly probable future sacrifice of assets or
services
constituting a present obligation
that is the result of a past transaction or event
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
What is a Liability? (cont.)
 Contractual obligation: a commitment that will
become a liability in the future, once an event has
occurred
 Contractual obligations are often called

executory contracts
If they are large and unusual, they may be
reported in the notes to the financial
statements
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
What is a Liability? (cont.)
 Matching of revenue and expense leads to
the recognition of liabilities as an offset to
expenses that are matched to revenue in a
period, even though there is no present
obligation to any specific individual or
organization, e.g., accrual of the estimated
costs of fulfilling warranties in the future for
goods sold in the current period
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
What is a Liability? (cont.)
 an estimate of the liability under special coupon or
other promotional activities carried out in the current
period (e.g., frequent flier points for an airline)
 an annual provision for major maintenance costs
that are incurred regularly, but not every year (e.g.,
the cost of relining furnaces in a steel mill that is
done every few years)
 a liability for environmental clean-up costs by a
resource company, even if it is under no legal
requirement (at the time of reporting) to incur such
costs
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
Contingent Liabilities vs.
Estimated Liabilities
 Contingent liability: is a potential liability that
will become a real liability only if and when another
event happens
 Contingent liabilities should be distinguished

from estimated liabilities
Estimated liabilities: those that are known to
exist, but for which the exact amount is unknown
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
Contingent Liabilities vs.
Estimated Liabilities (cont.)
 CICA Handbook states:
 In the preparation of the financial statements of
an enterprise, estimates are required for many
on-going and recurring activities. However, the
mere fact that an estimate is involved does not of
itself constitute the type of uncertainty which
characterizes a contingency [CICA 3290.04]
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
Examples of Contingent Liabilities
 Examples of contingent liabilities are as follows:
 a company is guarantor on loans extended to
others, such as to subsidiaries, parent companies,
other related companies (e.g., under common
ownership), or owners; if the primary borrower
defaults, the company becomes liable
 a company has received a government loan
that will be forgiven, if the company maintains
certain employment levels and/or makes specified
investments; if the conditions are not met, the loan
must be repaid
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
Reporting Contingent Liabilities
 An enterprise has the following three
possibilities for reporting contingent liabilities:
 accrue the estimated cost as a liability in the
balance sheet and as a loss on the income
statement
 disclose the contingency and the possible liability
in the notes to the financial statements
 neither accrue the contingency in the financial
statements nor disclose it in the notes
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
Reporting Contingent Liabilities
 The accounting treatment depends on two
characteristics of the contingency:
the likelihood of the contingency occurring
the measurability of the resulting liability or loss
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
Reporting Contingent Liabilities
(cont.)
 A contingent loss is accrued when

 the occurrence of the loss is likely, and the amount
can be measured
A contingent loss is disclosed when
 the occurrence of the loss is likely, but the amount
cannot be measured
 the occurrence of the loss is likely, and the amounts
can be measured and have been recorded, but
there is some chance that the amount recorded is
not high enough
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
Reporting Contingent Liabilities
(cont.)
 the likelihood of the loss event can’t be
determined, regardless of whether the amount
can be measured
 the occurrence of the loss is unlikely, but the
amounts involved are material; in other words,
the event would have a significant adverse effect on
the company
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
Valuation of Liabilities
 The basic principle of liability valuation is that

monetary liabilities should be reported at their
present value at issuance, adjusted for
amortization
Present value is calculated using the
borrower’s interest rate for debts of similar
term and risk
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
Current Liabilities
 A current liability: one that is due or

payable within the next operating cycle or
the next fiscal year, whichever period is
longer
Current liabilities normally are listed by
descending order to the strength of the
creditors’ claims
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
Current Liabilities (cont.)
 Bank debt and promissory notes are listed first,

and estimated liabilities and deferred credits are
listed last
A common sequence is:
 bank loans
 other notes payable
 current portion of long-term liabilities
 trade accounts payable
 other payables
 accrued liabilities
 unearned revenues
 miscellaneous deferred credits
13-17
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Sources of Short-Term Financing




Trade credit extended by suppliers is a source of
“interest-free” financing
Signing promissory notes that obligate the company
to pay the supplier (or an intermediary, such as a
bank) at or before a given date
Operating lines of credit are secured by a lien or
charge on accounts receivable and/or inventory, due
on demand
Large corporations are companies with good credit
ratings that can issue commercial paper
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Sources of Short-Term Financing (cont.)
 Assignment: company promises that the

proceeds of its accounts and/or notes
receivable will be assigned to the finance
company
Sale: company sells its accounts and/or notes
receivable to a finance company at a
discounted value and all payments are
collected by the finance company
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Long-Term Liabilities
 A long-term liability: a liability with repayment

terms extending beyond one year from the current
balance sheet date or the operating cycle of the
borrower, whichever is longer
Long-term debt is often an attractive means of
financing for the debtor
 creditors do not acquire voting privileges in the
debtor company, and issuance of debt causes no
ownership dilution
13-20
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Long-Term Liabilities (cont.)
 debt capital is obtained more easily than equity
capital for many companies, especially private
companies
 interest expense, unlike dividends, is tax
deductible
 a firm that earns a return on borrowed funds that
exceeds the rate it must pay in interest is using
debt to its advantage and is said to be successfully
levered (or leveraged)
13-21
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Long-Term Liabilities (cont.)
 Debt is an attractive investment for
creditors because it provides:
legally enforceable debt payments
eventual return of principal
a prior claim to assets if the corporation
restructures its debt or if it goes into
receivership or bankruptcy
13-22
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Long-Term Liabilities (cont.)
 Long-term debt can take a wide variety of
forms, including:
 bank loans
 notes payable
 mortgages
 other asset-based loans
 publicly-issued bonds, secured or unsecured
 long-term leases
13-23
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Bank Financing
 For accounting purposes, any loan that is not

current is long-term
From a banks’ point of view, non-current loans can
be identified as term loans and commercial
mortgages
 Term loans: debt financial instruments with a usual
term of one to five years
 term loans may be secured by charges on specific
assets including land, building, and other capital
assets
13-24
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Bank Financing (cont.)

The repayment terms of medium-term loans can
be structured in either of two ways:
 blended payments---the interest rate is fixed at the
beginning of the loan term, and regular equal
annuity payments are made that include both
principal and interest
 designated monthly principal payments, plus
accrued interest on the outstanding balance--the interest rate may be fixed at the beginning of
the loan term, or may float with prime interest rates
13-25
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Bank Financing (cont.)



Long-term loans, in the eyes of the banks, are
loans with repayment terms extending beyond
five years
The banks typically grant such loans as asset based financing or as commercial mortgages
Commercial mortgages are secured against land
and buildings, and involve regular blended
payments (e.g., monthly or semi-monthly) years,
and may be shorter
13-26
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Bank Financing (cont.)



The amortization period of such loans could be for
as long as 25 years, but the term, or the bank’s
commitment to extending the loan, is usually a shorter
period
The term normally will not exceed five years
When a long-term loan is extended at a fixed interest
rate, the interest rate is fixed only for the term of the
loan, not for the entire amortization period
13-27
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Bonds
 A bond: a debt security issued by corporations


and governments to secure large amounts of capital
on a long-term basis
A bond represents a formal promise by the issuing
organization to pay principal and interest in return
for the capital invested
A formal bond agreement, known as a bond
indenture, specifies:
 the terms of the bonds
 the rights and duties of both the issuer and the
bondholder
13-28
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Bonds (cont.)
 The bond indenture specifies:
any restrictions on the issuing company
the dollar amount authorized for issuance
the interest rate
payment dates
maturity date
any conversion and call privileges
13-29
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Exhibit 13-1
13-30
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Exhibit 13-1
13-31
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Other Sources of Long-Term Debt
 For small and most medium-sized private


companies, the chartered banks are the major
source of financing
Larger corporations can arrange loans with life
insurance companies or pension funds, which
have money to invest for long periods of time
Leasing companies are another source of assetbacked lending
13-32
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Debt Covenants
 Debt agreements often restrict the operations and
financial structure of the borrower to reduce the risk
of default
 Covenants: restrictions placed on a


corporation’s
activities as a condition of maintaining the loan
If the covenants are broken, the lender has the right
to call the loan; the lender can demand immediate
repayment of the principal
Bankers also refer to covenants as maintenance
tests
13-33
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Debt Covenants (cont.)
 Restrictions can be either accounting
based or behavioural
Accounting-based covenants:
 maximum debt:equity ratio
 minimum interest coverage ratio
 minimum inventory turnover (i.e., the
relationship between cost of goods sold and
inventory)
 restrictions on dividend payout
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
Debt Covenants (cont.)
 Restricted actions:
 limitations on the issuance of additional debt
without the permission of the lender
 restrictions on dividend payments
 prohibition or restriction on the redemption or
retirement of shares of the company to pledge
assets as security for other purposes
 requirement that current management or key
employees remain in place
 limitations on a transfer of control
13-35
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Sinking Funds

A debt agreement may require that the company
establish a sinking fund
 A sinking fund:


a cash fund restricted for retiring
the debt
Each year, the company pays into the sinking fund
The sinking fund may be trusteed, in which case the
fund is handled by the trustee and the company has
no access to the funds
13-36
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Sinking Funds (cont.)
 The trustee is responsible for investing the fund in

appropriate investments that often includes the
purchase of the company’s bonds in the open
market
Repurchase of the bonds to which the sinking
fund is linked has the effect of reducing the
outstanding debt, and companies often offset such
holdings against the outstanding bonds, so that
the balance sheet only shows the amount of
bonds outstanding
13-37
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Effective Versus Nominal Interest Rates
 The nominal interest rate: the interest rate
stated in the loan agreement
 The effective interest rate, or yield: the true


cost of borrowing; the rate that equates the price of
the liability to the present value of the interest
payments plus the maturity value based on
compounding periods
Financial markets express interest rates at nominal
amounts
The lender will quote the nominal interest rate and the
compounding period, and expect the borrower to
understand that the effective rate is higher
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Notes Payable
 Accounting for long-term debt is simple if the



effective interest rate and the nominal interest
rate are the same
Nominal rate = effective rate
PV of the future cash flows, discounted at the
effective interest rate, will equal the face value
of the debt
Interest is accrued as time passes, and
principal and interest payments are accounted
for as cash is disbursed
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Notes Payable (cont.)
 Nominal interest rate is materially different from


the market interest rate at the time the note is
issued
Present value techniques are used for the
valuation of the note, and accounting for the
periodic interest expense
Amortization of discount (or premium) can be by
either of two methods:
 the effective interest method
 straight-line method
13-40
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Balance Sheet Classification
 On a classified balance sheet, long-term


loans are classified as long-term liabilities
The portion of principal that is due within
the next year (or operating cycle) is
classified as a current liability
Any accrued interest at the balance sheet
date is also classified as a current liability
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Balance Sheet Classification (cont.)
 The usual practice is to disclose the total

amount of any outstanding long-term bonds or
loan, and then to show the reclassification of
the amount due within the next year as a
current liability
This disclosure can be either in the notes to
the financial statements or shown on the face
of the balance sheet
13-42
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
Bond Issue Costs
 Bond issue costs include legal, accounting,

underwriting, commission, engraving, printing,
registration, and promotion costs
These costs are paid by the issuer and reduce
the net proceeds from the bond issue,
increasing the effective cost for the issuer
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Bond Issue Costs (cont.)


There are two methods that may be used in
accounting for bond issue costs:
 deduct the issue costs from the net proceeds of the
bonds, and thereby include them in the bond
premium or discount
 account for the issue costs separately, as a
deferred charge that is amortized over the life of the
bond issue
Under either method, bond issue costs are
amortized over the bond term
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Up-Front Fees



Lenders frequently charge an up-front fee when
granting a loan
These are called administrative fees
For example, assume that a firm borrows $100,000 for
two years, and agrees to pay 7%, with interest paid
annually. In addition, the bank charges the firm an
administrative fee of $3,520 on the day the loan is
granted. The lender will advance the borrower the net
proceeds, or $96,480 ($100,000  $3,520), at the
inception of the loan
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Up-Front Fees (cont.)
 For many years, accounting practice allowed

the lender and borrower to take this fee onto the
income statement in the period of payment,
which resulted in fee revenue for the bank and
financing expense for the borrower
However, accountants often argue that this upfront fee is part of the cost of borrowing over the
life of the loan, and should be treated
accordingly
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Debt Retirement
 Bonds retired at maturity are recorded by reducing

the liability and the asset given in repayment; no
gain or loss arises
Bonds retired before maturity through call
redemption, or open market purchase, typically
involve recognition of a gain or loss as the
difference between the book value of the debt and
the consideration paid
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
Defeasance
 Extinguishment of debt may be accomplished

by defeasance, which requires a company to
place assets in an irrevocable trust sufficient to
pay the debt interest and principal
Defeasance is recorded with an entry that
removes the assets, liability, and related
accounts, and records a gain
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

In-Substance Defeasance
 In-substance defeasance is similar to

defeasance, except that the trust is not
irrevocable
Recent recommendations discourage removing
in-substance defeased debt obligations from
the balance sheets
13-49
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Foreign Exchange Considerations



Many Canadian companies borrow from foreign
lenders
The most common source of non-Canadian financing
is the U.S., both through U.S. banks and other
financial institutions and, for large public companies,
through the bond markets
The most obvious point of these loans is that they may
subject the borrowing company to the additional risk of
foreign exchange
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Accounting For Foreign CurrencyDenominated Debt--Unhedged Debt



The basic principle underlying balance sheet
reporting of foreign currency monetary liabilities is
that they should be reported in the balance sheet in
the equivalent amount of reporting currency
(normally, Canadian dollars for Canadian companies)
at the spot rate on the balance sheet date
The loan principal is translated into Canadian dollars
on the day it is borrowed at the current, or spot,
exchange rate
At every subsequent reporting date, the loan is remeasured at the spot rate
13-51
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Accounting For Foreign CurrencyDenominated Debt---Unhedged Debt (cont.)


If exchange rates have changed, an exchange
gain or loss will result
Under current Canadian rules, the exchange
gain or loss on a long-term loan is treated as
follows:
 for short-term liabilities, the gain or loss is
taken into income in the current period
 for long-term liabilities, the gain or loss is
deferred and amortized over the remaining
period until maturity
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
Hedged Debt
 If the loan is hedged, then the entity is not

exposed to unpredictable exchange gains or
losses
Since the presence of a hedge significantly
reduces the risk associated with debt that is not
denominated in Canadian dollars, it is important to
disclose the existence of a hedge in the notes to
the financial statements
13-53
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Disclosures for Long-Term Liabilities
 The required disclosures for long-term debt

are outlined in the CICA Handbook, Section
3210, “Long-term Debt” and Section 3860,
“Financial Instruments  Disclosure and
Presentation”
The long term debt section recommends the
following information be disclosed:
 for debentures and similar securities, the title
of the issue, interest rate, maturity date,
amount outstanding, sinking fund, if any, and
redemption or conversion privileges
 for mortgages and other long-term debt, the
same details to the extent practical
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Disclosures for Long-Term Liabilities
(cont.)
 the aggregate amount of payments required in the
next five years to meet sinking fund or retirement
provisions
 if the debt is denominated in a foreign currency,
then the currency in which the debt is to be repaid
must be disclosed
 secured liabilities must be shown separately, and
the fact that they are secured
 details of any defaults of the company in principal,
interest, sinking fund or redemption provisions
 interest expense on long-term debt, separately on
the income statement
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Disclosures For Long-Term Liabilities
(cont.)
 Section 3860 outlines the disclosure

requirements for financial instruments, a
generic term that includes long-term liabilities
these requirements supplement those of
Section 3210, and require disclosure in the
following areas:
 terms and conditions
 interest rate risk
 fair value
13-56
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