FA3
Lesson 2. Liabilities
1.
2.
3.
4.
5.
6.
Definition
Contingencies and estimated liabilities
Long-term debt and bonds payable
Debt retirement
Defeasance
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 Disclose in
if amount is
notes
uncertain
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 issue
Dr. Cash
Mkt
Cr. Bonds payable
Face
Dr. Discount on bonds payable Face-Mkt
or
Cr. Premium on bonds payable Mkt-Face
Mkt = market value of bond at date of issue
Face = face value of bond
Discount or premium arises if market interest
rate (yield) at date of issue differs from stated
interest rate.
Example: A13-10
Amortization of discount/premium
Effective interest method
Interest 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)