Liabilities

2. Liabilities Chapter 12

3. 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

4. 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 apresent obligation • that is the result of a past transaction or event

5. What is a Liability? (cont.) • accrual of the estimated costs of fulfilling warranties in the future for goods sold in the current period • 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

6. Types of Liabilities • There are two types of liabilities • financial liabilities • non financial liabilities • A financial liability is a financial instrument: A financial instrument is any contract that gives rise to a financial asset of one party and a financial liability or equity instrument of another party (CICA 3855.17a)

7. Types of Liabilities (cont.) • A financial liability cannot exist if there is no corresponding financial asset for another company or individual • Financial liabilities include not only direct financial liabilities such as bank loans and bonds, but also derivative instruments such as forward contracts and options • Financial liabilities are measured as to the fair value of the consideration received (CICA 3855.53) • Normally, the fair value is determined by the market value that is reflected in the transaction price

8. Types of Liabilities (cont.) • The term “non-financial liability” is not an official term; is not used in the CICA Handbook • A non-financial liability can be defined by what it is not – any liability that is not a financial liability • The liability has no offsetting financial asset on the books of another party. eg., • Revenues received in the current period but not yet earned • Costs that are expected to arise in the future but that are related to transactions, decisions, or events that took place in the current period

9. Types of liabilities (cont.) • Contractual Obligation: a commitment or agreement to enter into a transaction that will become a liability once an event contemplated in the agreement has occurred • The CICA Handbook suggests the following contexts for disclosure: • Commitments that involve a high degree of speculative risk • Commitments for expenditures that are much larger than usual • Commitments to issue shares • Commitments requiring a certain level of significant expenditure for a considerable time into the future

10. Types of liabilities (cont.) • Estimatedliabilities:those that are known to exist, but for which the exact amount is unknown • Estimated Liabilities pose valuation problems • This situation usually arises for non-monetary liabilities, or obligations to provide services rather than money • Warranty Liabilities are estimated liabilities

11. Types of liabilities (cont.) • Contingentliability:is a potential liability that will become a real liability only if and when another event happens

12. Types of liabilities (cont.) • 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

13. Types of liabilities (cont.) • Contingent liabilities should be distinguished from estimated liabilities • 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 acontingency[CICA 3290.04]

14. Types of liabilities (cont.) • An enterprise has the following three possibilities for reporting contingentliabilities: • 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

15. Types of liabilities (cont.) • The accounting treatment depends on two characteristics of the contingency: • the likelihood of the contingency occurring • the measurability of the resulting liability or loss

16. Types of 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

17. Types of 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

18. 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 Current Liabilities

19. 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

20. 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

21. 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

22. 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

23. 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)

24. 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 Long-Term Liabilities (cont.)

25. 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 Long-Term Liabilities (cont.)

26. 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

27. 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 Bank Financing (cont.)

28. 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 Bank Financing (cont.)

29. 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 will normally 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 Bank Financing (cont.)

30. 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 Bonds Payable

31. 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 Bonds Payable (cont.)

32. 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 asset-backed lending

33. 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 Debt Covenants

34. 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 Debt Covenants (cont.)

35. 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

36. 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

37. 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

38. 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

39. 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 Subsequent Measurement of Financial Liabilities

40. If 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 Subsequent Measurement of Financial Liabilities (cont’d)

41. Debt Issue Costs • Debt issue costs include legal, accounting, underwriting, commission, engraving, printing, registration, and promotion costs • These costs are paid by the issuer and reduce the netproceeds from the bond issue, increasing the effective cost for the issuer

42. Debt 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

43. 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

44. 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 up-front fee is part of the cost of borrowing over the life of the loan, and should be treated accordingly

45. 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

46. 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

47. 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

48. 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

49. 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 re-measured at the spot rate Accounting For Foreign Currency-Denominated Debt

50. 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 Accounting For Foreign Currency-Denominated Debt