ACT B861F

Accounting for
corporations
Lecture 3
 Contents
Unit Topic
1 An overview of financial accounting
2 Operating Activities
3 Financing Activities
4 Investing Activities
5 Other issues in financial reporting
Revision

2021/10/30 2
Assignment 1 due on 26th November 2021

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ACT B861

Session 3
Current liabilities,
contingencies and provisions

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 Question
Q: Where can we find “current liabilities”?
a. Statement of profit or loss and other
comprehensive income
b. Statement of financial position
c. Statement of cash flow

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 An obligation
• A source of a firm’s assets (i.e. I got a loan, now I
have cash)
• Always think of this from a firm’s perspective
• E.g. I borrowed money from HSBC (i.e. a loan) so
that I have cash to pay for supplies in my business,
thus my company owes the HSBC money
• Other obligations may arise from contracts, legal
requirements, normal business practice, custom etc
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 An example
Asset Liability Owner’s Capital
Dr Cr Dr Cr Dr Cr
+ - - + - +
100,000 100,000
(cash) (Loan from
grand-dad)

100,000 100,000

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 Liabilities
The 3 characteristics of a liability:
• Arise from past transactions or events
• Are present obligations (to transfer resources)
to other entities
• Result in future outflow of economic benefits

• (not necessarily a payment in cash)

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 Non-current or Current
• Current liabilities: normally payable within one
year or in the normal operating cycle
• Classifying liabilities as either current or long
term helps investors and creditors assess the
relative risk of a business’s liabilities
• “Does the payment require the use of current
assets?” “Will operating efficiency be
compromised?”
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 Current liabilities
• Accounts payable: trade credit offered on an
open account; invoice; 30, 45, 60 days
• Convenient for both the buyer (client) and the
supplier (transaction cost involved in payment
every time a purchase is made)
• E.g. a sandwich shop owner takes supplies from
the baker and the butcher on credit, paying once
every month
• Trade notes payable: written promissory note
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 Food for thought…
• Two sides of a coin; continuing the example from
the previous slide –
• A sandwich shop owner buying bread from a baker
on credit
• The sandwich shop’s perspective: Accts payable (a
current liability)
• The baker’s perspective: Accts receivable (a current
asset) i.e. money owed by a customer which will
be collected soon
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 Accrued liabilities (Accruals)
• Expenses already incurred but not yet paid off in cash
• E.g. annual cycle is 1st January to 31st December; rent is
$10,000 per month, and so far only $110,000 of rent has
been paid off in cash; obviously rent for 12 months is
$120,000
• Rent expense should therefore be $120,000; the unpaid
$10,000 should be entered as an accrual (a current
liability) on Statement of financial position
• Remember: an expense should be matched to the
period incurred, so it does not matter that the final
month’s rent hasn’t actually been paid in cash. 12
 Contingencies
• Contingent liability: involves an existing
uncertainty as to whether a present obligation
exists; whether the outflow amount can be
reliably determined; uncertainty only resolved
when a future event occurs
• It is never “accrued”, i.e. only disclosed in notes to
financial statements
• To be clear: not part of “liabilities” on SOFP; not
involved in the calculations
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 Contingent liability
• Example: a company breached environmental laws
when one of its tankers spilled some crude oil in an
ocean; the amount of claims could not however be
reliably determined
• Present obligation? Yes (due to legal and civil liabilities)
• Arises from a past event? Yes
• Amount of obligation (i.e. claims) cannot be reliably
measured (at least not at that point in time)
• Thus only a contingent liability → disclosed in notes
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 Provisions
• Past obligating event
• Present obligation
• Future outflow of economic benefits
• An unrecognised provision is a contingent liability
• To recognise a provision: need a reliable estimate
• Important:
• Provision (to provide for something): affect the
numbers
• Contingent liability: do not affect the numbers in
balance sheet
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 Provisions
• A liability with uncertain timing or amount of
future outflows
• Amount needs to be estimated (prior experience)
• E.g. provisions for warranties and refunds
• The vendor has an obligation to honour warranty
and refund requests
• Refund policy may be implicit
• Past practice → valid expectation
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Legal vs constructive obligation

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 Legal vs constructive obligation
• Legal: contract, legal precedents
• Constructive: past practice: “My next door
neighbour Mrs Chan bought a sweater from you
and she took it back 6 days later and asked for a
refund and she got her money back alright. You
should also give me my money back…”

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 IAS 37 – Provision
• Amount of outflow can be estimated
• Future outflow is probable: an event is more likely
than not to occur
• > 50%
• Probable =/= possible
• (probable does not mean possible)
• Possible → > 0%
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 Contingent asset
• An uncertain situation that might result in a gain
• Not recognised (not accrued)
• Prudence
• Gains should only be recognised when realised
(e.g. in a sale to an arm’s length party)
• May be disclosed in notes to financial statements

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ACT B861

Session 3
Long term liabilities

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 Long-term Liabilities
• If you own a company, where do you get the money to
buy equipment, raw materials etc?
• Can be your own funds i.e. owner’s equity, or capital, or
“investment”
• Likely to have funds from external sources: e.g. a loan
• What a company owes its creditors, e.g. a bank
• May borrow cash from a bank by signing a promissory
note
• No immediate need to repay
• Thus “non-current” or long term
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 Bonds
• Most common form of corporate debt is bonds
• Easier to sell 400,000 $1,000 bonds to many lenders, rather than
signing a $400 million note to borrow cash from a single institution
• For a bank to lend a sum of $400 million the bank would have to be a
big one and it needs to have a lot of confidence in the borrower’s
repayment ability
• Bonds obligate the issuing company to “borrow” some money now and
then repay a stated amount (the principal, nominal value, face amount
etc) at a specified maturity date
• Maturities for bonds may range from 10 to 40 years
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 Bonds
• e.g. if today I were to buy a bond that’s worth $10,000 which is
going to mature in 5 years’ time, I would be handing over $10,000
to an issuing company
• The issuer would be happy as they now have some cash (from me,
as well as other people, quite possibly) to invest in projects
• Since the issuer is borrowing money from me, s/he is required to
pay a “price” (or interest) to me; otherwise, why would I be
lending them money? Where is the incentive for me?
• The “price” to the issuer would be the interest that they would
have to pay me regularly (sometimes called coupons)
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 Bonds
• The periodic interest is a stated percentage of principal
(coupon rate, nominal rate)
• Most corporate bonds are debenture bonds
• i.e., secured only by the full faith and credit of the issuing
company
• No assets are pledged as security
• Mortgage or secured bond: backed by a lien on specified real
estate owned by the issuing company; less risky than
debentures, so command a lower interest rate.
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 Bonds
• Price of bond issue not necessarily equal to its principal amount
• If sells for more than the principal: at a premium
• If sells for less than principal amount: at a discount
• Market rate for a specific bond issue is influenced by the
creditworthiness of the company issuing the bonds
• Bond ratings: credit rating agencies, e.g. Standard & Poor;
Moody.
• Other things being equal, the lower the perceived riskiness of
the company issuing bonds, the higher the price those bonds
will command
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 An example
• Zero-coupon bonds: issued at a discount to par
value (face value)
• If a zero-coupon bond is selling at $950 and has a
face value of $1,000 (paid at maturity in one
year’s time), the bond's rate of return at the
present time is approximately 5.26%
• [(1000 - 950) ÷ 950] x 100%
• i.e. You pay $950 now, and you receive $1,000 in
a year’s time
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 An example
• For a person to pay $950 for this bond, s/he must
be happy with receiving a 5.26% return.
• Happy or not with this return depends on what
else is happening in the market
• If interest rates were to go up, and newly issued
bonds were to offer a yield of 10%, then the zero-
coupon bond yielding 5.26% would be much less
attractive
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 An example
• To be more attractive, the price of the zero-
coupon bond would need to go down enough
to match the same return yielded by
prevailing interest rates.
• i.e., bond's price: goes down from $950
(which gives a 5.26% yield) to $909.09 (which
gives a 10% yield)
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 An example
• If interest rate is to decrease to 2.5%, the zero-
coupon bond (with a yield of 5.26%) would then
look like a very good investment
• Good things would draw people to them.
• More people buying the bond would push the
price up (forces of supply and demand) until the
bond's yield matches the prevailing interest rate
of 2.5%
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 Calculating bond price
• It is often necessary to calculate the actual
price of a bond
• See example in the following slide
• Before we do that, we would need to
understand what the time value of money
means

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• .

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Present value

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But instead of "adding 10%" to each year it is easier to multiply by 1.10

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• .

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• Following on from the “Masterwear” example

• it says in the question “$42,000 is payable semiannually on 30th June

and 31st December. The bonds mature in three years”
• As per the annuity table, (n=6, i=7), the factor “4.7665” or 4.76654 (as
per your textbook) should be used; $42,000 x 4.76654 = $200,195
• $700,000 x 0.66634 (n=6, i=7; PV of $1 table) = $466,438
• $200,195 + $466,438 = $666,633; PV or the selling price of bonds
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Ex. 10-3

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• “Discount on bonds payable” (previous slide),
though being a “debit”, is NOT an asset account;
it is a reduction of the Bonds payable balance
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 Convertible bonds
• May be converted into (i.e. exchanged for) shares
of stock at the option of the bondholder
• Could be sold at a higher price
• Enable smaller firms and debt-heavy firms to get
access to the bond market
• A hybrid security: has features of both debt and
equity (fixed income security and ordinary
shares)
• More on shares later
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 Share based compensation
• An executive’s pay is tied to performance
• Uses compensation (pay) to motivate its recipients
• Actual compensation depends on the market
value of shares
• Incentivised to act in the best interest of
shareholders: performance related pay
• Closer to home – E.g. a real estate agent; a car
salesperson
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 Share options
• Sometimes an employee not really given shares; but the
option to buy shares in the future
• Often conditional on employees meeting certain
requirements e.g. staying with the company for a certain
period of time (vesting conditions)
• The option to buy a certain number of the firm’s shares at a
specified price during a specified period of time
• E.g. an option that allows an employee to buy shares that
cost $25 per share for $10 per share (current value)
• Intrinsic value of share option: $15 48
 Share options – fair value
• Ideally should measure the fair value of the services
rendered by the executives who receive the share
options
• IFRS assumes typically it is NOT possible to measure
directly the fair value of the services rendered by
employees for particular components of the package
• Pay packages may have a cash salary component and a
share option component
• Instead, measures the fair value of the share option
granted, as an indirect way of measuring the above
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 Share options – fair value
• Estimating fair value requires the use of one of
several option pricing models
• Such mathematical models assimilate a variety of
info about a company’s shares and the terms of
the share option to estimate the share option’s
fair value
• Specifically, such models should take into account
several factors such as:
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 Share options – fair value
– Exercise price of the option
– Expected term of the option
– Current market price of the share
– Expected dividends
– Expected risk-free rate of return during the term of the option
– Expected volatility of the share
– Others: expected employment termination patterns after option vest
• Value impossible to be measured, only approximated
• Techniques for estimating fair value have been among the most
controversial issues in the debate
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 Share capital
• Asset = Liability + Equity
• Equity: not often talked about in introductory accounting
courses; focus on asset and liability
• Various items: Share capital; retained profit (retained
earnings); reserves
• Share capital:
• Ordinary share (common share)
• Preference share (preferred share)
• 2 types: different rights and priorities
 Preference share
• Aka preferred share, preferred stock
• “preference” or “preferred” often seen as misleading
• Preference share: no voting rights
• (remember: shareholders are supposedly owners of the business they own shares
in, and owners should have a say in how the business is run, i.e. voting right)
• Asset = Liability + Equity
• Asset = Current liability + Non-current Liability + Equity
• Asset – Current liability = Equity + Non-current Liability (NCL)
• Many would see Preference share as a type of NCL
• Preference shares do generally have priority on cash dividends
• Though they may not receive any dividends at all, as a company has no legal
obligation to pay any dividend
 Ordinary share
• Aka common share, common stock
• Ordinary share definitely part of equity
• Owners of these shares are true owners of a
company
• Ordinary shareholders are invited to attend annual
general meetings (AGMs)
• They elect board of directors, among other things
• Board of directors hire general management for the
company, often include the CEO
 Equity – retained profit
• Retained profit, aka retained earning
• Asset = Liability + Equity
• Basic accounting equation; primarily reflects the structure of
statement of financial position (SFP)
• Statement of profit or loss: Revenue – Expenses = Profit
• Profit may be distributed to shareholders as dividend, or be retained
(thus the name retained profit) i.e. kept in the company
• Companies have no legal obligation to declare dividend
• Some famous companies are well known for rarely declaring dividends
• Profit, if kept in company, provides funds for research & development,
capital investment (i.e. buying machinery, equipment, property etc)
 Off balance sheet financing
• When a company needs money, one way is to borrow
• It would make sense to try to get a loan for as little cost as possible
(i.e. a low interest rate)
• Aka cost of debt
• If a company already has a lot of debt, or is heavily indebted, it is
understandable that a potential lender may be reluctant or hesitant to
lend the loan applicant any more money – why?
• To protect the moneylender (who runs a business and wants to make a
profit), some terms may be specified as part of the loan agreement to
safeguard against loss
• E.g. a loan covenant; restricting the maximum amount the borrower
may borrow from other lenders
• If the covenant is violated, the loan may be recalled immediately
 Off balance sheet financing
• Thus incentives for managers to minimise
reported liabilities on statement of financial
position
• Companies may try to obtain financing in such a
way that it does not show up on statement of
financial position, e.g. leases
• Lease: a contract specifying the terms under
which the owner (lessor) of a property transfers
the right to use the property to the lessee
 Off balance sheet financing
• An example: you would need some equipment to
make a certain product but you don’t have the
cash to pay for the equipment
• If you borrow money in order to buy the
equipment, the loan would show up as a liability
on your SFP
• Instead, you may choose to rent the equipment
from another company; if you do that, all you need
to do is to pay periodic rental payments which are
expensed in the statement of profit or loss
 Questions for reflection
• What leads to a change in the price of a company’s shares?
• Forces of supply and demand? What affects demand?
• “My next door neighbour says that’s a rising star…” “oh really? My
mother in law also said something similar”
• Financial statements: e.g. reported profit of a year
• Hypothetically, if I were a corporate executive, and if I wanted my
company’s share price to go up, I could try to report a net profit that
looks very favourable which indicates that my company is financially
healthy and strong
• My pay (I am the CEO) could be half fixed, half related to the
company’s share price movement
• I could also exercise my share options at the right time
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 Re-cap
• Current liabilities – why they exist
• Non current liabilities
• Contingencies and provision
• Time value of money
• Performance based compensation
• Share capital
• The significance of “interest”
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