Chapter 9

Liabilities
 Learning objectives
LO1: Describe the recording and reporting of various current liabilities.
LO2: Describe the reporting of non-current liabilities and the cash flows
associated with those liabilities.
LO3: Understand the nature of bonds (debentures) and record a bond’s
issuance, interest payments and maturity.
LO4: Account for a bond that is redeemed prior to maturity.
LO5: Understand additional liabilities such as leases & contingent liabilities.
LO6: Evaluate liabilities through the calculation and interpretation of
horizontal, vertical and ratio analyses.
 Learning objectives: Appendix

LO7: Determine a bond’s issuance price

LO8: Record bond interest payments under the effective interest

method.
But first what is happening in business today?

www.abc.net.au/news/abcnews24/business-in-90-seconds/
 LO1 Current liabilities

Describe the recording and reporting of various current

liabilities.

A current liability is an obligation of a business that is expected

to be satisfied or paid within one year.
 Current liabilities (2)
Current liabilities arise from regular business operations such as the
purchase of inventory, the compensation of employees, the repayment
of debt and the incurrence of taxes.

Most current liabilities (like accounts payable and notes payable) will be
satisfied through cash payment. Other current liabilities (like deferred
revenues or customer prepayments) will be satisfied when a service is
performed.
 Taxes as current liabilities
Businesses have a number of current tax obligations that are
classified as current liabilities.

These include:
• income taxes
• GST payable
• withholding taxes on the employee’s behalf
• payroll taxes that employers must pay (if their total payroll is over
threshold limit – e.g. 5.45% in NSW if total payroll is over $750,000 pa).
 Income taxes payable
Corporations (companies) like individuals, are subject to federal
taxation of income, which are typically current liabilities.

Assume a company has $25,000 of annual income tax expense and

plans to pay it in the next period. The company records this current
liability by debiting income tax expense and crediting income tax
payable, thus reducing equity and increasing liabilities.
 Goods and services taxes payable
• Another current liability example is GST payable.
• Each time a sale is made or service provided (which attracts GST)
the GST is added to the selling price.
• Assume on 1 August, a $1,000 item is sold and the company
collects 10% GST.
• The entry increases cash for the $1,100 received from the
customer, increases sales for the $1,000 earned from the sale, and
increases GST payable for the $100 of tax collected and now owed
to the ATO (Australian Taxation Office).
 Withheld taxes payable
• A third type of tax that generates a current liability is payroll taxes.
• When paying employee wages, employers must withhold income tax
owed by the employee.
• The employer then remits (pays) those taxes to the taxing authorities.
• Assume employees earn a monthly salary of $10,000. The employer
must withhold an amount and later send it to the ATO, resulting in a
liabilities.
 Recording a notes payable
On1 March, Brown borrows $30,000 by signing an
8 per cent, six-month note with Murray River Bank. The note calls for
interest to be paid when the note is repaid on 31 August. The entry to
record the note on 1 March is :

General journal
Date Description Debit Credit
1 Mar. Cash 30,000
Note Payable 30,000
 Calculation of interest
On 31 August, Brown must pay Murray Bank the original $30,000
borrowed plus the interest on the note. Interest over the six months
is calculated as follows:
Interest = Principle x Annual rate of interest x Time
outstanding
= $30,000 x 0.08 x 6/12 months
= $1,200
An adjusting entry would be required if Brown had a 30 June
financial year end ($30,000 x 0.08 x 4/12 months with a
Cr to Interest Payable).
.
 Payment of a notes payable
Brown would pay $31,200 to the bank and make the following entry on
31 August, increasing interest expense to reflect cost of borrowing the
$30,000, decreasing note payable because the note is paid back, and
decreasing cash for the principal and interest payment.
General journal
Date Description Debit Credit
31 Aug. Note Payable 30,000
Interest Expense 1,200
Cash 31,200
 Current portion on long-term debt
• Companies that borrow money on a long-term basis often pay part of
the principal on a short-term basis
• The current portion of non-current liabilities represents the portion of
the liability that will be paid within one year.
• The classification does not affect the borrowing or repayment of the
note. However, the statement of financial position reporting is
important.
• With Centro, ABC Learning and other companies, the incorrect
classification was said to have mislead investors.
 LO2 Non-current liabilities

Describe the reporting of non-current liabilities and the

cash flows associated with those liabilities.

A non-current liability is any obligation of a business that is

expected to be satisfied or paid in more than one year. The
most common and largest non-current liabilities often arise from
borrowing money and result in annual interest payments and
the eventual repayment or ‘rolling over’ of the debt.
 LO3 Bonds

Understand the nature of bonds (debentures) and record a

bond’s issuance, interest payments and maturity.

Bonds or debentures as they are sometimes called are less

popular than they once were. ‘Mum and Dad’ investors tend to
deposit money in a financial institution and the financial
institution lend to companies.
 Bonds or debentures
• Bonds are financial instruments that companies use to borrow money
on a long-term basis.
• Borrowers sell or issue bonds and record a liability as a promise to
pay future interest and repay the principal to a creditor in exchange for
the creditor’s cash today.
• The creditor (investor) buys bonds and records them as investments
(asset).
 Bond terms
The terms and features of a bond are determined by the borrowing
entity and can vary widely.

Common features are related to the following terms:

• Face value: the amount that is repaid at maturity.
• Stated interest rate: the contractual rate at which interest is paid.
• Maturity date: the date on which the face value must be repaid.
• Market (or effective) rate of interest: the rate of return that investors
demand for a bond of similar risk.
 Bond rates
• When a bond pays interest at a rate that is lower than creditors
demand, they will purchase the bond only if the price is discounted.
• By discounting the price, the borrower is increasing the rate of interest
that creditors earn.
• The effective interest rate earned equals the market rate of interest.
• Bonds that are issued for less than face value are issued at a discount.
 Bond rates (2)
• When a bond pays interest at a rate that is higher than creditors
demand, the borrower will sell the bond only if the price is raised.
• By raising the price, the borrower effectively lowers the rate of interest
that the creditor earns.
• The bond will sell only when the price is raised enough so that the
effective interest rate that the creditor earns equals the market rate of
interest.
• Bonds that are issued for more than face value are issued at a premium.
 Bond issuance at face value
On 1 July, 2016, York sells bonds with a face value of
$100,000. The bonds carry a 6 per cent interest rate and a 1 July, 2031,
maturity date. Interest is to be paid semiannually on 1 July and
1 January. The market rate of interest is also 6 per cent.

General journal
Date Description Debit Credit
1 Jul. Cash 100,000
Bonds Payable 100,000
 Recording interest payments
York Products pays interest on 1 July and 1 January of each year.
Interest paid = Face value x Stated interest rate x Time outstanding
= $100,000 x 0.06 x 6/12 months
= $3,000
General journal
Date Description Debit Credit
1 Jan. Interest Expense 3,000
Cash 3,000
 Recording accrued interest payments
York’s financial year ends 30 June and pays interest on 1 July.

General journal
Date Description Debit Credit
30 June Interest Expense 3,000
Interest Payable 3,000
1 July Interest Payable 3,000
Cash 3,000
 Bond repayment at maturity
On 1 July, 2031, York would record the repayment of the bonds in
addition to the last interest payment.

General journal
Date Description Debit Credit
2031
1 July. Bonds Payable 100,000
Cash 100,000
 Bond issuance at a discount
On 1 July, 2016, Nguyen Company issues bonds with a face value of
$200,000, a stated rate of 7 per cent, and a maturity date of 30 June,
2021. Interest is payable semiannually on 30 June and 31 December.
The bonds sell at 98 per cent of the face or $196,000.
General journal
Date Description Debit Credit
2016
1 July Cash 196,000
Discount on Bonds Payable 4,000
Bonds Payable 200,000
 Reporting discounted bonds on the
statement of financial position
The statement of financial position (balance sheet) will show the
carrying amount (or book value) of the bonds, which in this case, is
equal to the face amount minus the discount.

1 July, 2016
Bonds payable $200,000
Less: Discount on bonds payable 4,000
Carrying amount $196,000
 Recording interest payments
Nguyen pays interest on 30 June and 31 December

Interest paid = Face value x Stated interest rate x Time outstanding

= $200,000 x 0.07 x 6/12 months
= $7,000
 Recording interest payments (2)
General journal
Date Description Debit Credit
2016
31 Dec. Interest Expense 7,400
Discount on Bonds Payable 400
Cash 7,000

Discount at issuance
Discount amortised =
Number of interest payments

Straight line amortisation = $4,000 / 10 half years

 Two methods of amortisation
• There are two methods of amortising bond discounts or premiums:
– straight-line method
– effective interest rate method
• Because the straight-line method is easier to calculate and is often
close to the results from the effective interest method, the straight-line
method is demonstrated here.
• The effective interest method is also demonstrated in the chapter
appendix.
 Bond repayment at maturity
On 30 June, 2021, Nguyen would record the repayment of the bonds in
addition to the last interest payment.
General journal
Date Description Debit Credit
2021, 30 June Bonds Payable 200,000
Cash 200,000
 Bond issuance at a premium
1 January, 2016, McCarthy issues bonds with a face value of $50,000,
a interest rate of 8 per cent, and a maturity date of 31 December, 2018.
Interest is payable semiannually on 30 June and 31 December. The
bonds were sold at a premium of:
101.2 or ($50,000 x 101.2% = $50,600).
General journal
Date Description Debit Credit
2016
1 Jan. Cash 50,600
Premium on Bonds Payable 600
Bonds Payable 50,000
 Recording interest payments
Interest paid 30 June and 31 December.

Interest paid = Face value x Stated interest rate x Time outstanding

= $50,000 x 0.08 x 6/12 months
= $2,000
General journal
Date Description Debit Credit
2016
30 Jun. Interest Expense 1,900
Premium on Bonds Payable 100
Cash 2,000

Discount at issuance
Discount amortised =
Number of interest payments
 Bond repayment at maturity
On 31 December, 2018, McCarthy would record the repayment of the
bonds in addition to the last interest payment.
General journal
Date Description Debit Credit
2018, 31 Dec. Bonds Payable 50,000
Premium on Bonds Payable 100
Interest Expense 1,900
Cash 52,000
LO4 Redeeming a bond before maturity

Account for a bond that is redeemed prior to maturity.

Bonds are retired early for various reasons. A company may

simply want to reduce future interest expense or take
advantage of falling interest rates by replacing existing bonds
with less costly bonds.
 Redemption before maturity
Accounting for the early retirement of a bond consists of the following
three steps:
1. Update the carrying value of the bond.
2. Calculate gain or loss on the retirement (will depend on the price the
bonds are publically traded – known as the ‘call rate’).
3. Record the retirement.
 Recording the gain or loss on redemption
• When the carrying amount exceeds the call price and the company is
paying less than the value of the liability, a gain on the redemption is
recorded.
• In contrast, when the call price exceeds the carrying amount and more
than the value of the liability is paid, a loss on the redemption is
recorded.

Gain on redemption = Carrying Amount > Call price

Loss on redemption = Call price > Carrying Amount
 Example of a redemption
Melbourne Town issues a $20 million eight-year bond on 1 January 2018.
The bond has a stated interest rate of 5 per cent and is ‘callable’ at 103 any
time after 2022. The bond pays interest semiannually on 30 June and 31
December. The bond sells for $19.2m. Melbourne Town retires the bond
early on 31 December 2024.

General journal $’000 $’000

Date Description Debit Credit
31 Dec 2024 Bonds Payable 20,000
Loss on Redemption 700
Discount on Bonds Payable 100
Cash 20,600
Cash = $20,000 x 1.03 = $20,600
 LO5 Additional liabilities

Understand additional liabilities such as leases and

contingent liabilities.

AASB 16 Leases requires most leases to be recorded as an

asset and the corresponding liability, while AASB 137 defines a
contingent liability as a possible liability.
 Leases
• The lease is a contract in which the lessee has the risks and rewards
of ownership (but not the legal ownership), so a leased asset and the
lease obligation is recorded by the lessee as an asset and liability.
• A new accounting standard (AASB16) now covers leases, replacing
the previous standard (AASB117) discussed in the chapter.
AASB16 requires ALL LEASES to be recorded in the books of the
lessee as an asset and a liability the Statement of Financial Position
(balance sheet).
• There are two exceptions to the above requirement is:
– Leases with a duration of 12 months or less
– Leases of low value assets (tablets, phones, laptops etc…)
 Contingent liabilities
• A contingent liability is a possible obligation that arises from past
events and will only be confirmed by some future event beyond the
reporting entity’s control. Or it is a present obligation that is not
recognised because:
– it is not probable that payment will be required
– the amount cannot be measured with sufficient reliability
• Contingent liabilities are reported in the notes to the financial
statements.
• Woolworths reports their contingent liabilities in 2014 in Note 22.
LO6 Evaluating a company’s management of
liabilities
Evaluate liabilities through the calculation and
interpretation of horizontal, vertical and ratio analyses.

The amount a company should borrow compared to how much

the owners put in and leaves in (contributed capital and
retained earnings) is a major consideration for all company
financial analysis. Known as leverage or gearing, it is
fundamental to the financial risk of a business.
 Evaluating a company’s management
of liabilities
• As a company operates its business, it will generate liabilities. In fact,
the generation of liabilities is usually the easy part of a business.
• It is the repayment of those liabilities that can create significant
problems.
• An easy and useful place to start an examination of liabilities is with
horizontal and vertical analyses.
 Ratio analysis
In addition to a horizontal and vertical analyses of liabilities, it is a good
idea to conduct ratio analyses including:
• The current ratio
• The debt ratio (which can be calculated as debt to equity or debt to
total assets)
LO7 Determining a bond’s issuance price

Determining a bond’s issuance price using the effective

interest method

Bonds (or debentures) need to pay interest at a rate equal to

other securities of similar risk. The issue price is determined by
using the market rate and calculating the present value of the
interest payments and the final repayment of the principle.
 Determining a bond’s issuance price
The bond’s issuance price will always be the present value of
those future cash flows discounted back at the current
market rate of interest.
Assume that the market rate of interest is 8 per cent when Bowman
issues a $100,000 four-year bond that pays interest annually at a rate
of 10 per cent.
 Bowman example
$100,000 X 0.7350*

Premium case
8% market rate
Present value of a single payment
of $100,000 $73,500
Present value of an annuity
of $10,000 33,121
Issuance price 106,621
$10,000 X 3.3121

* Present value factors from Appendix A, Exhibit A4

 Bonds interest relations
Bonds are issued for:
• a premium when the stated interest rate exceeds the market rate
• face value when the two rates are equal
• a discount when the market interest rate exceeds the stated rate
 Now to Recap.

https://www.youtube.com/watch?v=o2EnAIMMGIM
 LO8 Effective interest method of
amortisation
Recording bond interest payments under the effective
interest method.

Interest expense is calculated using the face value of the bond

plus or minus the unamortised premium or discount. This is
them multiplied by the market interest rate and the premium or
discount is amortised by the difference between the stated
interest rate and the effective interest rate.
 Effective interest method of amortisation
• Under the effective interest rate method, interest expense is
calculated by multiplying the bond’s carrying amount (carrying value)
by the market rate of interest at issuance, by the time outstanding.

• Once interest expense is known, the amount of discount or premium

amortised is the difference between interest expense and interest
paid.
 Bowman example: recording the issuance
General journal
Date Description Debit Credit
2016
1 Jan Cash 106,621
Premium on Bonds Payable 6,621
Bonds Payable 100,000

Interest paid Face value x Stated rate $100,000 x 10% $10,000

Interest expense Carrying value x Market rate $106,621 x 8% $8,530
Premium amortised Interest paid – interest expense $10,000 – $8,530 $1,470
 Recording the first interest payment
At the end of the first year, interest expense would be
recorded as follows:
General journal
Date Description Debit Credit
2016
31 Dec. Interest expense 8,530
Premium on bonds payable 1,470
Cash 10,000
 Amortisation schedule of bond premium
Interest Interest paid Discount Interest Unamortised Carrying
payment amortised expense discount amount

$6,621 $106,621

1 $10,000 $1,470 $8,530 5,151 105,151

2 10,000 1,588 8,412 3,563 103,563
3 10,000 1,715 8,285 1,848 101,848
4 10,000 1,848 8,152 0 100,000
$40,000 $6,621 $33,379
 Effective Interest
https://www.youtube.com/watch?v=le1eHjpYiwM