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IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions and recognition, criteria b) liabilities, c) provisions for liabilities d) contingencies e) valuation and f) classification. 2. Know examples of short-term and long-term debts 3. Understand the accounting methods for long-term debts, including a) characteristics of long-term debts, b) mortgages and c) long-term debts without an explicitly stated interest rate, d) bond loans, inclusive the understanding the accounting procedure for loans with discounts/premiums and the difference between the method of nominal interest rate and effective interest rate method. Copyright 2000 by Harcourt Inc. All rights reserved.
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IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

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Page 1: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.1Chapter 9 – Learning objectives

1. Understand the concept of accounting liability in connection with obligations, including a) general definitions and recognition, criteria b) liabilities, c) provisions for liabilities d) contingencies e) valuation and f) classification.

2. Know examples of short-term and long-term debts 3. Understand the accounting methods for long-term debts,

including a) characteristics of long-term debts, b) mortgages and c) long-term debts without an explicitly stated interest rate, d) bond loans, inclusive the understanding the accounting procedure for loans with discounts/premiums and the difference between the method of nominal interest rate and effective interest rate method.

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 2: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.21.a. Definition liability

A liability is a present duty for the company resulting from a previous event, and the settlement of which is expected to result in a transfer of economic resources from the company (i.e. result in future negative (net) cash flows)

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 3: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.3

1.a. Def. debt item operationalized

An obligation fulfils the definition of debts, if the following three criteria are met:1.It is probable that there will be a transfer of resources from the

company in the future. 2. There is no or little possibility of avoiding settlement of the obligation. 3. The transaction/the event giving rise to the obligation has already

occurred. A mutually unexecuted contract, which will be fulfilled in the future, is not regarded

to be an obligation due to point 3. Example: In a contract a customer has committed himself to pay DKK x to another

company, which has committed itself to deliver the articles at a certain date. Thus, both parties have obtained a conditional right/obligation, but neither is regarded as an assets or a debt.

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 4: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.4

1.a. Constructive liability

A constructive liability is a liability, which occurs: When the company by virtue of its action has shown that it commits itself

to certain obligations and in this respect the company has created a justified expectation with the

third party about payment of these obligations Example. A Mercedes does not jump over mooses. By journalists´ tests of

the new A-class Mercedes the car made mysterious jumps/tipped over by taking evasive actions. The Mercedes image + business customs => expectations of the customers about repair.

Example. The legislation requires a 2-year warranty – the decisive point is the company’s real period of warranty.

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 5: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.5

Liabilities and provisions for liabilities

Liability: Present value of future transfers is pretty certain

Provision for liabilities: Uncertainty about timing and/or size of future payments with the consequence that only a probable estimate of the liability can be made

Page 6: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.6

1.a. Recognition criterion: Reliable value

The debt is included, when it is probable, that a transfer of economic resources of the company will take place, and the amount, with which the obligation is settled, can be stated to be sufficiently reliably.

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 7: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.7

1.b. Contingencies

An contingency exists if : A condition exists on the day of balance as a result of previous events, which

can potentially cause a drain of the economic resources of the company, but for which the existence of the obligation can only be confirmed by one and more uncertain future events, which are beyond the control of the company, or

a duty exists on the day of balance as a result of previous events, for which it is not probable that it will result in a drain of the economic resources of the company, or

An obligation exists, but the size obligation cannot be stated with adequate reliability

ONLY NOTE INFORMATION!!!!

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 8: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.8

1.b. Contingencies

Contingencies are “potential obligations”, but most often more “potential” than “obligations”

Contingencies can develop in another way than expected,and become liabilities. In that case they are recognized as liabilities/provisions for liabilities, when a drain on the economic resources of the company becomes probable. (the classification as a liability/a provision for liability depends on residual uncertainty)

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 9: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.9

1.c. Provisions for liabilities

The DCAA’s definition chapter: Provision for liabilities: Obligations for which the obligating event has occurred but with

uncertainty about amount and/or time of settlement. Uncertainty about the size of the settlement must not be too great, otherwise

it will be abuse of the reliable estimate criterion for recognition. (Fairly uncertain estimates of time of settlement will in contrast be more acceptable).

Only recognition of obligations that exist on the day of balance - not recognition of “obligations”, which is caused by future activities as e.g. future jubilee.

Example.: Guarantee obligations or similar (The Mercedes example), pensions liabilities to managers, guarantee obligation incurred, which are expected to result in future payments.

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 10: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.10 Figure 10.1 Classification of obligations based on the degree of security

Not generally recognized as accounting liabilitiesRecognized as accounting liabilities

more certain less certain

Copyright 2000 by Harcourt Inc. All rights reserved.

Obligations with fixed payment dates and amounts

Obligations with fixed payment amounts but estimated payment dates

Obligations arising from advances from customers on unexecuted contracts

Obligations for which the firm must estimate both the timing and the amount of payment (provisions)

Mutually unexecuted contracts or mutual promises

Contingent obligations

Notes payable, interest payable, bonds payable

accounts payable, salaries payable, taxes payable

rental fees received in advance, subscription fees received in advance

warranties payable, pension obligations

purchase commitments, employment commitments

unsettles lawsuits, off-balance sheet financing

Page 11: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.111.d. Valuation (1)

As the basic (“theoretical”) rule debts and provisions are stated at the present value of future payments, which have to be effected to fulfill the obligation.

The present value is calculated as future payments (interest and repayments etc.) discounted with an interest rate fixed on the basis of the specific circumstances, including e.g. the specific credit rating of the company. If a company has to pay DKK in a year, as to the amount the obligation will depend on the interest rate which is applied today.

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 12: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.12

1.d. Valuation (2)

Short-term debts generated by operations are not discounted in practice due to the insignificant numerical effect of discounting for short periods of time

Page 13: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.13

1.d. Valuation (3)

Liabilities generated by company operations and liabilities with a constant interest rate and held to maturity stated at amortized cost price, i.e. the net present value are stated on the basis of that interest rate, which existed when the debt arose. Short-term debt without an explicit interest rate is normally not discounted due to the insignificant effect of discounting for short periods of time.

Page 14: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.14

1.d. Valuation (4)

Other obligations are considered to result from trading and they are stated at market price, possibly an estimated market price (“fair value”) i.e. the net present value is estimated on the basis of the current interest rate for the obligation in question

Page 15: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.151.e. Classification

Debt/obligations are classified as (1) short-term debt and (2) long-term debt, and as (3) provisions for liabilities.

Short-term debt: Debt due within one year. Long-term debt: Debt due later than one year ahead . Debts, which are currently paid by several repayments (e.g. mortgage

bonds/mortgage loans), are slit in a short-term and long-term part, i.e. that part, falling due within the next year, is classified as short-term debt, whereas the remaining part is classified as long-term debt.

Provisions for liabilities are not specified in short-term and long-term parts

In Denmark that part of long- term debts due after 5 years must be disclosed in the notes to the accounts

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 16: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.162. Short-term debts

Examples of short-term debts: Prepayment received on account ( (e.g. subscriptions/construction contracts, provided

that the payment is for work that is not yet accomplished, otherwise a set-off is made to the asset produced – work in progress -> an exception from the principal rule in ÅRL not to make set offs in the accounts (but the set off must be made openly/visibly)

Trade payables Corporate tax Other debts (e.g. interests due, wages, holiday pay, Supplementary Pension Scheme,

tax deducted from income at source, VAT owed) Accruals and deferred (e.g. the lessee who has received a prepayment a rent, i.e. has a

”prepaid income” for the following year) Dividends to the shareholders of the company Credit institutions (bank debt, the part of the mortgage loan and other long-term

debts falling due within a year) Bank overdraft resulting from overdraft facilities is most often classified as short-term

debts on the grounds that normally the bank will be able to terminate such a credit with short notice (although the bank will seldom exercise that option)

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 17: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.173. Long-term debts

Examples of long-term debts:Bond loansCredit institutions (mortgage debt/bank debt etc.)Profit bearing instrument of debts (debt, where the interest rate

is dependable on profit)Convertible bond debt (debt, which later can be converted to

share capital)

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 18: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.183.a. Characteristics for long-term debts

Short-term debt is typically settled by one payment. In contrast most long-term debts are typically paid back by several consecutive payments, each consisting of a repayment and an interest payment (and perhaps an additional fee payment) – and as a consequence the present value of long-term is often very different from the undiscounted sum of all future payments resulting from the debt

Therefore, as a main rule long-term debt is actively stated to some kind of present value of the future payments.

For each of the consecutive payments a split is made between repayment and interest payment (and possible an additional borrowing fee payment), which altogether make up the total of that payment.

If the loan contract states the effective (variable) interest rate the nominal debt is = present value of debt.

By loans with (a constant) coupon (rate) the nominal interest rate (“the coupon”) will often deviate from the effective interest rate method due to the premium or the discount.

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 19: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.19

3.b. Mortgages

Mortgages follow the accounting principles for long-term liabilities. By raising the loan the liquid assets are debited, and the long-term

debt is credited. The debt is booked as the current value of the future payments.

As payment of the mortgage is effected, the liquid assets are credited – debit is effected on the long-term debt (the repayment part) and the interest costs in the income statement (the interest part)

The problem may, however, be to make meaningful estimates of the size of debt, interest and repayment

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 20: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.20

3.c. Long-term debt without explicitly charge of interest

Some contracts do not state interest rates explicitly, instead the interest rate is calculated as an additional charge in the purchase price.

US GAAP (and soon DK GAAP) claims, that long-term debt is raised at the current value, and that the repayments are divided in repayment and interest rates (however, in Denmark it has only been effected to a small extent)

If the interest rate is not stated, it is charged on the basis of the current value method, including the well-known repayments and an estimate for either

The market value (=the current value) or for the interest rate.For similar debt items.

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 21: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.21

3.d. Bond loans

In Denmark the two most applied types of bond loans are: 1. Loan with a constant coupon (with higher redemption yield) 2. Loan with a floating interest rate (with current regulation - often per annum)

The coupon (the interest) is typically paid currently on a bond loan. The coupon rate

is fixed by the issue of the bond loan and could also be named “the par value interest rate” or “the nominal interest rate”, but the real interest rate is often higher, because the loan proceed is lower than the nominal debt/the par value – the loan is issued with a discount

Both the repayments and the coupon payments may have very different time profiles depending on the type of loan (annuity loans, serial loans etc.).

At the time the loan issued the real interest rate, the effective interest rate on the loan is determined as the internal rate of return – the interest that result in identity of the proceeds of the loan and the net present value (the discounted value) of all future total payments on the loan (nominal payments of interest and of repayments)

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 22: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.22

3.d. Bond loans – at a discount or at a premium

The price of a bond is determined by the coupon rate of the bond relative to the market interest rate when the loan is issued. Generally a bond is sold (“issued”) at a price which is different from the price 100 when the loan is issued

If the market interest rate is lower than the coupon rate of the bond, the proceeds will exceed the par value of the bond, i.e. the bond is said to be issued with a premium

If the coupon rate, however, is lower than the market interest rate, the proceeds will be lower than at par value of the bond, i.e. the bond is issued with a discount (practically always the case in Denmark)

Thus, the bond issuer will often receive an amount, which is higher or lower (in Denmark normally always lower) than the par value of the bond.

The effective interest rate will therefore be different from the coupon rate, when the loan is issued with a premium/discount.

Copyright 2000 by Harcourt Inc. All rights reserved.

Page 23: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.23 3.d. Bond loan - treatment of prices at less than or more than par

Two ways of treating discount/premium: The nominal method Amortized cost price Nominal method: The whole discount amount is treated as a borrowing

cost in the year the loan is issued. The coupon rate is used to calculate debt = nominal debt and the interest costs for the rest of the term of the loan

(The method is not allowed any more) Amortized cost price: Debt and interest expenses are calculated in such a

way that the discount/premium is spread out as a borrowing cost over the term of the loan.

Page 24: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.243.d. Bond loans etc. Statutory requirement

DCAA §37 section. 2. After the first inclusion the company has to regulate currently the following at a amortized cost price: ..3) financial obligations except from those mentioned in section 1,1 paragraph 1 (debt in its ”trade stock”).

Page 25: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.25 3.d. Bond loans continued – amortized cost price

Two ways of calculating amortized cost price: Effective interest rate method Depreciation of discount/premium Effective interest rate method: The discount/premium is amortized over the term

of the debt via a calculation of the effective interest costs: The effective interest rate multiplied by calculated (”effective”) unpaid debt at the beginning of the date of payment (= market value of debt, if the market interest rate is (still) identical to the effective interest rate)

The discount is regarded to be an independent ”deduction to the par value of the debt”, which it is depreciated (i.e. systematically reduced) over the term of the loan (approximation of the effective interest rate method)

Page 26: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.26 3.d. Bond loans continued –amortized cost price

The Danish Company Accounts Act definition section: Amortized cost price: Amortized cost price is the value, to which a financial asset or a financial

obligation was measured when making the first calculation with 1) deduction of repayment 2) additional charge or deduction of the total depreciation of the difference

between the original calculated amount and the amount due on expiry 3) Deduction of depreciations of the original discountTHE LAW DOES NOT TAKE A DECISION ON THE METHOD OF

CALCULATION – EFFECTIVE INTEREST RATE WILL PERHAPS BE THE MOST WIDESPREAD METHOD.

Page 27: IX.1 Chapter 9 – Learning objectives 1. Understand the concept of accounting liability in connection with obligations, including a) general definitions.

IX.27 3.d. Bond loans – treatment of discount or premium by using the effective interest rate

method

The interest cost in the income statement is found as sum of: effective interest rate (found at the time of the issue of the bond) multiplied by calculated unpaid debt of the bond at the beginning of each payment period during the year.

The effective bond debt stated in the balance sheet at year end = the effective bond debt at the beginning of the year minus the sum of effective repayment during the year (= net present value of the future payments discounted by the effective interest rate)

The ”effective” unpaid debt shown in the balance will approach the nominal debt over the period, when the time of expiry is approached. Towards the time of expiry the nominal and the effective unpaid debts are nearly of the same amount.