Pursuant to the conceptual framework, for an item to be characterised as a liability the

definition of liabilities must be applicable to the transaction or event, and the

recognition criteria should also be satisfied.
Applying the definition of liabilities, there are three key components in the definition
of ‘liability’, these being:
1. There must be an expected future disposition of economic benefits to other entities.
2. There must be a present obligation.
3. A past transaction or other event must have created the obligation.
Turning our attention to the recognition criteria, once the transaction or event has
satisfied the requirements pertaining to the definition of a liability (the three
components above), it must then satisfy the two recognition criteria for liabilities,
these being:
1. It is probable that any future economic benefit associated with the item will
flow from the entity.
2. The item has a cost or value that can be measured with reliability.
2. What is a contingent liability and how should it be disclosed for financial reporting
purposes?

Answer: Paragraph 10 of AASB 137 defines a contingent liability as:

(a) a possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more
uncertain future events not wholly within the control of the entity; or
(b) a present obligation that arises from past events but is not recognised
because:
(i) it is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient
reliability.
A contingent liability is therefore considered to exist where there is a possibility (which
is below the level to be assessed as ‘probable’) that the reporting entity will be obliged
(not currently obliged) to transfer resources in the future as a result of a future
happening, for example, an agreement (such as a guarantee) that has already been
entered into or the outcome of a future event (such as a legal judgement in a negligence
claim), and the amount is potentially material. As there might be no current obligation
(the obligation is contingent upon a future event), the item would not qualify for
 inclusion in the statement of financial position. If the probability that a future cash flow
will occur is deemed to be remote then no disclosure is required. A contingent liability
is also deemed to exist when there is an existing obligation, but that obligation cannot
be measured with reasonable accuracy. If something cannot be measured with
reasonable accuracy then it will not be included in the statement of financial position.
A contingent liability should be disclosed in the notes to the financial statements.
Failure to be aware of potential and material liabilities that the firm may be subject to
can make the financial statements misleading.
3. If a reporting entity has an obligation to clean up a contaminated site, but does not believe
it can measure the liability with any reliability, then should the obligation be disclosed at all
within the financial statements and accompanying notes? If so, how would it be disclosed?

Answer:

Where the recognition criteria for a liability are not satisfied (that is, the future outflow
is perhaps not probable and/or reliably measurable), the item should not be included
within the statement of financial position (that is, a liability should not be recognised).
However, if it is possible that the firm will be obliged (although not currently obliged)
to transfer resources in the future as a result of an agreement that has already been
entered into—and the possibility is not deemed to be ‘remote’—and the amount is
potentially material, disclosure in the notes to the financial statements is appropriate.
Further, if there is an existing obligation, but the obligation cannot be measured with
reasonable accuracy, as might be the case with some obligations pertaining to
contaminated sites, then while the item cannot be disclosed in the statement of financial
position it would be appropriate to disclose it in the notes to the financial statements to
the extent it is potentially material.
In terms of the required disclosures relating to contingent liabilities, paragraph 86 of
AASB 137 requires:
Unless the possibility of any outflow in settlement is remote, an entity shall disclose
for each class of contingent liability at the end of the reporting period a brief
description of the nature of the contingent liability and, where practicable:
(a) an estimate of its financial effect, measured under paragraphs 36-52;
(b) an indication of the uncertainties relating to the amount or timing of any
outflow; and
(c) the possibility of any reimbursement.

4. An entity has determined that it will cost approximately $15 million to clean up a site that it
previously contaminated as a result of its operations. Pursuant to AASB 137, what attributes
should this proposed clean-up have if it is to satisfy the requirements necessary for labelling it
a provision?
Answer:

AASB 137 defines a provision as a liability of uncertain timing or amount. Paragraph

11 states that provisions can be distinguished from other liabilities such as trade
payables and accruals because there is uncertainty about the timing or amount of the
future expenditure required in settlement. According to paragraph 14 of AASB 137, a
provision shall be recognised when:
(a) an entity has a present obligation (legal or constructive) as a result of a past
event;
(b) it is probable that an outflow of resources embodying economic benefits will
be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.
If these conditions are not met, no provision shall be recognised.
If there is a legal requirement that $15 million must be paid to clean up the
contamination, and if the amount is deemed to be a reliable estimate of the clean-up
costs, then a provision should be recognised. However, even if there is not a legal
obligation then it is possible that there is a constructive obligation to undertake the
clean-up, and a provision would also be recognised. A constructive obligation is defined
in AASB 137 as:
an obligation that derives from an entity’s actions where:
(a) by an established pattern of past practice, published policies or a sufficiently
specific current statement, the entity has indicated to other parties that it will
accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those
other parties that it will discharge those responsibilities.
5. Determine whether the following items would be classified and recorded as liabilities:
(a) provision for repairs
(b) provision for long-service leave
(c) dividends payable
(d) a guarantee for the debts of a subsidiary.

Answer:

(a) Provision for repairs

Up until recent times, a provision for repairs had been disclosed as a liability,
possibly classified into current and non-current portions. However, from the
perspective of the conceptual framework, future repairs would not qualify as
liabilities as they do not involve a present obligation to an external party. AASB
137 also acts to exclude many planned future expenditures from being classified
as liabilities, and indeed, from being shown anywhere within the financial
statements if they do not create obligations to make future sacrifices of
economic benefits to parties external to the entity.
It would now be appropriate to call the future commitment for repairs an
‘allowance for repairs’. It would not be shown as a liability.
 (b) Provision for long-service leave
Under generally accepted accounting principles, a provision for long-service
leave would be shown as a liability, broken up into current and non-current
portions. As a future obligation exists to an employee (that is, to an external
party) which could be measurable with some accuracy (perhaps using various
actuarial assumptions), and it relates to work performed by the employee in the
past, the liability would also be recognised pursuant to the conceptual
framework and other accounting requirements.
(c) Dividends payable
Dividends payable is an interesting issue. Previously, under generally accepted
accounting principles, a provision for dividends would have been shown as a
current liability at the time they were proposed, rather than subsequently when
they were approved (typically at an annual general meeting held after the end
of the reporting period). This was the case even though the reporting entity did
not ratify the dividend until the annual general meeting which is typically held
a number of weeks after the end of the reporting period (and after reporting date
event). This seemed to be a reasonable thing to do if it was probable that the
dividend would be paid at a future date (that is, ratification appeared a
formality), and the dividend did relate to earnings made prior to year end.
However, pursuant to AASB 110 Events After the Reporting Period, a liability
for dividends payable can only be recognised once the ultimate payment has
been approved by the appropriate parties.
(d) A guarantee for the debts of a subsidiary
Under generally accepted accounting principles, and consistent with AASB
137, this would be classified as a contingent liability, and if it is potentially
material, then it should be disclosed in the notes to the financial statements. If
the guarantee has become enforceable then the liability would be included in
the statement of financial position as either a current or non-current liability.
The guarantee would not be classified as a liability for inclusion in the statement
of financial position (unless it had become enforceable) as the entity would not
be obliged to transfer resources as at the end of the reporting period.
6. What factors may cause the price of a debenture (also referred to as a ‘bond’) at issue date
to be different from its face value?
Answer:

The issue price of a debenture (or bond) will equal the face value when the coupon rate
on the debenture is the same as the rate required by the market.
If the market requires a higher rate of return than the coupon rate, then the debentures
will be issued at a discount. The issue price will be reduced sufficiently below par (or
face value) so as to cause the effective rate of return on the income stream, and
repayment of the principal, to be equal to the market’s required rate of return.
When the coupon rate is greater than the required market rate, then the issue price will
increase to the point at which the effective rate of return equals the rate of return
required by the market.
7. It is often argued that managers would prefer to show lower levels of debt than higher
levels of debt. Why do you think this might be so?

Answer:

All things being equal, it is generally considered that the higher the level of debt, the
higher the perceived risk of an entity. When an entity issues debt capital it is required
to pay interest periodically as well as the principal at the end of the debt term. Interest
payments reduce reported profits. If something is deemed to be equity then the related
payment is a dividend—and dividends are an appropriation of profits and therefore do
not reduce profits.
The greater the levels of debt, the greater the cash flow obligations which must be met
regardless of whether the entity is generating profits and/or positive cash flows from its
operations. This can be contrasted with equity capital. For ordinary shares there is no
fixed obligation to pay dividends.
Organisations often enter contractual arrangements which restrict the amount of debt
they can issue, such as debt-to-asset constraints. When debt levels are high this may be
considered as an indication that the organisation is close to breaching its debt covenants.
This could be viewed in a negative light by the capital market.

10. How would you determine the discount or premium on a debenture issue?

Answer:

It is determined by the difference between the present value of the future cash flows
associated with the debenture (interest and principal receipts), and the face value of the
debenture.
The present value of the future cash flows is determined by discounting the interest
annuity, and the principal repayment, at the market’s required rate of return. It is the
present value of the future cash flows associated with the liability that is used for the
purposes of disclosure within the statement of financial position. If the present value of
the debenture (also referred to as a ‘bond’) is lower than the face value of the debenture
then the difference is considered to represent a discount. Conversely, if the present
value of the debenture is greater than the face value of the debenture then the difference
is considered to represent a premium.

14. Sandringham Mining Ltd has been mining in a particular coastal area. A requirement of
the local Environmental Protection Authority is that the area be restored to a state that is
beneficial to the local fauna.

Answer:

There is a legal obligation enforceable by an external party, and hence a liability in the
form of a provision should be recognised. (We would classify it as a provision because
the amount and the timing of the payments are uncertain.) Assuming that the restoration
 work would not be undertaken for a number of years, then the provision would be
disclosed as a non-current liability. The liability, and the associated expense, should be
recognised over the life of the mine and throughout the operations of the entity and as
the work necessitating the restoration is undertaken. The liability would be discounted
to its present value.
18. Cactus Ltd issues some convertible notes in 2019. These notes are issued for $20 each and
allow note holders the option to convert each note to one ordinary share in Cactus Ltd. The
date for conversion is 31 July 2020. If the conversion option is not exercised, cash of $20 per
note will be paid to the note holders. At 30 June 2020 the price of Cactus Ltd’s shares is $18.00.
Would you disclose the notes as debt or as equity as at 30 June 2020?

Answer:

Paragraph 32 of AASB 132 states:

The issuer of a bond convertible into ordinary shares first determines the
carrying amount of the liability component by measuring the fair value of a
similar liability (including any embedded non-equity derivative features) that
does not have an associated equity component. The carrying amount of the
equity instrument represented by the option to convert the instrument into
ordinary shares is then determined by deducting the fair value of the
financial liability from the fair value of the compound financial instrument
as a whole.
Hence, we would determine the present value of $20 to be paid in one month and
allocate this to the liability component. The rate of interest to be used would be the
market’s required rate of return on a similar debt instrument that does not have the
attached equity component. The balance of the $20 (which would be small) would
represent the equity component. If the equity component is so small as not to be deemed
to be material then the whole instrument could be disclosed as debt.
19. On 1 July 2018 Michaela Ltd issues $1 million in five-year debentures that pay interest
each six month at a coupon rate of 10 per cent. At the time of issuing the securities, the market
requires a rate of return of 8 per cent. Interest expense is determined using the effective-interest
method.

REQUIRED
(a) Determine the issue price.
(b) Provide the journal entries at:
(i) 1 July 2018
(ii) 30 June 2019
(iii) 30 June 2020
Answer:

In this question, the interest payments of 10% are made each 6 months for 5 years.
Therefore, we will treat the debentures as offering a coupon rate of 5% over 10 periods.
Similarly, the market rate will be calculated as 4% for 10 periods.
(a) The issue price is equal to the present value of the interest annuity and the
principal repayment. The discount rate is the market’s required rate of return:
in this case, 4%.
Issue price: PV of principal = 1 000 000 x 0.6755642 = 675 564
PV of annuity = 50 000 x 8.1108957 = 405 545
1 081 109

Because the market rate is less than the coupon rate of the debentures, the
debentures are issued at a premium as shown above.
(b) (i) 1 July 2018
Dr Cash 1 081 109
Cr Debenture liability 1 081 109

To determine interest expense using the effective-interest method, we may use

the following table. Within the table, the interest expense is determined by
multiplying the opening liability (which is measured at present value) by the
required market rate of interest, in this case 4% per annum.

Opening Interest Cash Reduction Closing

liability expense payment in liability liability
Period
1 1 081 109 43 244 50 000 6756 1 074 353
2 1 074 353 42 974 50 000 7026 1 067 327
3 1 067 327 42 693 50 000 7307 1 060 020
4 1 060 020 42 401 50 000 7599 1 052 421
5 1 052 421 42 097 50 000 7903 1 044 518
6 1 044 518 41 781 50 000 8219 1 036 299
7 1 036 299 41 452 50 000 8548 1 027 751
8 1 027 751 41 110 50 000 8890 1 018 861
9 1 018 861 40 754 50 000 9246 1 009 615
10 1 009 615 40 385 50 000 9615 1 000 000

(ii) 30 June 2019 (which is the second 6-month period)

Dr Interest expense 42 974
Dr Debenture liability 7026
Cr Cash 50 000
(iii) 30 June 2020 (which is the fourth 6-month period)
Dr Interest expense 42 401
Dr Debenture liability 7599
Cr Cash 50 000