Chapter 11:

Liabilities, on and off balance sheet

General issues

Long-term debt, contingent liabilities



Liabilities, definition and classification

• present obligations based on past transactions or events that

require either future payment or future performance of services

A liability is a present obligation of the enterprise arising from past

events, the settlement of which is expected to result in an outflow from

the enterprise of resources embodying economic benefits. [IASC

Framework, paragraph 49]

recognized when incurred; end-of-period adjustments may be


valued at the amount due or at fair market value

classified as current or long-term; determinable or contingent


Long-term / current

• Long-term Liability

due beyond the current period or the normal operating

cycle, whichever is longer

used to cover long-term financing needs

• Current Liability

due within one year or within the normal operating cycle,

whichever is longer

incurred in connection with operating process

long-term liabilities may contain a current portion according

to the lapse of time

• to be shown separately


Part I: Current Liabilities

• Accounts Payable

sometimes called trade accounts payable

balances owed to others for goods and services purchased

on open account

time lag between resource inflow and payment

• Short-Term Bank Loans

„line of credit“ – short-term borrowing when needed

promissory note over the full amount uses to be signed

interest rate may vary over time

? Current liabilities as a percent of total liabilities for the Bank of New York and

AT&T are approximately 80 percent and 40 percent, respectively. Explain why these

two companies carry such different levels of current liabilities.


Notes Payable, accounting treatment when


written promises to pay a certain sum on a specified future


used to secure loans or to pay suppliers for goods

Case 1 - Interest stated separately

Sep 30 Cash 10.000

Notes Payable 10.000

(To record issuance of 9%,

90-day note to Commerzbank)

money received equal

to face value of note

Case 2 - Interest in face amount

money received equal to

present value of note

Sep 30 Cash 9.779

Discount on Notes Payable _221

Notes Payable 10.000

(To record issuance of zero-interest-bearing

90-day note to Commerzbank)


Accounting treatment of payment

Case 1 - Interest stated separately

Dec 30 Notes Payable 10.000

Interest Expense _225

Cash 10.225

(To record payment of

Commerzbank interest-bearing

note and accrued interest at


interest expense

= 10.000 x 9% x 90/360

Case 2 - Interest in face amount

interest expense is lower in

case 2 than in case 1 since the

effective amount borrowed

was lower, too.

Dec 30 Notes Payable 10.000

Cash 10.000

(To record payment of note

with interest included in

face amount)

Dec 30 Interest Expense ____221

Discount on Note Payable 221

(To record interest

expense on note payable)


other current debt

• Current Maturities of Long-Term Debt

portions of long-term debt maturing within the next year are

classified as current liabilities

e.g. installment due on a long-term liability, i.e. a loan

no journal entry necessary

• Short-Term Obligations Expected to Be Refinanced

don‘t require use of working capital within the next year

enterprise needs to demonstrate intent and ability to

refinance the obligation

• Dividends Payable

liability is incurred after the board‘s decision to pay out


liability exists until dividends are paid


Unearned Revenues

• examples:

sale of season tickets for a sports club

subscription of magazines

gift certificates

meal tickets

• accounting treatment

when payment is received: debit cash, and credit unearned

revenue account

when revenue is earned: debit unearned revenue, and credit

an earned revenue account

Type of Account Title

Business Unearned Revenue Earned Revenue

Airline Unearned Passenger Ticket Revenue Passenger Revenue

Restaurant Unearned Meal Revenue Meal Revenue

Magazine Publisher Unearned Subscription Revenue Subscription Revenue

Sports Club Unearned Ticket Revenue Ticket Revenue


Economic function of unearned revenue

• recognize unearned revenue when customers are

entitled to receive future service for their present

payment with certainty

to be distinguished from warranty reserves

Example – Microsoft

‣ unearned revenue increased year after year

‣ u.r. arise from sale of Windows and Office

you do not buy just the current version but future

improvements as well

‣ if sales are growing so is unearned revenue

Increases in unearned revenues may signal favorable future



Sales and Excise Taxes Payable

• federal and state authorities levy taxes on retail

transactions or rendering of services

tax collected by seller and then remitted to tax authority

to record a (gross) sale of € 232 given a sales tax of 16%,

the following entries are required:

Cash Sale

Apr 19 Cash 232

Sales 200

Sales Taxes Payable 32

similar entries to record collection of excise tax excise

tax payable



• Income Taxes Payable

expense in the year the income is earned

estimated because tax files are subject to review and


debit income taxes expense, credit income taxes payable

• Property Taxes Payable

fiscal year of tax authority often differs from the firm‘s fiscal


depending on period chosen to charge the taxes, estimates

may be necessary

provision for property taxes usually by a monthly accrual in

the company‘s books during the fiscal period of the taxing

authority for which the taxes are paid



• Definition

„ ... an existing condition, situation, or set of

circumstances involving uncertainty as to possible

gain (gain contingency) or loss (loss contingency) to

an enterprise that will ultimately be resolved when

one or more future events occur or fail to occur.“

[FASB] Statement of Financial Accounting Standards No.5, par.1 (1975)

Gain contingencies are not recorded.

Loss contingencies are not existing liabilities, but potential


liabilities contingent on occurence or nonoccurence of a

future event



• Dream Cars Inc., a car dealer, offers various

specialties to its customers:

Free repair of newly bought cars in case of defect within the

next two years

Free inspection on request by new customers within the

next six months with purchase of 4 new tires before

christmas (as a christmas customer appreciation special)

• No definite liability incurred; Uncertain:




• Nevertheless

it is probable, that a liability has been incurred, and

the liability can reasonably be estimated.

Record the estimated amount as a contingent liability!


Accounting for contingencies under US-GAAP


Contingent Loss

Contingent Gain

Probability of

Occurence High Reasonable Remote High Reasonable Remote

Is it estimable?

Yes No


Treatment Accrue Disclose Disclose Ignore Disclose Ignore Ignore

Source: Pratt, p. 432.


Common instances of loss

contingencies/contingent liabilities:

• Litigation, claims, and assessments

the cause for legal action occurred in the past

probability of unfavorable outcome assessed accoding to past


estimate of expected loss: legal action is decided but number of

claimants uncertain

pending litigation vs. actual/possible claims and assessments: no

exact amounts disclosed due to influence on position before the


• Guarantee and warranty costs

guarantee for credit default

product warranty

• Premiums and coupons.

• Environmental liabilities.

• Pensions and other postemployment benefit obligations.

see following pages


Guarantee and warranty costs

• Warranty: guarantee to repair or replace defective

goods during a predetermined period following the


• accounting either

Cash Basis – warranty costs charged to period in which

company complies with the warranty

Accrual Basis – warranty costs charged to period of sale as

operating expense

• Example (accrual basis): Michael Drums sells music

instruments. Per 100 units sold, 2 require warranty service. The

cost per service is estimated at € 70. In 2002, he sold 800 units.

Five warranty services have already been performed at costs

totalling € 430. So there remain eleven warranty services as an

estimated liability.


Journal entries for the example:

1. Sale of 800 units at average price € 100

Cash or Accounts Receivable 80.000

Sales 80.000

2. Recognition of warranty expense

Warranty Expense 430

Cash,Inventory, or Accrued Payroll _ _430

(warranty costs incurred)

Warranty Expense 770

Estimated Liability under Warranties _ _770

(to accrue estimated warranty costs)

3. Recognition of warranty costs incurred in 2003 (on 2002 sales)

Estimated Liability under Warranties 770

Cash, Inventory, or Accrued Payroll _ _770


Premiums and coupons

• Examples

frequent-flyer programs

bonus cards of department stores

toys that come with McDonalds junior meals

• Accounting problem again: estimation of the liability

incurred with the sales

(to comply with the matching principle)

• Journal entries – similar to „Drums example“


Example: Frequent-flyer program

• America West Airlines (Phoenix, Arizona), „Flight

fund“ started in 1987, over 1 million active members

program is the company‘s single largest current liability

(„Air traffic liability“)

Air traffic liability, $ 240 million (34% of current liabilities)

• Estimation

How many people are eligible for free air travel?

How many will redeem mileage during the current period?

Where are their destinations?

cost estimate for possible „free“ travel: „incremental cost



The World‘s Frequent Flyers...

Frequent-flyer miles

Number of miles Cumulative Number of miles Cumulative Cumulative un-

Year awarded by the awarded miles redeemed by redeemed miles redeemed miles/

airlines* to date* members to date program liability

to date*

1981 4,1 4,1 1,9 1,9 2,2

1982 16,8 20,9 12,9 14,8 6,1

1983 38,5 59,2 28,6 43,4 15,8


2000 1.440,0 10.009,3 349,5 3.379,1 6.630,2

2001 1.600,0 11.609,3 341,6 3.720,7 7.888,6

2002 1.646,0 13.255,3 402,9 4.123,6 9.131,7

*Totals (in billions) adjusted to reflect expiration of approximately 9-11% of airline miles.

Note: Due to trends in award activity, we estimate that 16-34% of all awards will go unredeemed.

This includes expirations.



Environmental liabilities

• result from obligation to clean up, say, toxic waste or to

landscape sites no longer used for business

sometimes very hard to estimate the liability

indemnity claims after environmental catastrophes

• For example: Bayer AG

“[28 ] Other provisions

Other provisions are valued in accordance with IAS 37

(Provisions, Contingent Liabilities and Contingent Assets)

using the best estimate of the extent of the obligation. Interestbearing

provisions are discounted to present value. Personnel

commitments mainly include annual bonus payments, long

service awards and other personnel costs. The miscellaneous

provisions include € 131 million for restructuring. Provisions

for environmental protection relate to future relandscaping,

landfill modernization and the remediation of land

contaminated by past industrial operations. Sufficient

provisions have been established for such commitments.”

[Bayer AG, Annual Report 2000, notes to financial statements.]


Part II: Long-term liabilities


Definition of a bond

Why issuing bonds

Types of bonds

Accounting for bond issues

Accounting for bond retirements

• Long-Term Notes Payable

• Reporting and Analysis of Long-Term Debt



• securities issued by, e.g. corporations or

governmental agencies, to obtain large-sum longterm


• normally due ten to fifty years after issue

• various covenants and restrictions for protection of

both lenders and borrowers

• small denominations allows collection of large sums

of money

• interest payment

annually or semiannually

zero bonds

• „bond issue“ refers to total number of bonds issued

at one time


Why issue bonds?

• to obtain large sums of money for long time that

cannot be collected otherwise e.g. from banks

• debt financing has some advantages over equity


stockholder controls remains unaffected

tax savings: interest expense is tax deductible

leverage effect: spread between return on assets and

interest cost is usually positive and increases return on


• Stock financing vs. bond financing – an example

€ 2 million needed to fund a project

alternative I – issues 100.000 shares at current price of € 20

per share

alternative II – issuance of € 2 million, 9% bonds at face



Funds obtained by ... issuance of ... issuance of

additional shares


(250.000 shares (150.000 shares



Earnings before interest

and income taxes € 700.000 € 180.000 € 700.000 € 180.000

Interest 0 0 180.000 180.000

Earnings before income taxes € 700.000 € 180.000 € 520.000 € 0

Income taxes at 35% 245.000 63.000 182.000 0

Net income € 455.000 € 117.000 € 338.000 0

Earnings per share € 1,82 € 0,47 € 2,25 0

RoE 9.1% 2.34% 11.27% 0%

Note: Net income under bond financing is lower than under stock financing, but return

on equity may be higher.

Note that interest cost will increase with leverage because of an increasing default


Volatility of earning increases.


How to issue bonds ?

• usually, approval by board of directors and general meeting of

shareholders necessary; authorized:

number of bonds

total face value and nominal interest rate

• face value: amount of principal the issuer must repay at maturity

• nominal interest rate determines amount of cash interest the issuer

has to pay (also stated rate of interest)

bonds are taken by investment banks („underwriters“) and sold to

the public

underwriters buy bonds for resale or on a commission basis

bondholders are represented by a trustee, typically a large bank

contract between company and bank is called bond indenture

specifies terms of the bond, rights, privileges, and limitations of


• bondholders receive bond certificates as evidence of the

company‘s debt to the bondholder; bondholders are creditors !


Types of Bonds

• Secured and Unsecured Bonds

secured bonds: bondholders have a claim to certain assets

of the company upon default, e.g. mortgage bond

unsecured bonds: issued against general credit of borrower

(debenture bonds)

• Term and Serial Bonds

term bonds: all bonds of an issue mature on the same date

serial bonds: bonds mature over several maturity dates

• Registered and Coupon Bonds

registered bonds: corporation maintains record of all


coupon bonds: bond not recorded in the name of the owner;

transferable by delivery

cont‘d next page


Types of Bonds, cont‘d

• Convertible and Callable Bonds

convertible bonds: bonds that can be converted into

common stock at the option of the holder

• bonds furnished with a stock option to reduce coupon

callable bonds: bonds that can be retired before maturity at

the issuer‘s option

• Income and Revenue Bonds

income bonds: interest payment only if company is


revenue bonds: interest on the bonds is paid from specific

revenue sources


Bond Ratings

• Moody‘s Investors Service, Standard & Poor‘s Corp.

and Fitch are the dominating rating agencies

Original Rating


Default Rate*

AAA 0.52%

AA 1.31%

A 2.32%

BBB 6.64%

BB 19.52%

B 35.76%

CCC 53.38%

*Percentage of defaults by issuers rated by Standard & Poor‘s over the past 15 years, based on

rating they were initially assigned. /// Data: Standard & Poor‘s


Accounting for Bonds Payable

• bonds are traded in the capital market

market rate (effective yield) of interest and (current) bond

prices are inversely related

• yield rate: the virtual interest rate r a bond purchased at the

current price in the market yields to the owner

• Let c denote the coupon, B the bond price, T the maturity

(time to repayment), face value = F.

• Then r is the solution to the following equation:




t ⎟ +

t= 1 1



( 1 + r) ( + r)

• The yield for longer term debt uses to be higher than for

shorter term debt (normal term structure of interest rates)

• yield rate (bond price) depend on credit rating



Accounting for Bonds Payable

face value € 300.000

stated rate of interest 7%

market rate of interest 10% 12%

schedule of payments year 1 year 2 year 3 year 4 year 1 year 2 year 3 year 4

interest € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000

principal € 300.000 € 300.000

present value of interest € 66.567 € 63.784

present value of principal € 204.904 € 190.655

present value (selling price) of the bond € 271.471 € 254.440


Inverse relation between interest rates and bond prices













2 4 6 8 10 12 14 16 18 20 % r

bond #1 – stated

rate of interest of c 1

= 5% and term to

maturity of T 1

= 10

bond #2 -stated

rate of interest of

c 2

> c 1

and term to

maturity of T 2

=T 1

bond #3 -stated

rate of interest of

c 3

=c 1

and time to

maturity T 3

= 5 < T 1

assumption: bonds 1-3 have the same face value = 100


Stated rate of interest, market rate of interest,

effective rate of interest, and bond issue prices:

• The stated rate of interest i = c/F maydifferfromthe

market rate of interest

since the yield must be equal to the market rate the issue

price must be adapted accordingly:

• If the stated rate is

lower than the market rate: issue price lower than face

value, bond sells at a discount

higher than the market rate: issue price exceeds face value,

bond sells at a premium

• at the date of issue




t ⎟ +

t= 1 1



( 1 + r) ( + r)


must hold with a given market rate r


Issuing Bonds At Face Value (“at par”)

• stated rate of interest i = r market rate of interest

• accounting entry: cash proceeds = face value of the bonds

Example: 5-year term bonds, face value of € 900.000, dated

January 1, 2004, interest rate 8%, annual interest payments on

January 1.

To record issuance of bonds on January 1

Cash 900.000

Bonds Payable 900.000

To record accrued interest expense at year end (December 31)

Bond interest expense 72.000

Bond interest payable 72.000


Issuing Bonds at Discount

• stated rate of interest i < r market rate of interest

Example: as before, but market rate of interest now 10%

(stated rate of interest 8%).


t= 1










discount is 68.234

has to be amortized over the time to maturity

• usually: straight line method: 68.234 / 5 = 13.647


Issuing Bonds at Discount

To record issuance of bonds on January 1

Cash 831.766

Discount on Bonds Payable 68.234

Bonds payable 900.000

To record accrued interest expense and accrued amortization at year-end

(December 31)

Bond interest expense 85.647

Discount on Bonds Payable 13.647

Interest Payable 72.000

Balance sheet presentation:

Long-term liabilities

Bonds Payable € € 900 900.000 000

Less: Discount on Bonds Payable 68.234 112.159 € 831.766 € 787.841


Issuing bonds at a premium

• stated rate of interest i > r market rate of interest

Example: as before, but market rate of interest now 6%

To record issuance of bonds on January 1

Cash 975.823

Premium on Bonds Payable 75.823

Bonds payable 900.000

To record accrued interest expense and accrued amortization at year-end

(December 31)

Bond interest expense 56.835

Premium on Bonds Payable 15.165

Interest Payable 72.000

Balance sheet presentation

Long-term liabilities

Bonds Payable € 900 € 000 900.000

Add: Premium on Bonds Payable 75.823 133.901 € 975.823 € 1.033.901 37

Amortizing Bond Premium / Bond Discount

• the bond premium (discount) is amortized over the

life of the bonds

straight-line method

effective interest method

• Straight-line method

equal amounts of the premium (discount) are amortized in

each period, equal interest expense recorded in each period

interest expense = interest to be paid + amortized discount

amortized discount = (face value – issue price) / number of

interest periods

interest expense = interest to be paid – amortized premium

amortized premium = (issue price – face value) / number of

interest periods


Effective interest method

• interest expense = bond carrying value ×

effective rate of interest

discount amortization = interest expense –

interest to be paid

premium amortization = interest to be paid –

interest expense

increasing amounts are amortized in each period

• interest expense is equal to a constant percentage

of the carrying value of the bonds

• interest expense recorded is, thus, increasing

under discount

and decreasing under premium amortization


Effective interest discount amortization schedule for

an 8% bond sold to yield 10%

Annual interest paid interest discount unamortized bond carrying

period expense amortization discount value

issue date 68.234 831.766

1 72.000 83.177 11.177 57.057 842.943

2 72.000 84.294 12.294 44.763 855.237

3 72.000 85.524 13.524 31.239 868.761

4 72.000 86.876 14.876 16.363 883.637

5 72.000 88.364 16.364 0 900.000


The journal entry to record accrued interest at December 31, 2004, is

Bond interest expense 83.177

Discount on bonds payable 11.177

Bond interest payable 72.000

... and bond interest expenses will keep rising as the carrying value of the

bonds increases.


Effective interest premium amortization schedule for

8% bonds sold to yield 6%

Annual interest paid interest premium unamortized bond carrying

period expense amortization premium value

issue date 75.823 975.823

1 72.000 58.549 13.451 62.372 962.372

2 72.000 57.742 14.258 48.115 948.115

3 72.000 56.887 15.113 33.002 933.002

4 72.000 55.980 16.020 16.982 916.982

5 72.000 55.019 16.981 1 900.001


The journal entry to record accrued interest on

December 31, 2004, is

Bond interest expense 58.549

Premium on bonds payable 13.451

Bond interest payable 72.000

... and bond interest expenses will keep falling as the

carrying value of the bonds decreases.


Zero Bonds

• bonds that bear no interest (explicitly) and are issued solely for


• also called deep discount bonds

Example: An 8-year zero bond with face value of € 10 million

(10.000 x € 1.000 each) is issued and sold at a price of € 3.270.000.

• What is the implicit interest rate ?


= €10.000.000⋅(1

+ i)


i =


8 −1




• The implicit interest rate is 15%. It is the interest rate that

equates (in present value terms) the cash received with the

amounts to be paid in the future.


• The journal entry to record the issuance of this zero

bond is

Cash 3.270.000

Discount on Bonds Payable 6.730.000

Bond Payable 10.000.000

• The schedule for bond discount amortization under

the effective interest method of one bond (to keep

the numbers small) is

cash interest expense discount unamortized bond carrying

paid amortization discount value

issue date 673 327

1 0 49 49 624 376

2 0 56 56 568 432

3 0 65 65 503 497

4 0 75 75 428 572

5 0 86 86 342 658

6 0 99 99 244 756

7 0 113 113 130 870

8 0 130 130 0 1.000


Accounting for Bond Retirements

• Redeeming bonds at maturity

Bonds Payable 900.000

Cash 900.000

... at maturity, the book value (carrying value) of the bond is equal

to its face value.

• Redeeming bonds before maturity

Bonds payable 900.000

Discount on Bonds payable 31.239

Loss on bond redemption 103.239

Cash 972.000

• ... here is the journal entry for retiring the 8% bond sold to

yield 10% at the end of the 3rd period given the market interest

rate now has declined to 8%.


Disclosure Requirements for Long-Term Debt

• composition of long-term debt

• long-term debt maturing within one year should be

reported as a current liability

• maturities of long-term debt during each of the next

five years

• any special arrangements, e.g. refinancing,

conversion into stock, „off-balance-sheet financing“


Off-Balance-Sheet Financing

• imprecise definition of liabilities allows off-balancesheet


• credit agreements usually contain covenants, i.e.

limitations to issuing further debt

• companies try to find ways to get money without

having to diclose debt on the balance sheet

• Ways to do that

form a new entity together with some other company so that

it does not have to be consolidated. The entity then borrows

money The two companies guarantee debt repayment and

disclose this fact as a contingent liability.

sell assets at a high price to such an entity

forward sales of products: a bank buys oil or natural gas


mezzanine capital



• Finance Lease: the lessor makes a fixed asset (e.g. a

piece of equipment) available to the lessee keeping

legal ownership but transferring the economic risk

and rewards to the lessee.

• lessee pays prespecified installments

• Accounting treatment

• Lessee‘s balance sheet shows

asset and accumulated depreciation as if owned;

a lease liability: long term liability: total of payments owed

• Lessor‘s balance sheet shows

Lease receivable; asset is taken out of balance sheet as if


• Operating lease: lessor keeps asset, lessee shows

neither asset nor liability

this treatment is controversial



• Autolease offers a car leasing contract under the

following rules:

Initial payment € 10000

monthly installments: € 200

duration: 3 years, maximum kilometers: 15 000 per year

current operating costs are borne by the lessee

the lessee has no purchase option at the end of the

contract, car has to be returned to lessor

the car is leased „full coverage insured“ by the lessor who

gets the insurance benefits

• this is an operating lease

initial payment is prepaid rent.


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