ECN 240 Lecture 7

Lecture Overview

  • Focus on Liabilities and related accounting aspects.

Structure of the Lecture

  • Liabilities: definitions and key terminology.

  • Uncertain liabilities: provisions and contingent liabilities.

  • Accounting for provisions.

  • Bad and doubtful debts.

Learning Objectives

  • Understand different types of liabilities.

  • Learn about provisions and their accounting treatment.

  • Gain knowledge on accounting for bad and doubtful debts.

Definition of Liabilities

  • IASB Definition: A liability is a present obligation arising from past events, expected to result in an outflow of resources embodying economic benefits.

  • Key Parts:

    • Present obligation exists now.

    • Arises from past events.

    • Involves outflow of economic resources (e.g., cash or other assets).

Classification of Liabilities

  • Current Liabilities:

    • Expected to be settled in normal operating cycle.

    • Held primarily for trading purposes.

    • Due within twelve months of balance sheet date.

    • No unconditional right to defer settlement for at least twelve months.

  • Non-current Liabilities:

    • All other liabilities not classified as current.

    • Reference: IAS1.

Disclosure Requirements

  • Users are interested in:

    • Total amount owed (capital/principal).

    • Due date (maturity profile).

    • Cost of liability (interest rate).

    • Guarantees attached (e.g., secured liabilities like mortgages).

  • Disclosure vs. Recognition:

    • Recognize: Include in financial statements.

    • Disclose: Include in the notes (less visibility).

Example: J Sainsbury Plc 2023 - Balance Sheet Extract

  • Current Liabilities (as of 4 March 2023):

    • Trade and other payables: £4,837m

    • Amounts due to Financial Services customers: £4,880m

    • Borrowings: £53m

    • Lease liabilities: £1,533m

    • Total Current Liabilities: £11,614m

  • Non-current Liabilities:

    • Borrowings: £603m

    • Lease liabilities: £4,956m

    • Total Non-current Liabilities: £7,291m

  • Total Liabilities: £18,905m

Accounting Policies for Liabilities

Trade Payables

  • Initially recognized at fair value, measured at amortized cost.

Non-current Liabilities Key Terms

  • Secured vs. Unsecured Loans:

    • Secured loans have collateral; unsecured loans do not and are riskier.

  • Bonds & Debentures:

    • Bonds are marketable loans; debentures are unsecured.

  • Finance Lease Obligations:

    • Amounts owed on leased assets classified as liabilities.

Covenants Related to Liabilities

  • Covenants: Legal conditions protecting creditors, typically involving limits on leverage ratios.

Accounting for Liabilities

  • Key transactions:

    • Interest:

      • Debit interest expense (income statement).

      • Credit cash.

    • Principal (Capital):

      • Debit loan account (balance sheet).

      • Credit cash (repayment).

Uncertain Liabilities

  • Types:

    • Provisions: Probable liabilities with uncertain timing or amount (more likely than not).

    • Contingent Liabilities: Possible liabilities dependent on uncertain future events.

Provisions Definition & Accounting

  • Provisions recognized if:

    • Present obligation from past event.

    • Payment is probable.

    • Amount can be estimated reliably (IAS 37).

  • Examples: Warranties, abandonment provisions, restructuring provisions.

Provisions - Case Study: PPI Scandal

  • Background: UK banks mis-sold payment protection insurance (PPI).

  • Regulatory obligation to refund customers led to large provisions (e.g., Lloyds: £19 billion).

Accounting for Provisions

  • Recognize provisions based on obligation, probability, and estimable amounts.

  • Use experience and probability for recurring events.

Provisions in Financial Statements

  • Increase in provisions generates a liability and cost in the income statement.

  • Provisions can be reversed if costs are less than expected.

Bad and Doubtful Debts

  • Bad Debts: Completely irrecoverable accounts.

  • Doubtful Debts: Uncertain recoverability with some expected cash.

  • Adjustments for these made after trial balance preparation.

Accounting for Bad and Doubtful Debts

  • Reflect prudence and matching principles.

  • IAS 39 requires proof of impairment post-recognition.

Bad Debt Write-Off Example

  • Writing off irrecoverable receivables reduces both assets (receivables) and increases expenses in the income statement.

Doubtful Debts Provision Accounting

  • Establish provision for doubtful debts based on estimated recoverability.

  • Changes in provisions reflect on income statements and affect profit.

Collective Provision for Doubtful Debts

  • Conditions must be met to create collective provisions on groups of similar receivables.

  • Based on historical experience, managed carefully to prevent manipulation.

Contingent Liabilities

  • Definition: Possible obligations dependent on uncertain future events (e.g., legal cases, government investigations).

  • Not recognized on the balance sheet; disclosed in notes instead.

Contingent Assets

  • Possible future assets not recognized on the balance sheet; only disclosed in notes.

Earnings Management Risks with Provisions

  • Provisions may be manipulated to adjust profits in financial reporting.

  • New management often increases provisions to later reverse them for profit boosts.

Profit Smoothing Techniques

  • Provisions used strategically to achieve stable profit reporting over time.

  • Stricter accounting rules have been established to mitigate these practices.