PART TWO

Measuring and Reporting

Assets, Liabilities & Equity
Chapter 9

Liabilities

Lata Chakravarthy

Learning Objectives

To learn about the characteristics of different

types of liabilities and how companies report the
same

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What are Liabilities?

Liabilities are present obligations arising from past
events
Which involves future outflow of resources for
settlement
For an obligation to be recognized as a liability, it should
be unavoidable regardless of what the company does.

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Classification of liabilities
Current & Non-Current
Definite liabilities (Accounts Payable, Bills
Payable, Accrued expenses, current maturities of
long term debt, bank overdraft) & Estimated
liabilities- Liabilities of uncertain time or amount
(Income tax, product warranties, pensions)
Secured (by pledge, hypothecation or mortgage of
specific assets or asset classes) & Unsecured
Contingent Liabilities- Either the occurrence of
the event (from which a future obligation will
arise) is uncertain or the amount of obligation
cannot be reasonably ascertained.
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Classification of liabilities
Current & Non-Current
Current
Trade payables, Bills payable, Bank overdraft,
Income tax payable, Unearned Revenue, Accrued
Expenses

Non-current
Debentures Payable (also known as bonds)
Long term bank loans
Pensions payable

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Non-Current Liabilities
Debentures Payable- Characteristics

Secured and Unsecured

Term & Serial
Convertible, partly convertible and non-convertible
Callable
Zero-coupon bonds or deep discount bonds

Debenture Trustee ( a bank) ensures that issuer

complies with terms of Debenture Trust Deed.
Debenture ratings- assigned by credit rating
agencies- professional judgement, not a
recommendation to buy/sell
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Non-Current Liabilities
Debentures Payable
Debentures may be issued at par, discount or
premium to face value
Debentures being financial liabilities, are
carried at fair value. Face value is not entered in
accounting records.
Effective interest method is used for
amortization of debenture discount or premium

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Non-Current Liabilities
Yield or Market Interest rate Effective rate of
interest
Yield is the rate of interest that investors expect
on debentures of a particular risk category
Greater the risk, higher the required yield
Yield varies based on several factors:

RBI bench mark rates

Expected inflation
Liquidity conditions
Level and terms of government borrowings

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Non-Current Liabilities
Yield and Coupon

Coupon is the rate at which annual or semi-annual

interest is paid
Coupon applied to face value gives amount of periodic
interest payment.
Fair Value of a debenture/loan is the sum of present value
of the principal and interest payments.
Discount rate used to arrive at the present value is the
yield
Yield is the market interest rate.

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Non-Current Liabilities
Yield and Coupon

If coupon = Yield, Fair Value = Face Value (debenture

will be issued at face value)
If coupon > Yield, Fair Value > Face Value (debenture
will be issued at a premium)
If coupon < Yield, Fair Value < Face Value (debenture
will be issued at a discount)

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Non-Current Liabilities
How to compute issue price
Issue price obtained by discounting the following
two kinds of cash flows using yield as the
discount rate
1. A series of interest payments
2. A single principal repayment at maturity

Problem 9A.1

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Non-Current Liabilities
Problem 9A.1: FV: 10,00,000 Coupon 10%
Term 15 years
a) Yield= 18% (9% semi-annual)
PV of 30 semi-annual payments @ 9% =
50000 x 10.2737 =513650
PV of 10,00,000 principal payment @ 9% = 10,00,000 x 0.754= 75400

Total (Issue Price)

589050
b) Yield = 10% (Coupon) Issue Price = 10,00,000
c) Yield = 8% (4% semi-annual)
PV of 30 semi-annual payments @ 4% =
50000 x 17.2920 =513650
PV of 10,00,000 principal payment @ 4% =10,00,000 x 0.3083= 75400

Total (Issue Price)

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1172900

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Non-Current Liabilities
Other Long term borrowings
Mortgages Payable
Conditional mortgage and equitable mortgage
Payments are made in equal instalments- interest
portion recorded as expense and principal portion
reduces mortgage payable

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Non-Current Liabilities
Other Long term borrowings
Leases
Operating Lease (Short-term rental arrangement)
Lease rentals are treated as expense by lessee

Finance Lease (equivalent to obtaining secured

loan)

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Non-cancellable lease contract

Risks and rewards transferred
Lease period substantially (>75%) covers life of asset
Lease rental substantially (>90%) recovers fair value of
asset

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Accounting for finance lease

Compute present value of minimum lease payment

using lessees incremental borrowing rate as
discount rate
Take the lower of fair value and present value of
minimum lease payments and record the lease as
asset and related liability at that value.
Provide for annual depreciation
Segregate lease payments into interest expense
and reduction of finance lease obligation.
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Other liabilities- Employee benefits

Short term benefits (salaries, medical care,

housing, car, paid annual leave, profit-sharing,
bonuses)
Post-employment benefits (PF, gratuity, pension,
post-employment healthcare) Deferred
Contribution plans and Deferred Benefit plans
Other long term benefits (long service leave,
sabbatical leave, deferred compensation)
Termination benefits
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Contingent Liabilities
Possible obligations arising from past events
Whose existence will be confirmed by
occurrence or non-occurrence of uncertain
event/s in future (which may not be in the
companys control) or
Present obligations from past events but
It is probable that may not be a future outflow to
settle the obligation or
A reasonable estimate of the amount of obligation
cannot be made
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Liability or contingent liability?

In 2011, Suzlon did not provide for the redemption
premium on its foreign currency convertible bonds
(FCCB) that were to mature in 2012 (the company
eventually defaulted). It treated it as a contingent
liability (off the balance sheet). The companys
argument was that since it wasnt clear how many
bondholders would convert, making a provision for
it was difficult.
But Suzlons share price was a sixth of its
redemption value then, says an expert. It was
likely that bondholders would choose to redeem.
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Liability or contingent liability?

The general practice of treating redemption premium as a
contingent liability cannot be justified, says Malegam.
As long as the bond is convertible at the option of the
holder, the company must still treat it as a redeemable bond
and provide for the redemption premium.
Suzlon says that if the bonds are called for redemption, it
has adequate share premium reserve to cover payments.
Analysts say given the companys finances, it would have
been inclined to present a favourable debt-equity ratio. A
company spokesperson denied this, saying, We are of the
firm view that a degree of leverage does not and should
not lead to a substantially different accounting practice.
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Liability or contingent liability?

Essar Oil was allowed to delay payment of sales
tax in Gujarat for 17 years. In 2010, when Essar
Energy, the UK-listed parent of Essar Oil, went for
an IPO, its income statement showed the entire
sales tax collected as a revenue item, and no
provision for a potential repayment. That helped
the company show a profit of $40 million in the
preceding nine months, instead of a loss of around
$133 million (the sales tax shown as revenue was
$173 million).
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Liability or contingent liability?

To compound matters, the Gujarat
government was contesting Essars
eligibility to participate in the tax deferment
scheme, calling for an immediate refund.
The case was in the Supreme Court, and an
adverse ruling could mean a payout of Rs
6,300 crore, compared to the companys
annual profit of around Rs 400 crore then.

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Liability or contingent liability?

Company executives said that as per their
lawyers advice, they expected a favourable
outcome to the case. In January 2012, Essar
lost; neither the Supreme Court nor the
Gujarat government was willing to accept
the companys plea of not having sufficient
monies. Essar Oil finally agreed to pay in
deferred instalments.

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ACCOUNTING FOR TAXES ON

INCOME
Current Tax
Tax payable on taxable profit
Usually paid in instalments as advance tax
Excess payment is current tax asset
(refund receivable)
Short payment is current tax liability (tax
payable)
Minimum Alternate Tax
Current Tax, if paid on taxable profit is normal
tax
If paid on accounting profit, it is MAT
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ACCOUNTING FOR TAXES ON

INCOME
Minimum Alternate Tax
Current Tax, if paid on taxable profit is
normal tax
If paid on accounting profit, it is MAT
Companies must pay higher of normal tax
and MAT.
However, MAT paid can be carried forward
and adjusted against normal tax payable, in
a specified number of years. This is called
MAT credit.
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Deferred Taxes
Systems of computing taxable income and
accounting profit differ because the objectives
are different.
Taxable income is determined in accordance
with income tax regulations whereas,
Accounting Profit is measured in accordance
with GAAP and the accounting policies
adopted by the company.
Therefore income tax expense and income
tax payable can be different.
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ACCOUNTING FOR TAXES ON

INCOME
Permanent differences are caused by items
that are included in the calculation of either
taxable income or accounting profit, but not
both.
Example: Concessional taxation or complete
exemption of certain kinds of income such as
export income or profits earned in notified
special regions.
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ACCOUNTING FOR TAXES ON

INCOME
Temporary differences (timing differences) are
caused by items that are included in the
calculation of both taxable income and
accounting profit but in different accounting
periods.
Example: Under Companies Act, straight line
depreciation is allowed- the rate is lower than
the corresponding written down value rate
allowed under Income Tax Act.
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ACCOUNTING FOR TAXES ON

INCOME
Temporary differences Examples (contd):
Warranty provisions are made in each period to match
sales revenue, but income tax authorities will allow
them when they are actually paid.

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ACCOUNTING FOR TAXES ON

INCOME
Since temporary differences reverse in
subsequent periods, their tax effects are
included in the income tax expense in the
profit & loss account.
Tax effect accounting is the method of
accounting for the tax effects of temporary
differences- requires determining Tax Base
and Temporary Differences.
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DEFERRED TAX LIABILITY

A deferred tax liability can be thought of as

the tax expected to be paid in future years on
income that has already been reported in the
income statement but which, because of the
tax law, has not yet been taxed.

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DEFERRED TAX LIABILITY

A deferred tax liability is the deferred tax effect of
taxable temporary differences.
The income tax expense for a period is
1. Tax payable on taxable income plus
2. Tax effect of temporary differences deferred to or
from other periods.

The amount of deferred tax liability = Amount of

temporary differences x income tax rate.

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DEFERRED TAX LIABILITY

For the example in excel sheet,
The amount of deferred tax liability = Amount of
temporary differences x income tax rate.
Deferred tax liability at the end of Year 1 = Rs.
1500 i.e.,
5000 x 30%
The income tax expense for Year 1 = Rs. 12,000 i.e.
Current tax = Rs. 10500
Deferred tax = Rs. 1500
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DEFERRED TAX LIABILITY

The income tax expense for year 1 is recorded as

follows:
Income tax expense a/c Dr. 12,000
Income tax payable a/c
Deferred tax liability a/c

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10,500
1,500

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DEFERRED TAX LIABILITY

At the end of Year 1, deferred tax liability will show a
balance of Rs.1,500.
At the end of Year 2, deferred tax liability will show a
balance of Rs.3,000.
When income tax expense for year 2 is recorded, the
following entry will be passed:
Income tax expense a/c Dr. Rs. 12,000
Income tax payable a/c
10,500
Deferred tax liability a/c
1,500
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DEFERRED TAX LIABILITY

The balance in deferred tax liability would be

reduced to zero when income tax expense for year 3
is recorded:
Income tax expense a/c Dr. Rs. 12,000
Deferred tax liability a/c Dr. Rs. 3,000
Income tax payable
Rs.15,000

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DEFERRED TAX ASSET

A deferred tax asset is recognized when the

charge in the financial statements is more than
the amount allowed for tax purposes.

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When does a company create a deferred

tax asset?
For example
Provisions made at the discretion of the management, such
as those for bad debts, which are not fully recognized by
tax authorities.
Expenses which are accounted for on an accrual basis
(that is, when they become due and not when they are
actually paid). Companies may charge off duty, cess and
tax dues against profits when they become due, but they
would be recognized for tax computation only when
actually paid.
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When does a company create a deferred

tax asset?
In such cases, a company is actually pre-paying
taxes pertaining to future years. For the year, the
profits that the taxman calculates would be higher
than those computed in the company's books of
accounts.
So, while the company shells out a
disproportionately high tax in the current year, it
would save on tax in the years when the expenses
or provisions actually materialize.

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DEFERRED TAX ASSET

Example
Bad debt provision reported is Rs. 10,000
Bad debts written off: Rs. 3,000
Tax department allows only the amount written off as
expense.
Assuming tax rate of 30%, firm will recognize deferred
tax asset of Rs. 2,100 (Rs. 7,000 * 0.30)
Accounting Standards specify stringent conditions for
recognition of deferred tax assets.
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When does a company create a deferred

tax asset?

Another situation where a company may actually

owe lower taxes on its future profits is
when a company has accumulated losses in its
balance-sheet. It can carry forward and set off
these losses in future years, against its profits, if it
does return to the black. If it does so, this will
significantly reduce its tax liability.

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How should a company account for a

deferred tax asset?
A company may recognize the excess tax
paid over and above the tax liability
calculated on the accounting profits as a
"deferred tax asset".

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How should a company account for a

deferred tax asset?
However, in the interests of conservative
accounting, companies should recognize such
deferred tax assets only if they actually anticipate
that their income in future will be enough to allow
the company to set off the losses or the excess tax
paid.

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Why account for deferred taxes?

By recognizing deferred tax liabilities in its books,
a company makes sure that the tax liability for any
particular year is reflected in that year's financials
and does not carry over to future profits.
It brings investors one step closer to understanding
exactly how much of a company's profits for a
period are from its operations (rather than from
fiscal savings).

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