Lecture 20-21 (Liabilities and equity)

Question 1

CURRENT LIABILITY

Answer 1

An entity shall classify a liability as current when:

a) it expects to settle the liability in its normal operating cycle.
b) it holds the liability primarily for the purpose of trading.
c) the liability is due to be settled within twelve months after the reporting period.
d) it does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period.

Question 2

Examples of current liabilities.

Answer 2

Bank finance, trade payables, taxation, accruals.

Question 3

CONTINGENT LIABILITIES

Answer 3

Obligations that are contingent upon (depend upon) some future event happening.

E.g.
Continuing legal proceedings against the company.
Guarantees to bank on behalf of third party borrowing.
Possible taxation penalties from a specific transaction undertaken.

Disclosed in notes to accounts rather than SoFP.

Question 4

NON CURRENT LIABILITY

Answer 4

Any liability that does not meet the definition of a current liability.
Liabilities that will be paid in more than one year.

Question 5

DEFERRED INCOME

Answer 5

Income received that relates to several future years.

Accruals concept tells us to match the income against the corresponding expenditure.

Question 6

Double entries for receiving deferred income.

Answer 6

When received:
Dr Bank
Cr Deferred Income

Each year, work out relevant proportion and:
Dr Deferred income
Cr Revenue

Question 7

Double entries for a loan.

Answer 7

REMEMBER work out how much loan would be repaid each month, extra is interest.
When a loan is first taken out record the cash received and show the liability to be repaid.
Dr Bank
Cr Loan

Repayment:
Dr Loan
Dr Interest (if interest)
Cr Bank (loan + interest)

Question 8

PROVISIONS

Answer 8

A provision is a liability of uncertain timing or amount.
Dr Provision
Cr Expense
Have to reverse when provision is released.

Question 9

Examples of provisions.

Answer 9

losses on contract
obsolescence of stock
costs related to closure of a division of the company
costs of decommissioning
cost of landscaping a site at the end of the period of use
warranties given repair of goods

Question 10

LOAN STOCK

Answer 10

If a company shows loan stock in its statement of financial position (balance sheet) this usually indicates that the stock is available for purchase and sale, in a manner similar to the purchase and sale of shares in a company.

Question 11

DEBENTURE

Answer 11

The legal meaning of the term debenture is a written acknowledgement of a debt. This means there will be a contract, in writing, between the company and the lender. The contract is called a debenture deed and is held by a trustee who is required to look after the needs of the lenders. If the company does not pay interest, or repay capital, on the due date, the trustee must take action to recover what is owed to the lenders. Debentures may be secured/unsecured, depending on what is stated in the debenture deed.

Question 12

BOND

Answer 12

Common use in USA ad name for loan capital. Found increasingly commonly in UK companies financial statements, particularly when they are raising finance in the international capital markets where US terminology is more familiar.

Question 13

COMMERCIAL PAPER, LOAN NOTES and BANK FACILITY

Answer 13

These are all names of short- to medium-term financing provided by banks or similar organisations. The interest payable is usually variable and the loan unsecured.

Question 14

UNSECURED LOAN

Answer 14

One where lender has no first claim to any particular assets of the company and, in the event of default, must wait for payment alongside all the other unsecured creditors. If there is no wording to indicate that he loan is secured, then the reader of financial statements must assume it is unsecured.

Question 15

SECURED LOAN

Answer 15

Means that the lender has first claim to named assets of the company. Where a debenture or loan stock is secured, and the company defaults on payment, the trustee for the debenture will take possession of the asset and use it to make the necessary repayment. In the event of the company not being able to pay al the amounts it owes, secured lenders come before unsecured lenders in the queue for repayment.

Question 16

What affects when a company repays loan?

Answer 16

Negotiations made on conditions of repayment. Some banks offer a range of repayment dates, allowing the company to choose when it will repay.
If the company needs the money, or else the interest rate is favourable, the company will borrow for longest period allowed under the contract.

If the company no longer needs the money, or else the interest rate is burdensome, the company will repay at the earliest possible opportunity.

Question 17

CONVERTIBLE LOAN

Answer 17

A source of finance which starts its life as a loan but, at some point in the future, may be converted to ordinary shares in the company. At the date of conversion, the lender becomes a shareholder.

If the project is not successful and the share price does not perform as expected, then the lender will not convert and will look for repayment of the loan on the due date.

Rate of interest normally lower because investors see potential additional rewards in the convertible loan.

Question 18

EFFECTIVE INTEREST RATE

Answer 18

Is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument.

Question 19

STEPPED BOND

Answer 19

A form of lending where the interest rate increases over the period of the loan.

Question 20

DEEP DISCOUNT BONDS

Answer 20

Issued at a price lower than its repayment amount.
The interest rate (coupon) paid during the life of the loan may be very low or there may be no interest paid at all during the period of the loan.

Question 21

INTEREST RATE SWAPS

Answer 21

Two companies can swap interest so pay on behalf of other companies. Can be a swap from variable to fixed rates.

Question 22

OWNER SHIP CLAIMS of a SOLE TRADER

Answer 22

Pay wages
Take goods
(DRAWINGS)
No formal approval required.

Question 23

OWNERSHIP CLAIMS of a COMPANY

Answer 23

Capital introduced = share capital 
Ordinary shares
- Carry voting rights
- Rank last on liquidation
Preference shares
- Redeemable
- Have fixed dividend rate
- Voting or non-voting 
- Cumulative
- Rank above ordinary shares for dividends on liquidation.

Question 24

FINAL DIVIDEND

Answer 24

At the end of the accounting year, after profits have been calculated, directors decide whether to pay a final dividend and, if so, how much.

Not a liability because it has not been approved by shareholders. It is a proposal from directors.

The proposal to pay the dividend is reported as an item in the directors’ report.

Dividends paid are reported in the Statement of changes in equity and notes.

Question 25

What information can a company provide to allow investors to decide if they want to purchase shares?

Answer 25

• Information required by Companies Act and Listing Rules
• Information on past financial statements
• Accountant’s report
• Forecast of profits
• Detail of assumptions made

Question 26

AUTHORISED (in terms of shares)

Answer 26

Amount that can be issued.

Question 27

Allotted, called up and fully paid.

Answer 27

Shares already issued.

Question 28

NOMINAL VALUE OF SHARES

Answer 28

Not necessarily the paid price.

Question 29

SHARE PREMIUM

Answer 29

Excess paid for share

Question 30

How to companies prevent issues with issuing more shares to raise money?

Answer 30

Rights issue:

• Offer existing shareholders option to purchase more shares.
• Maintains percentage shareholding for each owner.
• If price set below current market price of share this will be attractive.

Question 31

SHARE BUY BACK

Answer 31

Companies are permitted to buy back shares that have been issued.
The Companies Act sets limits on the proportion of shares that may be brought back from existing shareholders and set conditions on the availability of retained earnings to support the buy back.

When a company buys back its shares they may either cancel the shares or hold them as treasury shares. Treasury shares will be shown as a deduction from share capital in equity section of SoFP and transaction reported in statement of changes in equity.

Question 32

What are some reasons for buying back shares?

Answer 32

1. to return surplus cash to shareholders and reduce shareholding base.
2. to stabilise share prices in the short term where investors want to sell but for some reason there is a temporary lack of demand.

Question 33

Double entries for shares sold.

Answer 33

Dr Bank
Cr Share capital
Cr Share premium

Question 34

RETAINED EARNINGS

Answer 34

Accumulated profit/ loss from prior years
\+/- profit/loss that year
- dividends paid
=
Retained profit for year

Question 35

What other types of reserves are there?

Answer 35

Revaluation reserve

Exchange rate reserve

Question 36

STATEMENT OF COMPREHENSIVE INCOME

Answer 36

Changes in profit that are recognised but not realised so can’t go on income statement.

E.g. Revaluation of NCA or foreign currency gains or losses.

Starts with profit from income statement adjusted for any gains/losses that are recognised but NOT realised.

Question 37

STATEMENT OF CHANGES IN EQUITY

Answer 37

Shows movement in equity section of SoFP.
Shows profit or loss for period.
Movements in items reported directly to equity. (revaluation reserves)
Transactions with equity holders (movements in share capital and share premium and dividends paid).
Movement in retained earnings.
Changes in each class of equity.