Module 4:

Contingent Liabilities and Financial

Instruments
1

INTERNATIONAL FINANCE
AND ACCOUNTING
 Typical Liability Items (3M, 2022)
2

— Consolidated Balance Sheet

 Typical Liability Items (3M, 2022)
3

— Supplemental Balance Sheet Information

 Contingent Liability
4

• Typical liability is an amount that you already owe,

e.g., accounts payable—you already purchased
goods/service from suppliers and owe the invoiced
amount.

• A contingent liability is an amount that you could

potentially owe depending on the outcome of an
uncertain event. E.g., your company may incur a loss
due to ongoing lawsuits.

• What qualifies as contingent liability and when should

we record it?
 General Motors Case
5

General Motors personnel

understood in the spring of It wasn’t brought to the
2012 that there was a attention of its
safety issue at hand accountants until
(defective ignition switch) November 2013

May 2012 Nov 2013

During at least an 18-month period, accountants

at General Motors did not properly evaluate the
likelihood of a recall occurring or the potential
losses resulting from a recall of cars.
 Contingent Liability
6

— Journal entry:
Dr. Expense (loss)
Cr. Liability
Effect: increase expenses and increase liabilities

— What GM should have done in May 2012:

Evaluate the likelihood of a recall occurring & estimate the
potential losses resulting from a recall of cars
Dr. Recall loss
Cr. Provision for recall loss
 Contingent Liability
7

— Accounting practice should find its rationale in the

conceptual framework

— Let’s check the conceptual framework

q Definition of liabilities

q Recognition criteria
 Liability or Not?
8

— Assets
÷ Future benefits Equity = Assets – Liabilities
¢ Cash inflow
¢ Cost reduction Main components of equity:
¢ Receive service
• Capital transactions with owners
÷ Past transaction/events
¢ Purchase or self-creation • Income/Expenses accumulation
÷ Control
Income involves increase in equity
— Liabilities • Increase in Asset
÷ Future outflow of benefits • Decrease in Liability
¢ Cash outflow Expenses involve decrease in equity
¢ Provide service • Decrease in Asset
÷ Past transaction/events • Increase in Liability
÷ Obligation
 General Motors Case
9

General Motors personnel

understood in the spring of It wasn’t brought to the
2012 that there was a attention of its
safety issue at hand accountants until
(defective ignition switch) November 2013
Outflow?
Past events?
Obligation?May 2012 Nov 2013

During at least an 18-month period, accountants

at General Motors did not properly evaluate the
likelihood of a recall occurring or the potential
losses resulting from a recall of cars.
 Recognize or Not?
10

— Recognition means
Report as a line item on the financial statements, instead of
disclosing in the notes.

Two criteria:
¡ Future inflows or outflows of resources are probable

¡ The amounts are reasonably measurable

— Contingencies (e.g., recall of cars, lawsuits, business

restructuring, etc.):
÷ Qualify the definition of liabilities?
÷ Meet the recognition criteria to be recognized as liability?
 General Motors Case
11

General Motors personnel

understood in the spring of It wasn’t brought to the
2012 that there was a attention of its
safety issue at hand accountants until
(defective ignition switch) November 2013
Probable?
Measurable?
May 2012 Nov 2013

During at least an 18-month period, accountants

at General Motors did not properly evaluate the
likelihood of a recall occurring or the potential
losses resulting from a recall of cars.
 General Motors Case
12

General Motors personnel

understood in the spring of It wasn’t brought to the
2012 that there was a attention of its
safety issue at hand accountants until
(defective ignition switch) November 2013

May 2012 Nov 2013

During at least an 18-month period, accountants

at General Motors did not properly evaluate the
likelihood of a recall occurring or the potential
losses resulting from a recall of cars.
Paid a $1 million penalty to settle SEC charges.
 Blackberry Acct. Policy
13

Annual Report 2017

Notes 14 (c)
 Contingent Liability
14
— A contingent liability is an amount that you could potentially owe
depending on the outcome of an uncertain event.

— Contingent liability can arise from

¡ Legal obligation, or
¡ Constructive obligation (e.g., restructuring, customer loyalty programs)
÷ Constructive obligation: It’s NOT legal obligation
¢ It exists when a company’s past actions set a pattern of behavior and create a valid
expectation that it will take on the responsibilities

— Recognized under IFRS, when:

¡ There is a present obligations from past events
¡ It is probable that there will be an outflow of resources
¡ A reliable estimate of the obligation can be made

— IAS 37 Provisions, Contingent Liabilities and Contingent Assets provides

guidance for reporting liabilities (and assets) of uncertain timing,
amount or existence.
 Comparison of IFRS vs. U.S. GAAP
15

— The rules for recognition of a provision and disclosure of a

contingent liability is generally similar to the U.S. GAAP
¡ Not disclose if the likelihood is remote
¡ Disclose if possible but not probable
¡ Recognize if probable

— Difference between U.S. GAAP and IFRS (IAS 37):

¡ US GAAP provides no guidance on “probable”; in practice, likelihood in
between 70 to 90%
¡ IAS 37 defines “probable” as “more likely than not”, i.e., >50%
¡ U.S. GAAP estimates contingent liabilities using the low end of possible
amounts
¡ IAS 37 requires provision to be measured at the best estimate, discounted to
present value. The best estimate is the probability-weighted expected value
when a range of estimates exist or the midpoint of the range if all estimates
are equally likely
 Example: Provision for Litigation Loss
16

What if under U.S. GAAP and assuming it is 75% probable?

How to recognize the amount in journal entry?

Litigation Loss $1,000,000

Provision for Litigation Loss $1,000,000
Example: Provision for Litigation Loss
17
 Restructuring 1

18

A program planned and controlled by management that

changes either:
• The scope of business or the manner in which business is
conducted.
Examples of restructurings:
• The sale or termination of a line of business.
• The closure of business locations in a country or region.
• A change in management structure.
• A fundamental reorganization that has a material effect
on the nature and focus of the entity’s operations.
 Restructuring 1

19

Under IAS 37, a restructuring provision is recognized when:

• Detailed formal plan for restructuring.
• Valid expectation that the plan will be carried out.
• Cost is reasonably estimable, and the period of time is
reasonable.

U.S. GAAP: no recognition until a liability has been incurred.

• Thus, IFRS most likely shows loss earlier.
 Restructuring Example
20

— GM as an example
¡ November 2018: GM announced plans to cut production at several
factories and reduce its salaried workforce by 15 percent, more than
14,000 employees
¡ The reductions are part of a massive restructuring that will cost up to
$3.8 billion
¡ After announcing the restructuring plan in November 2018, GM
recorded restructuring cost in Q4 of 2018 as well as in the annual
report of 2018
Dr. Restructuring expense
Cr. Provision for termination benefits
 Restructuring Exercise
21

— The board of directors of Chestnut Inc. approved a restructuring

plan on November 1, Year 1. On December 1, Year 1, Chestnut
publicly announced its plan to close a manufacturing division in
New Jersey, and the company’s New Jersey employees were
notified that their jobs would be eliminated. Also on December 1,
Year 1, to ensure an orderly transition, management promised a
termination bonus of $10,000 to any employee who remains with
the company until his or her position is terminated in the fourth
quarter of Year 2. Chestnut estimates it will pay termination bonuses
to 120 employees at the end of Year 2, for a total of $1,200,000. The
present value of the estimated termination bonus is $1,000,000.
— Determine the provision that should be recognized for Chestnut’s
restructuring plan. Identify the date on which journal entries should
be made and the amounts to be recorded.
 Case Analysis
22

— Choose a multinational corporation that reports or discloses

about contingent liabilities (or contingencies)
Hint: more likely to find contingencies in high-tech, health care industries, vehicle
manufacturers, or companies that have announced restructuring plans.
— Find information about the company’s contingent liabilities
(or contingencies) in its annual report
¡ What are the main sources of the company’s contingent liabilities (e.g.,
lawsuits, restructuring, etc.)
¡ What’s the company’s accounting policy regarding contingent liabilities?
¡ Did they record contingent liabilities as a line item or disclose them in
the notes? What are the reasons they provide for this practice?
¡ Provide 2-3 examples of the events that the company discussed in the
annual report in relation to the contingent liabilities
¡ Something new your group learned from this analysis
— Summarize the information into 1-2 slides and designate one
or two speaker(s) to present to class
 Financial Instruments
23

Definitions
— IAS 32—a financial instrument is any contract that
gives rise to both a financial asset of one entity and a
financial liability or equity instrument of another
entity
— Example
¡ Shares: asset for investors; equity for the issuing company

¡ Bond: asset for bondholders; liability for the issuing company

 Financial Instruments
24

— Financial asset
¡ Cash
¡ Contractual right to:
÷ Receive cash or other financial asset
÷ Exchange financial assets or financial liabilities
¢ under potentially favorable conditions
¡ An equity instrument of another entity
¡ A contract that will or may be settled in entity’s own equity
instruments (e.g., warrants, preferred shares, share-based payment
arrangements)
÷ Equity instrument: any contract that evidences a residual interest in
the assets of an entity after deducting all of its liabilities.

— Example: cash, receivables, investments in shares/bonds

 Financial Instruments
25

— Financial liability
¡ A contractual obligation to
÷ Deliver cash or another financial asset
÷ Exchange financial assets or financial liabilities
¢ Under potentially unfavorable conditions

¡ A contract that will or may be settled in the equity’s own equity

instruments (e.g., warrants obligations, share repurchase
contracts)

— Example: payables, loans borrowed, issued bonds

 Equity Investment
26

Intent: to sell and profit from the change of price

I. Investment held for trading (HFT) Non-strategic
Investment

Strategic
Intent: to influence or control the investee Investment
I. Investor has control over the investee
II. Investor has significant influence on the investee
 Financial Assets
27

— Classification of Financial Assets

÷ Fair value through profit or loss (FVPL)
÷ Held-to-maturity investments
¢ e.g., long-term share investment, investment in bonds

÷ Loans and receivables

÷ Available-for-sale financial assets

— Measurement of Financial Assets under FVPL

¡ Initial—recorded at amount paid

¡ Subsequent—fair value (e.g., current market price)

Accounting Method for Share Investment
28

Significant
Influence

Control

Held For
Trading
(HFT)
 Equity Investment (Non-Strategic)
29

Investment held for trading (HFT)

¡ Acquired for the purpose of selling in the near term
¡ Part of a portfolio for short-term profit-taking
¡ All derivatives (speculative investments)

Accounting: Fair value through P/L (FVPL)

¡ Investment reported at fair value on the balance sheet
¡ Changes in fair value: unrealized gains or losses
¡ Unrealized gains or losses flow through Net Income
 FVPL Investment Example
30

Your company purchased 10,000 Apple Inc. common shares during 2019.
Purchase price was $120 per share. These shares are for short-term profit. Fair
value of the shares was $1,160,000 on December 31, 2019 (which is the fiscal year
end):
Investments Book Value Fair Value
Common shares of Apple $1,200,000 $1,160,000

Entry to record adjustment on Dec 31, 2019:

Loss on HFT Investment 40,000
HFT Investments 40,000

Investment sold on May 1, 2020 at $150 per share

Cash 1,500,000
Gain on HFT Investment 340,000
HFT Investments 1,160,000
 FVPL Investment Exercise
31

Suppose your company invested in Loblaw (Canadian Supermarket Chain)

• Purchased 1,000 Loblaw shares on Aug 12, 2022. Designates them as FVPL
investment.
• On Dec 30 2022 (i.e., fiscal year end), reported these shares at their fair value.
• Sold 500 shares on Feb 7, 2023.
• Sold the rest on Mar 16, 2023.

Required:
a. Find Loblaw share prices on the above dates (Google search, use close price)
b. Provide journal entries to record these transactions
c. What’s the total gain or loss from this investment
d. Determine the impact of this investment on your company’s net income of 2022
and 2023
 Bonds: An Introduction
32

— A bond is simply an I OWE YOU.

— Say, for example, Cynthia wants to raise $10,000 for
her new business venture.
— Instead of borrowing from the bank, she issues her
own Cynthia bonds to 10 of friends.
— The conditions of Cynthia bond
¡ a face value of $1000
¡ 10% annual interests (coupons) and
¡ a maturity of 2 years
 Bonds: An Introduction
33

¡ What this means is that, by year end Cynthia’s friends are

going to get their interests back $100 (e.g. $1000 x 10% =
$100).
¡ When this bond matures after 2 years (i.e. the second year),
they are going to get the principal plus all the interests for that
bond.

¡ Who is the borrower?

÷ Cynthia
¡ Who is the lender?
÷ Cynthia’s 10 friends
 Bonds: An Introduction
34

— A bond is a formal arrangement between the issuer

of the bond and the holder of the bond

— Bonds are issued to multiple lenders called

bondholders

— The bondholder lends a fixed amount to the issuer,

and the issuer promises to pay a fixed amount at
some later date, along with regular payments of
interest over the life of the bond
 Bonds: An Introduction
35

• Issuer of the bond – borrower

• Holders of the bond – creditor

Liability Asset (Investment)

Cynthia friends
 Bond Basics
36

— A bond is characterized by the following terms:

1. Face value: the principal amount that investors will receive at maturity
(denomination)
2. Maturity: the set date when the principal amount of the bond is repaid

3. Term to maturity: the time between bond issuance and maturity

4. Interest rate: at this rate investors will receive interest (annually or

semi-annually)
5. Price of the bond: how much investors pay for the bond
Example: The terms of Cynthia bond
• Face value: $1000
• 10% annual interest rate
• Maturity: 2 years from today
• Price of the bond: $1000 (at par)
 Bond Prices
37

Bond prices are quoted at a percentage of their face value

— A $1,000 bond quoted at 100 has a price of $1,000 ($1,000 × 1)

— A $1,000 bond quoted at 101.5 has a price of $1,015 ($1,000 ×

1.015)
— A $1,000 bond quoted at 98.5 has a price of $985 ($1,000 ×
0.985)

An example of bond price information:

Bonds Coupon Maturity Price Yield
Telus Series 5.75 September 8, 99.782 5.779
CAK Notes 2033
 Bond Prices
38

— A bond can be issued at:

¡ Par (maturity, face, or principal) value: A $1,000 bond
issued for $1,000.
¡ Premium: A price above par value. A $1,000 bond issued for
$1,015; the premium is $15
¡ Discount: A price below par value. A $1,000 bond issued for
$980; the discount is $20

— Bonds sell at a premium or a discount when the

interest rate promised by the bond is different from
the interest rate required by the investors.
 Issuing Bonds at Par
39

— Assume UVW Corporation issued $100 million 6% bonds

at par on Jan. 2, 2023. The bond matures in 10 years.
— Interest is paid semi-annually on Jan. 2 and July 2

— The issuance entry is:

Jan 2 Cash 100,000,000
Bonds Payble 100,000,000
 Issuing Bonds at Par
40

Assume interest is paid semi-annually on Jan. 2 and July 2

— To record the first semi-annual interest payment, July 2,

2023:
Jul. 2 Interest Expense 3,000,000
Cash 3,000,000

— To record the accrual of the second semi-annual interest

payment, on December 31, 2023:
Dec. 31 Interest Expense 3,000,000
Interest Payable 3,000,000

— To record the interest payment on January 2, 2024

Jan 2 Interest Payable 3,000,000
Cash 3,000,000
 Issuing Bonds at Par
41

— To record the principal payment at maturity, Jan.

2, 2032:

Jan 2 Bonds Payable 100,000,000

Cash 100,000,000
 Bonds Issued at Par Between Interest Dates
42

Assume UVW Corporation issued $100 million 6% bonds at par on

Mar. 1, 2023, rather than Jan. 2, 2023

— On Mar.1, Firms report bonds to be selling at a stated price “plus accrued

interest”.
— Issuance entry:

Mar.1 Cash 101,000,000

Bonds Payble 100,000,000
Interest Payable 1,000,000
(100,000,000*6%*(2/12))
 Bonds Issued at Par Between Interest Dates
43

— To record the first semi-annual interest payment on July 2,

2023 (Interest Prorated for 4 months) :
Jul. 2 Interest Expense 2,000,000
Interest Payable 1,000,000
Cash 3,000,000
— Record the accrual and the payment of the second semi-
annual interest on December 31 and January 2:
Dec. 31 Interest Expense 3,000,000
Interest Payable 3,000,000
Jan 2 Interest Payable 3,000,000
Cash 3,000,000
 Purchasing Bonds at Par
44

— Assume UVW Corporation issued $100 million 6% bonds

at par that mature in 10 years on Jan. 2, 2023.
— Interest is paid semi-annually on Jan. 2 and July 2
— Your company purchased $1 million UVW bonds on the
issuance day.

Now take the position of the bond holder.

Record the purchase of the $1 million UVW bond:
Dr. Investment in bonds 1,000,000
Cr. Cash 1,000,000
 Purchasing Bonds at Par
45

Assume your company purchased $1 million UVW bond

issued at par that mature in 10 years on Jan. 2, 2023; 6%
interest is paid semi-annually on Jan. 2 and July 2
— To record the receipt of first semi-annual interest, July 2, 2023:
Jul. 2 Cash 30,000
Interest revenue 30,000

— To record the accrual of the second semi-annual interest, on

December 31, 2023:
Dec. 31 Interest receivable 30,000
Interest revenue 30,000

— To record the interest payment on January 2, 2024

Jan 2 Cash 30,000
Interest receivable 30,000
 Bond Interest Rates
46

— The market price of a bond is the amount that

investors are willing to pay for the present value of
1) the principal payment plus What
borrower
2) the cash interest payments offers
— Two interest rates work to set the price of the bond
¡ Stated or contract rate: this determines the cash interest
paid by the borrower
¡ Market or effective rate: this is the rate investors demand
for lending their money What
investor
demands
 Bond Interest Rates
47

— Example: Bond with a stated (contract) interest rate of 9%

Issuing Shares Versus Bonds
48