Tools for Business Decision-Making Fourth Canadian Edition Financial Accounting: Prepared by: Peggy Coady Memorial University of Newfoundland & Catherine Seguin University of Toronto

Reporting and Analyzing Liabilities Chapter 10

3 Liabilities Obligations resulting from past transactions Classified as current and long- term Liabilities must be settled in the future by transfer of assets or services

Chapter 10 4 Current Liabilities Expected to be paid: –From existing current assets or through the creation of other current liabilities –Within one year Debts that do not meet both criteria are long-term liabilities

Chapter 10 5 Current Liabilities Types of current liabilities include: –Accounts payable and accrued liabilities –Operating line of credit –Notes payable –Sales taxes –Property taxes –Payroll –Current maturities of long-term debt

Chapter 10 6 Accounts Payable Amounts owing to creditors Normally due in 30 days Interest charged on overdue accounts only

Chapter 10 7 Operating Line of Credit Prearranged agreement between a company and a lender to allow the company to borrow up to an agreed-upon amount May result in bank indebtedness

Chapter 10 8 Notes Payable Often used instead of accounts payable Provide written documentation, if needed, for legal remedies Normally has interest attached Used for short-term and long- term financing needs

Chapter 10 9 Sales Tax Payable Federal Goods and Services Tax (GST) Provincial Sales Tax (PST or QST) Harmonized into one combined sales tax (HST) in some provinces

Chapter Sales Tax Payable May or may not be included in sale price Must be remitted periodically to respective governments

Chapter Property Taxes Payable Businesses that own property pay property taxes for each calendar year to municipal or provincial governments Property taxes are calculated at a specified rate for every $100 of the assessed valued of the property

Property Taxes Payable Upon receipt of the property tax bill (assume March), an expense is recorded for the months that have passed (assume January and February) Chapter 10 12

Property Taxes Payable When paid (assume May), expense is recorded for additional months that have passed, and prepaid is set up for remaining months Chapter 10 13

Property Taxes Payable Prepaid is cleared to expense at the end of year Chapter 10 14

Payroll and Employee Benefits Payable Employee payroll deductions –Canada pension plan (CPP) –Employment insurance (EI) –Federal and provincial income taxes –Other deductions at source Chapter 10 15

Chapter Payroll and Employee Benefits Payable Employer payroll contributions –CPP –EI –Workers’ compensation –Other

Payroll and Employee Benefits Payable Gross pay –Total amount of salaries or wages earned by employees Net pay –Gross pay owed to employees less employee payroll deductions Chapter 10 17

Chapter Current Maturities of Long-Term Debt The portion of the long-term debt that is due within the current year or operating cycle should be classified as a current liability

Chapter Discussion Question What are some examples of current liabilities a small retail clothing store located in a shopping mall might have?

Chapter Long-Term Liabilities Obligations to be paid after one year Includes long-term notes, bonds, and lease obligations

Chapter Long-Term Notes Payable Normally repayable in a series of periodic payments called installments May be secured by specific assets which are commonly referred to as mortgages

Chapter Long-Term Notes Payable Installment payments usually take one of two forms: –Fixed principal payments plus interest (fixed or floating interest) –Blended principal and interest payments

Instalment Payment Schedule — Fixed Principal Payments To illustrate, assume that Belanger Ltd issues a $120,000, 7 percent, 5-year note to obtain needed financing for the construction of a new research laboratory. The terms provide for monthly installment payments of $2,000 ($120,000 ÷ 60) Chapter 10 23

Chapter Instalment Payment Schedule — Fixed Principal Payments

Instalment Payment Schedule — Blended Payments To illustrate, assume that instead of fixed principal payments, Belanger Ltd repays its $120,000, 7 percent, 5-year note payable in equal monthly installments of $2,376 Chapter 10 25

Instalment Payment Schedule — Blended Payments Chapter 10 26

Chapter Bonds Payable A form of interest-bearing notes payable issued by corporations, universities, and government agencies Sold in small denominations, which makes them attractive to investors

Chapter Bonds Payable Secured (mortgage bond) vs. unsecured (debenture bond) Convertible bonds (into shares) Term bonds Serial bonds

Chapter Terminology Contractual interest rate –Stated rate which determines the amount of cash interest the borrower pays and the investor receives Market (effective) interest rate –Rate investors demand for loaning funds

Chapter Terminology Face value –Amount of principal due at maturity Present value –Value today of 1.bond face value to be received at maturity, and 2.interest payments to be received periodically after taking into account current interest rates

Chapter Discussion Question How are the market prices for bonds determined?

Chapter Accounting for Bond Issues Bonds may be issued at –Face value –Below face value (discount) –Above face value (premium)

Chapter Issuing Bond at Face Value Assume that Candlestick, Inc. issued $ 1 million, five-year, 5%, bonds dated January 1 at 100 (face value) Jan. 1 Cash1,000,000 Bonds Payable1,000,000 (To record sale of bonds at face value) Carrying Amount

Chapter Issuing Bond at Discount This occurs when the investor pays less than the face value of the bond WHY? –To adjust the contractual interest to the market interest rate

Chapter Issuing Bond at Discount Assume that on January 1, Candlestick, Inc. sells $1 million, five-year, 5% bonds at 98 Jan. 1 Cash980,000 Bonds Payable980,000 (To record sale of bonds at a discount) Carrying Amount $1,000,000 - $20,000

Chapter Issuing Bond at Premium This occurs when the investor pays more than the face value of the bond WHY? –To adjust the contractual interest to the market interest rate

Chapter Issuing Bond at Premium Assume that on January 1, Candlestick, Inc. sells $1 million, five-year, 5% bonds at 102 Jan. 1 Cash1,020,000 Bonds Payable1,020,000 (To record sale of bonds at a premium) Carrying Amount $1,000,000 + $20,000

Chapter Amortization of Bonds Premium or Discount The effective-interest method is used to amortize bond discount or premium With the effective-interest method the interest expense reflects the same percentage of the bond’s carrying amount each period

Amortization of Bonds Premium or Discount Chapter Illustration 10-6

Chapter Amortization of Bonds Premium or Discount Amortization spreads the cost of borrowing over the life of the bond Discount amortization increases interest expense Premium amortization reduces interest expense

Chapter Redeeming Bonds Before Maturity A company may decide to retire bonds before maturity in order to: –Reduce interest cost –Remove debt from its balance sheet A company should retire debt early only if it has sufficient cash resources

Chapter Redeeming Bonds Before Maturity When bonds are retired before maturity: –Eliminate carrying amount of the bonds at the redemption date –Record the cash paid –Recognize the gain or loss on redemption (gain if cost carrying amount)

Chapter Presentation of Long- Term Liabilities Report long-term debt separately in balance sheet and detail in notes Report current maturities of long-term debt as current liabilities Report in financing activities section of cash flow statement

Chapter Analysis of Long-Term Liabilities Liquidity –Current ratio Solvency –Debt to total assets –Times interest earned

Current Ratio Measure of a company’s ability to pay short-term obligations Chapter Current Liabilities Current Assets Current Ratio = Higher is better

Debt to Total Assets Indicates the extent to which a company’s debt could be repaid by liquidating assets Chapter Total Assets Total Liabilities Debt to Total Assets = Lower is better

Times Interest Earned Provides an indication of a company’s ability to meet interest payments as they come due Chapter Times Interest Earned = Earnings Before Interest Expense and Income Tax Expense (EBIT) Interest Expense Higher is better

Chapter Contingencies Events with uncertain outcomes Must be recorded in the financial statements if: –The company can reasonably estimate the expected loss and –If the loss is likely Otherwise, disclose in notes (unless remote)

Chapter Discussion Question Give examples of some contingent liabilities.

Chapter Off-Balance Sheet Financing A situation in which liabilities are not recorded on the balance sheet (e.g. operating leases)

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