Chapter 10 Reporting and Analyzing Liabilities

Question 1

Account for current liabilities

Answer 1

A current liability is a debt that will be paid (1) from existing current assets or through the creation of other current liabilities, and (2) within one year (from the date on the SFP) or operating cycle.

Examples of a current liability include:

1) operating line of credit that results in bank indebtedness;
2) accounts payable;
3) sales taxes, payroll deductions, and employee benefits, all of which the company collects on behalf of third parties;
4) property tax and interest on notes or loans payable, which must be accrued until paid.
5) the current portion of non-current debt that is due within the next year (must be deducted from the non-current debt and reported as a current liability).
6) unearned revenue
7) notes and loans payable

All of the above are “certain” or determinable liabilities - liabilities with a known payee, due date, and amount payable.

Provisions and contingent liabilities:

Provisions (e.g., product warranty) are liabilities of uncertain timing or amount; but there is no uncertainty about the fact that a liability will be recorded. A provision has three characteristics: 1) a present obligation that exists as a result of a past event, 2) a probable outflow of resources to settle the obligation, and 3) an ability to estimate the amount of this obligation.

Provisions are recorded in the accounts using reliable estimates based on past experience and future expectations.

Contingent liabilities are existing or possible obligations arising from past events. The liability is contingent (dependent) on whether or not some uncertain future event occurs that will confirm either its existence or the amount payable, or both.

One example of a contingent liability is a loan guarantee. This is when one company (for example, a parent company) guarantees or promises to assume the loan obligation if the other company (for example, a subsidiary company) is unable to repay the loan. The guaranteeing company will have an actual liability and a loss only if the borrower does not make the payments on the loan.

Contingent liabilities are disclosed in the notes and not recorded in the FS for two reasons: 1) the probability of an obligation being settled is only possible, not probable (defined under IFRS as “more likely than not,” which is normally interpreted to mean more than a 50% probability of occurring); 2) even if the probability is “more likely than not,” it may not be possible to estimate the amount of the liability.

Question 2

Account for instalment notes payable

Answer 2

Long-term notes payable are usually repayable in a series of instalment payments. Each payment consists of (1) interest on the unpaid balance of the note, and (2) a reduction of the principal balance. These payments can be either (1) fixed principal payments plus interest or (2) blended principal and interest payments.

With fixed principal payments plus interest, the reduction of principal is constant but the cash payment and interest expense decrease each period as the principal decreases.

With blended principal and interest payments, the reduction of principal increases while the interest expense decreases each period. In total, the cash payment (principal and interest) remains constant each period.

To record the 1st instalment payment:
Interest Expense
Bank Loan Payable
Cash

Instalment payment schedule: principle balance, interest expense, reduction of principle, cash payment (= reduction of principle + interest expense)

The reduction of principle amount is reported as a current liability (Current portion of mortgage/bank loan payable), and the principle balance is reported as a non-current liability (Mortgage/bank loan payable) in the SFP.

Question 3

Identify the requirements for the financial statement presentation and analysis of liabilities

Answer 3

In the income statement, interest expense (finance cost) is reported as “other revenues and expenses.” In the statement of financial position, current liabilities are usually reported first, followed by non-current liabilities.

Generally, non-current liabilities are measured and reported at the amount due when the liability is expected to be paid. There are exceptions to this, but these typically relate to bonds that are reported at their amortized cost. The fair value of the non-current debt should also be disclosed in the notes to the financial statements if it is possible to estimate it.

Full disclosure of non-current debt is very important. Summary data are usually presented in the statement of financial position. Detailed information (such as interest rates, maturity dates, assets pledged as collateral, and fair value, if available) are shown in the notes to the financial statements along with a list showing the amount of non-current debt that is scheduled to be paid off in each of the next five years.

The liquidity of a company (the short-term ability to pay its maturing obligations and to meet unexpected needs for cash within the next year) may be analyzed by calculating the current ratio, the receivables turnover, and the inventory turnover ratio:

Current ratio = current assets / current liabilities
Inventory turnover = cost of goods sold / average inventory
Receivable turnover = net credit sales / average gross accounts receivable

Companies that keep fewer liquid assets on hand must rely on other sources of liquidity (e.g., an operating line of credit). Consequently it is important to interpret a company’s liquidity ratios in the context of any unused lines of credit, which add to a company’s short-term financing flexibility. If liquidity ratios are low, lines of credit should be high to compensate.

The solvency of a company may be analyzed by calculating the debt to total assets (the extent to which assets are financed by debt) and times interest earned ratios (ability to meet interest payments as they come due). Another factor to consider is unrecorded debt, such as operating lease obligations.

Debt to total assets 资产负债率 = total liabilities / total assets
Times interest earned 利息保障倍数 = EBIT / interest expense

EBIT = profit + interest expense + income tax expense

EBIT, or earnings before interest and taxes expense, best represents the amount that is available to cover interest charges.

Question 4

Account for bonds payable

Answer 4

Bonds are issued at their present value (PV, or market value. The issue price is quoted as a percentage of the face value (or future value, FV) of the bonds (e.g. if the bond price is stated as 100, this means that the bonds will sell at 100% of the FV). The FV is a stated value that the bond issuer will pay to the investor on the maturity date of the bond.

To record the issue of bond:
Cash (debit)
Bonds Payable (credit)

PV depends on three factors: (1) FV, (2) number of interest periods, and (3) market interest rate per period. The process of finding PV is referred to as discounting the future amounts.

Issue price = the present value of all the future cash flows relating to the bond, i.e., the FV of the bond at maturity and periodic interest payments promised.

Issue price = PV of FV + PV of interest payment per period (based on coupon interest rate)
PV of FV = FV ☓ factor
PV of interest payment per period = interest payment per period ☓ factor’
Interest payment per period = FV ☓ coupon interest rate per period

Note that the bonds’ FV and the coupon interest rate are used to calculate the interest payment; while the market interest rate is used to determine the appropriate factor to be used for PV because it clearly has an impact on the bond price.

Bonds may be issued at face value, below face value (discount, coupon interest rate less than market interest rate), or above face value (premium, coupon interest rate higher than market interest rate).

Note that the issue of bonds at a discount does not mean there is doubt about the financial strength of the issuer. Conversely, the sale of bonds at a premium does not indicate that the financial strength of the issuer is exceptional.

The carrying amount of a bond is its face value less any unamortized discount, or plus any unamortized premium. At the date of issue, the carrying amount equals the bond’s issue price.

Bond discounts and bond premiums represent the difference between a bond’s FV and PV. They are essentially a form of additional interest (in the case of a discount) or interest saving (in the case of a premium). This additional interest or interest saving should be reflected as an increase or decrease in interest expense over the term covered by the bond through a process called amortization, which allocates the discount or premium amount within the bond payable account to interest expense over time. The most common way to do this is by using the effective-interest method:

Interest expense = carrying amount at beginning of period ☓ market interest rate

Interest payment = face amount ☓ coupon interest rate

Amortization amount = interest expense - interest payment

The amount of the discount or premium that is amortized is equal to the change in the present value of the bond during that period. The amortization of a bond discount increases interest expense and the bond’s carrying amount. The amortization of a bond premium decreases interest expense and the bond’s carrying amount.

Bonds are retired either (1) when they mature, or (2) when the issuing corporation purchases them on the open market before they mature.

To record bond retirement:
Bonds Payable (debite)
Cash (credit)

Question 5

Bond

Answer 5

A type of long-term debt issued by large corporations, universities, and governments that involves a promise to repay a large amount of money at a fixed future date.

Question 6

Collateral

Answer 6

Assets pledged as security for the payment of a debt.

Question 7

Contingent liabilities

Answer 7

Existing or possible obligations arising from past events. The liability is contingent (dependent) on whether or not some uncertain future event occurs that will con- firm either its existence or the amount payable, or both.

Question 8

Coupon interest rate

also known as the contractual or stated interest rate

Answer 8

The rate stated in a bond certificate used to determine the amount of interest the borrower pays and the investor receives.

Question 9

Discount

Answer 9

The difference between a bond’s face value and its issue price when it is sold for less than its face value. This occurs when the market interest rate is higher than the coupon interest rate.

Question 10

EBIT

Answer 10

Earnings (profit) before interest expense and income tax expense.

Question 11

Effective-interest method

Answer 11

A method of amortizing a bond discount or premium that results in a periodic interest expense that equals a constant percentage (the market or effective interest rate) of the bond’s carrying amount. Amortization is calculated as the difference between the interest expense and the interest paid.

Question 12

Employee benefits

Answer 12

Payments made by an employer for pen- sion, insurance, health, and/or other benefits paid on behalf of its employees.

Question 13

Financial liability

Answer 13

A form of financial instrument, represented by a contractual obligation to pay cash in the future.

While most liabilities are financial liabilities, one example of a liability that is not a financial liability is unearned revenue.

Question 14

Gross pay

Answer 14

The total compensation (such as salaries or wages) earned by an employee.

Question 15

Market interest rate

also known as the effective interest rate

Answer 15

The rate that investors demand for loaning funds to a corporation.

Question 16

Net pay

Answer 16

Gross pay less payroll deductions.

Question 17

Operating line of credit

also known as a credit facility

Answer 17

A pre-arranged agreement to borrow money at a bank, up to an agreed-upon amount.
Used to help companies manage temporary cash shortfalls.

Interest is usually charged at a floating interest rate on any amounts used from the line of credit. A floating (or variable) interest rate changes as market interest rates change and is usually based on the prime borrowing rate. The prime rate is the interest rate that banks charge their best customers. For other customers, banks will usually charge interest at the prime rate plus a specified percentage that takes into consideration the risk of lending to that customer.

Collateral (or security) for an operating line of credit normally includes some, or all, of the company’s current assets but may also include some non-current assets.

Amounts that are drawn on an operating line of credit result in a negative or overdrawn cash balance at year end. No special entry is required to record the overdrawn amount. The normal credits to cash will simply accumulate and are reported as bank indebtedness in the current liabilities section of the statement of financial position, with a suitable note disclosure describing the interest rate, collateral, and limit applicable to the line of credit.

Question 18

Payroll deductions

Answer 18

The employer incurs three types of liabilities related to the employees’ salaries or wages: (1) net pay owed to employees, (2) employee payroll deductions, and (3) employer payroll obligations.

Gross pay is the total amount of salaries or wages earned by an employee.

Payroll deductions are deductions from gross pay to determine the amount of a paycheque.

Net pay (the amount employer pays) = gross pay - payroll deductions

Some payroll deductions are mandatory, while others are voluntary. Mandatory payroll deductions include amounts withheld for federal and provincial income taxes. Other deductions include Canada Pension Plan (CPP) contributions, and employment insurance (EI) premiums. Companies might also withhold voluntary deductions for benefits such as health and pension plans, union dues, and charitable contributions, as well as for other purposes.

Employer payroll obligations include 1) the employer’s share of CPP and EI, and 2) employer funding of a workers’ compensation plan required by the provincial governments. All of these contributions, plus items such as employer-sponsored health plans and pensions and compensated absences (such as statutory holidays and vacation pay), are referred to together as employee benefits. The employer’s share of these costs is recorded as an employee benefits expense.

To record payroll and employee deductions:
Salaries Expense (debit)
     CPP Payable (credit)
     EI Payable
     Income Tax Payable
     Union Dues Payable
     Salaries Payable (net pay amount)

Note that while the employee payroll deductions are part of salaries expense, employer payroll costs are not. Employer payroll costs are debited to a separate expense account called Employee Benefits Expense.

To record employer's payroll cost:
Employee Benefits Expense (debit)
     CPP Payable (credit)
     EI Payable
     Workers' Compensation Payable
     Health Insurance Benefits Payable

To record payroll payment:
Salaries Payable (debit) (net pay amount)
Cash (credit)

Question 19

Premium

Answer 19

The difference between the issue price and the face value of a bond when a bond is sold for more than its face value. This occurs when the market interest rate is less than the coupon interest rate.

Question 20

Provisions

Answer 20

Liabilities of uncertain timing or amount. They are recorded in the accounts based on reasonable and probable estimates.

Question 21

Times interest earned

Answer 21

A mesure of a company’s solvency.

Times interest earned = profit (earnings) before interest expense and income tax expense / interest expense

Question 22

Sales taxes

Answer 22

Goods and Service Tax (GST)
Provincial Sales Tax (PST)
Harmonized Sales Tax (HST)

When a sale occurs, the retailer collects the sales tax from the customer and periodically (normally monthly) remits (sends) the sales tax collected to the designated federal and provincial collecting authorities. If a customer pays in advance giving rise to unearned revenue, no sales tax is recorded until later when the revenue is earned. In the case of GST and HST, collections may be offset against payments (that is, sales tax payments made by the company on its own eligible pur- chases). Only the net amount owing or recoverable will be paid or refunded.

To record sales and sales tax:
Cash (debit)
Sales (credit)
Sales Tax Payable (credit)

To record sales tax remit:
Sales Tax Payable (debit)
Cash (credit)

Question 23

Property taxes

Answer 23

Property taxes are generally for a calendar year, although bills are not usually issued until the spring of each year (after the property tax year has begun).

To record property tax expense prior to the payment:
Property Tax Expense (debit)
Property Tax Payable (credit)

To record property tax payment:
Property Tax Payable (debit)
Property Tax Expense (debit)
Prepaid Property Tax (debit)
     Cash (credit)

To record property tax expenses after payment:
Property Tax Expense (debit)
Prepaid Property Tax (credit)

Question 24

Accounts payable vs notes payable

Answer 24

1. An account payable that is supported by an invoice is an informal promise to pay, while a note payable is a written promise to pay that gives the payee a stronger legal claim.
2. An account payable arises only from credit purchases (amounts owed to suppliers), while a note payable can be used for credit purchases, extending an account payable beyond normal amounts or due dates, or to borrow money.
3. An account payable is usually due within a short period of time (such as 30 days) while a note payable can extend for longer periods (such as 30 days to up to one year, or even several years).
4. An account payable does not incur interest unless the account is overdue, while a note payable usually bears interest for its entire duration.

To record receipt of bank loan:
Cash (debit)
Bank Loan Payable (credit)

To accrue interest (due at maturity):
Interest Expense (debit)
      Interest Payable

To record payment
Bank Loan Payable (debit)
Interest Payable
Cash

Question 25

Credit ratings

Answer 25

Credit-rating agencies provide opinions about a company’s ability to make timely payments (of principal and interest) on its short- and long-term debt.

Short-term debt is rated using an “R” scale, with R-1 being the highest credit quality. Within this scale, the rating is further divided as R-1 (high), R-1 (middle), and R-1 (low) to further distinguish between high, superior, and satisfactory credit quality. Short-term debt rated as R-4 or R-5 is considered to be speculative.

Long-term debt is rated using a different letter scale than short-term debt. The highest-quality long-term debt is rated as AAA, superior quality as AA, and good quality as A. The credit scale descends to the D, or default, category. Generally, long-term debt rated below BBB is referred to as speculative and non-investment grade, with a higher risk of default.