Chapter 13 Theory Notes:

LO1: Understanding Liabilities

 Cash flow management is a key control factor for most companies.

 Control of expenses and A/P can improve the efficiency of a business and can be particularly
important during economic downturns.

L02: Define Liabilities, distinguish financial liabilities from other liabilities, and identify how they are
measured.

A liability is a present obligation of the entity to transfer an economic resource as a result of past events.

For a liability to exist, the following criteria must be satisfied:

1. The entity has an obligation (that is, a present duty or responsibility to others that it has no
practical ability to avoid).
a. For example, to pay a supplier for goods that they have purchased.
2. The obligation is to transfer an economic resource to another party or parties.
3. The obligation exists to a result of past transactions or events.
a. The entity has already obtained economic benefits such as a good or service, or taken an
action such as operating a particular business or operating in a particular market.
b. The entity will or may not have to transfer an economic resource. For example, a
company may have a contractual liability now, even though it may only be a obligated to
make a payment in a few months from now.

Current Definition and Characteristics

A liability requires a duty or responsibility to perform in a specific way, therefore:

 It suggests their might be an economic burden.

 This requirement can be enforced by legal means.

Entities must comply with statutes, laws, and regulations.

 A liability arises only if the provisions are violated.

A constructive obligation arises:

 From past or present practice.

 Indicates acknowledgement of a potential economic burden.

Financial Liabilities

A financial liability (under ASPE and IFRS) is any liability that is a contractual obligation to either:

1. Deliver cash or other financial assets to another party, or

2. To exchange financial instruments with another party under conditions that are potentially
unfavorable to the entity.

Liabilities that are created by legislation do not qualify as financial liabilities, they must be created by a
contract.
Classification and Measurement

 Currently, non-financial liabilities are recognized only if it is probably they will require an outflow
of economic resources.
 Financial and non-financial liabilities are measured differently.

Measurement of Financial vs. Non-Financial Liabilities

Financial Liabilities

 Initially measured at fair value

 Subsequent measurement generally at amortized cost (except those held for trading where fair
value is used)
 Include transaction costs at acquisition
 Transactions costs after acquisition are expensed
 Short-term liabilities are accounted at maturity value – little difference between fair value and
maturity value.

Non-Financial Liabilities

 ASPE: No specific measurement standards (measurement varies based on nature of liability)

 IFRS: Measured at best estimate of payment that would be required to settle the obligation at
the date of the statement of financial position.
o Usually at present value.
o Expected value or probability-weighted average of possible outcomes.
o Timing and amount are usually not fixed.

LO3: Define Current Liabilities and Identify and account for common types of current liabilities

Current Liabilities

 An important feature of liabilities is the timing of when they are due.

o Short-term maturity places a demand on current assets.
o Distant due date do not result in a claim on current assets.
 Separate current assets from non-current assets to show how working capital is used in the
normal operating cycle.
 Under IFRS, liabilities are classified as current when they meet anyone one of the following
conditions:
o Expected to be settled within normal operating cycle.
o Held primarily for trading
o Due within 12 months from the end of the reporting period.
o No unconditional right to defer settlement for at least 12 months after the date of the
settlement of financial position.
 ASPE has a less specific definition, similar intent although there may be minor differences in
application.

Bank Indebtedness
  Line-of-credit of revolving debt.
 Revolving debt arrangements: an arrangement entered with the bank that allows multiple
borrowings up to a negotiated limit.
 Repayments made whenever there are sufficient funds available.
 Usually collateral required some restrictions set.
 Amount borrowed reported on the SFP; availability of funds of funds and restrictions imposed
by the institution are typically displaced in the notes.

Accounts Payable

 Amounts owed for goods, supplies or services related to the entity’s ordinary business activities
purchased on open account.
o This means that evidence of the obligation’s existence comes from regular invoices rather
than from separate contracts for each transaction.
 Arise because of the time lag between receipt of goods and services and the payment for them.
 Usually recorded liabilities when the goods are received.
 Generally recorded when title has passed.
o If title has passed to the purchaser before the goods are received the transaction should
be recorded when the tittle passes.

Notes Payable

 Notes payable are written promises to pay a sum of money on a specified future date.
 Arises from purchases, finance or other transactions.
 Notes payable may be classified as either current or long-term.
 Notes payable may be interest-bearing or zero-interest bearing (non-interest bearing)
 In both cases, interest expense must be accrued regardless of when cash payment is made.

Notes Payable: Zero-Interest-Bearing

 For zero-interest-bearing notes, the difference between the present value of the note and the
face value of the note represents the interest.
 The interest expense is recorded over the life of the note.

Current Maturities of Long-Term Debt

 The portion of long-term debt maturing within 12 months from the date of the statement of
financial position is reported as a current liability.
 Portions of long-term debt should not be reported as current liabilities, if by contract, the are
retired by assets not classified as current assets.
 Any liability due on demand, or due on demand within a year or operating cycle, even if it has
payments due over a number of years, is reported as a current liability.
 If a long-term debt is violated and becomes payable on demand, the debt is classified as current.

Short-Term Debt Expected to be Refinanced

  Short-term debt obligations are classified as current except if they are expected to be refinanced
on a long-term basis, and no current assets will be required to settle it.
 Under IFRS, debt due within 12 months is classified as current, unless it is expected to be
refinanced under an existing agreement for at least 12 months.
 Under ASPE, currently maturing debt can be classified as long-term if there is irrefutable
evidence when the financial statements are completed that the debt has been or will be
converted to long-term obligation.

Example (1 of 2)

 Assume a company has $3 million of short-term debt at the reporting date. Company then
issues $2 million of long-term debt after the balance sheet date but before the financial
statements are issued.
o Under ASPE, only $2 million can be reclassified as long-term.
o Under IFRS, $3 million of maturing debt would still be classified as current; IFRS
requirements are more stringent: the agreement must be in place at the date of the
SFP.

Dividends Payable

Cash Dividend Payable

 An amount a corporation owes to its shareholders because the board authorized a dividend.
 Generally paid within three months.
 Classified as a current liability.

Preferred Dividends in Arrears

 Undeclared dividends on cumulative preferred shares are not a liability.

 Not an obligation until distribution is authorized.
 Disclose undeclared cumulative dividends in arrears in the notes.

Share or Stock Dividends

 Dividends payable in the form of additional shares.

 Not recognized as a liability
 Do not meet the definition of a liability – do not require future outlays of economic resources.

Rent and Royalties Payable

 This type of liability may be created by a “contractual agreement in which payments are
conditional on the amount of revenue that is earned or the quantity of product that is produced
or extracted.”
 Examples include the following
o Franchises: often pay the franchisor franchise fees calculated as a percentage of sales.
o Tenants: in shopping centers may be required to pay additional rents base don sales.
o Manufacturers: pay the holder of a patent a royalty for each unit produced.

Customers Advances and Deposits

  Customers may pay deposits that guarantee the payment of expected future obligations, the
performance of a future service or to cover possible future damage to property.
 They are classified as either current or non-current liabilities depending on the specific
conditions attached to the deposit.
 If settlement of the deposit cannot be deferred for a period of more than 12 months from the
SFP date, it is reported as a current liability.

Taxes Payable – Sales Tax

 In some provinces, sales tax is applied to transfers of tangible property and to certain services.
 The liability represents sales taxes that have been collected from customers but have not been
remitted to the appropriate government.
 Usually applied to the sale amount.

Taxes Payable – Goods and Services Tax

 Most business in Canada are subject to Goods and Services Tax (GST) – 5% since July 1, 2008
 GST is charged by each taxable entity, so business pay GST and also charges GST to their
customers.
 Therefore, accounting for GST involves two accounts:
o GST Payable: Liability, credited with GST charged on sales.
o GST Receivable: Asset, debited with GST paid to suppliers.
 The net amount of the GST Payable and the GST Receivable accounts is remitted to (due from)
Canada Revenue Agency (CRA)
 This net amount is reported on the statement of financial position as a current liability (credit
balance) or a current asset (debit balance)
 Some provinces charge Harmonized Sales Tax (HST) which is accounted for in the same way as
GST

Taxes Payable – Income Tax

 Corporations are charged federal and provincial tax based on taxable income.
 Since income tax returns are generally finalized after the financial statements have been issued,
companies generally estimate the total amount of income tax payable.
 Income taxes payable are reported a current liability.
 CRA reassessment amounts are charged to current operations; obvious arithmetic errors
through R/E.

LO4: Identify and account for the major types of employee-related liabilities

Employee-Related Liabilities

 Employee-related liabilities include the following:

o Salaries or wages owed to employees at end of the accounting period.
o Payroll deductions owed to CRA and others.
o Short-term compensated absences.
o Profit-sharing and bonuses.
 Usually reported as current liabilities.
Payroll Deductions

 Payroll deductions include statutory and discretionary deductions.

 Statutory (mandatory) deductions include:
o Canada (Quebec) Pension Plan [CPP/QPP]
o Employment Insurance (EI)
o Income Tax Withholding (Federal and Provincial)
 Discretionary deductions might include:
o Insurance premiums, union dues, employee savings.
 Until these deductions, along with matching amounts from the employer, are remitted to the
government or other entity, they are reported as current liabilities.

Short-Term Compensated Absences

 Compensated absences are periods of time taken off from active employment for which
employees are paid statutory holidays; vacations.
 The entitlement to such benefits is one of two types:
o Accumulated rights are rights that accrue with employee service.
o Non-accumulating compensated absences are benefits employee are entitled to by virtue
of their employment and the occurrence of an obligating event; paternity leave.

Accumulated Compensated Absences

 Some accumulated compensated absences can be carried forward to future periods, if not used:
vacation pay, paid sick leave.
 Some rights are vested – the rights do not depend on an employee’s continued service.
 Costs are accrued as expense and liability in the period in which the benefit is earned.
 Best measure – additional amount expected to pay in the future arising from earned benefits.
 Often current rate of pay is used.

Non-Accumulating Compensated Absences

 Benefits earned through employment and a specific situation: additional compensation and time
off for parental leave beyond government benefits, or short-term disability.
 Rights to the benefits are not vested.
 No basis for accrual of the costs and the associated liability, not recorded until the event occurs.
 When benefit is used, the total estimated expense and liability must be recognized at the time.

Profit-Sharing and Bonus Agreements

 Payments are in addition to regular salary or wage and are considered compensation.
 Can be based on regular rates of pay, productivity, or company profits.
 Obligations arising are reported as current liabilities at the reporting date.
o Usually relate to the period just ended.
o Usually based on results of the period just ended.
o Usually payable in the near term.
LO5: Explain the recognition, measurement, and disclosure requirements for decommissioning and
restoration obligations.

Decommissioning and Restoration Obligations

 Construction and operation of long-lived assets: obligations associated with retirement.

 Liability is known as an asset retirement obligation (ARO) or site restoration obligation.
 Examples
o Decommissioning nuclear facilities.
o Dismantling, restoring, reclaiming oil and gas properties.
o Closure, reclamation, removal of mining facilities.
o Closure and post close remediation of landfills.

Decommissioning and Restoration Obligations: Measurement

 Initially measured at “best estimate of the expenditure required to settle the present obligation”
 Obligation will be met in the future; future costs have to be discounted.

IFRS  Recognizes costs of both legal and constructive obligations. ARO costs related to the
acquisition are capitalized.

ASPE  Recognizes costs of legal obligations only. ARO costs related to the acquisition and
subsequent use (producing inventory) are capitalized.

Decommissioning and Restoration Obligations: Recognition (1 of 2)

 Involves adding estimated ARO costs to the carrying amount of the related asset; recognize a
liability.
 Obligation must be recognized in the period when the obligation is incurred.
 Liability is increased for the time value of money.
 Because ARO is measured on a discounted basis, interest is accrued each period.

LO6: Explain the issues and account for product guarantees, other customer program obligation, and
unearned revenues.

Product Guarantees and Warranty Obligations

 A continuing obligation results when an entity provides customer programs requiring that goods
or services be provided after the initial product or service is delivered.
 There are two approaches to accounting for the outstanding liability:
o Expense approach – used to account for liabilities relating to services provided after good
delivery; assurance-type warranties.
o Revenue approach – used to account for service type warranties not included in product
sale.
 A warranty (product guarantee) is a promise made by a seller to a buyer to correct problems
experienced with a product’s quantity, quality, or performance.
 Warranties and product guarantees are stand-ready obligations at the reporting date that result
in future costs that are often significant.
 Two types of warranties:
o Assurance-type warranties.
 Assurance-based approach.
 Associated expense is measured and matched to actual revenue.
 Liability is measured at the estimated cost of meeting the obligation.
 As actual costs are incurred, the liability is reduced.
 No effect on future income.
o Service-type warranties.
 Revenue-based approach
 Processed are unearned revenue at the point of sale
 Liability is measured at the value of the obligation, that is, the service to be
provided.
 The revenue is earned as the warranty service is provided; and the liability is
reduced.
 Some unearned revenue is recognized as a liability, recognized as revenue when
the obligation is satisfied.