CHAPTER 9 – LIABILITIES PROBLEM SOLUTIONS

Assessing Your Recall

9.1 The three essential characteristics of a liability are:

a) The liability represents a duty or responsibility to transfer assets or
services at a future date.
b) The entity that is obligated has little or no discretion to avoid the
future transfer.
c) The transaction or event that gives rise to the obligation has already
occurred.

9.2 A mutually unexecuted contract is a contract between two parties in which

neither party has performed its part of the agreement. A purchase
commitment would be an example of such a contract. The goods have not
been delivered and no cash has been paid to the seller. Under GAAP
mutually unexecuted contracts are not recorded in the financial statements.
Under some circumstances a loss on a mutually unexecuted contract must be
recognized prior to performance but gains are never recognized before
performance.

9.3 Under GAAP, liabilities are valued at the net present value of the
obligation. In the case of current liabilities the difference between the gross
amount and the net present value is so small that the gross amount is used.
This makes the accounting entries easier and does not produce materially
different amounts.

9.4 Warranty expense is an estimate of cost to be incurred in the future related

to current period sales. The actual costs are incurred when the product sold
in the current period requires repairs at a later date, and the company is
obligated to perform these repairs at no charge. Because the revenues from
product sales are recognized in the current period, the estimated warranty
costs must be estimated and matched to these revenues in order to determine
profit.

9.5 Unearned revenues are those revenues that have not yet met the criteria for
revenue recognition. Payments received by a magazine publisher for future
copies of the magazine would be an example. The unearned revenues are
recognized as liabilities on the books of the seller until the revenue
recognition criteria are met, at which time the liability is reduced and
revenue is recognized.

9.6 Employers often object when the government changes CPP/QPP or EI rates
because such changes increase current labour costs, and make it more
expensive for companies to hire additional employees. It is more expensive

1
 because the employer is required to make a separate contribution to
CPP/QPP and EI on behalf of each employee, in addition to the amount that
is deducted from each pay cheque.

9.7 The current portion of long-term debt is that portion of long-term debt that is
within one year of being due. It is recorded with the current liabilities
because this portion of long-term debt must be paid off in the upcoming year.
In order to present users of financial statements with a fair picture of all cash
outflows that are expected to occur within one year of the balance sheet date,
the current portion of long-term debt must be classified within current
liabilities.

9.8 Commitments are not recognized in the financial statements under GAAP
since they represent mutually unexecuted contracts. To the extent that one
party has performed part of the contract, such as when a deposit is made,
that portion of the contract is accounted for. The other circumstance under
which a commitment should be recognized is if there is a probable loss on the
commitment. This type of loss should be recognized in the financial
statements.

9.9 Loss contingencies may be recognized in the financial statements if two

criteria are met. They are:
a) Information available prior to the issuance of the financial statements
indicates that it is likely that an asset has been impaired or that a liability
has been incurred.
b) The amount of the loss can be reasonably estimated.

9.10 In the liability method, deferred taxes are calculated through estimating the
liability to pay taxes in the future based on the temporary differences that
exist in the current period. For example, although warranty expense hits the
income statement in the current period, the related tax savings occur in
future periods as the actual warranty costs are incurred. Thus, a future tax
asset is established in order to reflect the anticipated future tax benefit that
arises from a temporary difference existing in the current period.

9.11 In the liability method deferred taxes represents an estimate of the actual
liability to pay taxes in the future that arises because of current period
temporary differences. In the deferral method, deferred taxes is the
difference between the tax expense that is reported to shareholders (based on
the recognized revenues and expenses and the current tax rate) and actual
tax payable to Revenue Canada. Thus, the liability method focuses on the
balance sheet because it estimates the actual future tax asset or liability,
while the deferral method focuses on the income statement because it
estimates the tax expense that is reported to shareholders. Another
important difference between the liability and deferral methods is the effect

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 of changes in tax rates. Under the liability method, the existing future tax
asset or liability must be recalculated to reflect the change in rates, while no
such changes are made under the deferral method. A final difference is that
under the liability method, the future tax assets and liabilities must be
reviewed to ensure that the future tax impact is accurate.

9.12 Temporary differences: This term refers to differences in the carrying

values of assets / liabilities as recorded in the accounting records versus those
recorded in the tax records.
Permanent differences: This term refers to the difference that arises when
a revenue or expense is recognized for book or tax purposes but not the other.
This results in a permanent difference in the recognized revenues and
expenses between the tax books and the accounting reporting books. Under
GAAP no future income taxes are recognized for these types of differences.
Originating / Reversing Differences: Originating and reversing
differences arise in the context of timing differences. Because the issue is one
of timing, a difference between book and tax originates in one period but is
reversed in a subsequent period. For example, in the amortization of an
asset the amortization expense for tax purposes is typically higher than the
amortization for book purposes in the first few years of the asset’s life. This
would result in an originating difference. In the last half of the asset’s life
the amortization for book purposes will be higher than for tax purposes
resulting in a reversing difference.

Applying Your Knowledge

9.13 a) The liability represents a duty or responsibility to transfer assets or

services at a future date.
An argument that could be suggested in support of this is:
 future tax liabilities represent an estimate of the future tax obligation
that arises from current period temporary differences.
An argument that could be suggested against this is:
 changes in tax rules or rates are difficult to anticipate, so the future tax
liability might not be an accurate measure of the assets that must be
transferred in the future.
b) The entity that is obligated has little or no discretion to avoid the future
transfer.
An argument that could be suggested in support of this is:
 the items that cause temporary differences will reverse themselves in the
future and the tax will become payable.
An argument that could be suggested against this is:
 the company may use tax minimization opportunities such as continuing
to buy plant and equipment that is subject to CCA.

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c) The transaction or event that gives rise to the obligation has already
occurred.
An argument that could be suggested in support of this is:
 the obligation to pay taxes in the future occurs because of a temporary
difference that arose in the current period.
An argument that could be suggested against this is:
 because the income or expense that has caused the deferred taxes in the
future may indeed not be realized in the future, the argument can be made
that the transaction or event that will cause the future payment of tax has
not occurred yet.

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9.14 a)
1. A-Inventory 65,300
L-Accounts payable 65,300
L-Accounts payable 74,600
A-Cash 74,600
2. L-Unearned revenue 1,900
SE-Sales revenue 1,900
A-Cash 6,500
L-Unearned revenue 6,500
3. L-Bank indebtedness 5,000
A-Cash 5,000
SE-Interest expense 46
A-Cash 46
($12,300 - $5,000) x .075/12 = 46
4. L-Wages payable 3,500
A-Cash 3,500
SE-Wage expense 18,000
L-Wages payable 12,438
L-Person income tax payable 4,500
L-CPP payable 576
L-EI payable 486
SE-Wages expense 1,256
L-CPP payable 576
L-EI payable 680
5. L-Personal income tax payable 2,100
L-CPP payable 1,100
L-EI payable 1,230
A-Cash 4,430
6. SE-Interest expense 67
L-Interest payable 67
$10,000 x .08 / 12 = $67
7. A-Cash 4,000
L-Bank indebtedness 4,000

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b)
Current liabilities
Bank indebtedness $11,300
Accounts payable 36,400
Interest payable 67
Unearned revenue 6,500
Wages payable 12,438
Personal income tax payable 4,500
CPP payable 1,152
EI payable 1,166
Short-term note payable 10,000
$83,523

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9.15 a)
1. A-Computer system 26,500
L-Accounts payable 23,000
A-Cash 3,500

2. A-Inventory 96,000
L-Accounts payable 96,000

L-Accounts payable 89,000

A-Cash 89,000

3. A-Cash 35,000
L-Short-term loan 35,000

SE-Interest expense 117

L-Interest payable 117
($35,000 x .08 x .5/12)

4. L-Rent payable 24,000

SE-Rent expense 12,000
A-Cash 36,000

5. L-Unearned revenue 2,250

SE-Revenue 2,250

6. SE-Warranty expense 18,000

L-Obligations under warranties 18,000

L-Obligations under warranties 1,100

A-Cash 1,100

7. SE-Wages expense 4,200

L-Wages payable 4,200

8. SE-Interest expense 1,900

A-Cash 1,900
9. L-Bank loan 4,000
L-Current portion of LT debt 4,000

b) Current Liabilities:
Accounts payable $112,300

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 Wages payable 4,200
Interest payable 117
Obligations under warranties 49,900
Short-term loan 35,000
Current portion of long-term debt 4,000
$205,517
c) $4,000 of the 5 year bank loan represents the current-portion of
long-term debt because it requires the use of current assets and must be paid
during the upcoming year. The remaining $16,000 does not require the use of
current assets, and is thus classified as part of long-term liabilities.

9.16 a)

1. A-Inventory 556,400
L-Accounts payable 556,400

L-Accounts payable 521,500

A-Cash 521,500

2. SE-Warranty expense 43,764

L-Estimated warranty obligation 43,764

L-Estimated warranty obligation 39,040

A-Cash 39,040

3. L-Wages expense 142,000

L-Income tax payable 38,340
L-CPP payable 4,544
L-EI payable 3,834
A-Cash 95,282

SE-Wages expense 9,912

L-CPP payable 4,544
L-EI payable 5,368

b) Current liabilities:
Accounts payable $34,900
Income tax payable 38,340
CPP payable 9,088
EI payable 9,202
Estimated warranty obligation 4,724
$96,254

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9.17 a) Journal entries

Aug. A-Cash 18,000

L-Unearned advertising revenue 18,000

Sept. A-Cash 90,000

L-Unearned subscription revenue 90,000

To Dec. A-Cash 77,000

SE-Magazine revenue 77,000

SE-Printing expense 66,000

A-Cash 66,000

b) Adjusting journal entries

L-Unearned advertising revenue 9,000
SE-Advertising revenue 9,000

L-Unearned subscription revenue 45,000

SE-Subscription revenue 45,000

c)
University Survival Magazine
Income Statement
For the Year ended December 31, 20xx

Revenue:
Subscription revenue $ 45,000
Magazine revenue 77,000
Advertising revenue 9,000
Total revenue $131,000

Printing expense 66,000

Net income $ 65,000

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 d) Cash balance = $18,000 + $90,000 + $77,000 - $66,000 = $119,000

To: University Survival Magazine Owners

From: You name, Accountant
Re: Results of operations to December 31, 20xx

The results of operations to December 31, 20xx are a net income of $65,000.
This is substantially less than the current bank balance of $119,000. The
reason for this difference is that revenues are recorded only when they are
earned. The cash from both the subscriptions and the advertising was put in
the bank when it was received but the revenue recognized from these two
items needs to be spread out over the eight months for which the company
has an obligation to print the magazine. Therefore, the revenue from the
subscriptions and advertising represents only half of the cash that was
received.

9.18 a) Computers Galore should classify the one year warranty obligation as
current liabilities, because these obligations may require the use of current
assets and expire within one year. Regarding the two year warranties, part
of this obligation is current and part is long-term, depending upon when the
computers tend to require repairs. Based on past experience, Computer
Galore might be able to estimate the portion of the extended warranty
obligation that requires current funds, and the portion of that will not be
claimed within the upcoming year. If such an estimate cannot be made, the
principle of conservatism indicates that the entire obligation should be
classified as current.

b) Computers Galore should record a warranty expense with its computers

because the failure to do so would result in an overstatement of revenues.
Thus, the estimated cost of fulfilling the standard one- month warranty is the
amount of warranty expense that Computer Galore should recognize. The
cost of fulfilling the extended warranty obligations is not built into the sale
price of the computer, so no warranty expense need be recognized. The
additional warranty coverage has been paid for by the customers thus
creating an obligation rather than an expense.

c)
A-Cash 110,600
L-Estimated warranty obligation 110,600
A-Cash 114,750
L-Estimated warranty obligation 114,750
L-Estimated warranty obligation 64,200
A-Cash 64,200

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 L-Estimated warranty obligation 79,100
A-Cash 79,100

d) If the actual warranty costs incurred by Computer Galore are less

than the amount collected from customers for the warranty coverage, then
once the warranties expire, the remaining warranty obligation is eliminated,
and the difference is a current period revenue. If the actual warranty costs
are greater than expected, than the difference is recognized as an additional
warranty expense of the current period.

9.19 Cool Air Conditioning Company: Journal Entries

Period Transaction Debit Credit

Q1 A-Cash 125,000
L-Contract fees rec’d in advance1 125,000

SE-Contract expenses 80,000

A-Cash 80,000

L-Contract fees received in advance 125,000

SE-Contract revenue 2 125,000

Q2 A-Cash 200,000
L-Contract fees rec’d in advance3 200,000

SE-Contract expenses 66,000

A-Cash 66,000

L-Contract fees received in advance 150,000

SE-Contract revenue4 150,000

Q3 A-Cash 225,000
L-Contract fees rec’d in advance5 225,000

SE-Contract expenses 98,000

A-Cash 98,000

L-Contract fees received in advance 175,000

SE-Contract revenue6 175,000

Q4 A-Cash 100,000
L-Contract fees rec’d in advance7 100,000

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 SE-Contract expenses 115,000
A-Cash 115,000

L-Contract fees received in advance 175,000

SE-Contract revenue8 175,000

Notes:
1 $125,000 = 250 x $500
2 750 Contract outstanding on Jan. 1
+250 New contracts in Q1
1,000 Total contracts in Q1 x $125/quarter = $125,000
3 $200,000 = 400 x $500
4 1,000 Total contracts from Q1
- 200 Contracts that expire at end of Q1
800 Existing contracts that continue into Q2
+ 400 New contracts in Q2
1,200 Total contracts in Q2 x $125/quarter = $150,000
5 $225,000 = 450 x $500
6 1,200 Total contracts from Q2
- 250 Contracts that expire at end of Q2
950 Existing contracts that continue into Q3
+ 450 New contracts in Q3
1,400 Total contracts in Q3 x $125 / quarter = $175,000
7 $100,000 = 200 x $500
8 1,400 Total contracts from Q3
- 200 Contracts that expire at end of Q3
1,200 Existing contracts that continue into Q4
+ 200 New contracts in Q4
1,400 Total contracts in Q4 x $125 / quarter = $175,000

b) At the end of the year, 1,050 contracts were outstanding, at a value of

$237,500.

Quarter in which Quarters left Number of Value

contract initiated in contract contracts
2 1 400 $ 50,000
3 2 450 $112,500
4 3 200 $ 75,000
Totals 1,050 $237,500

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 c) Partial Balance Sheet
Current Liabilities:
Contract fees received in advance $237,500
Partial Income Statement
Contract revenue $625,000
Contract expense 359,000
$266,000

9.20 The first date at which the furniture company should mention anything
about the situation with Mia Thorn is at the date the suit is filed (June 10,
20x2). At this date the liability would be considered a contingent liability
and the company would have to evaluate whether it is likely that the suit
will be lost and would have to estimate the potential losses. It is unlikely
that the company will judge it to be likely that it will lose the suit so it would
seem that only a footnote disclosure would be required at this point. In fact,
if the company judges the chances of losing as remote even footnote
disclosure would not be required, although most companies would report a
suit such as this if the consequences are material.
On December 13, 20x2, even though the jury ruled against the company there
is still some doubt as to whether it will have to pay the claim because the
company still has the opportunity to appeal the decision. At this date,
footnote disclosure would be required and recognition of the loss could be
recognized if legal counsel thought that the appeal would not be successful.
By the end of 20x3 it is clear that the company has lost and at this point a
liability and associated loss would be recognized in the financial statements
if it had not been recognized earlier. Even if it had been recognized earlier
there would need to be an incremental entry for the additional amount
awarded.

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9.21 a) Liability method
Straight-line:
Annual book amortization = $38,000 / 8 = $4,750 per year
Year 20x1:
Book Tax
Income before amortization and $80,000 $80,000
tax
Amortization / CCA 4,750 3,8001
Income before taxes 75,250 76,200
Taxes @ 25% 19,050
Tax expense:
Current 19,050
Future (238)2
Tax expense 18,812
Net Income $56,438

1 $3,800 = $38,000 x 20% x ½

2 $238 = [($38,000 - $4,750) – ($38,000 - $3,800)] x 25%
SE-Current tax expense 19,050
L-Tax payable 19,050
A-Future income tax asset 238
SE-Future tax expense 238

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Year 20x2:
Book Tax
Income before amortization and $80,000 $80,000
tax
Amortization / CCA 4,750 6,8401
Income before taxes 75,250 73,160
Taxes @ 25% 18,290
Tax expense:
Current 18,290
Future 5232
Tax expense 18,813
Net Income $56,437

1 $6,840 = (38,000 - 3,800) x 20%

2 ($523) = ($238) – [($33,250 - $4,750) – ($34,200 - $6,840)] x 25%
SE-Current tax expense 18,290
L-Current tax payable 18,290
SE-Future tax expense 523
A-Future tax asset 238
L-Future tax liability 285

b) For 20x1, $238 appears under the account title Future income tax asset,
and for 20x2, $285 appears under the account title Future income tax
liability. The Future income tax asset account is classified as other assets on
the balance sheet, and the Future income tax liability account is classified as
other liabilities on the balance sheet.
c) Because there is a net Future income tax liability account, it means that
the company has used up more of the tax benefit from purchasing the asset
than is reflected in the book value of the asset. In other words, the book
value of the asset is greater than the undepreciated capital cost (UCC), so
less of a tax deduction is left for future years. As a banker, you should
regard this as an expected future cash outflow that occurs as the result of
deducting less CCA in the future, and thus paying more tax.

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9.22 a) Liability method

Straight-line:
Annual book amortization = ($18,000 - $3,000) / 5
= $3,000 per year

Year 20x1:
Book Tax
Income before amortization and $75,000 $75,000
tax
Amortization / CCA 3,000 2,7001
Income before taxes 72,000 72,300
Taxes @ 40% 28,920
Tax expense:
Current (Payable) 28,920
Future (120)2
Tax expense 28,800
Net Income $43,200

1 $2,700 = $18,000 x 30% x ½

2 $120 = [($18,000 - $3,000) – ($18,000 - $2,700)] x 40%
SE-Income tax expense 28,800
A-Future income tax asset 120
L-Income tax payable 28,920

b)
UCC Book Value Temporary Future tax
difference liability (asset)
20x1 15,300 15,000 (300) (120)
20x2 10,710 12,000 1,590 636
Total 1,290 516
20x3 7,497 9,000 213 85
Total 1,503 601

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 c) The future tax liability (asset) account changed from 20x1 to 20x2 because
of the half year rule for capital cost allowance. Thus, the tax book value
(UCC) exceeded the accounting book value in 20x1, creating a future tax
asset. In 20x2, because the half year rule is no longer in effect, UCC drops
below the accounting book vaue resulting in a taxable temporary difference
that eliminates the future tax asset and creates a future tax liability. In
20x3, accounting book value continues to exceed UCC, increasing the future
tax liability.

9.23 a)
Warranty liability = 4% x $2,590,000 = $103,600
Warranty costs incurred = 25,000
Deductible temporary difference = $ 78,600

Future tax asset = 32% x $78,600 = $ 25,152

b) The future tax asset would likely be reported as Other Assets (long-term)
on the balance sheet because the warranty covers a period of 5 years.
c) If the tax rate in 20x5 changed to 40%, then the future tax asset at that
date would need to be recalculated using the 40% tax rate. Since the tax rate
used to be 32%, the future tax asset would increase as a result of the higher
rate. In other words, a larger tax deduction would be available to the
company when the actual warranty costs were incurred.

Management Perspective Problems

9.24 As a stock analyst, you should look at a future tax liability as a real future
obligation of the company to pay taxes in excess of the tax rate applied to
accounting income. In other words, because of temporary differences that
originated in the past, taxable income is going to exceed accounting income in
the future and the company is going to pay more income taxes to Revenue
Canada. However, a future tax liability is different than a long-term bank
loan because there is more uncertainty regarding both the amount and the
timing of the obligation. For example, if a company continues to invest in
fixed assets, then the undepreciated capital cost is going to be less than the
accounting book value year after year, so that the future tax liability
continues to increase.

9.25 In terms of financial statement disclosure, you might find a footnote that
explains the risks associated with the manufacture and transportation of
chemicals, and outlines any contingent liabilities currently pending. In
assessing the company’s liabilities, you would be interested in the nature and
extent of such contingent liabilities, and the details of litigation that the
company faces.

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9.26 a) The sweeteners create a legal obligation of the company even though they
may not be recorded at the time of signing of the agreement since they could
be viewed as mutually unexecuted contracts. They have the potential,
however, to result in losses to the company if economic conditions change and
the company finds itself in a situation where it must deliver raw materials at
a fixed price.
b) As long as the current market price of the raw materials is at or below the
contract price that is fixed there is little to record relative to these contracts
as they would be viewed as mutually unexecuted.
c) Our answer to b) would change if the market price exceeded the contract
price. With each delivery the company would suffer a loss and the company
should accrue a loss on all of the contracts when it can reasonably estimate
the amount.
d) Shareholders should probably have some awareness of the existence of
these contracts since they have the potential to create losses for the company.
As mutually unexecuted contracts they are typically not recorded but footnote
disclosures could clearly be given.

9.27 a) Financial impact of rate changes

CPP EI
Old rates 3.2% of $10,000 = $320 3.78% of $10,000 = $378
Changed rates 3.6% of $10,000 = $360 3.7% of $10,000 = $370
Effect $ 40 $ (8)

Net effect = $ 32
x 20
$640

b) Memo

To: President of Company

From: Your Name, Accountant
Re: Financial impact of change in CPP and EI rates
The change in CPP and EI rates increases the cost of maintaining the
existing labor force in the amount of $640 per period. In addition, employee
contributions are also increasing, so that the net cheque that each employee
receives falls. The company might want to consider increasing wages in
order that employees not suffer decreases in income, and to ensure that the
company is able to attract employees. Any considerations of this nature will
result in additional labour costs for the company.

18
c) In order to reduce the impact of these rate changes, the company could
reduce its labor force, decrease the hours its employees work, or consider
moving to another country.

19
 Reading and Interpreting Published Financial Statements

9.28 a) For producing properties, the estimated costs for reclamation are
estimated and expensed over the life of the estimated reserves. The costs of
reclamation are part of the cost associated with generating the revenue from
the producing properties and therefore it is appropriate that these costs be
matched against the revenue as it is generated. For non-producing
properties, the accrued as liabilities when the costs are likely to be incurred
and can be reasonably estimated. Actual site reclamation costs are deducted
from the liability. The non-producing properties are not generating revenue
and therefore it is not possible to match these costs to anything. It is
therefore appropriate that they be expensed as soon as they are known.

b) Part of the cost associated with the revenue generated from producing
properties is the cost of cleaning up and restoring the property after the
revenue generation is complete. It is therefore appropriate to match these
costs against the revenue as it occurs. It is not appropriate to wait until the
actual costs are incurred because at that time there is no revenue against
which to generate these costs.

9.29 a) A line of credit is an agreement with a lending institution in which the

institution allows the company to access cash beyond the balance in its
account. As soon as this extra cash is accessed, the amount is owed to the
financial institution and interest is charged against the amount accessed. It
is a short-term loan. CAE would want to have lines of credit in various
currencies if it was buying from suppliers outside of Canada and repaying
those amounts in currencies other than the Canadian dollar.

b) A prime rate is the rate of interest charged by financial institutions to its

best customers, those with the best credit rating. It is usually the lowest
borrowing rate charged by the financial institution. The closer the interest
rate on the line of credit is to the prime rate, the greater the confidence that
the financial institution has in the company’s ability to repay the debt.

c) Unsecured means that there are no specific assets that are tied to the
debt. If the company fails to repay the debt, the financial institution would
have to sue the company for repayment and could not claim specific assets as
payment for the debt. If specific assets are tied to the debt and if the value of
those assets is sufficient to cover the outstanding debt, it is likely that CAE
could get a reduced rate of interest. When debt is secured, the risk on non-
payment is reduced and financial institutions are often willing to accept
reduced interest.

9.30 a) Customer deposits represent the amounts that clients have given to
Mackenzie to be invested.

20
 b) Customer deposits are likely long-term because most clients would be
interested in leaving their funds with Mackenzie to manage over an extended
period of time. Customers could, however, withdraw there funds within a
short period of time which gives the assets a short-term aspect.
c) This asset implies that Mackenzie is involved in loaning out mortgage
money. In fact, Mackenzie has a subsidiary operation called M.R.S. Trust
Company that manages residential and commercial mortgage portfolios. It is
listed with the assets because it represents the future mortgage payments
that will be made to the company in repayment of mortgage money borrowed.
To Mackenzie this is an asset.

9.31 a) A commercial paper program is a program whereby a company that has a

high credit rating borrows from another through the issuance of unsecured
promissory notes. The bank does not consider Xerox to be a particularly good
credit risk, however, because the interest rates on its long-term debt
instruments are much higher.
b) The short-term borrowing rate is much lower than the long-term
borrowing rate because the risk of Xerox defaulting on its short-term debt
has been assessed at much less than the risk of it defaulting on long-term
debt. In general, the interest rate on long-term borrowings is higher due to
expected inflation, and greater uncertainties associated with the long-term.
c) A secured debt means that the lender has claims against specific assets of
the borrowing company in the event of default. A company might choose to
issue secured debt in order to obtain a lower interest rate on the debt.

9.32 a) Dofasco’s statutory rate for income tax in 1998 is 42.98% ($120.4/$280.1).

b) The actual tax rate is 37.38% ($104.7/$280.1).

c) Permanent differences are differences between accounting and tax

reporting that never reverse themselves. An accounting item will never
become a tax item or a tax item will never become an accounting item. The
manufacturing and processing credit is a deduction allowed for tax purposes
but it is not an expense in the accounting records. The resource allowance is
a also a deduction allowed for tax purposes which is not an expense for
accounting purposes.

d) In 1998Dofasco actually paid $108.2 million in income tax to Revenue

Canada. This amount is shown as the current amount in the first table in
Exhibit 9-14.

9.33 a) Laidlaw likely included this note because there exists the distinct
possibility of a significant loss if the court rules against the subsidiary.
Although the company does not think that the courts will rule against it, the

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 company feels that this information is relevant for shareholders and other
decision-makers.
b) Laidlaw will likely continue to provide a note about this matter in its
financial statements until the court has ruled either in favor or against its
subsidiary. At this time, Laidlaw can remove the note and accrue an actual
loss if necessary.
c) The 1998 financial statements do not include a note on this contingency
any more. An examination of the financial statements does not reveal how
this issue was resolved. The lack of information probably means that the
resolution of the issue did not materially affect the company.

9.34 a) A line of credit is an agreement with a lending institution in which the

institution allows the company to access cash beyond the balance in its
account. As soon as this extra cash is accessed, the amount is owed to the
financial institution and interest is charged against the amount accessed.
b) The bank would raise the interest rate if it considered the risk of
collection higher than it was before. Also, the level of debt increased
significantly over the last year and this may have affected the bank’s decision
as well. Chai-Na-Ta may be able to convince the bank to lower the rate the
next time it renews the line of credit, if it pays off the current outstanding
debt within the given time frame.
c) When a debt is secured, it means that certain assets are pledged against
default of the debt. If the company cannot repay the debt, the bank can force
the company to sell the secured assets in order to recover the amount of the
debt. If the debt was not secured, it is probably that the interest rate would
increase because the bank’s ability to collect the amount owed in case of
default is less certain.

9.35 a) The “guaranteeing of indebtedness of third parties” means that the

company has agreed to act as a guarantor for other companies. If those
companies default on outstanding commitments, the creditor can come to
Alcan to collect the amount owed.

b) It was important for Alcan to include a note about the guarantees because
there is a possibility that Alcan could be required to pay these amounts in the
future if the third parties default. Users need to know about this possibility.
c) These commitments for the supplies of goods and services represent
mutually unexecuted contracts. As either side acts on the conditions of these
contracts – delivers goods, performs services, pays in advance or amounts
owed – the actions are recorded in the accounting system. Prior to such
actions nothing is recorded unless there is a likelihood of future losses
associated with these contracts. The fact that they are described in the

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 commitment sections of the notes indicates that they have not been recorded
in the accounting system.

Beyond the Book

9.36 Answers to this question will be depend on the company selected.

9.37 Answers to this question will be depend on the company selected.

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 CASE

9.38 The Bigger Motor Company

a) 1. Line of credit
If Bigger borrowed $60,000 in January, it would need to repay the money in
four montly instalments of $15,000 starting in February. If we assume that
the amount was borrowed on January 1 and repayments started February 1,
the cost of borrowing would be:
$60,000 x .09 x 1/12 = $450; repayment amount, $15,450
$45,000 x .09 x 1/12 = $338; repayment amount, $15,338
$30,000 x .09 x 1/12 = $225; repayment amount, $15,225
$15,000 x .09 x 1/12 = $113; repayment amount, $15,113
Total cost of borrowing is $1,126.

2. Accounts payable
If Bigger purchases $50,000 per month and does not pay in 30 days it forfeits
a $1,000 discount each month. This costs the company 12.2% (.02 / (60/365)).
As well, the delay of the $50,000 does not provide enough working capital if
the company needs $60,000.

3. Short-term bank loan

Cash balance that must be maintained = .15 x $75,000 = $11,250.
Cash balance available to be used = $63,750 which is enough to cover the
$60,000 need for working capital.
Assuming that the monthly payments are made at the end of each month, the
interest payments would be calculated as:
$75,000 x .07 x 1/12 = $438; repayment amount, $7,938
$67,500 x .07 x 1/12 = $394; repayment amount, $7,894
$60,000 x .07 x 1/12 = $350; repayment amount, $7,850
$52,500 x .07 x 1/12 = $306; repayment amount, $7,806
$45,000 x .07 x 1/12 = $263; repayment amount, $7,763
$37,500 x .07 x 1/12 = $219; repayment amount, $7,719
$30,000 x .07 x 1/12 = $175; repayment amount, $7,675
$22,500 x .07 x 1/12 = $131; repayment amount, $7,631
$15,000 x .07 x 1/12 = $88; repayment amount, $7,588
$7,500 x .07 x 1/12 = $44; repayment amount, $7,544
Total interest payments = $2,408

b) Students’ recommendations may vary. They should not choose the

accounts payable alternative. This alternative does not generate enough
working capital. If the student chooses the line of credit, the reason should
be that the total amount paid in interest is the least. However, the company
may not be able to make payments as high as $15,000 over four consecutive
months. If the student chooses the short-term loan, the reason should be that

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 this spreads the payments over a longer period of time and may make it
easier for the company to manage. Although the total interest paid over the
ten months is higher, the interest rate is lower. If the company has excess
cash it may be able to pay off the debt in a shorter period of time than the ten
months. This would save some interest costs.

Critical Thinking Question

9.39 a) The criteria for evaluating a contingency are 1) it is likely that some
future event will result in the company incurring an obligation which will
require the use of assets or the performance of a service and 2) the amount of
the loss can be reasonably estimated.
In the case of a resource company, these criteria would have to be applied to
their specific circumstance. If the company knew that it had an obligation to
clean up or restore the site to its original condition, it would meet the first
criteria and a contingency would be present. If it was not required to clean
up or restore the site and it had no intention of doing so, it could argue that
no contingency was present.
With respect to measurement of the future obligation, a more difficult
problem arises. If the company had not incurred these cost before, it would
have a difficult time arriving at a reasonable estimation of those future costs.
If it had cleaned up or restored previous sites, it would likely be able to
reasonably estimate these future costs. Another source of this information
would be the costs incurred by other companies that have cleaned up or
restored sites.
In general, the following criteria would determine what the company would
do:
 If it is likely that it will be involved in a future clean-up or restoration and
it can reasonably estimate the future cost of this activity, it should record a
portion of that future cost in each year that it recognized revenue from the
site.
 If it is likely that it will be involved in a future clean-up or restoration but
it is not possible to reasonably estimate the future cost of this activity, it
should disclose information about this contingency in the note to the financial
statements. As soon as it can reasonably estimate the future costs, it should
start recording them.
 If it is likely that it will clean up or restore the site, it does not need to
record or disclose any information about it.
b) Present (discounted) value of future cash flows is one of four different
measurement attributes of assets and liabilities used in practice (the others
are historical cost, replacement cost, and net realizable value). Recognition is
dependent upon an element having a relevant attribute, which in itself is a
function of the nature of the item and the relevance and reliability of the

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attribute measure. For example, equipment is most often reported using the
historical cost measurement attribute. The selection of this attribute
probably reflects the concern that other attributes are less reliable measures,
although many would question the relevance of the historical cost attribute,
especially for decisions such as determining the collateral value of an asset.
However, the accounting literature recognized that decision makers must
often trade off the relevance of information and the reliability of the measure.
This question addresses the reliability of present value measures. The most
common reason for viewing present value as a second choice for measurement
is that it is highly subjective and would need to be amended or modified over
time. In contrast, the direct measures described above generally are more
reliable because they can be objectively determined.
One of the primary characteristics of contingencies, such as lawsuits, is the
extended length of time over which the event will occur. Not only is the
litigation process time consuming (e.g., from the point in time in which
litigation is begun through initial settlement, appeals, and final verdict or
settlement), but the payment of damages may occur over an extended period
of time. In such cases, accountants may consider using present value to
measure litigation settlements although the CICA Handbook does not
specifically make this recommendation.

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