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C H APT ER

1 Reporting and Analyzing Liabilities


Study Objectives

Account for current liabilities.

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3.

Account for bonds payable.


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

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Liabilities
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Obligations resulting from past transactions

Classified as current and non-current

Liabilities must be settled in the future by transfer of assets or services

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Current Liabilities
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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 classified as noncurrent (or long-term) liabilities

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Current Liabilities
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Types of current liabilities include:
Bank indebtedness from operating lines of credit
Accounts payable and accrued liabilities Unearned revenue

Notes or loans payable


Sales taxes Property taxes

Payroll
Current portion of non-current debt
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Operating Line of Credit


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Prearranged agreement between a company and a lender to allow the company to borrow up to an agreed-upon amount:
To help manage temporary cash shortfalls

Interest is charged using a floating (or variable) interest rate


Security (collateral) may be required by bank When used, results in bank indebtedness
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Sales Taxes
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Expressed as % of the sales price
Provincial Sales Tax (PST 8% or QST) and
Goods and Services Tax (GST 5%) OR Harmonized Sales Tax (HST 13%)

May or may not be included in sale price


Sales taxes payable recorded

On remittance of sales taxes, the payable is decreased


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Property Taxes
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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

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Property Taxes Payable


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Upon receipt of the property tax bill (on March 1), an expense is recorded for the months that have passed (Jan and Feb)

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Property Taxes Payable (Continued) 1


When paid (on May 31), expense is recorded for additional months that have passed (March, April, May), and prepaid is set up for remaining months (June to Dec)

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Property Taxes Payable (Continued) 1


At December 31 (year-end date), prepaid is cleared to expense

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Payroll
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Three types of liabilities related to employee salaries and wages:
1. Salary and wages owed to employees (known as gross pay or gross earnings) 2. Payroll deductions required by law to be withheld from employees gross pay
Employees gross pay less payroll deductions is known as net pay (or take home pay)

3. Employer payroll obligations

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Employee Payroll Deductions


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Mandatory payroll deductions:
Canada pension plan (CPP)
Employment insurance (EI) Federal and provincial income taxes

Voluntary payroll deductions:


Benefits such as health, disability, and pension Union dues Charitable contributions
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Employer Payroll Obligations


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Employers share of CPP and EI

Workers compensation
Employee benefits:
Compensated absences (vacation, statutory holidays, sick days) Employer-sponsored health plans and pensions

Employers share of these costs is recorded as an employment benefits expense Until payroll deductions and costs are remitted to third parties (whom they are collected for), they are reported as current liabilities
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Short-Term Notes Payable


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A promise to pay a specified amount either at a future date or on demand Often used instead of accounts payable Provide written documentation, if needed, for legal remedies Normally has interest attached (at a fixed annual rate) Issued for varying periods:
If due within one year of financial statement date, they are classified as current liabilities
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Discussion Question
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What is the difference between an Accounts Payable and a Notes Payable?

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Short-Term Notes Payable: Example 1


HSBC Bank agrees to lend $100,000 on March 1, 2012, if Williams Coffee Shop Ltd. signs a $100,000, 6%, 4month bank loan maturing on July 1 (interest payable at maturity). Assume year-end is March 31. What entry is made upon receipt of cash and after note is signed? Is interest expense recorded periodically? If yes, what is the entry to accrue interest?

What is the entry recorded on maturity date?

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Short-Term Notes Payable: Example 1


What entry is made upon receipt of cash and after note is signed? March 1 Cash 100,000 100,000 Bank Loan Payable

(To record issue of 4-mth, 6% bank loan from HSBC)

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Short-Term Notes Payable: Example 1


Is interest expense recorded periodically? If yes, what is the entry to accrue interest? Interest accrues over the life of the bank loan and must be recorded periodically. Adjusting entry required to recognize interest expense and interest payable. Interest Expense 500 500 Interest Payable

($100,000 x 6% x 1/12)
(To accrue interest payable for 1-mth on HSBC loan)
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Short-Term Notes Payable: Example 1


What is the entry recorded on maturity date? At maturity on July 1, the face value of the bank loan ($100,000) plus interest accrued over the life of the loan has to be recorded. $500 interest has already been accrued in March. Interest Expense Interest Payable 1,500 1,500

($100,000 x 6% x 3/12)
(To accrue interest payable for April, May, and June) Bank Loan Payable Interest Payable Cash 100,000 2,000 102,000

(To record payment of HSBC bank loan and interest at maturity)


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Current Maturities of Non-Current Debt

The portion of non-current (long-term) debt that is due within the current year or operating cycle should be classified as a current liability Journal entry is not required to recognize this classification

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Non-Current Liabilities
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Obligations to be paid after one or more years classified as non-current Also known as financial liabilities (a type of financial instrument):
A contractual obligation to pay cash in the future

Includes long-term notes, bonds, and lease obligations May be secured or unsecured:
Secured notes are also known as mortgages

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Bonds Payable
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A form of interest-bearing notes payable

Large amount is divided into smaller denominations:


Makes them attractive to investors

Most have a fixed interest rate (coupon rate) May be secured or unsecured Payable at maturity or in installments

Redeemable bonds can be retired before maturity

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Bond Trading
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Convertible bonds can be converted to common shares at a stated price Bonds can also be traded on stock exchanges:
Bond prices are quoted as a percentage of the face value of the bonds (i.e. $1,000 bond with quoted
price of $97 sells at price 97% of face value or $970)

Market (or effective) interest rate (yield):


Rate investors demand for loaning funds

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Terminology
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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 The value today is dependent upon when the amounts are to be received, and the market rate on interest

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Accounting for Bond Issues


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Bonds may be issued at:
Face value
If market rate is equal to coupon rate

Below face value (discount)


If market rate is higher than coupon rate

Above face value (premium)


If market rate is lower than coupon rate

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Calculating the Price of a Bond Using Present Value Tables 1


Issue price = the present value of all future cash inflows (discounted at market rate of interest) Face value use Table 1 (PV of $1) to determine the factor to use to calculate the face value of bond
= PV factor x face value of bond

Interest use Table 2 (PV of an annuity of $1) to calculate the present value of bond interest
= PV annuity factor x periodic interest payment (payment calculated using coupon rate)

Sum the two to arrive at the price of the bond


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Calculating the Price of a Bond Using Financial Calculator 1


2nd P/Y, C/Y = Payments/year, compounding periods/year N = Total number of periods I/Y = ANNUAL effective interest rate PV = Present value PMT = Periodic payments (0 if only calculating the PV of the final FV payment) FV = Future value
Note: Individual calculators may differ
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Determining Issue Price of Bond Using a Financial Calculator 1


Use the highlighted row of keys for solving for present value
Note: Each calculator may differ in format

n: i: PV: PMT: FV:

Number of periods Market interest rate per period Present value Interest payment per period Future value

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Issuing Bonds at Face Value


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Assume that ABC Company Ltd. issued five-year $1 million 5% bonds dated January 1 at 100 (100% of face value). Interest on bonds is payable semiannually on January 1and July 31.
What is the entry to record the issuance of bonds?

How are the bonds reported in the Statement of Financial Position?


Do we need to record interest expense and accrue any interest for the year?

How is the bond interest reported in the Statement of Financial Position?

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Issuing Bonds at a Discount


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This occurs when investors pays less than the face value of the bond:
The coupon rate is too low investors can get a better rate elsewhere The bond price must therefore decrease to ensure that the yield (effective interest rate) is competitive Since the coupon rate is fixed, a lower bond price will result in a higher yield

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Issuing Bonds at a Discount (Continued)

Assume that on January 1, 2012 ABC Company Ltd., sells $1 million, five-year, 5% bonds at 95.7345 of face value. The market (effective) interest rate is 6% with interest payable on July 1 and January 1.
What is the present value of the bonds (issue price)?

What is the entry to record the issuance of bonds?


Do we have a discount or premium on the bond? What is the carrying amount of the bonds?

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Amortizing the Discount


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Bond discount is allocated to interest expense over the life of the bonds called amortizing the discount

Difference between interest expense (at the market rate or yield) and interest paid (at the coupon rate) is the discount to be amortized
What is the interest expense and paid for the first period? What is the discount to be amortized? What is the entry to record the payment of bond interest and amortization of bond discount (on 1st interest date)? What is the new carrying amount of the bonds? Any adjusting entries at Dec 31 (year-end) required?

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Issuing Bonds at a Premium


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This occurs when investors pays more than the face value of the bond:
The coupon rate is too high company does not have to offer such a high interest rate The bond price will therefore increase to ensure that the yield (effective interest rate) is competitive Since the coupon rate is fixed, a higher bond price will result in a lower yield

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Issuing Bonds at a Premium (Continued) 1


Assume that on January 1, 2012 ABC Company Ltd., sells $1 million, five-year, 5% bonds at 104.4915 of face value. The market (effective) interest rate is 4% with interest payable on July 1 and January 1.
What is the present value of the bonds (issue price)?

What is the entry to record the issuance of bonds?


Do we have a discount or premium on the bond? What is the carrying amount of the bonds?

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Amortizing the Premium


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Bond premium is allocated to interest expense over the life of the bonds called amortizing the premium

Difference between interest expense (at the market rate or yield) and interest paid (at the coupon rate) is the premium to be amortized
What is the interest expense and paid for the first period? What is the premium to be amortized? What is the entry to record the payment of bond interest and amortization of bond premium (on 1st interest date)? What is the new carrying amount of the bonds? Any adjusting entries at Dec 31 (year-end) required?

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Carrying Amount
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Carrying amount is face value of bond (-/+) unamortized discount/premium OR

PV of bond (-/+) amortized discount/premium


Discount increases carrying amount until it reaches maturity value; premium decreases the carrying amount

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Redeeming Bonds At Maturity


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At maturity, the bonds carrying amount is equal to their face value:
Regardless of the issue price of the bonds Any premium or discount will be fully amortized

No gain or loss occurs

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Redeeming Bonds Before Maturity 1


A company may decide to retire bonds before maturity in order to:
Reduce interest cost Remove debt from its balance sheet

When bonds are retired before maturity:


Update any unrecorded interest and amortization Eliminate carrying amount of the bonds at the redemption date

Record the cash paid


Recognize gain/loss on redemption (gain if cost < carrying amount; loss if cost > carrying amount)
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Redeeming Bonds Before Maturity 1


Assume at the end of the fourth year (eighth period), ABE Company Ltd., having sold its bonds at a premium, retires its bonds at 101 after paying the semi-annual interest. The carrying amount of the bonds at the redemption date is $1,009,709. What is the entry to record redemption of ABC Companys bonds at the end of the 8th interest period (Jan 1, 2016)?

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Statement Presentation
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Current liabilities
Reported as the first category of liabilities
Can be listed separately on statement of financial position or detailed in the notes

Normally listed in order of liquidity

Non-current liabilities
Report separately in statement of financial position and detail in notes Measured and reported at amortized cost
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Uncertain Liabilities
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Events with uncertain outcomes:
Who is owed
When it is owed, and/or How much is owed

Provisions are uncertain as to timing or amount


Contingent liabilities are possible obligations that are dependent upon some future event:
Should be recognized if more likely than not (IFRS)
Should be recognized if likely (ASPE)
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Comparing IFRS and ASPE


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