LIABILITIES

Chapter
11-1
 Learning outcomes
 Define liability, provision, contingent liability and
contingent asset and also describe their accounting
treatment.
 Distinguish between provisions, contingent liabilities
or contingent assets.
 Understand and apply the recognition and de-
recognition criteria for provisions.
 Measurement of provisions
 Disclosure requirements for provisions.
 Assess and account for adjusting and non-adjusting
events after the reporting period.
 Understand and analyze going concern issues arising
after the end of the reporting period.
Chapter
11-2
 Liabilities
Liabilities -- Definition
Definition

A liability is a present obligation of the entity

arising from past events, the settlement of which
is expected to result in an outflow from the entity
of resources embodying economic benefits.
An obligation that already exists. An obligation may
be legally enforceable as a result of a binding
contract or a statutory requirement, such as a legal
obligation to pay a supplier for goods purchased.

Obligations may also arise from normal business practice, or a desire to

maintain good customer relations or the desire to act in a fair way; even
though it is not legally enforceable by the customers of the entity.

Chapter
11-3
 Liabilities
Liabilities -- Definition
Definition

It arises out of a past transaction or event. For

example, a trade payable arises out of the
past purchase of goods or services, and an obligation
to repay a bank loan arises out of past borrowing.

The settlement of a liability should result in an

outflow of resources that embody economic benefits.
This usually involves the payment of cash or transfer
of other assets. A liability is measured by the value
of these resources that will be paid or transferred.

Chapter
11-4
 Offsetting
 Assets and liabilities must not be offset except when
offsetting is required by another Standard.
 The reporting of assets net of valuation allowances —
for example, obsolescence allowances on inventories
and doubtful debts allowances on receivables—is not
offsetting.

Chapter
11-5
 Liabilities
Liabilities

Liabilities are classified separately;

 Non Current liability
 Current Liabilities
 Deferred tax and other deferred balances must
not be classified as current assets or current
liabilities.

Chapter
11-6
 Tests for Determining Current Liabilities
A liability should be classified as a current liability if it satisfies
any of the following criteria:
 The entity expects to settle the liability in its normal operating
cycle.
 The liability is held primarily for the purpose of trading. This
means that all trade payables are current liabilities, even if
settlement is not due for over 12 months after the end of the
reporting period.
 It is due to be settled within 12 months after the end of the
reporting period.
 The entity does not have the unconditional right to defer
settlement of the liability for at least 12 months after the end
of the reporting period.

Liabilities that were originally non-current may become current in

a subsequent year, when they become repayable within 12 months.
Chapter
11-7
 Current
Current Liabilities
Liabilities

Current liability is debt with two key features:

1. Company expects to pay the debt from
existing current assets or through the
creation of other current liabilities.
2. Company will pay the debt within one year or
the operating cycle, whichever is longer.

Current liabilities include all payables, statutory

obligations, unearned revenues, advances, deposits,
accrued liabilities, loans and provisions
Chapter
11-8
 Accounting
Accounting for
for Current
Current Liabilities
Liabilities

Notes Payable
Written promissory note.
Require the borrower to pay interest.
Issued for varying periods.

Chapter
11-9
 Accounting
Accounting for
for Current
Current Liabilities
Liabilities

E11-2 On June 1, Melendez Company borrows $90,000

from First Bank on a 6-month, $90,000, 12% note.
Instructions
a) Prepare the entry on June 1.
b) Prepare the adjusting entry on June 30.
c) Prepare the entry at maturity (December 1), assuming
monthly adjusting entries have been made through
November 30.
d) What was the total financing cost (interest expense)?

Chapter
11-10
 Accounting
Accounting for
for Current
Current Liabilities
Liabilities

E11-2 On June 1, Melendez Company borrows $90,000

from First Bank on a 6-month, $90,000, 12% note.
a) Prepare the entry on June 1.
Cash 90,000
Notes payable

b) Prepare90,000
the adjusting entry on June 30.
$90,000 x 12% x 1/12 = $900

Interest expense 900

Interest payable
Chapter
11-11 900
 Accounting
Accounting for
for Current
Current Liabilities
Liabilities

E11-2 On June 1, Melendez Company borrows $90,000

from First Bank on a 6-month, $90,000, 12% note.
c) Prepare the entry at maturity (December 1), assuming
monthly adjusting entries have been made through
November 30.

Notes payable 90,000

Interest payable 5,400
Cash

d) What was the total financing cost (interest expense)?

95,400
$5,400
Chapter
11-12
 Accounting
Accounting for
for Current
Current Liabilities
Liabilities

E11-3 In providing accounting services to small

businesses, you encounter the following situations pertaining
to cash sales.
1. Warkentinne Company rings up sales and sales taxes
separately on its cash register. On April 10, the register
totals are sales $30,000 and sales taxes $1,500.
2. Rivera Company does not segregate sales and sales taxes.
Its register total for April 15 is $23,540, which includes a
7% sales tax.
Instructions: Prepare the entry to record the sales
transactions and related taxes for each client.

Chapter
11-13
 Accounting
Accounting for
for Current
Current Liabilities
Liabilities

E11-3 1. Warkentinne Company rings up sales and

sales taxes separately on its cash register. On April
10, the register totals are sales $30,000 and sales
taxes $1,500.
Cash 31,500
Sales
Sales tax payable
30,000
1,500

Chapter
11-14
 Accounting
Accounting for
for Current
Current Liabilities
Liabilities

E11-3 2. Rivera Company does not segregate sales and

sales taxes. Its register total for April 15 is $23,540,
which includes a 7% sales tax.
$23,540 / 1.07 = $22,000

Cash 23,540
Sales
Sales tax payable
22,000
1,540

Chapter
11-15
 Accounting
Accounting for
for Current
Current Liabilities
Liabilities

Unearned Revenue
Revenues that are received before the company
delivers goods or provides services.
1. Company debits Cash, and
credits a current liability
account (unearned revenue).
2. When the company earns
the revenue, it debits the
Unearned Revenue account,
and credits a revenue account.

Chapter
11-16
 Accounting
Accounting for
for Current
Current Liabilities
Liabilities

E11-4 Guyer Company publishes a monthly sports

magazine, Fishing Preview. Subscriptions to the magazine
cost $20 per year. During November 2008, Guyer sells
12,000 subscriptions beginning with the December issue.
Guyer prepares financial statements quarterly and
recognizes subscription revenue earned at the end of the
quarter.The company uses the accounts Unearned
Subscriptions and Subscription Revenue.
Instructions: (a) Prepare the entry in November for the
receipt of the subscriptions. (b) Prepare the adjusting
entry at December 31, 2008. (c) Prepare the adjusting
entry at March 31, 2009.

Chapter
11-17
 Accounting
Accounting for
for Current
Current Liabilities
Liabilities

E11-4 (a) Prepare the entry in November for the receipt

of the subscriptions. (b) Prepare the adjusting entry at
December 31, 2008. (c) Prepare the adjusting entry at
March 31, 2009.

Nov. 30 Cash (12,000 x $20) 240,000

Unearned subscriptions

Dec. 31 Unearned subscriptions

240,000 20,000
1 month Subscriptions revenue

Mar. 31 20,000subscriptions
Unearned 60,000
3 months Subscriptions revenue

Chapter
11-18 60,000
 Accruals
Accruals and
and Provisions
Provisions
Accruals are liabilities to pay for goods or services that
have been received or supplied but not yet invoiced.
There is often a degree of estimation in the
measurement of accruals but any inherent uncertainty is
much less than for provisions.

Provisions are liabilities of uncertain timing or amount.

Chapter
11-19
 Warranty
Warranty Provision
Provision

Recording a Warranties
Product Warranties
Promise made by a seller to a buyer to make good
on a deficiency of quantity, quality, or performance
in a product.

Estimated cost of honoring product warranty

contracts should be recognized as an expense in the
period in which the sale occurs.

Chapter
11-20
 Contingent
Contingent Liabilities
Liabilities
BE11-6 On December 1, Diaz Company introduces a
new product that includes a one-year warranty on
parts. In December, 1,000 units are sold. Management
believes that 5% of the units will be defective and
that the average warranty costs will be $80 per unit.
Prepare the adjusting entry at December 31 to accrue
the estimated warranty cost.
1,000 units x 5% x $80 = $4,000

Dec. 31 Warranty expense 4,000

Warranty liability 4,000

Chapter
11-21
 Disclosures
Disclosures about
about Provisions
Provisions
For each class of provision, an entity shall disclose:
a) the carrying amount at the beginning and end of the period;
b) additional provisions made in the period, including increases to
existing provisions;
c) amounts used (i.e. incurred and charged against the provision)
during the period;
d) unused amounts reversed during the period; and
e) the increase during the period in the discounted amount arising
from the passage of time and the effect of any change in the
discount rate.

A brief description of:

 The nature of the obligation;
 The expected timing of any settlement; and
 An indication of the uncertainties surrounding the amount and
timing of any settlement.
Chapter
11-22
 Paid Absences
• Employees often are given rights to receive
compensation for absence when they meet certain
conditions of employment.
• The compensation may be for paid vacations, sick
pay benefits, and paid holidays.
• When the payment for such absences is probable
and the amount can be reasonably estimated, the
company should accrue a liability for paid future
absences.
• When the amount cannot be reasonably
estimated, the company should instead disclose the
potential liability.
Chapter
11-23
 Accounting
Accounting for
for Current
Current Liabilities
Liabilities

Current Maturities of Long-Term Debt

Portion of long-term debt that comes due in the
current year.
No adjusting entry required.

Chapter
11-24
 Contingent
Contingent Liabilities
Liabilities
A contingent liability is either of the following:

 A contingent liability is a possible obligation that

arises from past events and whose existence will
be confirmed only by the occurrence or non-
occurrence of one or more uncertain future events
not wholly within the control of the entity.
OR
 A contingent liability is a present obligation that
arises from past events but is not recognized
because it is not probable that an outflow of
economic benefits will be required to settle the
obligation or the amount of the obligation cannot
Chapter be measured with sufficient reliability.
11-25
 Contingent
Contingent Liabilities
Liabilities

Three areas of probability:

Probable.
Reasonably possible.
Remote.

Contingent liabilities should be disclosed unless the

possibility of any outflow in settlement is remote

Chapter
11-26
 Decision Tree
Start

Present Obligation
No Possible Obligation?
arising as a result of No
an obligating event?

Yes
Probable Outflow No Remote Possibility? Yes
of economic
benefit?

Yes
Reliable estimate No
of the cost? No, rare

Yes
Account for item Disclose the item
as a provision as Contingent Do Nothing
Liability in a note
Chapter
11-27
 EVENTS AFTER THE REPORTING PERIOD:

 Events after the reporting period: Those events,

favourable and unfavourable that occur between the
end of the reporting period and the date the
financial statements are authorised for issue.
 Adjusting events: Events that provide evidence of
conditions that already existed as at the end of the
reporting period.
 Non-adjusting events: Events that have occurred
due to conditions arising after the end of the
reporting period.

Chapter
11-28
 Post-Retirement Benefits

 Provident Fund
 Gratuity
 Pension

Companies account for post-retirement benefits on the

accrual basis.

Chapter
11-29
 Post Retirement Plans

There are two types of plans:

In a defined-contribution plan, the plan defines the

contribution that an employer will make but not the
benefit that the employee will receive at retirement.
This is often referred to as a

In a defined-benefit plan, the employer agrees to pay

a defined amount to retirees, based on employees
meeting certain eligibility standards.

Chapter
11-30
 Working
Working Capital
Capital
Statement Presentation and Analysis
Illustration 11-4

Liquidity refers to
the ability to pay
maturing obligations
and meet unexpected
needs for cash.
The current ratio
permits us to compare
the liquidity of
different-sized
companies and of a
single company at Illustration 11-5

different times.
Chapter
11-31
 Key Concepts and Skills
 Understand what is working Capital
 Understand the components of the cash cycles and
why it is important

Chapter
11-32
 Balance Sheet Model of the Firm

Current
Liabilities
Current
Assets Net Long-Term
Workin Debt
g
Capital
How much
Fixed
short-term
Assets cash flow does
Shareholder
1 Tangible a company
s’ Equity
need to pay its
2 Intangible bills?
Chapter
11-33
 Tracing Cash and Net Working
Capital
 Current Assets are cash and other assets that are
expected to be converted to cash within the year.
 Cash

 Marketable securities

 Accounts receivable

 Inventory

 Current Liabilities are obligations that are expected

to require cash payment within the year.
 Accounts payable

 Accrued wages

 Taxes

Chapter
11-34
 Defining Cash in Terms of
Other Elements
Long-
Net Working Fixed Term +
Capital + Assets = Equity
Debt

Other
Net Working Current
= Cash + Current
Capital – Liabilities
Assets
Long- Other
Fixed
Cash = Term + Equity – Current + Current
– Assets
Debt Assets Liabilities

Chapter
11-35
 Defining Cash in Terms of Other
Elements
 An increase in long-term debt and or equity leads to
an increase in cash—as does a decrease in fixed
assets or a decrease in the non-cash components of
net working capital.
 The sources and uses of cash follow from this
reasoning.

Chapter
11-36
 The Operating Cycle and the Cash
Cycle
Raw material
purchased Cash
Finished goods sold received

Order Stock
Placed Arrives

Inventory period Accounts receivable period

Time
Accounts payable period

Firm receives invoice Cash paid for materials

Operating cycle
Chapter Cash
cycle
11-37
 The Operating Cycle and the Cash
Cycle

Cash cycle = Operating cycle Accounts

– payable period

In practice, the inventory period, the accounts

receivable period, and the accounts payable period are
measured by days in inventory, days in receivables, and
days in payables.

Chapter
11-38
 Example

 Inventory:
 Beginning = 200,000
 Ending = 300,000

 Accounts Receivable:
 Beginning = 160,000
 Ending = 200,000

 Accounts Payable:
 Beginning = 75,000
 Ending = 100,000

 Net sales = 1,150,000

 Cost of Goods sold = 820,000

Chapter
11-39
 Example
 Inventory period
 Average inventory = (200,000+300,000)/2 =
250,000
 Inventory turnover = 820,000 / 250,000 = 3.28
times
 Inventory period = 365 / 3.28 = 112 days

 Receivables period
 Average receivables = (160,000+200,000)/2 =
180,000
 Receivables turnover = 1,150,000 / 180,000 =
6.39 times
 Receivables period = 365 / 6.39 = 57 days

 Operating cycle = 112 + 57 = 169 days

Chapter
11-40
 Example

 Payables Period
 Average payables = (75,000+100,000)/2 = 87,500
 Payables turnover = 820,000 / 87,500 = 9.37
times
 Payables period = 365 / 9.37 = 39 days
 Cash Cycle = 169 – 39 = 130 days
 We have to finance our inventory for 130 days.
 If we want to reduce our financing needs, we need
to look carefully at our receivables, inventory
periods and payable period

Chapter
11-41
 Short Term Borrowing

The most common way to finance a temporary cash

deficit is to arrange a short-term loan.
 Unsecured Loans
 Secured Loans inventory as collateral.
 Other Sources

Chapter
11-42
 Study
Study Objectives
Objectives
1. Explain why bonds are issued.
2. Prepare the entries for the issuance of bonds and
interest expense.
3. Describe the entries when bonds are redeemed or
converted.
4. Describe the accounting for long-term notes
payable.
5. Contrast the accounting for operating and capital
leases.
6. Identify the methods for the presentation and
analysis of long-term liabilities.

Chapter
11-43
 Non
Non Current
Current Liabilities
Liabilities

 Bonds, Debentures,
 Term Finance Certificates
 Long Term Loans
 Redeemable Capital
 Deferred Liabilities
 Leased Liabilities

1.
Chapter
11-44
 Statement
Statement Analysis
Analysis and
and Presentation
Presentation

Analysis of Long-Term Debt

Two ratios that provide information about debt-
paying ability and long-run solvency are:

1. Debt to Total debt

=
total assets
Total assets

The higher the percentage of debt to total assets,

the greater the risk that the company may be
unable to meet its maturing obligations.

Chapter
11-45
 Statement
Statement Analysis
Analysis and
and Presentation
Presentation

Analysis of Long-Term Debt

Two ratios that provide information about debt-
paying ability and long-run solvency are:
Income before income taxes
Times and interest expense
interest =
earned Interest expense

Indicates the company’s ability to meet interest

payments as they come due.

Chapter
11-46
 Thank You

Chapter
11-47