1. Chapter 10 Reporting and Interpreting Liabilities 1© McGraw-Hill Ryerson. All rights reserved.

2. The Role of Liabilities Liabilities are created when a company: – Buys goods and services on credit – Obtains short-tem loans – Issues long-term debt © McGraw-Hill Ryerson. All rights reserved.2 Current liabilities are due within one year. LO1 Current liabilities may include a portion of Long-Term Debt that is due within one year.

3. Measuring Liabilities © McGraw-Hill Ryerson. All rights reserved.3 Initial liability = cash equivalent. Increase with additional obligations. Decrease when payments are made. Interest is not recorded when a liability is first recorded. Interest is incurred as time passes. LO2 + -

4. Current Liabilities Accounts Payable is increased (credited) when a company buys goods or services on credit. Accounts Payable is decreased (debited) when a company pays its account. Accounts Payable is interest-free unless it becomes overdue. © McGraw-Hill Ryerson. All rights reserved.4 Accounts Payable LO2

5. Accrued Liabilities Accrued Liabilities are obligations for expenses that have been incurred, but not yet paid at the end of the accounting period. Accrued Liabilities often include advertising, electricity, corporate income tax, interest, payroll tax and warranties. © McGraw-Hill Ryerson. All rights reserved.5 LO2

6. Accrued Payroll Payroll Deductions are the amounts deducted from each employee’s gross pay. They include Income Taxes, Canada Pension Plan and Employment Insurance. These amounts must be remitted to the appropriate government or agency. They are liabilities. © McGraw-Hill Ryerson. All rights reserved.6 LO2

7. A company has a payroll of $600,000. The total withheld is: employee income tax $100,550; CPP $28,500; EI $10,250; and United Way Contributions $10,000. The total cash paid to employees is $450,700. © McGraw-Hill Ryerson. All rights reserved.7 LO2 1 Analyze 2 Record

8. Employer Payroll Taxes are additional amounts employers must remit. Employers must match employees’ CPP amounts and must contribute 1.4 times the employees’ EI amount. © McGraw-Hill Ryerson. All rights reserved.8 LO2 1 Analyze 2 Record The employees’ CPP is $28,500, so the company must contribute an additional $28,500 to CPP; the employees’ EI is $10,250, so the company must contribute an additional $14,350 to EI.

9. Accrued Income Taxes Corporations must file a T2 tax return to determine the amount of federal and provincial tax. A corporation’s taxable income is multiplied by the company’s tax rate, which is often about 35%. Corporate income taxes are due three months after yearend. Most companies are required to pay instalments during the year. © McGraw-Hill Ryerson. All rights reserved.9 LO2

10. Notes Payable © McGraw-Hill Ryerson. All rights reserved.10 Establishing a Note Payable On November 1, 2012, a company borrows $100,000 cash on a one-year 6% note payable. Both principal and interest are due October 31, 2013. Notes Payable is the amount owed as a result of issuing promissory notes. 1 Analyze 2 Record LO2

11. Accruing Interest Expense On December 31, 2012, accrued interest revenue is recorded. LO2 © McGraw-Hill Ryerson. All rights reserved.11 Interest= P x R x T = $100,000 x 6% x 2/12 = $1,000 Note Payable Timeline 1 Analyze 2 Record

12. Recording Interest Paid On October 31, 2013, the company pays a $6,000 cash interest payment. LO2 © McGraw-Hill Ryerson. All rights reserved.12 The total interest is $6,000; $1,000 was expensed in 2012 and accrued December 31, 2012, and $5,000 is expense in 2013. 1 Analyze 2 Record

13. Recording Principal Paid On October 31, 2013, the company pays the $100,000 principal that is due. LO2 © McGraw-Hill Ryerson. All rights reserved.13 1 Analyze 2 Record

14. Let’s try it E10-2 E10-3 E10-5 © McGraw-Hill Ryerson. All rights reserved.14

15. Sales Tax Payable © McGraw-Hill Ryerson. All rights reserved.15 Recording a Sale with PST and GST A $1,000 sale is made in a province with 5% PST and 5% GST. The total cash received is $1,100, of which $50 is PST and $50 is GST. Most provinces charge PST on retail sales, the federal government charges GST; some provinces have combined both taxes into HST. These taxes must be collected from customers and remitted to the appropriate government. 1 Analyze 2 Record LO2

16. Unearned Revenue © McGraw-Hill Ryerson. All rights reserved.16 Receive Cash and Create a Liability On October 1, cash is received for a three-month subscription in advance at a rate of $10 per month ($30 total). If a customer pays for goods or services in advance, a liability is created. LO2 1 Analyze 2 Record

17. © McGraw-Hill Ryerson. All rights reserved.17 Fulfill part of the liability and earn revenue On October 31, one month ($10) has been earned. 1 Analyze 2 Record This entry would be repeated each month until all the Unearned Revenue has been earned. LO2

18. Let’s try it E10-6 © McGraw-Hill Ryerson. All rights reserved.18

19. Long-Term Liabilities Bonds are financial instruments that outline the future payments a company promises to make in exchange for receiving a sum of money now. © McGraw-Hill Ryerson. All rights reserved.19 Bonds Maturity Date The date on which a bond is due to be paid in full. Face Value The amount payable on a bond’s maturity date. Stated Interest Rate The rate stated on the face of the bond, which is used to compute interest payments. LO3

20. © McGraw-Hill Ryerson. All rights reserved.20 Bond Pricing Present Value is a mathematical calculation to determine how much future payments are worth today. Issue Price is the amount of money the company receives when a bond is issued. The amount may be equal to face value ($1,000), or the amount may be higher or lower than face value. LO3

21. © McGraw-Hill Ryerson. All rights reserved.21 Accounting for a Bond Issue Bonds Issued at Face Value General Mills receives $100,000 cash in exchange for issuing 100 bonds at their $1,000 face value. 1 Analyze 2 Record LO3

22. © McGraw-Hill Ryerson. All rights reserved.22 Bonds Issued at a Premium A Premium is the amount by which a bond’s issue price exceeds its face value. General Mills receives $107,260 cash in exchange for issuing 100 bonds at their $1,000 face value. The bond price is 107.26. $100,000 is the face value and $7,260 is a premium. 1 Analyze 2 Record LO3

23. © McGraw-Hill Ryerson. All rights reserved.23 Bonds Issued at a Discount A Discount is the amount by which a bond’s issue price is less than its face value. General Mills receives $93,376 cash in exchange for issuing 100 bonds at their $1,000 face value. The bond price is 93.376. $100,000 is the face value and $6,624 is a discount. 1 Analyze 2 Record Discount on Bonds Payable is a contra-liability. LO3

24. © McGraw-Hill Ryerson. All rights reserved.24 Relationships between Interest Rates and Bond Pricing 6% Stated Interest Rate on Bond 8% Market Interest Rate 6% Market Interest Rate 4% Market Interest Rate Investors will pay less than face value Investors will pay face value Investors will pay more than face value Bond Issued at a Discount Bond Issued at Face Value Bond Issued at a Premium Market Interest Rate is the rate that investors demand from a bond. Balance Sheet Reporting of Bond Liabilities LO3

25. © McGraw-Hill Ryerson. All rights reserved.25 Interest Expense Interest on Bonds Issued at Face Value General Mills issued $100,000 6% bonds January 2, 2012. After one month, on January 31, 2012, interest expense will be $100,000 x 6% x 1/12 = $500 1 Analyze 2 Record LO3

26. © McGraw-Hill Ryerson. All rights reserved.26 Interest on Bonds Issued at a Premium General Mills issued $100,000 6% bonds January 2, 2012 and received $107,260. General Mills received $107,260, but must pay back only $100,000 at maturity. The premium, $7,260, is a reduction in the cost of borrowing. Bond Amortization will reduce the interest expense. Bond Amortization is explained in the Supplements at the end of this chapter. LO3

27. © McGraw-Hill Ryerson. All rights reserved.27 Interest on Bonds Issued at a Discount General Mills issued $100,000 6% bonds January 2, 2012 and received $93,376. General Mills received $93,376, but must pay back only $100,000 at maturity. The discount, $6,624, is an increase in the cost of borrowing. Bond Amortization will increase the interest expense. Bond Amortization is explained in the Supplements at the end of this chapter. LO3

28. © McGraw-Hill Ryerson. All rights reserved.28 Bond Retirements Retirement at Maturity Most bonds are retired (paid off) at maturity. General Mills pays $100,000 cash to retire bonds at maturity. LO3 1 Analyze 2 Record

29. © McGraw-Hill Ryerson. All rights reserved.29 Early Retirement Bonds may be retired early, sometimes to reduce future interest expense, especially if interest rates have fallen. LO3 If bonds are retired early, a gain will arise if the cash paid to retire the bonds is less than the carrying value; a loss will arise if the cash paid is more than the carrying value. General Mills pays $103,000 cash to retire bonds early. 1 Analyze 2 Record

30. Let’s try it E10-8 © McGraw-Hill Ryerson. All rights reserved.30

31. Contingent Liabilities Contingent Liabilities are a result of past transactions or events; their ultimate outcome is not known until a future event occurs or fails to occur. Warranties and lawsuits may be contingent liabilities. © McGraw-Hill Ryerson. All rights reserved.31 LO4 ASPE for Contingent Liabilities Under IFRS, contingent liabilities are recorded if the estimated loss is “more likely than not” to occur.

32. Quick Ratio © McGraw-Hill Ryerson. All rights reserved.32 LO5 Cash + Short-term Investments + Accounts Receivable, Net Current Liabilities The Quick Ratio shows whether liquid assets are sufficient to pay current liabilities. The higher the number, the better able to quickly pay.

33. Times Interest Earned Ratio © McGraw-Hill Ryerson. All rights reserved.33 LO5 Net Income + Interest Expense + Income Tax Expense Interest Expense The Times Interest Earned Ratio shows whether sufficient resources are generated to cover interest costs. The higher the number, the better the coverage. If the times interest earned ratio is less than 1.0, the company is not generating enough income to cover its interest expense.

34. Supplement 10A Straight-Line Method of Amortization for Bonds © McGraw-Hill Ryerson. All rights reserved.34 S-10A The straight-line method of amortization evenly allocates the amount of bond premium or discount over each period of a bond’s life.

35. © McGraw-Hill Ryerson. All rights reserved.35 Straight-Line Bond Premiums General Mills received $107,260 on the issue date January 1, 2012, but will repay only $100,000 at maturity December 31, 2015. Using the straight-line method, the $7,260 premium is spread evenly as a reduction in interest expense over the four years of the bonds life. The annual $6,000 cash payment for interest will be reported as a $7,260/4 = $1,815 reduction in the bond premium and $6,000 - 1,815 = $4,185 interest expense. S-10A

36. © McGraw-Hill Ryerson. All rights reserved.36 1 Analyze 2 Record Bond Premium Amortization Schedule Straight-Line Method S-10A Constant Amount

37. © McGraw-Hill Ryerson. All rights reserved.37 Straight-Line Bond Discounts General Mills received $93,376 on the issue date January 1, 2012, but will repay only $100,000 at maturity December 31, 2015. Using the straight-line method, the $6,624 discount is spread evenly as an increase in interest expense over the four years of the bonds life. The annual $6,000 cash payment for interest will be reported as a $6,624/4 = $1,656 reduction in the bond discount and $6,000 + 1,656 = $7,656 interest expense. S-10A

38. © McGraw-Hill Ryerson. All rights reserved.38 Bond Discount Amortization Schedule Straight-Line Method 1 Analyze 2 Record S-10A Constant Amount

39. Supplement 10B Effective-Interest Method of Amortization for Bonds © McGraw-Hill Ryerson. All rights reserved.39 S-10B The effective-interest method of amortization allocates the amount of bond premium or discount in amounts corresponding to the bond’s carrying value. The effective-interest method of amortization is the required method under IFRS.

40. © McGraw-Hill Ryerson. All rights reserved.40 The Effective-Interest Method of Amortization requires an understanding of the present value of bond payments. The value of a bond is equal to the present value of the face amount plus the present value of the annual interest payments. If the bond interest rate (6%) exactly matches the rate required by investors (6%), investors will pay face value. If the bond interest rate (6%) is higher than the rate required by investors (4%), investors will pay a premium. If the bond interest rate (6%) is lower than the rate required by investors (8%), investors will demand a discount. S-10B

41. © McGraw-Hill Ryerson. All rights reserved.41 Effective-Interest Bond Premiums Interest = Carrying Value x Market Interest Rate x n/12 = $107,260 x 4% = $4,290 General Mills received $107,260 on the issue date January 1, 2012 which means the market rate must be 4%. Interest for 2012 is calculated: The 2012 annual $6,000 cash payment for interest will be reported as $4,290 interest expense and a $6,000 - $4,290 = $1,710 reduction in the bond premium. S-10B

42. © McGraw-Hill Ryerson. All rights reserved.42 Bond Premium Amortization Schedule Effective-Interest Method S-10B Varying Amount 1 Analyze 2 Record

43. © McGraw-Hill Ryerson. All rights reserved.43 Effective-Interest Bond Discounts Interest = Carrying Value x Market Interest Rate x n/12 = $93,376 x 8% = $7,470 General Mills received $93,376 on the issue date January 1, 2012, which means the market rate must be 8%. Interest for 2012 is calculated: The 2012 annual $6,000 cash payment for interest will be reported as $7,470 interest expense and a $1,470 - reduction in the bond discount. S-10B

44. © McGraw-Hill Ryerson. All rights reserved.44 Bond Discount Amortization Schedule Effective-Interest Method S-10B Varying Amount 1 Analyze 2 Record

45. Let’s try it E10-12 © McGraw-Hill Ryerson. All rights reserved.45