2. Prepared by: Jan Hájek Accounting Lecture no 7

3. I.O.U. Defined as debts or obligations arising from past transactions or events. Maturity = 1 year or lessMaturity > 1 year Current Liabilities Non-current/long- term Liabilities The Nature of Liabilities

4. The acquisition of assets is financed from two sources: Funds from creditors, with a definite due date, and sometimes bearing interest. Funds from owners DEBT EQUITY Distinction Between Debt and Equity

5. A current liability is a debt that can reasonably be expected to be paid 1. from existing current assets or in the creation of other current liabilities and 2. within one year or the operating cycle, whichever is longer. ACCOUNTING FOR CURRENT LIABILITIES

6. Types of liabilities 1) Definitely determinable 2) Estimated 3) Contingent

7. Definitely determinable current liabilities include : 1. Operating line of credit 2. Accounts and notes payable 3. Sales tax payable 4. Payroll and employee benefits 5. Unearned revenues 6. Current maturities of long-term debt ACCOUNTING FOR CURRENT LIABILITIES

8. OPERATING LINE OF CREDIT  A pre-authorized demand loan, allowing the company to write cheques up to a preset limit when needed.  Disclosed by footnote and by reporting any resulting bank overdraft as a current liability.

9.  Notes Payable are obligations in the form of written promissory notes that usually require the borrower to pay interest.  Notes payable may be used instead of accounts payable because it supplies documentation of the obligation in case legal remedies are needed to collect the debt.  Notes due for payment within one year of the balance sheet date are usually classified as current liabilities. NOTES PAYABLE

10. SALES TAXES PAYABLE  Sales tax is expressed as a stated percentage of the sales price of goods sold to customers by a retailer.  Sales tax includes the goods and service tax (GST), provincial sales tax (PST) or harmonized sales taxes (GST and PST combined).  The retailer (or selling company) collects the tax from the customer when the sale occurs, and periodically (usually monthly) remits the collections to the government.

11.  Salaries or wages payable represent the amounts owed to employees for a pay period.  Payroll withholdings include federal and provincial income taxes, Canada Pension Plan (CPP) contributions, and employment insurance (EI) premiums.  Employees may also voluntarily authorize withholdings for charity, retirement, medical, or other purposes.  Payroll withholdings are remitted to governmental taxing authorities. PAYROLL AND EMPLOYEE BENEFITS

12.  Unearned Revenues (advances from customers) occur when a company receives cash before a service is rendered.  Examples are when an airline sells a ticket for future flights or when a lawyer receives legal fees before work is done. UNEARNED REVENUES

13. CURRENT MATURITIES OF LONG-TERM DEBT  Another item classified as a current liability is current maturities of long-term debt.  Current maturities of long-term debt are often identified on the balance sheet as long-term debt due within one year.

14. ESTIMATED LIABILTIES  Obligation that exists but for which the amount and timing is uncertain.  However, the company can reasonably estimate the liability.  Examples include property taxes and warranty liabilities.

15. PROPERTY TAXES  Property taxes are accrued monthly based on the prior year’s tax bill.  When the property tax bill for the current year is received, the company will adjust its monthly expense for the remainder of the year.

16. PRODUCT WARRANTIES  Warranty contracts may lead to future costs for replacement or repair of defective units.  Using prior experience with the product, the company estimates what the cost of servicing the warranty will be.  Estimated warranty costs are accrued with a debit to warranty expense and a credit to estimated warranty liability.

17. CONTINGENT LIABILITIES  Contingent liabilities exist when there is uncertainty about the outcome.  Contingencies are accrued by a debit to an expense account and a credit to a liability account if both of the following conditions are met: 1. The contingency is likely, and 2. The amount of the contingency can be reasonably estimated.

18. FINANCIAL STATEMENT PRESENTATION  Each major type of current liability is listed separately.  Often list bank loans, notes payable, and accounts payable first, then other liabilities. COMINCO LTD. Current liabilities (Millions ) Bank loans and notes payable$ 5 Accounts payable and accrued liabilities 230 Income and resource taxes 36 Long-term debt due within one year 30 $301

20. INTERNAL CONTROLS FOR PAYROLL  The objectives of internal accounting control concerning payroll are 1. to safeguard company assets from unauthorized payrolls and 2. to assure the accuracy and reliability of the accounting records pertaining to payrolls.  Payroll activities include: 1. hiring employees 2. timekeeping 3.preparing the payroll 4. paying the payroll  These functions should be assigned to different departments or individuals. 4 Functions of Payroll

21. HIRING EMPLOYEES The human resources department is responsible for: 1.Posting job openings 2.Screening and interviewing applicants 3.Hiring of employees 4.Authorizing changes in pay rates during employment 5.Terminations of employment

22. TIMEKEEPING  Hourly employees are usually required to record time worked by “punching” a time clock – the time of arrival and departure are automatically recorded by the employee when he/she inserts a time card into the clock.  The employee’s supervisor must: 1.approve the hours shown by signing the time card at the end of the pay period 2.authorize any overtime hours for an employee.

23. PREPARING THE PAYROLL The payroll department prepares the payroll on the basis of two sources of input: 1.human resource department authorizations, and 2.approved time cards.

24. PAYING THE PAYROLL The comptroller’s department is responsible for the payment of the payroll. 1.Payment by direct deposit, or by cheque, minimizes the risk of loss from theft. 2.All direct deposit lists and cheques must be signed by the comptroller and their distribution protected by the comptroller’s department.

25. DETERMINING AND PAYING THE PAYROLL Determining the payroll involves calculating 1. gross earnings, 2.payroll deductions, and 3. net pay.

26.  Gross earnings is the total compensation earned by an employee.  There are three types of gross earnings: 1. wages 2.salaries 3.bonuses  Total wages are determined by applying the hourly rate of pay to the hours worked.  Most companies are required to pay a minimum of one and one-half times the regular hourly rate for overtime work. GROSS EARNINGS

27. PAYROLL DEDUCTIONS  The difference between gross pay and the amount actually received is attributable to payroll deductions.  Mandatory deductions consist of Canada Pension Plan (CPP, or QPP in Quebec), employment insurance (EI) and personal income tax.

28. PAYROLL DEDUCTIONS  Voluntary deductions pertain to withholdings for charitable causes, retirement, and other purposes.  All voluntary payroll deductions should be authorized in writing by the employee.  Voluntary payroll deductions do not result in a payroll expense to the employer.  Net pay is determined by subtracting payroll deductions from gross earnings.

29. EMPLOYER PAYROLL COSTS  CPP The employer must match each employee’s CPP contribution.  EI The employer is required to contribute 1.4 times each employee’s EI deductions.  Workplace Health, Safety, and Compensation Employers pay a specified percentage of their gross payroll to provide supplemental benefits for workers who are injured or disabled in the workplace.

30. ADDITIONAL FRINGE BENEFITS PAID ABSENCES  Employees may have the right to receive compensation for future benefits when certain conditions of employment are met.  The compensation may pertain to: 1.Paid vacation 2.Sick pay benefits 3.Paid holidays

31. ADDITIONAL FRINGE BENEFITS PAID ABSENCES  When the payment of compensation is probable and can reasonably be determined, a liability should be accrued.  When the amount can not be reasonably estimated, the potential liability should be disclosed.

32.  Many companies use a payroll register to accumulate the gross earnings, deductions, and net pay by employee for each period.  In some cases, this record is a journal or book of original entry.  The typical entry to record the employee costs in a payroll is to debit Salaries or Wages expense and to credit a variety of liability accounts.  When the payroll is paid, the liability accounts are debited and Cash is credited. RECORDING THE PAYROLL

33. RECOGNIZING PAYROLL EXPENSES AND LIABILITIES Academy Company records its payroll for the week ending June 15, 2002 with the journal entry above. Office Salaries Expense ($5,200) and Wages Payable ($12,010) are debited in total for $17,210 in gross earnings. Specific liability accounts are credited for the deductions made during the pay period. Salaries and Wages Payable is credited for $9,885.34 in net earnings. June 15 Office Salaries Expense Wages Expense CPP Payable EI Payable Income Tax Payable United Way Payable Union Dues Payable Salaries and Wages Payable To record payroll for the week ending June 15. 5,200.00 12,010.00 654.03 387.23 5,646.90 421.50 215.00 9,885.34 GENERAL JOURNAL Date Account titles and explanationDebitCredit Date Account Titles and Explanation Debit Credit

34. RECORDING EMPLOYER PAYROLL COSTS The entry to record the payroll costs associated with the Academy Company payroll results in a debit to Employee Benefits Expense for $2,056.65, a credit to CPP Payable for $654.03 ($654.03 x 1) and a credit to EI Payable for $542.12 ($387.23 x 1.4). Assuming a worker’s compensation rate of 1 percent, the comp-ensation payable liability would be for $172.10 ($17,210 x 1%). Vacation pay accrues at 4% and therefore the vacation payable will be 688.40 ($17,210 x 4%). GENERAL JOURNAL DateAccount Titles and ExplanationDebitCredit June 15Employee Benefits Expense CPP Payable EI Payable Workers’ Compensation Payable Vacation Pay Payable To record employer payroll costs on June 15 payroll. 2,056.65 654.03 542.12 172.10 688.40

35. The entry to record payment of the Academy Company payroll is a debit to Salaries and Wages Payable and a credit to Cash. RECORDING PAYMENT OF THE PAYROLL GENERAL JOURNAL Date Account Titles and Explanation Debi Credit June 15Salaries and Wages Payable Cash To record payment of payroll. 9,885.34

36. LONG-TERM LIABILITIES  Long-term liabilities are obligations that are expected to be paid after one year.  Long-term liabilities include bonds, long-term notes, and lease obligations.

37. BOND BASICS  Bonds are a form of interest-bearing notes payable issued by corporations, governments, and governmental agencies.  Bonds, like common shares, can be sold in small denominations (usually a thousand dollars), and as a result they attract investors.

38. WHY ISSUE BONDS?  From the standpoint of the corporation seeking long-term financing, bonds offer the following advantages over common shares: 1.Shareholder control is not affected. 2.Income tax savings result. 3.Earnings per share may be higher.

39. DISADVANTAGES OF BONDS  The major disadvantages resulting from the use of bonds are that interest must be paid on a periodic basis, and principal (face value) of the bonds must be paid at maturity.

40. TYPES OF BONDS SECURED AND UNSECURED  Secured bonds have specific assets of the issuer pledged as collateral for the bonds. A bond can be secured by real estate or other assets.  Unsecured bonds are issued against the general credit of the borrower; they are also called debenture bonds. No ASSET as Collateral

41. TYPES OF BONDS TERM AND SERIAL BONDS  Bonds that mature at a single specified future date are called term bonds.  In contrast, bonds that mature in instalments are called serial bonds. 2000 2001 2002 2003

42. TYPES OF BONDS REGISTERED AND BEARER  Registered bonds are issued in the name of the owner and have interest payments made by cheque to bondholders of record.  Bearer or coupon bonds are not registered; thus bondholders must send in coupons to receive interest payments.

43. TYPES OF BONDS CONVERTIBLE, REDEEMABLE, AND RETRACTABLE  Convertible bonds permit bondholders to convert the bonds into common shares at their option.  Redeemable (callable) bonds are subject to call and retirement at a stated dollar amount prior to maturity at the option of the issuer.  Retractable bonds are subject to redemption prior to maturity at the option of the holder.

44. ISSUING PROCEDURES  The face value is the amount of principal due at the maturity date.  The contractual interest rate, often referred to as the stated rate, is the rate used to determine the amount of cash interest the borrower pays and the investor receives.  Bond certificates, which provide information such as name of issuer, face value, contractual interest rate and maturity date, are authorized by the Board and printed.

45. DETERMINING THE MARKET VALUE OF BONDS  The market value (present value) of a bond is a function of three factors: the dollar amounts to be received, the length of time (n) until the amounts are received, and the market rate of interest (i) which is the rate investors demand for loaning funds to the corporation.  The process of finding the present value is referred to as discounting the future amounts.

46. TIME DIAGRAM DEPICTING CASH FLOWS $100,000Principal 01234567890123456789 $2,000$2,000$2,000$2,000$2,000$2,000$2,000$2,000$2,000 10 semi-annual interest payments

47. CALCULATING THE PRESENT VALUE OF BONDS  The market value of a bond is equal to the present value of all the future cash payments promised by the bond. Present value of $100,000 received in 10 periods $100,000 x 0.82035 (Table B-1: n=10, i=2%)$ 82,035 Present value of $2,000 received annually for 10 periods $2,000 x 8.98259 (Table B-2: n=10, i=2%) $ 17,965 Present (market) value of bonds$100,000

48. ACCOUNTING FOR BOND ISSUES Bonds may be issued at:  Face value  Below face value (discount) or  Above face value (premium).

49. ISSUING BONDS AT FACE VALUE  Bonds payable are reported in the long-term liability section of the balance sheet because the maturity date (January 1, 2008 in this case) is more than one year away. DateAccount Titles and Explanation Debit Credit Jan.1Cash Bonds Payable To record sale of bonds at face value. 1,000,000

50. ISSUING BONDS AT FACE VALUE Assuming that interest is payable semi-annually on January 1 and July 1 on the bonds, interest of $25,000 ($1,000,000 x 5% x 6/12) must be paid on July 1, 2003. The entry for the payment is: DateAccount Titles and Explanation Debit Credit July 1Bond Interest Expense Cash To record payment of bond interest. 25,000

51. DISCOUNT OR PREMIUM ON BONDS  Bonds may be issued below or above face value.  If the market (effective) rate of interest is higher than the contractual (coupon) rate, the bonds will sell at less than face value, or at a discount.  If the market rate of interest is less than the contractual rate on the bonds, the bonds will sell above face value, or at a premium.

52. INTEREST RATES AND BOND PRICES 4% 5% 6% Premium Face Value Discount Bond Contractual Interest Rate 5% Issued when Market Interest Bonds Sell Rates at

53. ISSUING BONDS AT A DISCOUNT Assume that on January 1, 2003, Candlestick Inc. sells $1 million, 5-year, 5 percent bonds at 95.7345 (95.7345 percent of face value) with interest payable on July 1 and January 1. The entry to record the issue is: DateAccount Titles and Explanation Debit Credit Jan. 1Cash Discount on Bonds Payable Bonds Payable To record payment of bond interest. 957,345 42,655 1,000,000

54. The $957,345 represents the carrying (or book) value of the bonds. On the date of issue, this amount equals the market price of the bonds. STATEMENT PRESENTATION OF BOND DISCOUNT The Discount on Bonds Payable account has a debit balance and is deducted from Bonds Payable on the balance sheet, as illustrated below: Long-term liabilities Bonds payable Less: Discount on bonds payable $1,000,000 42,655 $ 957,345

55. STRAIGHT-LINE METHOD OF BOND DISCOUNT AMORTIZATION  To comply with the matching principle, it follows that bond discount should be allocated systematically to each accounting period benefiting from the use of the cash proceeds.  The straight-line method of amortization of bond discount allocates the same amount to interest expense each interest period.

56. FORMULA FOR STRAIGHT-LINE METHOD OF BOND DISCOUNT AMORTIZATION  = Bond Discount Number of Interest Periods Bond Discount Amortization

57. Bond Discount Amortization Entries The entry to record the payment of bond interest and the amortization of bond discount on the first interest date (July 1, 2003) is: DateAccount Titles and Explanation Debit Credit July 1Bond Interest Expense Discount on Bonds Payable Cash To record payment of bond interest and amortization of bond discount. 29,265.50 4,265.50 25,000.00 Over the term of the bonds, the balance in Discount on Bonds Payable will decrease annually by the same amount until it reaches zero at the maturity date of the bonds. Thus, the carrying value of the bonds at maturity will be equal to the face value of the bonds.

58. EFFECTIVE INTEREST METHOD OF AMORTIZATION  The effective interest method is an alternative to the straight-line method of amortization.  Bond interest expense is calculated by multiplying the carrying value of the bonds at the beginning of the period by the effective interest rate.  The credit to Cash (or Bond Interest Payable) is calculated by multiplying the face value of the bonds by the contractual interest rate.  The bond discount or premium amortization amount is then determined by comparing bond interest expense with the interest paid or accrued.

59. EFFECTIVE INTEREST METHOD OF AMORTIZATION  Bond Interest Paid Bond Interest Expense Amortization Amount Carrying value of Bonds at Beginning of Period Market (Effective) Interest Rate  Face Amount of Bonds Contractua l Interest Rate   (1) (2) (3)

60. BOND DISCOUNT AMORTIZATION ENTRIES The entry to record the payment of bond interest and the amortization of bond discount on the first interest date (July 1, 2003) is: DateAccount Titles and Explanation Debit Credit July 1Bond Interest Expense Discount on Bonds Payable Cash To record payment of bond interest and amortization of bond discount. 28,720 3,720 25,000 Over the term of the bonds, the balance in Discount on Bonds Payable will decrease annually by the same amount until it reaches zero at the maturity date of the bonds. Thus, the carrying value of the bonds at maturity will be equal to the face value of the bonds.

61. ISSUING BONDS AT A PREMIUM To illustrate issuing bonds at a premium, assume that on January 1, 2003, Candlestick Inc. sells $1 million, 5-year, 5 percent bonds at 104.4915 (104.4915 percent of face value) with interest payable on July 1 and January 1. The entry to record the issue is: DateAccount Titles and Explanation Debit Credit Jan. 1Cash Bonds Payable Premium on Bonds Payable To record sale of bonds at a premium. 1,044,915 1,000,000 44,915

62. The $1,044,915 represents the carrying (or book) value of the bonds. On the date of issue, this amount equals the market price of the bonds. STATEMENT PRESENTATION OF BONDS PREMIUM Premium on Bonds Payable has a credit balance and therefore is added to Bonds Payable on the balance sheet, as illustrated below: Long-term liabilities Bonds payable Add: Premium on bonds payable $1,000,000 44,915 $1,044,915

63. BOND PREMIUM AMORTIZATION ENTRIES The entry to record the payment of bond interest and the amortization of bond premium using the straight-line method on the first interest date (July 1, 2003) is: DateAccount Titles and Explanation Debit Credit July 1Bond Interest Expense Premium on Bonds Payable ($44,915  10) Cash To record payment of bond interest and amortization of bond premium. 20,508.50 4,491.50 25,000.00 Over the term of the bonds, the balance in Premium on Bonds Payable will decrease annually by the same amount until it reaches zero at the maturity date of the bonds. Thus, the carrying value of the bonds at maturity will be equal to the face value of the bonds.

64. EFFECTIVE INTEREST METHOD OF AMORTIZATION  Bond Interest Paid Bond Interest Expense Amortization Amount Carrying value of Bonds at Beginning of Period Market (Effective) Interest Rate  Face Amount of Bonds Contractua l Interest Rate   (1) (2) (3)

65. BOND PREMIUM AMORTIZATION ENTRIES The entry to record the payment of bond interest and the amortization of bond premium on the first interest date (July 1, 2003) using the effective interest method is: DateAccount Titles and Explanation Debit Credit July 1Bond Interest Expense Premium on Bonds Payable Cash To record payment of bond interest and amortization of bond premium. 20,898 4,102 25,000 Over the term of the bonds, the balance in Premium on Bonds Payable will decrease annually by the same amount until it reaches zero at the maturity date of the bonds. Thus, the carrying value of the bonds at maturity will be equal to the face value of the bonds.

66. ISSUING BONDS BETWEEN INTEREST DATES When bonds are issued between interest payment dates, the investor must pay the market price for the bonds plus accrued interest since the last interest date. Assume that on March 1 Candlestick Inc. sells $1,000,000 of 5-year, 5 percent bonds at face value plus accrued interest. Interest is payable semi-annually on July 1 and January 1. The accrued interest is $8,333 ($1,000,000 x 5% x 2/12). The total proceeds on the sale of bonds is $1,008,333. The entry to record the sale is: DateAccount Titles and Explanation Debit Credit Mar. 1Cash Bonds Payable Bond Interest Payable To record sale of bonds at face value plus accrued bond interest. 1,008,333 1,000,000 8,333

67. ISSUING BONDS BETWEEN INTEREST DATES At the first interest date, it is necessary to eliminate the bond interest payable balance and to recognize the bond interest expense for the four months (March 1 to July 1) that the bonds have been outstanding. Interest expense in this example is $16,667 ($1,000,000 x 5% x 4/12). The entry on July 1 to record the first interest payment is: DateAccount Titles and Explanation Debit Credit July 1Bond Interest Payable Bond Interest Expense Cash To record payment of bond interest. 8,333 16,667 25,000

68. REDEEMING BONDS AT MATURITY Regardless of the issue price of bonds, the book value of the bonds at maturity will equal their face value. Assuming that the interest for the last interest period is paid and recorded separately, the entry to record the redemption of the Candlestick bonds at maturity is: DateAccount Titles and Explanation Debit Credit Jan. 1Bonds Payable Cash To record redemption of bonds at maturity. 1,000,000

69. BOND RETIREMENTS  Bonds may be redeemed before maturity because a company may decide to reduce interest cost and remove debt from its balance sheet.  When bonds are retired before maturity it is necessary to eliminate the carrying value of the bonds at the redemption date after updating interest, record the cash paid, and recognize the gain or loss on redemption and report as other gains or other losses in the income statement.

70. ACCOUNTING FOR OTHER LONG-TERM LIABILITIES  Long-term notes payable are similar to short- term interest-bearing notes payable except that the term of the note exceeds one year.  A long-term note may be secured by a mortgage that pledges title to specific assets as security for a loan.  Mortgage notes payable are widely used in the purchase of homes by individuals and in the acquisition of capital assets by many small and some large companies.

71. MORTGAGE NOTES PAAYBLE  Mortgage notes payable are recorded initially at face value and entries are required subsequently for each instalment payment. Fixed principal payment Blended principal and interest  In the balance sheet, the reduction in principal for the next year is reported as a current liability, and the remaining unpaid principal balance is classified as a long- term liability.

72. INSTALMENT PAYMENT SCHEDULE FIXED PRINCIPAL PAYMENT (A) (B) (C) (D) Cash Interest ReductionPrincipal Interest PaymentExpense of Principal Balance Period (B + C) (D x 7% x 1/12) (120,000/60) ( D - C ) Issue date$120,000 1 $2,700$ 700 $2,000 118,000 2 2,688 688 2,000 116,000 3 2,677 677 2,000 114,000 To illustrate, assume that Belanger Ltd. issues a $120,000, 7 percent, 5-year note on January 1, 2003, to obtain needed financing for the construction of a new research laboratory. The terms provide for monthly instalment payments of $2,000 ($120,000/60). The instalment payment schedule for the first few months is shown below:

73. INSTALMENT PAYMENT SCHEDULE BLENDED PAYMENT To illustrate, assume that Belanger Ltd. issues a $120,000, 7 percent, 5-year note on January 1, 2003, to obtain needed financing for the construction of a new research laboratory. The terms provide for monthly instalment payments of $2,376. The instalment payment schedule for the first few months is shown below: (B) (C) (D) (A) Interest ReductionPrincipal Interest Cash Expense of Principal Balance Period Payment (D x 7% x 1/12) (A - B) ( D - C ) Issue date$120,000 1 $2,376$ 700 $1,676 118,324 2 2,376 690 1,686 116,638 3 2,376 680 1,696 114,942

74. LEASE LIABILITIES OPERATING LEASE  In an operating lease the intent is temporary use of the property by the lessee with continued ownership of the property by the lessor.  The lease (rental) payments are recorded as an expense by the lessee and as revenue by the lessor. Car rental is an example of an operating lease

75. LEASE LIABILITIES CAPITAL LEASES  A capital lease transfers substantially all the benefits and risks of ownership from the lessor to the lessee.  In a capital lease, the present value of the cash payments for the lease are capitalized and recorded as an asset.

76. LEASE LIABILITIES CAPITAL LEASES  The lessee must record the lease as an asset (a capital lease) if any one of the following conditions exist: the lease transfers ownership of the property to the lessee (e.g., contains a bargain purchase option). The lease term is equal to 75% or more of the economic life of the leased property. The present value of the lease payments equals or exceeds 90% of the fair market value of the leased property.

77. CAPITAL LEASE ENTRIES  The leased asset is reported on the balance sheet under capital assets.  The portion of the lease liability expected to be paid in the next year is reported as a current liability.  The remainder is classified as a long-term liability.  If none of the four conditions for capitalizing a lease are met, the company does not report an asset. This procedure is referred to as off-balance sheet financing.