1. Financial Accounting: Tools for Business Decision-Making Financial Accounting: Tools for Business Decision-Making Second Canadian Edition Second Canadian Edition Prepared by: Barbara Trenholm University of New Brunswick & Peggy Coady Memorial University of Newfoundland

2. Reporting and Analysing Liabilities CHAPTER 10

3. Creditor claims on total assetsCreditor claims on total assets Existing debts and obligationsExisting debts and obligations Current and long-termCurrent and long-term Liabilities Liabilities must be settled in the future by transfer of assets or services

4. Current Liabilities Expected to be paid: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 long-term liabilities

5. Types of current liabilities include: Accounts payableAccounts payable Operating line of creditOperating line of credit Notes payableNotes payable Accrued liabilitiesAccrued liabilities Sales taxes payableSales taxes payable Property taxes payableProperty taxes payable Payroll and employee benefits payablePayroll and employee benefits payable Current maturities of long-term debtCurrent maturities of long-term debt Current Liabilities

6. Accounts Payable Amounts owing to creditorsAmounts owing to creditors Normally due in 30 daysNormally due in 30 days Interest charged on overdue accounts onlyInterest charged on overdue accounts only

7. Operating Line of Credit Prearranged agreement between a company and a lender to allow the company to borrow up to an agreed-upon amountPrearranged agreement between a company and a lender to allow the company to borrow up to an agreed-upon amount

8. Notes Payable Often used instead of accounts payableOften used instead of accounts payable Provide written documentation, if needed, for legal remediesProvide written documentation, if needed, for legal remedies Normally has interest attachedNormally has interest attached Used for short-term and long-term financing needsUsed for short-term and long-term financing needs

9. Sales Taxes Payable Federal Goods and Services Tax (GST)Federal Goods and Services Tax (GST) Provincial Sales Tax (PST)Provincial Sales Tax (PST) Harmonized into one combined sales tax (HST) in some provincesHarmonized into one combined sales tax (HST) in some provinces May or may not be included in sale priceMay or may not be included in sale price Must be remitted periodically to respective governmentsMust be remitted periodically to respective governments

10. Payroll and Employee Benefits Payable Employee payroll deductionsEmployee payroll deductions –Canada pension plan (CPP) –Employment insurance (EI) –Federal and provincial income taxes –Other deductions at source Employer payroll contributionsEmployer payroll contributions –CPP –EI –Workers’ compensation –Other

11. Current Maturities of Long-Term Debt The portion of the long-term debt that is due within the current year or operating cycle should be classified as a current liabilityThe portion of the long-term debt that is due within the current year or operating cycle should be classified as a current liability

12. Long-Term Liabilities Obligations to be paid after one yearObligations to be paid after one year Include bonds, long-term notes, and lease obligationsInclude bonds, long-term notes, and lease obligations

13. Bonds Payable A form of interest-bearing notes payable issued by corporations, universities, and government agenciesA form of interest-bearing notes payable issued by corporations, universities, and government agencies Sold in small denominations, which makes them attractive to investorsSold in small denominations, which makes them attractive to investors Secured (mortgage bond) vs. unsecured (debenture bond)Secured (mortgage bond) vs. unsecured (debenture bond) Convertible vs. redeemable/retractableConvertible vs. redeemable/retractable

14. Terminology Contractual interest rateContractual interest rate –Stated rate which determines the amount of cash interest the borrower pays and the investor receives Market (effective) interest rateMarket (effective) interest rate –Rate that investors demand for loaning funds

15. Terminology Face valueFace value –Amount of principal due at maturity Present valuePresent value –Value today of (1) bond face value to be received at maturity and (2) interest payments to be received periodically after taking into account current interest rates

16. Accounting for Bond Issues Bonds may be issued atBonds may be issued at –Face value –Below face value (discount) –Above face value (premium)

17. Issuing Bonds at Face Value Assume that Candlestick, Inc. issued $ 1 million, five-year, 10%, bonds dated January 1, 2004 at 100 (face value). Jan. 1 Cash 1,000,000 Bonds Payable Bonds Payable1,000,000 To record sale of bonds at face value

18. This occurs when the investor pays less than the face value of the bondThis occurs when the investor pays less than the face value of the bond WHY?WHY? To adjust the contractual interest to the market interest rateTo adjust the contractual interest to the market interest rate Issuing Bonds at Discount

19. Assume that on January 1, 2004, Candlestick, Inc. sells $1 million, five-year, 10% bonds at 98. Jan. 1 Cash 980,000 Discount on Bonds Payable Discount on Bonds Payable20,000 Bonds Payable Bonds Payable1,000,000 To record sale of bonds at a discount To record sale of bonds at a discount

20. Carrying (Book) Value of Bonds Bonds payable $1,000,000 Less: Discount on bonds payable 20,000 20,000$980,000 Long-term liabilities Carrying Value

21. This occurs when the investor pays more than the face value of the bondThis occurs when the investor pays more than the face value of the bond WHY?WHY? To adjust the contractual interest to the market interest rateTo adjust the contractual interest to the market interest rate Issuing Bonds at Premium

22. Assume that on January 1, 2004, Candlestick, Inc. sells $1 million, five-year, 10% bonds at 102. Jan. 1 Cash 1,020,000 Bonds Payable Bonds Payable1,000,000 Premium on Bonds Payable Premium on Bonds Payable20,000 To record sale of bonds at a premium To record sale of bonds at a premium

23. Carrying (Book) Value of Bonds Bonds payable $1,000,000 Add: Premium on bonds payable 20,000 20,000$1,020,000 Long-term liabilities Carrying Value

24. Amortization of Bond Premium or Discount There are two commonly used methods to amortize bond discount or premium:There are two commonly used methods to amortize bond discount or premium: Straight-line method—premium or discount is amortized to interest expense over the life of the bond in equal amountsStraight-line method—premium or discount is amortized to interest expense over the life of the bond in equal amounts Effective interest method—the interest expense reflects the same percentage of the bond’s carrying value; this is the preferred methodEffective interest method—the interest expense reflects the same percentage of the bond’s carrying value; this is the preferred method

25. Amortizing Bond Discounts or Premiums Straight-line methodStraight-line method –Constant periodic expense, varying % –Simpler, widely used Effective interest methodEffective interest method –Varying periodic expense, constant % –Conceptually superior, better match Both methods result in the same total amount of interest expense over the life of bonds. Both methods result in the same total amount of interest expense over the life of bonds.

26. Amortizing Bond Discounts or Premiums Amortization spreads the cost of borrowing over the life of the bondAmortization spreads the cost of borrowing over the life of the bond Discount amortization increases interest expenseDiscount amortization increases interest expense Premium amortization reduces interest expensePremium amortization reduces interest expense

27. Bond Retirements Bonds may be redeemed at maturity or before maturityBonds may be redeemed at maturity or before maturity

28. Redeeming Bonds Before Maturity A company may decide to retire bonds before maturity in order to:A company may decide to retire bonds before maturity in order to: –Reduce interest cost –Remove debt from its balance sheet A company should retire debt early only if it has sufficient cash resourcesA company should retire debt early only if it has sufficient cash resources

29. Redeeming Bonds Before Maturity When bonds are retired before maturity:When bonds are retired before maturity: –Eliminate carrying value of the bonds at the redemption date –Record the cash paid –Recognize the gain or loss on redemption (gain if cost carrying value)

30. Long-Term Notes Payable Normally repayable in a series of periodic payments called instalmentsNormally repayable in a series of periodic payments called instalments Instalment notes repayable in equal periodic amounts plus interest (fixed or floating interest) are called fixed principal paymentsInstalment notes repayable in equal periodic amounts plus interest (fixed or floating interest) are called fixed principal payments Instalment notes repayable in equal periodic amounts including interest are called blended principal and interest paymentsInstalment notes repayable in equal periodic amounts including interest are called blended principal and interest payments

31. Presentation of Long-Term Liabilities Report long-term debt separately in balance sheet and detail in notesReport long-term debt separately in balance sheet and detail in notes Report current maturities of long-term debt as current liabilitiesReport current maturities of long-term debt as current liabilities Cash inflows and outflows during the year from the principal portion of debt transactions are reported in the financing activities section of the cash flow statementCash inflows and outflows during the year from the principal portion of debt transactions are reported in the financing activities section of the cash flow statement

32. Analysis of Long-Term Liabilities LiquidityLiquidity –Current ratio –Acid-test ratio SolvencySolvency –Debt to total assets –Times interest earned

33. Current Ratio Measure of a company’s ability to pay short-term obligationsMeasure of a company’s ability to pay short-term obligations Current Liabilities Current Assets Current Ratio =

34. Acid-Test Ratio Measure of a company’s ability to pay immediate, short-term obligationsMeasure of a company’s ability to pay immediate, short-term obligations Acid-Test Ratio = Cash + Short-Term Investments + Accounts Receivable Current Liabilities

35. Debt to Total Assets Indicates the extent to which a company’s debt could be repaid by liquidating assetsIndicates the extent to which a company’s debt could be repaid by liquidating assets Total Assets Total Debt Debt to Total Assets =

36. Times Interest Earned Provides an indication of a company’s ability to meet interest payments as they come dueProvides an indication of a company’s ability to meet interest payments as they come due Times Interest Earned = Earnings Before Interest Expense & Income Tax Expense (EBIT) Interest Expense

37. Contingencies Events with uncertain outcomesEvents with uncertain outcomes Must be recorded in the financial statements if:Must be recorded in the financial statements if: –The company can reasonably estimate the expected loss and –If the loss is likely

38. Off-Balance Sheet Financing A situation in which liabilities are not recorded on the balance sheet (e.g. leasing)A situation in which liabilities are not recorded on the balance sheet (e.g. leasing) Operating lease involves temporary use of the property by the lessee with continued ownership of the property by the lessorOperating lease involves temporary use of the property by the lessee with continued ownership of the property by the lessor Lease (rental) payments are recorded as an expense by the lessee and as revenue by the lessorLease (rental) payments are recorded as an expense by the lessee and as revenue by the lessor

39. Off-Balance Sheet Financing If the lease contract transfers substantially all the benefits and risks of ownership to the lessee, the lease is in effect a purchase of the propertyIf the lease contract transfers substantially all the benefits and risks of ownership to the lessee, the lease is in effect a purchase of the property This type of lease is called a capital lease because the fair value of the leased asset is capitalized by the lessee when recording it on the balance sheetThis type of lease is called a capital lease because the fair value of the leased asset is capitalized by the lessee when recording it on the balance sheet

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