AFM101 Chapter Notes - Chapter 10: Deferred Tax, Contingent Liability, Deferred Income

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Chapter 10
ANSWERS TO QUESTIONS
1. Liabilities are obligations that result from transactions that require future payment of
assets or the future performance of services. The obligations are definite in amount or are subject
to reasonable estimation. A liability usually has a definite payment date known as the maturity or
due date. A current liability is a short-term liability; that is, one that will be paid during the coming
year or the current operating cycle of the business, whichever is longer. It is assumed that the
current liability will be paid out of current assets. All other liabilities are defined as long-term
liabilities.
2. One of the main sources of information available to external parties for determining the
number, type, and amounts of liabilities of a business are the published financial statements. The
statement of financial position includes liabilities and the notes to the statements contain further
detail on the liabilities that are on the statement of financial position as well as on contingent
liabilities and commitments. These statements have more credibility when they have been audited
by an independent auditor (usually a chartered accountant).
3. A liability is initially measured at its current cash equivalent amount. Conceptually, this
amount is the present value of all of the future payments of principal and interest. For a short-term
liability the current cash equivalent amount is usually the same as the maturity amount. The
current cash equivalent amount for an interest-bearing liability at the going rate of interest is the
same as the maturity value. For a long-term liability, the current cash equivalent amount will be
less than the maturity amount: (1) if there is no stated rate of interest, or (2) if the stated rate of
interest is less than the going rate of interest.
4. Most debts specify a definite amount that is due at a specified date in the future. However,
there are situations where it is known that an obligation or liability exists although the exact
amount is unknown. Liabilities that are known to exist but the exact amount is not yet known must
be recorded in the accounts and reported in the financial statements at an estimated amount,
assuming that a reasonable estimate can be made. Examples of a known obligation of an estimated
amount are estimated income tax at the end of the year, property taxes at the end of the year, and
obligations under warranty contracts for merchandise sold.
5. Working capital is computed as total current assets minus total current liabilities. It is the
amount of current assets that would remain if all current liabilities were paid, assuming no
loss or gain on liquidation of those assets.
6. The current ratio is the percentage relationship of current assets to current liabilities. It is
computed by dividing current assets by current liabilities. The current ratio is influenced by
the amount of current liabilities. Therefore, it is particularly important that liabilities be
considered carefully before classifying them as current versus long term. The shifting of a
liability from one of these categories to the other may significantly affect the current ratio.
This ratio is used by creditors because it is an important measure of a firm’s ability to meet
short-term obligations as they generally come due. Thus, the proper classification of liabilities
is particularly significant.
7. An accrued liability is an expense that was incurred before the end of the current period but
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing © 2011 McGraw-Hill Ryerson Limited. All rights reserved.
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has not yet been paid or recorded. Therefore, an accrued liability is recognized when such a
transaction is recorded. A typical example is wages earned during the last few days of the
accounting period but not recorded because the payroll was not prepared (or paid) that
included these wages. Assuming wages of $2,000 were incurred but not yet paid as at
December 31, the adjusting entry to record the accrued liability and the wage expense would
be as follows:
December 31:
Wage expense (+E SE) ................................................................. 2,000
  Wages payable (+L) ........................................................................ 2,000
8. Deferred revenue (also called unearned revenue or revenue collected in advance) is revenue
that has been collected in advance of being earned and recorded in the accounts by the entity.
Because the amount has already been collected and the goods or services have not yet been
provided, there is a liability to provide goods or services to the party who made the payment
in advance. A typical example is the collection of rent on December 15 for one full month to
January 15 when the accounting period ends on December 31. At the date of the collection of
the rent the following entry is usually made:
December 15:
Cash (+A)............................................................................................. 4,000
  Rent revenue (+R +SE) ......................................................... 4,000
On the last day of the period, the following adjusting entry should be made to recognize the
deferred revenue as a liability:
December 31:
Rent revenue (R SE).............................................................. 2,000
  Deferred rent revenue (+L).................................................... 2,000
The deferred rent revenue (credit) is reported as a liability on the statement of financial
position because two weeks’ occupancy is owed in the next period for which the lessee has
already made payment.
9. A note payable is a formal written contract prepared when a company borrows money. The
note specifies the amount borrowed, the date by which it must be repaid, and the interest rate
associated with the borrowing. Interest payable is the other liability associated with a note payable,
as interest regularly accrues on the note until it is repaid.
10. A provision is a liability that must be recognized when the following conditions are met: (1)
an entity has a present obligation as a result of a past event, (2) it is probable that cash or other
assets will be required to settle the obligation, and (3) a reliable estimate can be made of the
amount of the obligation. It differs from other liabilities in that there is uncertainty as to the amount
that will be required to settle the provision or the timing of the liability.
11. A contingent liability is not an effective liability; rather it is a potential future liability.
A contingent liability arises because of some transaction or event that has already
occurred which may, depending upon one or more future events (occurring or not
occurring), cause the creation of a true liability. A typical example is a lawsuit for
damages where an accident has occurred. Whether the defendant has a liability
depends upon the ultimate decision of the court. Pending that decision there is a
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contingent liability (and a contingent loss). This contingency must be recorded and
reported (debit, loss; credit, liability) if it is “likely” that the decision will require the
payment of damages, and the amount can be reasonably estimated. If the occurrence
of the confirming future event is not determinable, or if the event is likely to occur but
the amount of the loss cannot be reasonably estimated, information about the
contingent loss must be disclosed in the footnotes to the financial statements.
Disclosure of unlikely contingencies is desirable but not required.
12. Interest expense = $4,000 x 12% x 9/12 = $360.
13. The concept of the time value of money is another way to describe interest. Time value of
money refers to the fact that a dollar received today is worth more than a dollar to be received
at any later date because of interest that is earned over time.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing © 2011 McGraw-Hill Ryerson Limited. All rights reserved.
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