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Chapter 10

MGAB02H3 Chapter Notes - Chapter 10: Bulk Barn, Deferred Income, Promissory Note


Department
Financial Accounting
Course Code
MGAB02H3
Professor
Liang Chen
Chapter
10

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TOPIC 2: CH. 10 - REPORTING & INTERPRETING CURRENT LIABILITIES
Capital Structure: mixture of debt/equity that finances short/long-term operating requirements.
Current Liabilities: short-term obligations to be paid within a year.
Company has liquidity if it has ability to pay its current obligations
The quick ratio
is used to measure liquidity:
Quick Ratio = Quick Assets/Current Liabilities
Indicator of amount of quick assets (cash, investments, A/R) able to satisfy liabilities
HIGH ratio = GOOD liquidity, but TOO HIGH suggests INEFFICIENT use of resources
Ratio may be misleading
measure of liquidity as it can be influenced by small variations
in transaction flows. It can easily be manipulated, ex) managers can pay creditors
immediately prior to preparations of financial statements
**Liabilities are very important as they affect a company’s future cash flows/risk characteristics
Most liabilities are recorded as they occur during accounting period, such as trades
payable for purchases, loans from bank, notes payable to creditors.
Some liabilities can be determined with accuracy, such as salaries, interest - which
required accrual through adjusting entries at the end of the accounting period.
For other types, the exact amount is unknown until a future event, but must be estimated
and recorded.
ex) liability for a product warranty won’t be known until the work is carried out in
the future. But matching process requires warranty costs be recognized as an
expense during the same period in which the product was sold.
Since the costs & related liability are not known, they must be estimated
based on past experiences & recorded through adjusting entries.
CURRENT LIABILITIES
Many current liabilities have a direct relationship
to operating activities. Specific operating
activities are financed in part by related current liabilities.
EX)
Operating Activity
Current Liability
Purchase Merchandise
Trade Payables
Advertising
Accrued Liabilities
Services performed by employees
Accrued Liabilities
Provide warranty on products sold
Provisions

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TRADE Payables
Most companies do not make all their products, instead they buy from someone else.
These transactions are typically made on credit, with cash payments occurring after
goods/services have been provided. These transactions called trade payables
.
Trade Payables Turnover = Cost of Sales / AVG Net Trade Payables
Answers how well management is meeting obligations to suppliers, how well they can
pay back. Measure of liquidity.
In reality, numerator should be net credit purchases not COS. Since credit purchases not
usually reported in statements, we use total purchases of merch inventory as estimate,
assuming all purchases made on credit.
For merchandising companies, we compute purchases by adjusting COS for change in
inventory as: Purchases = Cost of Sales + Ending Inventory - Beginning Inventory
We use the T/P Turnover to find the Average Age of Payables:
AVG Age of Payables = 365 / T/P Turnover
HIGH turnover = company paying suppliers in a timely manner - shows how many days
company takes to pay supplier
This ratio doesn’t show whether company pays some creditors & not others, company
could pay last minute so ratio is high.
Low ratio = liquidity problems (not enough cash to pay back) or aggressive management
(company has min amount of cash needed for operating activities
ACCRUED LIABILITIES: expenses that have incurred but not yet paid for. ex) salaries/wages,
rent, interest, taxes.
Income Tax: there are two components, current/deferred portion. Current portion is payable
within time limits, deferred portion arises from differences between accounting/tax rules used to
determine income.
Other TAXES: such as GST, PST, which are taxes on goods.
DR Cash $1000
CR Sales Revenue $800
GST Payable $150
HST Payable $50
PAYROLL Liabilities: In addition to reporting salaries that have been earned but NOT paid,
companies must also report:
- Cost of unpaid benefits (retirement programs, vacation time, EI, health insurance)
Employers must also REMIT income tax & other social benefit contributions on behalf of their
employees to government agencies.
Employee Deductions: Laws require employers deduct an appropriate amount of income tax
each period from gross earnings of each employer. This amount is recorded by the employer, A
current liability between date of deduction & date on which the amount is remitted to the
government.
In total. Employer’s share of contributions remitted by a corporation on behalf of
employees to others can add up to 20% of employee’s gross earnings.

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EX) Assume Bulk Barn accumulated the following:
Salaries & Wages earned
$1.8m
Income taxes withheld
$450,000
CPP contributions
$71,000
EI contributions
$35,000
The entry to record payroll & employee deductions:
DR Compensation Expense (E) $1.8m
CR Liability for income taxes withheld (L) $450,000
CPP Payable (L) $71,000
EI Payable (L) $35,000
Cash $1.244m
The employer must also contributed an equal amount of CPP contributions and 1.4x the
employee’s contributions to EI. This entry records the taxes that employers must pay from their
own funds:
DR Compensation Expense (E) $120,000
CR CPP Payable (L) $71,000
EI Payable (L) $49,000
The compensation expense ($1.8m + $120,000) includes salaries/wages earned, as well
as the employer’s share of CPP & EI contributions
Cash paid to employees (1.244m) is LESS than total amount earned ($1.8m) SINCE
Bulk Barn must withhold both income taxes ($450,000) and employee’s share of CPP/EI
($71,000 + $35,000). The CPP/EI payable reflect both employee’s/employer’s share.
NOTES Payable: note specifies the amount borrowed, date by which must be paid, interest rate
associated with borrowing. Creditors willing to lend since interest is their compensation, this
concept is called the time value of money: interest associated with use of money over time.
To the borrower
, interest is an expense; to the creditor
, interest is revenue.
To calculate: you need 1) principal, 2) annual interest rate, and 3) time period for loan
Interest = Principal * Annual Rate * Time
EX) On November 1, 2014, Bulk Barn borrowed $100,000 cash on a 1-year, 6% note
payable. Interest payable on April 30, 2015 & October 31, 2015.
DR Cash $100,000
CR Note Payable, short term $100,000
The interest on this note is incurred as long as debt is outstanding. Interest Expense recorded
when it is incurred rather than when cash is actually paid. Since Bulk Barn uses the money for
two months during 2014 (Nov 2014 - year end), even though cash not paid until April 30.
Computation of interest expense for 2014 is:
Interest = $100,000 * 0.06 * 2/12 = $1,000
DR Interest Expense (E) $1,000
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