MGAB02H3 Chapter 10: Topic 2: Chapter 10

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University of Toronto Scarborough
Financial Accounting
Liang Chen

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 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. 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 CR Interest Payable (L) $1,000 On April 30, 2015, Bulk Barn would pay $3,000 in interest - which includes the $1,000 accrued/reported in 2014: DR Interest Expense (E) $2,000 Interest Payable (L) $1,000 CR Cash $3,000 CURRENT PORTION of Long-Term Debt: ​ company must reclassify long-term debt within a year of its maturity date as a current liability. EX) Bulk Barn signed note payable of $5m on June 1, 2013. Repayment on May 31, 2016. May 31, 2014 May 31, 2015 Non-current liabilities: $5m Current liabilities: $5m DEFERRED REVENUES: ​when company collects cash before revenue has been earned; liabilities until goods/services are provided. ➔ Reported as a liability since cash has been collected but related revenue has not been earned by end of accounting period. EX) Bulk Barn signs warranty contracts for goods sold during 2012 and received $81.6m from customers in advance: DR Cash (A) $81.6m CR Deferred Extended Warranty Revenue (L) $81.6m As time passes, Bulk Barn earns a portion of the deferred revenue on the new contracts as well as the ones recorded previously. EX) Assume that $74.7m was earned during 2012, entry to record the earned revenue is: DR Deferred Extended Warranty Revenue (L) $74.7m CR Revenue from Extended Warranties (R) $74.7 Gift Cards: ➔ When store sells the card, amount received is a ​liability​ ​UNTIL​ store ​delivers merchandise/service in ​future​. ➔ When gift ​card​ is ​used​: ◆ amount​ is recorded as a ​revenue​, ◆ Deferred revenue​ account is r ​ educed ◆ Cost​ of ​merchandise​/service is recorded as an ​expense PROVISIONS Reported on the BS When either the ​AMOUNT ​or T​ IMING​ of the ​liability ​is ​UNCERTAIN​, it is called a ​Provision​. Provision must be recognized when conditions are met: 1) Entity has a ​present​ ​obligations​ as result of a past event (party still owes money) 2) Probable​ that ​cash/assets​ will be ​required​ to ​settle​ obligation 3) Reliable​ ​estimate​ can b​ ade​ of ​amount​ of the obligation EX) Estimated liability created when company offers a warranty for its products. ➔ The cost of providing repair work must be estimated and recorded as a liability (and expense) in period in which product sold. Bulk Barn determines its warranty liability based on # of units sold, historical/anticipated rates of warranty claims, & cost per claim. Estimate of warranty expense for 2012 is $5m: DR Warranty Expense (E) $5m CR Provision for Product Warranty (L) $5m When the company receives units that require repair under warranty or “utilization” or the warranty and the cost incurred is $4m: DR Provisions for Product Warranty (L) $4m Cash (A) $4m ***This entry ​assumes​ Bulk Barn paid cash to satisfy warranty. If ​product​ is ​exchanged​ for another​ one, then ​Inventories​ account is​ redited​ instead of Cash. CONTINGENT Liabilities and COMMITMENTS EX) ​Students assume that not studying leads to failing a course. The actual course failure is a liability​ since the student will incur additional costs for repeating the course. Student may not know if failed until later on, but knows of the possibilities - making failure to study a ​Contingent Liability​. It is a ​possible liability​ created as a ​result​ of a ​past​ ​event​; not effective liability until an event occurs. EX) Lawsuits, Environmental Problems, Tax Disputes Depends on: 1) Probability of future economic sacrifice 2) Ability of management to estimate amount of liability reliably Level of Certainty of Present/Possible Should Liability be Disclosure Obligation Recognized? Requirements There is a present obligation that ​probably requires​ ​payment​. 1. Amount of liability ​CAN​ be estimated Provision must be
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