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
○ 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.
Many current liabilities have a direct relationship to operating activities. Specific operating
activities are financed in part by related current liabilities.
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
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
➔ 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
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
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
➔ 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
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
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
1. Amount of liability CAN be estimated Provision must be