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Chapter 10

Chapter 10 Notes

Financial Accounting
Course Code
Liang Chen

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Chapter 10 Reporting and Analyzing Liabilities Notes
Current Liabilities
x current liability—debt that will be paid within year and from existing current assets or through creation of other current liabilities
x debts that do not meet both criteria are classified as long-term liabilities
x financial statement users want to know whether company’s obligations are current or long-term, which is important since a
company that has more current liabilities than current assets often lacks liquidityi.e., short-term debt-paying ability
x users must look at total liabilities in order to assess company’s solvency—its ability to pay its interest and debt when due
x finally, users want to know types of liabilities a company has
x different types of current liabilities include bank indebtedness arising from operating lines of credit, notes payable, accounts
payable, unearned revenue, accrued liabilities such as salaries and interest, and current portion of long-term debt
Operating Line of Credit
x current assets do not always turn into cash at exact time that current liabilities must be paid, consequently most company have an
operating line of credit at their bank to help them manage temporary cash shortfalls
x operating line of credit—a pre-arranged agreement to borrow money at a bank, up to an agreed-upon amount
x floating (or variable) interest rate—an interest rate that changes over the term of the debt with fluctuating market rates
x collateral—assets pledged as security for the payment of a debt (e.g., land, buildings, and equipment in the case of a mortgage;
accounts receivable or inventory in the case of a bank loan)
x borrowings normally on short-term basis and are repayable immediately upon request by bank, rarely happening without notice
x with line of credit, bank simply covers any cheques written in excess of the bank account balance, up to the approved credit limit
x amounts drawn on operating line of credit result in negative, or overdrawn, cash balance at year end, but no special entry is
required to record overdrawn amount—normal credits to Cash will simply accumulate and are reported as bank indebtedness in
current liability section of balance sheet and with a suitable note disclosure
x amounts available to be drawn in future from operating line of credit adds to company’s liquidity
Short-Term Notes Payable
x notes payable—obligations in form of written notes; used instead of accounts payable because give lender written documentation
of obligation, which helps if legal action is needed to collect debt; frequently issued to meet short-term financing needs
x notes that are due for payment within year of balance sheet date are classified as current liabilities
x most notes are interest-bearing, with interest due monthly or at maturity
x while short-term notes can have floating interest rates, it is more usual for them to have a fixed interest rate
x fixed interest rate—an interest rate that is constant (unchanged) over the term of the debt
x account payable is informal promise to pay, while note payable is written promise to pay that gives payee stronger legal claim
x account payable arises only from credit purchases (amounts owed to suppliers), while note payable can be used for credit
purchases, extending account payable beyond normal amounts or due dates, or to borrow money
x account payable is usually due within short period of time, while note payable can extend for longer periods
x account payable does not incur interest unless account is overdue, while note payable bears interest for entire period of duration
x interest rates are always expressed as annual rate, regardless of term of note
Sales Taxes
x sales taxes may take form of Goods and Services Tax (GST), Provincial Sales Tax (PST), or Harmonized Sales Tax (HST)
x in Quebec, the PST is known as Quebec Sales Tax (QST)
x in many provinces, sales taxes are collectively known as retail sales tax (RST)
x in 2008, federal GST was assessed at rate of 5% across Canada, which is subject to change and PST rates vary from 0% to 10%
x in Newfoundland and Labrador, Nova Scotia, and New Brunswick, PST and GST have been combined into 13% HST
x retailer collects sales tax from customer when sale occurs, and periodically (normally monthly) remits (sends) sales tax collected
to designated federal and provincial collecting authorities
x in case of GST and HST, collections may be offset against payments (i.e., sales tax payments made by company on its own
eligible purchases) and only net amount owing or recoverable will be paid or refunded
x when sales taxes are remitted, GST and PST (or HST) Payable are debited and Cash is credited
x company does not report sales taxes as expense; it simply forwards amount paid by customer to respective government
x in all but 2 provinces, GST is charged on selling price of item before PST is applied, thus avoiding GST being charged on PST
x in Quebec and Prince Edward Island, PST is charged on GST
Property Taxes
x businesses that own property pay property taxes each year, which are charged by municipal and provincial governments, and are
calculated at specified rate for every $100 of assessed value of property (i.e., land and building)
x property taxes are generally for calendar year, although bills are not usually issued until spring of each year
x every employer incurs 3 types of liabilities related to employees’ salaries or wages: (1) net pay owed to employees, (2) employee
payroll deductions, and (3) employer payroll deductions
x first type of liability is amount of salary or wages owed to employees—management personnel are generally paid salaries, which
are expressed as specific amount per week, per month, or per year; part-time employees or employees paid on an hourly basis or
by the work produced (an amount per unit of product) are normally paid wages

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x gross paytotal compensation earned by employee; also known as gross earnings
x salaries and wages do not include payments made for services of professionals such as accountants, lawyers, and architects,
instead these are independent contractors rather than salaried employees
x payments to them are called fees, rather than salaries or wages
x payroll deductions—deductions from gross pay to determine amount of paycheque
x second type of liability is amount of payroll deductions required by law to be withheld from employees’ gross, or total, pay
x mandatory payroll deductions include amounts withheld for federal and provincial income taxes, Canada Pension Plan (CPP)
contributions, and employment insurance (EI) premiums
x companies might also withhold voluntary deductions for charitable, union, pension, insurance, and other purposes
x net pay—gross pay less payroll deductions; amount that employer must pay to employee
x in addition to liabilities incurred as result of employee payroll deductions, employers also incur another liability related to these
deductions—employer is expected to pay various payroll costs that are charged on certain payroll deductions, such as employer’s
share of CPP and EI
x in addition, provincial governments require employer funding of Workplace Health, Safety, and Compensation Plan
x employee benefits—payments made by employer to give pension, insurance, medical, or other benefits to its employees
x employer’s share of these costs is recorded as Employee Benefits Expense
x until payroll deductions and costs are remitted to third parties that they are collected for, they are reported as current liability
x while employee payroll deductions are part of Wages Expense, employer payroll costs are part of Employee Benefits Expense
Current Maturities of Long-Term Debt
x companies often have a portion of long-term debt that is due in current year
x it is not necessary to prepare adjusting entry to recognize current maturity of long-term debt
x proper statement classification of each balance sheet account is recognized when balance sheet is prepared
Long-Term Liabilities
x long-term debt is obligation that is expected to be paid after one year or longer
x often in form of long-term notes or bonds, which are form of financial instrument—more specifically financial liability
Long-Term Notes Payable
x long-term notes may have fixed or floating interest rates
x in periods of unstable interest rates, it is common for notes to have floating interest rate that changes as prime rate changes
x secured—describes debt, such as notes or bonds, for which specific assets of issuer have been pledged as collateral
x unsecured—describes debt that have been issued against general credit of borrower; also called debentures
x mortgage note payable—a long-term note secured by mortgage that pledges title to property as collateral for loan
x debentures—unsecured debt issued against general credit of borrower
x convertible debt—debt such as notes or bonds that have the option of being converted into (exchanged for) common shares
x convertible debt has features that are attractive to both debt holders and issuers—conversion often gives holder opportunity to
benefit if price of borrower’s common shares increase; until conversion, debt holder receives interest on debt; for issuer, debt
normally pays lower rate of interest than comparable debt securities that have no conversion option
x convertible debt has 2 basic aspects—(1) it is a liability because of agreement to repay principal upon maturity; (2) it is equity,
since debt holder has right to convert debt into shares—which must be recorded and presented separately on balance sheet
x long-term notes are repayable in series of periodic payments known as instalments and are paid monthly, quarterly, semi-
annually, or at another defined period
x each instalment payment consists of a mix of (1) interest on unpaid balance of loan, and (2) reduction of loan principal
x actual payment generally takes form: (1) fixed principal payments plus interest, or (2) blended principal and interest payments
Fixed Principal Payments
x instalment notes with fixed principal payments are repayable in equal periodic amounts, plus interests
x monthly interest expense is calculated by multiplying outstanding principal balance by interest rate
x because portion of principal balance is repaid each month, outstanding principal balance will change (decrease) each month
x instalment payment schedule is useful tool to help organize information and to provide information that helps prepare entries
x Column A, the cash payment, is total of instalment payment, which changes each period because interest changes
x Column B determines interest expense decreasing each period because principal balance, which calculates interest, decreases
x Column C is instalment payment, which is applied against principal—the instalment payment is constant each period in “fixed
principal payment plus interest” pattern
x Column D is principal balance, which decreases each period by amount of instalment payment
x with fixed principal payments, interest decreases each period (as principal decreases)
x portion applied to reduction of loan principal stays constant, but because of decreasing interest, total payment decreases
Blended Principal and Interest Payments
x instalment notes with blended principal and interest payments are repayable in equal periodic amounts, including interest
x result in changing amounts of interest and principal applied to the loan
x as with fixed principal payments, interest decreases each period (as principal decreases); however, in contrast, portion applied to
loan principal increases each period
x most consumer and mortgage loans use blended principal and interest payments rather than fixed principal payments
x instalment payment schedule can also be prepared for blended principal and interest payments
x Column A, the cash payment, is specified and is same for each period, which can be calculated mathematically
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