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Chapter 13

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Administrative Studies
ADMS 3595
Shaweta Roopra

ADMS 3595 Chapter 13 (Week 1) RECOGNITION AND MEASUREMENT Liability Definition and Characteristics  A liability is an obligation that arises from past transactions or events, which may result in a transfer of assets or services.  Liabilities have 3 essential characteristics o They carry a duty or a responsibility o The entity has little or no discretion to avoid the duty o The transaction or event that obliged the entity has already occurred  Constructive obligation occurs when past or present company practices show that the entity agrees to incur potential economic liabilities, such as regularly paying 6% sick pay instead of the required minimum 4%.  Non-financial liabilities are recognized only if It is probable (more likely than not) that the obligation would result in an outflow of cash or other economic assets. Financial Liabilities and Non-Financial Liabilities  A financial liability is any liability that is a contractual obligation: o To deliver cash or other financial assets to another entity or o To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity  A financial liability must be valid by contract  Any liability that is created by legislation, such as income tax payable, is not a financial liability Measurement Financial Liabilities  Recognized initially at fair value at time of acquisition, and at their amortized cost thereafter  Transaction costs that are a direct result of the issue of the liability are debited to its original fair value  Transaction costs associated with the issue of financial liabilities that are accounted for after acquisition at fair value are recognized in net income (they are expensed)  Short term liabilities, such as 30 and 60 day notes, are usually accounted for at their maturity value o Because the difference between the liability's fair value and its maturity value is not significant Non-Financial Liabilities  As these types of liabilities are not cash liabilities, they are not payable in cash, and therefore are measured in a different way  GAAP does not address the issue of non-financial liabilities, and therefore is measured in a variety of ways, depending on the liability. o Unearned revenues are measured at the FV of the goods/services to be delivered in the future.  Under IFRS, these types of liabilities are measured initially and at each reporting date thereafter at the best estimate of the amount the entity would pay at the date of the balance sheet to settle the liability o This is usually the PV of the resources needed to fulfill the obligation, measured at the expected value or probability weighted average of the range of possible outcomes COMMON CURRENT LIABILITIES  A liability is classified as current under IFRS when one of the following conditions is met: o It is expected to be settled in the entity's normal operating cycle o It is held primarily for trading o It is due within 12 months from the end of the reporting period o The entity does not have an unconditional right to defer its settlement for at least 12 months after the date of the balance sheet  Under GAAP, similar conditions must be met Bank Indebtedness and Credit Facilities  Instead of having to negotiate a new loan every time it needs funds, a company enters into an agreement with its bank that allows it to make multiple borrowings up to a negotiated limit.  The financial institution requires collateral and often sets restrictions on the company's activities or financial statement ratios that must be maintained  The amount of actual bank indebtedness is reported on the statement of financial position, while the total funds that the credit arrangement allows the company to borrow and any restrictions imposed by the financial institution are disclosed in the notes Accounts Payable  Accounts payable are balances owed to others for goods, supplies, or services related to the entity's ordinary business activities purchased on open account  A/P arises because of the time lag between the receipt of goods and services and the payment for them  Most liabilities are recorded when goods are received  If title passes before the goods reach the purchaser before goods are received, the liability is recorded when title passes Notes Payable  Written promises to pay a certain sum of money on a specified future date and may arise from purchases, financing or other transactions Interest Bearing Note Issued  Assume that Provincial Bank agrees to lend $100,000 on March 1, 2014, to Landscape Corp. and the company signs a $100,000 (PV), 4 month (N), 12% (I) note. The entry to record the cash received by Landscape Corp on March 1 is: March 1 Cash 100,000 Notes Payable 100,000  If Landscape Corp. has a December 31 year end buy prepared financial statements semi-annually, an adjusting entry is required to recognize the 4 months of interest expense and interest payable of $4,000 ($100,000 * 12% * 4/12 March 1-June 30) on June 30. The adjusting entry is: June 30 Interest Expense 4,000 Interest Payable 4,000  At maturity on July 1, Landscape Corp. pays the note's face value of $100,000 plus the $4,000 interest. The entry to record payment of the note and accrued interest is as follows: July 1 Notes Payable 100,000 Interest Payable 4,000 Cash 104,000 Zero-Interest Bearing Note Issued  Interest is included in the face amount of the note  The interest is the difference between the amount received when the note is signed and the higher face amount payable at maturity  The borrower receives the note's present value in cash and pays back the larger maturity value  Assume that Landscape Corp. issues a $100,000 (PV), 4 month (N), 0% interest note payable to the Provincial Bank on March 1. The note's PV is $96,154, based on the bank's discount rate of 12%. Landscape's entry to record this transaction is as follows: March 1 Cash 95,154 Notes Payable 95,154  If Landscape Corp prepares financial statements at June 30, the interest expense for the 4 month period to June 30 must be recognized along with the increase in the Notes Payable, $96,154 * 12% *4/12=$3,846, as follows: June 30 Interest Expense 3,846 Notes Payable 3,846 The notes Payable account now has a balance of $100,000, which is the amount borrowed plus  interest to June 30. On July 1, the note is repaid: July 1 Notes Payable 100,000 Cash 100,000 Current Maturities of Long Term Debt  When only a perk of a long term obligation is to be paid within the next 12 months, as in the case of a mortgage or of serial bonds that are to be retired through a series of annual installments, only the maturing portion of the principal of the long term debt is reported as a current liability, with the balance being reported as a long term liability.  Portions of long term obligations that will mature within the next 12 months should not be included as current liabilities if, by contract, they are to be retired by assets that have not been reported as current assets o In this situation, no current assets are used and no other current liabilities are created in order to repay the maturing liability  A liability that is due on demand or that will be due on demand within a year, is also classified as a current liability  Standard setters indicate that all of such callable debt meets the definition of a current liability, and that additional information about the callable debt can be explained in the notes to financial statements  Liabilities become callable by the creditor if there is a violation of a debt agreement (violation of the minimum debt/equity ratio)  If a long term debt agreement is violated and the liability becomes payable on demand, the debt is reclassified as current o Under IFRS, this holds even if the lender agrees between the date of the balance sheet statement and the date the financial statements are released, that it will not demand payment because of the violation.  At the date of the balance sheet statement, the entity did not have a right to defer the payment beyond 12 months from the reporting period o Under GAAP/ASPE, the liability is reclassified to the current category unless:  The creditor waives in writing the agreement requirements, OR  The violation has been cured within the grace period given in the agreement AND  It is likely that the company will NOT violate the covenant requirements within a year from the balance sheet date. Short-Term Debt Expected to be Refinanced  Are debt obligations that are scheduled to mature within one year from the balance sheet date  Under IFRS, if the debt is due within 12 months from the reporting date, it is classified as a current liability o This holds even if a long term refinancing has been completed before the financial statements have been released o The only exception is if at the balance sheet date, the entity expects to refinance it or roll it over under an existing agreement for at least 12 months and the decision is solely at its discretion. o The agreement to refinance the short term loan must be firm at the date of the balance sheet  Under ASPE, the short term liability expected to be refinanced is classified as a current liability unless either the liability has been refinanced on a long term basis or there is a non cancellable agreement to do so before the financial statements are completed, and nothing stands in the way of completing the refinancing. o If there is evidence, by the time the financial statements are completed, that the debt has been or will be converted into long term obligation, ASPE allows currently maturing debt to be classified as long term on the balance sheet. o If an actual refinancing occurs, the amount of the short term obligation that is excluded from current liabilities cannot be higher than the proceeds from the new obligation that is used to retire it. Dividends Payable  An amount that a corporation owed to its shareholders because the BOD has authorized a dividend payment  Because dividends are paid within one year of the declaration, they are classified as current liabilities  Although accumulated but undeclared dividends are not recognized as a liability until the BOD declared them payable, they are required to be disclosed in a note to the financial statements  Dividends that are payable in the form of addition shares are not recognized as a liability as they do not meet the definition of a liability, as they do not require future outlays of economic resources, and they are not enforceable, as the BOD can revoke them at any time before they are issued Rents and Royalties Payable  Created by a contractual agreement in which payments are conditional on the amount of revenue that is earned or the quantity of product that is produced/extracted Taxes Payable Sales Tax The balance in the sales tax payable account is the liability for sales taxes that have been collected  from customers buy not yet remitted to the appropriate government  The following entry shows the accounting for a sale on account of $3,000, when a 4% sales tax is in effect: Accounts Receivable 3,120 Sales Revenue 3,000 Sales Tax Payable 120 Goods and Service Tax  The entity deducts its input tax credit (the amount of GST the company paid on goods and services it purchased from suppliers) from the amount of GST the company collected, on behalf of the government, on sales to its customers GST payable is credits when GST is charged on sales (liability)   GST receivable is debited for GST paid to suppliers (asset)  Since GST is also paid on purchases of capital assets, it is possible for the GST receivable account to have a large balance than GST payable, in which case, a claim for reimbursement is made to the CRA  Assume Bateman Limited purchases merchandise for $150,000 plus GST of 5% ($7,500). The entry to record this transaction is as follows: Inventory 150,000 GST Receivable 7,500 Accounts Payable 157,500  If the goods are sold for $210,000 plus GST of 5% ($10,500), the sale entry is: Accounts Receivable 220,500 Sales Revenue 210,000 GST Payable 10,500  When GST and sales tax are levied on the same sale and purchase, assume that Smith Ltd. Sells supplies to Jones Corp. for $1,000 and both a 7% PST and a 5% GST applies to the amount. The entry made by each company follows: Smith Company (Vendor) Accounts Receivable 1,120 Sales Revenue 1,000 Sales Tax Payable 70 GST Payable 50 Income Tax  Assume that Forest Ltd. Determines, based on its taxable income for the year, that an income tax liability of $21,000 is payable, and further assume that no accruals or instalments have been made during the year. Forest makes the following entry at year end: Current Tax Expense 21,000 Income Tax Payable 21,000  If Forest Ltd. Had made a $20,000 tax instalment at the end of the year, the following entry would also have been made: Income Tax Payable 20,000 Cash 20,000  Assuming the $21,000 tax liability from above, Forest Ltd. Would then report an Income Tax Payable balance of $1,000 in the current liabilities section of its year end balance sheet.  If the company had made instalments of $23,000 there would be a $2,000 debit balance in the Income Tax Payable account, reported as Income Tax Receivable, a current asset  When the tax return is completed at year end and the actual amount of tax for the year is calculated, the expense is then adjusted, as follows: Installment Payments of $20,000 Current Tax Expense 20,000 Cash 20,000 Income taxes per tax return:$21,000 Current Tax Expense 1,000 Income Tax Payable 1,000 Employee Related Liabilities Payroll Deductions  Include employee income taxes, CPP/QPP, EI premiums, and miscellaneous items such as other insurance premiums, employee savings, and union dues  For CPP, both the employer and employee are taxes at the same rate (4.95%) based on the employee's gross pay  For EI, employees must pay a premium of 1.83% of insurable earnings up to a maximum of $839.97, while the employer is required to contribute 2.562% or 1.4 times the amount of employee premiums  Assume a weekly payroll of $10,000 that is entirely subject to CPP (4.95%), EI (1.83%), income tax withholdings of $1,320, and union dues of $88. The entry to record the salaries and wages paid and employee payroll deductions is: Salaries and Wages Expense 10,000 Employee Income Tax Deductions Payable 1,320 CPP Contributions Payable 495 EI Premiums Payable 183 Union Dues 88 Cash 7,914  The required payroll taxes are recognized as compensation-related expenses in the same accounting period as the payroll is recorded, and the entry for employer contributions is as follows: Payroll Tax Expense 751 CPP Contributions Payable (495 *1.0) 495 EI Premiums Payable (183 *1.4) 256  The employer then sends to the Receiver General for Canada the amount of income tax, CPP, EI withheld from employees, along with the employer's required contributions for CPP and EI. The entry to record the payment to the CRA for the payroll is: Employee Income Tax Deductions Payable 1,320 CPP Contributions Payable 990 EI Premiums Payable 439 Cash 2,749 Short Term Compensated Absences  Periods of time taken off from active employment for which employees are paid, such as statutory holidays and vacation, and can be accumulating or non-accumulating Accumulating rights to benefits  Employers have an unconditional obligation for vacation pay that accrues as the employees work, and is usually satisfied by paying employees their regular salaries when they are absent from work while taking vacation  Vested rights are when the employer is legally required to pay the benefits even if the employee no longer works for the organization o Vested right pay is expensed in the period in which the benefit is earned by the employee  Accumulated rights are rights that accrue with employee service, are not necessarily vested, but can be carried forward to future periods if not used in the period in which they were earned  The best measure for accumulated rights to be paid is the additional amount the entity expects to pay in the future.  Assume the following information for Amutron Limited that began operations on January 1, 2014. o The company employs 10 individuals who are paid $480/wk and this is the best estimate of the following year's wage as well o A total of 20 weeks of vacation is earned by all employees in 2014, but none is taken during the year o In 2015, the vacation weeks earned in 2014 are used when the current rate of pay has increased to $500/wk  The entry at December 31, 2014, to accrue the vacation pay entitlements earned by the employees is as follows: Salaries and Wages Expense 9,600 Vacation Wages Payable 9.600 $480/wk * 20 weeks  In 2015, the vacation time that is paid for is recorded as follows: Vacation Wages Payable 9,600 Salaries and Wages Expense 400 Cash $500*20wks 10,000 Non-Accumulating Rights to Benefits  Benefits that employees are entitled to by virtue of their employment and the occurrence of an obligating event, and these benefits do not vest  Because the employer has no basis on which to accrue the costs of these benefits and the associated liability, no entry is made until the obligating event occurs  When the parental leave is taken or the employee becomes disabled, the total estimated liability and expense associated with the event is recognized at that time  Assume that Sue Kim, an employee, applies for and is granted a 1 year parental leave to begin on April 18. Resource Corp. calculates that the benefit payable to Sue will be $200/wk. The company makes the following entry when she begins her leave: Employee Benefit Expense 10,400 Parental Leave Benefit 10,400 $200/wk * 52 wks in a year  As the compensated absence is taken and Sue Kim is paid, the liability is reduced  Assuming Resource Corp. has a biweekly payroll, the following entry is made each period: Parental Leave Benefits Payable 400 Cash 400 Profit Sharing and Bonus Agreement  Assume that a company has income before bonuses of $100,000 for 2014. The company has an annual bonus plan and determines in January 2015 that it will pay out bonuses of $10,700 related to the prior year. An adjusting entry dated December 31, 2014, is made to record the bonus as follows: Bonus Expense 10,700 Bonus Payable 10,700 In January 2015, when the bonus is paid, the entry is: Bonus Payable 10,700 Cash 10,700 NON-FINANCIAL LIABILITIES  Some liabilities are difficult to measure because the obligations will be met with goods and services and the timing of meeting the obligation and its amount are not fixed  Examples include unearned revenues, product guarant
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