Reporting and Analysing Liabilities

CHAPTER

10

• Creditor claims on total assetsCreditor claims on total assets• Existing debts and obligationsExisting debts and obligations• Current and long-termCurrent and long-term

LiabilitiesLiabilities

Liabilities must be settled in the Liabilities must be settled in the future by transfer of assets or future by transfer of assets or servicesservices

Current LiabilitiesCurrent Liabilities

• Expected to be paid:Expected to be paid:– From existing current assets or through the From existing current assets or through the

creation of other current liabilitiescreation of other current liabilities

– Within one yearWithin one year

Debts that do not meet both criteria Debts that do not meet both criteria are are long-term liabilitieslong-term liabilities

Types of current liabilities include:Types of current liabilities include:• Accounts payableAccounts payable• Operating line of creditOperating line of credit• Notes payableNotes payable• Accrued liabilitiesAccrued liabilities• Sales taxes payableSales taxes payable• Property taxes payableProperty taxes payable• Payroll and employee benefits payablePayroll and employee benefits payable• Current maturities of long-term debtCurrent maturities of long-term debt

Current LiabilitiesCurrent Liabilities

Accounts PayableAccounts Payable

• Amounts owing to creditorsAmounts owing to creditors• Normally due in 30 daysNormally due in 30 days• Interest charged on overdue accounts onlyInterest charged on overdue accounts only

Operating Line of CreditOperating Line of Credit

• Prearranged agreement between a company Prearranged agreement between a company and a lender to allow the company to borrow and a lender to allow the company to borrow up to an agreed-upon amountup to an agreed-upon amount

Notes PayableNotes Payable

• Often used instead of accounts payableOften used instead of accounts payable• Provide written documentation, if needed, Provide written documentation, if needed,

for legal remediesfor legal remedies• Normally has interest attachedNormally has interest attached• Used for short-term and long-term Used for short-term and long-term

financing needsfinancing needs

Sales Taxes PayableSales Taxes Payable

• Federal Goods and Services Federal Goods and Services Tax (GST)Tax (GST)

• Provincial Sales Tax (PST)Provincial Sales Tax (PST)• Harmonized into one Harmonized into one

combined sales tax (HST) in combined sales tax (HST) in some provincessome provinces

• May or may not be included May or may not be included in sale pricein sale price

• Must be remitted periodically Must be remitted periodically to respective governmentsto respective governments

Payroll and Employee Benefits Payroll and Employee Benefits PayablePayable

• Employee payroll deductionsEmployee payroll deductions– Canada pension plan (CPP)Canada pension plan (CPP)– Employment insurance (EI)Employment insurance (EI)– Federal and provincial income taxesFederal and provincial income taxes– Other deductions at sourceOther deductions at source

• Employer payroll contributionsEmployer payroll contributions– CPPCPP– EIEI– Workers’ compensationWorkers’ compensation– OtherOther

Current Maturities ofCurrent Maturities ofLong-Term DebtLong-Term Debt

• The portion of the The portion of the long-term debt that long-term debt that is due within the is due within the current year or current year or operating cycle operating cycle should be classified should be classified as a current liabilityas a current liability

Long-Term LiabilitiesLong-Term Liabilities

• Obligations to be paid after one yearObligations to be paid after one year• Include bonds, long-term notes, and lease Include bonds, long-term notes, and lease

obligationsobligations

Bonds PayableBonds Payable

• A form of interest-bearing notes payable A form of interest-bearing notes payable issued by corporations, universities, and issued by corporations, universities, and government agenciesgovernment agencies

• Sold in small denominations, which makes Sold in small denominations, which makes them attractive to investors them attractive to investors

• SecuredSecured (mortgage bond) vs. (mortgage bond) vs. unsecuredunsecured (debenture bond)(debenture bond)

• ConvertibleConvertible vs. vs. redeemable/retractableredeemable/retractable

TerminologyTerminology

• Contractual interest rateContractual interest rate– Stated rate which determines the Stated rate which determines the

amount of cash interest the borrower amount of cash interest the borrower pays and the investor receivespays and the investor receives

• Market (effective) interest rateMarket (effective) interest rate– Rate that investors demand for loaning Rate that investors demand for loaning

fundsfunds

TerminologyTerminology

• Face valueFace value– Amount of principal due at maturityAmount of principal due at maturity

• Present valuePresent value– Value today of (1) bond face value to be Value today of (1) bond face value to be

received at maturity and (2) interest payments received at maturity and (2) interest payments to be received periodically after taking into to be received periodically after taking into account current interest ratesaccount current interest rates

Accounting for Bond IssuesAccounting for Bond Issues

• Bonds may be issued atBonds may be issued at– Face valueFace value

– Below face value (discount) Below face value (discount)

– Above face value (premium)Above face value (premium)

Issuing Bonds at Face ValueIssuing Bonds at Face Value

Assume that Candlestick, Inc. issued $ 1 million, Assume that Candlestick, Inc. issued $ 1 million, five-year, 10%, bonds dated January 1, 2004 at five-year, 10%, bonds dated January 1, 2004 at 100 (face value).100 (face value).

Jan. 1 CashJan. 1 Cash 1,000,0001,000,000

Bonds PayableBonds Payable 1,000,0001,000,000

To record sale of bonds at face valueTo record sale of bonds at face value

• This occurs when the investor pays less This occurs when the investor pays less than the face value of the bondthan the face value of the bond

• WHY?WHY?• To adjust the contractual interest to the To adjust the contractual interest to the

market interest ratemarket interest rate

Issuing Bonds at DiscountIssuing Bonds at Discount

Issuing Bonds at DiscountIssuing Bonds at Discount

Assume that on January 1, 2004, Candlestick, Inc. Assume that on January 1, 2004, Candlestick, Inc. sells $1 million, five-year, 10% bonds at 98. sells $1 million, five-year, 10% bonds at 98.

Jan. 1 CashJan. 1 Cash 980,000980,000

Discount on Bonds PayableDiscount on Bonds Payable 20,00020,000

Bonds Payable Bonds Payable 1,000,0001,000,000

To record sale of bonds at a discountTo record sale of bonds at a discount

Carrying (Book) Value of BondsCarrying (Book) Value of Bonds

Bonds payable Bonds payable $1,000,000$1,000,000

Less: Discount on bonds payableLess: Discount on bonds payable 20,00020,000 $980,000$980,000

Long-term Long-term liabilitiesliabilities

Carrying ValueCarrying Value

• This occurs when the investor pays more This occurs when the investor pays more than the face value of the bondthan the face value of the bond

• WHY?WHY?• To adjust the contractual interest to the To adjust the contractual interest to the

market interest ratemarket interest rate

Issuing Bonds at PremiumIssuing Bonds at Premium

Issuing Bonds at PremiumIssuing Bonds at Premium

Assume that on January 1, 2004, Candlestick, Inc. Assume that on January 1, 2004, Candlestick, Inc. sells $1 million, five-year, 10% bonds at 102. sells $1 million, five-year, 10% bonds at 102.

Jan. 1 CashJan. 1 Cash 1,020,0001,020,000

Bonds PayableBonds Payable 1,000,0001,000,000

Premium on Bonds Payable Premium on Bonds Payable

20,00020,000

To record sale of bonds at a premiumTo record sale of bonds at a premium

Carrying (Book) Value of BondsCarrying (Book) Value of Bonds

Bonds payable Bonds payable $1,000,000$1,000,000

Add: Premium on bonds payableAdd: Premium on bonds payable 20,00020,000 $1,020,000$1,020,000

Long-term Long-term liabilitiesliabilities

Carrying ValueCarrying Value

Amortization of Bond Premium or Amortization of Bond Premium or DiscountDiscount

• There are two commonly used methods to There are two commonly used methods to amortize bond discount or premium:amortize bond discount or premium:• Straight-line methodStraight-line method——premium or discount is premium or discount is

amortized to interest expense over the life of amortized to interest expense over the life of the bond in equal amountsthe bond in equal amounts

• Effective interest methodEffective interest method——the interest the interest expense reflects the same percentage of the expense reflects the same percentage of the bond’s carrying value; this is the preferred bond’s carrying value; this is the preferred methodmethod

Amortizing Bond Discounts or Amortizing Bond Discounts or PremiumsPremiums

• Straight-line methodStraight-line method– Constant periodic expense, varying %Constant periodic expense, varying %– Simpler, widely usedSimpler, widely used

• Effective interest methodEffective interest method– Varying periodic expense, constant %Varying periodic expense, constant %– Conceptually superior, better matchConceptually superior, better match

Both methods result in the same Both methods result in the same totaltotal amount amount of interest expense over the life of bonds.of interest expense over the life of bonds.

Amortizing Bond Discounts or Amortizing Bond Discounts or PremiumsPremiums

• Amortization spreads the cost of borrowing Amortization spreads the cost of borrowing over the life of the bondover the life of the bond

• DiscountDiscount amortization increases interest amortization increases interest expenseexpense

• PremiumPremium amortization reduces interest amortization reduces interest expenseexpense

Bond RetirementsBond Retirements

• Bonds may be Bonds may be redeemed at redeemed at maturity or before maturity or before maturitymaturity

Redeeming Bonds Before MaturityRedeeming Bonds Before Maturity

• A company may decide to retire bonds A company may decide to retire bonds before maturity in order to:before maturity in order to:– Reduce interest cost Reduce interest cost

– Remove debt from its balance sheetRemove debt from its balance sheet

• A company should retire debt early only if it A company should retire debt early only if it has sufficient cash resourceshas sufficient cash resources

Redeeming Bonds Before MaturityRedeeming Bonds Before Maturity

• When bonds are retired before maturity: When bonds are retired before maturity: – Eliminate carrying value of the bonds at the Eliminate carrying value of the bonds at the

redemption dateredemption date

– Record the cash paidRecord the cash paid

– Recognize the gain or loss on redemption Recognize the gain or loss on redemption (gain if cost < carrying value; loss if cost > (gain if cost < carrying value; loss if cost > carrying value)carrying value)

Long-Term Notes PayableLong-Term Notes Payable

• Normally repayable in a series of periodic Normally repayable in a series of periodic payments called instalmentspayments called instalments

• Instalment notes repayable in equal periodic Instalment notes repayable in equal periodic amounts plus interest (fixed or floating amounts plus interest (fixed or floating interest) are called interest) are called fixed principal paymentsfixed principal payments

• Instalment notes repayable in equal periodic Instalment notes repayable in equal periodic amounts including interest are called amounts including interest are called blended blended principal and interest payments principal and interest payments

Presentation of Long-Term Presentation of Long-Term LiabilitiesLiabilities

• Report long-term debt separately in balance Report long-term debt separately in balance sheet and detail in notessheet and detail in notes

• Report current maturities of long-term debt as Report current maturities of long-term debt as current liabilitiescurrent liabilities

• Cash inflows and outflows during the year Cash inflows and outflows during the year from the principal portion of debt transactions from the principal portion of debt transactions are reported in the financing activities section are reported in the financing activities section of the cash flow statementof the cash flow statement

Analysis of Long-Term LiabilitiesAnalysis of Long-Term Liabilities

• LiquidityLiquidity– Current ratioCurrent ratio

– Acid-test ratioAcid-test ratio

• SolvencySolvency– Debt to total assets Debt to total assets

– Times interest earnedTimes interest earned

Current RatioCurrent Ratio

• Measure of a company’s ability to Measure of a company’s ability to pay short-term obligationspay short-term obligations

Current LiabilitiesCurrent Liabilities

Current AssetsCurrent AssetsCurrent Ratio =Current Ratio =

Acid-Test RatioAcid-Test Ratio

• Measure of a company’s ability to pay Measure of a company’s ability to pay immediate, short-term obligationsimmediate, short-term obligations

Acid-Test Ratio =Acid-Test Ratio =Cash + Short-Term Investments Cash + Short-Term Investments

+ Accounts Receivable+ Accounts Receivable

Current LiabilitiesCurrent Liabilities

Debt to Total AssetsDebt to Total Assets

• Indicates the extent to which a company’s Indicates the extent to which a company’s debt could be repaid by liquidating assetsdebt could be repaid by liquidating assets

Total AssetsTotal Assets

Total DebtTotal DebtDebt to Total Assets =Debt to Total Assets =

Times Interest EarnedTimes Interest Earned

• Provides an indication of a company’s ability Provides an indication of a company’s ability to meet interest payments as they come dueto meet interest payments as they come due

Times Interest Earned =Times Interest Earned =

Earnings Before Interest ExpenseEarnings Before Interest Expense

& Income Tax Expense (EBIT)& Income Tax Expense (EBIT)

Interest ExpenseInterest Expense

ContingenciesContingencies

• Events with uncertain outcomes Events with uncertain outcomes • Must be recorded in the financial Must be recorded in the financial

statements if: statements if: – The company can The company can reasonably estimatereasonably estimate the the

expected loss and expected loss and

– If the loss is If the loss is likelylikely

Off-Balance Sheet FinancingOff-Balance Sheet Financing

• A situation in which liabilities are not recorded A situation in which liabilities are not recorded on the balance sheet (e.g. leasing)on the balance sheet (e.g. leasing)

• Operating lease involves temporary use of Operating lease involves temporary use of the property by the lessee with continued the property by the lessee with continued ownership of the property by the lessorownership of the property by the lessor

• Lease (rental) payments are recorded as an Lease (rental) payments are recorded as an expenseexpense by the lessee and as by the lessee and as revenuerevenue by the by the lessorlessor

Off-Balance Sheet FinancingOff-Balance Sheet Financing

• If the lease contract transfers If the lease contract transfers substantially all substantially all the benefits and risks of ownershipthe benefits and risks of ownership to the to the lessee, the lease is in effect a purchase of the lessee, the lease is in effect a purchase of the propertyproperty

• This type of lease is called a This type of lease is called a capital leasecapital lease because the fair value of the leased asset is because the fair value of the leased asset is capitalized by the lessee when recording it on capitalized by the lessee when recording it on the balance sheetthe balance sheet