Financial Accounting_ Second Canadian Edition

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Financial Accounting_ Second Canadian Edition Powered By Docstoc
					CHAPTER

10
Reporting and Analysing Liabilities

Liabilities
• Creditor claims on total assets • Existing debts and obligations • Current and long-term
Liabilities must be settled in the future by transfer of assets or services

Current Liabilities
• Expected to be paid:
– From existing current assets or through the creation of other current liabilities – Within one year

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

Current Liabilities
Types of current liabilities include: • Accounts payable • Operating line of credit • Notes payable • Accrued liabilities • Sales taxes payable • Property taxes payable • Payroll and employee benefits payable • Current maturities of long-term debt

Accounts Payable
• Amounts owing to creditors • Normally due in 30 days • Interest charged on overdue accounts only

Operating Line of Credit
• Prearranged agreement between a company and a lender to allow the company to borrow up to an agreed-upon amount

Notes Payable
• Often used instead of accounts payable • Provide written documentation, if needed, for legal remedies • Normally has interest attached • Used for short-term and long-term financing needs

Sales Taxes Payable
• Federal Goods and Services Tax (GST) • Provincial Sales Tax (PST) • Harmonized into one combined sales tax (HST) in some provinces • May or may not be included in sale price • Must be remitted periodically to respective governments

Payroll and Employee Benefits Payable
• Employee payroll deductions
– – – – – – – – Canada pension plan (CPP) Employment insurance (EI) Federal and provincial income taxes Other deductions at source CPP EI Workers’ compensation Other

• Employer payroll contributions

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

Long-Term Liabilities
• Obligations to be paid after one year • Include bonds, long-term notes, and lease obligations

Bonds Payable
• A form of interest-bearing notes payable issued by corporations, universities, and government agencies • Sold in small denominations, which makes them attractive to investors • Secured (mortgage bond) vs. unsecured (debenture bond) • Convertible vs. redeemable/retractable

Terminology
• Contractual interest rate
– Stated rate which determines the amount of cash interest the borrower pays and the investor receives

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

Terminology
• Face value
– Amount of principal due at maturity

• Present value
– Value today of (1) bond face value to be received at maturity and (2) interest payments to be received periodically after taking into account current interest rates

Accounting for Bond Issues
• Bonds may be issued at
– Face value – Below face value (discount) – Above face value (premium)

Issuing Bonds at Face Value
Assume that Candlestick, Inc. issued $ 1 million, five-year, 10%, bonds dated January 1, 2004 at 100 (face value).
Jan. 1 Cash 1,000,000 Bonds Payable 1,000,000 To record sale of bonds at face value

Issuing Bonds at Discount
• This occurs when the investor pays less than the face value of the bond • WHY? • To adjust the contractual interest to the market interest rate

Issuing Bonds at Discount
Assume that on January 1, 2004, Candlestick, Inc. sells $1 million, five-year, 10% bonds at 98.
Jan. 1 Cash 980,000 Discount on Bonds Payable 20,000 Bonds Payable To record sale of bonds at a discount

1,000,000

Carrying (Book) Value of Bonds
Long-term liabilities
Bonds payable $1,000,000

Less: Discount on bonds payable

20,000

$980,000

Carrying Value

Issuing Bonds at Premium
• This occurs when the investor pays more than the face value of the bond • WHY? • To adjust the contractual interest to the market interest rate

Issuing Bonds at Premium
Assume that on January 1, 2004, Candlestick, Inc. sells $1 million, five-year, 10% bonds at 102.
Jan. 1 Cash 1,020,000 Bonds Payable Premium on Bonds Payable To record sale of bonds at a premium

1,000,000 20,000

Carrying (Book) Value of Bonds
Long-term liabilities
Bonds payable Add: Premium on bonds payable $1,000,000 20,000 $1,020,000

Carrying Value

Amortization of Bond Premium or Discount
• There are two commonly used methods to amortize bond discount or premium:
• Straight-line method—premium or discount is amortized to interest expense over the life of the bond in equal amounts • Effective interest method—the interest expense reflects the same percentage of the bond’s carrying value; this is the preferred method

Amortizing Bond Discounts or Premiums
• Straight-line method
– Constant periodic expense, varying % – Simpler, widely used

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

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

Amortizing Bond Discounts or Premiums
• Amortization spreads the cost of borrowing over the life of the bond • Discount amortization increases interest expense • Premium amortization reduces interest expense

Bond Retirements
• Bonds may be redeemed at maturity or before maturity

Redeeming Bonds Before Maturity
• A company may decide to retire bonds before maturity in order to:
– Reduce interest cost – Remove debt from its balance sheet

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

Redeeming Bonds Before Maturity
• When bonds are retired before maturity:
– Eliminate carrying value of the bonds at the redemption date – Record the cash paid – Recognize the gain or loss on redemption (gain if cost < carrying value; loss if cost > carrying value)

Long-Term Notes Payable
• Normally repayable in a series of periodic payments called instalments • Instalment notes repayable in equal periodic amounts plus interest (fixed or floating interest) are called fixed principal payments • Instalment notes repayable in equal periodic amounts including interest are called blended principal and interest payments

Presentation of Long-Term Liabilities
• Report long-term debt separately in balance sheet and detail in notes • Report current maturities of long-term debt as current liabilities • Cash inflows and outflows during the year from the principal portion of debt transactions are reported in the financing activities section of the cash flow statement

Analysis of Long-Term Liabilities
• Liquidity
– Current ratio – Acid-test ratio

• Solvency
– Debt to total assets – Times interest earned

Current Ratio
• Measure of a company’s ability to pay short-term obligations
Current Ratio =
Current Assets

Current Liabilities

Acid-Test Ratio
• Measure of a company’s ability to pay immediate, short-term obligations
Cash + Short-Term Investments + Accounts Receivable Current Liabilities

Acid-Test Ratio =

Debt to Total Assets
• Indicates the extent to which a company’s debt could be repaid by liquidating assets
Debt to Total Assets = Total Debt Total Assets

Times Interest Earned
• Provides an indication of a company’s ability to meet interest payments as they come due
Earnings Before Interest Expense & Income Tax Expense (EBIT) Times Interest Earned = Interest Expense

Contingencies
• Events with uncertain outcomes • Must be recorded in the financial statements if:
– The company can reasonably estimate the expected loss and – If the loss is likely

Off-Balance Sheet Financing
• A situation in which liabilities are not recorded on the balance sheet (e.g. leasing) • Operating lease involves temporary use of the property by the lessee with continued ownership of the property by the lessor • Lease (rental) payments are recorded as an expense by the lessee and as revenue by the lessor

Off-Balance Sheet Financing
• If the lease contract transfers substantially all the benefits and risks of ownership to the lessee, the lease is in effect a purchase of the property • This type of lease is called a capital lease because the fair value of the leased asset is capitalized by the lessee when recording it on the balance sheet


				
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posted:11/15/2009
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