FINANCIAL ACCOUNTING
A USER PERSPECTIVE
Hoskin • Fizzell • Davidson
Second Canadian Edition
Liabilities
Chapter Nine
Recognition for Liabilities
• Classify as liabilities if
– Transfer of assets or the delivery of
services or other benefits
– Company has little or no discretion
– Results from an event that has
already occurred
Contingent Liability
• If there is a possibility of the
future transfer of assets, and
• If the future obligation is
contingent on certain events
occurring, then
• Company should disclose in a
note to the financial statements
Valuation Methods
• Gross amount of the obligation
– May not measure obligation
accurately
– Ignores the time value of money
Valuation Methods
• Net present value of the obligation
– Recognizes the time value of money
– Future payments of principal and
interest are discounted back to the
current period using a discount rate
Valuation Methods
• Canadian practice
– Record liabilities at the present
value of the future payments
– Exception: short-term liabilities
Working Capital Loans and
Lines of Credit
• Short-term loan from a bank
• Secured by accounts receivable
or inventory balances
• Results in negative cash balance
Accounts Payable
• Occur when goods or services are
purchased on credit
• Called trade accounts payable
• Payment deferred for 30-60 days
• Generally do not carry interest
charges, unless payment is
delayed
Wages and Other Payroll
Payables
• Accrual of wages since the last pay
period
• Fringe benefits
– Health care, pensions, vacation pay
• Company acts as government agent
in collecting taxes
– Income taxes, CPP (QPP), EI, WCB
Wages and Other Payroll
Payables
• Deductions from employees’ earned
income
SE-Wages expense
7,500.00
L-Employee income tax payable
990.00
L-CPP contribution payable
240.00
L-EI taxes payable
202.50
A-Cash
6,067.50
Wages and Other Payroll
Payables
• Additional amounts paid by
employer
SE-Wages expense
L-CPP contribution payable
L-EI taxes payable
7,500.00
240.00
283.50
Short-Term Notes and Interest
Payable
• Short-term notes
– Borrowings that require repayment
in the next year or operating cycle
– Carry explicit interest rates, or
represent implicit interest amounts
• Interest expense and payable
– Recognized over the life of the loans
Short-Term Notes and Interest
Payable
• Example:
– Borrowing of $10,000 at 9%.
– Six monthly payments of $1,710.70
– Monthly instalments included
reductions of the principal, plus
interest
– Interest is calculated on the
decreasing amount of principal
Short-Term Notes and Interest
Payable
Month Payment Interest Principal Principal
Reduction Balance
10,000.00
1
1,710.70 75.00 1,635.70
8,364.30
2
1,710.70 62.73 1,647.97
6,716.33
3
1,710.70 50.37 1,660.33
5,056.00
4
1,710.70 37.92 1,672.78
3,383.22
5
1,710.70 25.37 1,685.33
1,697.89
6
1,710.70 12.81 1,697.89
-0-
Short-Term Notes and Interest
Payable
• Entry at the end of the first month
SE-Interest expense
75.00
L-Short-term note payable 1,635.70
A-Cash
1,710.70
Income Taxes Payable
• Companies are subject to taxes
– Federal corporate income taxes
– Provincial corporate taxes
• Payment of taxes does not always
coincide with the incurrence of
the tax
• Results in taxes payable
Warranty Payable
• Goods or services sold may result
in guarantees to the buyer
• May result in warranty service
• Estimate the amount of warranty
expense to match to the revenue
from the sale
– Estimate % based on past history
Warranty Payable
• Record the estimated warranty
obligation (in the period of the
sale)
SE-Warranty expense
460
L-Estimated warranty obligation
460
Warranty Payable
• Record the repair work (in the
period when the work is done)
L-Estimated warranty obligation
A-Cash
126
126
Unearned Revenues
• If customers are required to make
downpayments prior to the
receipt of goods or services
• Defer the recognition of revenue
• Liabilities
– Unearned revenues, or
– Deferred revenues
Current Portion of Long-Term
Debt
• When long-term debt comes
within a year of being due
• Must be reclassified as a current
liability
Commitments
• Purchase commitment
– An agreement to purchase items in
the future for a negotiated price
– Discuss in a note to the financial
statements if material to future
operations
Contingencies
• Contingent liabilities (losses)
– When the incurrence of the liability
is contingent upon some future
event
– Examples
• Settlement of a lawsuit
• Guarantee of another company’s loan
Contingencies
• In Canada, recognize a contingent
loss if:
– The use of assets or performance of
services are required
– The amount of the loss can be
reasonably estimated
Deferred Taxes
• Differing calculations:
– Income tax expense from the
income statement
– Income tax payable according to
Revenue Canada
• Two methods: Liability method
and Deferral method
Liability Method
• Focuses on the balance sheet
• Attempts to measure the liability
to pay taxes in the future based
on a set of assumptions about
future revenues and expenses
Liability Method
• Calculate (pro forma) future
income taxes payable based on
temporary differences existing in
the current period
• A liability in the current period
will become a tax deduction as
actual costs are incurred
Liability Method
• Assumptions
Income before tax and warranties
$10,000
Warranty expense (accounting purposes):
Year 1: $200
Actual warranty costs incurred:
Year 1: $ 50
Year 2: $ 70
Year 3: $ 80
Tax rate: 40%
Liability Method
Year 1 Year 2 Year 3
Beginning warranty
obligation
$ 200 $ 150 $
Actual warranty costs
incurred
50
70
Ending warranty
obligation
$ 150 $ 80 $
Tax rate
Future tax asset
Reduction of future
tax asset
80
80
-0-
40%
40%
40%
$ 60 $ 32 $ -0( $28) ( $32)
Liability Method
Income tax payable: Year 1 Year 2 Year 3
Income
$10,000 $10,000 $10,000
Actual warranty
costs
Taxes payable
Taxes payable
Future tax asset
Tax expense
50
70
80
9,950
9,930
9,920
3,980
3,972
3,968
$ 5,970 $ 5,958 $ 5,952
$ 3,980 $ 3,972 $ 3,968
(60)
28
32
$ 3,920 $ 4,000 $ 4,000
Deferral Method
• Focuses on the income statement
• Tax expense is based on the
recognized revenues and
expenses on the income statement
• Uses the tax rates in effect in the
current year
Deferral Method
Tax expense:
Income
Warranty expense
Tax expense
Net income
Year 1 Year 2 Year 3
$10,000 $10,000 $10,000
200
-0-09,800 10,000 10,000
3,920
4,000
4,000
$ 5,880 $ 6,000 $ 6,000
Taxes payable
$ 3,980 $ 3,972 $ 3,968
Deferred taxes
60
(28)
(32)
Differences
Liability Method
Deferral Method
• Balance sheet
• Income
focus
statement focus
• Future tax rate • Current tax rate
• Future reviews • Deferred taxes
of tax assets and drawn down; no
liabilities
periodic reviews