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
• Employer payroll contributions
–
–
–
–
CPP
EI
Workers’ compensation
Other
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
Carrying Value
$980,000
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
$1,000,000
Add: Premium on bonds payable
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
Acid-Test Ratio =
Cash + Short-Term Investments
+ Accounts Receivable
Current Liabilities
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