Reporting and Analyzing

Liabilities
Chapter 10

Liabilities
Definition
Current obligations arising from past transactions and
requiring future settlement of assets or services

2 classifications
Current liability will be settled within the year
Bank indebtedness, operating lines of credit,
notes payable, accounts payable and accrued
liabilities, taxes payable, interest payable,
current portion of long-term debt
Non-current will be settled beyond one year
Long-term debt, Deferred income taxes, bonds
payable

Example #1
XYZ Co. orders some equipment. The
machine costs $10,000 and monthly
installments will be paid every month once
the machine has arrived.
Is this a liability?
At the time of ordering? No.
Once goods arrive? Yes.

Example #2
Westjet collects money from customers
before the flights take place
Is this a liability?

Example #3
A parent company guarantees the debt of a
subsidiary company
This means that if the subsidiary company
cant pay, then the parent company is on
the hook for the loan
Is this a liability?
Maybe
Not an obligation to the parent until the
subsidiary defaults

Accounts payable
Amounts owing to creditors
An informal promise to pay
Normally due in 30 days
Interest may be charged on overdue
accounts

Operating line of credit

Prearranged agreement between a company
and a lender (usually a bank) to allow the
company to borrow up to an agreed-upon
amount
Interest is normally charged on amounts that
have been drawn on the line of credit
Normally short-term and repayable
immediately
Reported as bank indebtedness on the
balance sheet

Sales tax
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

Sales Taxes
The seller, or collector, of GST is an intermediary for the
government
Required to periodically send to the government all
sales taxes collected
Amount owing may be reduced by any GST paid to
suppliers with business purchases

GST
1. Record sales tax collected on every sale
Assume Crazy Canadian Clothing Inc. sold $107,500 of
goods in the month of November. Sales are subject to
5% GST.
Dr. Cash (or A/R)

112,875

Cr. GST payable

5,375

Cr. Revenue or Sales

107,500

GST
What if we had been told, instead, that they had
collected $112,875, which included GST. How
do we determine the sales or GST?
Revenue + GST = Amount collected
GST = Revenue * .05
Revenue + (Revenue * 0.05) = collected
1.05 * revenue = collected
Revenue = Collected / 1.05

GST
2. Record GST paid on every purchase:
Assume Crazy Canadian had made purchases of
$97,000 during November, including GST
Net purchases =$ 97,000 / 1.05 = $92,381
GST = $92,381 x 5% OR $97,000 $92,381 = $4,619
DR Asset or expense account
DR GST receivable
CR Accounts payable or cash

92,381
4,619
97,000

GST
3. Determine amount owing and record remittances made.
At the end of November, CCCI owes:
GST payable =

5,375

GST receivable = (4,619)

Net owing =

756

Assume payment is made for this amount

Dr. GST payable

5,375

Cr. GST receivable

4,619

Cr. Cash

756

Property taxes
A payable, or an accrued liability
Property tax assessments relate to a
calendar year, but are not normally received
until May or June.
From January June, companies must
estimate the expense amounts
Still required to record expenses in those
months and recognize the liability that is
accumulating

Event #1: ABC Company estimates 2014 property taxes

will be $4,200 for the year.
January 31, 2014
DR Property tax expense

350

CR Property tax payable

350

(4200 / 12 = 350)
This entry will be repeated in Feb, March, April and May
Event #2: On May 31, ABC paid $2,000 in property taxes.
DR Property tax payable
CR Cash

2,000
2,000

Event #3: On June 30, ABC receives the property tax bill for
2014. Actual taxes are $3,600 for the year.
Before we can make the June entry, we need to see where
we are for the year so far:
Property tax expense

DR
Jan
Feb
Mar
Apr
May

Property tax payable

DR

CR

350
350
350
350
350

350
350
350
350
350
May

1750

CR

2000
250

Jan
Feb
Mar
Apr
May

ABC Company
By the end of June, the property tax expense should be:
3,600 x (6/12) = 1,800
It currently is $1,750, therefore, we only need to _debit_
the expense _by $50_
Dr. Property tax expense
Cr. Property tax payable
At June 30:
Total expense
Total paid
Prepaid

50

= 1,800
= 2,000
= 200 (paid > expense)

50

Property tax
expense
DR
1,750
1,750

CR

Property tax
payable
DR

1,750
2,000
250

50
1,800

CR

200

50

Example, continued
Lets think about what our entry would be in July
for the property taxes, assuming no other cash
payment was made:
DR Property tax expense
CR Prepaid property tax
CR Property tax payable

300
200
100

There are 2 factors that need to be considered when

looking at prepaid or accrued expenses:
1.The timing of the expense
- This needs to be matched to the related
revenue OR the period the expense relates to
2.The cash payment made for the expense
When the timing of these two differ, we will have
either a prepaid expense (cash payment > expense)
OR an accrued liability / accrued expense (when
expense > cash payment)

Payroll Liabilities
Just as with sales tax, governments require
employers to withhold certain amounts from
employees and remit those amounts directly
to them
- Other entities may require or provide an
option for a similar mechanism (pension
plans, unions, etc.
Employers also have to pay a share of CPP
and EI, and possibly other benefits.

Payroll and Employee Benefits Payable

Employee payroll deductions
Canada pension plan (CPP)
Employment insurance (EI)
Federal and provincial income taxes
Other deductions at source (union dues,
support payments, private health plan
premiums, etc.)
Employer payroll contributions
CPP
EI
Other

Payroll liabilities
Crazy Canadian pays employees every second
Friday for hours worked the two weeks previous.
The cut off for hours is the Tuesday before pay
day.
Hours worked from Wed Nov 5 to Tuesday
November 18 were paid on Friday November 21.
Employees worked 130 hours in the pay period
at $17.00 per hour.
Crazy Canadian is required to withhold 4.95% for
CPP, 1.7% for EI and 15% for income taxes.
Two employees belong to the private health care
plan and pay $75 per pay period for benefits.

Payroll and Employee Benefits Payable

1. Record employee earnings and pay:
First, lets figure out how much they were paid:
Gross wages (130 x 17)
Less: CPP (2,210 *4.95%)
EI (2,210 x 1.7%)
Tax (2,210 x 15%)
Benefit payments
Net pay to employees

2,210
(109)
(38)
(332)
(150)
1,581

Payroll and Employee Benefits Payable

1. Record employee earnings and pay:
Dr. Wage expense
2,210
Cr. CPP payable
109
Cr. EI payable
38
Cr. Tax withheld payable
332
Cr. Due to benefit plan
150
Cr. Cash
1,581

Payroll and Employee Benefits Payable

2. Record employer costs
The government requires that companies also pay
CPP equal to the amount that employees pay, and
to pay EI of 1.4 times the employee amount.
Crazy Canadian also pays $100 per employee per
pay period to the benefit plan.
CPP owing
= 109 (same as employees)
EI owing = 53 (38 x 1.4)
Benefit plan = 200

Payroll and Employee Benefits Payable

2. Record employer costs
Dr. Benefit expenses
Cr. CPP payable
Cr. EI payable
Cr. Due to benefit plan

362
109
53
200

Payroll and Employee Benefits Payable

3. Record amounts remitted.

Crazy Canadian owes the government:

CPP = 109 + 109 = 218
EI = 38 + 53 - 91
Income taxes withheld = 332
Total owing to the federal govt = 641
And owes the benefit plan provider:
150 + 200 = 350

Payroll and Employee Benefits Payable

3. Record amounts remitted.
CPP payable
EI payable
Tax withheld payable
Cash

218
91
332

Due to benefit plan

Cash

350

641

350

Payroll liabilities
In our example, everything happened in
November.
What if the pay period spans 2 different months?
For example, say employees work from
November 19 December 2and are paid for that
time on December 5. What needs to happen in
November?
We need to record accrued wages
Do we need to record liabilities for withholdings
in November?
No.

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
The other side of Note receivable
See examples in the textbook

Current portion 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
Example: Distiller Inc. borrowed $50,000 on
January 1, 2014. The loan is to be repaid
equally over 5 years.
The current portion of LT Debt = 10,000

Provisions and Contingent Liabilities

We have seen many areas where we use
estimates in accrual accounting
These are the terms used for liabilities that have a
higher degree of uncertainty than payables

Provisions
This is the term used for liabilities that we are
certain will occur, but we are not certain about
the timing and/or the amount. Examples:
Warranties
Asset retirement costs
Pension liabilities

Contingencies
Contingencies are things that may become
a liability down the road.
We are unsure about the future settlement:
Past transaction
Present obligation
Future settlement

Lawsuits are a good example If we lose

this lawsuit well have to pay $X.
Not a present obligation until we actually lose
the lawsuit

Contingencies
Accounting rules specify when it needs to be
recorded as a liability; only discussed in the
notes; or nothing
There are two factors to consider:
1)Likelihood of event occurring
2)Amount needed if event occurs

Contingent Liabilities
Likely*
Measurable

Not Measurable

Record
Dr. Expense
Cr. Liability
MUST
discuss in
the notes

Not Likely
May discuss in
the notes
(disclose)
May discuss in
the notes
(disclose)

IFRS uses probable = more likely than not (>50% chance

of happening)
ASPE uses likely = higher requirement than probable

Long-term liabilities
Obligations to be paid after one year
Includes long-term notes, bonds, and lease
obligations

Long-term notes payable

Normally repayable in a series of periodic
payments called installments
May be secured by specific assets which are
commonly referred to as mortgages
May be unsecured
Installment payments usually take one of two
forms:
Fixed principal payments plus interest (fixed
or floating interest)
Blended principal and interest payments

Example
Assume Inco Ltd. receives a note payable for
$120,000 to be repaid over 5 years and with
interest at 7%.
Date loan is received:
Dr. Cash
120,000
Cr. Note payable (or long-term debt) 120,000

Instalment Payment Schedule

Fixed Principal Payment
Assume that the loan terms provide for monthly
installment payments of $2,000 ($120,000/60) plus
interest. The installment payment schedule for the first
few months is shown below:

Interest
Period
Issue date
1
2
3

(A)
Cash
Payment
(B + C)
$2,700
2,688
2,677

(B)
Interest
Expense
(D x 7% x 1/12)
$ 700
688
677

(C)
Reduction
of Principal
(120,000/60)
$2,000
2,000
2,000

(D)
Principal
Balance
(D-C)
$120,000
118,000
116,000
114,000

Instalment Payment Schedule Blended

Payment
Assume that instead of fixed principal payments, Inco Ltd
repays its $120,000, 7 percent, 5-year note payable in
blended monthly installments of $2,376. The installment
payment schedule for the first few months is shown below:

Interest
Period
Issue date
1
2
3

(A)
Cash
Payment
$2,376
2,376
2,376

(B)
Interest
Expense
(D x 7% x 1/12)
$ 700
690
680

(C)
Reduction
of Principal
(A - B)
$1,676
1,686
1,696

(D)
Principal
Balance
(D-C)
$120,000
118,324
116,638
114,942

With both types of installment notes payable, the reduction in

principal for the next year must be reported as a current
liability while the remaining unpaid principal is classified as a
long-term liability.

Journal entries
1st case:
Dr. Note payable
Dr. Interest expense
Cr. Cash

2000
700

2nd case:
Dr. Note payable
Dr. Interest expense
Cr. Cash

1676
700

2700

2736

Bonds
Bonds are a financing tool for companies
a way for them to get cash into the
company
They are a form of debt, as there is no
ownership that goes with them
There is a promise to pay the principle
amount at a fixed date in the future
Also a promise to pay some interest at
predetermined dates (can be at a 0% rate
of interest)

Bonds - example
On January 1, 2010, Cash Strapped Inc. issues
500 5 year, 6%, $1,000 bonds
$1000 is the face value
6% is the stated interest rate
Maturity date is December 31, 2014

Sold in small denominations, which makes them

attractive to investors
Convertible vs. redeemable/retractable

Bonds - Pricing
Lets assume you have $1,000 saved up that
you wont need for 5 years. You are looking to
invest that money.
CSI is issuing 5 year, $1,000 bonds with 0%
interest.
This entitles the bondholder the right to receive
$1,000 in 5 years, but no interest (interest = 0%)
Would you be willing to purchase this bond for
$1,000?

Bonds - Pricing
Assume FWC Ltd. is also issuing 5 year, $1,000
bonds but these bear interest at 6%
This entitles you to annual interest payments of
$60 and principle of $1,000 at the end of the 5
years.
Would you be willing to purchase this bond for
$1,000?

Bonds
What you should be willing to pay is going to
depend on the price of the bond
The bond price will be determined based on how
the stated rate of interest compares to market
rates of interest on similar bonds
The price of a bond is equal to the present value
of the future cash flows generated by the bond.

Bonds
Need to understand the concept of present value or
time value of money
Because we can invest our money, the present
value of a dollar in the future is something less
than a dollar
If I can earn 10% on my money, and I invest $0.91
today, I will have $1.00 in a year
So the present value of $1.00 one year from now,
if interest rates are 10% is $0.91
There are established ways to calculate present
values
Formulas and tables

Bond pricing
Assume CSI issues a 2 year, $1,000 bond that
offers interest at 10%, paid annually. Current
market interest rates for investments with similar
risk are offering 8%.
Given that CSI bonds will pay 10%, while
everything else in the market is paying 8%, what
would investors be willing to pay for these
bonds?
The answer is the present value of the future
cash flows, discounted at market interest rates

Bond pricing
Step 1: Determine cash flows
There are 2 cash flows present:
Interest
Paid annually
Based on face value and stated rate of interest
$1,000 x 10% = $100 per year

Face value
Paid at maturity
$1,000

Bond pricing
Step 2: Discount each of the types of cash flow
Interest is a different type of cash flow
Interest
Annuity regular, recurring cash flows

Face value
Lump sum one time cash payment

The present value of an annuity is calculated

differently from the present value of a lump sum or
one-time payment

Bond pricing
Step 2: Discount each of the types of cash flow
Interest/Annuity: we need to know:
Cash payments = $100
Discount rate = 8% (market rate)
Number of payments/periods = 2

We will use the tables presented at the end of the

chapter material to determine the factor
= 1.78326 x 100 = 178.33

Bond pricing
Discount the lump sum:
Cash payments = $1,000
Interest rate = 8
Number of payments/periods = 2

Using the tables presented at the end of the

Chapter material to determine the factor
= 0.857339 x 1000 = 857.34

Step 3: Add the two amounts together:

= 857.34 + 178.33 = 1,035.67
Investors should be willing to pay $1,035.67

Bond premiums
This is an example of a bond premium:
Because CSI is offering an interest rate above
anything else offered in the market, investors will
pay more than the face value for the bond

Similarly, we can have bond discounts

Arise when the stated rate < market rates
Assume instead that market rates are 12%
Recalculating the bond price, we get:
$100 x 1.69005 = 169.01
+ $1,000 x 0.79719 = 797.19
966.20

Why do rates differ?

Assume CSI identifies on January 1, 2015 that it
requires cash and that it will raise the money by
issuing bonds.
Advice from underwriters as to pricing based on
the markets perception of CSIs risk
Consider their situation how much interest can
they afford? How much can they raise with the
issue based on expected pricing? Etc.
Will determine the rate, but then must get the
certificates printed and issued takes time

Present value and rates

As the interest rate used to discount cash flows
goes up, what happens to the present value?
It goes down
Inverse relationship

Why is this the case?

Less money is needed today to receive the same
cash in the future more earnings

Accounting for bonds

Discounts and premiums result from
differences between bonds stated interest
rates and market rates at the date of issue of
the bonds.
The discount or premium is a contra account
and is included with the legal debt on the
corporations balance sheet, probably not
mentioned separately but disclosed in notes
if material.

Issuing Bonds at Par (face value)

Assume that Artisan Inc. issued $ 1 million, five-year, 5%, bonds dated January 1 at 100 (face value). (market interest = 5%)
Journal entry:
Dr. Cash 1,000,000
Cr. Bonds payable 1,000,000
To record bonds payable issued at par

Issuing Bonds at Discount

Assume that on January 1, Artisan, Inc. sells $1
million, five-year, 5% bonds at 98 (market rates are
>5%).
Journal entry:
Dr. Cash
Dr. Bond discount
Cr. Bonds payable

980,000
20,000

To record bonds issued at a discount

1,000,000

Carrying (Book) Value of Bonds

Long-term
liabilities
Bonds payable
Less: Discount on bonds payable

$1,000,000
20,000

$980,000

Issuing Bonds at Premium

Assume that on January 1, Artisan, Inc. sells
$1 million, five-year, 5% bonds at 102. (market
rates are < 5%)
Journal entry:
Dr. Cash
1,020,000
Cr. Bond premium
20,000
Cr. Bonds payable
1,000,000
To record bonds issued at a premium

Carrying (Book) Value of Bonds

Long-term
liabilities
Bonds payable
$1,000,000
Add: Premium on bonds payable
20,000 $1,020,000

Amortization of Bond Premium /Discount

There are two 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 bonds carrying value; this is the
preferred method

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

Example
On January 1, Year 1, Windemere Ltd. issued 4
year, $100,000 bonds at 7% when market rates
were 9%
Price of bonds = 93,521
Discount = $6,479

Example effective interest method

January 1, Year 1 (issue)
Dr. Cash
93,521
Dr. Bond discount
6,479
Cr. Bonds payable
100,000
To record bonds issued at a discount
December 31, Year 1 (pay interest)
Dr. Interest expense
7000
Cr. Cash
7000
To record interest payment

Example effective interest method

December 31, Year 1 (amortize bond discount)
Effective interest method:
- Amortizes the discount using the effective
interest = market interest rate
- Look to the bond amortization table at the start
- Use the amount that is the difference between
actual interest paid and effective interest

Example effective interest method

December 31, Year 1 (amortize bond discount)
DR Interest expense
CR Bond discount

To amortize bond discount

1417
1417

Example
December 31, Year 2 (amortize bond discount)
Dr. Interest expense
Cr. Bond discount
To amortize bond discount

1544
1544

Example effective interest method

December 31, Year 4 (record redemption of bond)
DR Bonds Payable
CR Cash

100,000
100,000

Example
Lets re-do the example using the straight line
method
On January 1, Year 1, Windemere Ltd. issued 4
year, $100,000 bonds at 7% when market rates
were 9%
Price of bonds = 93,521
Discount = $6,479

With straight line, we simply spread the bond

discount across the 4 years:
6479 / 4 = $1619.75

Example straight line

January 1, Year 1 (issue)
Dr. Cash
93,521
Dr. Bond discount
6,479
Cr. Bonds payable
100,000
To record bonds issued at a discount
December 31, Year 1 (pay interest)
Dr. Interest expense
7,000
Cr. Cash
7,000
To record interest payment

Example straight line method

December 31, year 1 (amortize bond discount)
Dr. Interest expense
Cr. Bond discount
To amortize bond discount

1,619.75
1,619.75

Example straight line method

December 31, Year 2 (amortize bond discount)
Dr. Interest expense 1619.75
Cr. Bond discount 1619.75
December 31, Year 4 (redeem bond)
Dr. Bonds payable
Cr. Cash 100,000

100,000

Amortizing Bond Discounts or Premiums

Straight-line method
Constant periodic expense, varying percent
Simpler and widely used as a result
Effective interest method
Varying periodic expense, constant percent
Conceptually superior, better matches expense
Required under IFRS
Both methods result in the same total amount
of interest expense over the life of bonds.

Discount/Premium Summary
Discount:
Book value < face value
Interest expense > stated rate
Premium:
Book value > face value
Interest expense < stated rate

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

Retiring bonds early

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)

Example
Assume Windemere redeemed the bonds on
January 1, Year 4, at 99 and had used the
effective interest method to amortize the bond
discount. Prepare the journal entry
DR Bonds payable
100,000
DR Loss on bond redemption
CR Bond discount (100,000-98,165)
CR Cash

835
1,835
99,000

Statement Presentation
Balance sheet
Current liabilities are first in order of
settlement dates
Non-current liabilities follow
Notes
Include information about repayment
schedules, interest rates, security
pledged, value of the security, etc.

Statement Presentation
Cash flow
Most current liabilities relate to operations
Receiving cash by issuing debt is a
financing activity
Paying cash to repay debt is also a
financing activity
Income Statement
Interest expense is reported as an
operating expense

Whats the issue with liabilities?

Companies sometimes have obligations that
dont quite meet the definition of a liability,
and so are not recorded on the balance sheet
May be an area subject to manipulation
Can be substantial, so its important to
know where to look for these

Times interest earned

-Used to determine if the company is able to meet
interest payments when they are due
- this ratio would be used if we were concerned
that a companys debt load is too high
- relates earnings to annual interest costs
- banks and other lenders would be particularly
interested in this ratio.

Times interest earned

How is it calculated?
= EBIT (earnings before interest and tax)

Interest expense

Calculation Results

2013 = 7538/1162

= 6.5

2012 = 5126/142

= 36.1

Interpretation

Times interest earned

How is it calculated?
= EBIT (earnings before interest and tax)

Interest expense

Calculation Results

2013

= 7,538 / 1,162

= 6.5

2012

= 5,126 / 142

= 36.1

Interpretation