CHAPTER 10

REPORTING AND ANALYZING LIABILITIES

Summary of Question TYPEs by LEARNING Objective, Level of difficulty, BLOOM’S TAXONOMY, CPA CODES, and AACSB Codes

LOD: E = Easy M = Medium H = Hard

Bloom’s: AN = Analysis AP = Application C = Comprehension K = Knowledge

CPA: F = Financial Reporting P = Professional & Ethical Behaviour CM = Communication

AACSB: AN = Analytic E = Ethics CM = Communication

*This topic is dealt with in an Appendix to the chapter.

Summary of Question TYPEs by LEARNING Objective, Level of difficulty, BLOOM’S TAXONOMY, CPA CODES, and AACSB Codes

(Cont’d)

LOD: E = Easy M = Medium H = Hard

Bloom’s: AN = Analysis AP = Application C = Comprehension K = Knowledge

CPA: F = Financial Reporting P = Professional & Ethical Behaviour CM = Communication

AACSB: AN = Analytic E = Ethics CM = Communication

*This topic is dealt with in an Appendix to the chapter.

SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE

Type: TF = True-False MC = Multiple Choice Ma = Matching

Ex = Exercise SAE = Short-Answer Essay CP = CPA

*This topic is dealt with in an Appendix to the chapter.

CHAPTER LEARNING OBJECTIVES

1. Account for current liabilities. A current liability is a debt that will be paid (1) from existing current assets or through the creation of other current liabilities, and (2) within one year or operating cycle. An example of a current liability is an operating line of credit that results in bank indebtedness. Current liabilities also include sales taxes, payroll deductions, and employee benefits, all of which the company collects on behalf of third parties. Other examples include deferred revenues, refund liabilities, short-term notes payable, property tax payable, and interest payable on notes or loans payable, that accrues until paid. Another current liability is the portion of debt that is due within the next year.

All of the above are “certain” or determinable liabilities. Provisions are “uncertain” liabilities that companies record because their outcome is probable and measurable. A contingent liability is an uncertain liability that a company does not record because it does not meet the two conditions necessary for recognition as a provision (probable and measurable). The terms and nature of each recorded provision and contingent liability are described in the notes accompanying the financial statements unless the probability of an outflow of resources arising from a contingent liability is remote, in which case, no provision is recorded and no note disclosure is made.

2. Account for interest bearing liabilities with principal due at maturity or on an instalment basis. Creditors issue notes payable or obtain bank loans to obtain more time to pay suppliers or to borrow money. Notes and bank loans can be current or non-current and normally require the payment of both interest and principal on the maturity date of the note or loan. Non-current notes (or mortgages) payable and bank loans are usually repayable in a series of equal instalment payments. Each payment consists of (1) interest on the unpaid balance of the loan or note, and (2) a reduction of the principal balance. Over time, the interest portion of these instalment payments decreases as the loan is paid down while the remaining portion of the payment allocated to principal will increase.

Companies often grow by using debt, as long as the rate of return on borrowed funds exceeds the interest charged on this type of financing. By using debt, shareholders' interests are not diluted, and companies can deduct interest expense on income tax returns when determining taxable income.

3. Identify the requirements for the financial statement presentation and analysis of liabilities. In the statement of income, interest expense (finance cost) is reported under “other revenues and expenses.” In the statement of financial position, current liabilities are usually reported first, followed by non-current liabilities. Within the current liability section, items are listed in the order they fall due. Typically, bank indebtedness (operating lines of credit) is listed first, followed by accounts payable and other types of payables, followed by deferred revenue and the current portions of any long-term debt.

The liquidity of a company may be analyzed by calculating the current ratio, in addition to the receivables and inventory turnover ratios. The solvency of a company may be analyzed by calculating the debt to total assets and times interest earned ratios. Considering the relationship between these two ratios is necessary to see if a company is taking advantage of, or being disadvantaged by, its use of debt.

4. Account for bonds payable (Appendix 10A). When issuing bonds, the Cash account is debited and the Bonds Payable account is credited for the issue price of the bonds. Bond prices can be determined by calculating the present value of the bond's cash outflows using the market interest rate when issuing the bond.

Bond discounts and bond premiums represent the difference between the face value and the price received for the bonds at their date of issue. They are amortized to interest expense over the life of the bonds using the effective-interest method of amortization. Amortization is calculated as the difference between the interest paid and the interest expense. Interest paid is calculated by multiplying the face value of the bonds by the coupon interest rate. Interest expense is calculated by multiplying the carrying amount of the bonds (which is equal to their present value at that time) at the beginning of the interest period by the market interest rate when the bonds were issued. The amortization of a bond discount increases interest expense and the bond’s carrying amount. The amortization of a bond premium decreases interest expense and the bond’s carrying amount.

When bonds are retired at maturity, Bonds Payable is debited and Cash is credited. There is no gain or loss at retirement.

TRUE-FALSE STATEMENTS

1. Amounts available to be drawn in the future from an operating line of credit improve a company’s liquidity.

2. Property tax payable is classified as a non-current liability because it is related to property, which is a non-current asset.

3. If a company’s fiscal year is the same as the calendar year used for property tax purposes, there should be no prepaid property tax on its year-end financial statements but there may be a property tax liability.

4. If drawing on an operating line of credit results in a negative cash balance, a current liability known as bank indebtedness results.

5. Interest expense on a bank loan payable is only recorded at maturity.

6. When a business sells an item and collects Harmonized Sales Tax (HST) on it, a current liability arises.

7. Payroll liabilities include the employer’s share of CPP contributions and EI premiums.

8. Provisions are liabilities of uncertain timing or amount, along with some uncertainty as to whether the liability will have to be paid.

9. A contingent liability may materialize in the future because of something that happened in the past.

10. Under IFRS, contingent liabilities should be recorded in the accounts if there is a remote possibility that the contingency will occur.

11. A financial liability means there is a contractual obligation to pay cash in the future.

12. Deferred revenue is a financial liability.

13. While short-term notes are generally repayable in full at maturity, most long-term notes are repayable in a series of periodic payments called instalments.

14. Long-term notes payable can only have floating interest rates.

15. Secured notes are often also referred to as mortgages.

16. Unsecured notes are issued against the general credit of the borrower.

17. Instalment payments consist of a mix of interest on the unpaid balance of the loan and a reduction of the loan principal.

18. The classification of a liability as current or non-current is important because it may affect the evaluation of a company’s liquidity.

19. The debt to total assets ratio measures the percentage of the total assets provided by creditors.

20. Interest (finance) expenses are separately reported in the “other gain and revenues” section of the statement of income.

21. The terms of an operating line of credit and a notes (loans) payable are disclosed in the notes to the financial statements.

22. Detailed information such as a list showing the amounts of non-current debt that is scheduled to be paid off in each of the next five years should be disclosed in the notes to the financial statements.

*23. The face value of a bond is the amount of principal and interest due at the maturity date.

*24. All transactions between bondholders and other investors must be recorded by the issuing corporation.

*25. If the market interest rate at the date of a bond issue is greater than the coupon interest rate, the bond will be issued at a premium.

*26. If bonds are issued at a discount, the issuing corporation will pay a principal amount that is less than the face amount of the bonds on the maturity date.

*27. Amortization of a bond premium decreases interest expense recorded by the issuer.

*28. The effective-interest method is required for companies reporting under IFRS, but optional for companies using ASPE if other methods do not result in material differences.

ANSWERS TO TRUE-FALSE STATEMENTS

*This topic is dealt with in an Appendix to the chapter.

MULTIPLE CHOICE QUESTIONS

29. The entry to record interest expense on a bank loan payable is a

(a) debit to interest expense and credit to note payable.

(b) debit to note payable and credit to interest income.

(c) debit to interest payable and credit to interest income.

(d) debit to interest expense and credit to interest payable.

30. Which of the following statements is true?

(a) If any portion of a non-current liability is to be paid in the next year, the entire debt should be classified as a current liability.

(b) “Current maturities of non-current debt” refers to the amount of interest on notes payable that must be paid in the current year.

(c) Even though current and non-current debt must be shown separately on the statement of financial position, it is not necessary to prepare a journal entry to recognize this.

(d) A non- current liability is an obligation that is expected to be paid within one year.

Use the following information to answer questions 31–32.

Angel Eyes Corporation operates on a calendar year basis. The company is in its first year of operations and received its annual property tax bill on March 31 for $21,000. The bill is due May 1. Even though the company records adjusting entries on a monthly basis, no entries related to property taxes have been recorded.

31. The March 31 entry to record property tax should be

(a) debit property tax expense $5,250 and credit property tax payable $5,250.

(b) debit property tax expense $21,000 and credit property tax payable $21,000.

(c) debits to prepaid property tax and property tax expense for $15,750 and $5,250, respectively and credits to property tax payable and cash for $15,750 and $5,250, respectively.

(d) debits to prepaid property tax and property tax expense for $15,750 and $5,250, respectively and credit to property tax payable for $21,000.

Ex. 94

Your friend, Benjamin Bluenote, recently opened a retail shoe store. He knows he needs to pay sales tax but isn't sure how much. The GST and PST are calculated by the cash register. The GST rate is 5% and the PST rate is 8%. Sales, before taxes, for the first month of operations based on the cash register reports were $250,000. All sales are for cash, debit card, or bank credit card. Cost of goods sold is 50% of sales and a perpetual inventory system is used.

Instructions

(a) Calculate the amount of GST and PST.

(b) Prepare the journal entry to record the sales and sales taxes, and cost of goods sold.

Ex. 95

On April 1, Aces Corporation borrows $160,000 from Rigor Bank by signing an 8-month, 3%, bank loan. Interest is due at maturity.

Instructions

Prepare the entries listed below associated with the bank loan on the books of Aces Corporation. Its year end is June 30.

(a) The entry on April 1 when the loan was received.

(b) Any adjusting entries necessary on June 30. Assume no other interest accrual entries have been made.

(c) The entry to record repayment of the loan at maturity.

Ex. 96

On June 1, Reliable Corporation borrows $120,000 from the bank by signing a 2-month, 3.5%, bank loan. Interest is due at the beginning of each month, commencing July 1.

Instructions

Prepare the entries listed associated with the bank loan on the books of Reliable Corporation.

(a) Prepare the entry on June 1 when the loan was received.

(b) Prepare any adjusting entries necessary on June 30 in order to prepare the monthly financial statements. Assume no other interest accrual entries have been made.

(c) Prepare the entry or entries required in July.

(d) Prepare the entry to record repayment of the loan at maturity on August 1.

Ex. 97

Jancy Corporation had cash sales of $150,000 for the month of August. Sales are subject to 13% harmonized sales tax (HST). Prepare the entry to record the sales.

Ex. 98

Fantastic Fashions has just completed its first quarter of operations. Below are transactions that have not yet been recorded. Prepare the journal entries listed below.

Jan 1 Pre-tax cash sales amounted to $75,000. HST is collected on all sales at a rate of 13%.

Jan 15 Signed a three month note for $12,000 to extend amounts owing on account to Trendy Taste Inc. Interest is 6% annually and due at maturity.

Mar 1 Received the annual property tax bill for $7,500 payable on June 1.

Apr 1 Paid salaries of $10,000; of this amount $495 is CPP, $178 is EI and $3,465 is for income taxes (record the employer portion as well).

Apr 15 Paid the note due.

Apr 29 A customer sued Fantastic Fashions for $200,000. Legal counsel has advised that it is unlikely damages will be awarded.

Jun 1 Paid the property taxes bill in full.

Ex. 99

In terms of provisions and contingent liabilities, what is the difference between probable (IFRS) and likely (ASPE).

Ex. 100

Explain the four differences between an account payable and a note payable.

Ex. 101

On December 31, 2022, Industrial Exporters issues a $365,000, 6%, 20-year mortgage. The terms require equal monthly payments of $2,615 (principal and interest).

Instructions

Prepare the journal entry for Jan 31, 2023 to record the first monthly payment. Include your calculations.

Ex. 102

On January 1, 2022, Barney Inc. issues a $480,000, 4%, 15-year note payable. The terms require equal semi-annual payments of $25,600.

Instructions:

Prepare the journal entry at Dec 31, 2022 to record the second semi-annual payment. Include your calculations.

Ex. 103

On December 31, 2022, Rabin Realty Limited issues a 10-year, 6%, $200,000 mortgage payable to finance the construction of a building. The terms provide for monthly instalment payments at the end of each month, commencing January 31, 2023.

Instructions

Record the issue of the mortgage payable on December 31, 2022.

Record the first two instalment payments on January 31, 2023 and February 28, 2023, assuming equal instalment payments of $2,220. Round your answers to the nearest dollar.

Ex. 104

The following instalment payment schedule is for a long-term instalment note payable:

Instructions

(a) Assuming payments are made annually, what is the interest rate on the note?

(b) Prepare the journal entry to record the first instalment payment.

(c) What are the current and non-current portions of the note at the end of period 1?

Ex. 105

On January 1, Marvelous Metals borrowed $1,200,000 at 7% for 15 years to begin the development of a new mine. Equal instalment payments must be made on the first day of each month.

Instructions

(a) Complete the instalment schedule listed below (round to the nearest dollar).

(b) Assuming the year end is March 31, prepare the necessary adjusting entry.

(c) Prepare the journal entries for the payments made on May 1 and June 1.

MARVELOUS METALS

INSTALMENT PAYMENT SCHEDULE- BLENDED PRINCIPAL PAYMENTS

Ex. 106

On January 1, 2022 Calcium Inc. borrowed $210,000, 4.5% for 5 years. Equal instalment payments of $23,685 are due semi-annually on June 30 and December 31.

Instructions

1. Prepare an instalment schedule for the first four payment periods.
2. Prepare all journal entries for the fiscal year 2022.
3. What are the current and non-current portions of the loan at the end of period December 31, 2022?

Ex. 107

National Supplies Corporation has the following selected accounts at December 31, 2022 after posting adjusting entries:

Accounts Payable $ 85,250

Bank Loan Payable, 3-month 125,000

Accumulated Depreciation—Equipment 22,000

Notes Payable, 5-year, 4% 75,000

Employee Benefits Expense 7,000

Interest Payable 10,400

Mortgage Payable 165,000

Sales Tax Payable 16,000

Instructions

(a) Prepare the current liability section of National Supplies’ statement of financial position, assuming $24,000 of the mortgage is payable next year.

(b) Comment on National Supplies’ liquidity, assuming total current assets are $225,000.

Ex. 108

The following information is available from the 2022 financial statements of Alpha Inc. and Omega Ltd.:

(in millions)

Alpha Inc. Omega Ltd.

Income tax expense $ 361 $ 766

Interest expense 480 1,423

Net income 654 948

Total assets 24,750 37,525

Total current liabilities 5,970 14,109

Total liabilities 16,485 31,816

Instructions

(a) Based on the information given, calculate the following ratios for each company:

1. Debt to total assets

2. Times interest earned

(b) What conclusion concerning each company’s long-run solvency can be drawn from these ratios?

Ex. 109

Village Home Products Ltd. sells furniture and appliances. It has been in business for many years and until now has not had any short-term loans. It has approached Friendly Bank for an operating line of credit. Its current ratio, receivable turnover, and inventory turnover for the past 2 years are presented below. You are the credit manager dealing with the application.

Instructions

Comment on the ratios presented in terms of the application for the line of credit and indicate what additional information you would like to receive from the company.

2023 2022

Current ratio 1.6:1 1.2:1

Receivable turnover 5.2 7.5

Inventory turnover 6.8 9.4

Ex. 110

Below is a list of Accounts for Crib Inc. Beside each account determine if it is a Current Liability (C) or a Non-current Liabilities (NC).

1. Accounts Payable

2. Notes Payable (due 9 months)

3. Bank Loan payable (due 16 months)

4. Deferred Revenue

5. Mortgage Payable (due in 20 years)

6. Salaries Payable

7. Sales Tax Payable

8. Current portion of Mortgage Payable

9. Notes payable (due in 12 months)

10. Operating Line of Credit

Ex. 111

Kahluha Manufacturers Inc. reported the following information in its financial statements:

KAHLUHA MANFACTURERS INC.

Statement of Financial Position

June 30

Assets 2023 2022

Cash $32,000 $29,000

Accounts receivable 7,500 5,500

Prepaid Insurance 1,100 1,450

Inventory 220,000 175,000

Building 145,000 155,000

Equipment 36,000 40,000

Total Assets $441,600 $405,950

Liabilities and shareholders’ equity

Accounts Payable $ 12,500 $14,500

Notes Payable 10,000 0

Bonds Payable 145,000 95,000

Long-Term Debt 116,000 175,000

Common shares 25,000 25,000

Retained earnings 133,100 96,450

Total liabilities and shareholders’ equity $441,600 $405,950

Revenue $450,000 $300,000

Operating expenses 300,000 210,000

Income from operations 150,000 90,000

Interest expense 6,000 9,000

Income tax expense 36,000 20,250

Net income $108,000 $60,750

Instructions

(a) Calculate the company’s debt to total assets and times interest earned ratios for each year.

(b) Determine if the change from 2022- 2023 is an improvement or deterioration.

(c) If industry averages for debt to total assets is 57% and times interest earned is 6 times, are Kahluha ratios comparable?

Ex. 112

The following data (000’s) has been extracted from the year-end reports for Grant Corporation:

2023 2022

Interest expense $28 $30

Income tax 270 240

Net income (a) 600

Current assets 3,085 (b)

Total Assets (c) 3,600

Current Liabilities (d) 1,510

Total Liabilities 2,240 (e)

Total Shareholders’ Equity $1,760 $1,800

Current ratio 2.5:1 1.4:1

Debt to total assets 56.0% 50.0%

Times interest earned 34.75 times (f)

Instructions

Solve for the missing data.

Ex. 113

Explain why a company may intentionally reduce their non-cash current assets (such as accounts receivable and inventory).

*Ex. 114

Explain the difference(s) between the coupon, market, stated, effective, contractual, and yield rates.

*Ex. 115

On January 1, 2022, Supreme Industrial Corp. issued bonds with a face value of $1,000,000. The bonds have a coupon interest rate of 5%, payable each July 1 and January 1.

Instructions

(a) Prepare the journal entry for the issue, assuming the bonds are issued at 98.5.

(b) Prepare the journal entry for the issue, assuming the bonds are issued at 104.5.

*Ex. 116

On January 1, 2022, Ainsle Corp. issued $600,000, 7%, 10-year bonds. The bonds pay semi-annual interest on July 1 and January 1. The market interest rate at the time of issue was 6%.

Instructions

(a) Calculate the issue price (round to nearest dollar).

(b) Record the issue of the bonds on Jan. 1.

(c) Record the first interest payment on July 1.

*Ex. 117

On January 1, 2022, Pinehill Ltd. issued $500,000, 6%, 5-year bonds, when the market interest rate was 8%. Interest is payable semi-annually on July 1 and January 1. The company has a calendar year end.

Instructions

(a) Using a financial calculator, calculate the issue price. Round to nearest dollar.

(b) Record the issue of the bonds.

(c) Record the first interest payment on July 1, 2022. Round to nearest dollar.

*Ex. 118

On January 1, 2022, North West Suppliers Ltd. issues $500,000, 6%, five-year bonds, with interest payable on July 1 and January 1. Since the market interest rate is 5%, the bonds sell for $521,880.

Instructions

For the issue date and first semi-annual period, complete (A) through (E) in the table below and show your calculations.

(A) (B) (C) (D) (E)

Interest Interest Expense Premium Unamortized Bond

Period to be Paid to be Recorded Amortization Premium Carrying amount

*Ex. 119

Emery Trust Inc. issued $100,000, a 5-year bond on January 1, 2022 paying 6% interest on a semi-annual basis every January 1 and July 1.

Instructions

Using a financial calculator, prepare the first-year journal entries for the bond issue and interest expense assuming that the company uses the effective interest method, a market interest rate of 4% and has a year-end of December 31, 2022.

*Ex. 120

Emery Trust Inc. issued $100,000, a 5-year bond on January 1, 2022 paying 4% interest on a semi-annual basis every January 1 and July 1.

Instructions

Using a financial calculator, prepare the first-year journal entries for the bond issue and interest expense assuming that the company uses the effective interest method, a market interest rate of 6% and has a year-end of December 31, 2022.

*Ex. 121

Calculate the selling price for each of the following bonds:

(a) 5% bonds with a par value of $100,000 due in 5 years, paying interest on January 1 and July 1 each year, issued at par.

(b) Bonds with face value of $500,000, due in 10 years, paying 7% interest semi-annually, issued at par.

(c) Bonds with a face value of $1,000,000 and a coupon rate of 10%, issued to yield 12%, due in 10 years, paying interest semi-annually.

(d) 8% bonds with a par value of $5,000,000 due in 5 years, paying interest on January 1 and July 1 each year, issued to yield 6%.

*Ex. 122

Harpers Group has $1,000,000 par value bonds with a coupon rate of 5% paid semi-annually. The bonds are selling for $981,415.

Instructions

Using a financial calculator, determine the yield assuming the bonds mature in:

2 years

5 years