Chapter 11 Notes - AFM 391 PDF

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Chapter 11: Current Liabilities and Contingencies A. INTRODUCTION  A number of factors affect the value of indebtedness: o The obligation is a financial liability or a non-financial liability; o The market rate of interest is different from that recorded in the loan documentation; o The market rate of interest has changed since the liability was incurred; o There is uncertainty about the amount owed; o The amount owed depends upon the outcome of a future event; or o The obligation is payable in a foreign currency  Amount reported for liabilities is important to creditors, investors, suppliers  Information on how much the company owes, to whom and when the amounts are due is useful to stakeholders in their decisions to lend to the firm, to invest or to extend trade credit B. DEFINITION, CLASSIFICATION, AND MEASUREMENT OF LIABILITIES 1. Liabilities defined Liability – a present obligation of the entity to transfer an economic resource as a result of past events Definition of Liability Includes Three key elements of IFRS: 1. It is a present obligation - legally enforceable but can also be constructive in nature (i.e. a company that regularly repairs products after the warranty period to maintain good customer relations would report a liability for the amounts that are expected to be expended both in the warranty period and in the period afterward) 2. Arising from a past event; and - not from a decision to do something in the future 3. Expected to result in an outflow of economic benefits - Expectation that you are going to give up something in the future to satisfy the creditor’s claim (i.e. cash, other assets, or services) 2.    

Recognition Recognition on the financial statements requires a liability to be measured reliably A precise dollar amount of obligation is not required, only a reliable estimate is required Rare that a reliable estimate cannot be obtained The fact that there is uncertainty over the amount or timing of payments (provisions) does not imply that a liability cannot be reliably measured  Liabilities with estimated amount: provisions (i.e. warranties) and contingent liabilities (lawsuits)

Provision – a liability in which there is some uncertainty as to the timing or amount of payment 3. Financial and non-financial liabilities Financial liability – a contractual obligation to deliver cash or other financial assets to another party  Initially measured at fair value  Subsequently measured at amortized cost  If held for trading (i.e. derivatives), then measured at fair value Non-financial liabilities are obligations that meet the criteria for a liability but are not financial liabilities, not contractual

 typically, through the delivery of goods or provision of services (i.e. warranty, unearned revenues)  Liabilities established by legislation (i.e. income taxes payable and provincial sales tax payable) are also non-financial liabilities as they are not contractual in nature  Measured using best estimate at balance sheet date Important to distinguish because some financial liabilities are required to be measured at their fair value rather than amortized cost Fair value – the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date 4. Current versus non-current liabilities Current liabilities – obligations that are expected to be settled within one year of the balance sheet date or the business’s normal operating cycle, whichever is longer.  Current liabilities are required to be presented separately from non-current liabilities in the BS  Certain financial liabilities classified as “at fair value through profit or loss (FVPL)” would also be reported as current liabilities  Distinction between current and non-current liabilities is made during the financial reporting phase, rather than the recognition process o i.e. a company takes a five-year loan, it records a debit to cash and a credit to loan in its GL. When it prepares its FS, it reports the principal amount of the loan due in the 12 months following the BS date as a current liability and the remainder as a non-current liability 5. Initial and Subsequent measurement  Measuring a liability is normally based on nature of the obligation 1. Financial liabilities at fair value through profit or loss (FVPL) should be initially and subsequently measured at fair value. Transaction costs are expensed 2. Other financial liabilities (not FVPL) should be initially measured at fair value minus the transaction costs directly associated with incurring the obligation. Subsequent to the date of acquisition, they are measured at amortized cost using the effective interest method 3. Non-financial liabilities measurement depends on their nature; may be best estimate or based on amount initially received i.e. warranties are recorded at management’s best estimate of the future cost of meeting the entity’s contractual obligations or look at competitors C. CURRENT LIABILITIES  Current liabilities arise from past events; the amounts to be paid is known or can be reasonably estimated  Contingencies arise from past events; the amount to be paid is determined by future events  Financial guarantees arise from contracts previously entered into; the amount to be paid is determined by future events 1. Trade payables (accounts payable) Trade payables – obligations to pay for goods received or services received/used

 Due to processing delays, not all invoices for trade payables will have been received at the yearend => needs to record an “accrued liability” for invoices not yet received (“in transit”  Amount owing is usually known with a high degree of certainty Few concerns to consider: 1. Cut-off: Caution must be taken to ensure the obligation is properly reported in the right period 2. Gross versus net: suppliers offer discounts to encourage early payment. Questions is, should a buyer report an obligation for the full amount of the net amount (minus the discount) o Gross: total amount owed, net = minus any discount o Both methods are used, mainly the gross method for simplicity

Example: Record journal entries for the gross and net methods for a $100,000 trade payable with terms of 2/10 net 30.

2. Common non-trade payables  Obligations that do not arise from ordering goods or services on account  Sales taxes payable, income taxes payable, dividends payable, royalty fees payable a) Sales taxes payable  Total sales taxes depend on province, vendor may be required to collect; o Federal Goods and Services Tax (GST) o Provincial Sales Tax (PST) o Or a combination, Harmonized Sales Tax (HST)  Business charges and collects taxes on its sales and remits the tax portion to the governments  Businesses permitted to deduct GST and HST paid on their purchases from the GST and HST collected and remit the net amount owing to the government. For PST, goods purchased for resale are exempt from PST, but businesses cannot recover PST paid on other purchases  For GST/HST: you have GST or HST recoverable (HST paid on purchases, debit account) and GST or HST payable (HST charged on sales, credit account) Example: Company B, located in Ontario, purchases $40,000 inventory on account. It subsequently sells goods that cost $30,000 on account for $50,000. And last, the company remits the net HST owing to CRA. The HST rate in Ontario is 13%. The company uses a perpetual inventory system. Solution: Purchase of goods: DR. Inventory DR. HST Recoverable ($40,000 * 13%) CR. Accounts payable

$40,000 5,200 45,200

Sale of goods: DR. Accounts receivable $56,500 CR. Sales CR. HST payable ($50,000 * 13%) DR. Cost of goods sole 30,000 CR. Inventory Settlement of sales tax obligation DR. HST payable CR. HST recoverable CR. Cash b)   

50,000 6,500 30,000

$6,500 5,200 1,300

Income taxes payable Businesses are required to pay tax on the taxable income they earn Amount of income tax owing is normally recorded as a current liability Withholdings from employees of federal/provincial income taxes reported as current liabilities

c) Dividends payables  Cash Dividends o Become a liability when declared (obligation => dividends payable liability)  Stock Dividends o Not a liability even when declared: no future outflows of economic resources involved o Recorded through retained earnings and other equity account(s) o Are revocable (can be cancelled) by the BOD at any time before they are issued  Dividends in Arrears on Preferred Shares o Undeclared cumulative preferred dividends not recognized as a liability o No declaration, no liability. Instead, it should be disclosed in the notes of FS d) Royalty fees payable  Franchise - the franchisor licenses its trademark, business practices, etc. to the franchisee  Most franchise agreements require the franchisee to franchisor (i.e. Tim Hortons) a royalty fee based on sales. Unpaid royalty fees are recorded as a current liability 3.    

Notes Payable Used in credits over extended periods, supported with a written promise to pay (promissory note) Can be current, non-current or a combination, based on payment due date(s) Can be interest bearing – measured at fair value; or Non-interest bearing – estimated using valuation techniques (i.e. discounted cash flows) o Non-interest bearing means no state interest rate, but there is still interest

Interest bearing: Record the issue of an interest-bearing note at the market rate of return DR. Inventory 200,000 CR. Notes payable 200,000 Non-Interest bearing: Record the issue of a non-interest bearing note for $80,000 due in one year DR. Automobile 76,190 CR. Notes payable (80,000/1.05) 76,190

4.     

Credit (loan) facilities Referred to as line of credit – permits borrowing on an ongoing basis Company can borrow up to an agreed limit and pay interest on the amount actually borrowed line of credit useful for seasonal businesses that require financing that varies through the year terms include collateral (security pledged), interest rate and fees, financial covenants (promises) Payable on demand – must repay the indebtedness if the bank issues a demand for repayment o The outstanding amount of line of credit is reported as current liability because of this

5. Warranties Warranty – a guarantee that a product will be free from defects for a specified period, agreeing to fix or replace them if they are faulty - Two types: warranty that is included in the sale price and warranty that is sold separately Warranty Embedded in Product:  Results in a provision and an expense (in the year of sale)  Estimate warranty provisions using expected value techniques o Expected value – weight possible outcomes by their associated probabilities  Subsequent claims charged to the provision o Offset to inventory, labour, or other expenses to satisfy the claim  For warranties beyond a year, all charged in year of sale but the expected obligation for the year => current liability and the remainder => non-current provision  Note: the entire warranty is expensed in the year of the sale => matching concept o We don’t use cash basis for recording warranty expense because it does not properly match expenses to revenues => overstate profitability Example: In 2020, Vanderhoof manufactured and sold $100,000,000 of cars. They provide a threeyear warranty on each new car it sells. Using expected value techniques, they estimate that the cost of the warranty obligation will be 1% of sales in each of the first two years following the year of sale, and 2% of sales in the third year following the sale. In 2021, the cost to Vanderhoof of meeting its warranty obligations was $900,000 ($500,000 for parts and $400,000 for labour). Solution: Journal entry to recognize the provision in 2020: DR. Warranty Expense $4,000,000 CR. Provision for warranty payable [$100,000,000 * (1% + 1% + 2%)]

4,000,000

Journal entry to recognize partial satisfaction of the warranty obligation in 2021: Dr. Provision for warranty payable $900,000 CR. Parts Inventory 500,000 CR. Wage Expense 400,000 If warranty obligations are immaterial, the costs can be expensed as the business incurs them. Warranty Sold Separately At time of sale: DR. Cash CR. Sales Revenue CR. Unearned Warranty Revenue

As time passes (Expense incurred) DR. Warranty Expense CR. Cash/Inventory/Payroll DR. Unearned Warranty Revenue CR. Warranty Revenue  Revenue determined based on expense incurred or time elapsed 6. Deferred revenues Deferred revenue (unearned revenue or deposits) – a non-financial obligation arising from the collection of revenue that has not yet been earned - Many companies require a partial or full payment prior to delivery of the good/service - Also arise from customer loyalty programs (treated differently, see next section) - May also have a current and a non-current liability portion like warranties - When good/service is provided, seller recognizes revenue in the normal manner Example: In December 2020, Kamlona Airlines Co. sold a $3,000 one-way ticket for a flight from Vancouver, British Columbia, to Repulse Bay, Nunavut, for passage in January 2021, and a $3,500 ticket from Toronto, Ontario, to Kugluktuk, Nunavut, for passage in February 2021. Kamlona does not maintain a customer loyalty program. The passengers fly at the scheduled time. Solution: To record the receipt of cash in December 2020 DR. Cash $6,500 CR. Deferred revenue 6,500 To recognize partial satisfaction of the obligation in January 2021 DR. Deferred revenue $3,000 CR. Revenue 3,000 To recognize satisfaction of the remaining obligation in February 2021 DR. Deferred revenue $3,500 CR. Revenue 3,500 7. Customer Incentives  Include: customer loyalty programs, discount vouchers (coupons), rebates  Change in management’s estimate for redemption is accounted for prospectively (don’t go back to change financial statements. Adjust estimate in the future)  Customer incentive obligations are reported as a current liability if the incentive can be redeemed at any time a. Customer loyalty programs  Offered by retails that award points for purchases that can be redeemed for merchandise, and airline frequent flyer plans that award miles that can be exchanged for future flights Two commonalities for all loyalty programs: 1. They grant the customer a material right to future goods or services for free or at a discount; and

2. The underlying transaction involves at least two performance obligations (multiple deliverables) i. Fulfilling the terms of the current sales (i.e. flight ticket); and ii. Meeting the loyalty plan commitment (i.e. free miles converted into a flight ticket) Factors to consider in determining the liability amount:  Should reflect the portion of the transaction price allocated to the future performance obligation  If the stand-alone selling price is not directly observable, an estimate must be made – known as relative fair value or proportional method. Consider factors such as the rate of redemption  Normally the transaction price should be adjusted to time value of money if there is a significant financing component, however, customer loyalty programs are exempt from this requirement Three common ways to offer awards: 1. Companies offer awards that they supply themselves 2. Businesses offer awards that are supplied by a third party 3. Customer has the choice of receiving awards from the firm’s own programs or from a third party Accounting for loyalty programs differs depending on who supplies the awards: 1. Awards supplied by the entity: two distinct components:  Revenue recognized when each component is earned  The reward segment is earned when the customer redeems the award At time of sale: DR. Cash/AR CR. Regular Revenue CR. Unearned Awards Revenue When awards are redeemed: DR. Unearned Awards Revenue CR. Awards Revenue 2. Third-part awards: Business records the full transaction price as revenue at the time of sale. The enterprise recognizes an expense for the cost of purchasing the points from the third party  Reduce liability as awards are used up At time of sale DR. Cash/AR CR. Sales Revenue DR. Loyalty Awards Expense CR. Liability for Loyalty Awards 3. Choice of awards: no specifics on how to account for this. Considerable processional judgment must be exercised Example: Accounting for Customer loyalty programs, own awards Frank’s Hotel Inc. maintains a customer loyalty program that grants members points for each hotel stay. Members can redeem these points, which do not expire, for future hotel stays. In 2020, the hotel received $5,000,000 in room-related revenue and awarded 50,000 points. The proportional stand-

alone sales price of the room revenues and the points were estimated to be $4,950,000 and $50,000 respectively. Management anticipated that 80% of the points will eventually be redeemed. In 2021, customers redeemed 30,000 of these points. In 2022, customers redeemed 10,000 of these points. Solution: Journal entry to recognize the room-related revenue in 2020 DR. Cash $5,000,000 CR. Room revenue 4,950,000 CR. Unearned revenue (award points) 50,000 Journal entry to recognize award point revenue in 2021 DR. Unearned revenue (award points) $37,500 CR. Award revenue 37,500 $50,000 / (50,000 points * 80%) points = $1.25/point (want to always find the value per point) $1.25 * 30,000 = $37,500 Journal entry to recognize award point revenue in 2022 DR. Unearned revenue (award points) $12,500 CR. Award revenue

12,500

Example: Accounting for customer loyalty programs, own awards Amber’s offers a customer loyalty program where customers earn points and may redeem points, which expire after five years, for a select group of small kitchen appliances. In 2020, Amber’s sales totaled $20,000,000; cost of goods sold was $16,000,000; and it awarded 50,000,000 points. Management allocated $19,910,000 of the transaction price to the sale of products and the remaining $90,000 to the reward plan obligation. The allocation was based on the relative stand-alone sales price of the component parts, including an expectation that only 60% of the points will be redeemed before expiry. In 2020, Amber purchased 3,000 blenders, paying $60,000 cash. The normal retail sales price of the blenders is $30 each. In 2021, customers redeemed 10,000,000 points (1,000 blenders). In 2022, customers redeemed 9,000,000 points (900 blenders). Solution: Journal entries for 2020 DR. Cash CR. Sales CR. Unearned revenue (award points) DR. Cost of goods sold CR. Inventory DR. Award point inventory (blenders) CR. Cash

$20,000,000 19,910,000 90,000 $16,000,00 16,000,000 $60,000 60,000

Journal entry to recognize award point revenue in 2021 DR. Unearned revenue (award points) $30,000 CR. Award revenue 30,000 DR. Premium expense (1,000 blenders * $20) $20,000 CR. Award points inventory (blenders) 20,000 Value/point = $90,000 / (50,000,000 * 60%) = $0.003/point => 10,000,000 points * 0.003 = $30,000

Journal entry to recognize award point revenue in 2022 DR. Unearned revenue (award points) $27,000 CR. Award revenue DR. Premium expense (900 blenders * $20) $18,000 CR. Award points inventory (blenders)

27,000 18,000

b.   

Discount vouchers (coupons) Entitles consumer to a discounted price on future purchases Accounting treatment is similar to that when awards for loyalty programs are supplied by entity Transaction price is allocated to the performance obligations on the basis of relative stand-alone sales prices adjusted for the probability of exercise and any discount available  Revenue is recognized for the voucher obligation when the future goods/services are delivered, or the option expires c. Rebates  Buyers submit evidence of purchase to the manufacturer, who then sends the customer a cheque  The transaction price (sales revenue) recognized must be downwardly adjusted to reflect the expected rate of rebate redemption against a liability  Estimated using expected value techniques 8. Other current liabilities a. Obligations denominated in foreign currencies Standard requires: 1. Translate into functional currency ...