Ch10 SM Libby3ce

8/9/2019 Ch10 SM Libby3ce

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Chapter 10Reporting and Interpreting Current Liabilities

ANSWERS TO QUESTIONS

1. Liabilities are obligations that result from transactions that require future payment ofassets or the future performance of services. The obligations are definite inamount or are subject to reasonable estimation. A liability usually has a definitepayment date known as the maturity or due date. A current liability is a short-termliability that is! one that will be paid during the coming year or the current operatingcycle of the business! whichever is longer. "t is assumed that the current liability willbe paid out of current assets. All other liabilities are defined as long-term liabilities.

#. $ne of the main sources of information available to e%ternal parties for determiningthe number! type! and amounts of liabilities of a business are the publishedfinancial statements. The balance sheet includes liabilities and the notes to thestatements contain further detail on the liabilities that are on the balance sheet aswell as on contingent liabilities and commitments. These statements have morecredibility when they have been audited by an independent auditor &usually achartered accountant'.

(. A liability is initially measured at its current cash equivalent amount. )onceptually!this amount is the present value of all of the future payments of principal andinterest. *or a short-term liability the current cash equivalent amount is usually the

same as the maturity amount. The current cash equivalent amount for an interest-bearing liability at the going rate of interest is the same as the maturity value. *or along-term liability! the current cash equivalent amount will be less than the maturityamount+ &1' if there is no stated rate of interest! or ' if the stated rate of interest isless than the going rate of interest.

,. ost debts specify a definite amount that is due at a specified date in the future.owever! there are situations where it is known that an obligation or liability e%istsalthough the e%act amount is unknown. Liabilities that are known to e%ist but thee%act amount is not yet known must be recorded in the accounts and reported inthe financial statements at an estimated amount! assuming that a reasonable

estimate can be made. /%amples of a known obligation of an estimated amount areestimated income ta% at the end of the year! property ta%es at the end of the year!and obligations under warranty contracts for merchandise sold.

0. orking capital is computed as total current assets minus total current liabilities. "tis the amount of current assets that would remain if all current liabilities were paid!assuming no loss or gain on liquidation of those assets.

Financial Accounting, 3ce, Libby, Libby, Short, Kanaan, Gowing 2008 McGraw-Hill Ryerson Limited !ll rights reser"ed

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2. The current ratio is the percentage relationship of current assets to currentliabilities. "t is computed by dividing current assets by current liabilities. The currentratio is influenced by the amount of current liabilities. Therefore! it is particularlyimportant that liabilities be considered carefully before classifying them as currentversus long term. The shifting of a liability from one of these categories to the othermay significantly affect the current ratio. This ratio is used by creditors because it isan important measure of a firm3s ability to meet short-term obligations as theygenerally come due. Thus! the proper classification of liabilities is particularlysignificant.

4. An accrued liability is an e%pense that was incurred before the end of the currentperiod but has not yet been paid or recorded. Therefore! an accrued liability isrecogni5ed when such a transaction is recorded. A typical e%ample is wagesearned during the last few days of the accounting period but not recorded becausethe payroll was not prepared &or paid' that included these wages. Assuming wagesof 6#!777 were incurred but not yet paid as at 8ecember (1! the adjusting entry torecord the accrued liability and the wage e%pense would be as follows+

8ecember (1+

age e%pense &/'99999999999999999 #!777

ages payable &L' ........9999999999999.. #!777

:. 8eferred revenue &usually called unearned revenue or revenue collected inadvance' is revenue that has been collected in advance of being earned andrecorded in the accounts by the entity. ;ecause the amount has already beencollected and the goods or services have not yet been provided! there is a liabilityto provide goods or services to the party who made the payment in advance. Atypical e%ample is the collection of rent on 8ecember 10 for one full month toent revenue &>?/'............................................ #!777

8eferred rent revenue &or >ent revenue collected inadvance' &=L'

........................................................ #!777

The deferred rent revenue &credit' is reported as a liability on the balance sheetbecause two weeks3 occupancy is owed in the ne%t period for which the lessee hasalready made payment.


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@. A note payable is a written promise to pay a stated sum at one or more specifieddates in the future. A note payable also specifies the interest rate associated withthe borrowing. ?ince notes payable require the payment of interest at a future pointin time! the liability account "nterest payable is usually associated with notespayable.

17. A contingent liability is not an effective liability rather it is a potential future liability.A contingent liability arises because of some transaction or event that has alreadyoccurred which may! depending upon one or more future events &occurring or notoccurring'! cause the creation of a true liability. A typical e%ample is a lawsuit fordamages where an accident has occurred. hether the defendant has a liabilitydepends upon the ultimate decision of the court. ending that decision there is acontingent liability &and a contingent loss'. This contingency must be recorded andreported &debit! loss credit! liability' if it is BlikelyC that the decision will require thepayment of damages! and the amount can be reasonably estimated. "f theoccurrence of the confirming future event is not determinable! or if the event islikely to occur but the amount of the loss cannot be reasonably estimated!

information about the contingent loss must be disclosed in the footnotes to thefinancial statements. 8isclosure of unlikely contingencies is desirable but notrequired.

11. "nterest e%pense D 6,!777 % 1#E % @F1# D 6(27.

1#. The concept of the time value of money is another way to describe interest. Timevalue of money refers to the fact that a dollar received today is worth more than adollar to be received at any later date because of interest that is earned over time.


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Authors Re!o""ended Solution Ti"e

#Ti"e in "inutes$

Exercises ProblemsAlternateProblems

Cases andProjects

No. Time No. Time No. Time No. Time 1 #7 / 1 (0 A1 (0 / 1 #0 / # #7 / # (0 / A# #0 / # #7 / ( 17 / ( #0 / A( ,7 ( #0 , (7 , (7 A, (7 , #7 8 0 #7 0 ,7 A0 10 0 #7 2 #7 / 2 #7 A2 #0 2 ,0 8 4 10 / 4 (7 A4 #0 4 #0 : #7 8 : (7 A: 17 / : #7 @ 17 / @ #0 A@ 07 8 @ #7 17 17 17 #7 17 #7 11 #0 11 #7 11 #7 1# 17 1# 17 / 1# G1( #7 1( (7 81, 10 10 #7 8

/ D /asy D oderate 8 D 8ifficult

G 8ue to the nature of such cases and projects! it is very difficult to estimate theamount of time students will need to complete the assignment. As with any open-endedproject! it is possible for students to devote a large amount of time to such assignments.hile students often benefit from the e%tra effort! we find that some become frustratedby the perceived difficulty of the task. Hou can reduce student frustration and an%iety bymaking your e%pectations clear. *or e%ample! when our goal is to sharpen researchskills! we devote class time discussing research strategies. hen we want the studentsto focus on a real accounting issue! we offer suggestions about possible companies orindustries.


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E%ERCISES

E10&1

E'entTitle o( Liabilit) A!!ount

A((e!ted b) E'ent A"ount o( Current Liabilit)

a. Inearned passenger revenue 6,47

b. 8eposits from customers 607!777

c. Jote payable

"nterest payable

617!777

6107 KD617!777 % .7@ % F1#'

d. Inearned subscription revenue 61!:77

e. Jone! assuming that the amountdue was paid within (7 days.

f. Jone! because the bill relates tocalls made in


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E10&*

>eq. 1

&a' )urrent assets &6#@0!177 M 61#0!777'........................... 6147!177)urrent liabilities+

Accounts payable........................................................ 627!777

"ncome ta%es payable.................................................. 1#!777

Liability for withholding ta%es....................................... (!777>ent revenue collected in advance............................. 1,!777

ages payable............................................................ 4!:77

roperty ta%es payable................................................ #!777Jote payable! 17E &due in 2 months'......................... 17!777

"nterest payable........................................................... (77 &17@!177'orking capital................................................................ 6 21!777

&b' )urrent ratio D 6147!177 617@!177 D 1.02

orking capital is critical for the efficient operation of a business. )urrent assetsinclude cash and assets that will be collected in cash within one year or the normaloperating cycle of the company. A business with insufficient working capital may notbe able to pay its short-term creditors on a timely basis and could! eventually! resultin bankruptcy.

The current ratio is a measure of liquidity. "t helps analysts assess a company3sability to meet its short-term obligations as they generally come due.

>eq. #

)ontingent liabilities that are disclosed in the notes to the financial statements do notaffect the total amount of current liabilities reported on the balance sheet. ence! theprevious computations are not affected by such disclosures.

E10&+

Current Ratio Wor,ing Capital

a. "ncrease Jo change

b. 8ecrease 8ecreasec. 8ecrease Jo change

d. 8ecrease Jo change

The above can be checked by calculating the values. Knoing that the current ratio is !and the amount of orking ca"ital is #$%!&'%''' the current assets are #!%&('%''' andthe current liabilities are #!%&('.


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E10&-

>eq. 1

arch (1! #774+)ompensation e%pense &=/?/'........................................ ##,!777

Liability for income ta%es withheld &=L'................................ ,2!777

Liability for union dues withheld &=L'.................................... (!777

Liability for insurance premiums withheld&=L'...................... 1!777

) payable &=L'................................................................. 12!,,0 /" payable &=L' .................................................................... @!211

)ash &A'.............................................................................. 1,4!@,,

ayroll for arch including employee deductions.

>eq. #

arch (1! #774+)ompensation e%pense &=/?/'........................................ #@!@77

) payable &=L'................................................................. 12!,,0

/" payable &=L'..................................................................... 1(!,00/mployer3s additional payroll e%penses for arch&6@!211 % 1., D 61(!,00'.

>eq. (

Liability for income ta%es withheld &L'.................................... ,2!777

Liability for union dues withheld &L'........................................ (!777

Liability for insurance premiums withheld &L'......................... 1!777

) payable &L' &612!,,0 % #'............................................... (#!:@7

/" payable &L' &6@!211 = 61(!,00'......................................... #(!722

)ash &A'.............................................................................. 170!@02

>emittance of employee deductions and employer-relatedamounts for arch.

>eq. ,

The total compensation e%pense was 6#0(!@77! comprised of 6##,!777 of salaries andwages plus 6#@!@77 of additional payroll charges levied on the employer.

The total payroll &salaries and wages' was 6##,!777. The take-home pay was 61,4!@,,and the percent of payroll that was take-home pay was 22E D 61,4!@,, 6##,!777.

/mployee compensation is a large cost for most organi5ations. /mployers are notconcerned about the distinction between salaries and fringe benefits because both aree%penses that are deductible for ta% purposes. /mployees sometimes prefer an e%tradollar in fringe benefits over an e%tra dollar of salary because some fringe benefits areeither not ta%able or are not ta%able in the current period. "n the absence of ta% effects!most employees prefer increases in salaries because they have full control over thosedollars.Financial Accounting, 3ce, Libby, Libby, Short, Kanaan, Gowing 2008 McGraw-Hill Ryerson Limited !ll rights reser"ed

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E10&.

>eq. 1

The additional labour e%pense was 617!@(( K62!71( = &6(!01, % 1.,'! which representsthe total of the additional payroll charges levied on the employer. The employees3 take-

home pay was 60@!(4( that is! the total of salaries and wages less the deductions paidby the employees &i.e.! 64@!777 M 6:!@77 M 61!#77 M 62!71( - 6(!01, D 60@!(4('.

>eq. #

;alance sheet liabilities+Liability for income ta%es withheld........................................................... 6 :!@77Liability for union dues withheld............................................................... 1!#77)anada ension lan contributions payable &62!71( = 62!71('............. 1#!7#2/mployment "nsurance contributions payable &6(!01, = &6(!01, % 1.,'' :!,(,Total...................................................................................................... 6(7!027

>eq. (

;oth managers and analysts would understand that a 17E increase in salaries is moree%pensive than a 17E increase in the employer3s share of ) &or any other benefit'.The reason is that many benefits are stated as a percentage of salary. As a result! thecost of a 17E increase in salaries results in an increase in both salaries and fringebenefits.

E10&/

>eq. 1

Jovember 1! #774+)ash &=A'........................................................................ ,!077!777

Jote payable &=L'........................................................ ,!077!777;orrowed on 2-month! 17E! note payable.

>eq. #

8ecember (1! #774 &end of the fiscal year'+

"nterest e%pense &=/?/'........................................... 40!777

"nterest payable &=L'.................................................... 40!777Adjusting entry for # months3 accrued interest

&6,!077!777 % 17E % #F1# D 640!777'.


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E10&/ #!ontinued$

>eq. (

April (7! #77: &maturity date'+

Jote payable &L'............................................................ ,!077!777

"nterest payable &per above' &L'.................................... 40!777

"nterest e%pense &6,!077!777 % 17E % ,F1#' &=/?/' 107!777

)ash &A'..................................................................... ,!4#0!777

aid note plus interest at maturity.

>eq. ,

"t is doubtful that long-term borrowing would be appropriate in this situation. After the)hristmas season! udson3s ;ay will collect cash from its credit sales. At this point! itdoes not need borrowed funds. "t would be costly to pay interest on a loan that was notneeded. "t might be possible to borrow for a longer term at a lower interest rate andinvest idle cash to offset the interest charges. udson3s ;ay should e%plore thispossibility with its bank but in most cases it would be better to borrow on a short-termbasis to meet short-term needs.

E10& &Amounts in thousands'

ate Assets Liabilities Shareholders E2uit)

Jov. 1! #774 )ash = 6,!077 Jote ayable = 6,!077 Jot Affected

8ec. (1! #774 Jot Affected "nterest ayable = 640 "nterest /%pense M 640

April (7! #77: )ash M 6,!4#0 Jote ayable M 6,!077"nterest ayable M 640

"nterest /%pense M 6107

E10&3

This type of classification is consistent with generally accepted accounting principles. Ananalyst wants liabilities classified in terms of the timing of the e%pected cash flows. "f a

short-term obligation is e%pected to be refinanced on a long-term basis! there will be nocash flow in the short term. "t is reasonable to classify that type of obligation as longterm.

"f a company classifies a short-term obligation as long term! it must have both the intentand ability to refinance the obligation. Analysts would be most concerned about thecompanyNs ability to refinance.


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E10&4

>eq. 1

arranty e%pense for #77: D 6(!277!777 % 7.77, D 61,!,77

>eq. #

/stimated warranty liability!


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E10&11

>eq. 1

ate Assets Liabilities Shareholders E2uit)

eq. #

*ebruary #:! #77@ )ash paid+ 617:!777 K6177!777 = &6177!777 % :E'

>eq. (

Transactions &a' and &c' have no impact on cash flows because there is neither aninflow nor an outflow of cash. Transaction &b' results in an inflow of cash fromborrowing! which is a financing activity. The *ebruary #: thpayment is an outflow ofcash. &Jote to instructor+ "f you have emphasi5ed the )ash *low ?tatement! you should

discuss the specific nature of these cash flows. The repayment of principal is a cashflow from financing activities and the payment of interest e%pense is a component ofcash flows from operating activities.'

>eq. ,

Assuming that the current ratio is greater than one prior to each transaction!transactions &a' and &b' will decrease the ratio! and transaction &c' will increase the ratio&the repayment of the note will also increase the current ratio'. The answer to this typeof question is not always obvious so it may be useful to BproveC it with hypotheticalnumbers. *or e%ample! assume that current assets are 6(2!777 and current liabilities

equal 61:!777 before transaction &a'. The current ratio is #.7. After the transaction!current assets increase to 60,!777 and current liabilities increase to 6(2!777! and thecurrent ratio decrease to 1.0. The reason for this decrease is that current assetsincrease by 07 percent whereas current liabilities increase by 177 percent! a largerpercentage.


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E1051*

*00. ;u55 does not have to record or disclose the liability because the chance of theliability occurring is remote.

*00/ ;u55 does not have to record or disclose the liability because the chance of the

liability occurring is remote.

*00 ;u55 should disclose the contingent liability in a note because the matter ispotentially significant but the occurrence &or non-occurrence' of the confirmingevent is not determinable.

*003 ;u55 should probably record the liability since the e%istence of a liabilityappears to be confirmed and the amount appears to be known. owever! onecould argue that although the jury has returned a verdict a liability need not berecorded if the company3s attorneys are very confident that the verdict will beoverturned on appeal. "n this case! a note would disclose the jury3s verdict and

the company3s confidence of having the verdict reversed.

*004 ;u55 must now record the loss and the liability because the e%istence of theliability and the amount &6107!777' are both known.

E10&1+

>eq. 1

&a' "ncome ta% payable+

#77:+ 61#!#77 % ,7E D 6,!::7

#77@+ 6#7!:77 % ,7E D 6:!(#7

&b' *uture income ta%+

#77:+ 6#!:77 % ,7E D 61!1#7 &originating! a credit M a liability'G

#77@+ 6#!:77 % ,7E D 61!1#7 &reversing! a debit M eliminates the liability'

GThis is a future income ta% liability &a credit' because the e%pense is deducted in theta% return before it is deducted in the income statement. "n other words! there will bemore income ta% in the future because of relatively higher ta%able amounts &and theliability will thus be eliminated'.


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E10&1+ #!ontinued$

The ta%-related amounts for #77: and #77@ are as follows+

*003 *004reta% income 610!777 1:!777Less early deduction of e%pense !:77' #!:77Ta%able income 1#!#77 #7!:77

"ncome ta% e%pense &preta% income % ,7E' 2!777 8r. 4!#77 8r."ncome ta% payable ,!::7 )r. :!(#7 )r.*uture income ta% 1!1#7 )r. 1!1#7 8r.

>eq. #

>eporting+*003 *004

"ncome statement+

"ncome ta% e%pense &see below'.......................................... 62!777 64!#77

;alance sheet+

)urrent Liabilities+ "ncome ta% payable........................................................... 6,!::7 6:!(#7

*uture income ta% liability 1!1#7 -7-

&Jote+ in practice! the current and future portions of income ta% e%pense would each bedisclosed.'

>eq. (

Ta% e%pense is based on income reported on the income statement. "t is a necessarycost associated with earning income and should be recorded in the same period.

"ncome ta% is the cost of doing business. Accountants apply the matching concept!which means the amount of ta% e%pense and ta%es currently payable are usuallydifferent.

E10&1-

>eq. 1&a' "ncome ta% payable+

#774+ 6#7!777 % (0E D 64!777

#77:+ 61,!777 % (0E D 6,!@77

&b' *uture income ta%+

#774+ 60!777 % (0E D 61!407 &originating! a debit M an asset'G#77:+ 60!777 % (0E D 61!407 &reversing! a credit M eliminates the asset'

GThis is a future income ta% asset &a debit' because the related revenue is included inthe income ta% return ' and therefore ta%ed! before it is included in the incomestatement M:'. This means that the income ta% was paid in advance &i.e.! aprepayment of income ta%'! and therefore represents an asset.


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E10&1- #!ontinued$

The ta%-related amounts for #774 and #77: are as follows+

*00 *003reta% income 610!777 1@!777

Add+ ta%able revenue 0!777 &0!777'Ta%able income #7!777 1,!777

"ncome ta% e%pense &preta% income % ,7E' 0!#07 8r. 2!207 8r."ncome ta% payable 4!777 )r. ,!@77 )r.*uture income ta% 1!407 8r. 1!407 )r.

>eq. #

/ntries to record income ta%es+*00 *003

"ncome ta% e%pense &=/?/'.................... 0!#07 2!207*uture income ta% asset &=A F MA' &>eq. 1'.. . 1!407o 1!407 r

"ncome ta% payable &=L' &>eq. 1'............... 4!777 ,!@77

oD originating rD reversing

>eq. (

>eporting+#774 #77:

In!o"e state"ent6

"ncome ta% e%pense..................................................... 60!#07 62!207

&"n practice! the current and future portions of income ta% e%pense would each bedisclosed.'

7alan!e sheet6

)urrent Assets+ *00 *003

*uture income ta% asset........................................... 61!407 6 M7M)urrent Liabilities+

"ncome ta% payable.................................................. 64!777 6,!@77

>eq. ,

There are separate rules governing the determination of ta% e%pense &OAA' and theamount of ta%es currently payable &"ncome Ta% Act' for public corporations. As a result!these two amounts are different for most companies. anagement must incur theadditional cost of preparing separate ta% and financial accounting reports in order tocomply with OAA. ?mall! privately-owned businesses that are not subject to OAAmay choose to use the ta% rules for financial reporting as well in order to save on thecost of preparing financial statements.


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E10&1.

>eq. 1


#774P6(#!777 % #:E D 6 :!@27

#77:P602!777 % #:E D 610!2:7

#77@P6:0!777 % #:E D 6#(!:77

&b' *uture income ta% &related to amorti5ation'+*00 *003 *004

?traight-line amorti5ation &640!777 ('............ 6 #0!777 6#0!777 6#0!777

Accelerated amorti5ation &))A per ta% return'.. (4!077 #0!777 1#!077Temporary difference...................................... 6&1#!077' 6M7M 61#!077ultiply by ta% rate............................................. % #:E P % #:E*uture income ta%.............................................. 6 &(!077' P 6 (!077

&originating

liabilitycredit'

&reversing

debit'

The originating difference is a liability &a credit' because additional income ta%es mustbe paid in the future. This results from lower amorti5ation deductions &))A' in the ta%return in the future that is! lower ta% deductions mean more income ta% in the future onother ta%able amounts.

>eq. #

>eporting+

*00 *003 *004In!o"e state"ent6

"ncome ta% e%pense.................................................... 61#!,27 610!2:7 6#7!(77

#774+ 6:!@27 = 6(!077 D 61#!,27.#77:+ 610!2:7 = 67 D 610!2:7.#77@+ 6#(!:77 - 6(!077 D 6#7!(77.

&Jote+ in practice! the current and future portions ofincome ta% e%pense would each be disclosed.'

;alance sheet+

)urrent Liabilities+ "ncome ta% payable................................................. 6:!@27 610!2:7 6#(!:77

Long-term Liabilities+ *uture income ta% liability 6(!077 6(!077 67


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8RO7LE9S

810&1

>eq. 1

eceived customer deposit.

eceived electricity bill.

8ecember (1+age e%pense &=/?/'............................................. 1#!777

ages payable &=L'..................................................... 1#!777Adjusting entry for unpaid wages.

>eq. #

8ecember (1+"nterest e%pense &=/?/'........................................... (7!777

"nterest payable &=L'.................................................... (7!777Adjusting entry for @ monthsN interest on note payable&6077!777 % :E % @F1# D 6(7!777'.


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810&1 #!ontinued$

>eq. (

Transa!tion E((e!t onCurrent Ratio

E((e!t onWor,ing Capital


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810&* #!ontinued$


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810&* #!ontinued$

>eq. , &Assuming current ratio is greater than one prior to each transactionFentry'

Transa!tion E((e!t

evenue = 6,!077

8ec. #7 )ash = 6177 8eposit on Trailer = 6177 Jo effect8ec. (1 Jo effect ages ayable = 64!#77 age /%pense - 64!#778ec. (1 Jo effect "nterest ayable = 6(!277 "nterest /%pense M

6(!277

G The purchases represent additional inventory on hand.


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810&+ #!ontinued$

>eq. #

Transa!tion E((e!t


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810&- #!ontinued$

>eq. (

8ate Assets Liabilities ?hareholders3 /quity8ec. (1! #77@ Jo impact ages ayable = 60!177 age /%pense - 60!177

ent >evenue = 6(!777

8ec. (1! #77@ Jo impact Inearned >ent >evenue= 61!777

>ent >evenue - 61!777

>eq. ,

;alance sheet at 8ecember (1! #77@+

)urrent Liabilities+

ages payable............................................................ 0!177

Inearned rent revenue ............................................... 1!777

>eq. 0

Accrual based accounting is more beneficial to financial analysts because it recordsrevenues when they are earned and e%penses when they are incurred! regardless ofwhen the related cash is received or paid. )ash-based accounting only recordsrevenues when they are received and e%penses when they are paid. A financial analyst

is looking towards the future of the company! so it is helpful to know how much cash willbe coming into and out of the company at later dates. )ash based accounting limitsfinancial analysts to only what has happened in prior periods and tells them very littleabout future events and cash flows that will affect the financial health of the company.

)ash basis accounting may also be susceptible to manipulation.


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810&.

>eq. 1

#774+arranty /%pense increases by 6# million arranty ayable increases by 6# million.

#77:+arranty ayable decreases by 6#!777!777 )ash decreases by 6#!777!777. There istherefore no warranty liability at the end of #77:.

>eq. #

#774+)ash increases by 617!777!777 Inearned >evenue increases by 617!777!777.

#77:+Inearned >evenue decreases by 6:!777!777 >evenue increases by 6:!777!777.

Therefore! the balance in Inearned >evenue at the end of #77: is 6#!777!777.

>eq. (

The company should probably report litigation e%pense and the related liability after thejury awarded damages. owever! if lawyers for ;runswick are very confident of theirgrounds for appeal! the company might only report a contingent liability in the notes tothe financial statements. "n such situations! good professional judgment must bee%ercised by management as well as the company3s attorneys and auditors.


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810&. #!ontinued$

>eq. ,

The current ratio for )oke is .:7! which is relatively a low ratio. "n isolation! it mightseem like an indication of trouble but analysts would look at much more information. *ore%ample! )oke was able to generate over 6#.# billion in cash from its operations. The

)ompany had a line of credit that will permit it to borrow 61.2 billion in credit. Analystswould also compare the ratio to similar companies. *or e%ample! the current ratio forepsi)o was .4@! i.e.! virtually identical to that of )oke. This brief e%ercise is intended toopen a discussion concerning the need to avoid placing too much emphasis on aspecific accounting number or ratio.

>eq. 0

any manufacturing companies have some adverse impact on our environment. "nmany cases! the law requires these companies to rectify these negative effects. Alcoarefers to these environmental cleanup efforts as Bremedial efforts.C Alcoa records thecost of future environmental cleanup efforts in the year that the need for rectifying thedamage is first becomes likely! instead of waiting until the year that the work is actuallyperformed. This policy is consistent with the matching principle. /nvironmental damagecan be thought of &by some people' as a necessary cost of producing aluminum.

According to that reasoning! the cost of future environmental cleanup efforts should bematched with the cost of the aluminum produced! rather than deferring recognition ofthe e%pense to the period in which the cleanup work actually takes place.


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810&/

>eq. 1

Esti"ated Warrant Liabilit)

1!700 ;eginning balance

arranty payments ,2@ Q arranty e%pense

@47 /nding balance 61!700 = Q M ,2@ D @47 Q D 6(:,

>eq. #

/stimated warranty liability &L'...................................... ,2@

)ash &A'.................................................................... ,2@

ayments to customers in e%change for returned products.

Jote+ ;ombardier simply returned cash to customers instead of repairing the defectiveproducts! thus the credit is to the cash account. "n some cases! repairs under

warranty affect the inventory accounts when parts must be replaced! as well as thewages payable account for the labour e%penses incurred to complete the repairs.The entry above assumes that the defective products have no value. "f they haveany value! then the inventory account would be debited for their value and theestimated warranty liability would be reduced accordingly.

arranty e%pense &=/?/'........................................ (:,

/stimated warranty liability &=L'.................................. (:,To recogni5e warranty e%pense for the period.

>eq. (

*00/ *00. *00-/stimated warranty liability F revenues 2.0@E 2.4@E 2.71E

The ratio increased in #770 then decreased slightly in #772. The increase may be due toan increase in the rate of defective products that requires a higher provision forwarranties. "t could also indicate that the company overstated the amount of theprovisions for the years #770 and #772 which resulted in higher ending balances for theestimated warranty liability account relative to the amount of revenues generated inthose years.

>eq. ,

The limited evidence that is available to us does not suggest that ;ombardier should bereducing is warranty liability in future years. Another ratio that would be helpful inaddressing this issue is that of warranty payments divided by revenues. This will show ifthe warranty costs are increasing or decreasing over time. Another factor to beconsidered is whether ;ombardier has changed &shortened or lengthened' the warrantyperiod for its products. "f the warranty period has become longer over time because ofcompetitive pressures! then the estimated liability should not be reduced.


10-24


25/51

810&

CASE A

>eq. 1

The cash deposit for each keg is potentially refundable to the depositor. /;) mustreturn the cash received if the customer returns the keg in future. ence! the Reg8eposits account is essentially a liability account. There is no information about timelimits or the percentage of kegs that are not returned. "t is possible! however! for /;)to estimate the portion of the deposits that is usually kept by the company and considerthis amount as revenue. This is very similar to the issues faced by companies that offerSpointsS that can be redeemed for services or products in the future! such as )anadianTire and etro-)anada. Assuming this is a current liability then the Reg 8epositsaccount would appear in the current liabilities section of the balance sheet. "f the valueis material then it may be disclosed as a separate item! otherwise it is combined with

other liabilities as part of S$ther current liabilities!S perhaps with an e%planatory note.

>eq. #

The company has received a reliable estimate that an amount of 61!#07 &07 % 6#0' willnever be returned to customers. This amount becomes revenue for the period. Thecompany recogni5es this revenue by making the following adjusting entry at year end+

Reg 8eposits &L' 1!#07>evenue from deposits 1!#07

CASE 7

>eq. 1

?eptember 1! #77:+)ash &=A'........................................................................ @!777

Inearned rent revenue &=L'....................................... @!777>eceived rent for si% months in advance.

8ecember (1! #77:+

Inearned rent revenue &L'............................................ 2!777>ent revenue &=> =?/'........................................... 2!777

To recogni5e rent revenue for four months of the year.

Alternatively! the cash received could have been credited to >ent >evenue. "n that casethe journal entries would be as follows+


10-25


26/51

810& #!ontinued$

)e"tember $% !''(+)ash &=A'........................................................................ @!777

>ent revenue &=> =?/'........................................... @!777

>eceived rent for si% months in advance.*ecember +$% !''(+>ent revenue &>?/'................................................ (!777

Inearned rent revenue &=L'....................................... (!777To recogni5e unearned rent revenue for two months of the year.

>eq. #The total amount received! 6@!777! will be partially earned in #77:. ?pecifically! 6#!777K&6@!777 F 1:' % , months is earned in #772! and the remainder! 64!777 will be earnedover the ne%t 1, months. ;y 8ecember (1! #77@! a total of 62!777 will have beenearned! and the other 61!777 will be earned in #717. As a result! 62!777 represents a

current liability! and 61!777 should be classified as a non-current liability on the8ecember (1! #77: balance sheet. owever classification of the 61!777 as non-currentmay not be considered material.

CASE C

April #77@+)ash &=A' K107 % 627..................................................... @!777

Inearned subscription revenue &=L'.......................... @!777>eceived one-year subscriptions from 107 customers.

April (7! #77@+Inearned subscription revenue &L'............................... (07

?ubscription revenue &=>=?/'.............................. (07

To recogni5e subscription revenue for one month from 47subscribers &47 % 60 per month'.


10-26


27/51

810&3

The current liability classification is based on the e%pectation that the company will paythe liabilities during the subsequent year. Analysts are interested in this classificationbecause it provides important information to use when predicting future cash flows. "f

management has the intent and the ability to refinance a short-term liability! then it willnot result in a cash outflow. "n this circumstance! it is appropriate to reclassify the debtas long term.

The current ratio for epsi)o is very low when compared to most companies. The)ompany! however! is not e%periencing a liquidity problem. "t generates large cashflows from operations and has a significant line of credit available if it needs additionalfunds. *urthermore! the industry traditionally operates with a relatively low current ratio.)oke! for e%ample! has a .:7 current ratio. "t is therefore unlikely that managementmade the reclassification simply to increase its current ratio. "nstead the )ompany wasprobably trying to get a better balance between short-term and long-term borrowings.

;ecause management has the ability and intent to refinance the borrowings on a long-term basis! the current ratio should be based on the reclassification. The analyst mightwant to use the ratio before reclassification if he or she thought that the reclassificationwas only intended to manipulate the ratio &which does not appear to be the case'. Theanalyst should use caution when comparing the current ratio for the current year &afterreclassification' with the ratio for the previous year &before reclassification'.

810&4

>eq. 1

ayables and accruals refer to amounts that should be paid to suppliers of goods andservices in the near future. The account balance increases when raw materials andmerchandise are purchased on account! and decreases when payments are made.

8eferred revenue represents an amount of cash &or other assets' received by thecompany in e%change for goods andFor services to be provided in the future. Theaccount balance increases with the receipt of cash from customers in advance! anddecreases when goods are delivered and services are provided to these customers.

8ividends payable reflects an amount of dividends that has been declared by thecompany3s board of directors but has not been paid yet. The account balance increases

when the board of directors declares dividends and is reduced when cash is paid toshareholders.

"ncome ta%es payable refers to an outstanding obligation to pay income ta%es to theta%ation authorities based on the current period3s ta%able income.


10-27


28/51

810&4 #!ontinued$

*uture income liabilities result from temporary differences caused by reporting revenuesand e%penses on the company3s income statement in conformity with OAA and on theta% return in accordance with the "ncome Ta% Act. The account balance increases when

temporary differences in accounting for specific revenue and e%pense items lead toreporting income before income ta%es that e%ceeds ta%able income for the period. Theaccount balance is reduced when the reverse occurs.

The current portion of debt obligations represents the portion of long-term debt that ispayable within one year of the balance sheet date. The account balance increaseswhen long-term debt is reclassified as a current liability and is reduced when the debt ispaid.

>eq. #

8eferred revenue! evenue earned during the year..................................... (!@04'8eferred revenue! 8ecember (1! #772 .......................... 6 #!27:

6(!1:7 = Q - 6#(!@04 D 6#!27: )ollections in advance D 6#(!(:0

e(erred Re'enue

(!1:7 ;eginning balance

arranty payments #(!@04 Q arranty e%pense

#!27: /nding balance

eq. (

>etained earnings........................................................... 14!7:(

8ividends payable....................................................... 14!7:(8eclaration of dividends payable to shareholders.

8ividends payable........................................................... 1,!@(@)ash............................................................................ 1,!@(@

ayment of cash dividends to shareholders.62!,7, = 614!7:( M Q D 6:!0,:


10-28


29/51

810&10

>eq. 1

8o not record a liability nor disclose a contingency. >ationale+ *or major auto

manufacturers these types of lawsuits occur from time to time and may be considered tobe a normal business risk &at least to some e%tent' in the industry. Also! in this case!because no specific lawsuit has been filed in respect of the new car any disclosure of acontingency would be so general that it would probably not provide useful information.

>eq. #

8o not record a liability nor disclose a contingency. >ationale+ "n this case! there is nodirect evidence of a possible contingency. "n fact! there is a great deal of uncertaintythat a contingency may e%ist at all. *or e%ample! we are told that the company3s productBmayC infringe on another company3s patent. *urthermore! we do not know the likelihood

that the other company will ever discover the possible infringement.

>eq. (

>ecord a liability. >ationale+ The liability e%ists &the Bclean-upC is required by provinciallaw' and the amount can be reasonably estimated. The amount of the liability would befor 6( million if the company3s management wishes to be conservative and include thehigher end of the estimated amount. Alternatively! management could report a liabilityfor 6#.0 million! representing the average of 6# and 6( million.

>eq. ,

>ecord a liability. >ationale+ rudence &i.e.! conservatism' suggests that the opinion ofthe company3s attorneys should be seriously considered. As such! it would beappropriate to record a liability. The amount recorded for the liability might be less than61!777!777 if the company3s attorneys are confident that the amount of damages will bereduced on appeal.

>eq. 0

>ecord a liability for 6#07!777. >ationale+ anagement has accepted its obligation tothe customer! intends to discharge it and the amount is known.


10-29


30/51

810&11

>eq. 1 and #*00/ *00. *00- *00+ *00* *001

)urrent ratio 1.74 7.@@ 7.:0 1.#1 7.@1 7.:7Accounts payable turnover #.,7 #.24 #.0# 1.:2 1.24Average age of payables &days' 10# 1(4 1,0 1@2 #1@

The current ratio fluctuated between 7.:7 and 1.#1 during the si%-year period andshowed signs of improvement over the last three years! #77,-#772. hile a currentratio that e%ceeds 1.7 provides a margin of safety for short-term creditors! ?uncor3scurrent ratio should be compared to the norm for the industry for a better assessment ofits current level.

The accounts payable turnover ratio shows an increasing trend indicating that ?uncor ispaying its trade supplies over shorter periods of time! as evidenced by the decreasingtrend in the average age of payables. hile the decrease in the average age of

payables does not benefit the company from a cash management perspective! itimproves its relationship with its trade suppliers! especially if the credit period grantedby the suppliers in shorter than the average age of payables.

>eq. (

The use of the L"*$ inventory costing method affects the cost of ending inventory andthe cost of goods sold! but it does not affect the cost of purchases. Therefore! if ?uncorused the *"*$ inventory costing method! then the inventory at the end of #772 would be6:(# &60:@ = 6#,('. This will increase the current assets to 6#!0,0 &6#!(7# = 6#,(' andthe current ratio to 1.1:. owever! both the accounts payable turnover ratio and theaverage age of payables would not be affected by the inventory costing method.

?ince the *"*$ cost provides a better indicator of the current value of inventorycompared to L"*$ cost! the current ratio under *"*$ provides a better indication of themargin of safety for short-term creditors. ;ut! the choice of an inventory costing methoddoes not affect the efficiency of managing accounts payable.

810&1*a. >emain the sameb. 8ecreasec. >emain the same

d. >emain the same &financing activity'

e. >emain the samef. 8ecreaseg. >emain the sameh. 8ecrease only for the interest that is paid &repayment of the principal is a

financing activity'i. "ncrease

j. 8ecrease


10-30


31/51

810&1+

>eq. 1

&a' "ncome Ta%es ayable+ 6(#!,77 (7E D 6@!4#7

&b' *uture "ncome Ta%?traight Line Amorti5ation+ 611!777 &6,,!777 - 67' F ,

Accelerated Amorti5ation &))A'+ &14!277'Temporary 8ifference+ 6& 2!277'ultiply by Ta% >ate+ (7E*uture "ncome Ta%+ 6&1!@:7' M $riginating liability

The originating difference is a liability &a credit' because additional income ta%esmust be paid in the future. This results from lower amorti5ation deductions &))A' inthe ta% return in the future that is! lower ta% deductions mean more income ta% in

the future on other ta%able amounts.

>eq. #

"ncome Ta% /%pense &=/?/' K&60@!777 M #7!777' % (7E 11!477

*uture "ncome Ta% Liability &=L'.................................. 1!@:7 "ncome Ta% ayable &=L' &6@!4#7 % 10E' 99999. 1!,0: )ash &A' &6@!4#7 % :0E'........................................... :!#2#

>eq. (

>eporting+

"ncome ?tatement for #774+"ncome Ta% /%pense........................611!477 :

:"n practice! the current and future portions of income ta% e%pense would each bedisclosed.

;alance ?heet! 8ecember (1! #774+


"ncome Ta% ayable 61!,0:Long-term Liabilities ::+

*uture "ncome Ta% Liability 61!@:7

::The future income ta% liability is classified as long-term because it is related to a long-term item &equipment'.


10-31


32/51

ALTERNATE 8RO7LE9S

A810&1

>eq. 1

eq. # &Adjusting and reclassification entries! 8ec. #1! #77:'

Long-term Liability &L'.................................................... 177!777

)urrent Liability &=L'................................................... 177!777Jote+ in practice! specific accounts would be used.

"nterest /%pense &=/?/'.......................................... (2!224

Accrued "nterest ayable &=L'..................................... (2!224&6007!777 % 17E % :F1# D 6(2!224'

age /%pense &=/?/'............................................. :0!777

ages ayable &=L'.................................................... :0!777Financial Accounting, 3ce, Libby, Libby, Short, Kanaan, Gowing 2008 McGraw-Hill Ryerson Limited !ll rights reser"ed

10-32


33/51

A810&1 #!ontinued$

"ncome Ta% /%pense &=/?/'.................................... 1#0!777

"ncome Ta% ayable &=L'............................................. @(!777

*uture "ncome Ta% Liability &=L'.................................. (#!777

>eq. (

;alance ?heet+

)urrent Liabilities ages ayable 6 :0!777 "ncome Ta% ayable @(!777 *uture "ncome Ta% Liability : (#!777 ?T ayable 477 Accrued "nterest ayable (2!224

8eferred >evenue (!777 Jote ayable 007!777 )urrent ortion of Long-term 8ebt 177!777Total )urrent Liabilities 6@77!(24

:"t is assumed that the future income ta% liability is a current item. A differentassumption could have been made.

>eq. ,

/ffect on current ratio assuming the ratio is lessthan one prior to each transactionFentry+

eclassification' 8ecreases8ecember (1! #77: &"nterest' 8ecreases

8ecember (1! #77: &ages' 8ecreases8ecember (1! #77: &"ncome ta%es' 8ecreases


10-33


34/51

A810&*

>eq. 1

ate Assets Liabilities Shareholders

E2uit)evenue= 60!777)ost of good soldamount not known


35/51

A810&+

>eq.1

#774

arranty /%pense increases by 6:!077!777 arranty ayable increases by6:!077!777.

#77:+arranty ayable decreases by 6:!077!777 no impact on arranty /%pense )ashdecreases by 6:!077!777. There is therefore no warranty liability at the end of #772.

*00 /%pense =6:.0 millionLiability =6:.0 million

*003 Liability M6:.0 million

)ash! ages ayable! "nventory M6:.0 million

>eq. #

)ustomer deposits are reported as a liability until! in the judgment of management! theassociated revenue has been earned.

"ncomplete 17-day cruises 6 ,.7 millionartial )ruises &17 days' 6: million &1 M 27E' (.# million)ruises not started 4.7 million

Total unearned revenue 61,.# million

>eq. (

any of the lawsuits against the company are not material in amount. The company didrecord 6(1.# million in losses related to litigation. "n one lawsuit! the company recordeda loss of 61# million! but had to reverse 6:.1 million of that amount when the actual losswas determined. The recording of the accrued loss reduced income. The reversalincreased income.

>eq. ,

hile the current ratio is low and tending downward! it is doubtful that /%%on ise%periencing financial difficulty. The company has a reputation for aggressive cashmanagement. "t would be useful to study the )ash *low ?tatement to determine if/%%on is generating significant cash resources from operating activities. "t would also beuseful to read analysts3 assessment of /%%on3s liquidity! especially compared to theliquidity of its competitors.


10-35


36/51

A810&+ (continued)

>eq. 0

To the e%tent that reasonable estimates can be made ;runswick records the cost of

future environmental cleanup efforts in the year that the underlying commitments &orplans' are made! rather than waiting until the year when the work is actually performed.$ne justification for this policy is the matching concept. Inder the matching concept allcosts related to earning revenue should be reported in the same accounting period asthe revenue. )onservatism is another important justification for the approach used by;runswick! i.e.! liabilities and e%penses should not be understated &nor should assetsand income be overstated'.

A810&-

>eq. 1A!!rued Warrant); *00.

1@!#@1 ;eginning balance

arranty payments ,7!@@4 Q arranty e%pense

(4!7,7 /nding balance

61@!#@1 = Q M ,7!@@4 D (4!7,7 Q D 60:!4,2

A!!rued Warrant); *00/

(4!7,7 ;eginning balancearranty payments 2,!:@: H arranty e%pense

2,!:(@ /nding balance

6(4!7,7 = H M 2,!:@: D 2,!:(@ H D 6@#!2@4

>eq. #

arranty e%pense &=/?/'........................................ @#!2@4

/stimated warranty liability &=L'.................................. @#!2@4

To recogni5e warranty e%pense for the year.

/stimated warranty liability &L'...................................... 2,!:@:

)ash! "nventory &A' andFor ages payable &=L'...... 2,!:@:

?ettlements made under the product warranty.


10-36


37/51

A810&- #!ontinued$

>eq. (

*00/ *00. *00-

arranty e%pense F net sales #.((E 1.0#E 1.0#E

The ratio increased in #772 by 0(E &7.:1E of net sales'. The increase may be due to anincrease in the rate of defective goods produced by the company or purchased fromparts suppliers. "t could also signal a conservative estimate of the warranty liabilityassociated with the introduction of new products that have not been tested in the marketyet.

>eq. ,

The information available for the three years indicates that the settlements made during

#770 and #772 were lower than the warranty e%pense that has been recogni5ed foreach of these years. This! combined with the increase in warranty e%pense as apercentage of net revenue! has resulted in increasing the balance of the Accruedwarranty account from 6,7!@@4 at the end of #770 to 62,!:@: at the end of #772. Theratio of warranty e%pense to net sales should be reviewed in #774 in light of thesettlements that are made during that year.

>eq. 0

E


38/51

A810&.

The contractual agreement that Oeneral ills entered into allows them to reclassify thecurrent borrowings as non-current debt. anagement would want to do this in order toimprove the current ratio and other measures of liquidity. A financial analyst3s answer

would not be different. A financial analyst would not be concerned because thecompany has the ability to e%tend the maturity dates of the debt beyond the currentyear.

A810&/

>eq. 1

Accounts payables and accrued liabilities refer to amounts that should be paid tosuppliers of goods and services in the near future. The account balance increases whenraw materials and merchandise are purchased on account! and decreases whenpayments are made.

)ustomers3 deposits represent an amount of cash &or other assets' received by thecompany as a deposit on future delivery of goods andFor services. The account balanceincreases with the receipt of cash from customers in advance! and decreases whengoods are delivered and services are provided to these customers.

8ividends payable reflects an amount of dividends that has been declared by thecompany3s board of directors but has not been paid yet. The account balance increaseswhen the board of directors declares dividends and is reduced when cash is paid toshareholders.

8eferred warranty plan revenue represents collections from customers who purchasedspecific plans that e%tend the warranty on the purchased goods beyond d the originalwarranty period offered by the product3s manufacturer. The account balance increaseswhen additional plans are sold to customers and is reduced when the deferred warrantyplan e%pires over time.

"ncome ta%es payable refers to an outstanding obligation to pay income ta%es to theta%ation authorities based on the current period3s ta%able income.

*uture income liabilities result from temporary differences caused by reporting revenuesand e%penses on the company3s income statement in conformity with OAA and on theta% return in accordance with the "ncome Ta% Act. The account balance increases whentemporary differences in accounting for specific revenue and e%pense items lead toreporting income before income ta%es that e%ceeds ta%able income for the period. Theaccount balance is reduced when the reverse occurs.


10-38


39/51

A810&/ #!ontinued$

>eq. #

8eferred warranty plan revenue! eq. (

>etained earnings &?/'................................................. 1,!4#0

8ividends payable &=L'............................................... 1,!4#08eclaration of dividends payable to shareholders.

8ividends payable &L'.................................................... 1,!1,0

)ash &A'.................................................................... 1,!1,0

ayment of cash dividends to shareholders.6(!:,, = 61,!4#0 M Q D 6,!,#,


10-39


40/51

A810&

>eq. 1 and #

*00/ *00. *00- *00+ *00* *001

)urrent ratio 7.@@ 7.@4 7.:, 7.4: 1.7@ 7.:@Accounts payable turnover ,.,1 2.7( 0.0# 0.(, 0.#7Average age of payables &days' :( 21 22 2: 47

The current ratio fluctuated between 7.4: and 1.7@ during the si%-year period andshowed signs of improvement over the last four years! #77(-#772. hile a current ratiothat e%ceeds 1.7 provides a margin of safety for short-term creditors! "mperial $il3scurrent ratio should be compared to the norm for the industry for a better assessment ofits current level.

The accounts payable turnover ratio shows an increasing trend between #77# and#770! indicating that "mperial $il paid its trade supplies over shorter periods of time! as

evidenced by the decreasing trend in the average age of payables. owever! the rationdropped significantly in #772 with a corresponding increase in the average age ofpayables. hile the increase in the average age of payables benefits the company froma cash management perspective! the company3s trade suppliers may not be pleasedwith this change! especially if the credit period granted by the suppliers in shorter thanthe average age of payables.

>eq. (

The use of the L"*$ inventory costing method affects the cost of ending inventory andthe cost of goods sold! but it does not affect the cost of purchases. Therefore! if "mperial

$il used the *"*$ inventory costing method! then the ending inventory would be muchlarger than the amount reported under L"*$! as show in the table below.

*00/ *00. *00- *00+ *00* *001

)urrent assets 60!(7@ 6,!@@@ 6(!:@4 6#!2#: 6#!@:7 6#!2:0Adjustment of inventory fromL"*$ to *"*$ 072 @,1 4@4 1!71( 1!,#@ 1!07@

Adjusted current assets 0!:10 0!@,7 ,!2@, (!2,1 ,!,7@ ,!1@,Adjusted current ratio 1.7@ 1.10 1.71 1.74 1.21 1.(@

The switch from L"*$ to *"*$ increases the current assets and the current ratio for

each of the si% years. owever! both the accounts payable turnover ratio and theaverage age of payables would not be affected by the inventory costing method.

?ince the *"*$ cost provides a better indicator of the current value of inventorycompared to L"*$ cost! the current ratio under *"*$ provides a better indication of themargin of safety for short-term creditors. ;ut! the choice of an inventory costing methoddoes not affect the efficiency of managing accounts payable.A810&3Financial Accounting, 3ce, Libby, Libby, Short, Kanaan, Gowing 2008 McGraw-Hill Ryerson Limited !ll rights reser"ed

10-40


41/51

a. 8ecreaseb. 8ecreasec. 8ecreased. >emain the same &financing activity'

e. 8ecreasef. >emain the sameg. 8ecreaseh. 8ecreasei. >emain the same

A810&4

>eq. 1


#774 P 64#!777 % (0E D 6#0!#77#77: P 6:4!777 % (0E D 6(7!,07

&b' *uture income ta%+/%pense+

#774 P 6:!777 % (0E D 6#!:77 &originating a credit M a liability':#77: P 6:!777 % (0E D 6#!:77 &reversing a debit M eliminates the liability'

:This is a future income ta% liability &a credit' because the related e%pense isdeducted in the ta% return before it is deducted in the income statement. Therefore!there will be a lower future ta% deduction and this will result in more income ta% in

the future on other ta%able amounts.

>evenue#77: P 62!777 % (0E D 6#!177 &originating a credit M a liability':#77@ P 62!777 % (0E D 6#!177 &reversing a debit M eliminates the liability'

:This is a future income ta% liability &a credit' because it is related to revenue that isincluded in the ta% return after it is included in the #77: income statement.Therefore! at the end of #77: there is an income ta% liability related to this temporarydifference.

Jet future income ta% amounts+

#774 P 6#!:77 &originating liability a credit'#77: P 6#!:77 &reversing a debit' - 6#!177 &originating a credit' D 6477! net debit#77@ P 6#!177 &reversing a debit'


10-41


42/51

A810&4 (continued)

>eq. #

/ntries to record income ta%es+

#774 #77:"ncome ta% e%pense &=/?/'.................... #:!777: #@!407::

*uture income ta% liability &>eq. 1' &=L'..... #!:77o 477r

"ncome ta% payable :::&=L'........................ 0!7,7 2!7@7 )ash ::::&MA' ............................................ #7!127 #,!(27

G 6#0!#77 = 6#!:77 D 6#:!777 GG 6(7!,07 M 6477 D 6#@!407::: "ncome ta%es payable per >eq. 1 times #7EGGGG "ncome ta%es payable per >eq. 1 times :7E oD originating rD reversing

>eq. (

>eporting+#774 #77:

"ncome statement+

"ncome ta% e%pense &note'.......................................... 6#:!777 6#@!407

Note6"n practice! the current and future portions of income ta% e%pense would bedisclosed for each year.

;alance sheet+


"ncome ta% payable &>eq. #'.................................... 0!7,7 2!7@7 *uture income ta% liability &>eq. 1'.......................... #!:77 #!177:

:6#!:77 M 6477 D 6#!177. This amount will reverse in #77@.

>eq. ,

A future income ta% amount will be paid at some point &perhaps! indefinite' in the futurewhereas current income ta%es payable will be paid on a specific date. As a result! most

analysts see the nature of these two liabilities as being somewhat different. To illustrate!some companies with an e%panding amount of plant and equipment may be able todefer future income ta%es indefinitely if the amount of new future income ta%es onrecently purchased assets e%ceeds the amount of the reversal on older assets. "n otherwords! the future income ta% liability is constantly increasing. "n this case! analystswould not include the amount of future income ta%es in their projections of cash flows.


10-42


43/51

CASES AN 8RO=ECTS

-N*N/ AN* NTE0P0ETN/ -NANCA1 N-203AT2NC810&1

&The solution is based on the annual report for Uan outte "nc. for the fiscal year endedarch (1! #774.'

>eq. 1

"ncome ta%es payable! arch (1! #774+ 61,!7@4!777

?ource+ ;alance sheet.

>eq. #

The company uses the indirect method to determine cash flow from operating activities.The increase in accounts payable and accrued liabilities affected cash flow from

operating activities favourably by 6(!1(@!777 for the fiscal year ended arch (1! #774.&Jote+ Uan outte discloses accounts payable as part of Baccounts payable andaccrued liabilitiesC.'

?ource+ Jote 14+ Additional information on cash flows

>eq. (

Long-term debt! including the current portion is 60#!,:7!777 &60#!74(!777 = 1!,74!777'at arch (1! #774.

?ource+ ;alance sheet.

>eq. ,

arch (1! #774*uture income ta% assets

)urrent 61!041!777Joncurrent (!##:!777

*uture income ta% liabilities M noncurrent 1!#71!777

?ource+ ;alance sheet

>eq. 0

ost-retirement or defined benefit pension programsThe balance sheet includes an amount of 6(!1(0 under $ther liabilities. This liability isrelated to post employment and retirement benefits as disclosed in Jote 1# to thefinancial statements.


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C810&*

&The solution is based on the annual report for The *or5ani Oroup Ltd. &*OL' for thefiscal year ended


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C810&+

&The solution is based on the annual report for Uan outte "nc. for the fiscal year endedarch (1! #774 and the annual report for The *or5ani Oroup Ltd. &*OL' for the fiscalyear ended CA ? CLUan outte+ 6 @2!7@( F 6 27!2#7 D 1.0@*OL+ 6(@(!1@2 F 6#((!70@ D 1.2@

?ource+ ;alance sheet of each company.

>eq. #

&i' Accounts ayable Turnover >atio &for the most recent fiscal year for each company'+

@an outte BL )ost of Ooods ?old 61@:!777 6:1#!(2(V Average Accounts ayable 6(2!41:.0 a 6#(4!2(0 b

D AF Turnover >atio 0.(@ (.,#

a&6(,!,(, = 6(@!77(' F # D 6(2!41:.0b&6#,,!#@( = 6#(7!@44' F # D 6#(4!2(0Jote+ Accounts payable includes Baccrued liabilitiesC in each case.

?ource+ "ncome statement and balance sheet of each company.

&ii' Long-term debt including the current portion reported under current liabilities+

@an outte6 60#!,:7 &60#!74( = 61!,74'

BL6 627!(:0 &60:!(7( = 6#!7:#'

?ource+ ;alance sheet of each company.


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C810&+ (continued)

>eq. (

The current ratios for Uan outte and *OL are comparable. They are both lower than #

&a common benchmark for assessing liquidity'.

Uan outte3s accounts payable turnover ratio is higher than *OL3s. owever! as noted inthe te%tbook! a high accounts payable turnover ratio &although usually suggestive ofgood liquidity' might instead imply an inefficient use of resources.

A more stringent measure of liquidity is the quick ratio! which is often defined as+

&)ash and cash equivalents = Accounts receivable' F )urrent liabilities

The quick ratio as at each company3s most recent fiscal year-end date is+

Uan outte+ &6,!::, = 6,:!,0@ =6:!(#7' F 627!2#7 D 1.7#

*OL+ &6##!40: = 620!0,(' F 6#((!70@ D 7.(:

Uan outte3s quick ratio is more than double that of *OL! indicating that Uan outte3sliquidity is much better than that of *OL.

*rom the foregoing calculations and brief discussion one might conclude that *OL3sliquidity is poor! especially when compared to that of Uan outte. $ne must be carefulbefore reaching such a conclusion. *or e%ample! the company continues to generatepositive cash flow from operating activities and has access to significant credit facilities!as e%plained in anagement3s 8iscussion and Analysis section of the annual report.


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-NANCA1 0EP20TN/ AN* ANA14)) CA)E)

C810&-

>eq. 1

The cost of a free ticket could be measured in terms of what economists callBopportunity cost.C "f providing free tickets meant that there were not sufficient seatsavailable to sell to paying passengers! the opportunity cost would be the lost revenuefrom not having e%tra seats. The incremental cost approach uses an estimate of cashe%penditures to measure the liability associated with a frequent flyer program! but manyanalysts probably prefer a broader definition that would reflect the total impact of theprogram on the profitability of the company &i.e.! the BcostC of lost revenues'.Infortunately! opportunity costs are very difficult to measure.

Another option would be to use the cost of providing the service using an estimated cost

per mileFpoint. This could be difficult to estimate.

>eq. #

?outhwest would debit an e%pense account because of the matching concept. The costof a frequent flyer program is an e%pense that should be matched with current revenue!i.e.! when a customer earns points towards future flights.

C810&.

>eq. 1 and #

*00/ *00. *00- *00+

Accounts payable turnoverG 11.2 1(.# 1#.2 11.2"nventory turnover 0., 0., 0.4 0.2

Accounts receivable turnover (4.0 (@.2 ,(.# (:.2

Average age of payables (1.0 #4.4 #@.7 (1.0

8ays supply of inventory 24.2 24.2 2,.7 20.#Average collection period @.4 @.# :., @.0Average period to convert inventory to cash 44.( 42.: 4#., 4,.4

)ash conversion cycle ,0.: ,@.1 ,(., ,(.#

G )ost of purchases D )ost of goods sold = /nding inventory M ;eginning inventory

The three turnover ratios show some variations in their levels during the four-yearperiod! #77(-#772. ;ut the variations are relatively small! which reflects stability in thecompany3s management of its cash.


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C810&/

?tudents will discuss a variety of issues. "n class! we like to e%plore such topics ascorporate responsibility for the environment and strategies that focus on maintainingclean operations versus costly clean-up. *rom a financial reporting perspective! we

emphasi5e the difficulty of measuring future environmental costs and the challenge ofproviding appropriate disclosure of any contingent liabilities in the notes to the financialstatements.

C810&

>" summari5es the history of the litigation award to JT for patent infringement inJote 10. A more comprehensive information set can be obtained! however! by readingthe notes from #77( until #772 accompanying this disclosure. "n #77(! >" disclosed!in Jote 1,! a litigation e%pense of 6,.@ million related to the JT lawsuit as well ascompensatory damages for 6#(.1 million assessed by a I.?. jury. "n total! the charges

related to the JT lawsuit contributed 6#4.: million to the overall Accrued litigation andrelated e%penses which totaled 607.4 million. >" also disclosed that it had filed anappeal and that the judge had determined that the rate of interest accruing on thecompensatory damages was the prime rate.

To make sure >" would pay if the long appeal process results in affirming the verdict!the company was ordered to create an interest-bearing account and make quarterlydeposits equal to the royalties >" would have paid to JT. The judge ruled that >"was also liable for pre-judgment interest on the royalties not paid to JT from the pointat which >" started earning revenue from JTNs technology! compounded quarterly atthe prime rate. ;y ay #77(! the I.?. court ruled that the royalty rate for any post-

judgment compensation to JT would increase by 07E! from 0.4E to :.00E and that>" had to pay :7E of JTNs attorneyNs fees incurred up to that date. >" thenrecorded an additional provision of 61(.0 million in the fourth quarter of fiscal year #77(for enhanced post-judgment compensation! as well as 60 million for the attorneyNs fees.>" also made a provision to pay interest on the post-judgment compensation. "n total!the company recorded an additional e%pense of 6##.0 million that included not only theamounts already mentioned but also pre-judgment interest and additional estimatedfuture costs of litigation in this matter. >" also disclosed that the total e%pense to datewas 60:.# million of which 64.0 million was disbursed by the end of fiscal year #77(.>" noted that the ultimate cost could be materially different from the provision.

?ure enough by the first quarter of fiscal #77, &as reported in Jote 12 for fiscal year#77,' the company had added 64.0 million to the provision. "t classified 62.( million asrestricted cash and reported on a final order to pay monetary damages to JT of 60(.4million. >" appealed the judge3s decision but continued to add to e%penses eachquarter to provide for post-judgment compensatory damages payable to JT should theinitial verdict be affirmed. ;y year end the provision recorded was 6(0.# million.


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C8 10& #!ontinued$

"n #770! >" disclosed in Jote 10 the progress of this litigation. The )ompanydisclosed quarterly additions to the bank account in which the post-judgment royaltieswere deposited. The appeal results were not conclusive as they revealed procedural

errors! but not substantive errors! and the appeal court left it to the district court todecide what effect this should have on the amount payable to JT. >" went on toreport that it had signed a binding agreement with JT on arch 12! #770 to pay JT6,07 million in return for unrestricted use of their patented technology and resolving allprevious claims. >" also reported the various components of a total incrementale%pense of 6(0#.2 million.

$n arch (! #772! >" and JT jointly announced that they settled the lawsuit. >"paid JT 621#.0 million in to settle all claims against >". As at *ebruary #2! #770!>" had accrued 6,07.7 million in respect of the JT litigation. As the final settlementamount paid on arch (! #772 was 621#.0 million! >" recorded an additional charge

to its #772 income in the amount of 612#.0 million.

>eq. #


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C0TCA1 T5NKN/ CA)E)

C810&3)urrent >atio orking )apital Liquidity

a. 8ecrease Jo )hange ?hort-term improvement

b. "ncrease "ncrease "mprovementc. "ncrease "ncrease "mprovementd. "ncrease Jo )hange Jo )hangee. Jo )hange Jo )hange "mprovementf. "ncrease "ncrease Jo )hangeG

G/mployees would be paid in any case. owever! the net result is that currentliabilities are reduced.

C810&4

hile the question focuses on ethics! we believe that students should analy5e theproposed strategy. >efusing to accept merchandise would result in a higher current ratio&assuming that it is currently greater than one'. "f the merchandise is purchased oncredit! a constant amount added to current liabilities and current assets results in alower current ratio. anagement could actually improve the current ratio by shippingmerchandise to customers because it would record accounts receivable based onselling price and reduce inventory based on cost.

There are legitimate ethical issues raised when management alters the operations of abusiness to achieve an accounting result. ?tudents should understand! however! thatmanagement in many organi5ations engage in behaviour designed to affect accountingreports! e.g.! asking or requiring employees to work overtime in order to shipmerchandise that has been ordered at year-end.

e have included strategies for affecting ratios as well as reported profits. e havefound some students believe some strategies are ethical but others are not. "n suchsituations! we have been able to have very meaningful discussions concerningsituational ethics.


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C810&10

?trong cash flows are associated with financial strength. A company with good cashflows often does not need a large amount of working capital because its ability togenerate cash provides it with an appropriate level of liquidity.

)ash flow represents a stream of new resources. orking capital is an inventory ofresources. ost analysts would prefer to see strong cash flows rather than a largeamount of working capital.

C810&11

The class discussion may take various forms. "t is important to emphasi5e the purposeof this assignment! namely that it is possible to have a consensus in accounting on anissue in the abstract but often there is considerable disagreement when the question is

more specific.

-NANCA1 0EP20TN/ AN* ANA14)) TEA3 P02,ECT

C810&1*

The response to this case will depend on the companies selected by the students.

-inal version6 3ay $(% !''(

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