Study Notes on Liabilities - Part 2

LIABILITIES - PART 2

9.1 Bills

  • Bills Payable vs. Accounts Payable:
      Bills payable differ from accounts payable in that the liability is evidenced by a bill of exchange or a promissory note. In certain industries, the purchaser of inventory typically gives an accepted bill of exchange or promissory note at the time of purchase.
      Bills are also often issued when a business borrows money from a bank or other financial institutions. Furthermore, bills payable can arise from the substitution of a bill for an overdue account payable.

  • Trade Bills:
      Trade bills payable can arise from transactions in the normal course of business, for example, the conversion of accounts payable to bills payable.

  • Commercial Bills:
      In addition to their use as trade bills, a more common application for bills of exchange is to obtain short-term finance. These bills are commonly referred to as commercial bills or accommodation bills.

Example of Bills Payable

  • On 1st January 2012, John sold goods to Joseph for K 12,000 and received three promissory notes from Joseph dated 1st January 2012 for three months.
      - Bill 1: K 3,000
      - Bill 2: K 4,000
      - Bill 3: K 5,000
      The second bill is immediately endorsed in favor of Peter, and on 4th January 2012, the third bill is discounted with the bank for K 4,700. Pass the entries in John’s journal, assuming the bills are met on maturity.

Journal Entries for John’s Transactions

  • Date | Particulars | Amount | Debit | Credit
      - 01-01-21 | Dr. Joseph | K 12,000 | | Cr. Sales | K 12,000 [Being goods sold to Mr. Joseph on credit]
      - 01-01-21 | Dr. Bills Receivable | K 3,000 | | Cr. Joseph | K 3,000 [The first bill for K 3,000 drawn]
      - 01-01-21 | Dr. Bills Receivable | K 4,000 | | Cr. Joseph | K 4,000 [The second bill for K 4,000 drawn]
      - 01-01-21 | Dr. Bills Receivable | K 5,000 | | Cr. Joseph | K 5,000 [The third bill for K 5,000 drawn]

  • Date | Particulars | Amount | Debit | Credit
      - 01-01-21 | Dr. Peter | K 4,000 | | Cr. Bills Receivable | K 4,000 [The bill drawn on Joseph endorsed to Peter]
      - 04-01-21 | Dr. Bank | K 4,700 | Dr. Discount | K 300 | Cr. Bills Receivable | K 5,000 [Being the bill discounted at a discount of K 300]
      - 04-04-21 | Dr. Bank | K 3,000 | | Cr. Bills Receivable | K 3,000 [The bill being honored]

9.2 Employee Benefits

  • Employee benefits represent one of the most significant recurring expenses for businesses, reflecting compensations paid to employees for services rendered under employment contracts.

  • These costs encompass both labor and fringe benefits, forming a substantial part of business expenditures.

  • Liabilities arise for various employee benefits which include unpaid wages and salaries until they are paid, as well as withheld deductions such as income tax.

  • Other liabilities stemming from employee benefits include sick leave, long-service leave, workers' compensation premiums, and superannuation.

  • This section outlines the expenses and liabilities related to employee benefits from the employer's perspective.

Definitions of Employee Benefits

  • Employee benefits comprise all forms of consideration given by an entity in exchange for services rendered by employees, which include:
      - Wages and salaries (including monetary and non-monetary fringe benefits)
      - Annual leave
      - Sick leave
      - Long-service leave
      - Maternity leave
      - Superannuation
      - Post-employment benefits

  • An employer can be described as an entity that utilizes the services of employees in return for providing employee benefits.

Measurement of Employee Benefits

  • Liabilities from employee benefits require two measurement methods:
      - Expected to be settled within 12 months of the reporting period's end, and deductions from wages within the next 12 months, should be recorded at their nominal amounts (i.e., undiscounted).
      - Long-term employee benefits must be measured at present value if material, defined as the future cash flows payable to these employees discounted back to the present using an appropriate discount rate.

Salary Income Calculation

  • Gross Pay:
      - The calculation starts with determining the gross pay or gross earnings in the form of wages or salary.

  • Deductions from Gross Pay:
      - The net pay or take-home pay that the employee receives is less than the gross pay due to necessary deductions.

  • Net Pay:
      - Net pay equals gross pay minus deductions.

Example of Salary Calculations

  • Gross Pay: $3650

  • Deductions:
      - Income tax instalments: $748
      - Superannuation contributions: $191
      - Insurance premiums: $90
      - Medical insurance: $178

  • Total Deductions: $1207

  • Net Pay Calculation:
      - Net Pay = Gross Pay - Total Deductions = $3650 - $1207 = $2443

Workers Compensation

  • Workers compensation refers to an insurance scheme that compensates employees for injuries, loss of limbs, and loss of life while working.

  • Employers are typically mandated to obtain workers' compensation insurance, incurring a yearly premium based on a percentage of estimated wages and salaries for the upcoming year.

  • Premium rates are variable and reflect occupational risks faced by employees in their jobs.

Public Holidays

  • Employees commonly receive at least 10 public holidays annually, equivalent to 2 weeks of work.

  • Example: In Papua New Guinea, 15 holidays were observed in 2019 with specific dates announced officially.

Long-Service Leave

  • Long-service leave signifies a paid leave granted to employees who have remained with the same employer for extended periods.

  • Even though long-service leave benefits accrue over long durations, all leave is paid at the applicable rate when taken.

9.3 GST Collections

  • In Australia, entities selling goods and services subject to GST must collect GST on behalf of the Taxation Office, creating a liability to pay collected GST.

  • Entities must include a liability account for GST payable in their general ledger.

  • The GST Payable account is classified as a current liability since entities need to submit the net GST payable to the Taxation Office periodically, typically quarterly.

Example of GST Transactions

  • Consider No Risk Computers Ltd, which sells computers for $2860 each, including GST. The journal entry upon sale includes:
      - Accounts Receivable: $2860
      - Sales: $2600
      - GST Payable: $260

  • Purchases from the supplier are recorded as follows:
      - Purchases/Inventory: $1540
      - GST Receivable: $140
      - Accounts Payable: $1400

Journal Entry for GST Payable Across Quarter

  • If the GST Payable account balance is $130,000 and the GST Receivable is $110,000, then the payment journal entry is as follows:
      - Date: July 28
      - GST Payable: $130,000
      - GST Receivable: $110,000
      - Cash at Bank: $20,000

9.4 Warranties

  • A provision for warranties must be established upon the sale of inventory since an obligation exists to sacrifice future economic resources, despite uncertainty in timings and amounts.

  • Accurate estimates for warranty costs can be derived using previous experiences with similar products or the experiences of others in the business sector.

  • Accounting for warranties necessitates creating a liability, termed Provision for Warranties, in the fiscal year products are sold, alongside recognizing an expense equivalent to the provision.

Example of Warranty Accounting

  • Assume No Risk Computers Ltd sells computers for $2860 (including GST) with a 1-year labor and parts warranty. Average repair cost estimates indicate $350 for defective unit repairs, with roughly 10% of units needing repairs.

  • If 2000 computers are sold in one year, the future warranty expense is calculated as follows:
      - Estimated future warranty expense = 2000 × 10% × $350 = $70,000

  • The journal entry to record this warranty expense would be:
      - June 30 Warranty Expense: $70,000
      - Provision for Warranties: $70,000

Journal Entry for Warranty Costs Incurred

  • Whenever warranty costs arise in the following year, the journal entry will be:
      - July 15 Provision for Warranties: $350
      - Cash at Bank: $350 [To cover costs for a faulty computer]

NON-CURRENT LIABILITIES

  • Non-current liabilities comprise long-term borrowings, including debentures, unsecured notes, mortgage loans, and long-term commitments under finance leases.

  • Other non-current liabilities may include provisions for long-service leave and warranties due beyond 12 months or the operating cycle, with any short-term portions classified as current liabilities.

Types of Non-Current Liabilities

  • Term Loans: Liabilities arising from borrowings for periods up to 10 years, with interest typically higher than overdraft loans. Security from the borrower's assets is generally required for these loans.

  • Mortgage Payable: A liability secured by specific property of the borrower, where the property serves as collateral.

  • Debentures or Bonds: A liability form issued for borrowing a large sum from multiple lenders, secured or unsecured as per the terms of issuance.

  • Other Non-Current Liabilities: Include unsecured notes, mortgage payables, term loans, lease obligations, deferred tax liabilities, pension benefit obligations, deferred revenue, product warranties, and contingent liabilities.

Onerous Contracts

  • An onerous contract is described as one where the unavoidable costs of fulfilling the contract obligations exceed the expected economic benefits.

  • Business scenarios like moving to new premises might lead to such contracts where costs of ending a lease agreement may be lower than ongoing obligations.

Debentures

  • A debenture is defined as a debt instrument via which companies raise capital. Unlike secured loans, they are not backed by physical assets but promise to repay interest and principal.

  • In final accounts, debentures appear under the "Liabilities" section of the balance sheet, with relevant interest expenses reported in the income statement.

Presentation of Debentures
Balance Sheet Presentation

  • Under Long-Term Borrowings, debentures are classified as non-current liabilities.

Income Statement Presentation

  • Interest Expense: Recorded as an expense within the income statement, reflecting the cost of servicing debenture debt.

  • Loss on Redemption: If debentures are redeemed above face value, this is treated as a loss.

  • Gain on Redemption: Conversely, if redeemed below face value, any difference is treated as a gain.

Conclusion

This section entailed a thorough examination of liabilities concerning financial accounting, incorporating various types and classifications of liabilities, and addressing key concepts such as employee benefits, warranty provisions, and GST obligations.