Mar 30

Introduction to Liabilities

  • Definition: A liability is defined as a present obligation to transfer economic resources as a result of past transactions.

Overview of Business Liabilities

  • Every business has liabilities, which are obligations that must be settled in the future.
  • Liabilities can include:
    • Taxes
    • Salaries
    • Government taxes (e.g., GST)
  • Businesses face liabilities from various components including:
    • Sales tax
    • Payrolls
    • Provisions
    • Contingent liabilities
    • Interest liabilities
    • Operating line credit
    • Liabilities of principal due at maturity
    • Advantages and disadvantages of debt financing

Liabilities Classification

  • Liabilities are classified into:
    • Current Liabilities:
    • Obligations expected to be settled within one year (or within the operating cycle if longer than twelve months).
    • Examples: Utilities bills, taxes, salaries.
    • Noncurrent Liabilities:
    • Obligations that are due beyond one year.
    • Example: A bank loan expected to be repaid over several years.

Types of Liabilities

  • Financial Liabilities: Contractual obligations to pay cash in the future, typically settled in cash.
    • Most liabilities fall under this category.
    • Examples include notes payable and loans.
    • Non-Financial Liabilities:
    • Examples include deferred revenues (unearned revenues) which are settled by delivering goods or services in the future.

Current Liabilities Explained

  • Current Liabilities:
    • Defined as obligations expected to be paid or settled within one year.
    • Most businesses function on a twelve-month operating cycle.
    • Examples include accounts payable, accrued payables (like salaries), and refund liabilities.

Accounts Payable vs. Accrued Liabilities

  • Accounts Payable:
    • Items purchased on credit that need payment at a future date.
  • Accrued Liabilities:
    • Expenses incurred but not yet paid (e.g., salaries, interest, taxes owed).

Refund Liabilities

  • Setting aside amounts for refunds to customers for goods and services rendered.
    • Recognizing these as liabilities until the actual refund is processed.

Discussion on Sales Tax

  • Businesses must remit sales tax collected to the government (GST).
    • If a product sold for $11,300, the sales tax collected is $1,300 (5% GST).
    • Sales tax payable is recorded as a liability until remitted.

Process of Handling GST:

  • Initial record on sale:
    • Total cash collected = Sales Price + GST
    • Sales Price = $10,000
    • GST Payable = $1,300
  • When remitting to government:
    • Cash decreases by $1,300
    • GST Payable recorded as a debit, reducing the liability.

Payroll Liabilities

  • Payroll Structure:
    • Employee gross pay includes fixed amounts, varying based on hours worked or contracts.
    • Payroll deductions such as federal/provincial taxes and insurance must be withheld by employers.
    • Employees receive net pay after all deductions.

Payroll Deductions

  • Common payroll deductions include:
    • Federal and provincial income tax
    • Canada Pension Plan (CPP)
    • Employment Insurance (EI)
    • Voluntary deductions (e.g., union dues, health insurance premiums).

Amortization Schedule for Loans

  • Important for installment payments to calculate:
    • Initial amount (
    • Interest amount (paid over the life of the loan)
    • Remaining loan balance.
  • Types of loans may vary, commonly include:
    • Operating lines of credit
    • Notes with fixed repayments
  • Formula for calculating monthly payments using PMT (payment amount) in financial calculators.

Example of a Loan Amortization:

  • Amount borrowed: 120,000 at 6% interest over five years.
  • Monthly payments structured to repay both the loan and interest.
  • Example breakdown for first month shows:
    • Total Payment: 2,320
    • Portion to Interest: 600
    • Portion to Principal: 1,720
    • Remaining Balance after Payment: 118,280.

General Accounting Entries for Loans

  • Journal entries essential for proper accounting of loans:
    • Upon Issuance:
    • Cash Account (debit)
    • Loan Payable Account (credit)
    • Upon repayment (example of the first installment):
    • Cash Account (debit)- representing cash outflow
    • Interest Expense (debit)
    • Principal Amount (debit)

Debt Financing Considerations

  • Advantages:
    • Enable faster growth for businesses, interest expense is tax-deductible.
  • Disadvantages:
    • Obligations must be met regardless of cash flow conditions.
  • Overall rule for maintaining a sustainable debt level includes:
    • Interest rates on debt must be lower than the rate of return on investments made with borrowed funds.