CH-16 Liabilities – Accounting : Book Guide

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Chapter 16: Liabilities Questions and solutions which have a GST version: • Problem 16.15 • Problem 16.19 • Additional exercise 16.21 Discussion questions 1. ‘Classification of liabilities is based on the same principles as the classification of assets.’ Do you agree with this? Why or why not? Currently, the main basis of classifying assets is according to their nature and function. This gives rise to a classification into current and non-current assets. Current assets are those that yield financial resources in the short term, typically within the operating cycle or within 12 months of the end of the reporting period This group of assets, by their nature, constitute assets within the operating cycle. Non-current assets are not part of the operating cycle and are largely classified on the basis of their nature and function. Liabilities, generally, are classified according to their nature and that is generally on the basis of time — those obligations which must be met within the operating cycle or within 12 months of the end of the reporting period as distinct from those which must be met a longer term into the future. The classification here appears to be based entirely on the timing of the future outflow of economic resources. However, this emphasis on timing also reflects the nature of the liabilities to some degree, e.g. trade creditors as opposed to debenture holders. A perusal of financial reports such as the JB Hi-Fi Ltd report on the company’s web site, reveals that assets are classified on the time/nature basis, and on the surface, liabilities are also classified on expected time of settlement. However, an effort is usually made to disclose much more about liabilities. Not only are they classified on the basis of time, but by other bases such as liquidity, secured v unsecured, source, and specific conditions (mortgage over land v secured debentures). Because of the diverse nature of liabilities, perhaps it is too limiting to restrict classification to just time and nature as with assets. 2. ‘Classification of liabilities as current or non-current is not that important. The money is paid out eventually anyway, so what’s the big deal? Discuss. It is true that all liabilities require future sacrifices of economic resources. Having no classification would still show all outstanding liabilities at the end of the reporting period. The issue is whether grouping or classifying liabilities is useful or improves the information in reports. Is analysing and interpreting reports enhanced by having a system of classification which groups liabilities which must be met within the operating cycle or within 12 months of the end of the reporting period, and separates these from liabilities which need to be met over a longer time frame? Liabilities result from a wide diversity of transactions and events, and the nature of liabilities differs greatly. Classification can assist users of reports to appreciate the nature of liabilities and assist in assessing the impact of both short-term and long-term liabilities on the operating cycle, and the long-term financial stability of the entity. Do users need to know such things as the effect of the payments on the operating cycle, whether interest payments on borrowings can be met, and whether repayments of long-term debt can be accommodated? If classifying liabilities improves the users’ ability to assess these things, then it can be argued that classification is useful. If classification of liabilities is to be abandoned, do we do away with the classification of assets and elements of equity? If classification on the basis of payment date is to be abandoned, is some other method of classification appropriate? 3. ‘The accounting treatment for a provision and a contingent liability is the same.’ Discuss. The statement is not true. A provision must be recognised as a liability and reported on the balance sheet. Provisions satisfy the definition of a liability and are defined as liabilities for which only the amount or timing of the future sacrifice of economic resources is uncertain. Nevertheless, they are recognised as liabilities. A contingent liability is a liability but is one that does not satisfy the recognition criteria for a liability because it is not yet probable that a future sacrifice of resources will be required, or the amount cannot be measured reliably. IAS 37/AASB137 states that contingent liabilities are not to be included in the financial statements but should be disclosed as a note to the financial statements. A provision and a contingent liability share a common element — there is the expectation that future sacrifices of economic resources of an entity will be required. They may all be regarded loosely as liabilities. However, there are subtle differences that must be considered when faced with the problem of recognising liabilities. In the past, these terms have been subjected to a variety of interpretations and definitions, and controversy as to whether to recognise, and hence report them, on the balance sheet. IAS37/AASB137 `Provisions, Contingent Liabilities and Contingent Assets’ makes a distinction in these terms. The distinction is made within the conceptual framework, which identifies subtle differences in these terms. 4. ‘Employees often fail to appreciate the true cost of their employment‘. Discuss. The take home pay of an employee, while significant, is only part of the cost to the employer. There are a number of additional, or ‘on‘ costs that need to be taken into account. These range from income tax through to superannuation payments and various leave related additional costs. When considering whether to employ an additional worker all these costs need to be considered. 5. Your accounting lecturer remarked: ‘The journal entries necessary to record the expense and liability in accounting for long service leave can be easily and logically derived. However, deciding when to record such entries and the dollar amount involved is problematic.’ Discuss. The statement is correct. The entries to account for LSL are straight forward — debit LSL expense to record the period expense and credit Provision for LSL to record the liability for LSL. When to make these entries and determining the amount to be expensed each period, as well as the amount of liability to be recorded has caused much debate by accountants over time. This is a clear case of being able to acknowledge the future sacrifice of economic resources, but there is a problem as to the timing and amount of those future sacrifices. When to make accounting entries, and determining the amount are problematic since many employees do not remain long enough to become eligible for LSL, and the employer does not become liable to pay LSL until the end of the employee’s qualifying period, e.g. ten years of employment. The question arises as to whether an entity should provide for LSL for a commencing employee who will not become eligible for LSL for ten years! Also, predicting the future liability is a difficulty since the employment history of all employees over time has to be considered, and the use of net present value techniques can also present difficulties such as the appropriate discount rate to use. Although IAS19/AASB 119 ‘Employee Benefits’ provides some guidance on how to account for LSL it still leaves the need to make estimates. LSL is to be recorded at the present value of estimated future payments to employees. The standard does prescribe the discount rate as that on government bonds at the end of the reporting period . 6. With reference to the Conceptual Framework, explain why future warranty costs should be recognised as a liability in the statement of financial position in the current period. The current framework defines a liability as having three key characteristics: •the entity must have a present obligation to an external party •the obligation must have resulted from past events •the entity must have a future outflow of resources embodying economic benefits, which represents a sacrifice of economic resources. In the case of future warranty costs the future economic sacrifice is fairly obvious. The past event or transaction is also straight forward. The existence of the present obligation is the area to consider in detail. Does the fact that the product has not yet become defective mean no present obligation exists? The answer is of course no, the fact of selling and the legal or constructive obligation to replace or repair a defective product creates the present obligation. Interestingly paragraph 60 of the framework specifically identifies the fact that warranties create obligations that should be recognised as a liability. The recognition criteria should also be considered. Probability of outflow are fairly easy to establish. Is the outflow measurable. Students should consider how the value of the provision might be measured. Reference to past experience and comparison with similar organisations in terms of product, industry etc. would be expected. 7. A family company, which had been operating successfully for five generations, continues to maintain a policy of raising money only through equity finance and never through debt. Discuss the advantages and disadvantages of adopting this policy. Would you recommend a continuation of this policy? Relying entirely on equity to finance expansion of a business does have advantages. Owners retain complete control over all of the assets of the business, and longer-term creditors for whatever reason cannot seize these. Assuming that the business is a company, complete control and management decisions rests with the equity providers. A problem could arise with this approach if expansion opportunities are ignored simply because it is not possible to obtain equity finance. The use of debt in financing expansion can have advantages. The entity can tap a wider source of finance and still retain complete control over the management and control of the entity. The interest paid on any borrowings is a tax deduction, and the after-tax cost of the debt is reduced. If the money so raised is invested to produce a return greater than the after-tax cost of the debt, existing shareholders can be better off. However, debt financing may require assets of the company to be provided as security, and this could restrict what can be done with these assets. If financing problems arise, these assets could be seized to repay the debt. Interest payments on the debt have to be met from ongoing operations, and must be part of cash management by the owners. Provision also must be made for the repayment of the debt. In summary, while there are advantages in remaining debt-free, significant benefits of borrowing can be lost. We recommend that debt be used only if it can be successfully managed. Starting with low debt financing can improve acceptance of its use, and the amount of debt financing can be expanded over time, as managers became more proficient in using it. Also, the level of debt financing can be kept low to reflect the risk profiles of the managers. 8. If a company is regarded as solvent, then it can be concluded that the company has no liquidity problems. Discuss. If a company is solvent, it can be concluded that at the date that the assessment of solvency is made, the company can pay its debts. In other words, the assets possessed by the entity can realise enough cash to pay its creditors. This indicates that the company has no liquidity problems at that date. However, liquidity problems can develop quickly. The solvency test is a short-term one and the strength of both short-term and long-term financial strength must be assessed. Liquidity and financial stability ratios can be used to assess both liquidity and financial stability. Trends in these ratios must be monitored carefully over time. These ratios can also give an appreciation of the ‘margin of liquidity‘ in the short term. Other factors reflected in such ratios as the debt and equity ratios, include the level of debt financing. If gearing is out of control, then the future financial position can be very precarious. The Cash Flow Statement is also an important report in assessing solvency as it describes the sources and uses of cash. A satisfactory liquidity position at the moment does not guarantee financial survival in the future. 9. A company issues debentures at 10%, the market rate at that time. What effect would an interest rate rise have? The company will be required to continue to pay the stated interest amount. This is the risk for the issuer, and careful consideration is put into setting the interest rate. With an interest rate rise the return on the debentures will be less than investors may be able to find for similar risk products elsewhere in the market. Holders of the debentures will have to sell them at a discount (less than their face value), or loss because of the lower interest than they might otherwise receive from the market. 10. ‘GST Payable should be treated a revenue account for the entity.’ Discuss. Although GST is collected when the entity makes a sale this is not part of the entity’s sales. The entity is responsible for collecting GST on behalf of the Australian Tax Office. This amount must be paid to the ATO at specified times in the future. Therefore, this amount is a current liability for the entity that has collected it. GST payables are offset against any GST the entity has paid on purchases. Effectively, this means that entities are acting as collection agents for the ATO. 11. The debt ratio is the inverse of the equity ratio. If the company increases its level of leveraging what will the effect be on the equity ratio? If a company increases its debt financing the equity ratio will decrease. This means that more of its assets have been financed by debt rather than equity. 12. What is leasing? Why might an organisation decided to lease an asset rather than purchase it? Leasing is a rental agreement in which the lessee obtains an asset from the lessor and has the right to use that asset for a specified period of time. In return the lessee pays the lessor a series of rental payments. There may be tax advantages of leasing assets. Lease contracts may be more flexible than loan agreements. The risk of obsolescence is shifted to the lessor. Exercises Exercise 16.1 Classification of liabilities How would each of the following liabilities be classified (current, non-current, or both) at the end of the financial year? (LO4)
Current liabilities:
Non-current liabilities:
•unearned revenue •10 year debentures (after 5 years)
•accrued expenses •mortgage loan (15-year)
•provision for warranty repair costs (1 year) •provision for long service leave
•annual leave payable •provision for warranty repair costs (1 year +).
•bills payable
•GST payable
•accounts payable (trade)
•dividend payable
•10 year debentures (after 9 ½ years).
Exercise 16.2 Classification of liabilities Classify each of following items as a contingent liability, a provision or neither. (a) an unresolved lawsuit against the entity for copyright infringement (b) allowance for doubtful debts (c) an arrangement to pay a bonus to salespersons for achieving sales over $50 000 (d) refurbishment costs of a machine that will need refurbishment in two years (e) an agreement to act as guarantor for another firm’s borrowings (f) environmental damage that an entity has undertaken to repair (g) one thousand 12% debentures issued at $100 (h) a warranty provided at time of purchase that the manufacturer undertakes to repair items that fail within 12 months. (LO3)
(a) An unresolved lawsuit against the entity for copyright infringement. Contingent Liability.
(b) Allowance for doubtful debts. Neither — adjustment to asset carrying amount.
(c) An arrangement to pay a bonus to salespersons for achieving sales over $50 000. Neither — no present obligation to make the payment.
(d) Refurbishment costs of a machine that will need refurbishment in two years. Neither — future cost.
(e) An agreement to act as guarantor for another firm’s borrowings. Contingent liability.
(f) Environmental damage that an entity has undertaken to repair. Provision.
(g) One thousand 12 % debentures issued at $100. Neither — non-current liability.
(h) A warranty provided at time of purchase that the manufacturer undertakes to repair items that fail within 12 months. Provision.
Exercise 16.3 Journal entries for bill financing The following were among transactions of Raven Industries Ltd during the financial years ending 30 June 2019 and 30 June 2020. Required (a) Record in general journal form all the above transactions, including any end-of-period adjustments required at 30 June 2019. (LO5) (a)
2019
Mar. 1 Cash at Bank 351 123.29
Unexpired Interest 8 876.71
Bills Payable 360 000.00
To record finance 90 day bill at 10% Interest = 360 000  0.10  90/365

May 30 Bills Payable 360 000.00
Cash at Bank 360 000.00
To record payment of bill

Interest Expense 8 876.71
Unexpired Interest 8 876.71
To record interest expense

June 1 Cash at Bank 148 027.40
Unexpired Interest 1972.60
Bills Payable 150 000
To record finance 60 day bill at 8% Interest = 150 000  0.08  60/365

June 30 Interest Expense 986.30
Unexpired Interest 986.30
To record interest expense accrued

July 31 Bills Payable 150 000.00
Cash at Bank 150 000.00
To record payment of bill

Interest Expense 986.30
Unexpired interest 986.30
To record interest expense
Exercise 16.4 Annual leave payable At 30 June 2020, the accountant for Braxton Brewery, Sue Robertson, is preparing the financial statements for the year ended on that date. To calculate the annual leave payable, the accountant had gathered the following information on employee annual salary weeks leave outstanding. Required (a) Calculate the annual leave payable liability for Braxton Brewery as at 30 June 20208 based on a 52-week year. (b) The balance of the annual leave payable liability before the above calculation was $5310. Show the general journal entry to record the appropriate balance in the Annual Leave Payable account. (LO5) (a)
Employee Annual salary Weeks leave outstanding Leave payable
Sue Robertson $130 520 6 $15 060
Jac Bunter 91 000 3 5 250
Xi Chen 71 760 4 5 520
Axel Hronky 65 000 4 5 000
Noel Kirabi 56 160 1 1 080
Jack Gilmore 50 960 5 4 900
Total $36 810
(b)

2020
June 30 Annual Leave Expense 31 500
Annual Leave Payable 31 500
To record year end annual leave liability ($36 180 – $5 310)
Exercise 16.5 Employee benefits On 21 November, the weekly payroll register of Python Ltd showed gross wages and salaries of $87 000. The organisation withheld $20 880 for income tax, $1670 for life insurance, $2500 for medical insurance premiums, and $8700 for superannuation deductions made on behalf of employees. Prior to this transaction the entity’s current liabilities (extract) were as follows. Required (a) Prepare the general journal entry to record the payroll and payroll deductions. (b) Prepare the general journal entry to record the employer’s contributions to the employees’ superannuation fund at the rate of 12% of gross payroll. (c) Prepare entries in the cash payments journal to record payment of the above liabilities. (LO5) (a)

21 Nov Wages and Salaries Expense 87 000
Australian Taxation Office 20 880
Life Insurance Payable 1 670
Health Insurance Payable 2 500
Superannuation Deductions Payable 8 700
Wages and Salaries Payable 53 250
To record gross payroll and deductions.
(b)
Superannuation Contributions Expense 10 440
Employer Superannuation Contribution Payable 10 440
To record employer super contribution at 12% of gross payroll.
(c)
Cash Payments Journal (extract)
Date Particulars Cash at Bank
Australian Taxation Office $62 640
Life Insurance Payable 4 175
Health Insurance Payable 6 250
Super Deductions Payable 26 100
Wages and Salaries Payable Employer Super Cont Payable 53 250 10440

Exercise 16.6 Warranties At 30 June 2020, Ting Sun Electronics adjusted its Provision for Warranties so that it would be equal to 5% of sales for the year ended on that date. Sales for the year ended 30 June 2020 were $1 600 000 and the Provision for Warranties before the adjustment was $47 000. On 6 October 2020, a successful claim for warranty on faulty goods to the cost of $900 was made on Ting Sun Electronics. Required (a) Prepare the general journal entry at 30 June 2020 to adjust the Provision for Warranties to the required level. (b) Record the payment of the warranty claim on 6 October 2020 in general journal format. (LO6) (a)
2020
June 30 Warranty Expense 33 000
Provision for Warranties 33 000
To provide for warranty expense related to sales made in the year ended 30 June.
($1 600 000  5%) – $47 000 = $33 000

(b)
2020
Oct. 6 Provision for Warranties 900
Cash at Bank 900
To record warranty costs incurred.

Exercise 16.7 Issue of debentures On 1 June, Sea Fare Enterprises received authorisation from its board of directors to issue $1 500 000 of 6% 10-year debentures dated 1 July. Interest is payable half-yearly on 31 December and 30 June each year. Required (a) Record the issue of the debentures in general journal entry form, assuming allotment of all debentures on 1 July. (b) Record interest payments for 31 December and 30 June in the first financial year of issue. (LO6) (a)

1 July Cash Trust 1 500 000
Application – Debentures 1 500 000
To record money received on application.

1 July Cash at Bank 1 500 000
Cash Trust 1 500 000
To record transfer of cash on allotment.

Application – Debentures 1 500 000
Debentures 1 500 000
To record allotment of debentures.

(b)

31 Dec. Debenture Interest Expense 45 000
Cash at Bank 45 000
To record half-yearly interest on 6% debentures

30 June Debenture Interest Expense 45 000
Cash at Bank 45 000
To record half-yearly interest on 6% debentures.

Exercise 16.8 Debentures issued at nominal value The following information relates to a debentures issue of Justice Ltd dated 1 January 2019. The company’s financial year-end is 30 June. Required (a) Prepare general journal entries to record: i. the issue of the debentures ii. the 30 June and 31 December 2019 interest payments iii. the 30 June 2020 interest payment. (b) Calculate the interest expense for the year ended 30 June 2020, and prepare the entry to close the Interest Expense account to the Profit or Loss Summary account. (c) Show how the debentures will be reported at 30 June 2020. (LO6) (a) i.
2019
Jan. 1 Cash Trust 500 000
Application – Debentures 500 000
To record money received on application.

Cash at Bank 500 000
Cash Trust 500 000
To record transfer of cash on allotment

Application – Debentures 500 000
Debentures 500 000
To record allotment of 500 debentures

ii.

June 30 Debenture Interest Expense 20 000
Cash at Bank 20 000
To record half-yearly interest on 8% debentures

Dec. 31 Debenture Interest Expense 20 000
Cash at Bank 20 000
To record half-yearly interest on 8% debentures

iii.

2020
June 30 Debenture Interest Expense 20 000
Cash at Bank 20 000
To record half-yearly interest on 8% debentures
(b)
2020
June 30 Profit or Loss Summary 40 000
Debenture Interest Expense 40 000
To transfer debenture interest expense.
(c)
Statement of Financial Position (extract) as at 30 June 2020
NON-CURRENT LIABILITIES
Debentures – 8% $500 000

Exercise 16.9 Mortgage payable Ensign Plus Ltd have recently purchased new premises in order to expand their inventory space. The cost of the premises was $1 280 000 and on 1 November they financed the purchase with a 7% loan to Hermitage Bank to be paid off over five years. Ensign paid a cash deposit of $350 000 and the agreement of the loan stipulates repayments will be $18 415 monthly. The first payment is due on 1 December. Assume interest is calculated monthly. Required (a) Prepare a general journal entry to record the payment due on 1 December. (b) Calculate the outstanding principal after the first payment is made on 1 December. (LO6) (a)
1 Dec Interest Expense $5425
Mortgage Payable $12 990
Cash at Bank $18 415
(b) $917 010. $1 280 000 – $350 000 = $930 000 less principal repayment $12 990 = $917 010 Exercise 16.10 Liquidity analysis The following information has been extracted from the financial statements of Blue Hills Ltd. Required (a) Calculate the following for 2020 and 2019: i. current ratio ii. quick ratio. (b) Comment on the liquidity and trend in liquidity, given that the industry average for these ratios are: current 2.3:1 and quick 1.3:1. (LO7) (a) i. 2019 2020 ii. 2019 2020 (b) By comparison with the industry average, the company’s liquidity position is not strong. The current ratios for both years are well under the average for the industry. Likewise, the quick ratios are well below the industry average. There has been a slight decrease in both ratios over the two years but the trend is not large enough to be concerned about at this stage. If the small unfavourable trend continues, the company may end up with a poor liquidity position. Exercise 16.11 Financial stability analysis The following information is available for Mods Media Ltd. Required (a) Calculate the following ratios for 2019 and 2020: i. debt ratio ii. equity ratio iii. capitalisation ratio. (b) What do these ratios indicate about the company’s gearing? (LO7) (a) 2019 i. Debt ratio = ii. Equity ratio = iii. Capitalisation ratio = 2020 i. Debt ratio = ii. Equity ratio = iii. Capitalisation ratio = (b) The trend from 2019 to 2020 shows that the level of debt financing has increased. Consequently, the level of equity financing has fallen. This means that the company is relying more heavily on debt financing, i.e. gearing has increased. Exercise 16.12 Calculation of long service leave liability Latte Services Ltd has three employees. Their employment contracts entitle them to 13 weeks leave after 10 years of service. Refer to the following information about each employee at 30 June 2020: Assume salaries are not expected to change, and ignore the effect of inflation. The employees are committed to the organisation and do not plan to resign but will take long-service leave as soon as available. You have found out the following information on current high-quality bond interest rates: Required (a) Calculate the value of the provision for long-service leave for Latte Services Ltd at 30 June 2020. (LO6) (a)
Employee Years of Service Current (Expected) Salary Accumulated LSL Liability* Discount Rate** NPV of LSL Liability***
Nathan 2 70 000 3 500 10% $1 632.75
Lucy 4 115 000 11 500 8% $7 247.30
Ava 8 190 000 38 000 6% $33 820.00
LSL Liability $42 700.05
* Accumulated LSL Liability = (Expected annual salary ÷ 52 weeks)  13 weeks  (Years of service ÷ Total Years required to be served ) = ($70 000/52)  13  (2/10) = $1 346.15  13  .2 = $3 500 ** Best Estimate. *** Net Present Value of LSL Liability = Accumulated LSL Liability ÷ (1 + Appropriate Bond Rate)n where n = number of years until long service leave will be taken (PV tables can also be used). Problems Problem 16.13 Calculations and journal entries for a payroll The following information is used to calculate Cleaning Capers Ltd’s payroll for the week ending 30 June 2020. Employees’ superannuation contribution is 9% of their gross pay. PAYG tax is taken out at 30% after subtracting the donations and superannuation. All employees also have the following deductions from their after-tax pay: 3.5% life insurance and 10% medical insurance. Required (a) Calculate ‘take-home’ pay for each employee. (b) Prepare a general journal entry to accrue the payroll and associated deductions. (c) Prepare a cash payments journal entry to record the payment of wages. (d) Assume that, on 6 July 2020, the company forwarded cheques to cover amounts withheld from employees’ wages for the month of June. Total income tax deductions were $6040. Other deduction liabilities were four times the total weekly deductions. Prepare a cash payments journal entry to record these payments. (LO5) (a)
Employee Gross Pay Salary Sacrifice – Donations Super PAYG After Tax Life Ins Medical Ins Take Home Pay
V. Gribben 952 20 85.68 253.90 592.42 20.73 59.24 512.45
D. Mitchell 1 240 40 111.60 326.52 761.88 26.67 76.19 659.02
F. Speight 2 180 50 196.20 580.14 1353.66 47.38 135.37 1170.91
P. Aiken 1 230 30 110.70 326.79 762.51 26.69 76.25 659.57
(b)
Wages Expense 5 602
Taxation Office 1487.35
Life Insurance 121.47
Donations Payable 140.00
Superannuation Payable 504.18
Medical Insurance Payable 347.05
Wages Payable 3001.95

(d)
Cash Payments Journal (extract)
Debits Credits
Date Accounts Debited Chq No. Other Accounts Accounts Payable Cash at Bank Discount Received

July 6 Taxation Office xx 6 040.00 6 040.00
Life Insurance xx 485.88 485.88
Donations Payable xx 560.00 560.00
Superannuation Payable xx 2 016.72 2 016.72
Medical Insurance Payable xx 1388.20 1388.20

Problem 16.14 Payroll transactions and liabilities The following accounts and balances appeared in the ledger of Chafezz Accountants Ltd on 30 April 2020: The following transactions occurred during May and June: Required (a) Prepare entries in general journal form for Chafezz Accountants Ltd to record the above transactions. (LO5) (a)
General Journal
2020
May 3 Taxation Office 32 210
Superannuation Fund 8 600
Medical Insurance Payable 1 480
Cash at Bank 42 290

May 31 Wages Expense 78 200
Taxation Office 19 550
Superannuation Fund 13 970
Medical Insurance Payable 1 560
Wages Payable 43 120

May 31 Wages Payable 43 120
Cash at Bank 43 120

May 31 Long Service Leave Expense 1 000
Annual Leave Expense 7 680
Sick Leave Expense 3 690
Provision for Long Service Leave 1 000
Annual Leave Payable 7 680
Sick Leave Payable 3 690

June 3 Taxation Office 19 550
Superannuation Fund 13 970
Medical Insurance Payable 1 560
Cash at Bank 35 080

June 27 Wages Expense 80 400
Taxation Office 2 1000
Superannuation Fund 13 510
Medical Insurance Payable 1 450
Wages Payable 44 440

June 28 Fringe Benefits Tax Expense 980
Cash at Bank 980

June 30 Wages Payable 44 440
Cash at Bank 44 440

June 30 Long Service Leave Expense 1 000
Annual Leave Expense 7 680
Sick Leave Expense 3 690
Provision for Long Service Leave 1 000
Annual Leave Payable 7 680
Sick Leave Payable 3 690

Exercise 16.15 Provision for warranty claim expenses Non-GST version Euro Classics Ltd has been operating a successful business for many years specialising in servicing and reconditioning repairs for classic European automobiles. Servicing costs $750, while reconditioning engines costs $1450. The business has a reputation for good customer service, an important feature of which is the 12 months parts and labour written warranty provided with each service. On 30 June 2019, the owners decided to introduce the practice of providing for warranty expenses at year-end, thereby establishing a warranty expense in the year the vehicles are serviced or reconditioned, and setting up a provision to cover future warranty expenses as they occur. Past records have been examined, and it has been established that, on average, one in twenty vehicles are subject to a claim under the warranty offered. The costs of warranty have amounted to $400 for serviced vehicles and $960 for reconditioned vehicles. During the year ended 30 June 2019, 500 vehicles were serviced and 260 engines were reconditioned. During the year ended 30 June 2020, 22 serviced vehicles and 15 reconditioned engines were repaired under the warranty. The costs of warranty work carried out by Euro Classics were all paid in cash. During the year, 680 vehicles were serviced and 240 engines were reconditioned. At 30 June 2020, it was decided that warranty costs in the following year would increase by 5%. (Ignore GST.) Required (a) Show the general journal entries to record the services/reconditioning for the year, and to establish the Provision for Warranty at 30 June 2019. (b) Show the general journal entries to record sales and the actual warranty costs incurred during the year ended 30 June 2020. (c) Show the general journal entry to adjust the Provision for Warranty at 30 June 2020. (d) Show how the above transactions would affect the financial statements for the 2 years. (LO4) (a)
2019
June 30 Cash at Bank/Accounts Receivable 752 000
Service Revenue 375 000
Reconditioning Revenue 377 000
To record sales for year 2019.

June 30 Warranty Expense 22 480
Provision for Warranty 22 480
To provide for future warranty costs. (Service 500  0.05  $400 = $10 000; Recondition 260  0.05  $960 = $12 480)
(b)
2020
June 30 Cash at Bank/Accounts Receivable 858 000
Service Revenue 510 000
Reconditioning Revenue 348 000
To record sales for year 2020.

June 30 Provision for Warranty 23 200
Cash at Bank 23 200
To record warranty costs. (Service 22  $400 = $8 800; Recondition 15  $960 = $14 400)

(c)
30 June Warranty Expense 27 096
Provision for Warranty 27 096
To adjust provision for future warranty costs. Service 680  0.05  $420 = $14 280; Recondition 240  0.05  $1008 = $12 096 + $720 under-provision for prior year’s warranties)
(d)
Income Statement (extract) for the year ended 30 June 2019
Less: Expenses
Warranty expense $22 480

Income Statement (extract) for the year ended 30 June 2020
Less: Expenses
Warranty expense $27 096

Statement of Financial Position (extract) as at 30 June
2020 2019
CURRENT LIABILITIES
Provision for Warranty 26 376 22 480

Problem 16.15 Provision for warranty claim expenses GST version Euro Classics Ltd has been operating a successful business for many years specialising in servicing and reconditioning repairs for classic European automobiles. Servicing costs $750, while reconditioning engines costs $1450. The business has a reputation for good customer service, an important feature of which is the 12 months parts and labour written warranty provided with each service. On 30 June 2019, the owners decided to introduce the practice of providing for warranty expenses at year-end, thereby establishing a warranty expense in the year the vehicles are serviced or reconditioned, and setting up a provision to cover future warranty expenses as they occur. Past records have been examined, and it has been established that, on average, one in twenty vehicles are subject to a claim under the warranty offered. The costs of warranty have amounted to $400 for serviced vehicles and $960 for reconditioned vehicles. During the year ended 30 June 2019, 500 vehicles were serviced and 260 engines were reconditioned. During the year ended 30 June 2020, 22 serviced vehicles and 15 reconditioned engines were repaired under the warranty. The costs of warranty work carried out by Euro Classics were all paid in cash. During the year, 680 vehicles were serviced and 240 engines were reconditioned. At 30 June 2020, it was decided that warranty costs in the following year would increase by 5%. Required (a) Show the general journal entries to record the services/reconditioning for the year, and to establish the Provision for Warranty at 30 June 2019. (b) Show the general journal entries to record sales and the actual warranty costs incurred during the year ended 30 June 2020. (c) Show the general journal entry to adjust the Provision for Warranty at 30 June 2020. (d) Show how the above transactions would affect the financial statements for the 2 years. (LO5) (a)
2019
June 30 Cash at Bank/Accounts Receivable 752 000
Service Revenue 340 909
Reconditioning Revenue 342 727
GST Payable 68 364
To record sales for year 2018.

June 30 Warranty Expense 22 480
Provision for Warranty 22 480
To provide for future warranty costs. (Service 500  0.05  $400 = $10 000; Recondition 260  0.05  $960 = $12 480)
(b)
2020
June 30 Cash at Bank/Accounts Receivable 858 000
Service Revenue 463 636
Reconditioning Revenue 316 364
GST Payable 78 000
To record sales for year 2019.

June 30 Provision for Warranty 23 200
Cash at Bank 23 200
To record warranty costs. (Service 22  $400 = $8 800; Recondition 15  $960 = $14 400)

Income Statement (extract) for the year ended 30 June 2020
Less: Expenses
Warranty expense $27 096

Statement of Financial Position (extract) as at 30 June
2020 2019
CURRENT LIABILITIES
Provision for Warranty 26 376 22 480
GST Payable 78 000 68 364
Problem 16.16 Alternative financing — shares versus debentures Trend Promotion Ltd, which has been trading profitably for many years, is planning to expand the business to meet the increasing demand for its services. The issue price of all shares is $2.50. It plans to invest $8 000 000 to finance this expansion, and as a result achieve an increase in profit before interest on debt and income tax of $1 600 000. A summary of financial results for the financial year ended 30 June 2020 is presented below. Management is considering whether to finance the expansion by selling 3 200 000 shares at $2.50 per share or by issuing 8% 10-year debentures at a nominal value of $100 each. Required (a) Assuming that the company achieves the expected increase in profit from the expansion, what will be the earnings per share for each of the alternative methods of financing proposed? (b) Discuss the disadvantage(s) of the method that produces the highest earnings per share. (c) What other factors might be considered by management in making its decision on the preferred financing method? (LO6) (a)
Existing Shares Debentures

Shares Currently Issued 4 200 000.00 4 200 000.00 4 200 000.00
Additional Shares 0.00 3 200 000.00 0.00
Total Shares 4 200 000.00 7 400 000.00 4 200 000.00
Debentures 8 000 000.00
Profit before income tax and debenture interest 3 000 000.00 4 600 000.00 4 600 000.00
Less: Debenture Interest 0.00 0.00 –640 000.00

Profit before income tax 3 000 000.00 4 600 000.00 3 960 000.00
Income Tax –900 000.00 –1 380 000.00 1 188 000.00
Profit 2 100 000.00 3 220 000.00 2 772 000.00
Earnings per share 0.50 0.44 0.66
(b) If profits and rates of return fall when there are high levels of debt the long-term financial stability of the company can be at risk. Using debt can have the reverse effect (EPS can fall) if the funds borrowed do not return at least the after-tax cost of the debt. The company will need to carefully manage cash flows to ensure the periodic interest can be paid when due, and that funds are available to repay the principal on the due date. Failure to do so will lead to some or all of the assets of the company being seized, and in the worst scenario, the liquidation of the company. (c) Management needs to consider the effect of its decision to borrow long-term on the financial standing of the company. Too much debt can cause the problems alluded to in B above — failure to meet periodic interest payments, and debt payments, can lead to liquidation of the company. Shareholders may become concerned at rising debt levels, leading to a reduced market price for the company’s shares. It may become more difficult even to raise additional equity capital if gearing is considered too high. Management also needs to consider any other conditions specified in the debenture deed that may become difficult to meet in the future. Problem 16.17 Mortgage loan to finance non-current assets Maryburn Imports Ltd has decided to purchase a new office building. It purchased land and a building for $5 250 000 on 1 December 2019. Agreed financing arrangements included payment of an initial deposit of 10% of the purchase price and the signing of a 7.5% p.a. mortgage contract which provided for quarterly payments of $168 961.88 over 10 years. The first quarterly payment was made on 1 March 2020. The company’s financial year ends on 30 June. Required (a) Prepare a quarterly payment schedule for payments made in the years ended 30 June 2020 and 2021. Head the columns with the following titles: Payment Date, Unpaid Balance at Beginning of Quarter, Cash Payment, Interest for One Quarter, Reduction in Principal, Principal Balance at End of Quarter. (b) Prepare journal entries associated with the land and building on 1 December 2019 for the financial year ended 30 June 2020. (The building was allocated 80% of the purchase price.) (Ignore GST.) (LO6) (a)
i. Payment Date ii. Unpaid balance at begin. of quarter iii. Cash Payment iv. Interest for one quarter (ii  1.875%) v. Reduction in Principal (iii – iv) vi. Principal at end of quarter (ii – v)
2019
1 December $5 250 000 $525 000 — $525 000 $4 725 000

2020
1 March 4 725 000 168 961.88 88 593.75 80 368.13 4 644 631.87
1 June 4 644 631.87 168 961.88 87 086.85 81 875.03 4 562 756.84
1 September 4 562 756.84 168 961.88 85 551.69 83 410.19 4 479 346.65
1 December 4 479 346.65 168 961.88 83 987.75 84 974.13 4 394 372.52

2021
1 March 4 394 372.52 168 961.88 82 394 .48 86 567.40 4 307 805.12
1 June 4 307 805.12 168 961.88 80 771.35 88 190.53 4 219 614.59

(b)

2019
Dec. 1 Land 1 050 000
Building 4 200 000
Mortgage Payable 5 250 000
To record purchase of land and building.

Dec. 1 Mortgage Payable 525 000
Cash at Bank 525 000

2020
Mar. 1 Interest Expense 88 593.75
Mortgage Payable 80 368.13
Cash at Bank 168 961.88
To record quarterly mortgage payment.

June 1 Interest Expense 87 086.85
Mortgage Payable 81 875.03
Cash at Bank 168 961.88
To record quarterly mortgage payment.

June 30 Interest Expense 28 517.23
Interest Payable 28 517.23
To record interest accrued at 30th June 2019
(Outstanding balance $4 562 756.84 at 1 June  7.5% / 12 months)

Problem 16.18 Ratios for analysing liabilities Several potential investors have been studying the affairs of Pelican Corporation to decide whether to invest in the company by purchasing unsecured notes which the company was proposing to issue. There was some speculation that the company was experiencing liquidity problems. The statements of financial position at 30 June 2019 and 2020 follow: Required (a) Calculate appropriate liquidity and financial stability ratios for the years ended 30 June 2019 and 2020. Research reveals that typical ratios in the industry for the current and quick ratios are 1.7:1 and 1.0:1 respectively. For financial stability ratios, industry averages are 2.5:1 for the capitalisation ratio and 60% for the debt ratio. (b) Comment on the liquidity and financial stability of the company, given the information available. (c) Would you, as one of the potential purchasers of the unsecured notes, lend money to the company? Explain why or why not. (LO7) (a)
Liquidity ratios: 2020 2019

Current ratio =

1.01 1.06
Quick ratio =

0.52 0.53

Financial stability ratios: 2020 2019

Debt ratio =

0.80 0.78

Capitalisation ratio =

4.9 4.6
(b) When compared with industry averages, the company’s liquidity position is poor. Both the current ratio and the quick ratio are well below the average for the industry, and the position has deteriorated further between 2019 and 2020. The company is highly geared with the debt ratio well in excess of the industry average. The position has worsened over the two years. This position is confirmed by the capitalisation ratio that is approaching 5, twice the industry average. The trend in this ratio is also worse over the two years. (c) We would not be interested in purchasing unsecured notes in this company. Its liquidity position is poor, and it is already heavily in debt. The asset backing to support further borrowing is too low. Problem 16.19 Journal entries for various liabilities Non-GST version Barrett and Taylor Ltd completed the following selected transactions during 2019 and 2020. The financial year for the company ends on 31 December. (Ignore GST.) Required (a) Show how the above transactions, including any necessary adjusting entries on 30 June 2020, would be recorded in the general and cash journals of the company. (LO5 and LO6) (a)
General Journal
2019
Jan. 6 Accounts Payable – Carter Ltd 12 000
Unexpired Interest 138.08
Bills Payable 12 138.08
To record 60 day bill at 7%
(Interest = $12 000  0.07  60/365)

Feb. 5 Interest Expense Bills Payable 69.04 69.04
Unexpired Interest 138.08
To record interest expense on renegotiated bill.

Bills Payable 12 069.04
Accounts Payable – Carter Ltd 12 069.04
To write back 60 day bill part paid and extended.

Accounts Payable – Carter Ltd 6 069.04
Unexpired Interest 49.88
Bills Payable 6118.92
To record 30 day bill at 10% for balance owing. (Interest = $6069.04  0.10  30/365)

Mar. 7 Interest Expense 49.88
Unexpired Interest To record interest expense on bill paid 49.88

June 15 Unexpired Interest 493.15
Bills Payable 493.15
To record unexpired interest 30 day bill at 8%. (Interest = $75 000  0.08  30/365)

June 30 Interest Expense 246.58
Unexpired Interest 246.58
To record interest expense on 30 day commercial bill to June 30 for 15 days.

July 15 Interest expense 246.57
Unexpired interest 246.57
Interest expense on 30 days billed for 15 days

Aug. 29 No transaction — no liability unless the borrower defaults.

Sept. 10 Purchases/Inventory 13 500.00
Accounts Payable – A.C.D Ltd 13 500.00
To record purchase of goods.

Nov. 1 Accounts Payable – McCaw Merchandise 12 000.00
Unexpired Interest 207.12
Bills Payable 12 207.12
To record 90 day bill at 7%
(Interest = $12 000  0.07  90/365)

Dec. 10 Unexpired Interest 1 479.45
Bills Payable 1 479.45
To record unexpired interest 60 day bill at 9%. (Interest = $100 000  0.09  60/365)

2020
Jan. 29 Interest Expense 1 479.45
Unexpired Interest 1 479.45
To record interest expense on commercial bill paid.

Feb. 8 Interest Expense 207.12
Unexpired Interest 207.12
To record interest expense on commercial bill paid.

Cash Receipts Journal (extract)
Debits Credits
Date Accounts Credited Cash at Bank Discount Allowed Accounts Receivable Other Accounts
2019
June 15 Bills Payable 74 506.85 74 506.85
Dec. 10 Bills Payable 98 520.55 98 520.55

Cash Payments Journal (extract)
Debits Credits
Date Accounts Debited Chq No. Other Accounts Accounts Payable Cash at Bank Discount Received
2019
Feb. 5 Carter Ltd 6 000.00 6 000.00
Mar. 7 Bills Payable 6 118.92 6 118.92
Apr. 23 Pro for Warranty 150.00 150.00
July 15 Bills Payable 75 000.00 75 000.00
Sept. 19 A.C.D Ltd 13 500.00 13 230.00 270.00

2020
Jan. 29 Bills Payable 100 000.00 100 000.00
Feb. 8 Bills Payable 12 207.12 12 207.12

Problem 16.19 Journal entries for various liabilities GST version Barrett and Taylor Ltd completed the following selected transactions during 2019 and 2020. The financial year for the company ends on 31 December. Required (a) Show how the above transactions, including any necessary adjusting entries on 30 June 2020, would be recorded in the general and cash journals of the company. (LO5 and LO6) (a)
General Journal
2019
Jan. 6 Accounts Payable – Carter Ltd 12 000
Unexpired Interest 138.08
Bills Payable 12 138.08
To record 60 day bill at 7%
(Interest = $12 000  0.07  60/365)