4587_1666_3_1412_51_lecture 6-Liabilities

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Liabilities



A Liability is a present obligation of the entity arising from past events, thesettlement of which is expected to result in an outflow from the entity ofresources embodying economic benefits.Examples:

• Buying goods on credit

• Accepting advance payments from customers• Taking a bank loan

• Outstanding paymentsCurrent Liability A liability is a current liability when it expects to settle the liability in itsnormal operating cycle. Examples: trade creditors; bills payable; bankoverdraft; unearned revenues ;accrued expenses ; bill payable ; sales taxpayable. Non- Current Liability / Long-term LiabilityExamples: debentures payable; mortgages, leases, long-term bank loansand pension payable. Secured Liability is backed by a pledge, hypothecation or mortgage of theborrower’s specific assets or asset classes in favour of the creditor . If theborrower defaults, the creditor can sell the assets and use the proceeds tosettle the dues. Un-Secured Liability is incurred based on the borrower’s general creditstanding and the creditor has a legal claim only against the borrower’s netassets.



CURRENT LIABILTIESBills Payable

1) A bill payable for Rs 10,000 drawn by Hindustan Finance for a

borrowing.

Cash ----------------------------Dr Rs 10,000To Bills Payable Rs 10,000

(To record 90-day, 12% bill payable of Rs 10,000)

2) When bill is paid on maturity

Bills Payable-------------------Dr Rs 10,000

Interest Expense---------------Dr Rs 300To Cash Rs 10,300

(Paid 90-day, 12% bill payable of Rs 10,000 with interest)



VAT and GSTValue Added Tax (VAT) is a state government levy on sales transaction.

1) On Sept. 27 ,Madhur & Co. bought goods for Rs 8,000 plus VAT at 10%.Purchases ------------------------------Dr Rs 8,000

VAT Credit Receivable --------------Dr Rs 800To Cash Rs 8,800

(to record purchase including VAT paid)

2) On Nov.19, it sells goods for Rs 10,000 plus VAT at 10%.

Cash--------------------------------------Dr Rs 11,000To Sales Rs 10,000To VAT Payable Rs 1,000

(to record sale and collection of VAT)

3) On Dec. 4, it remits the taxVAT Payable ---------------------------Dr Rs 1,000

To VAT Credit Receivable Rs 800To Cash Rs 200

(to record the payment of sales tax)Madhur & Co. effectively pays tax on Rs 200, the value added by it.



Estimated Liabilities

Example: It includes income tax , product warranties andemployee benefits.

Income TaxA company is a separate taxable entity. It must file tax returnsand pay income tax. The Central Government levies corporateincome tax in accordance with the Income Tax Act 1961.

Estimated income tax expense is Rs 36,000.

Income Tax Expense----------------Dr Rs 36,000

To Income Tax Payable Rs 36,000

(to record estimated income tax expense)



Product Warranty Liability

Citizen Ltd sells watches at an average price of Rs 1,500 with one year

warranty. Under the terms of the warranty , for one-year from the date ofsale the company will replace any defective parts free of charge and the

labor charges are to be paid by the customer.

During the year ended March 31,2011 the company sell 2,000 watches. Pastexperience shows that 5% of the watches are defective and that the cost ofwarranty replacement parts is Rs 50 per unit.

Assume that 13 watches are returned in April because of the defects and thecompany carries out repairs at a cost of Rs 45 per watch.

Calculate the estimated warranty liability and cost of repair under the

warranty scheme for Citizen Ltd. Also show how the company will recordthese in its books of account.



W/N 1 : Calculation of Estimated Warranty Liability Number of units sold 2,000Estimated rate of defective units 5%Estimated defective units 100Estimated cost per unit Rs 50

Estimated Warranty Liability Rs 5,000

W/N 2 : Calculation of the Cost of Repairs

13 watches were returned due to defects and were repaired@ Rs 45 per watch

Cost of Repairs = Rs 585

Product Warranty Expense----------------Dr Rs 5,000To Estimated Warranty Liability Rs 5,000

(to record the estimated warranty expense and liability)

Estimated Warranty Liability-------------Dr Rs 585To Cash (Merchandise Inventory) Rs 585

(to record replacement of parts in 13 watches under warranty)



Proposed Dividend

Proposed dividend becomes a liability when it is accepted bythe shareholders.

On May 19,2011 a company’s board recommends a dividend of Rs 50,000 for the last year.

Dividends---------------------------Dr Rs 50,000

To Proposed Dividends Rs 50,000

Contingent Liabilities

A contingent liability is (a) a possible obligation that arises from

past events and whose existence will be confirmed only by theoccurrence or non occurrence of one or more uncertain futureevents not wholly within the control of the entity or (b) a presentobligation that arises from past events but is not recognized.



LONG-TERM LIABILITIES

Debentures Payable

Debentures Issued at Par

On Jan.1,2011, Adnani Public Ltd issues 1,000 12% 10-year

secured debentures .The debentures are issued at par with theface value of Rs 100 each. Interest is payable semi-annually onJune 30 and Dec 31.

Jan. 1,2011 Cash --------------------Dr Rs 1,00,000

To Debentures Payable Rs 1,00,000

(issued 12% 10-year secured debentures at par)

June 30,2011 Debenture Interest Expense--------Dr Rs 6,000To Cash Rs 6,000

(paid semi-annually interest @ 12% on debentures)



Debentures Issued at DiscountAssume that Adnani Public Ltd issues debentures for Rs80,000 because the market rate of interest is 16%.

Cash ------------------------- Dr Rs 80,000To Debentures Payable Rs 80,000

(issued 12% 10-year secured debentures at a discount)

Debentures Issued at PremiumAssume that Adnani Public Ltd issues debentures for Rs1,12,000 because the market rate of interest is 10 %.

Cash -------------Dr Rs 1,12,000

To Debentures Payable Rs 1,12,000

(issued 12% 10-year secured debentures at a premium)



De-Recognition of Debenturesa) Redemption is the payment of debentures at maturity.

Assume that Adnani Public Ltd redeems its debentures and thus de-recognizes the liability.

Dec 31,2021 Debentures Payable------------Dr Rs 1,00,000

To Cash Rs 1,00,000

(paid face value of debentures at maturity)

b) Retirement is the early redemption of a debentures.Assume that on January 1,2014 Adnani Public Ltd retired at 82 the 12%debentures it had issued for Rs 80,359 on January 1,2011.On this date thecarrying amount of the debentures was Rs 84,919(this includes theamount invest plus semi-annual interest).

January 1, 2014 Debenture Payable---------- Dr 84,919

To Cash Rs 82,000

To Gain on Retirement of Debenture Rs 2,919

(retired 12%debentures at 82)

) C i At M t it



c) Conversion At MaturityOn the maturity of the convertible debentures the company derecognizesthe liability component and recognizes it as equity.Assume that on Dec 31,2015 Adnani Public Ltd`s debentures areconverted into 10,000 equity shares of Rs 10 each.

Dec 31,2015 Debentures Payable ---------------- Dr Rs 1,00,000To Equity Share Capital Rs 1,00,000

(conversion of debentures into equity share)

d) Conversion Before MaturityIf the amortized value of denture on the date of conversion (i.e. the datebefore maturity) is Rs 98,000 and debentures are converted into 10,000equity shares of Rs 10 each.

Dec 31,2015 Debentures Payable --------------------- Dr Rs 98,000Cash - --------------------- Dr Rs 2,000

To Equity Share Capital Rs 1,00,000(conversion of debentures into equity share)

The debenture holder needs to pay the difference between the amount ofshare capital and the amortized cost of the debentures in cash.Note :If the conversion price agreed upon is more than the face value ofthe share , the excess will go to the Share Premium Account.

D b t R d ti F d / Si ki F d



Debenture Redemption Fund / Sinking Fund

Koutons Ltd issues Rs 1,00,000 5-year debenture on January 1,2000.Thetrustee expects to get a return of 10% on the investment, net of expenses ofadministering the fund. Suppose if Re 1 is invested at the end of every year

for 5 years at 10%, it will cumulate Rs 6.1051 at the end of year 5. Theamount of sinking fund deposit is R 16,380 ( 1,00,000 / 6.1051).

Entry to record the amount deposited every year:Dec 31,2000 Sinking Fund Investment ----------------- Dr 16,380

To Cash 16,380

(paid the annual sinking fund deposit)

Entry to record the earnings on investments:Dec 1,2001 Cash -------------------------- Dr 1,638

To Income from Sinking Fund Investment 1,638

(received earnings on investments)

Dec 31,2001 Sinking Fund Investment -------------------- Dr 1,638To Cash 1,638

(invested interest received)



Year Beginning

Balance

(A)

Interest

Income

(B)

10% of A

Annual

Deposit

(C)

Ending

Balance

(D)

(A+B+C)

1 - - 16,380 16,380

2 16,380 1,638 16,380 34,398

3 34,398 3,440 16,380 54,218

4 54,218 5,422 16,380 76,020

5 76,020 7,600 16,380 1,00,000

Sinking Fund Investment



At the end of the fifth year, the investments will be sold and theproceeds utilized to repay debentures. Any gain or loss will berecognized at this time.

Assume that the investments are sold for Rs 1,02,500.The salewill be recorded as follows:

Dec 31,2001 Cash----------------------------- Dr 1,02,500

To Sinking Fund Investment 1,00,000

To Gain on Sale of Sinking Fund Investment 2,500(sold sinking fund Investment)

Dec 31,2001 Debentures Payable ------------- Dr 1,00,000

To Cash 1,00,000

(redeemed debentures on maturity)

Gain on sale of investments would appear on the profit andloss account.



Mortgages Payable

A mortgage is a legal arrangement in which a borrowing is

secured by specific immovable assets such as land, buildingand plant and machinery. If the borrower does not pay, thelender has the legal right to have the specific assets sold andpay himself out of the proceeds. Example home loan .

On January1 a mortgage debt of Rs 1,00,000 was obtained.The mortgage carries interest at the rate of 18% and isrepayable in 48 monthly installments of Rs 2,937.



Payment

Date Beginning

Principal

BalanceA

Monthly

Interest

1.5 % of AB

Monthly

Installment

C

Reduction

in

PrincipalD

(C-B)

Ending

Principal

BalanceE = A-D

Jan 1 - - - - 1,00,000

Feb1 1,00,000 1,500 Rs 2,937 1,437 98,563

Mar1 98,563 1,478 Rs 2,937 1,459 97,104

Apr 1 97,104 1,457 Rs 2,937 1,480 95,624

Feb 1 Interest Expense ------------------------- Dr Rs 1,500Mortgage Payable------------------------ Dr Rs 1,437

To Cash Rs 2,937(paid the monthly mortgage amount)

Repayment Schedule

L



Leases

Illustration: Abdullah & Co. signs an agreement with a leasingcompany to lease equipment.

i) The term of the lease is four years and the lease agreement isnon-cancellable . The equipment reverts to the lessor at theend of the period.

ii) Lease rental of Rs 28,679 must be paid at the beginning ofeach year. The first rental is payable on signing the agreement.

iii) The equipment has a fair value of Rs 1,02,000 at the inceptionof the lease, an estimated useful life of four years, and noresidual value.

iv) Abdullah & Co’s incremental borrowing rate is 12%.

v) The lessor is known to charge an interest rate of 10% on thelease.

vi) Abdullah & Co. uses the straight line method for depreciation of

similar equipment.



W/N 1 : Computation of the present value of the minimumlease payment:

Present value of four payment of Rs 28,679 each due in thebeginning at 10%

= Rs 28,679 x 3.4869 [Present Value of Annuity Table]

=Rs 1,00,000

• Take the lower of the fair value and the present value ofminimum lease payments.



Payment

Date

Beginning

Balance of Lease

Obligation

A

Monthly

Interest10 % of A

B

Lease

PaymentC

Reduction

inPrincipal

D

(C-B)

Ending

Balance of Lease

Obligation

E = A-D

1 Rs 1,00,000 - Rs 28,679 Rs 28,679 Rs 71,321

2 Rs 71,321 Rs 7,132 Rs 28,679 Rs 21,547 Rs 49,774 3 Rs 49,774 Rs 4,977 Rs 28,679 Rs 23,702 Rs 26,072

4 Rs 26,072 Rs 2,607 Rs 28,679 Rs 26,072 -

Lease Payment Schedule



1) Lease Equipment ----------------------------- Dr Rs 1,00,000

To Finance Lease Obligation Rs 1,00,000(arrangement of equipment on lease basis)

2) Depreciation on Leased Equipment ---------------- Dr Rs 25,000

To Accumulated Depreciation on Leased Equipment Rs 25,000(depreciation charged on leased equipment)

3) Finance Lease Obligation ------------------------- Dr Rs 28,679To Cash Rs 28,679

(paid the first lease rental)

4) Interest Expense ------------------------------------ Dr Rs 7,132Finance Lease Obligation ------------------------- Dr Rs 21,547

To Cash Rs 28,679(paid the second lease rental)

Accounting for Income Taxes



Accounting for Income Taxes

Accounting Profit is the profit or loss for a period before deducting tax expensetakes into consideration the following:

• recognition of receivables and payables , not just receipts and payments (accrualsystem)

• depreciation expense does not involve a cash outflow in the current period. Yet itis recognized to match expenses with related revenues.

• accountants recognize revenue only when we provide goods or services tocustomers. Unearned revenue represents the amount for which an enterprise isliable to provide goods and services in the future for payment already received.

Taxable profit (tax loss) is the profit (loss) for a period ,determined in accordancewith the rules established by the taxation authorities; income tax is payable(recoverable) on this income.

The taxation system sometimes works differently from the accounting system.The tax authorities calculate the value of an enterprise’s assets and liabilities inaccordance with the tax laws.For e.g. the tax and the accounting depreciation rates as well as methods differ.

Therefore , the carrying amount of a depreciable item for accounting purposes isdifferent from that for tax purposes.Current Tax is the amount of income tax payable (recoverable) in respect ofthe taxable profit (tax loss) for a period.

Ill t ti



Illustration:

Vipul & Co’s accounting profit is Rs 40,000 each year for three

years. At the beginning of the year 1, it buys a computer for Rs30,000 and depreciates it on a SLM over its estimated usefullife of three years.

The income tax law allows the asset to be expensed equally inthe first two years. The income tax rate is 30%.

i) Calculate the company’s taxable profit and current tax

expense.

ii) Calculate the deferred tax liability and income tax expense.

iii) How will the record the deferred tax liability in its books ofaccounts and present income tax expense in its Profit andLoss Account



Current Tax Expense

Year 1 Year 2 Year 3

Accounting Profit Rs 40,000 Rs 40,000 Rs 40,000

Add Depreciation Accounting Rs 10,000 Rs 10,000 Rs 10,000

Less Depreciation Tax (Rs 15,000) (Rs 15,000) -

Taxable Profit Rs 35,000 Rs 35,000 Rs 50,000

Current Tax Expense: 30% of

taxable profit

Rs 10,500 Rs 10,500 Rs 15,000

Year 1 Income Tax Expense ------------------------ Dr Rs 10,500To Income Tax Payable Rs 10,500





Deferred Tax Because of the difference between the accounting and tax , recovery orsettlement of that carrying amount could make the future tax paymentslarger or smaller. In such cases, the enterprise should recognize a deferredtax liability or deferred tax asset. Tax base and the temporary differencesare the building blocks of deferred tax accounting.

Tax base of an asset or liability is the amount attributed to that asset orliability for tax purposes. It is an amount that will be deductible for taxpurposes against any taxable economic benefits that will flow to an entity.

• Tax base of an asset is equal to its carrying amount.• Tax base of a liability is its carrying amount less any amount that will bedeductible for tax purposes in respect of that liability in future periods.

• Incase of revenue received in advance, the tax base of the resultingliability is its carrying amount less any amount that will be not taxable infuture periods.

Income Tax Expense comprises of current tax expense and deferred taxexpense



Calculating Tax Base

Year Cost

(A)

Tax Depreciation Allowance

(B)

50% of A in year 1 and year 2

Cumulative Tax

Depreciation

(C)

Tax Base

(D)

(A-C)

1 Rs 30,000 Rs 15,000 Rs 15,000 Rs 15,000 2 Rs 30,000 Rs 15,000 Rs 30,000 0

3 Rs 30,000 0 Rs 30,000 0

If the tax rate is 30%,what will be the deferred tax liability for Vipul & Co. on this asset.

Deferred Tax Liability

Year

Cost

(A)

Accounting Tax

Base

(E)

Taxable

Temporary

Difference

(F) = D-E

Deferred

Tax

Liability

(G)

30% of F

Depreciation

Expense (B)

1/3 of A

Accumulated

Depreciation

(C)

Carrying

Amount

(D)=A-C

1 Rs

30,000 Rs 10,000 Rs 10,000 Rs 20,000 Rs

15,000 Rs 5,000 Rs 1,500

2 Rs

30,000

Rs 10,000 Rs 20,000 Rs 10,000 0 Rs 10,000 Rs 3,000

3 Rs

30,000

Rs 10,000 Rs 30,000 0 0 0 0



Deferred Tax Expense and Income Tax Expense

Year Deferred Tax

Liability

(A)

Deferred Tax

Expense

(B)

Current Tax

Expense

( C)

Income Tax

Expense

(D)

1 Rs 1,500 Rs 1,500 Rs 10,500 Rs 12,000

2 Rs 3,000 Rs 1,500 Rs 10,500 Rs 12,000 3 0 (Rs 3,000) Rs 15,000 Rs 12,000



Presenting Income Tax Expense in Profit and Loss Account

Year 3 Year 2 Year 3

Profit Before

Depreciation

and Tax

Rs 50,000 Rs 50,000 Rs 50,000

Less

Depreciation

Expense

Rs 10,000 Rs 10,000 Rs 10,000

Profit

Before Tax Rs 40,000 Rs 40,000 Rs 40,000

Less: Income

Tax Expense

Current Rs 10,500 Rs 10,500 Rs 15,000

Deferred Rs 1,500 Rs 1,500 ( Rs 3,000)

Rs 12,000 Rs 12,000 Rs 12,000

Profit After

Tax

Rs 28,000 Rs 28,000 Rs 28,000



Year 1 Income Tax Expense ------------------------- Dr Rs 12,000

To Income Tax Payable Rs 10,500To Deferred Tax Liability Rs 1,500


To Balance c/d Rs 1,500 By Income Tax Expense Rs 1,500

Rs 1,500 Rs 1,500

Year 2 Income Tax Expense ------------------------- Dr Rs 12,000

To Income Tax Payable Rs 10,500To Deferred Tax Liability Rs 1,500


To Balance c/d Rs 3,000 By Balance b/d Rs 1,500

By Income Tax

Expense Rs 1,500

Rs 3,000 Rs 3,000



Year 3Income Tax Expense ------------------------- Dr Rs 12,000

Deferred Tax Liability ---------------------- Dr Rs 3,000

To Income Tax Payable Rs 15,000


To Income Payable Rs 3,000 By Balance b/d Rs 3,000

Rs 3,000 Rs 3,000

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4587_1666_3_1412_51_lecture 6-Liabilities