Chapter9

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Chapter 9 – Liabilities Blast from the past BFTP9-1 You run a merchandising business and this is your second year of operations. A few of the transactions for the year are provided below. 1. Your purchase 100 units of inventory for $10 each from a supplier, 2/10, n/30, FOB destination. 2. You purchase a computer on account, n/45, for $1,500, plus HST. 3. A customer has ordered a special product and provided a down payment of $500 cash. 4. You borrow $20,000 from the bank at an interest rate of 3% for 2 years. 5. Your accountant tells you that you owe Revenue Canada $6,000 of taxes on the income from the business. You have not paid any income taxes yet this year. 6. You have decided that there is too much work for one person and you hire an employee at $12 per hour. They have worked for you for 37.5 hours this week and you need to determine how much to pay them. Required: Analyze the transactions using the critical and enhancing questions. What elements are affected and why? (See the example in Chapter 3 to remind yourself about how to analyze each transaction!) 1 | P a g e
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What will you learn in this chapter? If you answered BFTP9-1 you likely realized the topic of this chapter: liabilities. Assets on the balance sheet have been the focus of many of the previous chapters but understanding liabilities and their effect on business decisions is critical for the long term success of any business. This is because assets, such as the long-lived assets from Chapter 8, are often purchased on account (or for credit). This allows businesses to delay payment and better manage cash flows. Remember, if a business provides credit terms to their customers the cash inflow from sales is delayed. By also purchasing on account the business can delay outflows of cash. In addition, many businesses would not be able to expand without borrowing money from creditors and lenders (banks). Finally, as businesses expand they hire employees and that involves not just salary expense but other expenses that must be paid to the government on behalf of the employee. Overall, understanding and managing your liabilities is an important part of managing a business's cash flows. What is the most frequently used liability account? Accounts payable is a commonly used liability account. In Chapter 3 you recorded purchases of office supplies and advertising material on account and in Chapter 5 you purchased inventory on account. Recall that Accounts Payable is used when you purchase, from a supplier, either goods or services and you owe the supplier cash in the future, due to a past purchase. What about an example? On May 1 your business, Educational Toys Inc., purchases 20 toys for $5 each, credit terms n/30. On May 31 you pay the supplier the amount owning. Analyzing the May 1 transaction first, what did the business get? Toys, which are owned, can be sold in the future for a higher price, and are due to a past purchase: an asset. You record an increase in Inventory for the cost of the toys, $100 (20 * $5). What did the business give away? An "I owe you" (IOU), a promise to pay your supplier cash in the future: a liability. You record an increase in Accounts Payable, $100. Analyzing the May 31 transaction next, what did the business get? You got back your IOU from the supplier, meaning that you do not owe anyone anything any more: Accounts Payable decreases by $100. 3 | P a g e
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What did the business give away? Cash, which no longer has any future benefit because it is no longer available: Cash decreases by $100. Record both transactions into the accounting equation using account names. (Remember, on the final exam you will not be given account names but must provide them yourself.) Date Assets Liabilities Equity Owner' s capital Retained earnings Profit Revenu e Expenses Cash Inventory Accounts payable Owner's capital Sales revenue Cost of goods sold May- 01 100 100 May- 31 -100 -100 Are accounts payable a current or a long term liability? Recall from Chapter 4 that liabilities are divided into current and long term liabilities. Because accounts payable are generally paid within the upcoming 12 months (1 year) they are considered a current liability. They are always listed first under the heading "Current Liabilities" on the balance sheet. Check your understanding (CYU9-1) In June your business has the following transactions: 1. On June 1 you purchase supplies for $400, plus HST, using your credit card. 2. On June 12 you purchase inventory from a supplier for $8,350, credit terms 2/10, n/45. 3. On June 22 you pay the supplier for the purchase of inventory on June 12. 4. On June 30 you pay the balance on your credit card. 5. On June 30 a review of your supplies shows that you have only $250 of supplies remaining. Record the above noted transactions into the expanded accounting equation using account names. You are required to provide the account names for this question. 4 | P a g e
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Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Owner's capital Retained Earnings What about the deferred revenue liability account? Sometimes customers pay you in advance. An example would be a business that provides access to a gym (gym memberships) or a publishing business (magazine subscriptions). Many smaller businesses offer deals if a customer pays in advance, such as a dog walking service offering a cheaper price if you pay for 10 walks in advance. Advance payments from customers are NOT revenue because the business has not done their job YET but they WILL do their job in the future. Therefore, advance payments are considered liabilities because the business received cash but has provided nothing in return AS YET. Instead, the business will provide a good or a service at some point in the future. The account used for this type of transaction is called Deferred revenue : a good or service owed to a customer in the future which is due to the past receipt of cash from that customer. What about an example? On October 12 Educational Toys Inc. announces that 150 copies of a new book in the Harry Potter® series will be available for pre-order. To reserve a copy, customers must pay in advance and they are guaranteed to receive the book before December 15. Within hours all 150 copies have been pre-ordered for $35 each. On December 10 Educational Toys Inc. receives the books, purchasing them on account, n/30, for $15 each from the publisher. On December 11 the books are shipped to all 150 customers. On December 22 Educational 6 | P a g e
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Toys pays the publisher in full. First let's analyze each of these business activities using the critical and enhancing questions and then record the results into the expanded accounting equation using account names. On October 12 what did Educational Toys' get? Cash, which is an asset because it is owned, has future benefit for the business and is due to a past receipt from a customer. Cash increases by $5,250 ($35 * 150 customers). What did Educational Toys give away? An "I owe you" (IOU) to the customers, an obligation to provide the book to customers on December 15. Deferred revenue increases by $5,250. On December 10 Educational Toys Inc. receives the books, purchasing them on account, n/30, for $15 each from the publisher. What did the business get? They received 150 books for $15 each so they record Inventory, increase $2,250 ($15 * 150 books). What did the business give away? An "I owe you" (IOU), an obligation to pay the supplier of the books in the future: Accounts Payable increases by $2,250. On December 11 the books are shipped to all 150 customers. Remember, NO cash is received because the customers have already paid in advance. What did the business get? They get back their IOUs from their customers (who they owed a book to) because they have now provided the books to the customers so they don't owe them anything any more: Deferred revenue decreases by $5,250. What did the business give away? A product was delivered (the business did its job) so they have the right to claim revenue: Sales Revenue increases by $5,250. Is this the only transaction to record? No. Educational Toys sold a product (see Chapter 5!) so they have to record the inventory transaction. What did the business give away? Inventory, so it no longer has future benefit for the business: Inventory decreases $2,250. What did the business get? Not clear! Move on to the enhancing questions. What did they use, consume, or incur to generate revenue? They used inventory to help them generate revenue: Cost of Goods Sold increases (higher expenses) by $2,250. On December 22 Educational Toys pays off their outstanding Accounts Payable. 7 | P a g e
What did the business get? The supplier returned the business's IOU so you no longer owe the supplier anything: Accounts payable decreases by $2,250. What did the business give away? Cash, which has no further future benefit because it is gone: Cash decreases by $2,250. All of these transactions should be recorded in the expanded accounting equation using account names. Date Assets = Liabilities + Equity Owner's Capital + Retained earnings Profit Revenue -Expenses Cash Inventory Supplies Accounts payable Deferred revenue Owner's capital Retained Earnings Sales revenue Cost of goods sold Oct. 12 5,250 5,250 Dec. 10 2,250 2,250 Dec. 11 -5,250 5,250 -2,250 2,250 Dec. 22 -2,250 -2,250 Total 3,000 0.00 0.00 0.00 0.00 0.00 0.00 5,250 2,250 Are deferred revenues current or long term liabilities? Deferred revenues can be either current or long term: it depends on when the service or good is due to the customer. For instance, if a subscription to a magazine is for 3 years then a portion would be current (the first 12 months of magazines) and the remainder would be long term (the next 2 years). However, generally deferred revenues are considered current liabilities, meaning that the good or service will be provided to the customers within the upcoming 12 months. Check your understanding (CYU9-2) You run a dog walking service, Walk UR Dog. As a Christmas special you offer your customers a coupon book: 30 walks for $10 each, a total cost of $300. This is a $150 savings on your usual charge of $15 per walk. Customers must pay in advance and they can collect one walk per day, weekdays only, any time over the next 6 months. You sell 8 coupon books on November 30 (a total of 240 walks), collecting cash from your customers. By December 31 you have provided a total of 80 walks to customers who have redeemed their coupons. 8 | P a g e
Record the transactions into the expanded accounting equation using account names. Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Supplies Accounts payable Deferred revenue Owner's capital Retained Earnings Service Revenue Nov. 30 Dec. 31 Total What happens if you borrow money from the bank? As a business expands it often has to borrow money from creditors, called a loan. There are two concepts that must be understood about loans: principal and interest. The principal is the amount borrowed. Generally (although not always) it must be repaid on a specific date in the future. The date it is due (must be paid) is determined by the agreement with the creditor (such as a bank). Interest is the cost of borrowing money and it is similar to rent: you pay rent when you borrow space and you pay interest when you borrow cash. Interest is due AFTER you have used the cash for a period of time (for example, at the end of every month). The cost of borrowing, the interest rate, is again determined by the agreement with the creditor. You never pay interest in advance. When you borrow from a creditor there are two main types of loans: an operating line of credit and a traditional bank loan. An operating line of credit is where the creditor sets a maximum loan amount and the business may borrow on the line of credit as needed but only up to the maximum amount allowed. For instance, a creditor may provide the business with an operating line of credit to a maximum of $50,000. Say the business only needs, and borrows, $22,500. That means the business can still borrow an additional $27,500 ($50,000 - $22,500) if it needs to, up to the maximum of $50,000. The business is REQUIRED to pay the interest when it is due but it does not need to pay back the principal at any specific date. Note that the business still owes the principal to the creditor and the creditor can REQUIRE them to repay it (so it is still a liability) but there is no specific date set to repay the amount borrowed. 9 | P a g e
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Note that on an operating line of credit the creditor charges interest every day on the outstanding balance, whatever it happens to be. The interest rate is generally variable. What does that mean? It means that the interest rate changes when there are changes in the market interest rate. The rate may be 3.5% one day but, if the market interest rate changes, it may be 3.75% or 3.25% the next day. Variable interest rates are typically lower than a fixed interest rate (which stays the same for the period of the loan). This may sound attractive but there is risk involved because interest rates may increase or decrease at any time. Why would a creditor offer this type of loan to a business? Because businesses need cash to operate (run the business) and, by providing an operating line of credit, the creditor earns revenue in the form of interest. Creditors encourage their customers to use an operating line of credit: the business gets the cash it needs when it needs it and the creditors get the revenue (interest revenue) they need to be profitable. A business may also take out a traditional bank loan : a set amount of money with a due date (also called the maturity date) and an interest rate. The interest rate may be set for the period of the loan (4.5% for 5 years) or variable (a 5 year loan where the interest rate changes as the market interest rate changes). As an example, assume the bank lends a business $80,000 for 9 months at 3% interest. The business will receive the full $80,000 immediately and be required to pay 3% interest on a monthly basis. At the end of every month the business would pay the bank $200 ($80,000 * 3% / 12 months). At the end of the 9 months the business must repay the principal amount: $80,000 is paid to the bank. VERY IMPORTANT – the 3% rate is ALWAYS an ANNUAL rate. Did you notice that the 3% was divided by 12 months? You always have to do this. The borrower does not pay 3% of $80,000 (i.e. $2,400) each and every month. $2,400 is the total interest paid in a year. 1/12 of that is paid each month. Also, the term, or length, of the loan, does not factor into this calculation. Regardless of which type of loan a business has, there is a promise to pay the bank the amount owed at some point in the future PLUS pay interest at the date specified by the creditor. When you borrow from the bank you must record a liability because you owe cash to the bank at some date in the future. You would use the account called Notes Payable . This can also be Loan Payable or Bank Loan Payable . Any of these terms are acceptable. Also, the Loan (or Notes, or Bank Loan) Payable account is for the principal amount only. If any interest is owing but not yet paid, use a separate liability account called Interest Payable. 10 | P a g e
What is the difference between Accounts Payable and Notes Payable? Both are liabilities, an obligation to pay cash in the future. However, an account payable is an implicit (implied, unspoken, understood) agreement between a business and a supplier, so there is no signed contract. The only document backing up the transaction is the supplier’s invoice. In addition, unless you are overdue (you have not paid your supplier within the credit terms), no interest is charged on outstanding Accounts Payable amounts. Notes Payable (Loan Payable, Bank Loan Payable) is more formal; it involves a signed agreement (contract) between two parties (the business, who is the borrower, and the bank, who is the lender) with an interest rate (fixed or variable). If the loan is a traditional bank loan there will also be a set maturity date (when the amount must be paid back). Recall that there are two important amounts with regards to a loan: the principal and the interest. The principal is the amount borrowed from the lender (bank). The interest is the charge the borrower pays for the right to use someone else's (the creditor's) money. When interest is owed, it must be paid, but not until the date set by the agreement between the borrower and the lender. That means you get to USE the principal for a while WITHOUT paying interest. You would pay it only when it is DUE. For example, say you borrow the principal on June 12 and your interest payments are due every month thereafter (you never pay interest in advance of using the money, only AFTER you have used it). That means that your FIRST interest payment will be on July 12, AFTER you have USED the money for 30 days! When you pay the interest the following accounts would be affected: Cash, decrease, and Interest Expense, increase (which would decrease Profit, decrease Retained Earnings, and decrease Equity). You have to record Interest Expense because you have incurred a cost to help you generate revenue. What about at year end, when you publish your financial statements. Assume your year end is December 31. Do you have to record anything? First, consider when you last paid (December 12). Note that you have USED the borrowed cash from the December 12 (last time you paid interest) to December 31 BUT you have not, as yet, paid for that use. In that case the interest must be accrued. Accrued means to gather together, so interest that is owed is "gathered" (calculated) and recorded as a liability when it is owed but not yet required to be paid. The account you would use is Interest Payable : the amount owed in the future which is due to a past transaction (using the cash but not paying for that use as yet). Interest is generally due monthly although it depends on the arrangements made with the lender. 11 | P a g e
TESTING TIP: Interest rates provided are ALWAYS annual interest rates, regardless of how long the loan is outstanding. For instance, assume you borrow $10,000 for 6 months at 3% interest. That interest rate, the 3%, is an annual interest rate (3% over 12 months). Students often make the mistake of thinking that, because the loan is outstanding for less than a year, the interest rate given must be for ONLY the months outstanding (3% over 6 months). THIS IS INCORRECT . Every interest rate you ever see is an annual interest rate, unless you are advised otherwise. In order to change the annual interest rate into a monthly interest rate you must ALWAYS divide by 12 (3% / 12 months = the monthly interest rate). What about an example? On May 1 Educational Toys Inc. borrowed $20,000 from the bank at 3% interest. The loan has to be repaid in 5 years (so this is a traditional bank loan). Interest must be repaid on the first day of every month. What did the business get? Cash, which is owned, can be used in the future to help the business, and it is due to a past transaction: asset. You record an increase in Cash, $20,000. What did the business give away? An "I owe you" (IOU), a promise to pay the bank cash in the future: liability. As noted above, the account you would use to record this liability is either Notes Payable or Bank Loan Payable (also Loan Payable). Record the business activity into the expanded accounting equation using account names. Date Assets = Liabilities Equity Owner's Capital Retained Earnings Profit Dividends Revenue Expenses Cash Loan Payable Service Revenue May 1 +20,000 +20,000 12 | P a g e + - - +
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Is a loan payable considered a current or long term liability? That depends on when the loan is due to be paid: within 1 year or longer? If a loan is due to be paid within the upcoming 12 months then it would be considered a current liability. However, if the loan is due beyond the upcoming year, it is recorded as a long term liability. For Educational Toys Inc. the loan would be reported as a Long Term Liability on the Balance Sheet because it is due in 5 years. But what about the interest on the loan? Interest is often difficult to understand so let's again use an analogy (an example that is similar, used to demonstrate an idea or concept) of rent. When you rent an apartment you are borrowing a space that belongs to someone else. In return for the use of that space you pay rent. Similarly, when you borrow money from a lender (like a bank) you have to pay interest in return for the use of the bank’s cash. Interest on a loan is similar to rent for an apartment - both involve the borrowing of something that does not belong to you and the payment of cash for the use of what was borrowed. What is the only difference between rent and interest? You pay rent at the beginning of the month for the space you will rent for the upcoming month - you pay in advance. Interest on a loan is only paid AFTER you have had the use of the money for a period of time. For instance, when you borrowed money from the bank on May 1 you would not pay any interest until June 1. The interest you pay on June 1 is for using the money for the PAST month, from May 1 to June 1! Interest is a factor of time and you only owe it AFTER you have had the use of the money. How does interest affect the business's accounting records? It is easier to understand using an example. Say a business has borrowed cash from the bank on May 1 (Like Educational Toys Inc. did) and their year-end is December 31. They will have to pay interest on June 1, July 1, August 1, September 1, October 1, November 1, and December 1. Each time they pay interest they are paying for the USE of the cash for the PRIOR month. That means that, on June 1, when they pay, they are paying for the USE of the cash for the month of MAY. On every one of the dates given above the business will record the payment in the expanded accounting equation: Cash decreases and Interest Expense increases. Remember that Interest Expense is an expense account that is used to record the interest charges that the business has incurred to help generate revenue. It therefore 13 | P a g e
belongs in the element expense. The business is now at December 31, their year-end. At that time they would have to produce financial statements and those statements must be free of error (faithful). The business last paid interest on December 1. When they paid on December 1 they were paying for the use of the money during the month of November. That means that, on December 31, they have had the use of the money for the whole month of December but they have not, as yet, paid any interest for that use. They therefore have to accrue the interest owed but not, as yet, paid. 14 | P a g e
Let's see that on a timeline, just to be clear. If you produce financial statements on December 31 you must record a liability for the interest that you owe the bank on December 31 (which you will pay on January 1). You would use the account called Interest Payable; a liability account which recognizes the interest that is owed to the bank in the future, in this case on January 1 of the next year. What about the other side of the transaction? You have had the USE of the money for the month of December, a cost which will help you to generate revenue. What element is defined as USED? Expense: you would record an Interest Expense . Would interest payable only be recorded at the end of the year? No. Businesses would have to record the Interest Payable and Interest Expense at the end of EVERY month if they were producing their financial statements on a monthly basis. Why? Because, at the end of every month, they OWE the interest (due in the future) for the USE of the money. The concept demonstrated above happens at the end of every single month. What about an example? Continuing with our example of Educational Toys Inc., recall that on May 1 they borrowed $20,000 from the bank at a 3% interest rate, maturing (due to be paid back) in 5 years. Interest is paid on the first day of every month. Assume that the current date is May 31. When was the last time the business paid interest? NEVER because they took out the loan on May 1! They OWE interest, which they will pay on June 1. But what about May 31, today's date? On May 31 the business has had the use of the cash for the month of May but they have not, as yet, paid it. They therefore have to accrue (gather together) that amount and record the interest owed. Let's analyze the transaction. What did the business get? The USE of cash for the month, which is an expense as you used 15 | P a g e
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the money to help you generate revenue. You record an increase in the Interest Expense account. What did the business give away? An "I owe you" (IOU), a promise to pay the bank cash in the future (June 1 actually), which meets the definition of a liability. As noted above, the account you would use to record this liability is Interest Payable . How do you calculate interest? The formula to calculate interest is as follows: Principal Amount * Interest Rate * Period Outstanding 12 months Remember that the principal is the amount of cash borrowed. The interest rate is the annual interest rate. Interest rates are always annual interest rates and must be divided by 12 months to change it into a monthly rate. The "Period Outstanding" is the number of months since the last time interest was paid. Usually this is 1 month but, depending on the terms of the loan agreement, this may be every 3 months or 6 months or not until the loan matures. Therefore, on May 31, Educational Toys Inc. would calculate their interest due as follows: $20,000 * 3% * 1 month 12 months The amount of the interest that Educational Toys Inc. owes on May 31 is $50, based on the formula given above. They will pay that amount on June 1. Why does the company have to record the interest payable on May 31 if they will pay it on June 1, the very next day? Because the external stakeholders want to know all the liabilities that a business has so they can make an informed decision. In addition, as a business owner, you would want to know what is owed by the business since that amount must be paid in a short period of time. By knowing what is due in the future you can make better decisions about the cash flowing in and out of the business. 16 | P a g e
Let's record both of these transactions, taking out the loan and owing the interest at the end of the month of May, in the expanded accounting equation using account names. Date Assets = Liabilities + Equity Owner's Capital Retained Earnings Profit Dividends Revenue Expenses Cash Loan Payable Interest Payable Service Revenue Interest Expense May 1 +20,000 +20,000 May 30 +50 +50 Balance +20,000 +20,000 +50 +50 What happens at the beginning of the next month? On June 1 Educational Toys must pay the bank for the interest owed. When interest is paid to the bank the liability, Interest Payable, decreases because the business no longer has an obligation to repay the bank: Interest Payable decreases $50. What did you give away? You gave away cash to pay the interest, so your Cash account decreases $50. Let's add this last transaction to the chart. Date Assets = Liabilities + Equity Owner's Capital Retained Earnings Profit Dividends Revenue Expenses Cash Loan Payable Interest Payable Service Revenue Interest Expense 17 | P a g e + - + + - +
May 1 +20,000 +20,000 May 30 +50 +50 Balanc e +20,000 +20,000 +50 +50 June 1 -50 -50 Balanc e 19,950 20,000 0 50 You can see that, at the end of every month, a business would have to accrue (accumulate or gather together) the interest that is owed on the first day of the following month. Is interest payable a current or long term liability? Interest payable is considered a current liability because it will be paid off within the upcoming 12 months. Check your understanding (CYU9-3) You own a pet supply business, supplying retail stores in and around Toronto. You plan to expand and, in order to do so, you require a computer system that will scan the bar codes of all products coming in and shipped out. You borrow $36,000 from the bank on October 1 at an interest rate of 5%. The loan is due in 3 years and you pay interest on the 1st day of every month. Using that borrowed cash you purchase the computer system, including scanners, for $35,000, on October 1. The equipment is estimated to last 10 years with no residual value. Since you don't produce financial statements until the end of the year you do not accrue interest until year end. Your year end is December 31. Provide all the entries, from October 1, required for the loan, including those required on December 31, your year end. (Hint: blast from the past...remember to make the entry for 18 | P a g e
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depreciation of the equipment!) In addition, provide the entry you would make on January 1 with regards to the loan. The chart is on the next page. 19 | P a g e
CYU9-3, continued Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expe Cash Equipment Acc. Depr. Accounts payable Loan Payable Interest Payable Owner's capital Retained Earnings Sales Revenue Depr. Expense Oct-01 Nov-01 Dec-01 Dec-31 Dec-31 Balance Jan-01 Total 20 | P a g e
What other liabilities should a business know about? Income Taxes Payable is another common liability account. It represents the amount of income tax that is owed to the government at a future date. The Canada Revenue Agency (CRA) charges businesses income tax based on the profit they earn. This is very similar to individuals paying income tax on the amount of they earn in salary or wages. The CRA charges income tax at different rates depending on how high the business's profit (before income tax) is expected to be for the year. This is again similar to individuals paying income tax at rates which are based on how high their total salary for the year is. As an example, say that Educational Toys Inc. has profit before income taxes of $16,880 at the end of the year. The business expects to pay 25% in income taxes but they have not, as yet, paid the CRA. Educational Toys has incurred a cost of doing business because the government will require them to pay their income taxes in the future. Do they owe the government at this time, when they have earned $16,880? Yes they do. As soon as they have profit, even if it's only $1, they owe 25% of that amount to the CRA in income taxes. When the business earns profit they have to record the cost of earning that profit and one of those costs is the income taxes they will have to pay in the future. Therefore, at the end of every month, if the business has earned ANY profit, they will accrue (gather together) the income taxes they will pay to the CRA in the future. What about an example? Educational Toys has profit (revenue less expenses) of $16,880 for the year ended December 31. Its tax rate is 25%. On June 28 Educational Toys pays the Canada Revenue Agency (CRA) the income taxes owed on the business's prior year's profit. (Incorporated companies in Canada have to file their tax returns and pay their taxes six months after their year-ends. Many companies pay taxes in monthly or quarterly installments.) At December 31 Educational Toys owes taxes and they must accrue them. Income Taxes Payable increases $4,220 ($16,880 * 25%). In addition, they must record Income Tax Expense, which is the income tax incurred to help generate revenue. Income Tax Expense increases by $4,220. Fast forward to June 28. At that date Educational Toys pays the CRA for the income taxes owed. What did it give up? It gave up cash so Cash decreases by $4,220. What did it get? It got back their IOU from the government because it has now paid off the obligation to pay income taxes in the future: Interest Payable decreases $4,220. 21 | P a g e
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Let's record both of those transactions into the expanded accounting equation using account names. Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Supplies Accounts payable Income Taxes Payable Owner's capital Retained Earnings Service Revenue Income Tax Expense Dec- 31 4,220 4,220 June 28 -4,220 -4,220 Total N/A 0.00 0.00 0.00 0.00 0.00 0.00 4,220 You can see that, at the end of every month, a business would have to accrue (accumulate or gather together) the income taxes that are owed and will be paid at some point in the future. In the new period (month or year) the business has to record the payment of the tax that was recorded as owed in the past. Is income taxes payable a current or long term liability? Income taxes payable is considered a current liability. This means that the taxes will be paid to the CRA within the upcoming 12 months. Check your understanding (CYU9-4) Pets4U is a pet supply company. On November 30 they had revenues of $65,400 and operating expenses of $54,000 for the month of November. They are charged a 25% tax rate. They accrue their income taxes at the end of every month and pay them on the 12 th of the following month (December 12 in this case). Record the income tax entries for Pets4U for November 30 and December 12. 22 | P a g e
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Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Supplies Accounts payable Income Taxes Payable Owner's capital Retained Earnings Service Revenue Income Tax Expense Nov- 30 Dec- 12 Total What about liabilities such as salaries payable? As noted in BFTP9-1, many businesses hire employees once the business begins to grow. For large businesses, particularly those providing services, salaries are the largest expense on the income statement. Accounting for that cost is important for business owners to understand. Even though many small businesses start out with only one employee (YOU, the owner), if a business wants to expand its operations it will, eventually, have to hire more people. Note that the process of hiring an employee is an event and not a transaction. Say you hire a new employee on Wednesday, November 2. The employee will start working the following Monday, November 7. On Wednesday, November 2, nothing is measurable as the employee hasn't done any work yet. (What did you get? Nothing! What did you give away? Nothing!) Once employees begin to work for the business you are USING their services (remember, use means expenses). At that time entries have to be recorded because you have used the services of your employees AND you owe your employees for that service. It is a transaction because it is both measurable and realized (happened in the past). Employees work for you with the understanding that they will be paid in the future for the services they are providing to your business. You might pay your employees weekly, bi- weekly (every 2 weeks), monthly (on the last day of every month) or bi-monthly (on the 15th and the last day of every month). Employees may be paid wages , which means that the employees are paid only for the hours they work. When employees are paid wages there is a delay between when they work and when they are paid. That's because the employer (you!) 23 | P a g e
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has to calculate how many hours the employee has worked. A calendar might help you understand this better. Say that you hire an assistant and he works 7.5 hours a day from November 7 to November 11 (Monday to Friday). He is paid weekly, every Friday. When would his first payday be? Would it be on November 11, after he works his first week? The answer is no. His first payday would be Friday, November 18. That's because the total hours he worked from November 7 to November 11 are not known on November 11. There is a delay of one week between the time he works and the date he is paid. This is always the case when employees work, and are paid, only for the hours they work. Sunday Monday Tuesday Wednesday Thursday Friday Saturday 1 2 3 4 5 6 7 - 7.5 hrs 8 - 7.5 hrs 9 - 7.5 hrs 10 - 7.5 hrs 11 - 7.5 hrs 12 13 14 15 16 17 18 - PAID for period Nov. 7 - 11 19 20 21 22 23 24 25 26 27 28 29 30 What about when employees are paid salary ? When an employee is a salaried employee it means that they have a yearly salary (amount) which is divided over the year. An example might help here too. Say that you hire an assistant. She will work Monday to Friday, 7.5 hours a day, for the year. You offer her a salary of $31,200 per year. How much is she paid every week? $31,200 / 52 weeks = $600 per week. Assume that your assistant starts on November 7 and will be paid weekly. When is her first payday? November 18, similar to an employee who earns wages based on the hours they work? The answer is no. Their first payday would be on November 11. Sunday Monday Tuesday Wednesday Thursday Friday Saturday 24 | P a g e
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1 2 3 4 5 6 7 - 7.5 hrs 8 - 7.5 hrs 9 - 7.5 hrs 10 - 7.5 hrs 11 - 7.5 hrs & PAID for Nov. 7 - 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Notice that she is paid ON the Friday FOR the Friday - the same day that she works, she is being paid. That is because the assistant is a salaried employee and she earns $120 a day ($600 / 5 days). There is no question about how many hours she worked since she is not paid by the hour. Instead, she gets the same amount every single day (although she is required to work the 7.5 hours to earn it!) She can therefore be paid on the Friday FOR Friday's work since she is expected to work that day for 7.5 hours anyway. How are employees paid? Many business owners who have never hired an employee think that it is a simple transaction: employees work for you and you pay them a salary (or wages) for that work. However, as an employer, you have a responsibility to withhold various taxes from the employee's salary on behalf of the government. That means you are an agent of the government and you must pay those amounts to the government on a monthly basis. In addition, as an employer, you must help to pay for the future welfare of your employees. This is an additional expense over and above what you pay your employees in salary. Employees are definitely needed to grow your business but the cost of employees is a far more complex concept than most business owners realize. What about an example? Assume you hire an employee to work for you. You pay him $12 per hour (wages) and he works 37.5 hours during the week. What will you pay him for that 1st week of work? 37.5 hours * $12 / hour = $450 25 | P a g e
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The amount, $450, is called the employee’s gross pay: the total amount the employee EARNED by working for the business. However, that is not the amount the employee will be paid. Why not? Because there are amounts that you, the employer, "withhold at source". You, the employer, withhold it (take it) from the employee’s earnings before you pay him. Businesses are required by the government to withhold (hold back, not pay) these amounts and to pay (remit) them to the government. Why does the government require employees to pay part of their salary to them? Everyone in Canada is required to pay for the services that the government provides (such as health care, national defence and security, and taking care of the highways between cities). Everyone also has to pay into the pension plan that will, eventually, pay them an income when they retire. Finally, everyone has to pay into a safety fund: if you lose your job you can apply to that safety fund to get support while you look for another job (Employment Insurance). If you are taking this course at a university or college the amounts you pay out of your salary to the government are helping to pay for your education (income taxes that are deducted from your pay cheque are used to fund universities and colleges!) What amounts are withheld at source? The three statutory (that is, legally required) amounts are: Canada Pension Plan (CPP), employment insurance (EI) and Employee Income Taxes (EIT). Let’s look at each individually. The Canada Pension Plan (CPP) is a retirement savings plan that is managed and controlled by the government. Everyone who works pays into this pension plan and, in return, when you retire, you will get an income from the pension plan. For instance, if you retire at 65, AND you have worked full time for 35 years, you will receive a payment from the government every single month, up to a maximum amount which is indexed to inflation. You pay into the CPP plan your whole working life and, when you reach 65, you get to collect your pension. Employment insurance (EI) is also deducted from an employee’s salary. Employment insurance benefits are paid to individuals who lose their jobs. If someone become unemployed and they can't find another job they can apply for employment insurance benefits and receive financial help (money) while they look for work or receive training. Benefits under employment insurance can last between 14 and 45 weeks, depending on the circumstances. The amount individuals can receive depends on their earnings before they 26 | P a g e
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lost their jobs. Individuals benefit from employment insurance only if they need it. Many individuals pay into EI their whole lives but never apply for employment insurance benefits. Employee Income taxes (EIT) are the income taxes everyone pays on their personal income. The income taxes paid benefit everyone in Canada as these amounts support services such as health care, public libraries, and universities, to name just a few. The government requires employers to withhold a portion of the employee's salary for income taxes based on what they estimate the employee will earn over the year. Rather than waiting till the end of the year to collect income taxes, the government requires everyone who earns a salary (or wages) to pay income taxes out of every pay cheque. At the end of the year everyone files an income tax return so the government can check that you paid enough. If you paid too much you get a refund. To summarize: when employees work for an employer they earn their salary (or wages), called the gross pay . Employers don’t pay the gross amount to employees. Instead, employers withhold CPP, EI, and EIT amounts from the employees’ pay cheques. The employees earn the gross amount, the employer holds back the amounts "withheld at source," and the employees are paid the difference, called net pay . What happens to the amounts that the employer withholds at source? The employer has to pay those amounts to the government! Yes, like HST that a business collects and then pays to the government, the amounts an employer withholds at source has to paid to the government, by the 15 th of the following month. What about an example? Say an employer has to pay their employee $100 salary (gross pay) on May 12. CPP is $3, EI is $2.00, and EIT is $5. What does the employee get? The net pay , $90 (100 – 3 – 2– 5). But what about the amounts withheld at source, the $10 (3 + 2 + 5)? The business has to remit (pay) this amount to the government, on a monthly basis. After it is collected from employees but before it is paid to the government, the amounts withheld at source are OWED to the government. You therefore have to record payables: CPP Payable, EI Payable and EIT Payable . These amounts, between the time they are withheld and the time they are paid to the government, are liabilities. Let’s record the payment of the salary to the employee in the expanded accounting equation, using account names. 27 | P a g e
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Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable Employee Income Taxes Payable Salary Expense May-12 -90 3 2 5 100 Notice that the employee was paid the net pay of $90. The remaining amounts are owed to the government. Assume also that you are required to pay the government the amount that is owed to them on May 30. What did the business get? The business got back its IOU from the government as it doesn’t owe the CRA anything any more. What did the business give away? The business paid cash to the government for the amounts that it owed them. Let’s add that to the chart. Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable Employee Income Taxes Payable Salary Expense May-12 -90 3 2 5 100 May-30 -10 -3 -2 -5 Balance -100 0 0 0 100 Notice that the business paid a total of $100 out in cash but that amount is split between what was paid to the employee ($90) and what was paid to the government on behalf of the employee ($10). To summarize: employees EARN their gross pay but the amount they get to take home, after all deductions, is a smaller amount called the net pay. 28 | P a g e
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What about a more realistic example? Say you run your own business and you hire Joe Bleaue to work for you. Joe has worked 37.5 hours this week and he earns $12 per hour. Joe works Monday to Friday, May 2 - May 6. Since Joe is paid wages you pay him on Friday, May 13 (one week delay). What is Joe's gross pay ? $12 * 37.5 hours = $450 What is Joe's net pay ? You, as Joe's employer, will have to withhold the following amounts: CPP, $22.28, EI, $7.69, EIT, $76.50. Joe would therefore only receive $343.53 as his net pay (450.00 - 22.28 - 7.69 - 76.50). The amounts withheld from Joe will be paid to the government by Joe's employer, which is you. Let’s record that into the expanded accounting equation with account names. Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable EIT Payable Wages Expense May-17 -343.53 22.28 7.69 76.50 450.00 Your employee, Joe, received his net pay, $343.53, but you now owe $106.47 (22.28 + 7.69 + 76.50) to the government. Add the two together (what you paid Joe and what you WILL pay the government in the future) and you get $450, the same as the Wages Expense. So employees are the only ones who fund government services? Well, no, that's not true. When employers hire employees they also have to pay into the Canada Pension Plan and Employment Insurance on behalf of their employees. Employers have to match the CPP amount and pay 1.4 times the EI contribution. That means that you, 29 | P a g e
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as Joe's employer, withhold the CPP amount of $22.28 from Joe but you would also have to record the same amount owed to the government by your business. The CPP Payable would therefore be $22.28 * 2 = $44.56. Half would come from the employee, Joe, and half from the employer, you. In addition, as Joe's employer, you would have to pay 1.4 times the EI amount paid by Joe: $7.69 + (7.69 * 1.4) = $18.46. Joe would pay $7.69 and you, as his employer, would pay $10.77. Basically there are employee contributions (Joe paid 22.28 + 7.69) and employer contributions (you, the employer, will pay $22.28 + (1.4 * 7.69) to both CPP and EI. Let’s add what you owe for CPP and EI to the chart. Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable Employee Income Tax Payable Wages Expense Employee Benefits Expense May-17 -343.53 22.28 7.69 76.50 450.00 May-17 22.28 10.77 33.05 Balance -343.53 44.56 18.46 76.50 0.00 0.00 450.00 33.05 Before you owed only $106.47 to the government on behalf of Joe but now you owe $139.52 (44.56 + 18.46 + 76.50). You have a wages expense of $450 but you have an Employee Benefits Expense of $33.05. Why does the employer have to pay for CPP and EI? Employers have to pay those amounts because they are responsible for helping employees plan for the future: the pension (CPP) they will collect when they retire and employment insurance (EI) benefits the employee will receive if they lose their job. 30 | P a g e
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What does that mean for employers? It means that hiring employees is expensive, both because of the salary you have to pay them and because of the employee benefits you have to pay on their behalf. So why would anyone hire employees? Because you can't do all the work yourself if you want to expand. You expand to generate more profit and you can't earn profit without incurring expenses. Let’s fast forward to the end of the month. You, the employer, has to pay the amount you owe to the government. You will pay the total amount owed to the government: CPP, EI, and EIT, a total of $139.52. Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable Employee Income Tax Payable Wages Expense Employee Benefits Expense May-17 -343.53 22.28 7.69 76.50 450.00 May-17 0 22.28 10.77 0 0 33.05 Balance -343.53 44.56 18.46 76.50 450.00 33.05 May-30 -139.52 -44.56 -18.46 -76.50 0 0 Balance -483.05 0.00 0.00 0.00 0.00 0.00 450.00 33.05 Notice that you paid Joe a gross pay of $450 but you ended up paying $483.05 in total, $450 for Joe and $33.05 for employee benefits. Hiring employees is necessary for growth and expansion but new businesses have to understand the total cost of hiring those employees. What about another example? Let’s do another example just to be sure you understand the issue of salaries and amounts withheld at source. Andersen Ltd. gross pay is $10,000. The employee portion of CPP is $495 and of EI is $175. EIT is $2,330. Andersen Ltd. pays its employees on September 20 and pays the government the amount owed on October 8. Record both entries. 31 | P a g e
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Always record the employees’ salary first. Andersen used the services of its employees so it records Salary Expense of $10,000. It withholds CPP, EI, and EIT from its employees’ pay cheques, a total of $3,000 (495 + 175 + 2,330) which it owes to the government. Andersen will set up CPP Payable for $495, EI Payable for $175 and Employee Income Taxes Payable for $2,330. The employees will get their net pay, $7,000, in cash. This is calculated by taking the gross pay and subtracting the CPP, EI and income taxes (10,000 – 495 – 175 - 2,330). 32 | P a g e
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Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable Employee Income Tax Payable Salary Expense Employee Benefits Expense Sept 20 -7,000 495 175 2,330 10,000 On the same date Andersen has to record the employee benefits it owes to the government. The business owes CPP and EI so it must record a liability equal to the amount it owes. Remember that CPP owed by Andersen is equal to the CPP owed by the employee but the EI amount owed by Andersen is equal to 1.4 times the employee’s amount. We must set up an additional CPP Payable for $495 and EI Payable for $245 (1.4 x $175). Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable Employee Income Tax Payable Salary Expense Employee Benefits Expense Sept 20 -7,000 495 175 2,330 10,000 Sept 20 0 495 245 0 0 740 Balance -7,000 990 420 2,330 10,000 740 On October 8 Andersen pays the government the amount owed, a total of $3,740 (990 + 420 + 2,330). Of that amount $740 comes from the employer, Andersen, and the remainder comes from the money withheld from the employees, $3,000. 33 | P a g e
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Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable Employee Income Tax Payable Salary Expense Employee Benefits Expense Sept 20 -7,000 495 175 2,330 10,000 Sept 20 0 495 245 0 0 740 Balance -7,000 990 420 2,330 10,000 740 Oct 8 -3,740 -990 -420 -2,330 0 0 Balance -10,740 0 0 0 10,000 740 As you can see from the chart, the amount paid out by Andersen is a combination of the salary for the employee ($10,000 gross pay) and the employee benefits Andersen owes the government in support of their employee’s future. Check your understanding (CYU9-5) Vassello Inc. pays its employees every two weeks on a Friday. The employees’ gross pay is $3,200. The employee portion of CPP is $158 and of EI is $55. Income taxes are $746. Vassello Ltd. pays its employees on August 21 and pays the government the amount owed to the CRA on September 6. Record all the entries related to salary in the expanded accounting equation below. Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable Employee Income Tax Payable Salary Expense Employee Benefits Expense 34 | P a g e
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What about HST? HST stands for harmonized sales tax and it is charged on most goods and services sold in Ontario. So far in this textbook, in the examples used, businesses have not charged their customers HST. However, when you bought something, such as office supplies, you PAID HST and it became a part of the cost of the asset. That is because this textbook assumes that the businesses were "small suppliers". This means that, in our examples, the business never had revenues of more than $30,000 per year (remember that is revenue, not profit). When a business has revenues of less than $30,000 per year they don’t have to register for HST. This means they don’t charge their customers HST and they don't get an HST credit when they pay HST on the goods and services they buy for the business. What happens if a business has revenues greater than $30,000 in a year? In the month after the month that the business earned greater than $30,000, the business MUST register for HST. From that point forward (even if they make less than $30,000 in revenues the following year) the business has to charge their customers HST. Businesses that register for HST have to collect HST on all taxable goods and services they sell to their customers. They are required to have a HST registration number and must file special HST returns on a regular basis – monthly, quarterly, or annually. What about the HST they pay on their purchases? They get an "HST credit" (actually it’s called an ‘input tax credit’) for the amounts they pay on their purchases. What do they pay to the government? The difference between what they collected from their customer and the amounts they paid on their purchases. What about an example? Say a business has revenues of $120,000. HST is 13% in Ontario, so their customers would actually pay them $135,600 ($120,000 + (120,000 * 13%)). That means that the business owes the government $15,600 ($135,600 - $120,000). However, assume that, during this same period, the business BOUGHT goods and services worth $58,000. That means they actually paid their suppliers $65,540 ($58,000 + (58,000 * 13%)). The business has paid $7,540 in HST ($65,540 - $58,000). How much do they owe the government? They owe them the difference: $8,060 ($15,600 - $7,540). This amount would be recorded as HST Payable , a liability that would be remitted (paid) to the government in the future. If the business paid out more HST then they collected 35 | P a g e
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from their customer it would be recorded as an HST Receivable , an asset that they would receive from the government in the future. Businesses generally have an HST Payable at the end of every period which they must remit to the government at a future date. Businesses that file monthly HST returns have 30 days to pay. How do you register for an HST account? You can register online at http://www.cra-arc.gc.ca . Check your understanding (CYU9-6) You start a snow shoveling/lawn mowing business. During your first year you generated $20,000 in revenue. Do you need to charge your customer HST? Why or why not? How are liabilities presented on the financial statements? As noted in Chapter 4, liabilities are divided between current (due in the upcoming 12 months) and long-term liabilities (due after 1 year) on the balance sheet. They are shown in order of when they are due. Under current liabilities, Accounts Payable is always listed FIRST, followed by all the other current liabilities. If there is no information about when the other current liabilities are due then their order can be random, as long as accounts payable is listed first. For long term liabilities the order is again based on when they are due. For instance, if you have two loans, one due in 2 years and one due in 10 years, the one due in 2 years would always be listed first. An example of the liabilities section of the balance sheet is provided below. Check back to Chapter 4 for more detailed information about the structure of the balance sheet. 36 | P a g e
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Liabilties Current liabilities Accounts payable 216 Unearned revenue 950 Income tax payable 1,300 CPP payable 40 EI payable 14 EIT payable 186 Interest payable 50 Total current liabilities 2,756 Long term liabilities Note payable, due in Year 2 2,500 Loan payable, due in Year 7 4,750 Total liabilities 7,250 Greene Company Balance Sheet (Partial) At December 31, Year 1 On the income statement, if it is a single step, all of the expenses, including employee benefits and interest expense, are listed together. If your business uses a multiple step income statement employee benefits would be included in operating expenses but the interest expense would be included under Other Revenues and Expenses. For the structure of the income statement, check back to Chapter 4 (single step) and Chapter 5 (multiple step). A partial balance sheet (liabilities only) is provided below. There is one error on the balance sheet above. Did you catch it? We’ll tell you what it is at the bottom of the next page. Putting it all together! A business’s liabilities are an important element that stakeholders have to consider when making decisions about a business. Liabilities must be paid as they come due and, if businesses don’t have the necessary cash to pay off their debts, they often end up in financial difficulty. In addition, if a business wants to expand it will have to borrow money from creditors. Being allowed to borrow money is only possible if the business has the ability to pay interest on its debts and, eventually, pay off the principal portion. If businesses don’t understand what liabilities they have and when they are due they can 37 | P a g e
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quickly reach a point where they are unable to make the necessary payments. Liabilities are therefore an important consideration for every business. Going forward! You have finished analyzing assets and liabilities, the two main elements on the balance sheet. Although equity is also present on the balance sheet you already know what makes up equity: the contributions owners make to the business and retained earnings. You now know about the individual accounts for each element and how important that knowledge is for business decision making. You also know that the details about individual accounts can lead to even better decision making. What, then, is left to learn? Business owners must be able to put it all together: look at their financial statements over time and use that information to make decisions about the future. In the next, and final, chapter you will be analyzing the financial statements as a whole. By looking at the financial statements over time (called comparative financial statements) business owners can better understand how their business has done in the past and how to use this information to determine what to do in the future. What’s the error on the balance sheet on the previous page? Did you notice that the year-end date is December 31, Year 1? The first note payable is due in Year 2 – so it should be a current liability, not long term! This was on a final exam not so long ago, and a lot of students missed it. Be careful and mind the details! 38 | P a g e
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What do I need to know for the final exam? A. Define the element liabilities and provide examples of common liability accounts. B. Define the account Accounts Payable. When is it used? Provide examples from past chapters. C. Provide all the entries necessary to demonstrate your understanding of how to use the Accounts Payable account. D. Define the account Deferred revenue. When is it used? Why is it a liability? E. Provide all the necessary entries to demonstrate your understanding of how to use the Deferred revenue account. F. Define an operating line of credit and compare it to a traditional bank loan. What is the same and what is different? G. Record all the entries required when borrowing money from a creditor (such as a Note Payable). H. Demonstrate how interest is calculated. Record the interest payments made on the loan as well as the amounts that must be accrued. I. Explain why incomes taxes payable is a liability account. What is it used for? J. Demonstrate your understanding of the entries made to the income tax payable account. When are they made and why? K. Why is the hiring and paying of employees important for any business to understand? L. Define CPP, EI, and EIT. M. Record the appropriate entries related to paying your employees, including the amounts withheld at source. N. What are employee benefits? Who pays them and why? What entries must be recorded? O. What is HST? When do businesses have to register their business for an HST number? What is HST Payable and when would a business record HST Receivable? P. How are liabilities presented on the balance sheet? How is interest expense presented on the income statement? Watch out for .... Remember that CPP withheld is matched but EI withheld is multiplied by 1.4 – not the other way around. Also - students often struggle with the issue of interest on loans. They forget that interest rates are always annual rates and must be divided by 12, regardless of how long the loan is outstanding. In addition, they treat interest that is paid at the beginning of the month as interest for the upcoming month (paid in advance) rather than the month that just passed. Remember that interest is a factor of time and it is owed only AFTER the cash that was borrowed has been used. 39 | P a g e
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In Class Demo Questions ICDQ9-1 If a customer gives your business money for a service that will be performed or for a good that will be delivered, is this considered to be a liability? Explain why or why not. ICDQ9-2 Fashion Bags Inc. sells purses, wallets and bags. Some of the transactions the business had during the month of May are as follows: May 1 Purchased inventory for $1,400, terms 2/10, n/30, shipped FOB shipping point. May 1 The appropriate party paid freight costs of $80. May 1 Borrowed $20,000 from the bank to expand the business. The interest rate is 3%. The interest is paid at the beginning of every month. The maturity date of the loan is in 5 years. May 8 Paid the supplier for the inventory purchased on May 1. May 30 Accrue for any interest owing on the loan. June 1 Paid the bank for the May interest. Record both of those transactions into the expanded accounting equation using account names. NOTE: the account names have been provided for you but note that this will not happen for the final exam! 40 | P a g e
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Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Cash Inventory Accounts payable Note Payable Interest Payable Owner's capital Retained Earnings Sales Revenue Interest Expense May-01 May-01 May-01 May-08 May-30 Jun-01 Total ICDQ9-3 On September 1 Rowe Inc. borrowed $18,000 from the bank. The bank charges 5% interest. The loan must be repaid in 1 year. The company has a December 31 year end. Record all the required entries related to the loan into the expanded accounting equation using account names. NOTE: the account names have been provided for you but note that this will not happen for the final exam! 41 | P a g e
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ICDQ9-3, continued Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Cash Accounts payable Note Payable Interest Payable Owner's capital Retained Earnings Sales Revenue Interest Expense Sep-01 Oct-01 Nov-01 Dec-01 Dec-31 Balance Jan-01 Total ICDQ9-4 Reese Ltd. is a new business. Recently the owner hired an employee. The following transactions with regards to the employee occurred in May and June: April 1 Hired Lisa Ali. She starts on Monday, April 11. April 24 Paid Lisa. For the last 2 weeks Lisa has worked 7.5 hours per day 5 days a week, Monday to Friday. She is paid $20 per hour. The following amounts were withheld at source: CPP of $28, EI of $10, and EIT of $292. April 24 Reese Ltd. records the appropriate amount of employee benefits. May 9 The business paid the amounts they owed the government. 42 | P a g e
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43 | P a g e
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ICDQ9-4, continued Record all the necessary transactions into the expanded accounting equation using account names. NOTE: the account names have been provided for you but note that this will not happen for the final exam! Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable EIT Payable Salary Expense Employee Benefits Expense ICDQ9-5 Daryl’s LawnCare Inc. provides lawn services in the Scarborough area. On June 1, Daryl agreed to provide lawn care for Sue Yee’s property for the next 3 months. Daryl charged her $200 per month. On June 5 Sue Yee paid Daryl $600. On June 15 and June 30 Daryl provided lawn care services. Using the critical and enhancing questions analyze each of the dates provided above. 44 | P a g e
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Additional space is provided on the next page. ICDQ9-5, continued Record all the necessary transactions into the expanded accounting equation using account names. NOTE: the account names have been provided for you but note that this will not happen for the final exam! Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses 45 | P a g e
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Cash Supplies Accounts payable Deferred revenue Owner's capital Retained Earnings Service Revenue 46 | P a g e
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ICDQ9-6 WebDEZine Inc. is a website design business that you run out of your home. You pay your business income taxes to the government every quarter, on the 14 th of the month, starting April 14 th . The income tax installment is based on the prior quarter’s income before income tax. This year, your 1 st quarter revenues and expenses are provided below: Month Revenue Expenses January $16,487 $8,351 February $18,597 $9,945 March $22,662 $14,258 WebDEZine has a 25% tax rate. They accrue their income taxes at the end of every month and pay them all on the 14 th of April. Record all the necessary transactions into the expanded accounting equation using account names. NOTE: the account names have been provided for you but note that this will not happen for the final exam! Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Supplies Accounts payable Income Taxes Payable Owner's capital Retained Earnings Service Revenue Income Tax Expense 47 | P a g e
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ICDQ9-7 You start a snow shoveling/lawn mowing business. During your first year you generated $27,800 in revenue. Do you need to charge your customers HST? Why or why not? ICDQ9-8 The following is a comprehensive question that tests your knowledge from not only this chapter but from prior chapters also. You run a merchandising business and this is your 2nd year of operations. A few of the transactions for the year are provided below. 1. Your purchase 100 units of inventory from a supplier for $20 each, 2/10, n/30, FOB destination. 48 | P a g e
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2. You purchase a computer on account, n/45, for $1,500, plus HST. It has an estimated useful life of 5 years and no residual value. 3. A customer has ordered a special product and provided a down payment of $500 cash. 4. You pay for your purchase in Transaction 1 within the discount period. 5. You borrow $20,000 from the bank at an interest rate of 3% for 2 years. 6. Your accountant tells you that you owe Revenue Canada $6,000 on the income from the business. You have not paid any income taxes yet. 7. You pay the interest on your loan, which is due today. 8. You pay off your outstanding accounts payable. 9. You have decided that there is too much work for one person and you hire an employee at $12 per hour. They have worked for you for 37.5 hours every week for the last 2 weeks and you pay them. You determine that CPP is $44, EI is 15, and EIT is $210. 10. You provide the special product to your customer (see transaction 3). The product has a cost of $220. ICDQ9-8, continued 11. You are at year end and you accrue the interest that will be payable at the start of the next month. 12. Your record 4 months of depreciation on the computer as you bought it 4 months ago. Record all the necessary transactions into the expanded accounting equation using account names. NOTE: the account names have been provided for you but note that this will not happen for the final exam! NOTE: the chart has been split into 3 parts, Assets, Liabilities, and Equity, because it is too large for 1 page. 49 | P a g e
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Assets Cash Inventory Equipment Accumulated Depreciation Trans. 1 Trans. 2 Trans. 3 Trans. 4 Trans. 5 Trans. 6 Trans. 7 Trans. 8 Trans. 9 Trans. 10 Trans. 11 Trans. 12 Total 50 | P a g e
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Liabilities Accounts payable Interest payable CPP Payable EI Payable EIT Payable Income tax payable Deferred revenue Notes payable Trans. 1 Trans. 2 Trans. 3 Trans. 4 Trans. 5 Trans. 6 Trans. 7 Trans. 8 Trans. 9 Trans. 10 Trans. 11 Trans. 12 Total 51 | P a g e
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Equity Owner's Capital Retained Earnings Profit Revenue Expenses Owner's Capital Retained Earnings Sales revenue Cost of goods sold Depreciation expense Interest expense Salary expense Employee Benefits Expense Trans. 1 Trans. 2 Trans. 3 Trans. 4 Trans. 5 Trans. 6 Trans. 7 Trans. 8 Trans. 9 Trans. 10 Trans. 11 Trans. 12 Total 52 | P a g e
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Practice Questions PQ9-1 Holden Inc. receives an advance payment of $1,600 from a customer for services to be performed next year. You, the accountant, record an increase in Cash and an increase in Service Revenue in the current year. Name the qualitative characteristic that you think applies and indicate if the qualitative characteristic has been VIOLATED (not followed) or FOLLOWED. Be sure to explain WHY you think that is true! PQ9-2 In order to meet their objectives, stakeholders have questions they need answered. Which stakeholder would most likely have the question "Does the business have existing loans? If so, what is the total value of the existing loans and when are they due?" Why would this stakeholder be interested in this information? 53 | P a g e
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PQ9-3 Holden Inc. receives an advance payment of $1,600 from a customer for services to be performed next year. In addition, Holden Inc. takes out a 9 month, 5% loan for $24,000 on November 1, which was appropriately recorded. Interest is paid at the beginning of every month. The business's yearend is December 31. The balances in the accounting equation, before the above transactions were recorded, are as follows: Assets are $128,452 and Equity are $43,670. What was the ending accounting equation at December 31, after all transactions are properly recorded? Assets Liabilities Equity Calculations: 54 | P a g e
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PQ9-4 Ankita Ltd. had the following transactions during the month of July. Date Transaction description Amount July 1 You have the following opening balances: Cash, $15,400; Accounts Receivable, $2,800; Inventory, $3,840; Accounts payable, $1,280; Owners' capital, $15,000; Retained earnings, $5,760 July 1 The customer who had the $2,800 outstanding accounts receivable balance pays within the discount period. The credit terms are 1/15, n/30. ?? July 1 Purchased a 1 year insurance policy for cash. $1,800 plus 8% sales tax July 3 Purchased 12 chairs for inventory from TAM Wholesale, credit terms 3/10, n/30, shipping terms FOB destination. $4,620 July 4 The appropriate party paid freight costs. $240 July 5 Purchased office supplies using a business credit card. $300 plus HST July 6 Pay off the outstanding A/P balance from last year. You are beyond the discount period on these older purchases. ?? July 7 Returned 2 chairs purchased from TAM Wholesale because they were damaged in transit, shipping them back FOB shipping point. $720 July 9 The appropriate party paid freight costs. $90 July 12 Paid TAM Wholesale for the goods purchased. ?? July 18 Purchased side tables from Wood Wholesale, credit terms 2/15, n/35, shipping terms FOB shipping point. $750 July 19 The appropriate party paid freight costs. $95 July 23 Paid the outstanding balance on the business credit card for the purchase of office supplies. ?? July 28 Paid Wood Wholesale. ?? July 31 Determined the amount of supplies that were remaining at the end of the month. $115 July 31 Recorded the use of insurance coverage for the month. ?? Required: Record the transactions into the expanded accounting equation using account names. The charts are provided on the next three pages, as a single chart is too big to fit on one page. Additional questions follow the chart. 55 | P a g e
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Assets Cash Total 56 | P a g e
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Liabilities Total 57 | P a g e
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Equity Owner's Capital Retained Earnings Profit Revenue Expenses Owner's Capital Retained Earnings Total 58 | P a g e
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59 | P a g e
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PQ9-4, continued Explain why Ankita Ltd. shipped the return chairs on July 7 using FOB shipping point instead of FOB destination. Why did this make sense? If Ankita Ltd. did not make the entries on July 31 what qualitative characteristic would they violate? Explain why you think that qualitative characteristic applies. Ankita Ltd. has monthly sales of approximately $15,000. It is in its 4th year of operations. Does Ankita charge their customers HST on the sale of chairs? Support your answer with reasoning. 60 | P a g e
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PQ9-5 You run Zoomba aerobics class, Get Fit with Zoomba. As a holiday special you offer your customers a coupon book: 20 classes for $10 each, a total cost of $200. This is a $100 savings on your usual charge of $15 per class. Customers must pay in advance and they can attend one class per day, weekdays only, any time over the next year. You sell 14 coupon books on November 30, collecting cash from your customers. By December 31 customers have used 84 coupons. Record the transactions into the expanded accounting equation using account names. Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash PQ9-6 You own a jewelry supply business, supplying retail stores in and around Toronto. You plan to expand and, in order to do so, you require a computer system that will scan the bar codes of all products coming in and being shipped out. You borrow $20,000 from the bank on October 1, at an interest rate of 4.5%. The loan is due in 18 months and you pay interest on the first day of every month. Using that borrowed cash you purchase a computer system, including scanners, for $22,000, on November 1. The equipment is estimated to last 10 years with $1,000 residual value. On the 1st day of every month you pay the interest to the bank. Your yearend is December 31. Provide all the entries, from October 1 to December 31, with regards to the loan and the computer. The chart is on the next page. 61 | P a g e
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PQ9-6, continued Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash 62 | P a g e
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PQ9-7 T-shirts 4U is a t-shirt supply company. At November 30 they had revenues of $28,200 and expenses of $15,400 for the month of November. They have a 25% tax rate. They accrue their income taxes at the end of every month and pay them on the 12 th of the following month (December 12 in this case). Record the income tax entries for T-shirts4U for November 30 and December 12. Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash PQ9-8 You are the owner of Hallow Ltd., a new business you started on Sept. 1. You use the FIFO method for tracking your inventory and the perpetual inventory system. You had the following transactions for the past month. All of your purchases and sales are on account. Dec. 1, opening 100 units at $13 each. Dec. 4 Purchased 350 wallets at $12 each. Dec. 6 Sold 275 units to a customer $32 each. Dec. 10 Purchased 100 units at $11.50 each. Dec. 14 Sold 205 units for $30 each to a customer. Dec. 16 Purchased 260 units for $10.50 each. Dec. 22 Sold 170 units for $29 to a customer. 63 | P a g e
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PQ9-8, continued Considering what you see in the chart, above, are you a retailer or a wholesaler? Why do you think so? Calculate the cost of goods sold and the ending inventory, using a perpetual inventory system. NOTE: more rows have been provided than you require. For every entry into the inventory control system record the transaction into the expanded accounting equation using account names. NOTE: only the cash account has been provided for you. Date Purchases Cost of goods sold Inventory on hand Quantity Unit cost Total Cost Quantity Unit cost Total Cost Quantity Unit cost Total Cost Totals: The accounting equation is provided on the next page. 64 | P a g e
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PQ9-8, continued Owner's Capital Owner's Capital Retained Earnings(Deficit) Opening Total: Assets Liabilities Equity Retained Earnings Profit Revenue Expenses What do you note about the cost of your inventory? What may be causing this? What, if anything, can you, the owner of the company, do about it? 65 | P a g e
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PQ9-8, continued Over the course of the month what is happening to your gross profit and your gross profit ratio per unit of inventory sold? (Calculate your gross profit ratio for each sale before commenting. Include the gross profit ratio calculations in your answer.) PQ9-9 Geloso Inc. pays its employees every two weeks on a Friday. The employees’ gross pay is $1,600. The employee portion of CPP is $79 and of EI is $25. Income taxes are $373. The company pays its employees on August 21 and pays the government the amount owed to the CRA on September 6. Record all the entries related to salary in the expanded accounting equation using account names. Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash - 16040 - 17400 66 | P a g e
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PQ9-10 On December 31, Year 3, Hickle Inc. has profit of $236,000, accounts receivable of $167,500, and an allowance for doubtful accounts of $-17,360. Net credit sales were $947,000 during the year. None of the following has been reflected in the accounting records of the business : Write-off of accounts receivable that are determined to be uncollectable. $22,500 Customers who were previously written off sent in a cheque. $6,500 Hickle estimates that 12% of its ending accounts receivable will be uncollectable in the upcoming year. ?? Record the above noted transactions into the expanded accounting equation using account names and answer the questions which follow. Assets Liabilities Equity Owner's Capital Retained Earnings Profit Revenue Expense Cash Owner's Capital Retained Earnings Opening balances Totals: Calculations: 67 | P a g e
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PQ9-10, continued If you calculate the outstanding accounts receivable as a percentage of net sales that were made on credit, what percentage of credit sales has not, as yet, been collected? Calculation: Assume the percentage you calculated in the past two years was 12.3% in Year 2 (last year) and 11.6% in Year 1 (two years ago). Would this concern you? Why or why not? The balance sheet of Hickle Inc. would show: What would be the profit for Hickle Inc. after the entries have all been made? Show your calculations. 68 | P a g e
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PQ9-11 You start a painting business. During your first year you generated $15,000 in revenue. Do you need to charge your customer HST? Why or why not? PQ9-12 You purchase equipment on May 1, Year 1, for $123,500. You estimate that the equipment will be used for 4 years and the residual value will be $3,500. Your year end is December 31. What will be the depreciation expense, accumulated depreciation, and the book value at each yearend? Be sure to complete the Year ended dates yourself. Year ended Depreciation expense Accumulated depreciation Book value Calculations: 69 | P a g e
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PQ9-12, continued Record the depreciation expense for December 31, Year 1 and December 31, Year 2. Year 1: Year 1 Asset Liabilities Equity Owners' Capital Retained Earnings Profit Revenue Expense Cash Balance Year 2: Year 2 Asset Liabilities Equity Owners' Capital Retained Earnings Profit Revenue Expense Cash Balance Continued on the next page. 70 | P a g e
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PQ9-12, continued Show the balance sheet presentation for the December 31, Year 2. Assume that, INSTEAD of keeping the equipment for its entire life, you sell the equipment on October 31, Year 4, for $27,000. Complete the chart. Year ended Depreciation expense Accumulated depreciation Book value Record all the entries you would make in Year 4. The chart is on the next page. 71 | P a g e
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PQ9-12, continued. Year 4 Asset Liabilities Equity Owners' Capital Retained Earnings Profit Revenue Expense Cash Balance PQ9-13 East York Art Gallery has 3 salaried employees who are paid bi-weekly, every 2nd Saturday. There are 3 full time employees working 7.5 hours each per day from Tuesday to Saturday. The gallery is closed on Sundays and Mondays. All of the employees are paid $15 per hour. On Saturday, September 24 the employees were paid for the period from Tuesday, September 13 to Saturday, September 24, the previous two weeks that they worked. The employee portion of CPP is $125 and of EI is $85. Income taxes are $675. On September 30th the company accrues for any wages owed. The employee portion of the CPP is $50, EI is $40 and income taxes are $270. The company pays their employees on Saturday October 8 th . CPP is $75 and of EI is $35. Income taxes are $506. The company pays the government the amounts owed to the CRA on October 11th. Record all the entries related to salary in the expanded accounting equation using account names. The chart is on the next page. 72 | P a g e
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PQ9-13, continued Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash PQ9-14 You decide to start your own import business. You buy goods from China and India and sell the goods to local stores in the Toronto area. In order to get your business up and running on October 14th you write a business plan and apply to your local credit union to borrow $24,000. You use your car as collateral. Your credit union likes your business plan, and advances you the money on November 1 st . The credit union offers you a 3.5 percent interest rate based on your past credit history and the current interest rate. The loan agreement requires that you make interest payments at the beginning of every month and that you repay the loan in full in 2 years. i. Record the transactions required into the expanded accounting equation using account names for the year. The chart is on the next page. 73 | P a g e
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PQ9-14, continued Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Why does the credit union require collateral for the loan? 74 | P a g e
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Blast From The Past - SOLUTION The solution to this question will not be provided. This question has been merged into the In Class Demo Questions and the concepts will be taken up in class. 75 | P a g e
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Check Your Understanding - SOLUTIONS CYU9-1 June 1: 400 x 1.13 = 452 June 22: 8,350 * 98% = 8,183 cash paid Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Inventory Supplies Accounts Payable Owner's capital Retained Earnings Sales Cost of Goods Sold Supplies Expense June 1 452 452 June 12 8,350 8,350 June 22 -8,183 -167 -8,350 June 30 -452 -452 June 30 -202 202 76 | P a g e
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CYU9-2 Sold: 8 * $300 each = $2,400 (for 8 * 30 walks = 240 walks in total) Earned by December 31: 80 walks / 240 walks * $2,400 = $800 revenue earned as you did your job. The remainder, $1,600, is services owed to the customers in the remaining 5 months. Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Supplies Accounts payable Deferred revenue Owner's capital Retained Earnings Service Revenue Nov. 30 +2,400 +2,400 Dec. 31 0 -800 +800 Total +2,400 +1,600 +800 CYU9-3 Interest expense: 36,000 * 5% per year = 1,800 Monthly interest expense: 1,800 / 12 months = 150 Depreciation: 35,000 / 10 years = 3,500 / year Purchase date: October 1 Use in year of purchase: 3 months Depreciation expense in year of purchase: 3,500 / 12 * 3 months = 875 Depreciation does not have to be recorded every month. Once at the end of the year, for that year’s total depreciation, is sufficient. 77 | P a g e
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Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Equipment Acc. Depr. Accounts payable Loan Payable Interest Payable Owner's capital Retained Earnings Sales Revenue Depr. Expense Interest Expense Oct-01 36,000 36,000 Oct-01 -35,000 35,000 Oct-31 150 150 Nov-01 -150 -150 Nov-30 150 150 Dec-01 -150 -150 Dec-31 150 150 Dec-31 -875 875 Balance 700 35,000 -875 36,000 150 875 450 Jan-01 -150 -150 Total 550 35,000 0 36,000 0 CYU9-4 Revenues – Expense = Income before income tax: 65,400 – 54,000 = 11,400 Income tax expense = 25% of income before income tax: 11,400 * 25% = 2,850 Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Supplies Accounts payable Income Tax Payable Owner's capital Retained Earnings Service Revenue Income Tax Expense Nov- 30 2,850 2,850 Dec- 12 -2,850 -2,850 0 Total -2,850 0 2,850 The income tax expense is the amount that is reported on the income statement. CYU9-5 78 | P a g e
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Employee benefits: CPP is matched, so $316; EI is 1.4 times the employee’s EI, $55 * 1.4 = $77. Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable Employee Income Tax Payable Salary Expense Employee Benefits Expense Aug 21 -2,241 158 55 746 3,200 Aug 21 158 77 235 Balance -2,241 316 132 746 3,200 235 Sept 6 -1,194 -316 -132 -746 Balance 3,435 0 0 0 3,200 235 CYU9-6 You start a snow shoveling/lawn mowing business. During your first year you generated $20,000 in revenue. Do you need to charge your customers HST? Why or why not? Not unless you are already registered for HST! Businesses can CHOOSE to register for HST even if they don't have revenue greater than $30,000. If they have CHOSEN to register for HST they would have to charge HST on their sales, even if their revenues are less than $30,000. If the business has NOT CHOSEN to register for HST early then they do not have to charge their customers HST. Why not? Because they have not reached $30,000 of revenues at this time. In the month after they reach revenues of $30,000 the business will have to register for HST and then start charging their customers HST. NOTE: from that point forward, regardless of their revenues, they will have to charge HST to their customers. 79 | P a g e
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Practice Questions - Solutions PQ9-1 Holden Inc. receives an advance payment of $1,600 from a customer for services to be performed next year. You, the accountant, record an increase in Cash and an increase in Service Revenue in the current year. Name the qualitative characteristic that you think applies and indicate if the qualitative characteristic has been VIOLATED (not followed) or FOLLOWED. Be sure to explain WHY you think that is true! - Violated the qualitative characteristic faithful as the records are not free of error - When you were paid in advance you have not completed the work so you can’t recognize the revenue - Instead you have an obligation to provide the goods or the service in the future which is a liability called deferred revenue PQ9-2 In order to meet their objectives, stakeholders have questions they need answered. Which stakeholder would most likely have the question "Does the business have existing loans? If so, what is the total value of the existing loans and when are they due?" Why would the stakeholder want this information? - Creditors (a bank for instance) would want this kind of information about existing debts - They would want to assess the business’s ability to pay existing loans and determine if the business is able to take on additional debt - They would also want to determine if the business can make the interest payments 80 | P a g e
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PQ9-3 Holden Inc. receives an advance payment of $1,600 from a customer for services to be performed next year. In addition, the company takes out a 9 month 5% loan for $24,000 on November 1, which was appropriately recorded. Interest is paid at the beginning of every month. The business's year-end is December 31. The balances in the accounting equation, before the above transactions were recorded, are as follows: Assets = $128,452 and Equity = $43,670. What was the ending accounting equation at December 31, after all transactions are properly recorded? Assets Liabilities Equity 153,952 110,482 43,470 Calculations: A =L + E Opening 128,452 84,782 43,670 1. + 1,600 + 1,600 2. + 24,000 +24,000 3. Nov 30 +100 -100* 4. Dec 1 -100 -100 5. Dec 31 +100 -100 153,952 110,482 43,470 *24,000 x 0.05 x 1/12 = 100 per month 81 | P a g e
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PQ9-4 Ankita Ltd. had the following transactions during the month of July. Date Transaction description Amount July 1 You have the following opening balances: Cash, $15,400; Accounts Receivable, $2,800; Inventory, $3,840; Accounts payable, $1,280; Owners' capital, $15,000; Retained earnings, $5,760 July 1 The customer who had the $2,800 outstanding accounts receivable balance pays within the discount period. The credit terms are 1/15, n/30. ?? July 1 Purchased a 1 year insurance policy for cash. $1,800 plus 8% sales tax July 3 Purchased 12 chairs for inventory from TAM Wholesale, credit terms 3/10, n/30, shipping terms FOB destination. $4,620 July 4 The appropriate party paid freight costs. $240 July 5 Purchased office supplies using a business credit card. $300 plus HST July 6 Pay off the outstanding A/P balance from last year. You are beyond the discount period on these older purchases. ?? July 7 Returned 2 chairs purchased from TAM Wholesale because they were damaged in transit, shipping them back FOB shipping point. $720 July 9 The appropriate party paid freight costs. $90 July 12 Paid TAM Wholesale for the goods purchased. ?? July 18 Purchased side tables from Wood Wholesale, credit terms 2/15, n/35, shipping terms FOB shipping point. $750 July 19 The appropriate party paid freight costs. $95 July 23 Paid the outstanding balance on the business credit card for the purchase of office supplies. ?? July 28 Paid Wood Wholesale. ?? July 31 Determined the amount of supplies that were remaining at the end of the month. $115 July 31 Recorded the use of insurance coverage for the month. ?? Required: Record the transactions into the expanded accounting equation using account names. The charts are available on the next three pages, as a single chart is too big to fit on one page. Additional questions follow the chart. 82 | P a g e
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Assets Cash Accounts Receivable Inventory Prepaid Insurance Office Supplies July 1 15,400 2,800 3,840 July 1 2,772 -2,800 July 1 -1,944 1,944 July 3 4,620 July 4 No entry July 5 339 July 6 -1,280 July 7 -720 July 9 No entry July 12 -3,783 -117 July 18 750 July 19 -95 95 July 23 -339 July 28 -735 -15 July 31 -224 July 31 -162 Total 9,996 0 8,453 1,782 115 83 | P a g e
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Liabilities Accounts Payable July 1 1,280 July 1 July 1 July 3 4,620 July 4 July 5 339 July 6 -1,280 July 7 -720 July 9 July 12 -3,900 July 18 750 July 19 -339 July 23 July 28 -750 July 31 July 31 Total 0 84 | P a g e
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Equity Owner's Capital Retained Earnings Profit Revenue Expenses Owner's Capital Retained Earnings Sales Discounts Supplies Expense Insurance Expense July 1 15,000 5,760 July 1 -28 July 1 July 3 July 4 July 5 July 6 July 7 July 9 July 12 July 18 July 19 July 23 July 28 July 31 224 July 31 162 Total 15,000 5,760 -28 224 162 85 | P a g e
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PQ9-4, continued Explain why Ankita Ltd. shipped the return chairs on July 7 using FOB shipping point instead of FOB destination. Why did this make sense? The original order on July 7 was FOB destination point. That means that TAM wholesaler the seller owned the inventory and was responsible for it while it was in transit. When 2 of the chairs were damaged in transit it was TAM wholesaler’s problem. Ankita Ltd. should not be required to pay for the returned inventory that they were not responsible for. Therefore it makes sense that Ankita Ltd. ships the damaged goods back FOB shipping point, making TAM wholesaler responsible for the returned shipping costs. If Ankita Ltd. did not make the entries on July 31 what qualitative characteristic would they violate? Explain why you think that qualitative characteristic applies. Faithful as the financial statements would be wrong. (assets overstated, expenses understated, equity overstated as profit it too high) Ankita Ltd. has monthly sales of approximately $15,000. It is in its 4th year of operations. Does Ankita charge their customers HST on the sale of chairs? Support your answer with reasoning. 15,000 x 12 = $180,000 in revenue. Yes, Ankita would have to register for HST as soon as the company’s revenue is greater than $30,000 and then it would have to begin to charge its customers HST. 86 | P a g e
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PQ9-5 You run Zoomba aerobics class, Get Fit with Zoomba. As a holiday special you offer your customers a coupon book: 20 classes for $10 each, a total cost of $200. This is a $100 savings on your usual charge of $15 per class. Customers must pay in advance and they can attend one class per day, weekdays only, any ime over the next year. You sell 14 coupon books on November 30, collecting cash from your customers. By December 31 customers have used 84 coupons. Record the transactions into the expanded accounting equation using account names. Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Deferred revenue Service Revenue Nov 30 2,800 2,800 * Dec 31 -840 ** 840 Total 2,800 1,960 840 *200 x 14 = 2,800, ** 10 x 84 coupons = 840 PQ9-6 You own a jewelry supply business, supplying retail stores in and around Toronto. You plan to expand and, in order to do so, you require a computer system that will scan the bar codes of all products coming in and being shipped out. You borrow $20,000 from the bank on October 1, at an interest rate of 4.5%. The loan is due in 18 months and you pay interest on the first day of every month. Using that borrowed cash you purchase a computer system, including scanners, for $22,000, on November 1. The equipment is estimated to last 10 years with $1,000 residual value. On the 1st day of every month you pay the interest to the bank. Your year end is December 31. Provide all the entries, from October 1 to December 31, with regards to the loan and the computer. 87 | P a g e
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The chart is on the next page. Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Computer Accum. Dep’n Bank Loan Interest Payable Interest Dep’n Oct 1 20,000 20,000 Oct 31 75 75 Nov 1 -75 -75 Nov 1 -22,000 22,000 Nov 30 75 75 Nov 30 -175 175 Dec 1 -75 -75 Dec 31 75 75 Dec 31 -175 175 88 | P a g e
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PQ9-7 T-shirts 4U is a t-shirt supply company. At November 30 they had revenues of $28,200 and expenses of $15,400 for the month of November. They have a 25% tax rate. They accrue their income taxes at the end of every month and pay them on the 12 th of the following month (December 12 in this case). Record the income tax entries for T-shirts4U for November 30 and December 12. Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Income tax payable Income tax expense Nov 30 3,200 3,200 Dec 12 -3,200 -3,200 Total -3,200 0 3,200 PQ9-8 You are the owner of Hallow Ltd., a new business you started on Sept. 1. You use the FIFO method for tracking your inventory and the perpetual inventory system. You had the following transactions for the past month. All of your purchases and sales are on account. Dec. 1, opening 100 units at $13 each. Dec. 4 Purchased 350 wallets at $12 each. Dec. 6 Sold 275 units to a customer $32 each. Dec. 10 Purchased 100 units at $11.50 each. Dec. 14 Sold 205 units for $30 each to a customer. Dec. 16 Purchased 260 units for $10.50 each. Dec. 22 Sold 170 units for $29 to a customer. 89 | P a g e
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Considering what you see in the chart, above, are you a retailer or a wholesaler? Why do you think so? Likely a wholesaler as we sell large quantities to customers. Calculate the cost of goods sold and the ending inventory, using a perpetual inventory system. NOTE: more rows have been provided than you require. For every entry into the inventory control system record the transaction into the expanded accounting equation using account names. NOTE: only the cash account has been provided for you. Date Purchases Cost of goods sold Inventory on hand Quantity Unit cost Total Cost Quantity Unit cost Total Cost Quantity Unit cost Total Cost Dec 1 100 13 1,300 Dec 4 350 12 4,200 100 13 5,500 350 12 Dec 6 100 13 3,400 175 12 175 12 2,100 Dec 10 100 11.50 1,150 175 12 3,250 100 11.50 Dec 14 175 12 2,445 30 11.50 70 11.50 805 Dec 16 260 10.50 2,730 70 11.50 3,535 260 10.50 Dec 22 70 11.50 1,855 100 10.50 160 10.50 1,680 Totals: 710 8,080 650 7,700 160 10.50 1,680 The accounting equation is provided on the next page. 90 | P a g e
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Date Assets Liabilities Equity Owner's Capital Retained earnings Profit Dividend s Revenue Expenses Cash Accounts Receivable Inventory Accounts Payable Sales Cost of Goods Sold Opening 1,300 Dec 4 4,200 4,200 Dec 6 8,800 8,800 Dec 6 -3,400 3,400 Dec 10 1,150 1,150 Dec 14 6,150 6,150 Dec 14 -2,445 2,445 Dec 16 2,730 2,730 Dec 22 4,930 4,930 Dec 22 -1,855 1,855 What do you note about the cost of your inventory? What may be causing this? What, if anything, can you, the owner of the company, do about it? - Change in the exchange rate - Reduction in the price by your supplier - A new supplier with cheaper products - Reduction in the shipping costs - Other answers as appropriate 91 | P a g e
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Over the course of the month what is happening to your gross profit and your gross profit ratio per unit of inventory sold? (Calculate your gross profit ratio for each sale before commenting. Include the gross profit ratio calculations in your answer.) 8,800 6,150 4,930 -3,400 -2,445 -1,855 5,400 3,705 3,075 5,400/8,800 = 61.36% 3,705/6,150 = 60.24% 3,075/4,930 = 62.37% Even though you were decreasing your selling price (from $32 to $29 per unit) the reduction in your COGS was more, resulting in a higher gross profit ratio. PQ9-9 Geloso Inc. pays its employees every two weeks on a Friday. The employees’ gross pay is $1,600. The employee portion of CPP is $79 and of EI is $25. Income taxes are $373. The company pays its employees on August 21 and pays the government the amount owed to the CRA on September 6. Record all the entries related to salary in the expanded accounting equation using account names. Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable EIT Payable Salary expense Employee Benefit Expense Aug 21 -1,123 79 25 373 1,600 Aug 21 79 35 114 Sept 6 -591 -158 -60 -373 Balance -1,714 0 0 0 1,600 114 92 | P a g e
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PQ9-10 On December 31, Year 3, Hickle Inc. has profit of $236,000, accounts receivable of $167,500, and an allowance for doubtful accounts of $-17,360. Net credit sales were $947,000 during the year. None of the following has been reflected in the accounting records of the business : Write-off of accounts receivable that are determined to be uncollectable. $22,500 Customers who were previously written off sent in a cheque. $6,500 Hickle estimates that 12% of its ending accounts receivable will be uncollectable in the upcoming year. Record the above noted transactions into the expanded accounting equation using account names and answer the questions which follow. Assets Liabilities Equity Owner's Capital Retained Earnings Profit Revenue Expense Cash Accounts Receivable Allowance for doubtful accounts Accounts payable Owner's Capital Retained Earnings Bad debt expense Opening balances 167,500 -17,360 947,000 1 -22,500 +22,500 2 +6,500 -6,500 +6,500 -6,500 3 -16,040 +16,040 Totals: n/a 145,000 -17,400 947,000 16,040 Calculations: -1,360 Have -16,040 Adjustment -17,400 Need (145,000x12%) 93 | P a g e
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PQ9-10, continued If you calculate the outstanding accounts receivable as a percentage of net sales that were made on credit, what percentage of credit sales has not, as yet, been collected? Calculation: 145,000/947,000 = 15.31% Assume the percentage you calculated in the past two years was 12.3% in Year 2 (last year) and 11.6% in Year 1 (two years ago). Would this concern you? Why or why not? Yes, this would concern me as the percentage has increased steadily over the last 3 years. The concern is the higher the accounts receivable balance and the slower we collect the cash the more likely it is that we will never be able to collect the outstanding A/R. The balance sheet of Hickle Inc. would show: Accounts receivable $145,000 Less AFDA (17,400) Net realizable value 127,600 What would be the profit for Hickle Inc. after the entries have all been made? Show your calculations. Before adjustments $236,000 Less bad debt expense 16,040 $219,960 Note that bad debt expense reduces the profitability of the business! It is the cost of selling on credit. 94 | P a g e
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PQ9-11 You start a painting business. During your first year you generated $15,000 in revenue. Do you need to charge your customer HST? Why or why not? No you don’t have to charge your customers HST because your revenue is less than $30,000. PQ9-12 You purchase equipment and have following information: Cost $123,500 Ready for use date May 1, Y ear 1 Estimated useful life 4 years Residual value (or salvage value) $3,500 Your year end is December 31. Do the following: Calculate the depreciable amount. $120,000 (123,500-3,500) Determine the annual depreciation. $30,000 (120,000/4 years) Determine the monthly depreciation. $2,500 (30,000/12 months) 95 | P a g e
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Complete the chart: Year ended Months Used Depreciation expense Accumulated depreciation Book value (cost – acc. depr.) 31-Year 1 8 20,000 20,000 103,500 31-Year 2 12 30,000 50,000 73,500 31-Year 3 12 30,000 80,000 43,500 31-Year 4 12 30,000 110,000 13,500 30-Year 5 4 10,000 120,000 3,500 Record the depreciation expense for December 31, Year 1 and December 31, Year 2. Year 1: Year 1 Asset Liabilities Equity Owners' Capital Retained Earnings Profit Revenue Expense Cash Equipment Accumulated Depreciation Depreciation Expense Balance 123,500 Dec 31 -20,000 20,000 Balance 123,500 -20,000 20,000 Year 2: Year 2 Asset Liabilities Equity Owners' Capital Retained Earnings Profit Revenue Expense Cash Equipment Accumulated Depreciation Depreciation Expense Balance 123,500 -20,000 0 Dec 31 -30,000 30,000 Balance 123,500 -50,000 30,000 Continued on the next page. 96 | P a g e
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Show the balance sheet presentation for the December 31, Year 2. Property, plant and equipment Equipment $123,500 Less accumulated depreciation (50,000) Net book value 73,500 Assume that, INSTEAD, you sold the equipment on October 31, Year 4, for $27,000. Complete the chart: Year ended M onths Used Depreciation expense Accumulated depreciation Book value (cost – acc. depr.) 31-Y ear 1 8 20,000 20,000 103,500 31-Y ear 2 1 2 30,000 50,000 73,500 31-Y ear 3 1 2 30,000 80,000 43,500 31-Y ear 4 1 0 25,000 105,000 18,500 Record all the entries you would make in Year 4. The chart is on the next page. 97 | P a g e
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PQ9-12 , continued. Year 4 Asset Liabilities Equity Owners' Capital Retained Earnings Profit Revenue Expense Cash Equipment Accumulated Depreciation Gain on disposal of equipment Depreciation Expense Balance 123,500 -80,000 0 Oct 31 -25,000 25,000 Balance 123,500 -105,000 Oct 31 +27,000 - 123,500 + 105,000 +8,500 Cost – accumulated depreciation = net book value 123,500 – 105,000 = 18,500 Selling price – net book value 27,000 – 18,500 = 8,500 gain PQ9-13 98 | P a g e
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East York Art Gallery has 3 salaried employees who are paid bi-weekly, every 2nd Saturday. The company has 3 full time employees who work 7.5 hours per day from Tuesday to Saturday. The gallery is closed on Sunday and Mondays. The employees are paid $15 per hour. On Saturday September 24 th the employees were paid for the previous two weeks that they worked. The employee portion of CPP is $125 and of EI is $85. Income taxes are $675. On September 30th the company accrues for any wages owed. The employee portion of the CPP is $50, EI is $40 and income taxes are $270. The company pays their employees on Saturday October 8 th . CPP is $75 and of EI is $35. Income taxes are $506. The company pays the government the amounts owed to the CRA on October 11th. Record all the entries related to salary in the expanded accounting equation using account names. Date Assets Liabilities Equity Owner's Capital Retained Earnings Revenue Expenses Cash CPP Payable EI Payable EIT Payable Wages/Salary Payable Salary expense Employee Benefit Expense Sept 24 -2,490 125 85 675 3,375* Sept 24 125 119 244 Sept 30 50 40 270 990 1,350* Sept 30 50 56 106 Oct 8 -2,399 75 35 506 -990 2,025*** Oct 8 75 49 124 Oct 11 -2,335 -500 -384 -1,451 *7.5 hours x 10 days x $15 per hour x 3 employees = $3,375 ** Draw a timeline (Tuesday Sept 27 to Friday September 30) equals 4 days 7.5 hours x 4 days x $15 per hour x 3 employees = $1,350 *** Draw a timeline (Saturday Oct 1 to Saturday October 8) equals 6 days (closed Sunday and Monday) 7.5 hours x 6 days x $15 per hour x 3 employees = $2,025 99 | P a g e
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PQ9-14 You decide to start your own import business. You buy goods from China and India and sell the goods to local stores in the Toronto area. In order to get your business up and running on October 14th you write a business plan and apply to your local credit union to borrow $24,000. You use your car as collateral. Your credit union likes your business plan, and advances you the money on November 1 st . The credit union offers you a 3.5 percent interest rate based on your past credit history and the current interest rate. The loan agreement requires that you make interest payments at the beginning of every month and that you repay the loan in full in 2 years. ii. Record the transactions required into the expanded accounting equation using account names for the year. Date Assets Liabilities Equity Owner's capital Retained earnings Profit Revenue Expenses Cash Loan Payable Interest Payable Interest expense Oct 14 No entry Nov 1 24,000 24,000 Nov 30 70 70 Dec 1 -70 -70 Dec 31 70 70 Total 23,930 24,000 70 70 24,000 x 0.035 x 1/12 = 70 Why does the credit union require collateral for the loan? In case the person who received the loan is unable to repay back the debt. The credit union can recover some of its loss resulting from the person defaulting on the loan. 100 | P a g e
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Author:John J Wild, Ken W. Shaw, Barbara Chiappetta Fundamental Accounting Principles
Publisher:McGraw-Hill Education
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