Accounting 2 Dersi 4. Ünite Özet

Introduction

In order to finance the acquisition of assets, companies have two types of financing options: debt financing and equity financing.

Debt financing is represented on “Liabilities” section whereas equity financing is represented on the “Equity” section of a balance sheet.

Liability is defined as the present obligation of a company arising from past events and fulfillment of which causes the outflow of economic benefits in terms of payments of cash, transfer of assets or rendering of services.

Liabilities have three main characteristics:

• They occur because of a past transaction or event.
• They create a present obligation for future payment of cash or services.
• They are an unavoidable obligation.

Depending on their maturities, liabilities can be split into two main categories as “ current liabilities (short term liabilities) ” and “ non-current liabilities (long term liabilities) ”.

Accounting for Current Liabilities

Liability is defined as the present obligation of a company arising from past events and

Current liabilities must be paid either with cash or with goods and services within one year or within the entity’s normal operating cycle if the operating cycle is longer than a year.

Operating cycle of a merchandising company begins with the purchase of merchandise inventory and ends when the cash from sales is collected from customers.

The current liabilities are obligations that will be paid out of current assets and are due within a short time, usually within one year.

Current liabilities represent the existing obligations whose fulfillment are expected to result in outflow of economic benefits in the following fiscal year.

Accounts Payable

Accounts payable arise from purchasing goods or services for use in a company’s operations. Amounts owed for goods or services purchased on account are accounts payable.

Accounts Payable are typically short term as credit terms are usually between 30 and 90 days.

Example: On May 1, Lakers Company, a retailer of sports equipment, purchased 200 pairs of basketball shoes at different sizes and models from BNA Corporation from 250 TL/shoe on account. The payment is due on July 1. Accounts payable occur on May 1 because Lakers Company receives the goods (shoes) before payment has been made. Lakers Company will pay this debt on July 1 because the due date is July 1. (See p. 92)

Notes Payable

In cases of purchases on credit or borrowings, companies may issue promissory notes as an arrangement to formalize the repayment of a certain amount of cash at a certain date to a third party. If it is expected to be paid in the following fiscal year, these promissory notes are recorded as notes payable in current liabilities section of balance sheet.

Example: Raptors Company had purchased inventories for 10,000 TL on account due June 15. However, on June 15, the company did not have enough cash to meet its obligations, so they requested a one-month extension in maturity, in exchange of 1,000 TL interest and issued onemonth promissory note. In this case, Raptors Company will have to pay 11,000 TL on July 15.

Company exchanged its payable with a new one in order to extend the maturity by paying an additional 1,000 TL just because of its insufficient funds. In other words, company settled its accounts payable by creating another liability with an additional interest. ( See p. 94)

Short-Term Bank Loans

Companies generally need short term financing in order to use in their normal operations and they borrow these funds from banks with short-term maturities. These borrowings from banks to be fully repaid in the same fiscal year is classified as Short-Term Bank Loans.

A very common form of short-term bank loans is the “line of credit ”. Companies can choose when to take out the funds, pay back and repeat again as long as they stick to the terms, such as payment on time and in full.

Example: On November 1, Mr. Blum, the owner of Blum Company, borrowed 100,000 TL from the bank with 12% interest rate and 10 months maturity. Both the interest and principal will be paid at the end of maturity. The payment at maturity includes interest expense, interest payable (interest remaining from previous period) and the principal amount. ( See pp. 95-96)

Current Portion of Long-Term Bank Loans

Companies may prefer long-term borrowings more than the short-term loans, depending on the amount of funds to borrow.

Long-term liabilities are often paid back in periodic payments, called installments. Long-term liability installments that are due within the coming year must be classified as a current liability as Current Portion of Long Term Loan.

Example: On 31 October 2018, Bulls Corporation borrowed 400,000 TL from Dollar Bank with 2 years maturity and 15% interest rate with semiannual payments. On the date of borrowing, Bulls Corp. should record the loan as long-term bank loans. When the balance sheet date comes, the amount to be paid in the following fiscal year is recorded as current portion of long-term loans. Then company calculates the accrued interest and adds the amount to long-term bank loan. (See pp. 96-97)

Accruals

When an expense incurs but is not paid yet, it should be recorded as accrued expense. In other words, accruals can be defined as liabilities for unpaid expenses.

Unearned Revenues

When the company receives an advanced payment, an obligation occurs for delivering the goods or rendering the service for which the customer has made payment. Therefore, company must record a liability in its financial statements and this liability is named unearned revenue.

Example: On December 25, to get prepared for the final exams, Mrs. Hardworking has agreed with Coursery Education to take private courses for 25 hours from 200 TL/hour and paid 5,000 TL in advance. Until the end of the year, Company has lectured 10 hours with Mrs. Hardworking and the last course is given as of January 10. In this case, the Coursery Company has to report a liability of 5,000 TL upon the collection of cash in advance, on December 25. ( See pp. 99-100)

Tax Payables

When a company reports positive income in the income statement, it becomes subject to taxation. The amount of tax that the company must remit to the government is determined by using the reported net income and income tax rate applied in the country.

In some countries, profitable companies are required to remit income tax installments to the government on a monthly or quarterly basis. For example, in Turkey, companies pay prepaid tax on their quarterly income, these payments are accumulated in an account named prepaid tax and at the end of the fiscal year, total prepaid amount is deducted from annual corporate income tax.

Tax authorities do not allow some expenses to be used as a deduction in taxable income. Thus, these expenses in general are called “non-deductible expenses”.

Value Added Tax (VAT)

Whenever a good or service is delivered, Value Added Tax (VAT) occurs. VAT is a kind of sales tax.

When the goods and services are delivered, the amount of tax is recorded as VAT received, and in cases of purchases, it is VAT paid account that the amount is recorded in.

At the end of each fiscal year, these two accounts on VAT are considered. If VAT received exceeds the VAT paid, this means the seller company has collected more than what it has already paid to government as VAT. Then at year-end, a liability account should be recorded: VAT Payable.

Company has to pay this amount to tax office. In opposite case, where VAT paid is more than VAT received, this means that the company has paid more tax. Then, it collected from customers on behalf of government. The excess amount is recorded in an asset account; VAT Deductible.

VAT received is the amount that the seller receives from customers in order to pay to government at year-end, whereas VAT paid is the amount paid to the government with the intermediary of suppliers.

VAT paid is not a part of product cost while VAT received is not a part of company’s revenue. They refer to payments to and collections on behalf of tax office respectively.

Payroll Accounting

The amount of salaries or wages before any deduction is called “gross pay” and the net amount of cash that the employers receive after all deductions are made is called “net (take-home) pay”.

There are two types of deductions from the gross pay:

1. Required (Mandatory) deductions, which are the withholdings, stated by laws and regulations, such as income taxes and social security premiums etc.
2. Optional (Voluntary) deductions, which the employees desire to pay additionally for special purposes, such as health insurance and pension plan payments etc.

“Salaries” are monthly payments to employees whereas “wages” are the payments to employees on an hourly basis.

Employers play an intermediary or tax collector role by law by collecting money from employees and passing it on to third parties.

Estimated Liabilities (Provisions)

Companies may present obligations that the amounts or timing (or both) are not certainly known. These obligations must be reported in the balance sheet as liability, at an amount dependent on managements’ best estimations. These kinds of liabilities are called estimated liabilities or provisions.

In order to inform the users on time, management may use estimations and assumptions. The use of estimates is an essential part of reporting and it does not undermine the reliability of financial reports. However, according to the recognition criteria, if the uncertainty in amount is so great that reliable measurement is not provided, then that item is not reported directly in financial statements and it is reported in footnotes to financial statements.

Example: Cavaliers Company produces and sells ledscreen TVs and provides customers the warranty to either repair or replace the product depending on the nature of defects detected. During the year 2018, company has sold 1,200 led-screen TVs. The past experiences show that, on average 5% of sold products are brought back to be repaired and another 3% to be replaced. The average cost of repairing the led-screen TVs was 3,000 TL and replacement costs were 10,000 TL on average.

Since the company provides warranty to repair or replace the defective TVs, at the end of each year it should estimate an amount to incur as warranty expense and a liability for it. (See pp. 105-106)

Contingent Liabilities

If the existence of an obligation is dependent on the occurrence of one or more future events, the obligation is a contingent liability. In other words, the probability of occurrence determines the existence of a liability.

If a present obligation exists but the amount to settle the obligation cannot be estimated reliably, the obligation is a contingent liability.

The two general recognition criterion for liabilities are the possibility of economic benefit outflow and reliably measurement of the amount.

Contingent liabilities are reported just in footnotes because of the uncertainty included in its measurement or existence.

Example: Heat Corporation is a construction company that builds apartments. On June 25, after the end of working day, workers forgot to lock the entrance to the construction area. The children in the neighborhood entered the area and started to play with hoist. One of the children felt down and broke his arm. His parents filed a lawsuit against the company for damages claiming an indemnity of 100,000 TL.

In this case, Heat Corporation should, at first, examine the probability of losing the lawsuit. If it is probable, then the second criteria of measurement reliability is considered. There are three possible cases and three treatments by Heat Corporation;

1. Almost impossible to lose the lawsuit; so does not pay any indemnity – No Liability Reported
2. Probably will lose the lawsuit, however the amount of indemnity cannot be estimated reliably – Liability Disclosed in Footnotes
3. Probably will lose the lawsuit and the amount of indemnity can be estimated reliably – Journalized and Reported in Financial Statements

Reporting Current Liabilities and Liquidity

Financial statement users want to know whether a company’s obligations are current or long-term. It is important for a company to pay all of its liabilities ( solvency ); however, it is vitally important to pay its current liabilities ( liquidity ). A company that has more current liabilities than current assets often lacks liquidity, or short-term debt-paying ability. What is called “ current ” is either the benefits to be received (for assets), or obligations to be met (for liabilities), in one-year period.

Liquidity is an indicator of reliability level for a company in terms of either survival or credibility.

Since the liabilities are usually paid by using cash as an intermediary, companies’ cash generating ability becomes another critical point to consider. As the third financial statement, after the balance sheet for financial position and income statement for financial performance, the statement of cash flows helps users to evaluate the cash generating ability of the company.

In order to assess the company from these perspectives, investors and creditors generally imply ratio analysis, as well as other financial statement analysis methods.

Ratios represent the relationships between financial statement items to make it possible to assess the financial position and performance of companies.