Hrudka Corp. has manufactured a broad range of quality products since 1988. The following information is available for the company's fiscal year ended February 28, 2011.
1. The company has $4 million of bonds payable outstanding at February 28, 2011, that were issued at par in 2000. The bonds carry an interest rate of 7%, payable semi-annually each June 1 and December 1.
2. Hrudka has several notes payable outstanding with its primary banking institution at February 28, 2011. In each case, the annual interest is due on the anniversary date of the note each year (same as the due dates listed). The notes are as follows:
3. Hrudka has a two-year warranty on selected products, with an estimated cost of 1% of sales being returned in the 12 months following the sale, and a cost of 1.5% of sales being returned in months 13 to 24 following sale. The warranty liability outstanding at February 28, 2010, was $5,700. Sales of warrantied products in the year ended February 28, 2011, were $154,000. Actual warranty costs incurred during the current fiscal year are as follows:
Warranty claims honoured on 2009–2010 sales ………… $4,900
Warranty claims honoured on 2011–2011 sales ………… 1,100
$6,000
4. Regular trade payables for supplies and purchases of goods and services on open account are $414,000 at February 28, 2011. Included in this amount is a loan of $23,000 owing to an affiliated company.
5. The following information relates to Hrudka’s payroll for the month of February 2011. The company’s required contribution for EI is 1.4 times that of the employee contribution; for CPP it is 1.0 times that of the employee contribution.
Salaries and wages outstanding at February 28, 2011 …………. $220,000
EI withheld from employees …………………………………. 9,500
CPP withheld from employees ………………………………… 16,900
Income taxes withheld from employees ……………………….. 48,700
Union dues withheld from employees ………………………… 21,500
6. Hrudka regularly pays GST owing to the government on the 15th of the month. Hrudka's GST transactions include the GST that it charges to customers and the GST that it is charged by suppliers. During February 2011, purchases attracted $28,000 of GST, while the GST charged on invoices to customers totalled $39,900. At January 31, 2011, the balances in the GST Recoverable and GST Payable accounts were $34,000 and $60,000, respectively.
7. Other miscellaneous liabilities included $50,000 of dividends payable on March 15, 2011; $25,000 of bonuses payable to company executives (75% payable in September 2011, and 25% payable the following March); and $75,000 in accrued audit fees covering the year ended February 28, 2011.
8. Hrudka sells gift cards to its customers. The company does not set a redemption date and customers can use their cards at any time. At March 1, 2010, Hrudka had a balance outstanding of $950,000 in its Unearned Revenues-Gift Cards account. The company received $225,000 in cash for gift cards purchased during the current year and $375,000 in redemptions took place during the year. Based on past experience, 15% of customer gift card balances never get redeemed. At the end of each year, Hrudka recognizes 15% of the opening balance of Unearned Revenues as earned during the year.
Instructions
(a) Prepare the current liability section of the February 28, 2011 balance sheet of Hrudka Corp. Identify any amounts that require separate presentation or disclosure under private enterprise GAAP.
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(b) For each item included as a current liability, identify whether the item is a financial liability. Explain.
(c) If you have excluded any items from the category of current liabilities, explain why you left them out.
(d) Assume that Hrudka Corp. is not in compliance with the debt covenants in the note payable due October 30, 2013, in item 2 above. How would this affect the classification of the note on the balance sheet?
(e) For a manufacturer such as Hrudka, how should the revenue from unredeemed gift cards be shown on the income statement, as opposed to revenue from redeemed gift cards?
SOLUTION
(a)
Current Liabilities:
Trade payables ($414,000 – $23,000)
$ 391,000
Liability to affiliated company
23,000
Notes payable ($150,000 + $200,000)
350,000
GST payable (Schedule 6)
11,900
Dividends payable
50,000
Bonus payable (75% X $25,000)
18,750
Unearned revenue – Gift cards (Schedule 1)
657,500
Accrued liabilities (Schedule 2)
545,749
Total current liabilities
$2,047,899
Schedule 1:
Unearned Revenues – Gift cards, Mar. 1, 2010
$ 950,000
New gift card purchases
225,000
Gift card redemptions
(375,000)
(375,000)
15% of Mar. 1, 2010 balance recognized as revenue (15% X $950,000)
(142,500)
(142,500)
Unearned revenue – Gift cards, Feb. 28, 2011
$657,500
Schedule 2:
Interest payable (Schedule 3)
$ 122,709
Warranty liability (Schedule 4)
1,240
Salaries and wages payable
220,000
Employee withholdings payable (Schedule 5)
105,300
Union dues payable
21,500
Audit fee payable
75,000
Total accrued liabilities
$545,749
Schedule 3:
Interest on the bond
($4,000,000 X 7% X 3/12)
$ 70,000
Interest on Note due 04/01/11
($150,000 X 8% X 11/12)
11,000
Interest on Note due 01/31/12 ($200,000 X 9% X 1/12)
1,500
Interest on Note due 03/15/12
($500,000 X 7% X 11.5/12)
33,542
Interest on Note due 10/30/13 ($250,000 X 8% X 4/12)
6,667
Total interest payable
$ 122,709
Schedule 4:
Warranty liability 02/28/10
$5,700
Less warranty claims on 2009-2010 sales
(4,900)
(4,900)
Remaining warranty liability
800
Warranty liability on 2010-2011 sales for following 12 months ($154,000 X 1%)
1,540
Less: warranty claims on 2010-2011 sales
(1,100)
(1,100)
Current warranty liability 02/28/11
$1,240
Schedule 5:
EI premiums payable (2.4 X $9,500)
$ 22,800
CPP contributions payable (2 X $16,900)
33,800
Employee income tax deductions payable
48,700
Employee withholdings payable
$105,300
Schedule 6:
Net GST payable, 01/31/11 ($60,000 – $34,000)
$ 26,000
Less: payment to government on 15th of Feb./11
(26,000)
(26,000)
GST charged on February sales
39,900
Net of GST recoverable
(28,000)
(28,000)
Net GST payable, 02/28/11
$11,900
All current liabilities listed with the exception of the unearned revenues – gift cards and the warranty liability, the employee withholdings payable (employee income tax deductions payable, EI premiums payable and CPP contributions payable) and GST payable are financial liabilities.
A financial liability is any liability that is a contractual obligation to deliver cash or another financial asset to another party. A contractual obligation refers to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable at law. Contracts, and thus financial instruments, may take a variety of forms and need not be in writing.
Items such as deferred revenue and most warranty obligations are not financial liabilities because the probable outflow of economic benefits associated with them is the delivery of goods and services rather than cash or another financial asset.
GST payable and employee withholdings payable are not considered financial liabilities because they are not contractual in nature. They are created as a result of statutory requirements imposed by governments.
Items excluded from current liabilities:
Bonds payable were excluded based on the assumption that the bonds will not be redeemed in the coming period or operating cycle, whichever is longer.
Notes payable due 03/15/12 and 10/30/13 were excluded because their due date is beyond the coming period.
Warranty Liability for costs of 1.5% of 2010-2011 sales (1.5% X $154,000 = $2,310) would be shown as a long-term liability. The costs of honouring the warranty would occur beyond the coming period.
Bonus payable in March 2012 ($25,000 X 25% = $6,250).
(d) If Hrudka is not in compliance with the bank’s debt covenants, the note would be reclassified as a current liability. A breach of the covenants of long-term debt gives the creditor the right to demand short-term repayment of the debt. The note can be classified as noncurrent only if the creditor waives the covenant requirements or the violation has been cured within the grace period and it is likely Hrudka will not violate the covenant within a year from the balance sheet date.
(e) Revenue from redeemed cards should be shown with other product sales and offset against cost of sales to accurately measure gross profit. Revenues from unredeemed gift cards do not have a related product cost and will distort the gross margin if they are included in product sales revenues. They should be shown as a separate source of revenue. Given the increasing popularity of gift cards, the revenue should be shown as an ongoing source of revenue in the income from operations section of the income statement and not as “other revenues”.