CHAPTER THREE

CURRENT LIABILITIES

3.1 The Nature of Liabilities

The question, “What is a liability?” is not easy to answer. For example, is preferred stock a
liability or an ownership claim? The first reaction is to say that preferred stock is in fact an
ownership claim, and companies should report it as part of stockholders’ equity. In fact,
preferred stock has many elements of debt as well. The issuer (and in some cases the holder)
often has the right to call the stock within a specific period of time—making it similar to a
repayment of principal. The dividend on the preferred stock is in many cases almost
guaranteed (the cumulative provision)—making it look like interest. As a result, preferred
stock is one of many financial instruments that are difficult to classify. To help resolve some
of these controversies, the FASB, as part of its conceptual framework, defined liabilities as
“probable future sacrifices of economic benefits arising from present obligations of a
particular entity to transfer assets or provide services to other entities in the future as a
result of past transactions or events. ”In other words, a liability has three essential
characteristics:

1. It is a present obligation that entails settlement by probable future transfer or use of

cash, goods, or services.
2. It is an unavoidable obligation.
3. The transaction or other event creating the obligation has already occurred.

3.2 Classification of Liabilities

Because liabilities involve future disbursements of assets or services, one of their most
important features is the date on which they are payable. A company must satisfy currently
maturing obligations in the ordinary course of business to continue operating. Liabilities with
a more distant due date do not, as a rule, represent a claim on the company’s current
resources. They are therefore in a slightly different category. This feature gives rise to the
basic division of liabilities into (1) current liabilities and (2) long-term debt. Recall that
current assets are cash or other assets that companies reasonably expect to convert into cash,
sell, or consume in operations within a single operating cycle or within a year (if completing
more than one cycle each year).

When a company or a bank advances credit, it is making a loan. The company or bank is
called a creditor (or lender).The individuals or companies receiving the loan are called
debtors (or borrowers). Debt is recorded as a liability by the debtor. Long-term liabilities are
debt due beyond one year. Thus, a 30-year mortgage used to purchase property is a long-term
liability. Current liabilities are debt that will be paid out of current assets and are due within
one year.

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Current liabilities are “obligations whose liquidation is reasonably expected to require use
of existing resources properly classified as current assets, or the creation of other current
liabilities.” This definition has gained wide acceptance because it recognizes operating
cycles of varying lengths in different industries. This definition also considers the important
relationship between current assets and current liabilities.

The operating cycle is the period of time elapsing between the acquisition of goods and
services involved in the manufacturing process and the final cash realization resulting from
sales and subsequent collections. Industries that manufacture products requiring an aging
process, and certain capital-intensive industries, have an operating cycle of considerably
more than one year. On the other hand, most retail and service establishments have several
operating cycles within a year.

3.3 Types of current liabilities

Here are some typical current liabilities:

1. Accounts payable. 7. Income taxes payable

2. Notes payable 8. Employee-related liabilities
3. Dividends payable 9. Current maturities of long-term debt
4. Customer advances and deposits 10. Short-term obligations expected to be
5. Unearned revenues. refinanced
6. Sales taxes payable

Accounts Payable

Accounts payables, or trade accounts payable, are balances owed to others for goods,
supplies, or services purchased on open account. Accounts payable arise because of the time
lag between the receipt of services or acquisition of assets and the payment for them. The
terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually state this period of extended credit,
commonly 30 to 60 days. Most companies record liabilities for purchases of goods upon
receipt of the goods. If control has passed to the purchaser before receipt of the goods, the
purchaser should record the transaction at the time of transfer of control. A company must
pay special attention to transactions occurring near the end of one accounting period and at
the beginning of the next. It needs to ascertain that the record of goods received (the
inventory) agrees with the liability (accounts payable), and that it records both in the proper
period. Measuring the amount of an account payable poses no particular difficulty. The
invoice received from the creditor specifies the due date and the exact outlay in money that is
necessary to settle the account. The only calculation that may be necessary concerns the
amount of cash discount.

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Notes Payable

Notes payable are written promises to pay a certain sum of money on a specified future date.
They may arise from purchases, financing, or other transactions. Some industries require
notes (often referred to as trade notes payable) as part of the sales/ purchases transaction in
lieu of the normal extension of open account credit. Notes payable to banks or loan
companies generally arise from cash loans. Companies classify notes as short-term or long-
term, depending on the payment due date. Notes may also be interest-bearing or zero-
interest-bearing.

Interest-Bearing Note Issued

Assume that Castle National Bank agrees to lend $100,000 on March 1, 2017, to Landscape
Co. if Landscape signs a $100,000, 6 percent, four-month note. Landscape records the cash
received on March 1 as follows.

If Landscape prepares financial statements semiannually, it makes the adjusting entry to

recognize interest expense and interest payable of $2,000 ($100,000 × 6% × 4/12) at June
30.

If Landscape prepares financial statements monthly, its adjusting entry at the end of each
month is $500 ($100,000 × 6% × 1/12).
At maturity (July 1), Landscape must pay the face value of the note ($100,000) plus
$2,000 interest ($100,000 × 6% × 4/12). Landscape records payment of the note and
accrued interest as follows.

Zero-Interest-Bearing Note Issued

A company may issue a zero-interest-bearing note instead of an interest-bearing note. A
zero-interest-bearing note does not explicitly state an interest rate on the face of the note.
Interest is still charged, however. At maturity, the borrower must pay back an amount
greater than the cash received at the issuance date. In other words, the borrower receives
in cash the present value of the note. The present value equals the face value of the note
at maturity minus the interest or discount charged by the lender for the term of the note.

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In essence, the bank takes its fee “up front” rather than on the date the note matures. To
illustrate, assume that Landscape issues a $102,000, four-month, zero-interest bearing
note to Castle National Bank. The present value of the note is $100,000. Landscape
records this transaction as follows.

Landscape credits the Notes Payable account for the face value of the note, which is
$2,000 more than the actual cash received. It debits the difference between the cash
received and the face value of the note to Discount on Notes Payable. Discount on
Notes Payable is a contra account to Notes Payable, and therefore is subtracted from
Notes Payable on the balance sheet.
The balance sheet presentation on March 1 would be.

The amount of the discount, $2,000 in this case, represents the cost of borrowing
$100,000 for 4 months. Accordingly, Landscape charges the discount to interest expense
over the life of the note. That is, the Discount on Notes Payable balance represents
interest expense chargeable to future periods. Thus, Landscape should not debit Interest
Expense for $2,000 at the time of obtaining the loan.

Dividends Payable
A cash dividend payable is an amount owed by a corporation to its stockholders as a
result of its board of directors’ authorization. At the date of declaration, the corporation
assumes a liability that places the stockholders in the position of creditors in the amount
of dividends declared. Because companies always pay cash dividends within one year of
declaration (generally within three months), they classify them as current liabilities. On
the other hand, companies do not recognize accumulated but undeclared dividends on
cumulative preferred stock as a liability. Why? Because preferred dividends in arrears are
not an obligation until the board of directors authorizes the payment. Nevertheless,
companies should disclose the amount of cumulative dividends unpaid in a note, or show
it parenthetically in the capital stock section. Dividends payable in the form of additional
shares of stock are not recognized as a liability. Such stock dividends do not require
future outlays of assets or services. Companies generally report such undistributed stock
dividends in the stockholders’ equity section because they represent retained earnings in
the process of transfer to paid-in capital.

Customer Advances and Deposits

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Current liabilities may include returnable cash deposits received from customers and
employees. Companies may receive deposits from customers to guarantee performance
of a contract or service or as guarantees to cover payment of expected future obligations.
For example, a company like Alltel Corp. often requires a deposit on equipment that
customers use to connect to the Internet or to access its other services. Alltel also may
receive deposits from customers as guarantees for possible damage to property.
Additionally, some companies require their employees to make deposits for the return of
keys or other company property. The classification of these items as current or
noncurrent liabilities depends on the time between the date of the deposit and the
termination of the relationship that required the deposit.

Unearned Revenues
A magazine publisher such as Condé Nast receives payment when a customer subscribes
to Golf Digest. An airline company such as American Airlines sells tickets for future
flights. And software companies like Microsoft issue coupons that allow customers to
upgrade to the next version of their software. How do these companies account for
unearned revenues that they receive before delivering goods or rendering services?
1. When a company receives an advance payment, it debits Cash, and credits a
current liability account identifying the source of the unearned revenue.
2. When a company recognizes revenue, it debits the unearned revenue account,
and credits a revenue account.
To illustrate, assume that Allstate University sells 10,000 season football tickets at $50
each for its five-game home schedule. The entries for Allstate University’s unearned
ticket revenue are presented as follows

As subsequent games are played, Allstate satisfies a performance obligation and records
sales revenue (and reduces Unearned Sales Revenue). The account Unearned Sales
Revenue represents unearned revenue. Allstate reports it as a current liability in the
balance sheet as the school has a performance obligation. As the school recognizes
revenue, it reclassifies the amount from Unearned Sales Revenue to Sales Revenue.
Unearned revenue is material for some companies. In the airline industry, for example,
tickets sold for future flights represent almost 50 percent of total current liabilities.
The balance sheet reports obligations for any commitments that are redeemable in
goods and services. The income statement reports revenues related to performance
obligations satisfied during the period.

Sales Taxes Payable

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Retailers must collect sales taxes from customers on transfers of tangible personal
property and on certain services and then must remit these taxes to the proper
governmental authority. Gap, for example, sets up a liability to provide for taxes
collected from customers but not yet remitted to the tax authority. The Sales Taxes
Payable account should reflect the liability for sales taxes due various governments. The
entry below illustrates use of the Sales Taxes Payable account on a sale of $3,000 when a
4 percent sales tax is in effect.

Income Taxes Payable

Any federal or state income tax varies in proportion to the amount of annual income.
Using the best information and advice available, a business must prepare an income tax
return and compute the income taxes payable resulting from the operations of the current
period. Corporations should classify as a current liability the taxes payable on taxable
income, as computed per the tax return. Unlike a corporation, proprietorships and
partnerships are not taxable entities. Because the individual proprietor and the members
of a partnership are subject to personal income taxes on their share of the business’s
taxable income, income tax liabilities do not appear on the financial statements of
proprietorships and partnerships.

Employee-Related Liabilities
Companies also report as a current liability amounts owed to employees for salaries or
wages at the end of an accounting period. In addition, they often also report as current
liabilities the following items related to employee compensation.
1. Payroll deductions.
2. Compensated absences.
3. Bonuses.

Payroll Deductions

The most common types of payroll deductions are taxes, insurance premiums, employee
savings, and union dues. To the extent that a company has not remitted the amounts
deducted to the proper authority at the end of the accounting period, it should recognize
them as current liabilities.

Compensated Absences

Compensated absences are paid absences from employment—such as vacation, illness,

and holidays. Companies should accrue a liability for the cost of compensation for future
absences if all of the following conditions exist.

(a) The employer’s obligation relating to employees’ rights to receive compensation for
future absences is attributable to employees’ services already rendered.

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(b) The obligation relates to the rights that vest or accumulate.

(c) Payment of the compensation is probable.

(d) The amount can be reasonably estimated.

Bonus Agreements

Many companies give a bonus to certain or all employees in addition to their regular
salaries or wages. Frequently the bonus amount depends on the company’s yearly profit.
For example, employees at Ford Motor Company share in the success of the company’s
operations on the basis of a complicated formula using net income as its primary basis
for computation. A company may consider bonus payments to employees as additional
wages and should include them as a deduction in determining the net income for the
year.

Current Maturities of Long-Term Debt

Companies reports as part of its current liabilities the portion of bonds, mortgage notes,
and other long-term indebtedness that matures within the next fiscal year. It categorizes
this amount as current maturities of long-term debt. Companies, like PepsiCo, exclude
long-term debts maturing currently as current liabilities if they are to be:

1. Retired by assets accumulated for this purpose that properly has not been shown as
current assets,

2. Refinanced, or retired from the proceeds of a new debt issue, or

3. Converted into capital stock.

In these situations, the use of current assets or the creation of other current liabilities
does not occur. Therefore, classification as a current liability is inappropriate. A
company should disclose the plan for liquidation of such a debt either parenthetically or
by a note to the financial statements. When only a part of a long-term debt is to be paid
within the next 12 months, as in the case of serial bonds that it retires through a series of
annual installments, the company reports the maturing portion of long-term debt as a
current liability, and the remaining portion as a long-term debt. However, a company
should classify as current any liability that is due on demand (callable by the creditor) or
will be due on demand within a year (or operating cycle, if longer). Liabilities often
become callable by the creditor when there is a violation of the debt agreement. For
example, most debt agreements specify a given level of equity to debt be maintained, or
specify that working capital be of a minimum amount. If the company violates an
agreement, it must classify the debt as current because it is a reasonable expectation that
existing working capital will be used to satisfy the debt. Only if a company can show
that it is probable that it will cure (satisfy) the violation within the grace period specified
in the agreements can it classify the debt as noncurrent.

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 3.4 Presentation of current liabilities on the balance sheet

In practice, current liabilities are usually recorded and reported in financial statements at their
full maturity value. Because of the short time periods involved, frequently less than one year,
the difference between the present value of a current liability and the maturity value is
usually not large. The profession accepts as immaterial any slight overstatement of liabilities
that results from carrying current liabilities at maturity value.

The current liabilities accounts are commonly presented as the first classification in the
liabilities and stockholders’ equity section of the balance sheet. Within the current liabilities
section, companies may list the accounts in order of maturity, in descending order of amount,
or in order of liquidation preference.

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