CHAPTER 3

CURRENT LIABILITIES
• A current liability is a debt with two key features:
• (1) The company reasonably expects to pay the debt from existing
current assets or through the creation of other current liabilities.
• (2) The company will pay the debt within one year or the operating
cycle, whichever is longer.
• Debts that do not meet both criteria are classified as long-term
liabilities.
• Most companies pay current liabilities within one year out of
current assets, rather than by creating other liabilities.
• Companies must carefully monitor the relationship of current
liabilities to current assets. This relationship is critical in evaluating a
 company’s short-term debt paying ability. A company that has more
current liabilities than current assets may not be able to meet its
current obligations when they become due.
• Current liabilities include notes payable, accounts payable, and
unearned revenues.
• They also include accrued liabilities such as taxes, salaries and
wages, and interest payable. In previous chapters we explained the
entries for accounts payable and adjusting entries for some current
liabilities. In the following sections, we discuss other types of
current liabilities.
• Notes Payable
• Companies record obligations in the form of written promissory
notes, called notes payable. Notes payable are often used instead of
accounts payable because they give the lender formal proof of the
 obligation in case legal remedies are needed to collect the debt.
Notes payable usually require the borrower to pay interest.
Companies frequently issue them to meet short-term financing
needs.
• Notes are issued for varying periods. Those due for payment within
one year of the balance sheet date are usually classified as current
liabilities.
• To illustrate the accounting for notes payable, assume that First
National Bank agrees to lend $100,000 on March 1, 2010, if Cole
Williams Co. signs a $100,000, 12%, four-month note. With an
interest-bearing promissory note, the amount of assets received
upon issuance of the note generally equals the note’s face
value.Cole Williams Co. therefore will receive $100,000 cash and
will make the following journal entry.
• Mar. 1 Cash …………………..100,000
Notes Payable …………………………100,000
• (To record issuance of 12%, 4-month note to First National Bank)
• Interest accrues over the life of the note, and the company must
periodically record that accrual. If Cole Williams Co. prepares
financial statements on June 30, it makes an adjusting entry at June
30 to recognize interest expense and interest payable of $4,000
($100,000 x 12% x 4/12).
• Face Value x Annual x Time in terms
• of the note Interest rate of One Year
• $100,000 x 12% x 4/12 = $4,000
• Cole Williams makes an adjusting entry as follows:
• June 30 Interest Expense …….4,000
• Interest Payable ………………….4,000
• (To accrue interest for 4 months on First National Bank note)
• In the June 30 financial statements, the current liabilities section of
the balance sheet will show notes payable $100,000 and interest
payable $4,000. In addition, the company will report interest
expense of $4,000 under “Other expenses and losses” in the income
statement. If Cole Williams Co. prepared financial statements
monthly, the adjusting entry at the end of each month would have
been $1,000 ($100,000 x 12% x 1/12).
• At maturity (July 1, 2010), Cole Williams Co. must pay the face value
of the note ($100,000) plus $4,000 interest ($100,000 12% 4/12). It
records payment of the note and accrued interest as shown below.
• July 1 Notes Payable ………..100,000
• Interest Payable …………4,000
• Cash………………………………………. 104,000
• (To record payment of First National Bank interest-bearing note and
accrued interest at maturity)
• Sales Taxes Payable
• As a consumer, you know that many of the products you purchase
at retail stores are subject to sales taxes. Sales taxes are expressed
as a stated percentage of the sales price.
• The retailer collects the tax from the customer when the sale
occurs. Periodically (usually monthly), the retailer remits the
collections to the state’s department of revenue.
• Under most state sales tax laws, the selling company must ring up
separately on the cash register the amount of the sale and the
amount of the sales tax collected.(Gasoline sales are a major
exception.) The company then uses the cash register readings to
credit Sales and Sales Taxes Payable. For example, if the March 25
cash register reading for Cooley Grocery shows sales of $10,000 and
sales taxes of $600 (sales tax rate of 6%), the journal entry is:
• Mar. 25 Cash ……………10,600
• Sales …………………………10,000
• Sales Taxes Payable………. 600
• (To record daily sales and sales taxes)
• When the company remits the taxes to the taxing agency, it debits
Sales Taxes Payable and credits Cash.
• Sales tax payable ………600
• Cash …………………………………….600
• The company does not report sales taxes as an expense.
• It simply forwards to the government the amount paid by the
customers. Thus, Cooley Grocery serves only as a collection agent
for the taxing authority.
• Sometimes companies do not ring up sales taxes separately on the
cash register.
• To determine the amount of sales in such cases, divide total receipts
by 100% plus the sales tax percentage. To illustrate, assume that in
the above example Cooley Grocery rings up total receipts of
$10,600. The receipts from the sales are equal to the sales price
 (100%) plus the tax percentage (6% of sales), or 1.06 times the sales
total. We can compute the sales amount as follows.
• $10,600 / 1.06 = $10,000 Sales amount
• Thus, Cooley Grocery could find the sales tax amount it must remit
to the state ($600) by subtracting sales from total receipts ($10,600
$10,000).
• If total sales revenue is credited by 10,600 Adjusting entry can be
made.
• Sales revenue …….600
• Sales tax payble ………………600

• Unearned Revenues
• A magazine publisher, such as Sports Illustrated, receives
customers’ checks when they order magazines. An airline company,
such as American Airlines, receives cash when it sells tickets for
future flights. Through these transactions, both companies have
incurred unearned revenues—revenues that are received before
the company delivers goods or provides services
• How do companies account for unearned revenues?
• 1. When a company receives the advance payment, it debits Cash,
and credits a current liability account identifying the source of the
unearned revenue.
• 2. When the company earns the revenue, it debits the Unearned
Revenue account, and credits an earned revenue account.
• To illustrate, assume that Superior University sells 10,000 season
football tickets at $50 each for its five-game home schedule. The
university makes the following entry for the sale of season tickets:
• Aug. 6 Cash ……………….500,000
• Unearned Football Ticket Revenue….. 500,000
• (To record sale of 10,000 season tickets)
• As the school completes each of the five home games, it earns one-
fifth of the revenue. The following entry records the revenue
earned.

• Sept. 7 Unearned Football Ticket Revenue…. 100,000

• Football Ticket Revenue……………………………… 100,000
• (To record football ticket revenue earned)
• Organizations report any balance in an unearned revenue account
(in Unearned Football Ticket Revenue, for example) as a current
liability in the balance sheet.
• Type of Account Title
• Business Unearned Revenue Earned
Revenue
• Airline Unearned Passenger Ticket Revenue Passenger
Revenue
• Magazine publisher Unearned Subscription Revenue
Subscription Revenue
• Hotel Unearned Rental Revenue Rental
Revenue
• Insurance company Unearned Premium Revenue Premium
Revenue
• Current Maturities of Long-Term Debt
• Companies often have a portion of long-term debt that comes due
in the current year. That amount is considered a current liability.
• For example, assume that Wendy Construction issues a five-year
interest-bearing $25,000 note on January 1, 2010. Each January 1,
starting January 1, 2011, $5,000 of the note is due to be paid. When
Wendy Construction prepares financial statements on December
31, 2010, it should report $5,000 as a current liability. It would
report the remaining $20,000 on the note as a long-term liability.
Current maturities of long-term debt are often termed long-term
debt due within one year.
• Cash ……………… 25,000
 Notes payable-Long-term……. 25,000
• To report cash received by issuing a five year note.
• Notes payable-long-term 5,000
Notes payable-current………………. 5,000
• To report current portion of the long-term debt.
• Contingent liability
• With notes payable, interest payable, accounts payable, and sales
taxes payable, we know that an obligation to make a payment
exists. But suppose that your company is involved in a dispute with
the Internal Revenue Service (IRS) over the amount of its income tax
liability. Or suppose your company is involved in a lawsuit which, if
you lose, might result in bankruptcy. How should you report this
major contingency? The answers to these questions are difficult,
 because these liabilities are dependent—contingent—upon some
future event.
• In other words, a contingent liability is a potential liability that may
become an actual liability in the future.
• How should companies report contingent liabilities? They use the
following guidelines:
• 1. If the contingency is probable (if it is likely to occur) and the
amount can be reasonably estimated, the liability should be
recorded in the accounts.
• 2. If the contingency is only reasonably possible (if it could happen),
then it needs to be disclosed only in the notes that accompany the
financial statements.
• 3. If the contingency is remote (if it is unlikely to occur), it need not
be recorded or disclosed.
• Recording a Contingent Liability
• Product warranties are an example of a contingent liability that
companies should record in the accounts. Warranty contracts result
in future costs that companies may incur in replacing defective units
or repairing malfunctioning units. Generally, a manufacturer, such
as Black & Decker, knows that it will incur some warranty costs.
From prior experience with the product, the company usually can
reasonably estimate the anticipated cost of servicing (honoring) the
warranty.
• The accounting for warranty costs is based on the matching
principle. The estimated cost of honoring product warranty
contracts should be recognized as an expense in the period in which
 the sale occurs. To illustrate, assume that in 2010 Denson
Manufacturing Company sells 10,000 washers and dryers at an
average price of $600 each. The selling price includes a one-year
warranty on parts.
• Denson expects that 500 units (5%) will be defective and that
warranty repair costs will average $80 per unit. In 2010, the
company honors warranty contracts on 300 units, at a total cost of
$24,000.
• At December 31, it is necessary to accrue the estimated warranty
costs on the 2010 sales. Denson computes the estimated warranty
liability as follows.
• Number of units sold ………………………..10,000
• Estimated rate of defective units ………..5%
• Total estimated defective units ………….500
• Average warranty repair cost ……………. $80
• Estimated product warranty liability.. $40,000
• The company makes the following adjusting entry.
• Dec. 31 Warranty Expense… 40,000
• Estimated Warranty Liability… 40,000
• (To accrue estimated warranty costs)
• Denson records those repair costs incurred in 2010 to honor
warranty contracts on 2010 sales as shown below.
• Estimated Warranty Liability… 24,000
• Repair Parts ……………………………………..24,000
• (To record honoring of 300 warranty contracts on 2010 sales)
• The company reports warranty expense of $40,000 under selling
expenses in the income statement. It classifies estimated warranty
liability of $16,000 ($40,000 - $24,000) as a current liability on the
balance sheet.
• In the following year, Denson should debit to Estimated Warranty
Liability all expenses incurred in honoring warranty contracts on
2010 sales. To illustrate, assume that the company replaces 20
defective units in January 2011, at an average cost of $80 in parts
and labor. The summary entry for the month of January 2011 is:
• Jan. 31 Estimated Warranty Liability…. 1,600
• Repair Parts………………………………….. 1,600
• (To record honoring of 20 warranty contracts on 2010 sales)
•
• Disclosure of Contingent Liabilities
• When it is probable that a company will incur a contingent liability
but it cannot reasonably estimate the amount, or when the
contingent liability is only reasonably possible, only disclosure of the
contingency is required. Examples of contingencies that may require
disclosure are pending or threatened lawsuits and assessment of
additional income taxes pending an IRS audit of the tax return.
• The disclosure should identify the nature of the item and, if known,
the amount of the contingency and the expected outcome of the
future event. Disclosure is usually accomplished through a note to
the financial statements, as illustrated by the following.
• Illustration of Contingencies. From time to time, third parties assert
patent infringement claims against the company. Currently the
company is engaged in several lawsuits regarding patent issues and
 has been notified of a number of other potential patent disputes. In
addition, from time to time the company is subject to other legal
proceedings and claims in the ordinary course of business, including
claims for infringement of trademarks, copyrights and other
intellectual property rights....The Company does not believe, based
on current knowledge, that any of the foregoing legal proceedings
or claims are likely to have a material adverse effect on the financial
position, results of operations or cash flows.

• The full-disclosure principle requires that companies disclose all

circumstances and events that would make a difference to financial
statement users. Some important financial information, such as
contingencies, is not easily reported in the financial statements.
Reporting information on contingencies in the notes to the financial
statements will help investors be aware of events that can affect the
financial health of a company.