Chapter Three: Current Liabilities

3.1. The nature of liabilities

FASB, defines 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.", the settlement of which is expected to result
in an outflow from the company of resources, embodying economic benefits. In other words, a
liability has three essential characteristics:
 It is a present obligation.
 It arises from past events.
 It results in an outflow of resources (cash, goods, services).
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) non-current liabilities. The following part
of these session focuses on the current liabilities.
Illustration: Identify whether obligations are current liabilities. Cardinal Company has the
following obligations at December 31:
(a) A note payable for Br. 100,000 due in 2 years,
(b) A 10-year mortgage payable of Br. 300,000 payable in ten Br. 30,000 annual payments,
(c) Interest payable of Br. 12,000 on the mortgage, and
(d) Accounts payable of Br. 60,000. For each obligation, indicate whether it should be classified
as a current liability. (Assume an operating cycle of less than one year.)
Current liabilities generally are obligations that the company is to pay within the coming year or
its operating cycle, whichever is longer. Within the current liabilities section, companies usually
list notes payable first, followed by accounts payable.
Most companies pay current liabilities within one year by using 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.
3.3 Types of current liabilities
A current liability is reported if one of two conditions exists:
 The liability is expected to be settled within its normal operating cycle; or

Fundamentals of Accounting II CH-03 Page 1

  The liability is expected to be settled within 12 months after the reporting date.
Here are some typical current liabilities:
1. Accounts payable. 6. Customer advances and deposits.
2. Notes payable. 7. Unearned revenues.
3. Current maturities of long-term debt. 8. Sales and value-added taxes refinanced.
4. Short-term obligations expected to be payable. 9. Income taxes payable
5. Dividends payable. 10. Employee-related liabilities.
3.3.1 Accounts Payable
Accounts payable 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 title to 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 title has
passed to the purchaser before receipt of the goods, the company should record the transaction at
the time of title passage. 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.
To illustrate the difference between the gross and net methods, assume the following transactions.
Gross Method Net Method
1. Purchase cost Br.10,000, terms 2/10, net 30
Purchases …………………. 10,000 Purchases ………………. 9,800
Accounts Payable ……………10,000 Accounts Payable ………… 9,800
2. Invoices of Br. 4,000 are paid within discount period
Accounts Payable ……….. 4,000 Accounts Payable ………. 3,920
Purchase Discounts …………. 80 Cash ……………………… 3,920
Cash ………………………… 3,920
3. Invoices of Br. 6,000 are paid after discount period
Accounts Payable ……….. 6,000 Accounts Payable ………. 5,880
Cash ………………………… 6,000 Purchase Discounts Lost ….. 120
Cash ……………………… 6,000
3.3.2. Notes Payable
Written promises to pay a certain sum of money on a specified future date. Notes payable are often
used instead of accounts payable because they give the lender formal proof of the obligation in

Fundamentals of Accounting II CH-03 Page 2

case legal remedies are needed to collect the debt. Companies frequently issue notes payable to
meet short-term financing needs. Notes may be interest-bearing or zero-interest-bearing.
Notes are issued for varying periods of time short-term or long-term. Those due for payment within
one year of the statement of financial position date are usually classified as current liabilities.
To illustrate the accounting for notes payable, assume that a Addis micro finance agrees to lend
Br.100,000 on September 1, 2012. if Yanet stationary trading signs a Br. 100,000, 12%, four-
month note maturing on January 1. When a company issues an interest bearing note, the amount
of assets it receives upon issuance of the note generally equals the note’s face value.
Yanet stationary trading therefore will receive Br. 100,000 cash and will make the following
journal entry.
 Sept. 1 Cash …………………………… 100,000
Notes Payable ……………………… 100,000
(To record issuance of 12%, 4-month note to Addis micro-finance)

Interest accrues over the life of the note, and the company must periodically record that accrual.
If Yanet stationary trading prepares financial statements annually, it makes an adjusting entry at
December 31 to recognize interest expense and interest payable of Br. 4,000 (Br. 100,000X12%
X 4/12).
Yanet stationary trading makes an adjusting entry as follows:
 Dec. 31 Interest Expense …………… 4,000
Interest Payable ………………. 4,000
(To accrue interest for 4 months on Addis micro-finance note)
In the December 31 financial statements, the current liabilities section of the Statement of cash
flow will show notes payable Br. 100,000 and interest payable Br. 4,000.
In addition, the company will report interest expense of Br. 4,000 under “Other income and
expense” in the income statement.
If Yanet stationary trading prepared financial statements monthly, the adjusting entry at the end
of each month would have been Br. 1,000 (Br. 100,000X 12% X1/12).
At maturity (January 1, 2015), Yanet stationary trading must pay the face value of the note (Br.
100,000) plus Br. 4,000 interest (Br. 100,000 X 12% X 4/12). It records payment of the note and
accrued interest as follows.
Jan. 1 Notes Payable ………………. 100,000
Interest Payable ……………. 4,000
Cash …………………………….. 104,000
(To record payment of Addis micro finance interest-bearing note and accrued interest at maturity)

Fundamentals of Accounting II CH-03 Page 3

Illustration (Zero-Interest-Bearing Note): On March 1, Yanet stationary issues a $104,000, four-
month, zero-interest-bearing note to Addis micro finance. The present value of the note is
$100,000. yanet stationary records this transaction as follows
March.1 Cash …………………………….… 100,000
Discount on notes payable …………... 4,000
Notes payable ………………….. 104,000

Current liabilities
Notes payable $104,000
Less: Discount on notes payable 4,000 $100,000
The Discount on Notes Payable is a contra account to Notes Payable.
3.3.3 Current Liabilities other than A/P and N/P
A. Sales Taxes (Turn Over Tax -TOT)) Payable
As a consumer, you know that many of the products you purchase at retail stores are subject to
sales taxes. Many governments also are now collecting sales taxes on purchases made on the
Internet as well. Sales taxes are expressed as a percentage of the sales price. The selling company
collects the tax from the customer when the sale occurs. Periodically (usually monthly), the retailer
remits the collections to the government’s department of revenue.
Under most government sales tax laws, the selling company must enter separately on the cash
register the amount of the sale and the amount of the sales tax collected. The company then uses
the cash register readings to credit Sales Revenue and Sales Taxes Payable.
For example, if the March 25 cash register reading for Gerji Stationary shows sales of Br. 10,000
and sales taxes of Br. 200 (sales tax rate of 2%), the journal entry is:
Mar. 25 Cash ……………………... 10,200
Sales Revenue …………………. 10,000
Sales Taxes Payable …………… 200
(To record daily sales and sales taxes)
Exercise: Meaza Auto Supply does not segregate sales and sales taxes at the time of sale. The
register total for March 16 is Br. 13,440. All sales are subject to a 2% sales tax. Compute sales
taxes payable, and make the entry to record sales taxes payable and sales.
B. Value-Added Taxes Payable
Value-added taxes (VAT) are used by tax authorities more than sales taxes (over 130 countries
require that companies collect a value-added tax). As indicted earlier, a value added tax is a
consumption tax. This tax is placed on a product or service whenever value is added at a stage of
production and at final sale. A VAT is a cost to the end user, normally a private individual, similar
to a sales tax (TOT).

Fundamentals of Accounting II CH-03 Page 4

Illustration
1. Addis Company grows wheat and sells it to Shewa Baking for Br. 10,000. Addis Company
makes the following entry to record the sale, assuming the VAT is 15 percent.
Cash……………………………………..11,500
Sales Revenue……………………………10,000
Value-Added Taxes Payable………………1,500
(Addis Company then remits the Br. 1,500 to the tax authority.)
2. Shewa Baking makes loaves of bread from this wheat and sells it to All Mart Supermarket for
Br. 20,000. Shewa Baking makes the following entry to record the sale, assuming the VAT is 15
percent.
Cash………………………………………23,000
Sales Revenue …………………………… 20,000
Value-Added Taxes Payable………………..3000
Shewa Baking then remits Br. 1,500 to the government, not Br. 3,000. The reason: Shewa Baking
has already paid Br. 1,500 to Addis Company. At this point, the tax authority is only entitled to
Br. 1,500. Shewa Baking receives a credit for the VAT paid to Addis Company, which reduces the
VAT payable.
3. Chuchu Supermarket sells the loaves of bread to consumers for Br. 2,400. Chuchu Supermarket
makes the following entry to record the sale, assuming the VAT is 15 percent.
Cash ……………………………………. 2,760
Sales Revenue ………………………….. 2,400
Value-Added Taxes Payable …………… 360
C. Unearned Revenues
How do companies account for unearned revenues that are received before goods are delivered or
services are provided?
 When a company receives the advance payment, it debits Cash and credits a current
liability account identifying the source of the unearned revenue.
 When the company recognizes revenue, it debits an unearned revenue account and credits
a revenue account.

Fundamentals of Accounting II CH-03 Page 5

To illustrate, assume that Buna Football club sells 10,000 season soccer tickets at Br. 50 each for
its five-game home schedule. Logo University records the sales of season tickets as follows.
August 6. Cash ……………………………. 500,000
Unearned Sales Revenue …………………. 500,000
(To record sale of 10,000 season tickets)
After each game, Buna club makes the following entry.
September 7. Unearned Sales Revenue ………100,000
Sales Revenue ……………………… 100,000
(To record soccer ticket revenue)
The account Unearned Sales Revenue represents unearned revenue. Buna club reports it as a
current liability in the statement of financial position because the school has a performance
obligation. As ticket holders attend games, Buna recognizes revenue and reclassifies the amount
from Unearned Sales Revenue to Sales Revenue.
D. 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. As an example, assume that Nohi Construction issues a five-year
interest-bearing Br. 25,000 note on January 1, 2013. This note specifies that each January 1,
starting January 1, 2014, Nohi should pay Br. 5,000 of the note. When the company prepares
financial statements on December 31, 2013, it should report Br. 5,000 as a current liability and Br.
20,000 as a non-current liability. (The Br. 5,000 amount is the portion of the note that is due to be
paid within the next 12 months.) Companies often identify current maturities of long-term debt on
the statement of financial position as long-term debt due within one year.
It is not necessary to prepare an adjusting entry to recognize the current maturity of long-term debt.
At the statement of financial position date, all obligations due within one year are classified as
current and all other obligations as non-current liabilities.
E. Dividends Payable
A cash dividend payable is an amount owed by a corporation to its shareholders as a result of board
of directors’ authorization (or in other cases, vote of shareholders). At the date of declaration, the
corporation assumes a liability that places the shareholders 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. Undeclared
dividends on cumulative preferred stock not recognized as a liability. Dividends payable in the
form of shares of stock are not recognized as a liability. Reported in equity.
Illustration
1. When a dividend is declared
Cash dividend ………………………… 10,000
Dividend payable ………………………. 10,000

Fundamentals of Accounting II CH-03 Page 6

 2. When the dividend is paid
Dividend payable ……………………… 10,000
Cash …………………………………….. 10,000
Until the cash dividend is paid to the shareholder, it will be reported as part of the Current Liability
in the “Statement of Financial Position”.
F. Customer advances and deposits
Customer advances and deposits refer to funds received by a business from a customer before they
have been earned. These funds are recorded as “Customer Advances and Deposits” on the
business’s financial statements. A customer may pay in advance for goods being delivered or
services being provided. When a seller receives an advance payment before it has done anything
to earn the payment, the correct accounting is to recognize the advance as a liability, until such
time as the seller fulfills its obligations under the terms of the underlying sales agreement. Include
returnable cash deposits received from customers and employees. May be classified as current or
long-term.
Illustrations: Sports Pro Magazine sold 12,000 annual subscriptions on August 1, 2010, for $18
each. Prepare Sports Pro's August 1, 2010, journal entry and the December 31, 2010, annual
adjusting entry.
Aug. 1 Cash ……………………… 216,000
Unearned revenue …………………………. 216,000
(12,000 x $18)
Dec. 31 Unearned revenue ………….. 90,000
Subscription revenue ………………………. 90,000
($216,000x5/12 = $90,000)
G. Employee-Related Liabilities will be discussed in chapter 4

3.4. Short-Term Notes Payable

Notes may be issued when merchandise or other assets are purchased. They may also be issued to
creditors to temporarily satisfy an account payable created earlier.
For example, assume that a business issues a 90-day, 12% note for $1,000, dated August 1, 2007,
to Murray Co. for a $1,000 overdue account. The entry to record the issuance of the note is as
follows:
Accounts Payable––Murray Co. ---------------- 1 0 0 0
Notes Payable -------------------------------------1 0 0 0
(Issued a 90-day, 12% note on account.)

Fundamentals of Accounting II CH-03 Page 7

When the note matures, the entry to record the payment of $1,000 principal plus $30 interest
($1,000 X 12% X 90/360) is as follows:
Notes Payable ------------------------------------- 1 0 0 0
Interest Expense --------------------------------------- 3 0
Cash ------------------------------------------------- 1 0 3 0
(Paid principal and interest due on note.)
3.5. 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 before non-current liabilities in the
statement of financial position. 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.
Illustration:

Fundamentals of Accounting II CH-03 Page 8