Fundamental of Accounting II Chapter Three

CHAPTER THREE
Current Liabilities
3.1. The Nature of Current Liabilities
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. 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.
Current liability is reported if one of two conditions exists:
1. The liability is expected to be settled within its normal operating cycle; or
2. The liability is expected to be settled within 12 months after the reporting date.
This definition has gained wide acceptance because it recognizes operating cycles of varying
lengths in different industries.
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.
3.2. Classification of liabilities: -
Liabilities are classified as long- term liability and short-term liability. 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. Current liability is a debt that a company reasonably expected to pay
from the existing current asset or through the creation of other current liabilities and within
one year or the operating cycle whichever is longer.
Liabilities that are to be paid out of current assets and are due within a short time, usually
within one year, are called current liabilities. Current liabilities include notes payable,
accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and
wages, and interest payable.
3.3. Types of current liabilities
The following are the types of current liabilities
Account 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.

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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.
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.
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.
Interest-Bearing Notes Issued
Assume that Castle National Bank agrees to lend €100,000 on March 1, 2015, to Landscape
Co. if Landscape signs a €100,000, 6 percent, four-month note. Landscape records the cash
received on March 1 as follows.
March 1, 2015
Cash 100,000
Notes Payable 100,000
(To record issuance of 6%, 4-month note to Castle National Bank)
If Landscape prepares financial statements semi-annually, it makes the following adjusting
entry to recognize interest expense and interest payable of €2,000 (€100,000 x 6% x 4/12) at
June 30, 2015.
June 30, 2015
Interest expense 2,000
Interest Payable 2,000
(To record interest for 4 months on Castle National Bank)
If Landscape prepares financial statements monthly, its interest expense at the end of each
month is €500 (€100,000 x 6% x 1/12).
At maturity (July 1, 2015), Landscape must pay the face value of the note (€100,000) plus
€2,000 interest (€100,000 x 6% x 4/12). Landscape records payment of the note and accrued
interest as follows.
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July 1, 2015
Notes payable 100,000
Interest Payable 2,000
Cash 102,000
(To record payment of Castle National Bank interest-bearing note and accrued interest at
maturity)
Interest expense 2,000
Interest Payable 2,000
(To record interest for 4 months on Castle National Bank)
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.
To illustrate, assume that Landscape issues a €102,000, four-month, zero-interest-bearing
note to Castle National Bank on March 1, 2015. The present value of the note is €100,000.
Landscape records this transaction as follows.
March 1, 2015 Cash 100,000
Note Payable 100,000
(To record issuance of 4-month, zero-interest-bearing note to Castle
Landscape National Bank)
credits the Notes Payable account for the present value of the note, which is €100,000. If
Landscape prepares financial statements semi-annually, it makes the following adjusting
entry to recognize the interest expense and the increase in the note payable of €2,000 at June
30, 2015.
June 30, 2015 Interest expense 2,000
Note Payable 2,000
At maturity (To record interest for 4-month on Castle National Bank)
(July 1, 2015),

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Landscape must pay the face value of the note, as follows.

July 1, 2015 Note payable 102,000
Cash 102,000
(To record payment of Castle National Bank zero-interest-bearing at
maturity)

In this case, the amount of interest expense recorded and the total cash outlay are exactly the
same whether Landscape signed a loan agreement with a stated interest rate or used the zero-
interest-rate approach.
Current Maturities of Long-Term Debt
Companies report 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.
A company should classify as current any liability that is due on demand (callable by the
creditor) or will be due on demand within one 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.
Short-Term Obligation Expected to be Refinanced
Short-term obligations are debts scheduled to mature within one year after the date of a
company’s statement of financial position or within its normal operating cycle. Some short-
term obligations are expected to be refinanced on a long-term basis. These short-term
obligations will not require the use of working capital during the next year (or operating
cycle).
Refinancing a short-term obligation on a long-term basis means either replacing it with a
long-term obligation or equity securities, or renewing, extending, or replacing it with short-
term obligations for an uninterrupted period extending beyond one year (or the normal
operating cycle) from the date of the company’s statement of financial position.
To illustrate, assume that Haddad Company provides the following information related to its
note payable.
• Issued note payable of €3,000,000 on November 30, 2015, due on February 28, 2016.
Haddad’s reporting date is December 31, 2015.
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• Haddad intends to extend the maturity date of the loan (refinance the loan) to June 30,
2017.
• Its December 31, 2015, financial statements are authorized for issue on March 15, 2016.
• The necessary paperwork to refinance the loan is completed on January 15, 2016. Haddad
did not have an unconditional right to defer settlement of the obligation at December 31,
2015.
In this case, Haddad must classify its note payable as a current liability because the
refinancing was not completed by December 31, 2015, the financial reporting date. Only if
the refinancing was completed before December 31, 2015, can Haddad classify the note
obligation as non-current. The rationale: Refinancing a liability after the statement of
financial position date does not affect the liquidity or solvency at the date of the statement of
financial position, the reporting of which should reflect contractual agreements in force on
that date.
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.
Dividends payable in the form of additional shares are not recognized as a liability. Such
share dividends do not require future outlays of assets or services.
Customers Advances and Deposits
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.
The classification of these items as current or non-current 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 receives payment when a customer subscribes to its magazines. An
airline company sells tickets for future flights. And software companies like Microsoft (USA)
issue coupons that allow customers to upgrade to the next version of their software. How do

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these companies account for unearned revenues that they receive before providing goods or
performing services?
To illustrate, assume that Logo University sells 10,000 season soccer tickets at $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
After (To record sales of 10,000 season tickets)
each
game, Logo University makes the following entry
Sept. 7 Unearned Sales Revenue 100,000
Sales Revenue 100,000
(To record sales of 10,000 season tickets)

The account Unearned Sales Revenue represents unearned revenue. Logo University reports
it as a current liability in the statement of financial position because the school has a
performance obligation. As ticket holders attend games, Logo recognizes revenue and
reclassifies the amount from Unearned Sales Revenue to Sales Revenue.
Sales and Value-Added Taxes Payable
Most countries have a consumption tax. Consumption taxes are generally either a sales tax or
a value-added tax (VAT).
Sales Taxes Payable
To illustrate the accounting for sales taxes, assume that Halo Supermarket sells loaves of
bread to consumers on a given day for €2,400. Assuming a sales tax rate of 10 percent, Halo
Supermarket makes the following entry to record the sale.

Cash 2,640
Sales Revenue 2,400
Sales Taxes Payable 240

Value-Added Taxes Payable

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.
Assume the following examples

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1. Hill Farms Wheat Company grows wheat and sells it to Sunshine Baking for $1,000.
Hill Farms Wheat makes the following entry to record the sale, assuming the VAT is
15 percent.

Cash 1,150
Sales Revenue 1,000
Value-Added Taxes Payable 150

Hill Farms Wheat then remits the $150 to the tax authority.
2. Sunshine Baking makes loaves of bread from this wheat and sells it to Halo
Supermarket for $2,000. Sunshine Baking makes the following entry to record the
sale, assuming the VAT is 15 percent.

Cash 2,300
Sales Revenue 2,000
Value-Added Taxes Payable 300

Sunshine Baking then remits $100 to the government, not $200. The reason: Sunshine Baking
has already paid $150 to Hill Farms Wheat. At this point, the tax authority is only entitled to
150. Sunshine Baking receives a credit for the VAT paid to Hill Farms Wheat, which reduces
the VAT payable.
3. Halo Supermarket sells the loaves of bread to consumers for $2,400. Halo
Supermarket makes the following entry to record the sale, assuming the VAT is 10
percent.

Cash 2,760
Sales Revenue 2,400
Value-Added Taxes Payable 360

Halo Supermarket then sends only $60 to the tax authority as it deducts the $300 VAT
already paid to Sunshine Baking.
Income Taxes Payable
Corporations should classify as a current liability the taxes payable on net 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.
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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.
Social Security Taxes: Most governments provide a level of social benefits (for retirement,
unemployment, income, disability, and medical benefits) to individuals and families. The
benefits are generally funded from taxes assessed on both the employer and the employees.
These taxes are often referred to as Social Security taxes or Social Welfare taxes. Funds for
these payments generally come from taxes levied on both the employer and the employee.
Employers collect the employee’s share of this tax by deducting it from the employee’s gross
pay, and remit it to the government along with their share.
Income Tax Withholding: Income tax laws generally require employers to withhold from
each employee’s pay the applicable income tax due on those wages. The employer computes
the amount of income tax to withhold according to a government-prescribed formula or
withholding tax table.
Payroll Deduction Example: Assume a weekly payroll of $10,000 entirely subject to Social
Security taxes (8%), with income tax withholding of $1,320 and union dues of $88 deducted.
The company records the wages and salaries paid and the employee payroll deductions as
follows.
Salaries and Wages Expense 10,000
Withholding Tax Payable 1,320
Social Security Taxes Payable 800
Union Dues Payable 88
Cash 7,792

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It records the employer payroll taxes as follows.

Payroll Tax Expense 800
Social Security Taxes Payable 800
The employer must remit to the government its share of Social Security tax along with the
amount of Social Security tax deducted from each employee’s gross compensation. It should
record all unremitted employer Social Security taxes as payroll tax expense and payroll tax
payable.
3.4. Short-Term Notes Payable
Companies record obligations in the form of written notes as 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.
Companies frequently issue notes payable to meet short-term financing needs. Notes payable
usually require the borrower to pay interest. Notes are issued for varying periods. Those due
for payment within one year of the balance sheet date are usually classified as current
liabilities.
Illustration: Hong Kong National Bank agrees to lend HK$100,000 on September 1, 2017, if
C.W. Co. signs a HK$100,000, 12%, four-month note maturing on January 1.
Instructions
a) Prepare the journal entry on September 1.
b) Prepare the adjusting journal entry on December 31, assuming monthly
adjusting entries have not been made.
c) Prepare the journal entry at maturity (January 1, 2018).
Solution
A.

Cash 100,000
Sep, 1 Notes Payable 100,000
B. Adjusting entry
Interest expense 4,000
Dec, 31 Interest Payable 4,000
Accrued Interest 100,000 x 12% x 4/12 = $4,000
C. Prepare the journal entry at maturity (January 1, 2018
Note payable 100,000
Jan. 1, 2018 Interest Payable 4,000
Cash 104,000

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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 after 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.

Detail and supplemental information concerning current liabilities should be sufficient to

meet the requirement of full disclosure. Companies should clearly identify secured liabilities,
as well as indicate the related assets pledged as collateral. If the due date of any liability can
be extended, a company should disclose the details.
Accounts payable arise primarily from the acquisition of materials and supplies to be used in
the production of goods or in conjunction with providing services. Payables that arise from
transactions with suppliers in the normal course of business, which customarily are due in no
more than one year, may be stated at their face amount rather than at the present value of the
required future cash flows if the effect of discounting is immaterial.
Notes Payable
Companies record obligations in the form of written notes as 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.

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Companies frequently issue notes payable to meet short-term financing needs. Notes payable
usually require the borrower to pay interest. Notes are issued for varying periods. Those due
for payment within one year of the balance sheet date are usually classified as current
liabilities.
Illustration: Hong Kong National Bank agrees to lend HK$100,000 on September 1, 2017, if
C.W. Co. signs a HK$100,000, 12%, four-month note maturing on January 1.
Instructions
d) Prepare the journal entry on September 1.
e) Prepare the adjusting journal entry on December 31, assuming monthly
adjusting entries have not been made.
f) Prepare the journal entry at maturity (January 1, 2018).
Solution
A.

Cash 100,000
Sep, 1 Notes Payable 100,000
B. Adjusting entry
Interest expense 4,000
Dec, 31 Interest Payable 4,000
Accrued Interest 100,000 x 12% x 4/12 = $4,000
C. Prepare the journal entry at maturity (January 1, 2018

Note payable 100,000

Jan. 1, 2018 Interest Payable 4,000
104,000
Unearned Revenues: Revenues that are received before goods are delivered or services are
performed.
1. Company increases (debits) Cash and increases (credits) a current liability
account, Unearned Revenue.
2. When the company recognizes revenue, it decreases (debits) the unearned
revenue account and increases (credits) a revenue account.
Illustration: Busan Park sells 10,000 season football tickets at $ 50,000 each for its
five-game home schedule. The club makes the following entry for the sale of season
tickets (in thousands of $):

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Cash 500,000
Aug, 6 Unearned ticket revenue 500,000
As each game is completed, Busan Park records the revenue earned.
Unearned ticket revenue 100,000
Sept, 7 ticket revenue 100,000
Current Maturities of Long-term Debt
u Portion of long-term debt that comes due in the current year.
u No adjusting entry required.
Illustration: Wendy Construction issues a five-year, interest-bearing €25,000 note on January 1,
2017. This note specifies that each January 1, starting January 1, 2018, Wendy should pay
€5,000 of the note. When the company prepares financial statements on December 31, 2017,
1. What amount should be reported as a current liability? $5,000
2. What amount should be reported as a long-term liability? $20,000
A contingent liability is: (a) A possible obligation that arises from past events and whose
existence will be confirmed only by the occurrence or non-occurrence of uncertain future
events not wholly within the control of the entity or
(b) A present obligation that arises from past events but is not recognized b/c:
(i) it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation, or
(ii) the amount of the obligation cannot be measured with sufficient reliability
Contingent liabilities are not recognized in the financial statements because they are
1. A possible obligation (not yet confirmed),
2. A present obligation for which it is not probable that payment will be made, or
3. A present obligation for which a reliable estimate of the obligation cannot be made.
Disclosure
For each class of contingent liability:
Ø Description of the nature of the contingent liability
Ø Estimate of its financial effect
Ø Indication of the uncertainties relating to the amount or timing of any outflow
Ø Possibility of any reimbursement
Ø No recognition of a contingent liability

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