Current liabilities, basically, are obligations arising from past events which must be paid or settled within a year or within the operating cycle of the business, whichever is longer. These obligations are settled by using current assets (such as cash or inventory) or by the creation of other current liabilities.
The distinction between current liabilities and current asset is very important in evaluating a company’s ability to meet its short-term obligations as they come due, as is the proper classification of liabilities as either current or long-term.
Through this post, I am going to bring you into a closer look of current liabilities. Although there won’t be any journal entries presented, there are much more detail overviews [from differences angle of perspectives] to current liabilities. Enjoy!
Determining and Valuing Current Liabilities Are not Easy
The amounts reported for current liabilities generally are based on the amounts payable in cash or in goods and services. If an obligation arises from a bank loan, purchasing goods from a supplier on credit, monthly utility bills, or employee salaries and payroll tax liabilities, it is easy to determine that the obligation exists and identify the party to be paid and the amount owed. However, not all potential obligations are that straightforward.
Sometimes it is difficult to determine if a liability actually exists, and if it does exist, it may be difficult to determine the precise amount, the specified party involved, or both. As one would expect, the accounting concept of conservatism also applies to liabilities. As a result, some liabilities are based on estimated amounts, whereas other potential obligations may be omitted from the balance sheet and described only in the footnotes to the financial statements.
A contingent liability is a potential obligation arising from a past transaction, but whether an actual liability exists depends on or is contingent upon a future outcome.
Assume your company sells goods to a customer and accepts a one-year note receivable. Rather than waiting a year to collect the note and interest, you sell the note to the bank with recourse. If the customer defaults and does not pay the bank when the note matures, your company is obligated to pay the bank.
Does a liability exist?
At this moment, the existence of this liability is contingent on a future outcome: whether the customer pays the bank at maturity or defaults on the loan.
Accounting guidelines for contingent liabilities are based on the likelihood that a liability exists and the ability to estimate the amount. If the liability is probable and one can make a reasonable estimate of the amount, it will be included as a liability on the balance sheet and often described in the financial statement footnotes. However, if it is only reasonably possible that there will be an unfavorable outcome, it will be described in the footnotes and not appear on the balance sheet.
It is common to see a caption for contingent liabilities on the balance sheet, but with no dollar amount. This form of disclosure is meant to call the reader’s attention to information discussed in the footnotes.
Returning to the example of selling a note receivable with recourse, if you think it is probable that the customer will default and that you will have to pay the bank, you will report the amount you expect to pay as a liability in your balance sheet and the loss in your income statement. If it is reasonably possible but not probable that the customer will default, footnote disclosures will describe the sale with recourse and state that it is reasonably possible the customer will default and also will provide an estimate of the amount of the recourse liability.
As one would imagine, contingent liabilities are challenging, controversial issues, and considerable judgment is involved in determining how they should be treated in financial statements, particularly those arising from pending litigation and environmental obligations.
An estimated liability may involve uncertainty about the amount owed or the specific party to whom there is an obligation.
Consider a case of a manufacturer that provides warranty coverage on its products and that approximately 5 percent of the products it sold in past years were returned for replacement under the warranty.
Does a liability exist?
Probably. The obligation under the warranty may be viewed as a contingent liability, but on the basis of past experience it is probable that the company will incur warranty replacement costs on some of the products sold this year, too. Even though it is not known precisely how many products will be returned for replacement or the specific customers involved, drawing upon past experience it is possible to make a reasonable estimate of the overall warranty costs that will be incurred.
The estimated warranty costs for products sold should be treated as expenses and thus matched with the sales revenue earned during the current year, and the estimated warranty obligation for products that are still under warranty coverage but have not yet been returned for replacement should be reported as liabilities in the year-end balance sheet.
Accounts Classified Under Current Liabilities
From the discussion above, it makes sense that current liabilities are generally obligations that must be fulfilled or debts that must be repaid within a year and that long-term liabilities are not due for at least a year or perhaps will not be settled in full for many years. The distinction between current and long-term assets and liabilities is significant. Such classifications provide valuable information about liquidity, which refers not only to how quickly current assets will generate cash but also to a company’s ability to meet its short-term obligations as they become due.
The current liability section of a balance sheet typically includes the items shown below:
- Accounts payable: amounts the company owes to suppliers and others for goods and services purchased on credit.
- Notes payable: formal promissory notes with specific maturity dates, interest rates, and repayment terms.
- Estimated warranty obligations: estimated costs of repairs and replacements for products sold under warranty.
- Unearned revenues: amounts a company received from customers in advance, including sales of gift certificates, subscriptions, future rent, and customer deposits for special orders.
- Accrued liabilities [or accrued expenses]: expenses for which the company has not yet paid, such as salaries and wages, interest on notes payable, and utilities.
- Payroll tax liabilities: payroll taxes withheld from employees and employer payroll taxes which have not yet been paid to the taxing authorities.
- Income taxes payable: income taxes the company owes on the basis of its estimated or completed income tax return for the year.
- Dividends payable: cash dividends declared by a corporation’s board of directors to distribute a portion of corporate earnings to the stockholders.
- Current portion of long-term debt: the amount due and payable in the coming year on a long-term loan, such as the next year’s monthly payments on a 30-year mortgage note payable.
Next, we are going to go into a more detail on each of the above accounts. Read on…
Accounts Payable [Trade Payables]
Accounts payable also are referred to as trade payables; they arise from normal business trade transactions and typically represent amounts owed to suppliers for goods and services purchased on credit. The normal credit period may be 30 days, but it can be longer in certain industries.
If the credit terms are n/10 EOM, the amount billed is due within 10 days after the end of the month. Cash discount terms may be offered as an incentive for early payment.
If the credit terms are 1/10 net/30 on a $10,000 account balance, it means that if the balance is paid within 10 days of the invoice, a 1 percent cash discount of $100 can be taken, otherwise one must pay the full $10,000 within 30 days (net/30).
If a company’s current assets are not generating cash quickly enough for the company to take advantage of the discounts offered by its suppliers, it might consider a short-term borrowing arrangement in order to do so; the 1 percent discount, if annualized, is an 18 percent effective annual interest rate.
Assume the company will have the money to pay the full invoice price of $10,000 when it is due in 30 days, but would need to borrow money to be able to pay the invoice 20 days earlier and receive the cash discount of $100. If it borrowed $10,000 at 18% interest for 20 days, it would pay $100 of interest ($10,000 x 18% x 20/360 days = $100). It would pay $100 interest to receive a $100 cash discount and break even. But if it could borrow the money for less than 18%, it would come out ahead.
When cash discounts are offered, a company might record its purchase of merchandise at the full invoice price of $10,000 and deduct the cash discount taken to arrive at an inventory cost of $9,900. Another company might record the purchase at $9,900 if it plans to take the discount and instead monitor the amount of the discounts it missed as this can be costly.
Notes payable are formal promissory notes with specific maturity dates, interest rates, and repayment terms.
Estimated Warranty Obligations
Concepts pertaining to contingent and estimated liabilities were discussed already on the first section of this post. Obligations and/or unearned revenues arising from warranties and similar arrangements pose some interesting and challenging accounting issues due to the uncertainties involved.
When a company provides warranty coverage for the products it sells, the warranty coverage provided can be viewed from at least two different perspectives. In the case of the manufacturing company that was discussed earlier in this section, the estimated warranty costs were considered to be an additional expense associated with the product sales, even though the precise number of products that would be returned under the warranty and the specific customers involved were unknown at that time.
In that case, drawing upon its past experience, the manufacturer estimated the warranty costs it expected it would incur and treated those costs as expenses of the current year which were matched with the sales revenue earned that year. The obligation for estimated warranty costs on products that were still under warranty coverage but had not yet been returned for replacement was reported as a liability in the year-end balance sheet. This treatment is referred to as an expensed warranty approach. You should note that given the uncertainty involved, considerable judgment is used when estimating the costs and the remaining unsettled warranty obligation, which can provide unethical managers an opportunity to paint a more favorable picture of the company than may actually exist.
Another perspective to warranty coverage can be taken which is referred to as a sales warranty approach. In this approach, the warranty coverage is viewed as a separate sales component, much like a service contract, which is discussed further in the unearned revenue section below.
Unearned revenues represent obligations that must be fulfilled in the future for which the company has been paid in advance. Common examples of unearned revenues include customer deposits for special orders, amounts received from sales of gift cards and certificates, online and print subscriptions, health club memberships, and future rental payments. You may find potentially returnable deposits, such as a lease security deposit, included in unearned revenues.
The revenues associated with these advance collections will be reported in the income statement in the period in which the goods or services are provided, or the customer’s rights to a returnable deposit have expired or the customer has not met the conditions specified in the arrangement.
Gift cards are increasingly popular, and many merchants have found that they provide substantial amounts of income and no cost when gift recipients fail to use the cards or have a few unused dollars remaining.
Referring back to the warranty example discussed earlier, a company may treat a portion of the selling price of its product as a separate warranty component, much like a service contract, or separately sell extended warranty coverage. The amount assigned to the warranty is unearned revenue that later will be earned over the period covered by the warranty. Rebates, coupons, premiums, frequent flyer miles and other award programs pose unique issues in determining the amount of revenue to be recognized at the time of sale versus at some future date.
Accrued Liabilities (Accrued Expenses)
Accrued liabilities (or accrued expenses) represent expenses which have been incurred but are unpaid, such as salaries and wages, interest on notes payable (even if the note is long-term), and utilities. If employees earn vacation, sick pay, or personal leave days, according to the matching principle, the amounts earned each period should be included in the operating expenses in the income statement, and the estimated liability for days earned but not yet taken will be a current liability on the balance sheet.
Payroll Tax Liabilities
Payroll tax liabilities include the income tax [and Social Security and medicare for US) taxes the employer withheld from employee paychecks and additional payroll taxes imposed on the employer that have not been deposited or paid to the taxing authorities. The amount reported as salaries and wages expense in the income statement represents employee’s gross pay, and salaries and wages payable on the year-end balance sheet represents the net amount owed to employees after withholdings.
However, the employer must remit not only the payroll taxes withheld from employees, but also the additional employer payroll taxes it owes.
Income Taxes Payable
Corporations are taxable entities and so any unpaid income taxes based on quarterly estimates or the completed income tax return are reported as current liabilities. However, income taxes on profits earned by sole proprietorships and partnerships are personal liabilities of the owner or owners, not liabilities of the business entity. Differences between accounting income and taxable income may result in deferred income taxes.
A corporation may distribute a portion of its earnings to the stockholders by declaring a cash dividend. There is no guarantee that common stockholders will receive cash dividends even if the corporation has paid regular cash dividends in the past; dividends are declared at the discretion of the board of directors.
There are usually several days between the date a dividend is declared and the time it actually is paid. If a cash dividend has been declared but it has not been paid yet, current liabilities will include the amount of the dividend payable.
Corporations may also issue preferred stock, which does carry a stated dividend rate, and preferred stock dividends must be paid before the common stockholders may receive cash dividend distributions. However, even the stated amount of the preferred stock dividend is not a liability until the board of directors formally declares that the dividend will be paid. The board of directors instead may declare a stock dividend that will be paid in additional shares of stock rather than in cash. This is not a current liability as it will not be settled with current assets or current liabilities; the dividend declared will be reported in stock-holders’ equity.
Current Portion Of Long-Term Debt
Some borrowing arrangements require that a portion of the debt be repaid each year, such as an installment loan or serial bonds payable. If this is the case, the principal amount due and payable in the coming year is included in current liabilities and the remaining principal balance is reported as a long-term liability and presented on a balance sheet, along with additional footnote disclosures.
Have those above detail enough?
Not yet you said. Alright, I am going to enrich the perspective to the current liabilities further. Let’s go on…
Current Liabilities [a More Detail Perspective]
As with current assets, the guideline used to distinguish current liabilities is more specific than was mentioned earlier. Current liabilities are obligations that are due within a year or within the operating cycle of the business, whichever is longer, and are settled by using current assets or through the creation of other current liabilities.
You might already [or not yet] understood that a produce store or a meat shop may have an operating cycle of a few days, whereas a clothing retailer may have four operating cycles within a year if it stocks seasonal apparel and a construction contractor or liquor producer may have an operating cycle that spans several years. But along with the operating cycle, there are other factors that must be considered in deciding under which category some liabilities should be reported.
Sometimes certain liabilities are reported in both the current and long-term liability classifications of the balance sheet.
If a business has a 30-year mortgage note payable which it used to finance the purchase of land and its office building, one most likely would classify the mortgage note payable as a long-term liability. However, if the business is required to make monthly installment payments on the loan, the monthly principal payments for the coming year should be classified as a current liability, whereas the remaining principal balance of the loan should be classified as long-term.
Thus, you might find the current portion of long-term debt included among the current liabilities, which represents the portion of the loan principal balance that must be repaid within the coming year. The remaining loan balance will be reported as a long-term liability as this amount is not payable for at least one year in the future.
The current versus long-term classification depends on when obligations are due and what resources will be used to settle those obligations.
To complicate matters, the second part of the definition of a current liability also requires a bit more explanation. Current liabilities are obligations which will be settled by using current assets or through the creation of other current liabilities.
Let’s assume your business sells gift certificates or gift cards that the recipient can present to receive products you sell in your store.
Is this a current liability?
Yes, the obligation will be settled by using a current asset: the merchandise inventory chosen when the gift certificate is redeemed.
Perhaps your business has a 90-day note payable to the bank, but rather than requiring you to pay it off and negotiate another new loan, the bank permits you to replace it with another 90-day loan.
Is this a current liability?
Yes, the obligation will be settled through the creation of another current liability: another 90-day note payable.
Another example pertains to dividends, a way corporations return part of the business’s profits to their owners (stockholders). A corporation can declare a cash dividend to be paid to the stockholders at a specified future date; this sounds like and is a current liability. But if it is a stock dividend, meaning that the corporation plans to give the owners more shares of stock in the corporation, it is not a current liability because it will not be settled by using cash but rather with equity: more shares of stock.
Are we enough with case examples? Not yet, you said. Alright, let’s turn to another example that requires a bit more thought. Follow on…
Corporations often borrow substantial amounts of money for long periods by issuing bonds payable. The corporation generally is required to pay the interest owed each year (usually every six months) but does not have to pay back the amount borrowed for many years, maybe not for 100 years as in the case of the Walt Disney Company bonds issued a few years ago. For the first 99 years, the bonds payable would appear as a long-term liability on Disney’s balance sheet.
But where is this liability reported at the end of year 99?
If Disney must repay the bonds within the coming year, it seems that it should be classified as a current liability.
In most cases, bonds payable maturing within the coming year would be a current liability.
But, what if Disney created a fund, setting money aside each year to pay off the bonds when due, and the fund could not be used for any other purpose? Should the bonds payable within the coming year be reported as a current liability in this case?
Probably not; Disney has a fund set aside for this purpose and will not use its current assets to pay the obligation.
The system of classifying liabilities into current and long-term categories provides valuable information even though one has to think carefully about the sources of money that are available to settle some types of obligations.
Current Liabilities and Current Liquidity
If current assets consist of cash and other assets that will generate cash soon and current liabilities are obligations that must be settled or debts that must be repaid soon, the relationship between current assets and current liabilities seems quite important. In fact, much attention is focused on this in evaluating a company’s liquidity: its ability to meet its currently maturing obligations.
Have you ever worried about making your monthly mortgage payment on time because your next payday falls a couple days after the due date? Or maybe you just changed jobs, and although you will be paid a higher salary, your first paycheck will be delayed. Your house is worth $300,000 and your loan balance is $160,000, and so you could pay off the loan in full easily if you sold your house. Your net worth is $140,000 and you are solvent, meaning that you have more assets than liabilities. But you plan to live in your house, not sell it; you will have your paycheck soon, but you need a few more days to make this month’s mortgage payment.
But what if you have been laid off and can’t find a new job?
At first, it might seem like a temporary cash crunch, but when you still haven’t landed a new job after several months, it is a much bigger problem. You aren’t very liquid, and if this goes on for too long, you no longer will be solvent.
Similarly, a business may face a temporary cash crunch, but over the long run, if it continues to have problems coming up with enough cash from its normal operations to pay its bills on time (or in your case, a regular paycheck), it (you) cannot survive indefinitely. Suppliers may discontinue extending credit and demand to be paid in cash at the time of purchase or service. Banks may become unwilling to make even a short-term loan when the borrower’s ability to repay it on time, if at all, is in question. Even if the bank approves a loan, it may be at a high interest rate to compensate for this additional risk.
Working Capital and The Current Ratio
Working capital is a term used commonly to describe the relationship between current assets and current liabilities; it provides an indication of a company’s short-term liquidity: its ability to pay its current obligations when due using cash it generates from its routine operations.
Working capital is the excess of current assets (which generate cash) over current liabilities (which use cash).
A company with $300,000 of current assets and $200,000 of current liabilities has $100,000 of working capital follow:
Current Assets – Current Liabilities = Working Capital
$300,000 – $200,000 = $100,000
It would seem that this company is in a better position to be able to repay its short-term obligations on time and has a fairly good cushion in case something unexpected arises than is a company that also has $300,000 of current assets but has $295,000 of current liabilities and only $5,000 of working capital.
The relationship between current assets and current liabilities also can be expressed as a ratio that indicates the amount of current assets for every dollar of current liabilities, also indicating whether there is an acceptable cushion.
In this case, one would say the company has 1.5 times as many current assets as current liabilities, or $1.50 of current assets for every $1.00 of current liabilities.
Current Assets/Current Liabilities
= $300,000/$200,000 = 1.5 to 1