There are tens [if not hundreds] of items [transactions] to be classified as “current liabilities”. The bigger business most likely have more of these items. Therefore, confusion on classifying items [whether they are under current liabilities or not] is more than understandable. ASC 210-10-45 contains several examples of current liabilities. It also contains broad general descriptions of the types of items to be shown as current liabilities. These obligations can be divided into those where: (1) Both the amount and the payee are known; (2) The payee is known but the amount may have to be estimated; (3) The payee is unknown and the amount may have to be estimated; and (4) The liability has been incurred due to a loss contingency.
Examples of each of the foregoing types of current liabilities and short overviews are discussed in this post. Enjoy!
Type-1. Amount and Payee Known
Accounts Payable – Accounts payable arise primarily from the acquisition of materials and supplies to be used in the production of goods or in conjunction with the providing of services. ASC 835-30 states that payables that arise from transactions with suppliers in the normal course of business and that are due in customary trade terms not to exceed one year may be stated at their face amount rather than at the present value of the required future cash flows.
Notes Payable – Notes payable are more formalized obligations that may arise from the acquisition of materials and supplies used in operations or from the use of short-term credit to purchase capital assets (ASC 835-30 also applies to short-term notes payable).
Dividends Payable – Dividends payable become a liability of the enterprise when the board of directors declares a cash dividend. Since declared dividends are usually paid within a short period of time after the declaration date, they are classified as current liabilities.
Unearned revenues – Unearned revenues or advances result from customer prepayments for either performance of services or delivery of product. They may be required by the selling enterprise as a condition of the sale or may be made by the buyer as a means of guaranteeing that the seller will perform the desired service or deliver the product. Unearned revenues and advances should be classified as current liabilities at the balance sheet date if the services are to be performed or the products are to be delivered within one year or the operating cycle, whichever is longer.
Refundable Deposits – Refundable deposits may be received to cover possible future damage to property. Many utility companies require security deposits. A deposit may be required for the use of a reusable container. Refundable deposits are classified as current liabilities if the firm expects to refund them during the current operating cycle or within one year, whichever is longer.
Accrued Liabilities – Accrued liabilities have their origin in the end-of-period adjustment process required by accrual accounting. Commonly accrued liabilities include wages and salaries payable, benefits payable, interest payable, and taxes payable. In addition an employer may have a current obligation for the employer portion of FICA tax and FUTA (unemployment) tax. Payroll taxes are not legal liabilities until the associated payroll is actually paid.
Agency Liabilities – Agency liabilities result from the legal obligation of the enterprise to act as the collection agent for customer or employee taxes owed to various federal, state, or local government units. Examples of agency liabilities include sales taxes, income taxes withheld from employee paychecks, and employee FICA contributions.
Product Financing – Product financing liabilities originate when an entity sells and agrees to repurchase its inventory with the repurchase price equal to the original sales price plus the carrying and financing costs. The purpose of this transaction is to allow the seller to arrange financing on the original purchase of the inventory. The transaction is accounted for as a borrowing rather than as a sale.
Current Maturing Portion Of Long-Term Debt – Current maturing portion of long-term debt is shown as a current liability if the obligation is to be liquidated by using assets classified as current. However, if the currently maturing debt is to be liquidated by using other than current assets (i.e., by using a sinking fund that is properly classified as a noncurrent investment), then these obligations should be classified as long-term liabilities. Obligations that, by their terms, are due on demand (ASC 470-10-45-10) or will be due on demand within one year (or operating cycle, if longer) from the balance sheet date, even if liquidation is not expected to occur within that period, are classified as current liabilities.
Noncurrent debt may be due on demand under certain circumstances – Long-term obligations that contain call provisions be classified as current liabilities, if as of the balance sheet date one of the following occurs:
- The debtor is in violation of the agreement and that violation makes the obligation callable.
- The debtor is in violation of the agreement and that violation, unless cured within the grace period specified in the agreement, makes the obligation callable.
However, if circumstances arise that effectively negate the creditor’s right to call the obligation, the obligation may be classified as long-term. Examples are:
- The creditor has waived the right to call the obligation caused by the debtor’s violation or the creditor has subsequently lost the right to demand repayment for more than one year (or operating cycle, if longer) from the balance sheet date.
- Obligations contain a grace period for remedying the violation, and it is probable that the violation will be cured within the grace period. In these situations, the circumstances must be disclosed.
Demand notes having scheduled repayment terms – In some instances, a loan will call for scheduled payments and, in the alternative, state that it is due on demand or may be affected by a subjective acceleration clause. According to ASC 470, an obligation is considered due on demand even if a debt agreement specifies repayment terms, if the creditor can demand payment at any time. This situation is distinguished from a subjective acceleration clause, which is addressed separately.
Increasing-rate debt – Arrangements commonly referred to as “increasing-rate notes” are debt instruments that mature at a defined, near-term date, but which can be continually extended (renewed) for a defined longer period at the option of the debtor, with predefined increases in the interest rate as extensions are elected. The effective outstanding term of the debt is to be estimated after considering plans, ability and intent to service the debt. Based upon this term, the borrower’s periodic interest rate is determined by the use of the interest method. Thus, a constant yield will be computed and additional interest will be accrued during the earlier portions of the final term.
Debt Interest Costs – Debt interest costs should be amortized over the estimated outstanding term of the debt. Any excess accrued interest resulting from paying the debt before the estimated maturity date is an adjustment of interest expense. It may not be treated as an extraordinary item. The classification of the debt as current or noncurrent should be based on the source of repayment. Thus, this classification need not be consistent with the period used to determine the periodic interest cost. For example, the time frame used for the estimated outstanding term of the debt could be a year or less, but because of a planned long-term refinancing agreement the noncurrent classification could be used. Furthermore, the term-extending provisions of the debt instrument should be evaluated to ascertain whether they constitute a derivative financial instrument under ASC 815. If so, the derivative element is in all likelihood not “clearly and closely related” to the host instrument (the debt), and thus would have to be reported separately and carried at fair value.
Long-term obligations that contain subjective acceleration clauses – Long-term obligations that contain subjective acceleration clauses are classified as current liabilities if circumstances (such as recurring losses or liquidity problems) indicate that the clause will be exercised and payment will be due within one year (or one operating cycle). If, instead, the likelihood of the acceleration of the due date were remote, the obligation would be reported as long-term debt. Situations between the two extremes require disclosure (ASC 470-10-45).
Classification of long-term obligations when there are violations of covenants – Most commercial debt agreements contain a range of financial covenants. The failure to meet these often provides the lender with the contractual right to accelerate the due date, commonly to make the full amount due and payable on demand. Unless a waiver is obtained in such a situation, the balance sheet would have to reflect the nominally long-term debt as a current liability, which in turn might create going concern issues for management and the outside auditors to address and report on. While a complete waiver, effectively a promise by the lender to not exercise its rights under the financial covenants for at least one year from the balance sheet date, makes it possible to continue presenting the debt as noncurrent, great care must be exercised in interpreting the substance of such an agreement. In practice, many waivers are not effective and can not form the basis for continued accounting for the debt as noncurrent. For example, a waiver “as of” the current balance sheet date provides no real comfort, since the lender is entitled to assert its rights as soon as the very next day. Likewise, a waiver pending the next scheduled submission of a borrower’s covenant compliance letter (generally quarterly, possibly monthly) offers no assurance that the borrower will successfully meet its obligations, and hence affords no basis for presentation of the debt as noncurrent.
Classification of borrowings outstanding under certain revolving credit agreements – Borrowings outstanding under a revolving credit agreement sometimes include both a subjective acceleration clause and a requirement to maintain a lockbox into which the borrower’s customers send remittances that are then used to reduce the debt outstanding. These borrowings are short-term obligations and are classified as current liabilities unless the entity has the intent and ability to refinance the revolving credit agreement on a long-term basis (i.e., the conditions in ASC 470-10-45 are met). However, if the lockbox is a “springing” lockbox, which is a lockbox agreement in which remittances from the borrower’s customers are forwarded to its general bank account and do not reduce the debt outstanding until and unless the lender exercises the subjective acceleration clause, the obligations are long-term since the remittances do not automatically reduce the debt outstanding if the acceleration clause has not been exercised.
Short-term obligations expected to be refinanced – Short-term obligations expected to be refinanced may be classified as noncurrent liabilities if the conditions specified in ASC 470-10-45-11 all are met. An entity may reclassify currently maturing debt (other than obligations arising from transactions in the normal course of business that are due in customary terms) as long-term, provided that the entity intends to refinance the obligation on a long-term basis and its intent is supported by either of the following:
- Post-balance-sheet-date issuance of a long-term obligation or equity securities. After the date of the entity’s balance sheet but before that balance sheet is issued, longterm obligations or equity securities have been issued for the purpose of refinancing the short-term obligations on a long-term basis.
- Refinancing agreement. Before the balance sheet is issued, the entity has entered into a financing agreement that clearly permits the entity to refinance the short-term obligation on a long-term basis on terms that are readily determinable.
If reclassification of the maturing debt is based upon the existence of a refinancing agreement, then the following requirements must be met:
- The refinancing agreement is noncancelable and will not expire within one year or operating cycle of the balance sheet date.
- The replacement debt will not be callable except for violation of a provision of the refinancing agreement with which compliance is objectively determinable or measurable.
- The entity is not in violation of the terms of the refinancing agreement.
- The lender or investor is financially capable of honoring the refinancing agreement.
The amount of currently maturing debt to be reclassified cannot exceed the amount raised by the replacement debt or equity issuance, nor can it exceed the amount specified in the refinancing agreement. If the amount specified in the refinancing agreement can fluctuate, then the maximum amount of debt that can be reclassified is equal to a reasonable estimate of the minimum amount expected to be available on any date from the due date of the maturing obligation to the end of the fiscal year. If no estimate can be made of the minimum amount available under the financing agreement, then none of the maturing debt can be reclassified as long-term. If debt or other agreements limit the ability of the organization to fully utilize the proceeds of the refinancing agreement (for example, a clause in another debt agreement sets a maximum debt-to-equity ratio), then only the amount that can be drawn without violating the limitations expressed in those other agreements can be reclassified to long-term. ASC 470-10-55 states that if an entity uses current assets after the balance sheet date to liquidate a current obligation, and then replaces those current assets by issuing either equity securities or long-term debt before the issuance of the balance sheet, the currently maturing debt must still be classified as a current liability.
Type-2. Payee Known but Amount May Have to Be Estimated
Taxes payable – Taxes payable includes federal, state, and local income taxes. The amount of income taxes payable is an estimate because the tax laws and rates in effect when the accrual is determined may differ from the tax laws and rates in effect when the taxes ultimately are paid. Temporary differences in recognition and measurement between accounting standards and tax laws create deferred tax liabilities (and deferred tax assets). The portion deemed currently payable must be classified as a current liability. The remaining amount is classified as a long-term liability.
Property Taxes Payable – Property taxes payable represents the unpaid portion of an entity’s obligation to a state or other taxing authority that arises from ownership of real property. ASC 720-30 indicates that the most acceptable method of accounting for property taxes is a monthly accrual of property tax expense during the fiscal period of the taxing authority for which the taxes are levied. The fiscal period of the taxing authority is the fiscal period that includes the assessment or lien date. A liability for property taxes payable arises when the fiscal year of the taxing authority and the fiscal year of the entity do not coincide or when the assessment or lien date and the actual payment date do not fall within the same fiscal year. For example, XYZ Corporation is a calendar-year corporation that owns real estate in a state that operates on a June 30 fiscal year. In this state, property taxes are assessed and become a lien against property on July 1, although they are not payable until April 1 and August 1 of the next calendar year. XYZ Corporation would accrue an expense and a liability on a monthly basis beginning on July 1. At year-end (December 31), the firm would have an expense for six months’ property tax on their income statement and a current liability for the same amount.
Bonus Payments – Bonus payments may require estimation since the amount of the bonus may be affected by the entity’s net income for the year, by the income taxes currently payable, or by other factors. Additional estimation is necessary if bonus payments are accrued on a monthly basis for purposes of interim financial reporting but are determinable only annually by using a formula whose values are uncertain until shortly before payment.
Compensated absences – Compensated absences refer to paid vacation, paid holidays, paid sick leave, and other paid leaves of absence. ASC 710-10-25 states that an employer must accrue a liability for employee’s compensation of future absences if all of the following conditions are met:
- The employee’s right to receive compensation for future absences is attributable to employee services already rendered.
- The right vests or accumulates.
- Payment of the compensation is probable.
- The amount of the payment can be reasonably estimated.
If an employer is required to compensate an employee for unused vacation, holidays, or sick days even if employment is terminated, then the employee’s right to this compensation is said to vest. Accrual of a liability for nonvesting rights depends on whether the unused rights expire at the end of the year in which earned or accumulate and are carried forward to succeeding years. If the rights expire, a liability for future absences should not be accrued at year-end because the benefits to be paid in subsequent years would not be attributable to employee services rendered in prior years. If unused rights accumulate and increase the benefits otherwise available in subsequent years, a liability should be accrued at year-end to the extent that it is probable that employees will be paid in subsequent years for the increased benefits attributable to the accumulated rights and the amount can be reasonably estimated.
ASC 710-10-25-7 allows an exception for employee paid sick days that accumulate but do not vest. No accrued liability is required for sick days that only accumulate. However, an accrual may be made. The Board stated that these amounts are rarely material and the low reliability of estimates of future illness coupled with the high cost of developing these estimates indicates that accrual is not necessary. The required accounting should be determined by the employer’s actual administration of sick pay benefits. If the employer routinely lets employees take time off when they are not ill and allows that time to be charged as sick pay, then an accrual should be made.
Pay for other employee leaves of absence that represent time off for past services (jury duty, personal days) should be considered compensation subject to accrual. Pay for employee leaves of absence that will provide future benefits and that are not attributable to past services rendered would not be subject to accrual. ASC 710-10-25 does not provide guidance as to whether accruals should be based on current pay rates or expected future rates of pay and does not provide guidance regarding discounting of the accrual amounts.
ASC 710-10-25-4 et seq. contains the accounting requirements regarding sabbatical leaves or other similar benefit arrangements that require the completion of a minimum service period, and for which the benefit does not increase with additional years of service.
Under these arrangements, the individual continues to be a compensated employee and is not required to perform duties for the entity during his/her absence. Assuming the conditions set forth above are met, the compensation cost associated with a sabbatical or other similar arrangement must be ratably accrued over the presabbatical periods of service.
ASC 712 specifies the use of the four conditions of ASC 710-10-25 to identify the need to accrue an obligation for postemployment benefits other than pensions. Postemployment benefits other than pensions are benefits paid after termination of employment but before retirement to or on behalf of former or inactive employees, their beneficiaries, and covered dependents. Examples of those benefits are salary continuation agreements, supplemental unemployment compensation, severance benefits, workers’ compensation and other disability-related payments, job training or job placement services and continuation of health care or life insurance benefits after employment. If the four conditions are met, a liability is accrued. If one or more of the conditions are not met, the employer should assess whether a liability should be accrued under ASC 450. If neither ASC 710-10-25 nor ASC 450 is applicable because the amount cannot be reasonably estimated, this fact must be disclosed.
Type-3. Payee Unknown and the Amount May Have to Be Estimated
Sales Incentives – Sales incentives are usually offered by an enterprise to increase product sales. They may require the purchaser to accumulate a specified number of miles, points, box tops, wrappers, or other proofs of purchase. They may or may not require the payment of a cash amount. If the incentive offer terminates at the end of the current period but has not been completely accounted for, or if it extends into the next accounting period, a current liability for the estimated number of redemptions that are expected in the future period would be recorded. If the incentive offer extends for more than one accounting period, the estimated liability must be divided into a current portion and a long-term portion.
Product Warranties – Product warranties providing for repair or replacement of defective products may be sold separately or may be included in the sale price of the product. If the warranty extends into the next accounting period, a current liability for the estimated amount of warranty expense expected in the next period must be recorded. If the warranty spans more than the next period, the estimated liability must be partitioned into a current and long-term portion. ASC 460, requires disclosure of product warranties in the notes to financial statements. Entities are required to disclose the following information:
- The nature of the product warranty, including how the warranty arose and the events or circumstances in which the entity must perform under the warranty.
- The entity’s accounting policy and methodology used to determine its liability for the product warranty, including any liability (such as deferred revenue) associated with an extended warranty.
- A reconciliation of the changes in the aggregate product warranty liability for the reporting period. The reconciliation must include five components: (1) the beginning aggregate balance of the liability, (2) the reductions in the liability caused by payments under the warranty, (3) the increase in the liability for new warranties issued during the period, (4) the change in the liability for adjustments to estimated amounts to be paid under preexisting warranties, and (5) the ending aggregate balance of the liability.
- The nature and extent of any recourse provisions or available collateral that would enable the entity to recover the amounts paid under the warranties, and an indication (if estimable) of the approximate extent to which the proceeds from recovery or liquidation would be expected to cover the maximum potential amount of future payments under the warranty.
- The disclosures required by ASC 850 if the warranties are granted to benefit related parties.
A proposed FASB staff position would also require the above disclosures for an indemnification clause included by a software vendor-licensor in a software licensing agreement that indemnifies the licensee against liability and damages (including legal defense costs) arising from any claims of patent, copyright, trademark or trade secret infringement by the software vendor’s software.
Future Product Returns – Future product returns are accrued if a buyer has a right to return the product purchased and the sale is recognized currently. An accrual for returns must reduce both revenue and the associated cost of sales (ASC 605-15). In the relatively unlikely situation where the reporting entity is unable to make a reasonable estimate of the amount of future returns, the sale cannot be recognized until the return privilege has expired or conditions permit the loss to be estimated, at which point it would become reportable. Examples of factors that might impair the ability to reasonably estimate a loss are
- Susceptibility of the product to technological or other obsolescence
- A lengthy period over which returns are permitted
- Absence of experience with returns on similar products sold to similar markets
- Sales are few, significant, and have unique terms (rather than a large number of relatively homogeneous sales of small dollar amounts).
Environmental Remediation Liabilities – Obligations arising from pollution of the environment have become a major cost for businesses. ASC 410-30 sets forth a very detailed description of relevant laws, remediation provisions and other pertinent information, which is useful to auditors as well as to reporting entities. In terms of accounting guidance, ASC 450 contains the principal standard to be interpreted in the context of environmental obligations (e.g., determining the threshold for accrual of a liability, etc.) and its sets “benchmarks” for liability recognition. The benchmarks for the accrual and evaluation of the estimated liability (i.e., the stages which are deemed to be important to ascertaining the existence and amount of the liability) are
- The identification and verification of an entity as a potentially responsible party (PRP), since ASC 410-30 stipulates that accrual should be based on the premise that expected costs will be borne by only the “participating potentially responsible parties” and that the “recalcitrant, unproven and unidentified” PRP will not contribute to costs of remediation
- The receipt of a “unilateral administrative order”
- Participation, as a PRP, in the remedial investigation/feasibility study (RI/FS)
- Completion of the feasibility study
- Issuance of the Record of Decision (RoD)
- The remedial design through operation and maintenance, including postremediation monitoring
The amount of the liability that is to be accrued is affected by the entity’s allocable share of liability for a specific site, and by its share of the amounts related to the site that will not be paid by the other PRP or the government. The categories of costs to be included in the accrued liability include incremental direct costs of the remediation effort itself, as well as the costs of compensation and benefits for employees directly involved in the remediation effort. The SOP indicates that costs are to be estimated based on existing laws and technologies, and are not to be discounted to estimated present values unless timing of cash payments is fixed or reliably determinable.
Incremental Direct Costs – Incremental direct costs will include such items as fees paid to outside law firms for work related to the remediation effort, costs relating to completing the RI/FS, fees to outside consulting and engineering firms for site investigations and development of remedial action plans and remedial actions, costs of contractors performing remedial actions, government oversight costs and past costs, the cost of machinery and equipment dedicated to the remedial actions that do not have an alternative use, assessments by a PRP group covering costs incurred by the group in dealing with a site, and the costs of operation and maintenance of the remedial action, including costs of postremediation monitoring required by remedial action plan.
ASC 410-30 states that potential recoveries cannot be offset against the estimated liability, and further notes that any recovery recognized as an asset should be reflected at fair value, which implies that only the present value of future recoveries can be recorded. It also stipulates that environmental clean up costs are not unusual in nature, and thus cannot be shown as extraordinary items in the income statement. Furthermore, it is presumed that the costs are operating in nature, and thus cannot normally be included in “other income and expense” category of the income statement, either. Disclosure of accounting policies regarding recognition of the liability and of any related asset (for recoveries from third parties) are also needed, where pertinent.
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