Current Liabilities

Liabilities in General

1. Liabilities have three key elements, which are shown below. This definition is taken from the FASB's conceptual framework. a. Liabilities represent probable future sacrifices of economic benefits; b. Liabilities are obligations to transfer assets or provide services in the future; c. Liabilities are the result of past transactions or events.

Liabilities in General Continued

2. It is important to note that, for a liability to be recognized in the accounts, it is not necessary to know the identity of the creditor, the exact amount that will be paid, or even the due date. Contingent liabilities, discussed later, are a category of liability for which one or more of these information items are not known as of the balance sheet date. However, the three elements from the conceptual framework above must be met by all liabilities if one is to be recognized in the accounts.

List the three key elements of liabilities.

1. Probable future sacrifice of economic benefits; 2. Obligations to transfer assets or provide services in the future; 3. Result of past transactions or events.

Which liability requires more future cash payments: a current liability reported at $2 million or a noncurrent liability reported at $2 million?

How are current liabilities valued and recorded?

Liabilities

Liabilities : Represent outsider claims to a firm's assets or are enforceable claims for services to be rendered by the firm.

Current Liabilities (CL) or Noncurrent Liabilities (NCL)

1. Most current liabilities (CL) are due within one year of the balance sheet. All other debt is noncurrent. Liabilities are presented on the balance sheet in increasing order of maturity. That is, current liabilities are presented first, and then, noncurrent liabilities are presented. CL include accounts payable, wages payable, income taxes payable, utilities payable, accrued payables, some notes payable, and many others. Noncurrent liabilities (NCL) include bonds payable, some notes payable, lease liabilities and pension liabilities.

How should a short-term note payable refinanced every six months on a continuous basis be classified?

The classification of this note is Current.

Valuation of Liabilities

b. NCLs are reported at the present value of all future payments (principal and interest), discounted at the prevailing rate of interest for similar debt on the date of issuance. Present value is the current sacrifice to retire the debt. Interest is the difference between the total future payments and present value. Interest is not recognized until time passes. Note: Caution: A CL and NCL reported in the balance sheet at equal values (for example, both $100,000) may require greatly different cash payment totals over their terms due to interest on the NCL principal.

Liabilities Example

1. A firm signed a contract to perform services the following year. At the current balance sheet date, the firm has no liability because no resources have been exchanged. Only a contract has been signed. There is no past transaction that substantiates the liability as of the balance sheet date. There is no future obligation to provide services because neither party has executed the contract. None of the elements of the liability is met.

Current Liabilities Example

1. A note payable due 3/1/x2 is expected to be refinanced continuously on a 4-month basis, each time substituting a new 4 month note for the old. That is the intent of the debtor firm. The note due 3/1/x2 is classified as a CL in the 12/31/x1 balance sheet because it meets the second part of the CL definition. Although the expectation is that no current asset will be used to retire the debt, there is no certainty that the debtor firm will be able to continue this practice. For example, the debtor firm cannot control the creditor who may decide not to refinance. Interest rates may increase substantially changing the strategy of the debtor firm. Caution: Most liabilities due within one year of the balance sheet are CLs. But there are exceptions - some are classified as NCL.

Distinction between Current and Noncurrent Liabilities

1. Current liabilities -- Are those that meet two criteria: a. Due in the coming year or the operating cycle of the business, whichever is longer; b. An obligation to be met by the transfer of a current asset or the "creation of another current liability." i. The operating cycle is the period from acquiring inventory and other resources, to sale, to receipt of cash from the receivable. Most firms have operating cycles much shorter than a year. One measure of the operating cycle is 365/inventory turnover + 365/AR turnover = number of days required to sell the inventory on hand + number of days required to collect receivables.

Current Liabilities Example

2. A note is due 5 months from the balance sheet date but payable in the common stock of the debtor. The debtor does not reduce current assets in payment of this debt. A later lesson discusses another example - the refinancing of short-term debt on a long-term basis.

Definite or Contingent.

2. Definite liabilities actually exist at the balance sheet. Contingent liabilities have some uncertainty at the balance sheet date. Their existence is contingent on an event that may or may not occur after the balance sheet. A contingent liability may be accrued as a definite liability, is disclosed as a contingency, or is not considered a liability at all. Most liabilities are definite. Examples of contingent liabilities include lawsuits, warranties and guarantees. Contingent liabilities are covered in a subsequent lesson.

Liabilities Example 2

2. Do airline frequent flyer programs create liabilities for airline companies? The answer is yes, because all three parts of the definition of a liability are met. The airline has (1) an obligation to provide service (2) in the future (3) as a result of a past transaction (customers achieving the requisite miles or credit card purchases for a free flight). Airline companies accrue this liability. Again, none of the following is known at the time of the accrual: the identity of the creditor, amount to be paid, or due date.

Distinction between Current and Noncurrent Liabilities

2. Noncurrent liabilities -- Are defined by exclusion. That is, noncurrent liabilities are those that do not meet the criteria necessary for classification as a current liability. Example: 1. A bond payable liability is due four years from the balance sheet. This liability is classified as noncurrent. 2. If the bond liability matures serially, and a portion of the principal balance is due at the end of each year, then the amount due the following year is classified as a current liability in the balance sheet for the current year and is labeled: current maturities of long-term debt.

Current Liabilities Example

3. A bond liability due next year for which the firm has created a sinking fund investment (noncurrent asset) for bond retirement is classified as an NCL because payment will reduce noncurrent assets not current assets. Caution: Most liabilities due later than one year after the balance sheet date are NCLs, but there are exceptions - some are classified as CLs.

Accounts Payable

3. Accounts payable are recognized at the time of purchase or at the time that services are received by the business entity. In relation to purchased merchandise, the payable should be recognized at the point in which the merchandise is included in the company's inventory. The module on inventory discusses this issue in further detail (F.O.B. title test and goods on consignment). Several additional accounts such as purchases, purchases returns and allowances and others are created to accommodate the specifics of inventory purchasing.

Current Liabilities Example

4. Long-term obligations callable on demand by the creditor are classified as current. Because the creditor can call in the debt, the debtor must report it as current. A creditor may require this provision in the debt contract to reduce the risk of losing principal. Such provisions also may be added in case the debtor violates a debt restriction. For example, a debt contract requires the debtor to maintain a current ratio (CA/CL) of 3.0 or more. If the ratio falls below 3.0, the debt is due on demand by the creditor, unless the debtor "cures" the violation within the next reporting period.

A Closer Look at Current Liabilities (CL)

A Closer Look at Current Liabilities (CL) A. The essence of a CL is that it is expected to reduce the firm's liquidity within one year of the balance sheet date or operating cycle, whichever is longer. A CL payable with a current asset clearly will reduce the firm's liquidity. But what about the second part of the definition "creation of another CL"? B. CLs that are continuously refinanced (rolled over) by replacing them with other CLs due later (but within one year of the balance sheet date) must still be classified as CL, even though no current asset will be used to extinguish them in the year after the balance sheet date.

Accounts Payable

Accounts Payable -- 1. These payables are also called trade payables. They represent the amount a business enterprise owes to suppliers and other entities that provide goods or services to the company. 2. These payables are typically for a short duration, usually 30 days. In some instances, the time period can be 45 or 60 days.

Accounts Payable

B. Subsequent lessons provide additional examples of definite liabilities. For example, corporations often provide an estimate of fourth-quarter income taxes at year end: Income tax expense xxx Income tax payable xxx 1. The amount recorded in this adjusting journal entry is an estimate of the amount due for the year; the exact amount often is subject to dispute because the process of preparing a corporation's income tax return is affected by ambiguities in the tax law and other issues. The first three quarterly payments also are estimates. Subsequent lessons consider income tax reporting in greater depth.

Classification of Liabilities

Classification of Liabilities -- Liabilities are classified in two ways: (1) current liabilities (CL) or noncurrent liabilities (NCL), and (2) definite or contingent.

Definite Liabilities

Definite liabilities are not dependent on any future event. The existence of these liabilities is determined by a current event or a past transaction or event. Definite liabilities include liabilities payable in definite amounts (e.g., accounts payable), those which can only be estimated (e.g., estimated income tax payable), and accrued liabilities that are recorded for expenses recognized before payment is made (e.g., utilities payable). Not all definite liabilities can be measured with certainty. Some are estimated and reported at an approximate amount.

What do liabilities represent?

Represent outsider claims to a firm's assets or are enforceable claims for services to be rendered by the firm.

Valuation of Liabilities

a. CLs are reported valued at the amount due, or nominal amount. Liabilities for services are measured at the amount received. For example, the unearned revenue (liability) for an amount received by an airline before a flight is provided is measured at the amount received for the ticket.

Valuation of Liabilities

c. Although in theory all debt should be reported at present value, for practical reasons CL are not discounted because the difference between present and nominal (future) value is typically not material.