Chapter 3

Current Liabilities
3.1 Current Liabilities
A current liability is a debt that the company expects to pay within one year or the operating cycle,
whichever is longer. Debts that do not meet this criterion are classified as non-current liabilities. 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.
Current liabilities include notes payable, accounts payable and unearned revenues. They also include accrued
liabilities such as taxes, salaries and wages, and interest payable. In the sections that follow, we discuss a few
of the common types of current liabilities.

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 of time.
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 Hong Kong National Bank agrees to lend
Br100,000 on September 1, 2014, if C. W. Co. signs a Br100,000, 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. C. W. Co. therefore will receive Br100,000 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 Hong Kong National Bank)
Interest accrues over the life of the note, and the company must periodically record that accrual. If C. W. Co.
prepares financial statements annually, it makes an adjusting entry at December 31 to recognize interest
expense and interest payable of Br 4,000 (Br100,000 × 12% × 4/12). Illustration 3-1 shows the formula for
computing interest and its application to C. W. Co.’s note.
Face Value × Annual Interest Rate × Terms of Note One Year = Interest
Br100,000 × 12% × 4/12 = Br 4,000
C. W. Co. makes an adjusting entry as follows.
Dec. 31 Interest Expense 4,000
Interest Payable 4,000
(To accrue interest for 4 months on Hong Kong National Bank note)
In the December 31 financial statements, the current liabilities section of the statement of financial position
will show notes payable Br 100,000 and interest payable Br4,000. In addition, the company will report
interest expense of Br4, 000 under “Other income and expense” in the income statement. If C. W. Co.
prepared financial statements monthly, the adjusting entry at the end of each month would have been Br1,000
(BR100,000 3 12% 3 1/12).

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At maturity (January 1, 2015), C. W. Co. must pay the face value of the note (Br100,000) plus Br4,000
interest (BR100,000 3 12% 3 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 Hong Kong National Bank interest-bearing note and accrued interest at maturity)

Sales Taxes 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
Cooley Grocery shows sales of BR10,000 and sales taxes of BR600 (sales tax rate of 6%), the journal entry is:
Mar. 25 Cash 10,600
Sales Revenue 10,000
Sales Taxes Payable 600
(To record daily sales and sales taxes)
When the company remits the taxes to the taxing agency, it debits Sales Taxes Payable and credits Cash. The
company does not report sales taxes as an expense. It simply forwards to the government the amount paid by
the customers. Thus, Cooley Grocery serves only as a collection agent for the taxing authority.
Sometimes, companies do not enter sales taxes separately on the cash register. To determine the amount of
sales in such cases, divide total receipts by 100% plus the sales tax percentage. To illustrate, assume that in
the above example Cooley Grocery enters total receipts of Br10,600. The receipts from the sales are equal to
the sales price (100%) plus the tax percentage (6% of sales), or 1.06 times the sales total. We can compute
the sales amount as follows.
Br10,600 ÷ 1.06 = Br10,000
Thus, Cooley Grocery could find the sales tax amount it must remit to the government (Br600) by subtracting
sales from total receipts (Br10,600 - Br10,000).
Unearned Revenues
An airline company, such as Qantas Airways (AUS), often receives cash when it sells tickets for future
flights. A magazine publisher, such as Finance Asia (HKG), receives customers’ payments when they order
magazines. Season tickets for concerts, sporting events, and theater programs are also paid for in advance.
How do companies account for unearned revenues that are received before goods are delivered or services
are provided?
1. When a company receives the advance payment, it debits Cash and credits a current liability account
identifying the source of the unearned revenue.
2. When the company recognizes revenue, it debits an unearned revenue account and credits a revenue
account.

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To illustrate, assume that the Busan IPark (KOR) sells 10,000 season football tickets at Br50 each for its five-
game home schedule. The club makes the following entry for the sale of season tickets (in thousands of W).
Aug. 6 Cash 500,000
Unearned Ticket Revenue 500,000
(To record sale of 10,000 season tickets)
As each game is completed, Busan IPark records the recognition of revenue with the following entry (in
thousands of W).
Sept. 7 Unearned Ticket Revenue 100,000
Ticket Revenue 100,000
(To record football ticket revenue)
The account Unearned Ticket Revenue represents unearned revenue, and Busan IPark reports it as a current
liability. As the club recognizes revenue, it reclassifies the amount from unearned revenue to Ticket Revenue.
Unearned revenue is material for some companies. In the airline industry, for example, tickets sold for future
flights represent almost 50% of total current liabilities. At United Airlines (USA), unearned ticket revenue
was its largest current liability, recently amounting to over Br1 billion. Illustration 3-2 shows specific
unearned revenue and revenue accounts used in selected types of businesses.
Illustration 3-2 unearned revenue and revenue accounts

Business Unearned Revenue Revenue Recognized

Airline Unearned Ticket Revenue Ticket Revenue
Magazine publisher Unearned Subscription Revenue Subscription Revenue
Hotel Unearned Rent Revenue Rent Revenue
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 Wendy Construction issues a five-year interest-
bearing Br25,000 note on January 1, 2013. This note specifies that each January 1, starting January 1, 2014,
Wendy should pay Br5,000 of the note. When the company prepares financial statements on December 31,
2013, it should report Br5,000 as a current liability and Br20,000 as a non-current liability. (The Br5,000
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.
Reporting Uncertainty
Contingent liability: - Potential liability that may become an actual liability in the future.
Three levels of probability and accounting treatment:
Probability Accounting
 Probable Accrue and Footnote
 Reasonably possible Footnote
 Remote Ignore

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Product Warranties
Promise made by a seller to a buyer to make good on a deficiency of quantity, quality, or performance in a
product. Estimated cost of honoring product warranty contracts should be recognized as an expense in the
period in which the sale occurs.
STATEMENT PRESENTATION AND ANALYSIS
PRESENTATION
Current liabilities are presented after non-current liabilities on the statement of financial position. Each of the
principal types of current liabilities is listed separately. In addition, companies disclose the terms of notes
payable and other key information about the individual items in the notes to the financial statements.
Companies seldom list current liabilities in the order of liquidity. The reason is that varying maturity dates
may exist for specific obligations such as notes payable. A more common method of presenting current
liabilities is to list them by order of magnitude, with the largest ones first. Or, as a matter of custom, many
companies show notes payable first and then accounts payable, regardless of amount. Then, the remaining
current liabilities are listed by magnitude. Illustration 3-3 shows this form of presentation.
EVAN COMPANY
Balance Sheet
December 31,2017
Assets
- Current Assets Br 500,000
- Property, Plant and Equipment (net) 150,000
- Other Long-Term Assets 520,000
Total Assets Br 1,170,000
Liabilities and Owner’s Equity
Current liabilities
- Note Payable Br 40,000
- Account Payable 110,000
- Unearned Revenue 30,000
- Salaries and Wages Payable 90,000
- Warranty Liability 25,000
- Current Maturities of Long-Term Debt 65,000
Total Current Liabilities 360,000
- Non-current Liabilities 620,000
Total Liabilities 980,000
- Owner’s Equity 190,000
Total Liabilities and Owner’s Equities Br 1,170,000
ANALYSIS
Use of current and non-current classifications makes it possible to analyze a company’s liquidity. Liquidity
refers to the ability to pay maturing obligations and meet unexpected needs for cash. The relationship of
current assets to current liabilities is critical in analyzing liquidity. We can express this relationship as an
amount of currency (working capital) and as a ratio (the current ratio). The excess of current assets over
current liabilities is working capital.
Illustration 3.4 shows the formula for the computation of Croix Company’s working capital, assuming current
assets were Br20,856 and current liabilities Br 16,210.
Current Assets – Current Liabilities = Working Capital
Br 20,856 – Br 16,210 = Br 4,646

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As an absolute birr amount, working capital offers limited informational value. For example, Br1 million of
working capital may be far more than needed for a small company but inadequate for a large corporation.
Also, Br1 million of working capital may be adequate for a company at one time but inadequate at another
time.
The current ratio permits us to compare the liquidity of different-sized companies and of a single company
at different times. The current ratio is calculated as current assets divided by current liabilities. The formula
for this ratio is illustrated below, along with its computation using Croix Company’s current asset and current
liability data
Current Assets ÷ Current Liabilities = Current Ratio
Br 20,856 ÷ Br 16,210 = 1.29:1
Historically, companies and analysts considered a current ratio of 2:1 to be the standard for a good credit
rating. In recent years, however, many healthy companies have maintained ratios well below 2:1 by
improving management of their current assets and liabilities. Croix Company’s ratio of 1.29:1 is probably
adequate but certainly below the standard of 2:1.

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