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CH 3

The document discusses current liabilities including short-term notes payable, accounts payable, and the current portion of long-term debt. It provides examples of accounting entries for issuing notes payable to creditors or receiving loans, as well as paying notes payable at maturity. Current liabilities are debts that companies expect to pay within one year from current assets.

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21 views

CH 3

The document discusses current liabilities including short-term notes payable, accounts payable, and the current portion of long-term debt. It provides examples of accounting entries for issuing notes payable to creditors or receiving loans, as well as paying notes payable at maturity. Current liabilities are debts that companies expect to pay within one year from current assets.

Uploaded by

mathewos
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Fundamentals of Accounting-II

2023

Chapter Three

Current Liabilities and Payroll system in Ethiopia

3.1. The Nature of Current Liabilities


A current liability is a debt with two key features: (1) The Company reasonably expects to pay
the debt from existing current assets or through the creation of other current liabilities. (2) The
company will pay the debt within one year or the operating cycle whichever is longer.

Debts that do not meet both criteria are classified as long-term 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.

Most current liabilities arise from two basic transactions:

i. Receiving goods or services prior to making payment.


ii. Receiving payment prior to delivering goods or services.
An example of the first type of transaction is accounts payable arising from purchases of
merchandise for resale. An example of the second type of transaction is unearned rent arising
from the receipt of rent in advance.

1.2 Short-Term Notes Payable and Current Portion of Long-Term Debt

I. 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 of time. Those due for payment within one year

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Fundamentals of Accounting-II
2023
of the balance sheet date are usually classified as current liabilities. Notes may be issued when
merchandise or other assets are purchased. They may also be issued to creditors to temporarily
satisfy an account payable created earlier.

Illustration 3.1

For example, assume that a business issues a 90-day, 12% note for Br.1, 000, dated August 1,
2006, to Murray Co. for a Br.1, 000 overdue accounts. The entry to record the issuance of the
note is as follows:

Aug 1 Accounts Payable 1,000


Notes Payable 1,000
(Issued a 90-day, 12% note on account.)

When the note matures, the entry to record the payment of Br.1, 000 principal plus Br.30 interest
(Br.1, 000 x12% x 90/360) is:

Oct 30 Notes Payable 1,000


Interest Expense 30
Cash 1,030
The interest expense is reported in the Other Expense section of the income statement for the
year ended December 31, 2010. The interest expense account is closed at December 31. Notes
may also be issued when money is borrowed from banks. Although the terms may vary, many
banks would accept from the borrower an interest-bearing note for the amount of the loan.

Illustration 3.2

For example, assume that First National Bank agrees to lend Br.100, 000 on September 1, 2010,
if Wondu Co. signs a Br.100,000, 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. Wondu Co. therefore will receive Br.100, 000 cash
and will make the following journal entry.

Sept. 1 Cash 100,000


Notes Payable 100,000

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Fundamentals of Accounting-II
2023
(To record issuance of 12%, 4-month note to First National Bank)
Interest accrues over the life of the note, and the company must periodically record that accrual.
If Wondu Co. prepares financial statements annually, it makes an adjusting entry at December 31
to recognize interest expense and interest payable of Br.4, 000 (Br.100, 000 x 12% x 4/12).

Wondu makes an adjusting entry as follows:

Dec. 31 Interest Expense 4,000


Interest Payable 4,000
(To accrue interest for 4 months on First National Bank note)
On December 31 financial statements, the current liabilities section of the balance sheet will
show notes payable Br.100, 000 and interest payable Br.4, 000. In addition, the company will
report interest expense of Br.4, 000 under “Other expenses and losses” in the income statement.
If Wondu Co. prepared financial statements monthly, the adjusting entry at the end of each
month would have been Br.1, 000 (Br.100, 000 x 12% x 1/12). At maturity (January 1, 2013),
Wondu Co. must pay the face value of the note (Br.100, 000) plus Br.4, 000 interest (Br.100, 000
x 12% x 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 First National Bank interest-bearing note and accrued interest at
maturity)
Sometimes a borrower will issue to a creditor a discounted note rather than an interest-bearing
note. Although such a note does not specify an interest rate, the creditor sets a rate of interest and
deducts the interest from the face amount of the note. This interest is called the discount. The
rate used in computing the discount is called the discount rate. The borrower is given the
remainder, called the proceeds. A zero-interest-bearing note does not explicitly state an interest
rate on the face of the note. 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.

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Fundamentals of Accounting-II
2023

Illustration 3.3

To illustrate, assume that Lemma issues a Br.104, 000, four-month, zero-interest bearing note to
Dashin Bank. The present value of the note is Br.100, 000. Lemma records this transaction as
follows.

March 1 Cash ……………………….. 100,000

Discount on Notes Payable…. 4,000


Notes Payable …….......... 104,000
(To record issuance of 4-month, zero-interest-bearing note to Dashin Bank)
Discount on Notes Payable is a contra account to Notes Payable, and therefore is subtracted from
Notes Payable on the balance sheet. When the note is paid, the following entry is recorded:

Notes Payable …….......... 104,000


Cash …………………. 104,000
ii. 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.

Illustration 3.4

As an example, assume that Tamiru Construction issues a five-year interest-bearing Br.25, 000
notes on January 1, 2011. This note specifies that each January 1, starting January 1, 2012,
Tamiru should pay Br.5, 000 of the note. When the company prepares financial statements on
December 31, 2011, it should report Br.5, 000 as a current liability and Br.20, 000 as a long-term
liability. (The Br.5, 000 amounts 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 balance sheet
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 balance sheet date, all obligations due within one year are classified as current, and
all other obligations as long-term.

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