Financial Accounting Fifth Edition

Current Liabilities

8
CHAPTER BUSF-SHU250
Jing Dai

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Part A
CURRENT LIABILITIES

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 Liabilities
• A Liability is a present responsibility to
sacrifice assets in the future due to a
transaction or other event that
happened in the past.
• What benefits are sacrificed?
q Accounts payable
q Notes payable
q Salaries payable
q Deferred revenue

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Current vs. Long-Term Liabilities

Current Long-Term
• Usually payable within • Payable in more than one
one year from the balance year from the balance
sheet date sheet date
Operating cycle: The time it takes to produce revenue.
If a company has an operating cycle longer than one year, its current liabilities are
defined by the operating cycle rather than by the length of a year.
For some companies (a winery, for example), it takes longer than a year to
perform the activities that produce revenue.

A company with a 3-month operating A company with a 15-month operating

cycle would classify current liabilities cycle would classify current liabilities as
as those due within one year. those due within 15 months.

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Which one is more risky?
q Current liabilities vs. long-term liabilities
q Firms will be forced into bankruptcy when they
are unable to pay current liabilities as they
became due.
q Less-risky firms may enjoy lower interest rates on
borrowing and command higher stock prices for
new stock listings.

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Main categories of current
liabilities
• Accounts payable
• Notes payable
• Payroll liabilities
• Other current liabilities:
deferred revenue, sales tax
payable, and the current portion
of long-term debt

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Current Liabilities Section for
Southwest Airlines
SOUTHWEST AIRLINES
Balance Sheet (partial)
($ in millions)
Current liabilities:
Accounts payable $1,178
Accrued liabilities 1,985
Air traffic liability 3,115
Current maturities of long-term debt 566
Total current liabilities $6,844

• No prescribed order for presenting

accounts
• No uniformity regarding precise caption

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Accounts Payable (Trade accounts
payable)
• Amounts owed to suppliers of merchandise or
services on open account.
q Open account means that the only formal credit
instrument is the invoice.
• Most accounts payable are current liabilities,
but they could be long-term liabilities,
depending on the due date.
• Do accounts payable bear interest?

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Notes Payable
• Note signed by a firm promising to repay
the bank the amount borrowed plus
interest
• Many are routinely renewed, some tend
to resemble long-term debt
• Interest on notes is calculated as:

Face Annual Fraction

Interest = value × ×
interest rate of the year

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11
Line of Credit & Commercial Paper
• Line of credit:
q Informal agreement with bank
q Permits a company to borrow up to a prearranged limit
• Can borrow $100,000 from bank whenever want. Pay interest for everyday
used.

q No entry when the line of credit if first negotiated

q Recorded similar to notes payable when the line of credit is used

• Commercial paper:
q Borrowing from another company rather than a bank
q Due within 30 to 270 days
q Interest rate is usually lower than on a bank loan
q Recording is the same as the recording for notes payable.

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Key Point

Many short-term loans are arranged under an

existing line of credit with a bank, or for larger
corporations in the form of commercial paper, a
loan from one company to another.

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Payroll

For labor-intensive companies, payroll liabilities make

up a significant portion of current liabilities. We
will look at how payroll is calculated for both
employees and employers.

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Payroll Costs for Employees and
Employers
Let’s assume you are hired at a Let’s assume you hire an employee
monthly salary of $5,000. at a monthly salary of $5,000.
Do you think how much you can Do you think how much you
take home? need to pay?

Employee Costs Employer Costs

• Federal and state income taxes • Federal and state unemployment taxes
• Employee portion of Social Security • Employer matching portion of Social
and Medicare (FICA taxes) Security and Medicare (FICA taxes)
• Employee contributions for health, • Employer contributions for health,
dental, disability, and life insurance dental, disability, and life insurance
• Employee investments in retirement • Employer contributions to retirement
or savings plans or savings plans

Withheld and remitted to the Fringe benefits

government by employers
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 Payroll
Hawaiian Travel Agency has a total payroll for the month of January of $100,000
for its 20 employees. Details are provided below:

The amount
that employees
can take home

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Key points
• Federal and state income taxes
q The amount withheld varies according to the amount the employee earns and
the number of exemptions the employee claims.

• Social security and medicare taxes(FICA taxes)

q 7.65% (6.2% social security tax up to a base amount$128,400 + 1.45%
medicare tax with no maximum)
q How much FICA taxes on an annul salary of $100,000 vs $178,400?

• The employee must remit income tax and FICA taxes. But the following
two are optional.
q The employee portion of health, dental, disability, and life insurance
q The employee portion of retirement or employee savings plans

• The employer matches FICA tax on behalf of the employee

q How much does the government actually collect on each employee’s
salary?
q 15.3% (7.65% employee+7.65% employer)

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Summary
Employee salaries are reduced by
withholdings for federal and state income
taxes, FICA taxes, and the employee portion
of insurance and retirement contributions.
The employer incurs additional payroll
expenses for unemployment taxes, the
employer portion of FICA taxes, and
employer insurance and retirement
contributions.

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Other Current Liabilities
• Deferred revenues: liability account used to
record cash received in advance of the sale or
service
• Sales tax payable: sales taxes collected from
customers by the seller
• Current portion of long-term debt: debt that
will be paid within the next year

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Revenue Recognition Policy of United
Airlines
United Airlines sells tickets and collects the cash price several days,
weeks, or sometimes months before the actual flight. Do you think
United Airlines records the revenue when it sells the ticket or
when the flight actually takes place?

UNITED AIRLINES
Notes to the Financial Statements (excerpt)

Revenue Recognition—The company records passenger ticket sales and tickets

sold by other airlines for use on United as passenger revenue when the
transportation is provided. The value of unused passenger tickets is included in
current liabilities as Advance ticket sales.

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Example
Deferred Revenues
• When a company receives cash in advance, it debits Cash and
credits Deferred Revenue, a current liability account
• Assume Apple sells iTunes gift cards to a customer for $100
Debit Credit
Cash ………………………………………………….. 100
Deferred Revenue ……………………… 100
(Receive cash for gift card)

• When the customer purchases and downloads, say, $15 worth

of music, Apple records the following:
Debit Credit
Deferred Revenue ……………………………… 15
Sales Revenue …………………………….. 15
(Record revenue for music downloaded)

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Example
Sales Tax Payable
• In some states, companies are required to collect sales tax when
selling goods or services and then remitting those back to the
state or local government
• The collection of cash from the customer creates a liability for
the company
• Assume you buy lunch in the airport for $15 plus 10% sales tax.
The airport restaurant records the journal entry as shown.
Debit Credit
Cash ……………………………………………….. 16.50
Sales Revenue …………………….…….. 15.00
Sales Tax Payable (= $15 × 10%)… 1.50
(Record sales and sales tax)
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Key Point
Sales taxes collected from customers
by the seller are not an expense.
Instead, they represent current
liabilities payable to the government.

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Current Portion of Long-Term
Debt
• The current portion of long-term
debt= the amount owed next
year.
• Long-term obligations are reclassified and reported as current
liabilities when they become payable within the upcoming year
• For example, a note payable that matures in 10 years is reported
as a long-term liability for the first 9 years, but as a current liability
in the tenth year

Important: Is
there a liquidity
problem next year
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Concept Check 8–1
Which of the following is typically considered a
current liability?
a. Salaries payable
b. Prepaid insurance
c. Mortgage payable due in 30 years
d. Accounts receivable
Current liabilities are payable within one year. Salaries
payable are generally paid in less than a year. Prepaid
insurance and accounts receivable are assets, and the
mortgage payable due in 30 years is a long-term liability.

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Concept Check 8–2
On October 1, a company signs a $10,000, 5%, 6-
month note payable. How much interest would be
recorded by December 31 of the same year?
a. $250
b. $125
c. $500 Interest is recorded for the period from the
d. $0 date of the signing of the note (10/1) to the
end of the fiscal year (12/31). The amount
recorded for three months is:

Interest = $10,000 × 5% × 3/12 = $125

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Concept Check 8–3
Which of the following items is paid solely by the
employer?
a. Federal and state income taxes on employees’
wages
b. Social Security taxes
c. Federal and state unemployment taxes
d. Medicare taxes
Companies are required by law to withhold federal and state income taxes
from employees’ paychecks. Employers are also required to withhold Social
Security and Medicare taxes from employees’ paychecks. In addition,
employers may withhold optional deductions, such as medical insurance
premiums, contributions to retirement programs, and other fringe benefits.
Unemployment taxes are NOT withheld, because they are paid solely by the
employer.
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Concept Check 8–5
A home improvement store sells some merchandise
to a customer. The price of the merchandise is $200
and the sales tax rate is 6.5%. How much would be
recorded in the sales tax payable account?
a. $13.00
b. $213.00 Sales tax payable at the time of
c. $130.00 the sale would be computed as
the price of the merchandise
d. None of the above multiplied by the sales tax rate.
In this case:

$200 × 0.065 (or 6.5%) = $13.00

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Part B
CONTINGENCIES

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 Contingent Liabilities
• What is a small word for contingent liabilities? Examples?:
If Liability Lawsuits
• An existing uncertain situation that might result in a loss Product warranties
depending on the outcome of a future event
Environmental problems
Premium offers
Estimate Can't Estimate
Dr. Loss 100
Probable Footnote
Cr. Contigent Liability 100
Loss Disclosure Can’t make entry
Reasonably Possible Footnote Disclosure
Remote Ignore
Gain Ignore Conservatism

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 Warranties
Why offered? Marketing
Asset or Expense? Expense (Selling and Administrative)
Dec 31 Management estimates NEXT year’s repairs of computers sold This year
Adjusting entry:

Uniqueness of Liability: To whom do we owe?

When do we have to pay?
How much do we owe?

But statistically estimate total

When computer breaks and customer make warranty claims, we make
the transaction entry

Is the balance in the Warranty

Liability account always equal to
Warranty Expense? 31
 Concept Check 8–6
Which of the following statements is true with
respect to warranty liabilities?
a. Warranty expense needs to be recorded in the
period the warranty repair is made.
b. The warranty expense account balance will
always equal the warranty liability account
balance.
c. The warranty liability account is debited as
actual repairs are made.
d. All of the above are true.
The warranty expense needs to be recorded in the same accounting period that the
sale is made. The warranty expense account is rarely equal to the warranty liability
account. The warranty liability is increased when the estimated liability is recorded
and reduced over time (by a debit) for the actual warranty expenditures.
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Concept Check 8–7
During its first year of business, Oceanic, Inc. has
sales of $300,000 and pays warranty claims of
$10,400. Oceanic offers a one-year warranty and
anticipates that warranty costs will total 5% of sales.
What is the balance in Oceanic’s Warranty Liability
account at the end of the first year?
a. $15,000 The estimated amount of total warranty
b. $4,600 expense is $300,000 × 5% = $15,000. Since
payments of $10,400 were made during the
c. $25,400 year, the remaining warranty costs estimated
d. $20,800 to occur next year is:
$15,000 – $10,400 = $4,600.
The Warranty Liability account will have a
balance of $4,600 at the end of the first year.
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 Liquidity Analysis
Liquidity: Ability to pay Current Debt

If it is negative, what does that mean?

If it is $40,000, what does that mean?
Not the best measure of liquidity for comparing across companies, because
the ratio does not control for the relative size of each company

Is a higher current ratio always a positive signal?

What is difference between the 2 ratios? Inventory and prepaid rent

Quick assets are current assets more readily convertible to cash
q Exclude current assets such as inventory and prepaid rent

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 Liquidity Management
Debt Covenant: Must keep certain ratios, or else

Games Managers Play

CA=$5, CL=$4, Current ratio=5/4=1.25

To improve, CA=$5-1, CL=$4-1, Current ratio=4/3=1.33
How???

CA=$3, CL=$4, Current ratio=3/4=0.75

To improve, CA=$3+1, CL=$4+1, Current ratio=4/5=0.8
How???

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End of Chapter 8

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