In the four preceding chapters, we worked our way down the asset side of the balance sheet, examining cash, accounts receivable, inventory, and long-term assets. We now turn to the other half of the balance sheet. In this chapter, we will look at current liabilities.
The definition of liabilities touches on the present, the future, and the past. Liabilities have three essential characteristics. Liabilities are: probable future sacrifices of economic benefitsarising from present obligations to other entitiesresulting from past transactions or events.Recall that assets represent probable future benefits. In contrast, liabilities represent probable future sacrifices of benefits. Most liabilities require the future sacrifice of cash. For instance, accounts payable, notes payable, and salaries payable usually are paid in cash. Unearned revenue arises when a company receives payment in advance of providing the product or service it’s selling. This obligation requires giving up inventory or services rather than cash to satisfy the debt.
In a classified balance sheet, we categorize liabilities as either current or long-term. In most cases, current liabilities are payable within one year, and long-term liabilities are payable more than one year from now. Current liabilities are usually, but not always, due within one year. But for some companies (a winery, for example), it takes longer than a year to perform the activities that produce revenue. We call the time it takes to produce revenue the operating cycle. 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.
When a company borrows cash from a bank, the bank requires the firm to sign a note promising to repay the amount borrowed plus interest. The borrower reports its liability as notes payable.Companies often use short-term debt because it usually offers lower interest rates than long-term debt.When a company borrows money, it pays the lender interest in return for using the lender’s money during the term of the loan. Interest is stated in terms of an annual percentage rate to be applied to the face value of the loan. Shown here is the formula to calculate interest.
Assume Southwest Airlines borrows $100,000 from Bank of America on September 1, 2015, signing a 6%, six-month note for the amount borrowed plus accrued interest due six months later on March 1, 2016. On September 1, 2015, Southwest will receive $100,000 in cash and record this entry.
However, if Southwest’s reporting period ends on December 31, 2015, the company should not wait until March 1, 2016, to record interest. Instead, the company records the four months’ interest incurred during 2015 in an adjustment prior to preparing the 2015 financial statements. Since the firm will not pay the 2015 interest until the note becomes due (March 1, 2016), it records the $2,000 interest as interest payable.The entry on March 1 does the following:• Removes the note payable ($100,000)• Records interest expense for January and February 2016 ($1,000)• Removes the interest payable recorded in the December 31, 2015, entry ($2,000)• Reduces cash ($103,000)
For a lender, like the bank, the note is a note receivable rather than a note payable, and it generates interest revenue rather than interest expense. Shown here are the transactions that are recorded by the lender.
Many companies prearrange the terms of a note payable by establishing a line of credit with a bank. A line of credit is an informal agreement that permits a company to borrow up to a prearranged limit without having to follow formal loan procedures and prepare paperwork. Notes payable is recorded each time the company borrows money under the line of credit. However, no entry is made up front when the line of credit is first negotiated, since no money has yet been borrowed.If a company borrows from another company rather than from a bank, the note is referred to as commercial paper. The recording for commercial paper is exactly the same as the recording for notes payable described earlier. Commercial paper is sold with maturities normally ranging from 30 to 270 days. Since a company is borrowing directly from another company, the interest rate on commercial paper is usually lower than on a bank loan. Because of this, commercial paper has thus become an increasingly popular way for large companies to raise funds.
Accounts payable, sometimes called trade accounts payable, are amounts the company owes to suppliers of merchandise or services that it has bought on credit. When a company purchases inventory on account (if it does not pay immediately with cash), it increases Inventory and Accounts Payable. Later, when the company pays the amount owed, it decreases both Cash andAccounts Payable.
This illustration summarizes payroll costs for employees and employers.
Companies are required by law to withhold federal and state income taxes from employees’ paychecks and remit these taxes to the government. The amount withheld varies according to the amount the employee earns and the number of exemptions the employee claims.Employers also withhold Social Security and Medicare taxes from employees’ paychecks. Collectively, Social Security and Medicare taxes are referred to as FICA taxes, named for the Federal Insurance Contributions Act (FICA). This act requires employers to withhold a 6.2% Social Security tax up to a maximum base amount plus a 1.45% Medicare tax with no maximum. Therefore, the total FICA tax is 7.65% (6.2% + 1.45%) on income up to a base amount ($113,700 in 2013) and 1.45% on all income above thebase amount.Besides the required deductions for income tax and FICA taxes, employees may opt to have additional amounts withheld from their paychecks. These might include the employee portion of insurance premiums, employee investments in retirement or savings plans, and contributions to charitable organizations. The employer records the amounts deducted from employee payroll as liabilities until it pays them to the appropriate organizations.
By law, the employer pays an additional (matching) FICA tax on behalf of the employee. The employer’s limits on FICA tax are the same as the employee’s. Thus, the government actually collects 15.3% (7.65% employee + 7.65% employer) on each employee’s salary.In addition to FICA, the employer also must pay federal and state unemployment taxes on behalf of its employees. The Federal Unemployment Tax Act (FUTA) requires a tax of 6.2% on the first $7,000 earned by each employee. This amount is reduced by a 5.4% (maximum) credit for contributions to state unemployment programs, so the net federal rate often is 0.8%. Under the State Unemployment Tax Act (SUTA), in many states the maximum state unemployment tax rate is 5.4%, but many companies pay a lower rate based on past employment history.Additional employee benefits paid for by the employer are referred to as fringe benefits. Employers often pay all or part of employees’ insurance premiums and make contributions to retirement or savings plans.
Assume that Hawaiian Travel Agency has a total payroll for the month of January of $100,000 for its 20 employees. Its withholdings and payroll taxes are shown in this illustration.
Company also records its employer-provided fringe benefits as Salaries Expense and records the related credit balances to Accounts Payable: as shown in the first journal entry.Companypays employer’s FICA taxes at the same rate that the employees pay (7.65%) and also pays unemployment taxes at the rate of 6.2%. The agency records its employer’s payroll taxes as shown in the second journal entry.Company incurred an additional $28,850 in expenses ($15,000 for fringe benefits plus $13,850 for employer payroll taxes) beyond the $100,000 salary expense. Also notice that the FICA tax payable in the employee withholding is the same amount recorded for employer payroll tax. That’s because the employee pays 7.65% and the employer matches this amount with an additional 7.65%. The amounts withheld are then transferred at regular intervals, monthly or quarterly, to their designated recipients. Income taxes, FICA taxes, and unemployment taxes are transferred to various government agencies, and fringe benefits are paid to the company’s contractual suppliers.
Unearned revenue refers to liability created when cash is received in advance of the sale or service.Companies selling products subject to sales tax are responsible for collecting the sales tax directly from customers and periodically sending the sales taxes collected to the state and local governments. The selling company records sales revenue in one account and sales tax payable in another.The current portion of long-term debt is the amount that will be paid within the next year. Management needs to know this amount in order to budget the cash flow necessary to pay the current portion as it comes due. Investors and lenders also pay attention to current debt because it provides information about a company’s bankruptcy risk.
Assume Apple Inc. sells an iTunes gift card to a customer for $100. This is recorded with the first entry. As you can see, Apple Inc. records the receipt of cash, but does not credit Sales Revenue. Rather, since the iTunes have not been downloaded yet, the company credits Unearned Revenue, a liability account. While it may seem unusual for an account called Unearned Revenue to be a liability, think of it this way: Having already collected the cash, the company now has the obligation to earn it. When the customer purchases and downloads, say, $15 worth of music, Apple records the second journal entry.As the company earns revenue from music downloads, it decreases (debits) Unearned Revenue and increases (credits) Sales Revenue. The customer has a balance of $85 on his gift card, and Apple Inc. has a balance in Unearned Revenue, a liability account, of $85 for future music downloads.
Suppose you buy lunch in the airport for $15 plus 9% sales tax. The airport restaurant records this entry. Suppose you buy lunch in the airport for $21.80 that includes a 9% sales tax. Here, we divide the total cash paid by 1.09 (1 + 9% sales tax rate) to separate the sales price ($20 = $21.80 ÷ 1.09) and sales tax payable ($1.80). This is recorded with two entries as shown here.
The current portion of long-term debt is the amount that will be paid within the next year. Management needs to know this amount in order to budget the cash flow necessary to pay the current portion as it comes due. Investors and lenders also pay attention to current debt because it provides information about a company’s bankruptcy risk.Long-term obligations are reclassified and reported as current liabilities when they become payable within the upcoming year (or operating cycle, if longer than a year).
Southwest Airlines had total borrowings of $3,154 million. Of that amount, $271 million is due in the next year and the remaining $2,883 million is recorded as long-term debt.In Southwest Airlines’ balance sheet, the company records the $3,154 million in current and long-term debt, as shown in this illustration.
Many companies are involved in litigation disputes, in which the final outcome is uncertain. In this section, we discuss how to report these uncertain situations, which are broadly called contingencies.
A contingent liability may not be a liability at all. Whether it is depends on whether an uncertain event that might result in a loss occurs or not.
This illustration provides a summary of accounting treatment for contingent liabilities.
Assume Dell introduces a new laptop computer in December that carries a one-year warranty against manufacturer’s defects. Based on industry experience with similar product introductions, Dell expects warranty costs will be an amount equal to approximately 3% of sales. New laptop sales for the month of December are $1.5 million. The warranty expense is recorded using the first entry.If customers make claims costing $12,000 in December, we record the warranty expenditures as shown in the second entry:The entries to record these transactions are shown here along with the T-account for Warranty Liability.Remember, the liability is increased by warranty expense but then is reduced over time by actual warranty expenditures.
A contingent gain is an existing uncertain situation that might result in a gain, which often is the flip side of contingent liabilities. In a pending lawsuit, one side—the defendant—faces a contingent liability, while the other side—the plaintiff—has a contingent gain.We do not record contingent gains until the gain is certain. The nonparallel treatment of contingent gains follows the same conservative reasoning that motivates reporting some assets (like inventory) at lower-of-cost-or-market.
Liquidity refers to having sufficient cash (or other current assets convertible to cash in a relatively short time) to pay currently maturing debts. Because a lack of liquidity can result in financial difficulties or even bankruptcy, it is critical that managers as well as outside investors and lenders maintain close watch on this aspect of a company’s well-being. Here we look at three liquidity measures: working capital, the current ratio, and the acid-test ratio. All three measures are calculated using current assets and current liabilities.
Working capital the difference between current assets and current liabilities. A large positive working capital is an indicator of liquidity—whether a company will be able to pay its current debts on time. However, working capital is not the best measure of liquidity when comparing one company with another, since it does not control for the relative size of each company.
The current ratio is calculated by dividing current assets by current liabilities. A current ratio greater than 1 implies more current assets than current liabilities. Recall that current assets include cash, current investments, accounts receivable, inventories, and prepaid expenses. As a rule of thumb, a current ratio of 1 or higher often reflects an acceptable level of liquidity. A current ratio of, say, 1.5 indicates that for every dollar of current liabilities, the company has $1.50 of current assets.In general, the higher the current ratio, the greater the company’s liquidity. But we should evaluate the current ratio, like other ratios, in the context of the industry in which the company operates. Keep in mind, though, that not all current assets are equally liquid, which leads us to another, more specific ratio for measuring liquidity.
The acid-test ratio, or quick ratio, is similar to the current ratio but is based on a more conservative measure of current assets available to pay current liabilities. We calculate it by dividing “quick assets” by current liabilities.Quick assets include only cash, current investments, and accounts receivable. By eliminating current assets, such as inventory and prepaid expenses, that are less readily convertible into cash.
It also is important to understand the effect of specific transactions on the current ratio and acid-test ratio. Both the current ratio and acid-test ratio have the same denominator, current liabilities, so a decrease in current liabilities will increase the ratios.Likewise, an increase in current liabilities will decrease the ratios.The ratios are affected by changes in current assets too. It depends on which current asset changes. Both ratios include cash, current investments, and accounts receivable. An increase in any of those will increase both ratios. However, only the current ratio includes inventory and other current assets. An increase to inventory or other current assets will increase the current ratio, but not the acid-test ratio.
Management can influence the ratios that measure liquidity to some extent. A company can influence the timing of inventory and accounts payable recognition by asking suppliers to change their delivery schedules.A debt covenant is an agreement between a borrower and a lender that requires certain minimum financial measures be met or the lender can recall the debt.