12 1 Identify and Describe Current Liabilities Principles of Accounting, Volume 1: Financial Accounting

Short-term debt is typically the total of debt payments owed within the next year. The amount of short-term debt as compared to long-term debt is important when analyzing a company’s financial health. For example, let’s say that two companies in the same industry might have the same amount of total debt. The treatment of current liabilities for each company can vary based on the sector or industry.

Both the current and quick ratios help with the analysis of a company’s financial solvency and management of its current liabilities. Banks, for example, want to know before extending credit whether a company is collecting—or getting paid—for its accounts receivable in a timely manner. Up until that time, the future liability may be noted in the disclosures that accompany the financial statements.

1. Terms of the loan require equal annual principal repayments of $10,000 for the next ten years.
2. Accrued expenses generally are taxes, utilities, wages, salaries, rent, commissions, and interest expenses that are owed.
3. The ratio, which is calculated by dividing current assets by current liabilities, shows how well a company manages its balance sheet to pay off its short-term debts and payables.
4. When the payment is due on October 4, Higgins Woodwork Company forms an arrangement with their lender to reimburse the $50,000 plus a 10-month interest.
5. The proper classification of liabilities as current assists decision-makers in determining the short-term and long-term cash needs of a company.

Interest is an expense
that you might pay for the use of someone else’s money. Assuming that you owe $400, your interest charge for
the month would be $400 × 1.5%, or $6.00. To pay your balance due
on your monthly statement would require $406 (the $400 balance due
plus the $6 interest expense). For example, assume the owner of a clothing boutique purchases
hangers from a manufacturer on credit. The basics of shipping charges and credit
terms were addressed in
Merchandising Transactions if you would like to refresh
yourself on the mechanics.

What’s the Difference Between Current Liabilities and Non-Current Liabilities?

You first
need to determine the monthly interest rate by dividing 3% by
twelve months (3%/12), which is 0.25%. The monthly interest rate of
0.25% is multiplied by the outstanding principal balance of $10,000
to get an interest expense of $25. The scheduled payment is $400;
therefore, $25 is applied to interest, and the remaining $375 ($400
– $25) is applied to the outstanding principal balance. Next month, interest
expense is computed using the new principal balance outstanding of
$9,625. This
means $24.06 of the $400 payment applies to interest, and the
remaining $375.94 ($400 – $24.06) is applied to the outstanding
principal balance to get a new balance of $9,249.06 ($9,625 –
$375.94).

Assume that the customer prepaid the service on
October 15, 2019, and all three treatments occur on the first day
of the month of service. We also assume that $40 in revenue is
allocated to each of the three treatments. Proper reporting of current liabilities helps decision-makers
understand a company’s burn rate and how much cash is needed for
the company to meet its short-term and long-term cash obligations. If misrepresented, the cash needs of the company may not be met,
and the company can quickly go out of business. A percentage of the sale is charged to the customer to cover the tax obligation (see Figure 12.5).

Sometimes liabilities (and stockholders’ equity) are also thought of as sources of a corporation’s assets. For example, when a corporation borrows money from its bank, the bank loan was a source of the corporation’s assets, and the balance owed on the loan is a claim on the corporation’s assets. However, for Vendor XYZ the accrued interest is an asset and booked as income.

Accrued Expense

Also, since the customer could request a refund before any of the services have been provided, we need to ensure that we do not recognize revenue until it has been earned. The following journal entries are built upon the client receiving all three treatments. First, for the prepayment landlord tax guide of future services and for the revenue earned in 2019, the journal entries are shown. Proper reporting of current liabilities helps decision-makers understand a company’s burn rate and how much cash is needed for the company to meet its short-term and long-term cash obligations.

Examples of Current Liabilities

The sales tax rate varies by state and local
municipalities but can range anywhere from 1.76% to almost 10% of
the gross sales price. Some states do not have sales tax because
they want to encourage consumer spending. Those businesses subject
to sales taxation hold the sales tax in the Sales Tax Payable
account until payment is due to the governing body. Assume, for example, that for the current
year $7,000 of interest will be accrued. In the current year the
debtor will pay a total of $25,000—that is, $7,000 in interest and
$18,000 for the current portion of the note payable.

Taxes Payable

The corporation would make the identical entry at the end of each quarter, and the total in the payable account would be $60,000. Since the loan was obtained on August 1, 2017, the interest expenditure in the 2017 income statement would be for five months. However, if the loan had been accepted on January 1, the annual interest expense would have been 12 months. The quick ratio is the same formula as the current ratio, except that it subtracts the value of total inventories beforehand.

An increase in current liabilities over a period increases
cash flow, while a decrease in current liabilities decreases cash
flow. Noncurrent liabilities are long-term obligations with payment typically due in a subsequent operating period. Current liabilities are reported on the classified balance sheet, listed before noncurrent liabilities. Changes in current liabilities from the beginning of an accounting period to the end are reported on the statement of cash flows as part of the cash flows from operations section.

Under accrual accounting,
a company does not record revenue as earned until it has provided a
product or service, thus adhering to the revenue recognition
principle. Until the customer is provided an obligated product or
service, a liability exists, and the amount paid in advance is
recognized in the Unearned Revenue account. As soon as the company
provides all, or a portion, of the product or service, the value is
then recognized as earned revenue. Noncurrent liabilities are long-term obligations with payment
typically due in a subsequent operating period. Current liabilities
are reported on the classified balance sheet, listed before
noncurrent liabilities. Changes in current liabilities from the
beginning of an accounting period to the end are reported on the
statement of cash flows as part of the cash flows from operations
section.

The company’s accountants record a $1 million debit entry to the audit expense account and a $1 million credit entry to the other current liabilities account. When a payment of $1 million is made, the company’s accountant makes a $1 million debit entry to the other current liabilities account and a $1 million credit to the cash account. Considering the name, it’s quite obvious that any liability that is not current falls under non-current liabilities expected to be paid in 12 months or more. Referring again to the AT&T example, there are more items than your garden variety company may list one or two items. Long-term debt, also known as bonds payable, is usually the largest liability and is at the top of the list. Companies of all sizes finance part of their ongoing long-term operations by issuing bonds that are essentially loans to each party that purchases the bonds.

For example, accrued interest might be interest on borrowed money that accrues throughout the month but isn’t due until month’s end. Or accrued interest owed could be interest on a bond that’s owned, where interest may accrue before being paid. An accrual is something that has occurred but has not yet been paid for. This can include work or services that have been completed but not yet paid for, which leads to an accrued expense.

Sometimes, companies use an account called other current liabilities as a catch-all line item on their balance sheets to include all other liabilities due within a year that are not classified elsewhere. A note payable is usually classified as a long-term (noncurrent) liability if the note period is longer than one year or the standard operating period of the company. However, during the company’s current operating period, any portion of the long-term note due https://simple-accounting.org/ that will be paid in the current period is considered a current portion of a note payable. The outstanding balance note payable during the current period remains a noncurrent note payable. On the balance sheet, the current portion of the noncurrent liability is separated from the remaining noncurrent liability. No journal entry is required for this distinction, but some companies choose to show the transfer from a noncurrent liability to a current liability.

Accrued interest is the amount of interest that is incurred but not yet paid for or received. If the company is a borrower, the interest is a current liability and an expense on its balance sheet and income statement, respectively. If the company is a lender, it is shown as revenue and a current asset on its income statement and balance sheet, respectively. Generally, on short-term debt, which lasts one year or less, the accrued interest is paid alongside the principal on the due date. To illustrate the difference between interest expense and interest payable, let’s assume that a company borrows $200,000 on November 1 at an annual interest rate of 6%.

Higgins Woodwork Company borrowed $50,000 on January 4 to build a new industrial facility. This implies you’ll pay $112.50 monthly in interest on your friend’s debt. For example, divide by four if your interest period is quarterly and by 365 if your interest period is daily. That would be the interest rate a lender charges when you borrow money from them. Whether the underlying debt is short-term or long-term, interest is deemed payable. In that case, it shows that a corporation is defaulting on its debt commitments, and this amount may be a critical aspect of financial statement analysis.

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