Liability is the obligation of a particular entity that has the responsibility to transfer assets or provide services.
A liability is a probable future payment of assets or services that a company is presently obligated to make as a result of past transactions or events.
Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
What is a Liability?
Liabilities are obligations to pay money, render future services, or convey specified assets. They are claims against the company’s present and future assets and resources.
Example of liability is when a firm raises its fund by selling deposits, securities, etc., or when an individual or institution takes a loan from the financial institution.
The question. “What is a liability?” is not easy to answer.
For example, it is preferred stock ownership claim and companies should report it as part of stockholders’ equity. Preferred stock has many elements of debt as well.
The issuer (and in some cases the holder) often has the right to call the stock within a specific period making it similar to the repayment of principal, flic dividend on the preferred stock is in many cases almost guaranteed (the cumulative provision) making it look like interest.
As a result, preferred stock is but one of many financial instruments that are difficult to classify.
To help resolve some of these controversies, the FASB, as part of its conceptual framework study, defined liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events”.
In other words, liability has three essential characteristics:
- 11 is a present obligation that entails settlement by probable future transfer or use of cash, goods, or services.
- It is an unavoidable obligation.
- The transaction or other event creating the obligation has already occurred.
Because liabilities involve future disbursements of assets or services, one of their most important features is the date on which they are payable.
A company must satisfy currently maturing obligations in the ordinary course of business to continue operating.
Liabilities with a more distant due date do not, as a rule, represent a claim on the company’s current resources. They are therefore in a slightly different category.
Current Liability / Short-Term Debt
Current liabilities are usually obligations for goods and services acquired, and taxes owed, and other accruals of expenses. They include deposits received, advance payments, trade acceptances, notes payable, short-term bank loans, as well as the current portion of longterm debt.
According to L.J. Gitman, “Short-term financing is debt that matures in one year or less and is used to fulfill seasonal and current asset needs.”
According to J. Freed and Eugene, “Short-term credit is defined as any liability originally scheduled for payment with’ in one year.”
So current liability is usually obligations for goods and services which are carried during one year.
What are the major disclosure requirements in SEC FRR No. 1, section 203, regarding the terms of short-term debt?
The SEC in Financial Reporting Releases (FRR) No. 1, section 203, has significantly expanded the disclosure requirements in SEC filings (not necessarily in annual reports) regarding the terms of short-term debt:
- Footnote disclosure of compensating balance arrangements, including those not reduced to writing.
- Balance sheet segregation of;
- Legally restricted compensating balances and
- compensating balances relating to long-term borrowing arrangements if the compensating balance can be computed at a fixed amount at the balance sheet date.
- Disclosure of short-term bank and commercial paper borrowings:
- Commercial paper borrowings are separately stated in the balance sheet.
- The average interest rate and terms are separately stated for short-term bank and commercial paper borrowings at the balance sheet date.
- Average interest rate, average outstanding borrowings, and maximum month-end outstanding borrowings for short-term bank debt and commercial paper combined for the period.
- Disclosure of amounts and terms of unused lines of credit for short-term borrowings arrangements (with amounts supposing commercial paper separately stated) and unused commitments for long-term financing arrangements.
Current liabilities are obligations due within one year or the company’s operating cycle, whichever is longer.
Recall that current assets are cash or other assets that companies reasonably expect to convert into cash, sell, or consume in operations within a single operating cycle or within a year if completing more than one cycle each year).
Current liabilities are obligations whose liquidation is reasonably expected to require the use of existing resources properly classified as current assets or the creation of other current liabilities.
This definition has gained wide acceptance because it recognizes operating cycles oi varying lengths in different industries. This definition also considers the important relationship between current assets and current liabilities.
The operating cycle is the time elapsing between the acquisition of goods and services involved in the manufacturing process and the final cash realization resulting from sales and subsequent collections.
Industries that manufacture products requiring an aging process, and certain capital intensive industries, have an operating cycle of considerably more than one year.
On the other hand, most retail and service establishments have several operating cycles within a year.
Liability should be classified as a current liability when it;
- is expected to be settled in the normal course of the company’s operating cycle; or
- is due to be settled within twelve months of the balance sheet date.
In practice, current liabilities are usually recorded in accounting records and reported in a financial statement at their full maturity value.
Because of the short periods involved frequently less than- one year, the difference between the present value of the current liability and the maturity value is not usually large.
Types of Current Liabilities
There are several types of current liabilities:
- Accounts payable.
- Notes payable.
- Current maturities of long term debts.
- Dividends payable.
- Returnable deposits.
- Unearned revenue.
- Sales tax payable.
- Income tax payable.
- Sales Tax Payable/Vat Payable
- Customer advances and deposits.
- Payroll Taxes and Income tax withholding.
- Employee-related liabilities.
- Interest payable.
- Property tax payable.
Let’s look at some of them and how they are posted in the journal.
Accounts Payable
Accounts payable are oral promises to pay a certain sum of money on a specified future date and may arise from purchases or other transactions.
Accounts payable, or trade accounts payable, are balances owed to others for goods, supplies, or services purchased on open account. Accounts payable arise because of the time lag between the receipt of services or acquisition of title to assets and the payment for them.
The terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually state this period of extended credit, commonly 30 to 60 days.
Most companies record liabilities for purchases of goods upon receipt of the goods.
If the title has passed to the purchaser before receipt of the goods, the company should record the transaction at the time of the title passage.
A company must pay special attention to transactions occurring near the end of one accounting period and at the beginning of the next.
It needs to ascertain that the record of goods received (the inventory) agrees with the liability (accounts payable) and that it records both in the proper period.
Measuring the amount of an account payable poses no particular difficulty.
The invoice received from the creditor specifies the due date and the exact outlay in money that is necessary to settle the account. The only calculation that may be necessary concerns the amount of cash discount.
There is some condition: 2/10, n/30 (2% discount, if paid within 10 days, the gross amount in 30 days or 2/10 E.O.M) pass necessary journal entries.
|
Important Journal for Accounts Payable | |||
| 1 | For the purchase of goods on account | ||
| Purchase | Debit | ||
| Accounts payable | Credit | ||
| 2 | For receiving service on account | ||
| Servicing expenses | Debit | ||
| Accounts payable | Credit | ||
| 3 | For the discount received by paid liability in due date | ||
| Accounts payable | Debit | ||
| Cash | Credit | ||
|
Discount revenue (To record the payment with the discount period) | Credit | ||
| 4 | Sales less than the lower of cost and market price | ||
| Accounts payable | Debit | ||
|
Cash (To record the payment after the discount period) | Credit | ||
Notes Payable
Notes payable are written promises to pay a certain sum of money on a specified future date and may arise from purchases or other transactions.
Notes may be classified as short term and long term, depending upon the payment due date. Notes may also be interest-bearing or zero interest bearing. Pass necessary entries related to notes payable.
Notes payable are written promises to pay a certain sum of money on a specified future date.
They may arise from purchases, financing, or other transactions. Some industries require notes (often referred to as trade notes payable) as part of the sales/ purchases transaction instead of the normal extension of open account credit.
Notes payable to banks or loan companies generally arise from cash loans. Companies classify notes as short-term or long-term, depending on the payment due date. Notes may also be interest-bearing or zero-interest-bearing.
Important Journal for Notes payable | |||
| 1 | For purchase on account | ||
| Purchase | Debit | ||
| Accounts payable | Credit | ||
| 2 | Issued a note to account payable | ||
| Accounts payable | Debit | ||
| Notes payable (To record issuance on of notes payable) | Credit | ||
| 3 | Cash paid on notes payable to creditor at maturity | ||
| Notes payable | Debit | ||
| Cash | Credit | ||
| 4 | Cash paid on notes payable with interest at maturity | ||
| Notes payable | Debit | ||
| Interest payable | Debit | ||
| Cash | Credit | ||
| 5 | Dishonored the notes payable | ||
| Notes payable | Debit | ||
| Accounts payable | Credit | ||
| 6 | For taking loan by non-interest bearing notes | ||
| Cash | Debit | ||
| Discount on notes payable | Debit | ||
| Notes payable | Credit | ||
| 7 | For payment of non-interest-bearing notes after expiry of due date | ||
| Notes payable | Debit | ||
| Interest expenses | Debit | ||
| Discount on notes payable | Credit | ||
| Cash | Credit | ||
| # | Adjusting entry For accrued interest on notes payable | ||
| Interest Expense | Debit | ||
| Interest payable (To record accrued interest on notes payable) | Credit | ||
Interest-Bearing Note Issued
Assume that Castle National Bank agrees to lend $100,000 on March 1, 2010. to Landscape Co. if Landscape signs a $100,000, 6 percent, four-month note.
Landscape records the cash received on March 1 as follows;
|
March 1 | ||
| Cash | Debit | |
| Notes Payable (To record issuance of 6%, 4-month note to Castle National Bank) | Credit | |
If Landscape prepares financial statements semiannually, it makes the following adjusting entry to recognize interest expense and interest payable of $2,000 ($100,000 x 6%) at June 30:
|
June 30 | ||
| Interest Expense | Debit | |
| Interest Payable (To accrue interest for 4 months on Castle National Banknote) | Credit | |
If Landscape prepares financial statements monthly, its adjusting entry at the end of each month is $500 ($100,000 x 6% x 1/12).
At maturity (July 1); the landscape must pay the face value of the note ($100,000) plus $2000 interest ($100,000 x 6% x 1/4) landscape records payment of the note and accrued interest as follows;
|
July 1 | ||
| Notes Payable | Debit | |
| Interest Payable | Debit | |
| Cash (To record payment of Castle National Bank interestbearing note and accrued interest at maturity) | Credit | |
Zero Interest Bearing Note Issued
A company may issue a zero-interest-bearing note instead of an interest-bearing note. A zero-interest-bearing note does not explicitly state an interest rate on the lace of the note. Interest is still charged, however.
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 hole at maturity minus the interest or discount charged by the lender for the term of the note.
In essence, the bank takes its fee “up front” rather than on the date the note matures.
To illustrate, assume that Landscape issues a $102,000, four-month, zero-interest- bearing note to Castle National Bank.
The present value of the note is $100,000. Landscape records this transaction as follows.
| March 1 | ||
| Cash | Debit | |
| Discount on Notes Payable | Debit | |
| Notes Payable (To record issuance of 4-month, zero-interest-bearing note to Castle National Bank) | Credit | |
Landscape credits the Notes Payable account for the face value of the note, which is $2,000 more than the actual cash received.
It debits the difference between the cash received and the face value of the note to Discount on Notes Payable.
Discount on Notes Payable is a contra account to Notes Payable and therefore is subtracted from Notes Payable on the balance sheet.
The illustration below shows the balance sheet presentation on March 1;
| Current liabilities | ||
| Notes payable | 102,000 | |
| Less: Discount on notes payable | 2000 | |
| 100,000 | ||
The amount of the discount, $2,000 in this case, represents the cost of borrowing $100,000 for 4 months.
Accordingly, Landscape charges the discount to interest expense over the life of the note. I hat is, the Discount on Notes Payable balance represents interest expense chargeable to future periods.
Thus Landscape should not debit Interest Expense for $2,000 at the time of obtaining the loan.
Current Maturities of Long-Term Debt
The portion of bonds, mortgage notes and other long term indebtedness that matures within the next fiscal year-current maturities of long term debts is reported as a current liability.
PepsiCo reports as part of its current liabilities the portion of bonds, mortgage notes, and other long-term indebtedness that matures within the next fiscal year.
lt categories this amount as current maturities of long-term debt.
Companies, like PepsiCo. exclude long-term debts maturing currently as current liabilities if they are to be:
- Retired by assets accumulated for this purpose that properly has not been shown as current assets,
- Refinanced, or retired from the proceeds of a new debt issue, or
- Converted into capital stock.
In these situations, the use of current assets or the creation of other-current liabilities does not occur.
Therefore, classification as a current liability is inappropriate.
A company should disclose the plan for liquidation of such a debt either parenthetically or by a note to the financial statements.
When only a part of long-term debt is to be paid within the next 12 months, as in the case of serial bonds that it retires through a series of annual installments, the company reports the maturing portion of long-term debt as a current liability and the remaining portion as long-term debt.
However, a company should classify as current any liability that is due on demand (callable by the creditor) or will be due on demand within a year (or an operating cycle, if longer).
Liabilities often become callable by the creditor when there is a violation of the debt agreement.
For example, most debt agreements specify a given level of equity to debt be maintained, or specify that working capital is of a minimum amount If the company violates an agreement, it must classify the debt as current because it is a reasonable expectation that existing working capital will be used to satisfy the debt.
Only If a company can show that it is probable that it will cure (satisfy) the violation within the grace period specified in the agreements can it classify the debt as noncurrent.
Dividend Payable
The dividend is a part of the profit that is declared by the corporation to its shareholders. Cash dividends are always paid within one year of declaration (generally. within 3 months they are classified as a current liability.
| Important Journal for Dividend Payable | |||
| 1 | For declaration of dividend | ||
| Dividend expense | Debit | ||
| Dividend payable | Credit | ||
| 2 | For payment of dividend by cash | ||
| Dividend payable | Debit | ||
| Cash | Credit | ||
Returnable Deposits
Deposits may be received from customers to guarantee the performance of a contract or service or as guarantees to cover payment of excepted future obligations.
For example, telephone companies often require a deposit upon the installation of a phone.
Deposits may also be received from customers as a guarantee for possible damage to property left with the customer.
Current liabilities of a company include returnable cash deposits received from customers and employees. Deposits may be received from customers to guarantee the performance of a contract or service to cover payment of expected future delegations.
Unearned Revenue
Airlines often sell tickets for a future flight, restaurants may be issue meal tickets that can be exchanged or used for future meals, advance house rent, tuition fees all are unearned revenue.
A magazine publisher, such as Golf Digest receive payment when a customer subscribes to its magazines
An airline company, such as American Airlines, sells tickets for future flights. And software companies, like Microsoft issue coupons that allow customers to upgrade to the next version of their software.
How do these companies account for unearned revenues that they receive before delivering goods or rendering services?
- Upon receipt of the advance, debit cash, and credit a current liability account identifying the source of the unearned revenue.
- Upon earning the revenue, debit the unearned revenue account and credit an earned revenue account.
To illustrate, assume that Allstate University sells 10,000 season football tickets at $50 each for its five-game home schedule, Allstate University records the sales of season tickets as follows:
| To record sale of 10,000 season tickets | ||
| Cash | Debit | |
| Unearned Football Ticket Revenue | Credit | |
| After each game, Allstate University makes the following entry; To record football ticket revenues earned | ||
| Unearned Football Ticket Revenue | Debit | |
| Football Ticket Revenue | Credit | |
Unearned Football Ticket Revenue is, therefore, unearned revenue. Allstate University reports it as a current liability in the balance sheet.
As revenue is earned, a transfer from unearned revenue to earned revenue occurs. Unearned revenue is material for some companies: In the airline industry, tickets sold for future flights represent almost 50 percent of total current liabilities.
The illustration below shows specific unearned and earned revenue accounts used in selected types of businesses.
| Specific unearned and earned revenue accounts used in selected types of businesses | ||
| Account Title | ||
|
Type of Business | Unearned Revenue | Earned Revenue |
| Airline | Unearned Passenger Ticket Revenue | Passenger Revenue |
| Magazine publisher | Unearned Subscription Revenue | Subscription Revenue |
| Hotel | Unearned Rental Revenue | Rental Revenue |
| Auto dealer | Unearned Warranty Revenue | Warranty Revenue |
| Retailers | Unearned Gift Card Revenue | Sales Revenue |
The balance sheet should report obligations for any commitments that are redeemable in goods and services. The income statement should report revenues earned during the period.
Sales Tax Payable
Sales tax levied by a city or state on the retail sale of merchandise. Sales taxes on the transfer of intangible property and on certain services must be collected from customers and remitted to the proper government authority.
Retailers like Walmart, Circuit City, and GAP must collect sales taxes from customers on transfers of tangible personal property and certain services and then must remit these taxes to the proper governmental authority.
GAP, for example, sets up a liability to provide for taxes collected from customers but not yet remitted to the tax authority.
The Sales Taxes Payable account should reflect the liability for sales taxes due to various governments. The entry below illustrates the use of the Sales Taxes Payable account on a sale of $3,000 when a 4 percent sales tax is in effect.
| Sales | Debit | |
| Sales Taxes Payable | Credit |
Sometimes the sales tax collections credited to the liability account are not equal to the liability as computed by the governmental formula.
In such a case, GAP adjusts the liability account by recognizing a gain or a loss on sales tax collections.
Many companies do not segregate the sales tax and the amount of the sale at the time of sale. Instead, the company credits both amounts in total in the Sales account.
Then, to reflect correctly the actual amount of sales and the liability for sales taxes, the company would debit the Sales account for the amount of the sales taxes due to the government on these sales and would credit the Sales Taxes Payable account for the same amount.
To illustrate, assume that the Sales account balance of $150,000 includes sales taxes of 4 percent. Thus, the amount recorded in the Sales account is comprised of the sales amount plus sales tax of 4 percent of the sales amount.
Sales, therefore, are $144,230.77 ($150,000 / 1.04) and the sales tax liability is $5,769.23 ($144,230.77 X 0.04; or $150,000 – $144,230.77).
The following entry would record the amount due to the taxing unit.
| Sales | $5.769.23 | |
| Sales Taxes Payable | $5.769.23 |
Income Tax Payable
Any federal or state income tax varies in proportion to the amount of annual income.
Using the best information and advice available, a business must prepare an income tax return and compute the income tax payable resulting from the operations of the current period.
Corporations should classify as a current liability the taxes payable on net income, as computed per the tax return.
Unlike a corporation, proprietorships and partnerships are not taxable entities.
Because the individual proprietor and the members of a partnership are subject to personal income taxes on their share of the business’s taxable income, income tax liabilities do not appear on the financial statements of proprietorships and partnerships.
Most corporations must make periodic tax payments throughout the year in an authorized bank depository or a Federal Reserve Bank. These payments are based upon estimates of the total annual tax liability
As the estimated total tax liability changes, the periodic contributions also change. If in a later year the taxing authority assesses an additional tax on the income of an earlier year, the company should credit Income Taxes Payable and charge the related debit to current operations.
Differences between taxable income under the tax laws and accounting income under generally accepted accounting principles sometimes occur.
Because of these differences, the amount of income tax payable to the government in any given year may differ substantially from income tax expense as reported on the financial statements.
Sales Tax Payable/Vat Payable
Sales tax levied by a city or state on the retail sale of merchandise. Sales taxes on the transfer of intangible property and on certain services must be collected from customers and remitted to the proper government authority.
| Sales Tax Payable/Vat Payable Journal | |||
| 1 | When the advance is received | ||
| Cash | Debit | ||
| Unearned revenue | Credit | ||
| 2 | When the revenue is earned (Adjusting entries) | ||
| Earned revenue | Debit | ||
| Earned revenue | Credit | ||
| 3 | When the Earned Revenues are transferred to income summary | ||
| Earned revenue | Debit | ||
| Income summary | Credit | ||
Customer Advances and Deposits
Current liabilities may include returnable cash deposits received from customers and employees. Companies may receive deposits from customers to guarantee the performance of a contract or service or as guarantees to cover payment of expected future obligations.
For example, a company like Alltel Corp often requires a depose on equipment that customers use to connect to the Internet or to access its other services.
Alltel also may receive deposits from customers as guarantees for possible damage to property.
Additionally, some companies require their employees to make deposits for the return of keys or other company property.
The classification of these items as current or noncurrent liabilities depends on the time between the date of the deposit and the termination of the relationship that required the deposit.
Salary, Wages, and Bonuses payable
Salary, Wages mid Bonuses of employees accrue daily.
Normally; no entry is made for these expenses until payment is made
Al the end of an accounting period when a more precise matching of revenue and expense is desired, liability for unpaid salaries and is recorded.
Salaries and wages of officers and other employees accrue daily. Normally, no entry is made for these expenses until payment is made.
Al the end of an accounting period when a more precise matching of revenue and expense is desired, liability for unpaid salaries and is recorded
| Salary, Wages, and Bonuses payable Journals | |||
| 1 | Accrued at the end of the period (Adjusting entry) | ||
| Wages and salaries expense | Debit | ||
| Wages and salaries payable | Credit | ||
| 2 | At the beginning of the next period | ||
| Wages and salaries payable | Debit | ||
| Wages and salaries expense | Credit | ||
| 3 | When the payment of the next accounting period | ||
| Wages and salaries expense | Debit | ||
| Cash | Credit | ||
Payroll Taxes And Income tax withholding
The Federal Insurance Contributions Act (FICA); generally referred to as social security legislation, provides for taxes on employers and employers to provide funds lot federal old age, survivor, disability, in mi-mu provident fund benefits for certain individuals and of their families.
| Labilities for payroll-related tax | ||
| Payroll taxes expense | Debit | |
| Income tax payable | Credit | |
| Provident fund payable | Credit | |
| FICA tax payable | Credit | |
| SUTA tax payable | Credit | |
Warranties for Replacements
A warranty is a seller’s obligation to replace or correct a product or service that fails to perform as expected within a specified period.
Many companies agree to provide free service on unit s failings to perform satisfactorily or to replace defective goods.
When these agreements involve significant future costs and experience indicates a definite future obligation exists, an estimate of such costs should be made and matched against current revenue.
Warranties for Replacements Journal | |||
| 1 | When expenses change for warranty | ||
| Warranties expenses | Debit | ||
| Estimated liability under warranties | Credit | ||
| 2 | When incurred warranty expenses | ||
| Estimated liability under warranties | Debit | ||
| Cash/inventory parts | Credit | ||
| 3 | Adjustment of estimate for warranty repairs | ||
| Estimated liability under warranties | Debit | ||
| Warranties expenses | Credit | ||
Warranties for Services
A warranty is a promise made by a seller to a buyer to make good on a deficiency of quantity, quality or performance of a product.
It is commonly used by manufacturers as a sales promotion technique. Warranties cost are sometimes called future cost or after cost or post-sales cost.
Warranty costs are a classic example of a loss contingency
There are two basic methods of accounting for warranty costs.
- Cash basis method
Warranty costs are changed lo the period in which the seller complies with the warranty.
No liability is recorded for future costs arising from warranties and period of sales not necessarily charged with the cost of making goods on outstanding warranty.
- Accrual Basis Method
Warranty costs are charged to operating expenses in the year of sales.
Expense warranty approach
The expense warranty approach charges the estimated future warranty costs to operating expenses in the year of sales or manufacture.
For example, Kajol company sells 100 units al $5000 each by its year ended December 31, 2007, each machine is under warranty for one year and the company has estimated from experience with a similar machine, that the warranty cost will probably average 200 per unit.
Further, as a result of parts replacements and services rendered in compliance with machinery warranties, the company incurs $4.000 in warranty costs in 2019 and $16,000 in 2020.
Expense warranty approach journal | |||
| 1 | Sale of 100 machines $5000 each 2019 | ||
| Cash/Accounts Receivable | Debit | ||
| Sales | Credit | ||
| 2 | Recognition of warranty expense, 2020 | ||
| Warranty Expense | Debit | ||
| Cash/Inventory (Warranty costs incurred) | Credit | ||
| Warranty Expense | Debit | ||
| Estimated liability under warranties (To accrue estimated warranty cost) | Credit | ||
| The 31.12.2020 balance sheet would report estimated liability under warranties at a current liability of $16000, and income Malcmeri for 2020 would report warranty expense of $20.000. | |||
| 3 | Recognition of warranty costs incurred in 2020 (on 2019 machine sales) | ||
| Estimated liability under warranties | Debit | ||
| Cash / Inventory (Warranty costs incurred) | Credit | ||
Sales Warranty Approach
The sales warrant approach defers a certain percentage of the original sales price until some future time when actual costs are incurred or warranty expires.
A warranty is sometimes sold separately from the product, for example;
Lump Electronic Company sells Computer at an average price of $30.000/- and also offers each customer a separate 5-years warranty contract for $1.000 that requires the company to perform periodic services and to replace defective parts.
During 2019, the company sold 200 computers, and straight-line recognition of warranty revenues occurs.
| Sale of 200 computers at Tk30000 and addition warranty, 2019 | ||
| Cash | 60,001,000 | |
| Sales (200 X 30,000) | 60,000,000 | |
| Unearned warranty revenue | 1,000 | |
| The entry to recognize revenue at the end of the first year (using straight-line-amortization) would be as follows; | ||
| Unearned warranty revenue | 200 | |
| Warranty revenue ( 1000 / 5 years ) | 200 | |
How does the expense warranty approach differ from the sales warranty approach?
The expense warranty approach and the sales warranty approach are both variations of the accrual method of accounting for warranty costs, the expense warranty approach charges the estimated future warranty costs to operating expense in the year of sale or manufacture.
The sales warranty approach defers a certain percentage of the original sales price until some future time when actual costs are incurred or the warranty expires.
Difference Between the cash basis method and the accrual method of accounting for warranty costs
Under the cash basis method. warranty costs are charged to expense in the period in which the seller or manufacture performs in compliance with the warranty.
No liability is recorded for future costs arising from -warranties and the period of sales is not necessarily charged with the cost of making goods on outstanding warranties.
Under the accrual method, a provision for warranty costs is made at the time of sales or as the productive activity takes place.
The accrual method may be applied two different ways- expense warranty versus sales warranty method- but under either method, the attempt is to match warranty expense to the related revenues.
Under what conditions a short-term obligation should be excluded from current liabilities
An enterprise should exclude a short-term obligation from current liabilities only if;
- it intends to refinance the obligation on a long-term basis, and
- it demonstrates an ability to consummate the refinancing.
Employee Related Liabilities
Amounts owed to employees for salaries or wages at the end of an accounting period are reported as a current liability.
Some employee-related liabilities are;
- Payroll deductions.
- Compensated absences.
- Postretirement benefits.
- Bonuses.
Payroll deductions
The most common types of payroll deductions are taxes, insurance premiums, employee savings, and union dues, Io the extent that a company has not remitted the amounts deducted to the proper authority at the end of the accounting period, it should recognize them as current liabilities.
Compensated absences
Compensated absences are absences from employment such as vacation, illness and holidays for which employees are paid any way.
Postretirement benefit
There are two different types of postretirement benefits;
- pensions, and
- postretirement health care and life insurance benefits.
Bonus
Many companies give a bonus to certain or all officers and employees in addition to their regular salary or wages.
Analysis of Current Liabilities
The distinction between current liabilities and long-term debt is important. It provides information about the liquidity of the company.
Liquidity regarding liability is the expected time to elapse before its payment. In other words, a liability soon to be paid is a current liability.
A liquid Company is better able to withstand a financial downturn. Also, it has a better chance of taking advantage of investment opportunities that develop.
Analysts use certain basic ratios such as net cash flow provided by operating activities to current liabilities, and the turnover ratios for receivables and inventory, to assess liquidity.
Two other ratios used to examine liquidity are the current ratio and the acid-test ratio.
Current Ratio
The current ratio is the ratio of total current assets to total current liabilities. An illustration shows its formula.
|
Current ratio = Current assets – Current liabilities |
The ratio is frequently expressed as coverage of so many limes. Sometimes it is called the working capital ratio because working capital is the excess of current assets over current liabilities.
A satisfactory current ratio does not disclose that a portion of the current assets may be tied up in y slow-moving inventories.
With inventories, especially raw materials and work in process, there is a question of how long it will lake to transform them into the finished product and what ultimately will be realized in the sale of the merchandise.
Eliminating the inventories, along with any prepaid expenses, from the number of current assets might provide better information for short-term creditors. 1 herefore, some analysts use the acid-test ratio in place of the current ratio.
Acid-test Ratio
Many analysts favor an acid-test or quick ratio that relates total current liabilities to cash, marketable securities, and receivables.
Acid-test ratio formula
| Acid test ratio = (Cash + Short-term investments + Net receivables) / Current liabilities |
To illustrate the computation of these two ratios, we use the information for Best Co. in Illustration. The illustration shows the computation of the current and acid-test ratios for Best Buy.
| Current ratio = Current assets / Current liabilities = 9,081 / 6,301 = 1.44 times. Acid test ratio = (Cash + Short-term investments + Net receivables) / Current liabilities = 4,341 / 6301 = 0.69 times. |
From this information, it appears that the Best company’s current position is adequate.
A comparison to another retailer. Circuit City, whose current ratio is 1.68 and whose acid-test ratio is 0.65, indicates that Best Buy is carrying less inventory than its industry counterparts.
Non-Current Liabilities
Non-Current Liabilities are the obligations of the company which are expected to get paid after one year and the examples of which include long term loans and advances, long term lease obligations, deferred revenue, bonds payable and other Non-Current Liabilities.
Non-Current Liabilities are those set of liabilities that are taken to undertake capital expenditure and its maturity is beyond 12 months from the reporting date.
List of Non-Current Liabilities
- Long Term Borrowings.
- Secured/Unsecured Loans.
- Long Term Lease Obligations.
- Deferred Tax Liabilities.
- Provisions.
- Derivative Liabilities.
- Other Liabilities Getting due After 12 Months.
Long Term Liability
Long-term liabilities are liabilities with a future benefit over one year, such as notes payable that mature longer than one year.
In accounting, the long-term liabilities are shown on the right side of the balance sheet representing the sources of funds, which are generally bounded in the form of capital assets.
Discuss required disclosure of long term liabilities
The note disclosures should contain information about long-term liabilities, including long-term debt instruments such as bonds, notes, loans, and leases payable, as well as other long-term liabilities such as compensated absences, claims, and judgments, as follows:
- Beginning- and end-of-year balances
- Increases
- Decreases
- The portions of each item that are due within one year of the statement date
- Information on the governmental funds is typically used to liquidate long-term liabilities in prior years. The disclosure should also indicate whether the government has decided to depart from the historical trend and use other funds to liquidate liabilities. The purpose of this disclosure is to give readers additional information about future claims against financial resources to help them assess the fund balances of specific funds.
Information about net pension obligations is required to be disclosed in a separate pension note using the requirements of GASB Statement 27, Accounting for Pensions by State and Local Governmental Employers.
Presentation of Current Liabilities and Current Assets
In practice, current liabilities are usually recorded and reported in financial statements at their full maturity value. Because of the short time periods involved, frequently less than one year, the difference between the present value of the current liability and the maturity value is usually not large.
The profession accepts as immaterial any slight overstatement of liabilities that results from carrying current liabilities at maturity value.
The current liabilities accounts are commonly presented as the first classification in the liabilities and stockholders’ equity section of the balance sheet. Within the current liabilities section, companies may list the accounts in order of maturity, in descending order of amount, or in order of liquidation preference.
This table presents an example of the Presentation of Current Liabilities and Current Assets.
| March 3, 2007 $ | Feb. 25, 2006 $ | |
| Current Assets | ||
| Cash and cash equivalents | 1,205 | 748 |
| Short-term investments | 2,588 | 3,041 |
| Receivables | 548 | 449 |
| Merchandise inventories | 4,028 | 3,338 |
| Other current assets | 712 | 409 |
|
Total Current Assets | $9,081 | $7,985 |
| Current Liabilities | ||
| Accounts payable | 3,934 | 3,234 |
| Unredeemed gift card liabilities | 496 | 469 |
| Accrued compensation and related expenses | 332 | 354 |
| Accrued liabilities | 990 | 878 |
| Accrued income taxes | 489 | 703 |
| Short-term debt | 41 | – |
| Current portion of long-term debt | 19 | 418 |
|
Total Current Liabilities | 6,301 | 6,056 |
The detail and supplemental information concerning current liabilities should be sufficient to meet the requirement of full disclosure.
Companies should clearly identify secured liabilities, as well as indicate the related assets pledged as collateral.
If the due date of any liability can be extended, a company should disclose the details. Companies should not offset current liabilities against assets that it will apply to their liquidation.
Finally, current maturities of long-term debt are classified as current liabilities. A major exception exists when a company will pay a currently maturing obligation from assets classified as long-term.
For example, if a company will retire a bond payable using a bond sinking fund that is classified as a long-term asset, it should report the bonds payable in the longterm liabilities section.
The presentation of this debt in the current liabilities section would distort the working capital position of the enterprise.
If a company excludes a short-term obligation from current liabilities because of refinancing, it should include the following in the note to the financial statements:
- A general description of the financing agreement.
- The terms of any new obligation incurred or to be incurred.
- The terms of any equity security issued or to be issued.
When a company expects to refinance on a long-term basis by issuing equity securities, it is not appropriate to include the short-term obligation in stockholders’ equity.
At the date of the balance sheet, the obligation is a liability and not stockholders’ equity. Illustration shows.the disclosure requirements for an actual refinancing situation.
| December 31, 2010 $ | |
| Current liabilities | |
| Accounts payable | 3,600,000 |
| Accrued payables | 2,500,000 |
| Income taxes payable | 1,100,000 |
| Current portion of long-term debt | 1,000,000 |
| Total Current Liabilities | 8,200,000 |
| Long-term debt | |
| Notes payable refinanced in January 2011 (Note 1) | 2,000,000 |
| 11% bonds due serially through 2021 | 15,000,000 |
| Total Long-term Debt | 17,000,000 |
| Note I: On January 19, 2011, the Company issued 50,000 shares of common stock and received proceeds totaling $2,385,000, of which $2,000,000 was used to liquidate notes payable that matured on February 1, 2011. Accordingly, such notes payable have been classified as long-term debt at December 31, 2010. | |