Financial Accounting Fourth Edition

Current Liabilities

CHAPTER

8 Spiceland Thomas Herrmann

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Part C
NOTES RECEIVABLE

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Learning Objective 7

LO57 Account for notes receivable and interest

revenue.

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Illustration 513
Note Receivable
Similar to accounts receivable but include a
written debt agreement, or note
Normal debit balance
Classified as either current or noncurrent asset
depending on time until due date
Face value $ 10,000 Date February 1, 2018

Due date Six months after date I promise to pay to the

order of Kimzey Medical Clinic
Payee Ten thousand and no/100 dollars
for value received with interest at the rate of 12% .
Interest rate Justin Payne

Maker

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Recording Notes Receivable
Kimzey provided $10,000 of services to Justin
Payne, who is not able to pay immediately
Justin Payne signs a promissory note, offering to
pay $10,000 plus 12% interest in six months
(August 1).
February 1, 2018 Debit Credit
Notes Receivable 10,000
Service Revenue . 10,000
(Accept a six-month, 12% note receivable for services provided)

No interest is recorded on February 1

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Key Point
Notes receivable are similar to accounts
receivable except that notes receivable are
formal credit arrangements made with a written
debt instrument, or note.

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Collection of Notes Receivable
and Interest
After six months, Kimzey collects the full amount
owed by Justin, including interest
Face Annual Fraction
Interest = value interest rate of the year
$600 = $10,000 12% 6/12

August 1, 2018 Debit Credit

Cash . 10,600
Notes Receivable 10,000
Interest Revenue 600
(Collect note receivable and interest)
(Interest revenue = $10,000 12% 6/12)

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Illustration 514
Calculating Interest Revenue over
Time for Kimzey Medical Clinic
2018 2019
Nov. 1 May 1
(Note issued) (Note due)
Nov. Dec. Jan. Feb. Mar. Apr.
$100 $100 $100 $100 $100 $100

2 months of 4 months of
interest revenue interest revenue
In 2018 = $200 in 2019 = $400

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 Accrue Interest and Collect Interest
On December 31, 2018, Kimzey accrues interest for
note receivable accepted on November 1, 2018.
December 31, 2018 Debit Credit
Interest Receivable 200
Interest Revenue 200
(Accrual interest revenue = $10,000 12% 2/12)

On May 1, 2019, the maturity date, Kimzey collects the

note of $10,000 and the interest of $600.
May 1, 2019 Debit Credit
Cash . 10,600
Notes Receivable 10,000
Interest Receivable (from 2018) .. 200
Interest Revenue (from 2019) 400
(Collect note receivable and interest; Interest revenue = $10,000 12% 4/12)
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Concept Check 510
A company accepts a note receivable of $5,000 on
September 1, 2018, that matures in 10 months and
has stated interest of 6%. What amount of interest
revenue will the company record in 2018 and 2019?
a. 2018 = $100; 2019 = $150
b. 2018 = $125; 2019 = $125
c. 2018 = $150; 2019 = $100
d. 2018 = $0; 2019 = $250
Interest Face Annual Fraction
=
Revenue value interest rate of the year
2018: Interest Revenue = $5,000 6% 4/12 = $100
2019: Interest Revenue = $5,000 6% 6/12 = $150
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Part A
CURRENT LIABILITIES

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Learning Objective 1

LO81 Distinguish between current and long-term

liabilities.

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Current vs. Long-Term Liabilities

Current Long-Term

Due within one year or an Due in more than one year

operating cycle or operating cycle

Operating cycle = Time it takes to perform the activities that

produce revenues (for example, buy
inventory, sell to customers, and collect cash)

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Illustration 81
Bankruptcy of United Airlines
UNITED AIRLINES
Management Discussion and Analysis (excerpt)
Over the past several years, United and indeed the entire airline industry have faced severe
business challenges and fundamental industry changes which have produced material
adverse impacts on earnings, financial position and liquidity.
Operating revenues for the airline industry in general, as well as for United, have been
adversely impacted by several factors. The growth of low cost carriers; excess seat capacity;
pricing transparency; reduced demand for high-yield business travel; global events such as
the war in Iraq, the outbreak of disease as well as the fear of terrorist attacks since
September 11, 2001; and the enactment of federal taxes on ticket sales to fund additional
airport security measures, have caused earnings to decline.

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Illustration 82
Current Liabilities Section for
Southwest Airlines
SOUTHWEST AIRLINES
Balance Sheet (partial)
($ in millions)

Current liabilities:
Current debt $ 258
Accounts payable and accrued liabilities 2,768
Other current liabilities 2,897
Total current liabilities $5,923

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Concept Check 81
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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Learning Objective 2

LO82 Account for notes payable and interest

expense.

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Notes Payable
Note signed by a firm promising to repay the
amount borrowed plus interest
Interest on notes is calculated as:

Face Annual Fraction

Interest = interest rate
value of the year

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Recording Notes Payable
Assume Southwest Airlines borrows $100,000 from
Bank of America on September 1, 2018, signing a 6%,
six-month note.

September 1, 2018 Debit Credit

Cash . 100,000
Notes Payable .......... 100,000
(Issue notes payable)

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Recording Interest Payable and
Repayment of Notes Payable
Year-end adjusting entry for interest payable
Sept. 1 to Dec. 31
December 31, 2018 Debit Credit
Interest Expense (= $100,000 6% 4/12) 2,000
Interest Payable ........................ 2,000
(Record interest incurred, but not paid)

Repayment of note
March 1, 2019 Debit Credit
Jan. 1 to Mar. 1
Notes Payable (face value)..... 100,000
Interest Expense (= $100,000 6% 2/12) 1,000
Interest Payable (= $100,000 6% 4/12) . 2,000
Cash........................................... 103,000
(Pay notes payable and interest)
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Key Point
We record interest expense in the period in
which we incur it, rather than in the period in
which we pay it.

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Concept Check 82
If a company signs a $10,000, 5%, 6-month note
payable on October 1, how much interest would be
recorded by December 31 of the same year?
a. $250
b. $125
c. $500 Interest is recorded from the date of the
d. $0 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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Line of Credit & Commercial Paper
Line of credit:
Informal agreement
Permits a company to borrow up to a prearranged
limit
Recorded similar to notes payable
Commercial paper:
Borrowing from another company rather than a bank
Sold with maturities ranging from 30 to 270 days
Interest rate is usually lower than on a bank loan

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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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Accounts Payable
Amounts owed to suppliers of merchandise or
services
Sometimes called trade accounts payable

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Learning Objective 4

LO84 Explain the accounting for other current

liabilities.

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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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Illustration 85
Revenue Recognition Policy of
United Airlines
UNITED AIRLINES
Notes to the Financial Statements (excerpt)
Airline RevenuesWe record passenger fares and cargo revenues as operating revenues
when the transportation is provided. The value of unused passenger tickets is included in
current liabilities as advance ticket sales. We periodically evaluate the balance in advance
tickets sales and record any adjustments in the period the evaluation is completed.

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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 it earns the revenue, the company debits Deferred

Revenue and credits Sales Revenue
Suppose the customer downloads $15 worth of music
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
Debt that will be paid within the next year
For example, a 20-year mortgage is split and reported
as the portions that are due:
1. Within the next year (current liability)
2. After the next year (long-term liability)
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

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Illustration 86
Current Portion of Long-Term Debt
SOUTHWEST AIRLINES
Balance Sheet (partial)
($ in millions)

Current liabilities:
Current portion of long-term debt $ 258
Long-term liabilities:
Long-term debt 2,434
Total borrowings $2,692

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Concept Check 85
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 .065 (or 6.5%) = $13.00

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Part B
CONTINGENCIES

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Learning Objective 5

LO85 Apply the appropriate accounting treatment

for contingencies.

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Contingent Liabilities
An existing uncertain situation that might result
in a loss depending on the outcome of a future
event

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Illustration 87
Criteria for Reporting a Contingent Liability
1. The likelihood of payment is
a. Probablelikely to occur;
b. Reasonably possiblemore than remote but less than
probable; or
c. Remotethe chance is slight.
2. The amount of payment is
a. Reasonably estimable; or
b. Not reasonably estimable.

A contingent liability is recorded only if:

1. The loss is probable and,
2. The amount is reasonably estimable
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Illustration 88
Accounting Treatment of
Contingent Liabilities
Amount of payment is:

Likelihood of Reasonably Not Reasonably

payment is: Estimable Estimable

Probable Liability recorded Disclosure required

Reasonably possible Disclosure required Disclosure required
Remote Disclosure not required Disclosure not required

December 31 Debit Credit

Loss.. Estimate
Contingent Liability .................... Estimate
(Record a contingent liability)

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Illustration 89
Disclosure of Contingencies by
United Airlines
UNITED AIRLINES
Notes to the Financial Statements (excerpt)

Legal and Environmental Contingencies. United Airlines has certain contingencies

resulting from litigation and claims (including environmental issues) incident to the
ordinary course of business. Management believes, after considering a number of factors,
including (but not limited to) the views of legal counsel, the nature of contingencies
to which we are subject and prior experience, that the ultimate disposition of these
contingencies will not materially affect the Companys consolidated financial position or
results of operations.
Contingency for Frequent-Flyer Program Awards. Uniteds MileagePlus frequent-flyer
program awards mileage credits to passengers who fly on United, United Express,
and certain other airlines that participate in the program. When a travel award
level is attained by a MileagePlus member, we record a liability for the estimated
cost of such awards.

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Accounting for Warranties
Assume warranty costs are estimated to be 3% of sales. December sales are $1.5
million and customers make warranty claims of $12,000 in January of the
following year.
December 31 Debit Credit
Warranty Expense.... 45,000
Warranty Liability .................... 45,000
(Record liability for warranties)

January 31 Debit Credit

Warranty Liability. 12,000
Cash ...................................... 12,000
(Record actual warranty expenditures)

Warranty Liability
45,000 Estimated expense
Actual payment 12,000
33,000 Final balance
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Common Mistake
Some students think the balance in the
Warranty Liability account is always equal to
Warranty Expense. Remember, the Warranty
Liability account is increased when the
estimated warranty liability is recorded, but
then is reduced over time by actual warranty
expenditures.

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 Concept Check 86
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 87
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 Oceanics 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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Contingent Gains
An existing uncertain situation that might
result in a gain
In a lawsuit, the defendant faces a contingent
liability, while the other sidethe plaintiff
has a contingent gain
Contingent gains are not recorded until the
gain is certain
Nice example of conservatism

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Key Point
Unlike contingent liabilities, contingent gains are
not recorded until the gain is certain and no
longer a contingency.

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Learning Objective 6

LO86 Assess liquidity using current liability ratios.

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Liquidity Analysis
Liquidity: refers to having sufficient cash or
other current assets to pay currently maturing
debts
Lack of liquidity can result in financial
difficulties or even bankruptcy
Three liquidity measures:
Working capital
Current ratio
Acid-test ratio

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Working Capital
Working capital = Current assets Current liabilities
Measure of current assets remaining after paying
current liabilities
A large positive working capital is an indicator of
liquidity
Not the best measure of liquidity for comparing
across companies, because the ratio does not control
for the relative size of each company

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Current Ratio
Current assets
Current Ratio =
Current liabilities
The amount of current assets available for every
$1 of current liabilities
The higher the current ratio, the greater the
companys liquidity
A current ratio of, say, 1.5 indicates that for every
dollar of current liabilities, the company has $1.50
of current assets

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Common Mistake
As a general rule, a higher current ratio is better.
However, a high current ratio is not always a
positive signal. Companies having difficulty
collecting receivables or holding excessive
inventory will also have a higher current ratio.
Managers must balance the incentive for strong
liquidity (yielding a higher current ratio) with the
need to minimize levels of receivables and
inventory (yielding a lower current ratio).

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 Acid-Test Ratio
Cash + Current investments
+ Accounts receivable
Acid-test ratio =
Current liabilities
The amount of quick assets available for every $1 of
current liabilities
Quick assets are current assets more readily
convertible to cash
Exclude current assets such as inventory and prepaid rent
By excluding less liquid current assets, the acid-test
ratio may provide a better overall indication of a
companys liquidity
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Key Point
Working capital is the difference between
current assets and current liabilities. The current
ratio is equal to current assets divided by
current liabilities. The acid-test ratio is equal to
quick assets (cash, current investments, and
accounts receivable) divided by current
liabilities. Each measures a companys liquidity,
its ability to pay currently maturing debts.

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Concept Check 88
The current ratio is:
a. Computed as the difference between current
assets and current liabilities
b. Computed as current assets divided by current
liabilities
c. A measure of profitability
d. All of the above
The current ratio is calculated by dividing current assets
by current liabilities. It is a measure of liquidity (not
profitability).

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End of Chapter 8

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