CHAPTER 1



CHAPTER 8

Current Liabilities and the Time Value of Money

Reviewing the Chapter

Objective 1: Identify the management issues related to current liabilities.

1. Liabilities, one of the three major parts of the balance sheet, are legal obligations for the future payment of assets or the future performance of services. The primary reason for incurring current liabilities is to meet needs for cash during the operating cycle.

2. If a company’s cash flows are inadequate to meet its current liabilities, the company could be forced into bankruptcy; thus, careful management of cash flows related to current liabilities is critical. Another issue in managing cash flows and current liabilities is the length of time creditors allow for payment. Common measures of this time are payables turnover and days’ payable. Payables turnover (measured in number of “times”) shows the relative size of a company’s accounts payable. The formula for calculating it is as follows:

|Cost of Goods Sold ( |

|Change in Merchandise Inventory |

|Average Accounts Payable |

Days’ payable shows the average length of time a company takes to pay its accounts payable. It is computed as follows:

|365 days |

|Payables Turnover |

3. Ethical reporting of liabilities requires that they be properly recognized, valued, classified, and disclosed. A liability should be recognized (recorded) at the time it is incurred. However, for accrued and estimated liabilities, it is necessary to make adjusting entries at the end of an accounting period. Contracts representing future obligations are not recorded as liabilities until they become current obligations.

4. Liabilities are valued at the actual or estimated amount of money necessary to satisfy the obligation or at the fair market value of the goods or services that must be delivered.

5. Current liabilities are obligations expected to be satisfied within one year or the normal operating cycle, whichever is longer. They are normally paid out of current assets or with cash generated from operations. Long-term liabilities are obligations due beyond one year or the normal operating cycle.

6. Supplemental disclosure of some liabilities may be required in the notes to the financial statements—for example, when a company has special credit arrangements that can influence potential investors’ decisions.

Objective 2: Identify, compute, and record definitely determinable and estimated current liabilities.

7. Current liabilities consist of definitely determinable liabilities and estimated liabilities.

8. Definitely determinable liabilities are obligations that can be measured exactly. They include accounts payable, bank loans and commercial paper, notes payable, accrued liabilities, dividends payable, sales and excise taxes payable, current portions of long-term debt, payroll liabilities, and unearned revenues.

a. Accounts payable, sometimes called trade accounts payable, are obligations currently due to suppliers of goods and services.

b. To finance current operations by borrowing funds, companies often obtain a line of credit with a bank. Companies with excellent credit ratings can also borrow short-term funds by issuing commercial paper (unsecured loans sold to the public).

c. Short-term notes payable are current obligations evidenced by promissory notes. Interest is usually stated separately on the face of the note.

d. Accrued liabilities (also called accrued expenses) are actual or estimated liabilities that exist at the balance sheet date but are unrecorded at that date. An end-of-period adjustment is needed to record both the expenses and the accrued liabilities.

e. Dividends payable represent a corporation’s obligation to distribute earnings to stockholders. This obligation arises only when the board of directors declares a dividend.

f. Most states and many cities levy a sales tax on retail transactions. The federal government also charges an excise tax on some products. The merchant must collect payment for these taxes at the time of the sale; the related journal entry records both the receipt of cash and the tax liabilities.

g. If a portion of long-term debt is due within the next year and is to be paid from current assets, that amount should be classified as a current liability; the remaining debt should be classified as a long-term liability.

h. Payroll liabilities are a business’s employee-related obligations. Payroll accounting applies only to an organization’s employees, who are under its direct supervision and control; it does not apply to independent contractors, such as lawyers and CPAs. A business is not only responsible for paying its employees wages or salaries; it is also obligated for such items as social security (FICA) taxes, Medicare, and unemployment taxes. In addition, it must withhold income taxes from its employees’ gross earnings and remit them to the appropriate government agencies. Some companies also contribute to medical insurance for employees and to pension funds.

i. Unearned revenues represent obligations to deliver goods or services in return for advance payment. When delivery takes place, Unearned Revenue is debited, and a revenue account is credited.

9. Estimated liabilities are definite obligations, but the amount of the obligations must be estimated at the balance sheet date because the exact figure will not be known until a future date. Examples of estimated liabilities are corporate income taxes, property taxes, promotional costs, product warranties, and vacation pay.

a. A corporation’s income tax depends on its net income, a figure that often is not determined until well after the balance sheet date.

b. Property taxes are levied on real and personal property. Very often, a company’s accounting period ends before property taxes have been assessed, and the company must therefore estimate the taxes.

c. Promotional costs associated with such things as coupons, rebates, and frequent flyer programs are usually treated as a reduction in sales rather than as an expense.

d. When a company sells a product with a warranty, a liability exists for the length of the warranty. Many warranties will remain in effect in subsequent accounting periods. However, the warranty expense and liability must be recorded in the period of the sale no matter when the company makes good on the warranty. Therefore, at the end of each accounting period, the company should make an estimate of future warranty expense that will apply to the present period’s sales.

e. In a company in which employees earn vacation pay for working a certain length of time, the company must estimate the vacation pay that applies to each payroll period. The debit is to Vacation Pay Expense, and the credit is to Estimated Liability for Vacation Pay. The liability decreases (is debited) when an employee receives vacation pay.

Objective 3: Distinguish contingent liabilities from commitments.

10. Businesses are required to disclose contingent liabilities and commitments in the notes to their financial statements.

a. A contingent liability is a potential liability that may or may not become an actual liability. The uncertainty about its outcome is settled when a future event does or does not occur. Contingent liabilities arise from things like pending lawsuits, tax disputes, and failure to follow government regulations. Two conditions must be met before a contingency is entered in the accounting records: the liability must be probable, and it can be reasonably estimated.

b. A commitment is a legal obligation that does not qualify for recognition as a liability. Leases and purchase agreements are the most common examples of commitments.

Objective 4: Define the time value of money, and apply it to future and present values.

11. The timing of the receipt and payment of cash (measured in interest) is an important consideration in making business decisions. The effect of the passage of time on holding or not holding money is called the time value of money. Interest is the cost of using money for a specific period of time; it may be calculated on a simple or compound basis.

a. When simple interest is computed for one or more periods, the amount on which interest is computed does not increase each period (that is, interest is not computed on principal plus accrued interest).

b. However, when compound interest is computed for two or more periods, the amount on which interest is computed does increase each period (that is, interest is computed on principal plus accrued interest).

12. Future value is the amount an investment will be worth at a future date if invested at compound interest.

a. Future value may be computed on a single sum invested at compound interest. Table 1 in your text facilitates this computation.

b. Future value may also be computed on an ordinary annuity (i.e., a series of equal payments made at the end of equal intervals of time) at compound interest. Table 2 in your text facilitates this computation.

13. Present value is the amount that must be invested now at a given rate of interest to produce a given future value or values.

a. Present value may be computed on a single sum due in the future. Table 3 in your text facilitates this computation.

b. Present value may also be computed on an ordinary annuity. Table 4 in your text facilitates this computation.

Objective 5: Apply the time value of money to simple accounting situations.

14. Present value may be used in accounting to (a) determine the value of an asset being considered for purchase, (b) calculate deferred payments for the purchase of an asset, (c) account for the investment of idle cash, (d) accumulate funds needed to pay off a loan, and (e) determine numerous other accounting quantities, such as the value of a bond, pension and lease obligations, and depreciation.

Summary of Journal Entries Introduced in Chapter 9

| | | | | | | |

|A. |(LO2) |Cash |XX (amount received) |

| | | |Notes Payable | |XX (face amount) |

| | | | |Issued promissory note with interest stated | | |

| | | | |separately | | |

| | | | | | | |

|B. |(LO2) |Notes Payable |XX (face amount) |

| | |Interest Expense |XX (amount incurred) |

| | | |Cash | |XX (maturity amount) |

| | | | |Payment of note with interest stated separately | | |

| | | | | | | |

|C. |(LO2) |Interest Expense |XX (amount accrued) |

| | | |Interest Payable | |XX (amount accrued) |

| | | | |To record interest expense on note with interest | | |

| | | | |stated separately | | |

| | | | | | | |

|D. |(LO2) |Cash |XX (amount collected) |

| | | |Sales | |XX (price charged) |

| | | |Sales Tax Payable | |XX (amount to remit) |

| | | |Excise Tax Payable | |XX (amount to remit) |

| | | | |Sale of merchandise and collection of sales and | | |

| | | | |excise taxes | | |

| | | | | | | |

|E. |(LO2) |Wages Expense |XX (gross amount) |

| | | |Employees’ Federal Income Taxes Payable | |XX (amount withheld) |

| | | |Employees’ State Income Taxes Payable | |XX (amount withheld) |

| | | |Social Security Tax Payable | |XX (employees’ share) |

| | | |Medicare Tax Payable | |XX (employees’ share) |

| | | |Medical Insurance Premiums Payable | |XX (employees’ share) |

| | | |Pension Contributions Payable | |XX (employees’ share) |

| | | |Wages Payable | |XX (take-home pay) |

| | | | |To record payroll | | |

| | | | | | | |

|F. |(LO2) |Payroll Taxes and Benefits Expense |XX (total employer payroll taxes) |

| | | |Social Security Tax Payable | |XX (employer’s share) |

| | | |Medicare Tax Payable | |XX (employer’s share) |

| | | |Medical Insurance Premiums Payable | |XX (employer’s share) |

| | | |Pension Contributions Payable | |XX (employer’s share) |

| | | |Federal Unemployment Tax Payable | |XX (amount incurred) |

| | | |State Unemployment Tax Payable | |XX (amount incurred) |

| | | | |To record payroll taxes and other costs | | |

|G. |(LO2) |Cash |XX (amount prepaid) |

| | | |Unearned Subscriptions | |XX (amount to earn) |

| | | | |Receipt of annual subscriptions in advance | | |

| | | | | | | |

|H. |(LO2) |Unearned Subscriptions |XX (amount earned) |

| | | |Subscription Revenues | |XX (amount earned) |

| | | | |Delivery of monthly magazine issues | | |

| | | | | | | |

|I. |(LO2) |Income Taxes Expense |XX (amount estimated) |

| | | |Income Taxes Payable | |XX (amount estimated) |

| | | | |To record estimated federal income taxes | | |

| | | | | | | |

|J. |(LO2) |Product Warranty Expense |XX (amount estimated) |

| | | |Estimated Product Warranty Liability | |XX (amount estimated) |

| | | | |To record estimated product warranty expense | | |

| | | | | | | |

|K. |(LO2) |Cash |XX (fee charged) |

| | |Estimated Product Warranty Liability |XX (cost of part) |

| | | |Service Revenue | |XX (fee charged) |

| | | |Merchandise Inventory | |XX (cost of part) |

| | | | |Replacement of part under warranty | | |

| | | | | | | |

|L. |(LO2) |Vacation Pay Expense |XX (amount incurred) |

| | | |Estimated Liability for Vacation Pay | |XX (amount owed or accrued) |

| | | | |Estimated vacation pay expense | | |

| | | | | | | |

|M. |(LO2) |Estimated Liability for Vacation Pay |XX (amount taken) |

| | | |Cash (or Wages Payable) | |XX (amount paid or payable) |

| | | | |Wages of employees on vacation | | |

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