Current Liabilities in Accounting

A liability is an obligation to convey assets or perform services at some future
date. For purposes of balance sheet analysis, it is important to make a distinction
between short-term or current liabilities and long-term liabilities.

The Nature of Current Liabilities

Current liabilities include (1) those obligations which will require payment from
existing current assets and (2) all other obligations that are to be paid from current
assets within one year. Generally, current liabilities arise from day-to-day business
operations (i.e., Accounts Payable, Salaries Payable, etc.). Others may result from
the need for short-term loans (i.e., Notes Payable) and still others from management-created
long-term obligations having a definite relationship to a short-term period (i.e.,
current maturity values of long-term loans).

Proper recognition and accurate measurement of all current liabilities are necessary
in order to avoid overstatement of assets, long-term liabilities or net income (i.e.,
the entire balance sheet equity section). Further, current and long-term liabilities
must be accurately distinguished so that net working capital will be properly stated.
Finally, the preparation of meaningful cash budgets requires that a complete record
of all current liabilities be kept.

Valuation of Current Liabilities

Current liabilities (i.e., legal debts and obligations) are generally recorded in
the accounts and reported in financial statements at face value. In those rare instances
where exact amounts are’ not available, estimates are made, to determine the present
value of a future outlay; using the discount method described in APB Opinion No.
21, “Interest on Receivables and Payables.”

Four distinct categories can be identified with respect to the element of uncertainty
which affects the valuation of these future payments as current

liabilities: definitely determinable liabilities, liabilities arising from operating
results, estimated liabilities and contingent liabilities.

Definitely Determinable Liabilities

These liabilities generally originate from contracts or legal statutes which fix
the amount of the obligation and its due date rather precisely. Therefore, the basic
accounting problem is determining that the obligation does in fact exist and that
it is properly recorded.

Trade Accounts and Notes Payable:
Procedures for handling the recording and control
of trade accounts and trade notes payable center around purchase journals, voucher
registers, accounts payable ledgers or open invoice files, etc. Generally these
records, or any combination- of them, will yield ample evidence as to the existence,
amount and due date of unpaid obligations. For statement purposes it is important
that particular attention be paid to transactions occurring near the end of one
accounting period and the beginning of the next so that the liability for goods
received is recorded in the same period as the merchandise is included in inventory.

Loan Obligations:
Items of this type include notes and loans payable
and any portion of long-term debt that will mature during the coming operating cycle.
However, if such portion of long-term debt will not require the use of current funds
(such as retirement through the operation of a special-purpose sinking fund), the
debt should be reported as noncurrent with an appropriate note.

According to APB Opinion No. 21, if no interest is explicitly stated’, or if the
rate of interest is unreasonably low, then interest must be imputed (that is, it
is understood to be included in the total). If adequate interest is not included,
the cost of the asset will be overstated and interest expense understated. The APB
opinion does not apply to payables or receivables arising with suppliers or customers
in the normal course of business which are due on ordinary trade terms.

Dividends Payable:
Dividend obligations are created only by action of
a company’s board of directors. The declaration by the board represents a legal

Obligation to pay the cash dividend in the amount specified at the specified  time. It always creates a current liability.
Accumulated but undeclared dividends on cumulative preferred stock create no liability;
however, the existence of such accumulated dividends in arrears should be disclosed
by footnote.

Accrued Liabilities:
Unpaid obligations resulting from contractual commitments
(e.g., payrolls) or government legislation (e.g., taxes) are referred to as accrued
liabilities or accrued expenses. Taxes are generally material in nature and are
usually shown under a separate heading among current liabilities. Some accruals
(e.g., accrued interest) are often combined with their respective liabilities, while
most others are shown in a combined form under a single heading. Some types of accruals
require special attention.

Liabilities Arising From Operating Results

Some liabilities cannot be measured until the results of operations are known. In
these cases, the basic accounting problem is estimating appropriate amounts for
interim monthly or quarterly statements.

Income Taxes:
This liability applies only to corporate, estate and
trust income. Earnings from the operation of sole proprietorships and partnerships
are treated as personal income of the parties involved, and generally require no
disclosure of a liability.

When a corporate Federal income tax liability is expected to exceed a specified
amount, advance payment of that excess amount is required according to established
tax law schedules; nonpayment is subject to penalty.

Any liability not covered by the advance payment is due at specified dates in the
following taxable year.

Estimated Liabilities

This category refers to liabilities which are indeterminate as to amount and due
date, but which exist and can be estimated with a reasonable degree of accuracy
as long as there is objective evidence on which to base the amount of such obligation.
Such liabilities may be either current or long term. The two main groups of estimated
liabilities are discussed below.

Liabilities for Premiums and Other Customer Advances:
Premium coupons,
tokens, tickets, certificates, etc. which entitle the holder to merchandise, cash,
or the performance of a service at some future time are considered customer advances.
Such obligations should appear as an estimated liability on the balance sheet of
the issuing company. As the coupons are redeemed, a debit is made to the estimated
liability account with an offsetting credit to either a revenue account (if the
redemption value is greater than the cost of the item) or to a premium inventory
account (if the redemption value is equal to the cost of the item).

Actual claims are generally a small percentage of the total amount available for
redemption. At year end, therefore, the estimated liability for premium claims and/or
the estimated amount of forfeited claims must be determined. Forfeited claims are
easily calculated when a specified expiration date occurs during the year. However,
where claims must be honored indefinitely, both estimates must be based on the company’s
past experience. For example, if a company’s records indicate that redemptions average
40% of outstanding premium coupons, the estimated liability account must be reduced
with an offsetting credit to an income account.

Liabilities Under Guarantees and Warranties. This liability group arises from product
sales (e.g., cars, televisions, etc.) or contracts (e.g., rentals where the lessee
must restore property to a specified condition on termination). Although such liabilities
may originate at the point of sale or as contracts mature and premises are used,
it is always necessary to estimate the company’s liability (and make periodic entries
debiting an expense account and crediting an account for the estimated liability),
even if the account amount must be adjusted once final performance costs are determined.

For tax purposes, these estimates are deductible only when performance costs have
been incurred. However, tax considerations in this case should be minimally considered
in the preparation of periodic financial statements, since to do otherwise might
overstate income and understate liabilities, particularly when such liabilities
are material in amount.

Service contracts for major appliances covering specified time periods constitute
another aspect of this liability category. In this case, the price of a service
contract is treated as deferred revenue which is recorded on a prorated basis over
the contract’s life. Estimates of periodic income realized may be based on a company’s
past experience.

Contingent Liabilities

The term contingent liabilities refer to potential future obligations which may
or may not in fact materialize. It is thus distinguished, from estimated liabilities,
which do exist but are uncertain as to amount, due date and/or payee. Typical contingent
liabilities include:

(1) Pending Lawsuits. Litigation against a company is carried as a contingent liability
until such time as the claim is actually settled (i.e., after all appeals, upon
out-of-court agreement). Lawsuits pending as of the balance sheet date are generally
included as footnotes without mentioning dollar values.

(2) Endorsements. When recourse is involved in discounting notes receivable or assigning
accounts receivable, the company endorses such debts and may become liable in the
event that the original debtor defaults.

(3) Income Taxes. In the event that the IRS fails to accept a company’s tax return
as submitted and assesses additional taxes, a contingent liability is created pursuant
to an audit. Specific disclosure need be made; frequently, however, a footnote noting
IRS examination and final determination of tax liability for certain years may be
included. Except in cases of fraud or failure to file a tax return, the statute
of limitations prevents the IRS from auditing returns more than three years old.

In reporting contingent liabilities, the sole objective is adequate disclosure of
such contingency and if determinable, the amount involved. Disclosure in the financial
statements may be made by

(1) A parenthetical comment following the item heading

(2) Footnote

(3) Inclusion of item among liabilities without extending a dollar amount or (4)
appropriation of retained earnings.

Current Liabilities in the Balance Sheet

There are two considerations with respect to current liabilities in the balance

(1) Listing Order. Current liabilities are generally listed according to amount
(largest to smallest), although they may be listed by due dates when differences
in maturity are significant. Liquidation priorities (i.e., taxes, wages, etc.) should
be ignored in the interest of the going-concern assumption.

(2) Detail of Disclosure. The kinds of headings’ used under Current Liabilities
will depend on the purpose of the balance sheet. The following classification is
generally acceptable:

Notes Payable to Banks

Notes Payable to Trade Creditors Accounts Payable to Trade Creditors Other Notes
and Accounts Payable Estimated Income Taxes Payable Other Accrued Liabilities

Amounts Due to Officers and Employees Other Current Liabilities

Liabilities ‘which will be liquidated by the issuance of capital stock should be
included under stockholders’ equity.