Financial Accounting: Current Liabilities (Chapter 8)

Flashcards covering key concepts from Chapter 8 on Current Liabilities in Financial Accounting, including definitions, accounting treatments for notes payable, contingencies, warranties, and liquidity analysis ratios.

What is a liability in financial accounting?

A liability is an obligation of a company to transfer some economic benefit in the future.

What are some common examples of liabilities?

Accounts payable, notes payable, salaries payable, and deferred revenue.

How are current liabilities distinguished from long-term liabilities?

Usually payable within one year from the balance sheet date (or within the operating cycle if longer), while long-term liabilities are payable in more than one year.

What is an operating cycle?

The length of time from spending cash to provide goods and services to a customer until collection of cash from that customer.

Which makes a company look riskier: reporting a liability as long-term or current?

Reporting a liability as current generally makes a company look riskier as it implies a sooner obligation to pay.

Which of the following is typically considered a current liability: Salaries payable, Prepaid insurance, Mortgage payable due in 30 years, or Accounts receivable?

Salaries payable.

What is a 'Notes Payable'?

A note signed by a firm promising to repay the amount borrowed plus interest.

How is interest on notes payable calculated?

Interest = Face value × Annual interest rate × Fraction of the year.

Why do companies often use short-term debt?

Short-term debt usually offers lower interest rates than long-term debt because the risk of default is lower with loans of shorter durations.

When is interest expense recorded?

Interest expense is recorded in the period in which it is incurred, rather than in the period in which it is paid.

What is a line of credit?

An informal agreement that permits a company to borrow up to a prearranged limit.

What is commercial paper?

A form of short-term borrowing from another company rather than a bank, typically with maturities ranging from 30 to 270 days.

Why are accounts payable an attractive form of financing for businesses?

Suppliers generally do not charge interest on the amount owed.

What are 'contingencies' in accounting?

Uncertain situations that can result in a gain or a loss for a company.

Under what conditions is a contingent liability recorded?

A contingent liability is recorded only if a loss is probable and the amount is reasonably estimable.

What are the three categories for the likelihood of payment for a contingent liability?

Probable, Reasonably possible, and Remote.

What is the accounting treatment for a contingent liability that is probable and reasonably estimable?

A liability is recorded.

What is the accounting treatment for a contingent liability that is reasonably possible?

Disclosure is required, regardless of whether the amount is reasonably estimable.

What is the most common example of contingent liabilities?

Warranties.

When is a product warranty recognized as a liability at the time of sale?

When the warranty is probable to result in an expenditure and its cost is reasonably estimable.

How is the Warranty Liability account affected as actual repairs are made?

The Warranty Liability account is debited (decreased).

Unlike contingent liabilities, when are contingent gains recorded?

not recorded until the gain is certain and no longer a contingency.

What does 'liquidity' refer to in financial analysis?

Liquidity refers to having sufficient cash or other current assets to pay currently maturing debts.

What are the three main liquidity measures?

Working capital, current ratio, and acid-test ratio.

How is working capital calculated and what does it indicate?

Working capital = Current assets - Current liabilities. A large positive working capital indicates sufficient current assets to pay current obligations.

How is the current ratio calculated and what does it indicate?

Current ratio = Current assets / Current liabilities. It indicates the amount of current assets available for every $1 of current liabilities; a higher ratio generally indicates greater liquidity.

What are 'quick assets' as used in the acid-test ratio?

Quick assets include only cash, current investments, and accounts receivable, excluding other current assets like inventory and prepaid rent.

How is the acid-test ratio calculated and what does it indicate?

Acid-test ratio = (Cash + Current investments + Accounts receivable) / Current liabilities. It provides a more conservative measure of liquidity than the current ratio.

What is accounts payable?

Amounts owed to suppliers of merchandise or services. Most are current liabilities, but they could be long-term liabilities, depending on the due date.