Chapter 8: Current and Contingent Liabilities

Chapter 8: Current and Contingent Liabilities

I. Liabilities

  • Definition: Liabilities are probable debts or obligations resulting from past transactions, to be settled with assets or services.
  • Current Liabilities: Obligations expected to be settled within one year or the operating cycle, whichever is longer.
  • Risk: Debt is viewed as riskier than equity due to the mandatory nature of interest repayment.
  • Measurement: Liabilities are recorded at their current cash equivalent (the amount the creditor would accept to cancel the debt immediately).
  • Liquidity Analysis:
    • Working Capital = Current Assets (CA) - Current Liabilities (CL)
    • Current Ratio = CA / CL

II. Current Liabilities

  • Current liabilities are expected to be paid:

    1. Using a current asset (usually cash) or service
    2. Within one year or the operating cycle

  • Types of Current Liabilities:

    • Accounts Payable (Trade Accounts Payable)
    • Accrued Liabilities:
    • Wages Payable
    • Sales Taxes Payable
    • Payroll Taxes Payable
    • Interest Payable
    • Unearned Revenue (Deferred Revenues): Money received for services not yet delivered.
    • Current Maturities of Long-Term Debt: The portion of long-term debt that is due within the next year should be classified as a current liability.
    • Example: ABC Co. with a 5-year, $500,000 note payable and annual installments of $100,000.

III. Contingent (Estimated) Liabilities

  • Classification:

    • Recorded: Probable & can be estimated
    • Contingent: Probable but cannot be estimated - noted in footnotes
    • Do Nothing: Remote (not likely to occur)

  • Recording: If a liability (e.g., lawsuit, warranty) is probable and can be estimated:

    • Record at the end of the period with an Adjusting Journal Entry (AJE):
    • Journal Entry:
      • Expense XXX
      • Estimated Liability XXX

  • Example: A product sold for $60,000 includes a warranty for 24 months. If past experience shows a 5% defect rate, the estimated liability is calculated as:

    60,000imes0.05=3,00060,000 imes 0.05 = 3,000

IV. Current Liabilities: Notes Payables

  • Types of Notes:

    • Interest-Bearing Notes:
    • Non-Interest Bearing Notes:
    • Principal and interest are due at maturity, interest deducted in advance.
    • Example: ABC Co. borrows $60,000 on a 6-month non-interest bearing note.
    • Cash received at signing after deducting interest:
      • 60,000−(60,000imes0.10imes612)=57,00060,000 - (60,000 imes 0.10 imes \frac{6}{12}) = 57,000

  • Effective Interest Rate Calculation:

    Effective Interest Rate =
    Interest:ExpenseBorrowed:Amount\frac{Interest : Expense}{Borrowed : Amount}

  • Example Calculation:

    • Interest Expense: $3,000
    • Amount borrowed: $57,000
    • Effective Interest Rate for 6 months:
    • 3,00057,000×100=5.26%\frac{3,000}{57,000} \times 100 = 5.26\%
    • Annualized: 5.26%×2=10.52%5.26\% \times 2 = 10.52\%