Chapter 9: Current Liabilities

Current Liabilities: Overview

Current liabilities are obligations that an entity must settle within a year or within its operating cycle, whichever is longer. They represent short-term financial obligations that can affect a company's liquidity and are important for assessing the company's financial health. The significance of current liabilities includes their role as indicators of short-term cash requirements, measurements of current financial health, and their normal recording at face value.

Learning Objectives

Significance and Valuation Methods

• LO1: Understand the significance of current liabilities to users, emphasizing their impact on liquidity and operational capacity.

• LO2: Explore the valuation methods for current liabilities, typically recorded at face value.

Current Liabilities from Transactions

• LO3 - Lenders: Identify current liabilities associated with lenders—bank indebtedness (revolving credit, short-term loans) and current portions of long-term debt, which require specific accounting treatments.

• LO4 - Suppliers: Describe trade accounts payable and how they arise from credit purchases.

• LO5 - Customers: Explain deferred revenue and the accounting for liabilities created by advance payments for goods and services.

• LO6 - Employees: Discuss wages payable and related accounting entries.

• LO7 - Government: Identify remittances due to the government, including property and corporate taxes.

• LO8 - Shareholders: Recognize dividends payable and their recording once declared.

• LO9: Calculate financial ratios such as accounts payable turnover ratios and assess financial health.

Characteristics of a Liability

Liabilities possess certain defining characteristics:

1. Present obligations of the entity.

2. Expected settlement through the outflow of economic resources.

3. Result from past events that create a legal or constructive obligation.

Current Liabilities and Lenders

Bank Indebtedness

• Revolving credit facilities provide firms liquidity to manage short-term cash shortages. Financial institutions may charge standby fees on unused credit lines. Loans may be secured with collateral, including inventory or accounts receivable.

Current Portion of Long-Term Debt

• This aspects involves blended payments (principal + interest) on longer-term loans. The principal portion due within the next year must be classified separately as a current liability.

Current Liabilities with Suppliers

Trade Accounts Payable

• Arise when firms purchase goods/services on credit, typically due within 30-60 days. They usually do not bear explicit interest charges, therefore regarded as ‘free debt’. Considerations may include early payment discounts.

Current Liabilities with Customers

Deferred Revenue

• Receipts of cash prior to delivery of goods/services establish a liability (deferred revenue). Revenue is recognized when goods/services are delivered.

• Sample Entries:

  • Initial sale: Cash XXX
    Deferred Revenue XXX

  • Delivery: Deferred Revenue XXX
    Sales Revenue XXX

Gift Cards

• Represent obligations to provide goods/services equivalent to the card value until redeemed. Unused amounts (breakage) can be recognized as revenue.

• Sample Entries:

  • At purchase: Cash XXX
    Deferred Revenue XXX

  • At redemption: Deferred Revenue XXX
    Sales Revenue XXX
    Cost of Goods Sold XXX
    Inventory XXX

Loyalty Programs

• Points redeemed for purchases create separate performance obligations. Companies must allocate a part of the transaction price to these points.

Warranty Liabilities

Assurance Type Warranty

• Obliges the seller to fulfill performance expectations at the time of sale, necessitating an estimation of warranty costs.

• Entries: Warranty Expense + Warranty Provision recorded based on estimated costs.

Service Type Warranty

• Extends service beyond standard warranty, considered a separate performance obligation with deferred revenue recognized proportionate to the warranty period.

Current Liabilities with Employees

Wages Payable

• Reflect wages due to employees alongside source deductions (income tax, CPP, EI). A structured accounting approach involves entries for employee compensation, employer contributions, and payments.

Example of Payroll Accounting

1. Employee Entry: Wage Expense XXX
   Employee Income Taxes Payable XXX
   CPP Payable XXX
   Cash XXX

2. Employer Entry: Wage Expense XXX
   CPP Payable XXX
   EI Payable XXX

Current Liabilities with Government

• Obligations can include a variety of taxes payable. Corporate taxes are based on annual net income, with liabilities typically due within two months post-year end.

Current Liabilities with Shareholders

• Dividends Payable: Recorded when declared. Details include the necessary journal entry of the dividends declared and their payable counterpart.

Financial Statement Analysis

Accounts Payable Turnover Ratio

• This ratio calculates how many times a company settles its trade payables within a year, revealing efficiency in managing payables.

Accounts Payable Payment Period

• Transforming the turnover ratio into a payment period assists in understanding payment behaviors to suppliers. A longer period indicates a change in terms or cash flow management.

Example: Roots Corporation

• Analyze variations in turnover ratios between two consecutive years to infer operational efficiencies or supplier negotiations.

• The increase in accounts payable payment period from one year to the next may indicate challenges in cash management or enhanced negotiation power with suppliers, impacting supplier relationships.