Chapter 10: Current Liabilities

In this chapter you will learn about how current liabilities affect businesses, how they are controlled, accounted for, and reported in financial statements.
 

What are current liabilities?

Companies obtain resources through borrowing, owners' investments, and management operations. Sources of borrowed resources are called liabilities. Current liabilities are sources of resources that must be paid within 12 months from the end of the accounting period. Current liabilities are sources of approximately one-third of the resources (assets) of large merchandising companies. Liabilities that do not have to be paid in the next 12 months are called long-term liabilities, which will be discussed in the following chapter. Long-term liabilities are also sources of approximately one-third of the resources of large merchandising companies.

In terms of the accounting equation, current liabilities are liabilities, as shown below. The numbers in parentheses refer to the chapters in which the accounts are discussed.
 

Resources

=

Sources of Resources

Assets

=

Liabilities

+

Stockholders' Equity

Current Assets
  Cash and cash equivalents (6) 
  Accounts receivable (7)
  Allowance for uncollectible accounts (7)
  Merchandise inventory (8)
Property, plant, & equipment
  Land (9)
  Buildings (9)
  Accumulated depreciation, buildings (9)
  Equipment (9)
  Accumulated depreciation, equipment (9)
  Autos & trucks (9)
  Accumulated depreciation,
autos & trucks (9)

 

Current Liabilities (10)

 

Revenues
  Sales (7)
  Sales returns and allowances (7)
Cost of goods sold (8)
Operating Expenses
  Bank service expense (6)
  Uncollectible accounts expense (7)
  Depreciation expense (9)
Other Revenues & Expenses
  Interest revenue (6)
  Interest expense (6)
  Gain or loss on disposal of property, plant, and equipment (9)

You should note in the above that we have progressed to the right side of the accounting equation. The previous four chapters examined resources (assets). This and the following three chapters will examine sources of resources (liabilities and stockholders' equity).
 

The nature of current liabilities

Current liabilities include many different accounts, all of which have the same common characteristic: they must be paid within 12 months of the end of the accounting period being considered. For example, Target Corporation had current liabilities of approximately $11 billion on February 3, 2007. Target is obligated to pay its creditors $11 billion before February 3, 2008. The exact dates by which payments must be made depend upon the contracts between Target and its creditors. The following paragraphs examine several current liabilities that are important to merchandising companies: notes payable, accounts payable, sales taxes payable, income taxes payable, and salaries and wages payable.
 

Notes Payable

Notes payable are sources of resources. They are written promises to pay specified dollar amounts, on specific dates, to the owners of the notes. The dollar amounts to be paid include the amount borrowed, called principal, and interest.

Notes payable usually result from companies buying merchandise or property, plant, and equipment. For example, assume the Nicholas Corporation purchases $50,000 of office equipment on January 15 by signing a $50,000, 10%, 180 day note payable. This contract means Nicholas Corporation will receive $50,000 of office equipment on January 15 and will pay $50,000 plus interest on July 13.

Show the effects on the company's resources and sources of resources of buying the $50,000 of equipment.
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

+ $50,000
office equipment

=

+ $50,000
notes payable

 

 

 

 

The office equipment purchase on credit increased the company's resources (assets) and sources of resources (liabilities). Liabilities increased because, in effect, the office equipment was borrowed. The note payable would be considered a current liability because it must be paid on July 13, which is 180 days after the equipment was purchased.

Remembering that assets increase with debits and debits equal credits, prepare the journal entry to record the $50,000 purchase of office equipment.
 

Date

Description

Post.
Ref.

Debits

Credits

Jan. 15

Office Equipment

 

50,000

 

 

     Notes Payable

 

 

50,000

 

Office equipment purchase

 

 

 

As the 180 days pass, the dollar amount the Nicholas Corporation owes for the equipment continues to grow because of the 10% interest feature of the note payable. At the end of 180 days, the company will owe the $50,000 principal plus $2,465.75 interest ($50,000 x .10 x 180/365). Remember the formula: interest = principal x interest rate x time.

Show the effects of interest on the company's resources and sources of resources.
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

 

 

+ $2,465.75

interest payable

 

 

+

- $2,465.75

interest expense

The 180-days' interest (cost of borrowing) did not increase the company's resources because the company did not acquire any additional equipment other than the $50,000. The company's sources of resources increased and decreased by $2,465.75. Liabilities increased by $2,465.75 because the company owes $2,465.75 more at the end of 180 days than it did when the $50,000 were borrowed. Stockholders' equity decreased because management was responsible for borrowing the $50,000. Stockholders' equity decreased as the interest expense increased. Remember expenses reduce stockholders' equity.

Remembering that assets increase with debits and debits equal credits, prepare the journal entry to record the 180-days' interest.
 

Date

Description

Post.
Ref.

Debits

Credits

July 13

Interest Expense

 

$2,465.75

 

 

     Interest Payable

 

 

$2,465.75

 

Note payable interest

 

 

 

As discussed in previous chapters, interest expense appears on the income statement as part of other revenues and expenses. Although the $2,465.75 interest is related to the note payable, it is recorded in a separate current liability account called interest payable.

As you remember from earlier chapters, companies review their account balances for reasonableness at the end of each accounting period. If the Nicholas Corporation were to prepare monthly financial statements, the interest expense and interest payable accounts would be adjusted each month to record interest rather than waiting until the end of the 180-day note payable period. For example, for January, the interest cost would be $232.88 ($50,000 x .10 x 17/365). Through a series of journal entries, like the one above, the interest payable liability would grow to $2,465.75 by July 13. The appropriate amount of interest expense would be recorded each month and closed to income summary at the end of each month.

When the amount borrowed though notes payable is repaid, the principal and interest are both paid. On July 13, the Nicholas Corporation would pay $52,465.75: $50,000 principal + $2,465.75 interest.

Show the effects on the company's resources and sources of resources.
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

- $52,465.75
cash

=

- $50,000
notes payable

- $2,465.75 interest payable

 

 

 

 

The company's resources (assets) and sources of resources (liabilities) both decreased when the note payable was paid off. Assets decreased because cash was paid out. Liabilities decreased because once the cash was paid, the company no longer owed its creditors for the note payable or interest.

Remembering that assets increase with debits and debits equal credits, prepare the journal entry to record the note payable payment.
 

Date

Description

Post.
Ref.

Debits

Credits

July 13

Notes Payable

 

50,000.00

 

 

Interest Payable

 

2,465.75

 

 

     Cash

 

 

52,465.75

 

Note payable payment

 

 

 


 

** You now have the background to do text exercise 10.1, 10.2, and 10.3.
 

Accounts Payable

Accounts payable are sources of resources. They are promises to pay certain dollar amounts, on specific dates, to suppliers for products or services purchased from them. For practical purposes, the major difference between notes payable and accounts payable is that accounts payable do not include interest if they are paid on time. If accounts payable are paid late, however, it is common for an interest charge to be added to the accounts payable payment required. Most accounts payable are current liabilities because they usually must be paid within 30 to 60 days.

As discussed in the inventory chapter (Chapter 8), merchandising companies often purchase merchandise on credit. For example, assume the Nicholas Corporation purchases $20,000 of merchandise on account on November 13. The merchandise must be paid for within 30 days.

Show the effects on the company's resources and sources of resources.
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

+ $20,000
merchandise inventory

=

+ $20,000
accounts payable

 

 

 

 

The merchandise purchase on credit increased the company's resources (assets) and sources of resources (liabilities). Liabilities increased because, in effect, the merchandise was borrowed. The accounts payable would be considered a current liability because it must be paid on December 12, which is 30 days after it was purchased.

Remembering that assets increase with debits and debits equal credits, prepare the journal entry to record the $20,000 purchase of merchandise.
 

Date

Description

Post.
Ref.

Debits

Credits

Nov. 13

Merchandise Inventory

 

20,000

 

 

     Accounts Payable

 

 

20,000

 

Merchandise purchase

 

 

 

When the amount borrowed through accounts payable is repaid, attention must be given to the payment terms. It is common for suppliers to provide incentives for companies to pay their bills early. Such incentives allow companies to reduce their payments if they pay early. For example, assume the purchase terms of the $20,000 merchandise purchased by the Nicholas Corporation were 2/10, n/30. Purchase terms of 2/10, n/30 allow the company to reduce the amount it would have to pay its supplier by 2% if it pays within 10 days (this is the meaning of the 2/10), otherwise the full $20,000 must be paid within 30 days (this is the meaning of the n/30). If the Nicholas Corporation pays its bill on November 20, it would have to pay only $19,600 not $20,000. The company would be allowed a 2% discount on its $20,000 purchase, which is $400 ($20,000 x .02).

Show the effects on the company's resources and sources of resources of the November 20 payment.
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

- $19,600
cash

- $400
merchandise inventory

=

- $20,000
accounts payable

 

 

 

 

The company's resources (assets) and sources of resources (liabilities) both decreased when the accounts payable was paid off. Assets decreased because $19,600 cash was paid out. Assets also decreased by $400 because, in effect, the merchandise inventory that was originally recorded at $20,000 when it was purchased, was corrected by a $400 reduction in the purchase price. Since the company only paid $19,600 for the merchandise, it should not be recorded in the accounting system at $20,000. Liabilities decreased because once the cash was paid, the company no longer owed its creditor $20,000 for the accounts payable.

Remembering that assets increase with debits and debits equal credits, prepare the journal entry to record the accounts payable payment.
 

Date

Description

Post.
Ref.

Debits

Credits

Nov. 20

Accounts Payable

 

20,000

 

 

     Cash

 

 

19,600

 

     Merchandise Inventory

 

 

400

 

Accounts payable payment

 

 

 

You should note in the above entry that the full amount of the $20,000 accounts payable liability was eliminated even though the company only paid $19,600 cash. The $400 discount was allowed by the supplier to encourage the Nicholas Corporation to pay early.
 

Practice Exercise

The Christopher Corporation purchased $50,000 of merchandise on account on August 12. Purchase terms were 2/10, n/30.

1. How much will the Christopher Corporation have to pay for the merchandise if it pays on August 20?

Purchase terms of 2/10, n/30 mean the Christopher Corporation will be allowed a 2% purchase discount if the merchandise is paid for within 10 days. If the bill is paid on August 20, which is within 10 days of the purchase, only $49,000 will have to be paid, calculated as follows.

$50,000 purchase – ($50,000 x .02 discount) = $50,000 - $1,000 = $49,000 cash payment required.

2. How much will the Christopher Corporation have to pay for the merchandise if it pays on September 3?

Purchase terms of 2/10, n/30 mean the Christopher Corporation will be allowed a 2% purchase discount if the merchandise is paid for within 10 days. If the bill is paid on September 3, which is not within 10 days of the purchase, the full $50,000 will have to be paid.
 

** You now have the background to do text exercise 10.4 and 10.5.

 

 

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