Current Liabilities

Ch. 10: Current Liabilities 395

Chapter 10

Current Liabilities

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

What Are Current Liabilities?

As you remember from previous chapters, one way in which companies obtain resources is to borrow them. The resources are called assets and the sources of the resources are called liabilities. If the dollar amount of the borrowed resources must be paid within one year to the company or person from whom the resources were obtained, the liabilities are considered to be current liabilities. If, on the other hand, the resources do not have to be paid for within a year, the liabilities are considered long-term liabilities. For example, if a company borrows $100,000 from a bank on January 15, the result could be an increase in resources (cash) and an increase in liabilities (notes payable). If the cash must be repaid to the bank by July 15, six months after it was borrowed, the notes payable would be considered current liabilities. If the cash must be repaid to the bank by July 15, 18 months after it was borrowed, the notes payable would be considered long-term liabilities.

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

Assets
Current Assets
Cash and Cash Equivalents (6)
Accts. Receivable (7)
Allow. for Uncoll. Accounts (7)
Merchandise
Inventory (8)
Property, Plant, & Equipment
Land (9)
Buildings (9)
Accum. Depr., Buildings (9)
Equipment (9)
Accum. Depr., Equipment (9)
Autos & Trucks (9)
Accum. Depr., Autos & Trucks (9) / = / Liabilities
Current Liabilities (10) / + / Stockholders' Equity
Revenues
Sales (7)
Sales Returns & Allowances (7)
Cost of Goods Sold (8)
Operating Expenses
Uncollectible Accts. Expense (7)
Depreciation Exp. (9)
Bank Service Exp. (6)
Other Revenues & Expenses
Interest Revenue (6)
Interest Expense (6)
Gain or Loss on Disposal of Prop., Plt., & Eq. (9)

The dollar amount of current liabilities differs from company to company. Exhibit 10-1 presents current liabilities for three merchandising companies and compares them to the companies' total assets. As Exhibit 10-1 shows, there are many differences among the companies. For example, on January, 31, 2007, Wal-Mart's current liabilities were approximately $52 billion while Federated Department Stores’ were approximately $6 billion. The data show current liabilities are sources of approximately 30% of the resources (assets) of the three companies. Since 30% of the assets of the companies were obtained through current liabilities, the other 70% must have come from long-term liabilities, owners' investments, or management operations (net income). These other sources of resources will be examined in following chapters.

Exhibit 10-1
Current Liabilities and Total Assets ($ millions)
January 31, 2007
Company / Current
Liabilities / Total
Assets / Percent
Federated Department Stores / $6,359 / $29,559 / 21.5
Target / $11,117 / $37,349 / 29.8
Wal-Mart / $51,754 / $151,193 / 34.2

The Nature of Current Liabilities

There are many different current liabilities, all of which have the common characteristic that they must be paid for within twelve months. Exhibit 10-2 lists the major current liabilities for three merchandising companies. Once again, there are many differences among the companies. For example, Wal-Mart's accounts payable were approximately $28 billion while Federated Department Stores’ were approximately $2 billion.

Exhibit 10-2
Current Liabilities ($ millions)
January 31, 2007
Current Liability / Federated
Department
Stores / Target / Wal-Mart
Notes Payable / $641 / $0 / $2,570
Accounts Payable / $2,454 / $6,575 / $28,090
Taxes Payable / $962 / $872 / $706
Current Portion of Long-term Debt / $9 / $1,362 / $5,428
Other / $2,293 / $2,308 / $14,960
Totals / $6,359 / $11,117 / $51,754

Because there are many different types of current liabilities, it would be difficult to examine them all in one textbook, let alone one chapter. The following sections of this chapter examine some of the more important current liabilities. As you proceed through this material you should already be familiar with some of it because specific current liabilities were discussed in previous chapters when resources were examined. For example, in the following discussion of accounts payable, you will recognize much material from the Chapter 8 merchandise inventory coverage.

Notes Payable

Notes payable are written promises to pay known 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. For example, if on January 23, Lowell Merchandising Corporation signed a $78,000, 6%, 90-day note payable to Medford Company, Lowell Merchandising Corporation would have to pay Medford Company $79,153.97 on April 22. The $79,153.97 is the $78,000 principal borrowed plus interest of $1,153.97 ($78,000 x .06 x 90/365). The 90/365 fraction represents the number of days the money was borrowed (90) divided by the number of days in a year (365). The use of this fraction is necessary because it is common to state interest rates, such as the 6%, on an annual or 365-day basis. It is important to note that on January 23, as soon as the companies agree on the terms of the $78,000 note, both companies know the Lowell Merchandising Corporation must pay $79,153.97 to the Medford Company on April 22. Thus, once a note payable is issued, the companies know the dollar amount borrowed ($78,000), the dollar amount that must be paid ($79,153.97), and the date on which the amount must be paid (April 22).

Notes payable usually arise when companies buy merchandise or property, plant, and equipment. Continuing the Lowell Merchandising Corporation example, if the company acquired $78,000 of merchandise inventory from Medford Company by signing a note payable, the effects on the accounting equation would be as follows.

Total
Resources / = / Sources of Borrowed Resources / + / Sources of
Owner Invested Resources / + / Sources of
Management Generated Resources
Assets / = / Liabilities / + / Stockholders' Equity
+ $78,000 / = / + $78,000

Lowell Merchandising Corporation's resources (assets) increase by $78,000 because they now have $78,000 more merchandise inventory. Lowell Merchandising Corporation's sources of resources (liabilities) increase because they owe $78,000 to Medford Company. In terms of a journal entry, remembering assets increase with debits and debits must equal credits, the following entry would result.

Date / Description / Posting
Ref. / Debits / Credits
Jan. 23 / Merchandise Inventory / 131 / 78,000
Notes Payable / 211 / 78,000
Merch. inventory purchase

As time passes and Lowell Merchandising Corporation uses the merchandise inventory obtained from Medford Company, the dollar amount Lowell Merchandising Corporation owes to Medford Company increases. This increase is for interest. For example, if Lowell Merchandising Corporation acquired the $78,000 merchandise inventory from Medford Company on January 23, and paid for it on the same day, January 23, Lowell Merchandising Corporation would pay only $78,000. If, however, Lowell Merchandising Corporation waits until April 22, Lowell Merchandising Corporation would have to pay Medford Company $1,153.97 interest on the $78,000. Remember, interest is calculated as follows: principal x rate x time = $78,000 x .06 x 90/365 = $1,153.97. Over 90 days, until Lowell Merchandising Corporation pays Medford Company, the cost of borrowing affects Lowell Merchandising Corporation's accounting equation as follows.

Lowell Merchandising Corporation's assets do not change because the company has not acquired additional resources from Medford Company, other than the $78,000 of merchandise inventory, nor has it paid out any resources. Lowell Merchandising Corporation's liabilities (interest payable) increase by $1,153.97 because on April 22, they now owe an additional $1,153.97 to Medford Company. Lowell Merchandising Corporation's stockholders' equity decreases by the $1,153.97 cost of borrowing (interest expense). In terms of a journal entry, remembering liabilities increase with credits and debits must equal credits, the following entry would result.

Date / Description / Posting
Ref. / Debits / Credits
April 22 / Interest Expense / 522 / 1,153.97
Interest Payable / 217 / 1,153.97
Interest on Notes Payable

The interest expense resulting from notes payable is reported as part of other revenues and expenses on the income statement. Interest payable is reported on the balance sheet as a current liability if it must be paid within 12 months.

Since you are familiar with the accounting process, the $1,153.97 in the above journal entry may be a bit troublesome to you. In fact, although the total interest expense for 90 days is $1,153.97, it would not all be recorded in April. The adjusting process discussed in Chapter 4 suggests Lowell Merchandising Corporation would record interest expense in each month it uses the $78,000 of resources obtained from Medford Company but not repaid to them. Lowell Merchandising Corporation would record the following amounts of interest expense for each month.

Month / Interest Expense
January (9 days: 23rd thru 31st) / $115.40 / ($78,000 x .06 x 9/365)
February (28 days) / 359.01 / ($78,000 x .06 x 28/365)
March (31 days) / 397.48 / ($78,000 x .06 x 31/365)
April (22 days: 1st thru 22nd) / 282.08 / ($78,000 x .06 x 22/365)
Total (90 days) / $1,153.97 / ($78,000 x .06 x 90/365)

Each interest expense amount would be recorded through a journal entry like the one shown above. Once the $282.08 expense is recorded on April 22, the total interest expense and total interest payable recorded from January 23 through April 22 will be $1,153.97.

When Lowell Merchandising Corporation pays back the amount borrowed from Medford Company through notes payable ($78,000) and pays the related interest ($1,153.97), the effect is to reduce Lowell Merchandising Corporation's resources and sources of resources, as follows.

Lowell Merchandising Corporation's assets decrease because its cash has been reduced. Lowell Merchandising Corporation's liabilities decrease because it no longer owes $79,153.97 to Medford Company. In terms of a journal entry, remembering assets decrease with credits and debits must equal credits, the following entry would result.

Date / Description / Posting
Ref. / Debits / Credits
April 22 / Notes Payable / 211 / 78,000.00
Interest Payable / 217 / 1,153.97
Cash / 111 / 79,153.97
Notes payable payment

A careful review of the above example shows Lowell Merchandising Corporation acquired $78,000 of merchandise inventory from Medford Company by paying $79,153.97. In total, resources decreased by $1,153.97 (merchandise inventory increased by $78,000 and cash decreased by $79,153.97) and stockholders' equity decreased as a result of the $1,153.97 interest expense. The important question to consider is why would Lowell Merchandising Corporation pay $79,153.97 for $78,000 of merchandise inventory? The answer, of course, is Lowell Merchandising Corporation expects to be able to sell the merchandise inventory to its customers at prices resulting in more than $79,153.97. In effect, by borrowing merchandise inventory from Medford Company and selling it to customers at higher prices, Lowell Merchandising Corporation expects to increase its resources. For example, if Lowell Merchandising Corporation can sell the merchandise inventory to customers for $90,000, Lowell Merchandising Corporation's resources would increase by $10,846.03 ($90,000 - $79,153.97). The fact that companies like Lowell Merchandising Corporation can increase resources through the above process is why such companies are willing to borrow even though it costs them interest.

In addition to buying merchandise and property, plant, and equipment by issuing notes payable to suppliers, some large companies borrow cash by issuing notes payable to individuals and other companies who buy them as investments. Such notes payable having initial maturities of less than 270 days and minimum denominations of $25,000 are known as commercial paper. For example, for the two-year period ended January 31, 2007, Federated Department Stores reported as a current liability commercial paper averaging approximately $600 million.

Individuals and companies buy commercial paper, such as Federated Department Stores’, for the interest they can earn by owning it. Banks are major purchasers of commercial paper. From the standpoint of the issuing company, such as Federated Department Stores, commercial paper is very similar to notes payable. When a company issues commercial paper, it receives cash. At some point in the future, the cash must be repaid along with interest. Certain common practices relating to the sale of commercial paper have resulted in a few relatively minor differences between the accounting for notes payable and commercial paper. For the purposes of this text, however, you should be aware of the following major points with regard to commercial paper. First, commercial paper is a source of cash resources for many large corporations, such as Federated Department Stores. When cash is received, resources (assets) and sources of resources (liabilities) increase. Over time, the loan must be repaid along with interest. The interest expense is recognized in the periods during which the cash is used. As you noticed, the major points related to commercial paper are the same as those for notes payable. This would be expected because commercial paper is just a special type of notes payable.

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

Accounts Payable

Accounts payable are dollar amounts owed to suppliers for products or services purchased from them. For merchandising companies, the vast majority of accounts payable arises through the purchase of merchandise inventory, as discussed in Chapter 8. Accounts payable and notes payable have many similarities. They are both current liabilities if they must be paid within one year. The date by which they must be paid and the dollar amount required to be paid are known at the time they are created. Remember the previous discussion of the Lowell Merchandising Corporation's January 23, signing of a $78,000, 6%, 90-day note payable to Medford Company. On January 23, as soon as the companies agreed on the terms of the note, both companies knew the Lowell Merchandising Corporation must pay $79,153.97 ($78,000 principal + $1,153.97 interest) to the Medford Company on April 22. Similarly, when companies purchase merchandise or services on account, they immediately know the dollar amount that must be paid and the date by which the payment must be made.