11.1: Identify and Describe Current Liabilities (2024)

Proper Current Liabilities Reporting and Calculating BurnRate

When using financial information prepared by accountants,decision-makers rely on ethical accounting practices. For example,investors and creditors look to the current liabilities to assistin calculating a company’s annual burnrate. The burn rate is the metric defining the monthly andannual cash needs of a company. It is used to help calculate howlong the company can maintain operations before becoming insolvent.The proper classification of liabilities as current assistsdecision-makers in determining the short-term and long-term cashneeds of a company.

Another way to think about burn rate is as the amount of cash acompany uses that exceeds the amount of cash created by thecompany’s business operations. The burn rate helps indicate howquickly a company is using its cash. Many start-ups have a highcash burn rate due to spending to start the business, resulting inlow cash flow. At first, start-ups typically do not create enoughcash flow to sustain operations.

Proper reporting of current liabilities helps decision-makersunderstand a company’s burn rate and how much cash is needed forthe company to meet its short-term and long-term cash obligations.If misrepresented, the cash needs of the company may not be met,and the company can quickly go out of business. Therefore, it isimportant that the accountant appropriately report currentliabilities because a creditor, investor, or other decision-maker’sunderstanding of a company’s specific cash needs helps them makegood financial decisions.

Accounts Payable

Accounts payable accounts for financialobligations owed to suppliers after purchasing products or serviceson credit. This account may be an open credit line between thesupplier and the company. An open credit line is a borrowingagreement for an amount of money, supplies, or inventory. Theoption to borrow from the lender can be exercised at any timewithin the agreed time period.

An account payable is usually a less formal arrangement than apromissory note for a current note payable. Long-term debt iscovered in depth in Long-Term Liabilities. For now, know that for some debt,including short-term or current, a formal contract might becreated. This contract provides additional legal protection for thelender in the event of failure by the borrower to make timelypayments. Also, the contract often provides an opportunity for thelender to actually sell the rights in the contract to anotherparty.

An invoice from the supplier (such as the one shown in Figure 12.2) detailing the purchase, credit terms, invoicedate, and shipping arrangements will suffice for this contractualrelationship. In many cases, accounts payable agreements do notinclude interest payments, unlike notes payable.

For example, assume the owner of a clothing boutique purchaseshangers from a manufacturer on credit. The organizations mayestablish an ongoing purchase agreement, which includes purchasedetails (such as hanger prices and quantities), credit terms (2/10,n/60), an invoice date, and shipping charges (free on board [FOB]shipping) for each order. The basics of shipping charges and creditterms were addressed in Merchandising Transactions if you would like to refreshyourself on the mechanics. Also, to review accounts payable, youcan also return to Merchandising Transactions for detailed explanations.

Unearned Revenue

Unearned revenue, also known as deferredrevenue, is a customer’s advance payment for a product or servicethat has yet to be provided by the company. Some common unearnedrevenue situations include subscription services, gift cards,advance ticket sales, lawyer retainer fees, and deposits forservices. As you learned when studying the accounting cycle(Analyzingand Recording Transactions, The Adjustment Process, and Completing the Accounting Cycle), we are applying theprinciples of accrual accounting when revenues and expenses arerecognized in different months or years. Under accrual accounting,a company does not record revenue as earned until it has provided aproduct or service, thus adhering to the revenue recognitionprinciple. Until the customer is provided an obligated product orservice, a liability exists, and the amount paid in advance isrecognized in the Unearned Revenue account. As soon as the companyprovides all, or a portion, of the product or service, the value isthen recognized as earned revenue.

For example, assume that a landscaping company provides servicesto clients. The company requires advance payment before renderingservice. The customer’s advance payment for landscaping isrecognized in the Unearned Service Revenue account, which is aliability. Once the company has finished the client’s landscaping,it may recognize all of the advance payment as earned revenue inthe Service Revenue account. If the landscaping company providespart of the landscaping services within the operating period, itmay recognize the value of the work completed at that time.

Perhaps at this point a simple example might help clarify thetreatment of unearned revenue. Assume that the previous landscapingcompany has a three-part plan to prepare lawns of new clients fornext year. The plan includes a treatment in November 2019, February2020, and April 2020. The company has a special rate of $120 if theclient prepays the entire $120 before the November treatment. Inreal life, the company would hope to have dozens or more customers.However, to simplify this example, we analyze the journal entriesfrom one customer. Assume that the customer prepaid the service onOctober 15, 2019, and all three treatments occur on the first dayof the month of service. We also assume that $40 in revenue isallocated to each of the three treatments.

Before examining the journal entries, we need some keyinformation. Because part of the service will be provided in 2019and the rest in 2020, we need to be careful to keep the recognitionof revenue in its proper period. If all of the treatments occur,$40 in revenue will be recognized in 2019, with the remaining $80recognized in 2020. Also, since the customer could request a refundbefore any of the services have been provided, we need to ensurethat we do not recognize revenue until it has been earned. While itis nice to receive funding before you have performed the services,in essence, all you have received when you get the money is aliability (unearned service revenue), with the hope of iteventually becoming revenue. The following journal entries arebuilt upon the client receiving all three treatments. First, forthe prepayment of future services and for the revenue earned in2019, the journal entries are shown.

For the revenue earned in 2020, the journal entries wouldbe.

Thinking about Unearned Revenue

When thinking about unearned revenue, consider the example ofAmazon.com, Inc.Amazon has a large businessportfolio that includes a widening presence in the online productand service space. Amazon has twoservices in particular that contribute to their unearned revenueaccount: Amazon Web Services and Prime membership.

According to Business Insider,Amazon had $4.8 billion inunearned revenue recognized in their fourth quarter report(December 2016), with most of that contribution coming from AmazonWeb Services.¹This is an increase from prior quarters. The growth is due tolarger and longer contracts for web services. The advance paymentfor web services is transferred to revenue over the term of thecontract. The same is true for Prime membership.Amazon receives $99 in advancepay from customers, which is amortized over the twelve-month periodof the service agreement. This means that each month, Amazon onlyrecognizes $8.25 per Prime membership payment as earnedrevenue.

Current Portion of a Note Payable

A note payable is a debt to a lender withspecific repayment terms, which can include principal and interest.A note payable has written contractual terms that make it availableto sell to another party. The principal on a noterefers to the initial borrowed amount, not including interest. Inaddition to repayment of principal, interest may accrue.Interest is a monetary incentive to the lender,which justifies loan risk.

Let’s review the concept of interest. Interest is an expensethat you might pay for the use of someone else’s money. Forexample, if you have a credit card and you owe a balance at the endof the month it will typically charge you a percentage, such as1.5% a month (which is the same as 18% annually) on the balancethat you owe. Assuming that you owe $400, your interest charge forthe month would be $400 × 1.5%, or $6.00. To pay your balance dueon your monthly statement would require $406 (the $400 balance dueplus the $6 interest expense).

We make one more observation about interest: interest rates aretypically quoted in annual terms. For example, if you borrowedmoney to buy a car, your interest expense might be quoted as 9%.Note that this is an annual rate. If you are making monthlypayments, the monthly charge for interest would be 9% divided bytwelve, or 0.75% a month. For example, if you borrowed $20,000, andmade sixty equal monthly payments, your monthly payment would be$415.17, and your interest expense component of the $415.17 paymentwould be $150.00. The formula to calculate interest on either anannual or partial-year basis is:

In our example this would be

$20,000×9%×112=$150$20,000×9%×112=$150

The good news is that for a loan such as our car loan or even ahome loan, the loan is typically what is called fully amortizing. At this point, you just need toknow that in our case the amount that you owe would go from abalance due of $20,000 down to $0 after the twentieth payment andthe part of your $415.17 monthly payment allocated to interestwould be less each month. For example, your last (sixtieth) paymentwould only incur $3.09 in interest, with the remaining paymentcovering the last of the principle owed. See Figure 13.7 for an exhibit that demonstrates thisconcept.

Applying Amortization

Car loans, mortgages, and education loans have an amortizationprocess to pay down debt. Amortization of a loan requires periodicscheduled payments of principal and interest until the loan is paidin full. Every period, the same payment amount is due, but interestexpense is paid first, with the remainder of the payment goingtoward the principal balance. When a customer first takes out theloan, most of the scheduled payment is made up of interest, and avery small amount goes to reducing the principal balance. Overtime, more of the payment goes toward reducing the principalbalance rather than interest.

For example, let’s say you take out a car loan in the amount of$10,000. The annual interest rate is 3%, and you are required tomake scheduled payments each month in the amount of $400. You firstneed to determine the monthly interest rate by dividing 3% bytwelve months (3%/12), which is 0.25%. The monthly interest rate of0.25% is multiplied by the outstanding principal balance of $10,000to get an interest expense of $25. The scheduled payment is $400;therefore, $25 is applied to interest, and the remaining $375 ($400– $25) is applied to the outstanding principal balance. This leavesan outstanding principal balance of $9,625. Next month, interestexpense is computed using the new principal balance outstanding of$9,625. The new interest expense is $24.06 ($9,625 × 0.25%). Thismeans $24.06 of the $400 payment applies to interest, and theremaining $375.94 ($400 – $24.06) is applied to the outstandingprincipal balance to get a new balance of $9,249.06 ($9,625 –$375.94). These computations occur until the entire principalbalance is paid in full.

A note payable is usually classified as a long-term (noncurrent)liability if the note period is longer than one year or thestandard operating period of the company. However, during thecompany’s current operating period, any portion of the long-termnote due that will be paid in the current period is considered acurrent portion of a note payable. The outstandingbalance note payable during the current period remains a noncurrentnote payable. Note that this does not include the interest portionof the payments. On the balance sheet, the current portion of thenoncurrent liability is separated from the remaining noncurrentliability. No journal entry is required for this distinction, butsome companies choose to show the transfer from a noncurrentliability to a current liability.

For example, a bakery company may need to take out a $100,000loan to continue business operations. The bakery’s outstanding noteprincipal is $100,000. Terms of the loan require equal annualprincipal repayments of $10,000 for the next ten years. Paymentswill be made on July 1 of each of the ten years. Even though theoverall $100,000 note payable is considered long term, the $10,000required repayment during the company’s operating cycle isconsidered current (short term). This means $10,000 would beclassified as the current portion of a noncurrent note payable, andthe remaining $90,000 would remain a noncurrent note payable.

The portion of a note payable due in the current period isrecognized as current, while the remaining outstanding balance is anoncurrent note payable. For example, Figure 12.4 shows that $18,000 of a $100,000 note payable isscheduled to be paid within the current period (typically withinone year). The remaining $82,000 is considered a long-termliability and will be paid over its remaining life.

In addition to the $18,000 portion of the note payable that willbe paid in the current year, any accrued interest on both thecurrent portion and the long-term portion of the note payable thatis due will also be paid. Assume, for example, that for the currentyear $7,000 of interest will be accrued. In the current year thedebtor will pay a total of $25,000—that is, $7,000 in interest and$18,000 for the current portion of the note payable. A similar typeof payment will be paid each year for as long as any of the notepayable remains; however, the annual interest expense would bereduced since the remaining note payable owed will be reduced bythe previous payments.

Interest payable can also be a current liability if accrual ofinterest occurs during the operating period but has yet to be paid.An annual interest rate is established as part of the loan terms.Interest accrued is recorded in Interest Payable (a credit) andInterest Expense (a debit). To calculate interest, the company canuse the following equations. This method assumes a twelve-monthdenominator in the calculation, which means that we are using thecalculation method based on a 360-day year. This method was morecommonly used prior to the ability to do the calculations usingcalculators or computers, because the calculation was easier toperform. However, with today’s technology, it is more common to seethe interest calculation performed using a 365-day year. We willdemonstrate both methods.

For example, we assume the bakery has an annual interest rate onits loan of 7%. The loan interest began accruing on July 1 and itis now December 31. The bakery has accrued six months of interestand would compute the interest liability as

$100,000×7%×612=$3,500$100,000×7%×612=$3,500

The $3,500 is recognized in Interest Payable (a credit) andInterest Expense (a debit).

Taxes Payable

Taxes payable refers to a liability createdwhen a company collects taxes on behalf of employees and customersor for tax obligations owed by the company, such as sales taxes orincome taxes. A future payment to a government agency is requiredfor the amount collected. Some examples of taxes payable includesales tax and income taxes.

Sales taxes result from sales of products or services tocustomers. A percentage of the sale is charged to the customer tocover the tax obligation (see Figure 12.5). The sales tax rate varies by state and localmunicipalities but can range anywhere from 1.76% to almost 10% ofthe gross sales price. Some states do not have sales tax becausethey want to encourage consumer spending. Those businesses subjectto sales taxation hold the sales tax in the Sales Tax Payableaccount until payment is due to the governing body.

For example, assume that each time a shoe store sells a $50 pairof shoes, it will charge the customer a sales tax of 8% of thesales price. The shoe store collects a total of $54 from thecustomer. The $4 sales tax is a current liability until distributedwithin the company’s operating period to the government authoritycollecting sales tax.

Income taxes are required to be withheld from an employee’ssalary for payment to a federal, state, or local authority (hencethey are known as withholdingtaxes). This withholding is a percentage of the employee’sgross pay. Income taxes are discussed in greater detail inRecord Transactions Incurred in Preparing Payroll.