Accounting: The Language of Business (Part 66)

But a lot of businesses out there don't see the return on investment, they look at it as a liability, and until they can understand that proactive security actually returns, gives them a return on investment, it's still a hard sell for people.

Kevin Mitnick

Current Liabilities (Part A)

by

Charles Lamson

If you are employed, you know that your paycheck is normally less than the total amount you earned because your employer deducted amounts for such items as federal income tax and social security tax.

Your employer has a liability to you for your earnings until you are paid. Your employer also has a liability to deposit the taxes withheld. In the next several posts, we will discuss liabilities for amounts that must be paid within a short period of time. In addition to liabilities related to payroll and payroll taxes, we will discuss liabilities from notes payable and product warranties.

The Nature of Current Liabilities

Your credit card balance is probably due within a short time, such as 30 days. Such liabilities that are to be paid out of current assets and are due within a short time, usually within one year, are called current liabilities. Most current liabilities arise from two basic transactions:

1. Receiving goods or services prior to making payment.

2. Receiving payment prior to delivering goods or services.

 An example of the first type of transaction is accounts payable arising from purchases of merchandise for resale. An example of the second type of transaction is unearned rent arising from the receipt of rent in advance. Some additional examples of current liabilities that we discussed in previous posts are:

• Taxes payable---the amount of taxes owed to governmental units

• Interest payable---the amount of interest owed on borrowed funds

• Wages payable---the amount owed to employees

In the next several posts, some other common current liabilities will be introduced. These include short-term notes payable, contingencies, payroll liabilities, and employee fringe benefits.

Short-Term Notes Payable and Current Portion of Long-Term Debt

The current liability section of the balance sheet can contain items that are used to finance business operations, such as short-term notes payable and the portion of long-term debt that is due within the coming period.

Short-Term Notes Payable

Notes may be issued when merchandise or other assets are purchased. They may also be issued to creditors to temporarily satisfy an account payable created earlier. For example, assume that a business issues a 90-day, 12% note for $1,000, dated August 1, 2023, For a $1,000 overdue account. The entry to record the issuance of the note is as follows:

When the note matures, the entry to record the payment of $1,000 principal plus $30 interest ($1,000 * 12% * 90/360) is as follows:

The interest expense is reported in the Other Expense section of the income statement for the year ended December 31, 2023. The interest expense account is closed at December 31.

The preceding entries for notes payable are similar to those we discussed in an earlier post for notes receivable. Notes payable entries are presented from the viewpoint of the borrower, while notes receivable entries are presented from the viewpoint of the creditor or lender. To illustrate, the following entries are journalized for a borrower (Bowden Co.), who issues a note payable to a creditor (Koker Co.):

Notes may also be issued when money is borrowed from banks. Although the terms may vary, many banks would accept from the borrower an interest-bearing note for the amount of the loan. For example, assume that on September 19 a firm borrows $4,000 from First National Bank by giving the bank a 90-day, 15% note. The entry to record the receipt of cash issuance of the note is as follows:

On the due date of the note (December 18), the borrower owes $4,000, the principal of the note, plus interest of $150 ($4,000 x 15% X 90/360). The entry to record the payment of the note is as follows:

Sometimes a borrower will issue to a creditor a discounted note rather than an interest-bearing note. Although such a note does not specify an interest rate, the creditor sets a rate of interest and deducts the interest from the face amount of the note. This interest is called the discount. The rate used in computing the discount is called the discount rate. The borrower is given the remainder, called the proceeds.

To illustrate, assume that on August 10, Cary Company issues a $20,000, 90-day note to Rock Company in exchange for inventory. Rock discounts the note at a rate of 15%. The amount of the discount, $750, is debited to Interest Expense. The proceeds, $19,250, are debited to Merchandise Inventory. Notes Payable is credited for the face amount of the note, which is also its maturity value. This entry is shown below.

When the note is paid the following entry is recorded. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED. PP. 435-437*

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