Chapter 8 - Current Liabilities and the Time Value of Money

This chapter provides a quick overview of various issues related to the accounting for current liabilities.
We will not use class time to introduce the present value computations that are presented in this chapter.
If you are not familiar with present value computations, you should review this part of the chapter on
your own for use in future chapters. After studying this chapter, you should be able to:
1. Explain how the issues of recognition, valuation, classification, and disclosure apply to
liabilities.
2. Define and discuss the typical types of current liabilities you would find on a balance sheet.
3. Define an estimated liability and prepare journal entries required to account for this type of
liability.
4. Define a contingent liability and discuss the accounting treatment of contingent liabilities.
5. Compute and analyze the payables turnover and days’ payable ratios.

Key Points to Remember:

1. General rules for accounting for liabilities

Liability recognition rules - liabilities must be recorded in the period in which the transaction
occurred which created the liability.
Valuation rules - liabilities must be recorded at the amount of money need to pay the debt or the
fair market value of goods or services to be delivered. For long-term liabilities, this value
must represent the present value of the obligations.
Classification rules - liabilities must be classified as either current or long-term based on their
maturity date
Disclosure requirements - companies must disclose all information related to liabilities such as
balances, interest rates, cash requirements, unused lines of credit, and collateral
arrangements for existing debts.

2. Common categories of current liabilities

Definitely determinable liabilities -- current liabilities that are set by contract or by statute and can be
measured exactly
Estimated liabilities -- debts or obligations of a company for which the exact amount cannot be
known until a later date (warranties, vacation pay, sick leave, coupons for discounted
services)
Contingent liabilities - potential future liability that is the result of a past transactions (lawsuits)

3. Accounting for estimated liabilities

Adjusting journal entry to record the estimated liability at year end (Example: Warranty Expense)
Warranty Expense $$
Estimated Liability for Warranties $$

Entry required when the liability is completed or paid for

Estimated Liability for Warranties $$
Cash, Inventory, (etc.) $$

4. Accounting for contingent liabilities

Accounting rules - record in a journal entry if probable and you can estimate the amount

Jounal entries to record contingent liabilities are the same as the entries for estimated liabilities
If the contingency is reasonably probable it should be discussed in the footnotes to the financial
statements
5. Accounts Payable ratios:

Payables turnover = Cost of Goods Sold + Change in Merchandise Inventory

Average Accounts Payable

(This ratio indicates how long, on average, the company takes to pay its accounts payable.)

Days’ Payable = 365

Payables Turnover

CHAPTER 8 REVIEW

I. VOCABULARY (Complete each of the following statement by filling in the appropriate word or words)

1. Legal obligations for the future payment of assets or the future performance of services that result
from past transactions are ___________________.

2. Current liabilities that are set by contract or by statute and can be measured exactly are
______________________ liabilities.

3. Definite debts or obligations for which the exact amounts cannot be known until a later date are
______________________ liabilities

4. Potential future liabilities whose existence is dependent on some future event are
__________________ liabilities.

5. Under GAAP, contingent liabilities are recorded as liabilities only if the potential liability is
______________ and its amount can be ________________.

6. Contingent liabilities that do not meet the criteria to be recorded as such are normally disclosed in
the __________________ to the financial statements.

II. MULTIPLE CHOICE (Circle the letter that best completes each of the following statements)

1. Current liabilities are debts that are expected to be satisfied within

a. one year.
b. the normal operating cycle.
c. one year or operating cycle, whichever is shorter.
d. one year or operating cycle, whichever is longer.

2. Which of the following would most likely be classified as a current liability?

a. Mortgage payable
b. Bonds payable
c. Dividends payable
d. Five-year notes payable

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3. On January 1, 20X1, Hillcrest Company, a calendar-year company, issued $80,000 of notes payable,
of which $20,000 is due on January 1 for each of the next four years. The proper balance sheet
presentation on December 31, 20X1 is
a. Current Liabilities, $80,000.
b. Long-Term Liabilities, $80,000.
c. Current Liabilities, $20,000; Long-Term Liabilities, $60,000.
d. Current Liabilities, $60,000; Long-Term Liabilities, $20,000.

4. Recording estimated warranty expense in the year of the sale is required by which accounting
principle?
a. Consistency
b. Matching
c. Full disclosure
d. Historical cost

5. Contingent liabilities are those liabilities

a. whose final resolution depends on some future event.
b. whose amount can be reasonably estimated.
c. such as pending litigation.
d. all of the above.

III. QUESTIONS/PROBLEMS

1. A company enters into a contract to purchase a certain quantity of goods from another company
during the following month. At this point, would a liability exist? Explain why or why not.

2. What are contingent liabilities? Give an example of a contingent liability that is accrued and one
that is just disclosed in the financial statements. Explain what criteria are used in deciding
whether to accrue (record) a contingent liability.

ANSWERS

I. VOCABULARY

1. liabilities
2. definitely determinable
3. estimated
4. contingent
5. probable, reasonably estimated
6. footnotes

II. MULTIPLE CHOICE

1. d 4. b
2. c 5. d
3. c

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III. QUESTIONS/PROBLEMS

1. A liability would not exist because, at this point, the goods have not be delivered, and no
obligation therefore exists.

2. A contingent liability arises when the existence of the obligation, the amount due, and/or the
settlement date is uncertain. With contingent liabilities, unlike other liabilities, the resolution of
the uncertainty depends on some future event. Product warranties will create contingent
liabilities for the firm. These liabilities are probable and can reasonably be estimated based on
past experience; therefore, the liabilities, according to GAAP, are to be accrued. If the amount of
probable liabilities such as pending or threatened litigation cannot reasonably be estimated, a
footnote disclosure is necessary to inform the users of the financial statement about such likely
outcome(s).