OCW041: Reporting and Analyzing Current Liabilities

Reporting Current Liabilities

Current liabilities are reported first in the liability section of the balance sheet because they have first claim on company assets.

Learning Objectives

Explain how current liabilities are shown on the financial statements

Key Takeaways

Key Points

  • Current liabilities are typically due and paid for during the current accounting period or within a one year period. They are paid off with assets or other current liabilities.
  • For many companies, accounts payable is the first balance sheet account listed in the current liabilities section. Accounts payable includes goods, services, or supplies that were purchased with credit and for use in the operation of the business and payable within a one year period.
  • Long-term liabilities are listed in a separate section after current debt; however, for all long-term liabilities, any amounts due in the current fiscal year are reported under the current liability section.

Key Terms

  • audit: An independent review and examination of records and activities to assess the adequacy of system controls, to ensure compliance with established policies and operational procedures, and to recommend necessary changes in controls, policies, or procedures
  • bond: Evidence of a long-term debt, by which the bond issuer (the borrower) is obliged to pay interest when due, and repay the principal at maturity, as specified on the face of the bond certificate. The rights of the holder are specified in the bond indenture, which contains the legal terms and conditions under which the bond was issued. Bonds are available in two forms: registered bonds and bearer bonds.

Current Liabilities in the Balance Sheet

The balance sheet, or statement of financial position, is a snapshot of a company’s assets, liabilities, and owner’s equity on a given date. The presentation of the balance sheet should support the accounting equation of assets = liabilities + owner’s equity. Liabilities are disclosed in a separate section that distinguishes between short-term and long-term liabilities. Short-term, or current liabilities, are listed first in the liability section of the statement because they have first claim on company assets. Current liabilities are typically due and paid for during the current accounting period or within a one year period. They are paid off with assets or other current liabilities.

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Most current liabilities have a claim on cash or other assets.: Current liabilities is the first section reported under liabilities on the balance sheet.

Accounts Payable

For many companies, accounts payable is the first balance sheet account listed in the current liabilities section. For example, accounts payable for goods, services, or supplies that were purchased with credit and for use in the operation of the business and payable within a one-year period would be current liabilities. Accounts payable are typically due within 30 days. Amounts listed on a balance sheet as accounts payable represent all bills payable to vendors of a company, whether or not the bills are more or less than 30 days old. Therefore, late payments are not disclosed on the balance sheet for accounts payable. An aging schedule showing the amount of time certain amounts are past due may be presented in the notes to audited financial statements; however, this is not common accounting practice.

Other Liabilities

In addition to current liabilities, long-term liabilities are listed in a separate section after current debt. Long-term liabilities can include bonds, mortgages, and loans that are payable over a term exceeding one year. However, for all long-term liabilities, any amounts due in the current fiscal year are reported under the current liability section.

What Goes on the Balances Sheet and What Goes in the Notes

The balance sheet lists current liability accounts and their balances; the notes provide explanations for the balances, which are sometimes required.

Learning Objectives

Explain why a company would use a note to the balance sheet

Key Takeaways

Key Points

  • All liabilities are typically placed on the same side of the balance sheet as the owner’s equity because both those accounts have credit balances.
  • Current liabilities and their account balances as of the date on the balance sheet are presented first on the balance sheet, in order by due date. The balances in these accounts are typically due in the current accounting period or within one year.
  • Current liability information found in the notes to the financial statements provide additional explanation on the account balances and any circumstances affecting them. Accounting principles can sometimes require this type of disclosure.

Key Terms

  • LLC: Limited liability company.
  • pension: A regularly paid gratuity paid regularly as benefit due to a person in consideration of past services; notably to one retired from service, on account of retirement age, disability, or similar cause; especially, a regular stipend paid by a government to retired public officers, disabled soldiers; sometimes passed on to the heirs, or even specifically for them, as to the families of soldiers killed in service.
  • LLP: Limited liability partnership.

The Balance Sheet

In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership, a corporation, or other business organization, such as an LLC or an LLP. Assets, liabilities, and the equity of stockholders are listed as of a specific date, such as the end of a fiscal year or accounting period. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a company’s calendar year. Balance sheets are presented with assets in one section, and liabilities and equity in the other section, so that the two sections “balance. ” The fundamental accounting equation is: assets = liabilities + equity ([).

The Balance Sheet: If an error is found on a previous year’s financial statement, a correction must be made and the financials reissued.

Current Liabilities on the Balance Sheet

All liabilities are typically placed on the same side of the report page as the owner’s equity because both those accounts have credit balances (asset accounts, on the other hand, have debit balances). Current liabilities and their account balances as of the date on the balance sheet are presented first, in order by due date. The balances in these accounts are typically due in the current accounting period or within one year. Current liabilities can represent costs incurred for employee salaries and wages, production and build up of inventory, and acquisition of equipment which are needed and used up during normal business operations.

Information in the Notes

Current liability information found in the notes to the financial statements provide additional explanation on the liability balances and any circumstances affecting them. Accounting principles can sometimes require the disclosure of specific information for the benefit of the financial statement user. For example, companies that pay pension plan benefits require additional footnote disclosure that provide the user with additional details on pension costs and the assets used to fund it.

Reporting Contingencies

Contingencies are reported as liabilities if it is probable they will incur a loss, and their amounts can be reasonably estimated.

Learning Objectives

Summarize how contingencies are reported on the financial statements

Key Takeaways

Key Points

  • A loss contingency is not reported if it can not be recognized due to improbability (not more than 50% likely to occur) and/or the amount of the loss can not be reliably measured or estimated. Gain contingencies are reported on the income statement when they are realized (earned).
  • A probable contingency is defined as more than 50% likely to occur because there was a past obligating event.
  • If a probable loss can be estimated based on historical information, then it can be reliably measured.

Key Terms

  • product warranty: In retail, a guarantee of the reliability of a product under conditions of ordinary use; should the product malfunction within a stipulated amount of time after the purchase, the manufacturer or distributor is typically required to provide the customer with a replacement, repair, or refund.
  • obligation: A legal agreement stipulating a specified payment or action; the document containing such agreement.

Reporting Contingencies

Loss Contingencies and Liabilities

Contingencies are reported as liabilities on the balance sheet and/or disclosed in the notes to the financial statements when it is probable they will incur a loss and when the loss can be reasonably estimated.

Probability

Probable is defined as more than 50% likely to occur due to a past obligation. The past obligating event defines a future payment event as a payment due on a specific date from the company, who is linked to an obligating event by a specific agreement.

Loss Contingency

A loss contingency is not reported if:

  • A loss contingency is less than 50% likely to occur due to a past obligation.
  • The amount of the loss can not be reliably measured or estimated.

Gain Contingency

Gain contingencies are reported on the income statement when they are realized (earned).

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Funds may be lost due to contingent liabilities.: Conservative accounting principles state that companies should report loss contingencies as they occur.

Estimating a Loss Contingency

Reliability

A probable loss contingency can be measured reliably if it can be estimated based on historical information. For example, to accrue a provision for product warranty costs, assume that minor repairs cost 5% of the total product sales and an estimated 5% of products may require minor repairs within 1 year of sale. Major repairs cost 20% and 1% of products may require major repairs in 3 years.

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Car Repairs: Cars require regular maintenance. Such contingent liabilities can be estimated reliably based on historical cost and readily available information.

Provision Estimation

The provision is calculated by multiplying 5% of total product cost by 5% of products needing minor repair and then adding 20% of cost for major repair, multiplied by 1% of products needing major repair.

5% x 5% + 20 % x 1% (of budgeted total sales)

A warranty expense is debited for the provision amount that will offset product sales revenue in the income statement and a credit is posted to warranty provision liability. The amount for repairs occurring in year one is reported in the current liability section of the balance sheet; the portion relating to major repairs in three years is disclosed as long-term liability. As the warranty claims are made, the liability account is debited and cash is credited for the cost of the repair. The long-term liability warranty provision is moved to the current liability section in the accounting period occurring three years after the product sale.

Current Ratio

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.

Learning Objectives

Explain how a company would use the current ratio

Key Takeaways

Key Points

  • The current ratio is calculated by taking total current assets and dividing by total current liabilities. The ratio is an indication of a firm’s market liquidity and ability to meet creditor ‘s demands.
  • Acceptable current ratios vary from industry to industry and are generally between 1.5% and 3% for healthy businesses. If a company’s current ratio is in this range, then it generally indicates good short-term financial strength.
  • If the value of a current ratio is considered high, then the company may not be efficiently using its current assets, specifically cash, or its short-term financing options. A high current ratio can be a sign of problems in managing working capital.
  • When a current ratio is low and current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations (current liabilities).

Key Terms

  • creditor: A person to whom a debt is owed.
  • liquidity: An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.
  • current liabilities: obligations of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer
  • current ratio: current assets divided by current liabilities

Current & Financial Ratios

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm’s current assets to its current liabilities. Along with other financial ratios, the current ratio is used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm’s creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%.

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Ratios can be used to analyze financial trends.: The current ratio can be use to evaluate a company’s liquidity.

The current ratio is calculated by taking total current assets and dividing by total current liabilities.

Uses for Current Ratio

The ratio is an indication of a firm’s market liquidity and ability to meet creditor’s demands. Acceptable current ratios vary from industry to industry and are generally between 1.5% and 3% for healthy businesses.

If a company’s current ratio is in this range, then it generally indicates good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations (current liabilities).

High vs. Low Current Ratio

If the value of a current ratio is considered high, then the company may not be efficiently using its current assets, specifically cash, or its short-term financing options. A high current ratio can be a sign of problems in managing working capital (what is leftover of current assets after deducting current liabilities). While a low current ratio may indicate a problem in meeting current obligations, it is not indicative of a serious problem. If an organization has good long-term revenue streams, it may be able to borrow against those prospects to meet current obligations. Some types of businesses usually operate with a current ratio of less than one. For example, when inventory turns over more rapidly than accounts payable becomes due, the current ratio will be less than one. This can allow a firm to operate with a low current ratio.

Acid Test Ratio

The acid-test, or quick ratio, measures the ability of a company to use its near cash or quick assets to pay off its current liabilities.

Learning Objectives

Describe how a company uses the acid test ratio

Key Takeaways

Key Points

  • The acid-test ratio is calculated by adding cash, cash equivalents, marketable securities, and accounts receivable. The sum is then divided by current liabilities.
  • Generally, the acid test ratio should be 1:1 or higher; however, this varies widely by industry. In general, the higher the ratio is, the greater the company’s liquidity (i.e., the better able to meet current obligations using liquid assets ).
  • The acid-test ratio, like other financial ratios, is a test of viability for business entities but does not give a complete picture of a company’s health.

Key Terms

  • inventory: A detailed list of all of the items on hand.
  • liquidity: An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.

Acid-Test and Financial Ratios

The acid-test ratio, also known as the quick ratio, measures the ability of a company to use its near cash or quick assets to immediately extinguish or retire its current liabilities. Quick assets include the current assets that can presumably be quickly converted to cash at close to their book values. The numerator of the ratio includes “quick assets,” such as cash, cash equivalents, marketable securities, and accounts receivable.

The acid-test ratio, like other financial ratios, is a test of viability for business entities but does not give a complete picture of a company’s health. For example, if a business has large amounts in accounts receivable which are due for payment after a long period (say 120 days) and essential business expenses and accounts payable are due for immediate payment, the quick ratio may look healthy when the business is actually about to run out of cash. In contrast, if the business has negotiated fast payment terms with customers and long payment terms from suppliers, it may have a very low quick ratio yet good liquidity.

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A low acid-test ratio may be a sign of poor use of cash by a business.: The acid-test ratio is similar to the current ratio except the value of inventory is omitted from the calculation.

Uses of Acid-Test Ratio

The acid-test ratio is calculated by adding cash, cash equivalents, marketable securities, and accounts receivable. The sum is then divided by current liabilities. Note that the calculation omits inventory and a different version of the formula involves subtracting inventory from current assets and dividing by current liabilities. Generally, the acid test ratio should be 1:1 or higher; however, this varies widely by industry. In general, the higher the ratio is, the greater the company’s liquidity (i.e., the better able to meet current obligations using liquid assets). A company with a quick ratio of less than 1 cannot currently pay back its short-term liabilities.

Working Capital Management Analysis

Working capital is a financial metric that represents the operational liquidity of a business, organization, or other entity.

Learning Objectives

Identify working capital and discuss how a company would use it

Key Takeaways

Key Points

  • Net working capital is calculated as current assets minus current liabilities. Positive working capital is required to ensure that a firm is able to continue its operations and has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.
  • Cash flows can be evaluated using the cash conversion cycle — the net number of days from the outlay of cash for raw material to receiving payment from the customer.
  • Profitability can be evaluated by looking at return on capital (ROC). This metric is determined by dividing relevant income for the 12 months by the cost of capital used. When ROC exceeds the cost of capital, firm value is enhanced and profits are expected in the short term.

Key Terms

  • deficiency: Inadequacy or incompleteness.
  • discounted cash flows: A method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) — the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.

Definition of Working Capital

Working capital (abbreviated WC) is a financial metric that represents the operational liquidity of a business, organization, or other entity. Along with fixed assets, such as property, plant, and equipment, working capital is considered a part of operating capital. Positive working capital is required to ensure that a firm is able to continue its operations and has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. A company can be endowed with assets and profitability but short on liquidity if its assets cannot be converted into cash.

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If money grew on trees, companies would never have a working capital shortage.: Sufficient working capital ensures a company is able to meet its short term obligations.

Uses of Working Capital

Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital commonly used in valuation techniques such as discounted cash flows (DCFs). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. The ability to meet the current portion of debt (payable within 12 months) is critical because it represents a short-term claim to current assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit.

Managing Working Capital

Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Working capital management entails short-term decisions, usually relating to the next one-year period and are based in part on cash flows and/or profitability.

Evaluating Working Capital Management

Cash flows can be evaluated using the cash conversion cycle — the net number of days from the outlay of cash for raw material to receiving payment from the customer. Because this number effectively corresponds to the time that the firm’s cash is tied up in operations and unavailable for other activities, management generally aims for a low net count.

Profitability can be evaluated by looking at return on capital (ROC). This metric is determined by dividing relevant income for the 12 months by the cost of capital used. When ROC exceeds the cost of capital, firm value is enhanced and profits are expected in the short term.


Source: Accounting