Chapter 8: Current and Contingent Liabilities – Financial Accounting Study Notes

Current and Contingent Liabilities

Distinguishing Between Current and Long-Term Liabilities

Liabilities are financial obligations that a company must settle in the future. They are classified based on their due dates and relevance to business operations.

• Current Liabilities: Debts payable in cash within one year or one operating cycle. These are linked to daily business operations.

• Long-Term Liabilities: Debts due after one year are classified as long-term liabilities.

Example: Accounts payable for inventory purchases are current liabilities, while a 5-year bank loan is a long-term liability.

Operating Activity	Current Liability
Purchasing inventory, supplies, paying operating expenses	Accounts payable
Borrowing money for operations	Notes payable and accrued interest payable
Paying employees	Accrued salaries, wages, and related payroll taxes payable
Paying income taxes	Accrued income tax payable
Fulfilling warranty claims	Accrued warranties payable
Processing advance cash payments from customers	Unearned (deferred) revenue

Accounts Payable and Accounts Payable Turnover

Accounts payable are amounts owed for products or services bought on credit. The accounts payable turnover ratio is a key liquidity metric for retail businesses, showing how often a company pays off its accounts payable annually.

• Definition: Accounts payable turnover measures the number of times a year the company can pay its accounts payable.

• Formula:

$\text{Accounts Payable Turnover} = \frac{\text{Cost of Goods Sold (COGS)}}{\text{Average Accounts Payable}}$

To express turnover in days:

$\text{Days Payable Outstanding} = \frac{365}{\text{Accounts Payable Turnover}}$

Example: If COGS is $1,000,000 and average accounts payable is $200,000, turnover is 5 times per year.

Notes Payable and Accrued Interest

Notes payable are written promises to pay a certain amount of money at a future date, usually with interest. Short-term notes payable are due within one year (or operating cycle if longer) and are often used to finance business operations.

• Example: Purchase of inventory for $8,000 on January 1, 2024, in exchange for a short-term note payable due in one year with 10% interest.

• Interest must be accrued at year-end if the fiscal year ends before the note matures.

Accrued Interest Calculation:

$\text{Interest Expense} = \text{Principal} \times \text{Interest Rate} \times \frac{\text{Months Accrued}}{12}$

For 9 months (Jan–Sep): $8,000 \times 0.10 \times \frac{9}{12} = $600$

At maturity, the company pays the principal and any remaining interest.

Current Portion of Long-Term Debt

The current portion of long-term debt is the principal amount of long-term debt due within one year (or longer operating cycle). It is reclassified from long-term to current liability at year-end.

• Also known as: Current maturity or current installment.

• Classification: Short-term liability.

Example: If a company has a $100,000 loan with $20,000 due next year, $20,000 is classified as a current liability.

Accrued Liabilities and Unearned Revenue

Accrued liabilities are expenses that have been incurred but not yet paid. Unearned revenue is cash received before goods or services are provided.

Sales Taxes Payable

• Sales taxes collected from customers are liabilities until remitted to the government.

• Example: $200,000 sales with 5% sales tax ($10,000) collected in cash.

Payroll Liabilities

• Salary Expense: Gross pay creates payroll liabilities.

• Employee Income Tax Payable: Tax withheld from employees.

• FICA Tax Payable: 6.2% Social Security (up to $137,700) plus 1.45% Medicare.

• Salary Payable: Net pay owed to employees.

• Bonus: Extra compensation.

Example: $10,000 salary expense, $1,200 income tax payable, $800 FICA payable. Total payroll cost: $10,800.

Accrued Warranties Payable

• Warranties obligate companies to fix, replace, or refund defective products within a set time.

• Warranty costs should be recorded in the same period as the product's sales revenue.

• Businesses estimate warranty expenses and the corresponding liability.

Example: Black & Decker estimates 3% of $100,000 sales will require replacement ($3,000 warranty expense).

If actual defects are $2,800, the company records the replacement and adjusts the liability.

Unearned Revenues

• Also called deferred revenues or revenues collected in advance.

• Cash received before earning the revenue is a liability until goods/services are provided.

Example: Amazon.com collects $3 million for 1-year memberships. As time passes, revenue is recognized proportionally.

At year-end, if half the service period has passed, half the revenue is recognized.

Contingent Liabilities

Contingent liabilities are potential obligations that depend on the outcome of future events. Common examples include lawsuits, tax disputes, and environmental claims.

• FASB Guidelines:

  • Accrue a contingent liability if it is probable the loss will occur and the amount can be reasonably estimated.

  • Disclose a contingency in a financial statement note if it is reasonably possible a loss will occur.

  • No need to report a contingent loss that is unlikely to occur.

Example: A company facing a probable lawsuit loss of $500,000 would accrue the liability; if the loss is only possible, it is disclosed in the notes.

Robotic Process Automation (RPA) in Accounts Payable

Robotic Process Automation (RPA) uses software bots to automate routine, repetitive tasks in the accounts payable process, increasing efficiency and accuracy.

• Steps performed by an accounts payable bot:

  1. Checks email for vendor invoices and saves them in a cloud folder.

  2. Scans paper invoices and adds them to the cloud folder.

  3. Reads documents and logs invoice data into an Excel sheet.

  4. Verifies purchase order numbers and approves or flags for human review.

  5. Inputs invoices into accounts payable, initiating payment.

  6. Follows organization rules for vendor payment approval.

  7. Flags exceptions for human review.

  8. Sends daily email confirmation of completed tasks.

• Benefits:

  • No errors in invoice entry.

  • Complete log for audit and review.

  • Employees can focus on value-added activities.

Example: An RPA bot processes hundreds of invoices daily, reducing manual workload and improving accuracy.

Additional info: Academic context and examples have been expanded for clarity and completeness.