Chapter 9 – Current Liabilities: Contingencies, and the

Time Value of Money

Current Liabilities
• The balance sheet generally presents two categories of liabilities: current and long term.
• Current liabilities finance the working capital of the company.
• At any given time during the year, current liabilities may fluctuate substantially.
• The company must generate sufficient cash flow to retire these debts as they come due.
• As long as the company’s ratio of current assets to current liabilities stays fairly constant from
quarter to quarter or year to year, financial statement users will not be too concerned.
• Current liability Accounts that will be satisfied within one year or the current operating cycle (also
called a short-term liability).
• Some companies list the accounts in the Current Liability category in the order of payment due
date – the account that requires payment first is listed first, the account requiring payment next
is listed second, etc.
• Although current liabilities are not due immediately, they are still recorded at face value, that is,
the time until payment is not taken into account.
• The face value amount is generally used for all current liabilities because the time period involved
is short enough that it is not necessary to record or calculate an interest factor.
• The current liability classification is important because it is closely tied to the concept of liquidity.
• Management of a fi rm must be prepared to pay current liabilities within a short time period.
Therefore, management must have access to liquid assets, cash, or other assets that can be
converted to cash in amounts sufficient to pay the current liabilities.
• Firms that do not have sufficient resources to pay their current liabilities are often said to have a
liquidity problem.
• Ratio to help creditors or potential creditors determine a company’s liquidity is the current ratio.
• If the firm has a large amount of inventory, it is sometimes useful to exclude inventory
(prepayments are also excluded) when computing the current ratio. That provides the “quick”
ratio.
• A current ratio of current assets to current liabilities of 2 to 1 is usually a comfortable margin. And
a quick ratio of at least 1.5 to 1 would be preferred so that the company could pay its bills on time.
• The actual current and quick ratios of companies vary widely and depend on the company, the
management policies, and the type of industry.

Accounts Payable
• Accounts Payable: amounts owed for inventory, goods, or services acquired in the normal course
of business.
• Often, Accounts Payable is the first account listed in the Current Liability category because it
requires the payment of cash before other current liabilities.
• Accounts payable usually do not require the payment of interest, but terms may be given to
encourage early payment.
• The accounts payable system must be established in a manner that alerts management to take
advantage of discounts offered.
• Normally, a firm has an established relationship with several suppliers, and formal contractual
arrangements with those suppliers are unnecessary.
Notes Payable
• Notes Payable: amounts owed that are represented by a formal contract.
• The most important difference between accounts payable and notes payable is that an account
payable is not a formal contractual arrangement, whereas a note payable is represented by a
formal agreement or note signed by the parties to the transaction.
• Notes payable may arise from dealing with a supplier or from acquiring a cash loan from a bank or
creditor.
• Notes that are expected to be paid within one year of the balance sheet date should be classified
as current liabilities.
• The accounting for notes payable depends on whether the interest is paid on the note’s due date
or is deducted before the borrower receives the loan proceeds.
 With the first type of note, the terms stipulate that the borrower receives a short-term loan
and agrees to repay the principal and interest at the note’s due date.
• Banks also use another form of note, one in which the interest is deducted in advance. This is
sometimes referred to as discounting a note because a Discount on Notes Payable account is
established when the loan is recorded.
• Discount on notes payable: a contra liability that represents interest deducted from a loan in
advance.
• The Discount on Notes Payable account should be treated as a reduction of Notes Payable.

• The original balance in the Discount on Notes Payable account represents interest that must be
transferred to interest expense over the life of the note.

• The interest rate on a discounted note is always higher than it appears.

Current Maturities of Long-Term Debt
• Current maturities of long-term debt: the portion of a long-term liability that will be paid within
one year (also called long-term debt, current portion).
• This account should appear when a firm has a liability and must make periodic payments.

• When an investor or a creditor reads a balance sheet, he or she wants to distinguish between debt
that is long term and debt that is short term. Therefore, it is important to segregate the portion of
the debt that becomes due within one year.
 The process should be repeated each year until the bank loan has been fully paid.
• The balance sheet account labeled Current Portion of Long-Term Debt should include only the
amount of principal to be paid.
• The amount of interest that has been incurred but is unpaid should be listed separately in an
account such as Interest Payable.

Taxes Payable
• Corporations pay a variety of taxes, including federal and state income taxes, property taxes, and
other taxes.
• Usually, the largest dollar amount is incurred for state and federal income taxes.
• Taxes are an expense of the business and should be accrued in the same manner as any other
business expense.
• Taxes are an expense when incurred (not when paid) and must be recorded as a liability as
incurred.
Other Accrued Liabilities
• Accrued liability: a liability that has been incurred but has not yet been paid (e.g. salaries payable
or interest payable).

IFRS and Current Liabilities

• U.S. standards do not require a classified balance sheet, and financial statements of some U.S.
companies may list liabilities in order by size or by order of liquidity.
• International accounting standards require companies to present classified balance sheets with
liabilities classified as either current or long term.
• An unclassified balance sheet based on the order of liquidity is acceptable only when it provides
more reliable information.

Reading the Statement of Cash Flows for Changes in Current

Liabilities
• Most current liabilities are directly related to a firm’s ongoing operations.
• The change in the balance of each current liability account should be reflected in the Operating
Activities category of the statement of cash flows.
• A decrease in a current liability account indicates that cash has been used to pay the liability and
should appear as a deduction on the cash flow statement.
• An increase in a current liability account indicates a recognized expense that has not yet been paid.

• If a current liability is not directly related to operating activities, it should not appear in that
category. For example, if a company uses some notes payable as a means of financing, distinct
from operating activities, those borrowings and repayments are reflected in the Financing
Activities rather than the Operating Activities category.
Contingent Liabilities
• Contingent liability: an existing condition for which the outcome is not known but depends on
some future event (also called contingent loss).
• Accountants must exercise a great deal of expertise and judgment in deciding what to record and
in determining the amount to record.
• The actual amount of the liability must be estimated because we cannot clearly predict the future.
• The important issue is whether contingent liabilities should be recorded and, if so, in what
amounts.
• Management would rather not disclose contingent liabilities until they come due because
investors and creditors judge management based on the company’s earnings, and the recording
of a contingent liability must be accompanied by a charge to (reduction in) earnings.

Contingent Liabilities That Are Recorded

• A contingent liability should be accrued and presented on the balance sheet if it is probable and if
the amount can be reasonably estimated.
• The terms “probable” and “reasonably estimated” must be defined based on the facts of each
situation.
• Estimated liability: a contingent liability that is accrued and reflected on the balance sheet.
• A common contingent liability that firms must present as a liability involves product warranties
and guarantees – the expense of fixing a product depends on some of the products becoming
defective; an uncertain, although likely, event.
• At the end of each period, the selling firm must estimate how many of the products sold in the
current year will become defective in the future and the cost of repair or replacement.

• The amount of warranty costs that a company presents as an expense is of interest to investors
and potential creditors.
• If the expense as a percentage of sales begins to rise, a logical conclusion is that the product is
becoming less reliable.
• The company must analyze past warranty records carefully and incorporate any changes in
customer buying habits, usage, technological changes, and other changes in the process of
estimation of warranties.
• Another example of contingent liabilities is premium, or coupon offers that accompany many
products.
• At the end of each year, the company must estimate the number of premium offers that will be
redeemed, and the cost involved and must report a contingent liability for that amount.
• Legal claims that have been filed against a firm are also examples of contingent liabilities.
• They represent a contingent liability because an event has occurred but the outcome of that event,
the resolution of the lawsuit, is not known.
• The defendant must make a judgment about the lawsuit’s outcome to decide whether the item
should be recorded on the balance sheet or disclosed in the notes, and the accountant must make
an independent judgment based on the facts and not be swayed by the desires of other parties.
• When the legal claim’s outcome is likely to be unfavorable, a contingent liability should be
recorded on the balance sheet.

Contingent Liabilities That Are Disclosed

• A contingent liability must be disclosed in the financial statement notes but not reported on the
balance sheet if the contingent liability is at least reasonably possible.
• Note disclosure does not affect the important financial ratios that investors use to make decisions.
• Most lawsuits, however, are not recorded as liabilities because the risk of loss is not considered
probable or the amount of the loss cannot be reasonably estimated.
• If a company does not record a lawsuit as a liability, it still must consider whether the lawsuit
should be disclosed in the notes to the financial statements.
• Readers of the financial statements and analysts must read the notes carefully to determine the
impact of such contingent liabilities.
• The amount and the timing of the cash outlays associated with contingent liabilities are especially
difficult to determine.

Contingent Liabilities vs Contingent Assets

• Contingent Asset: an existing condition for which the outcome is not known but by which the
company stands to gain (also called contingent gain).
• Contingent liabilities that are probable and can be reasonably estimated must be presented on
the balance sheet before the outcome of the future events is known. This accounting rule applies
only to contingent losses or liabilities and not to contingencies by which the firm may gain
(contingent assets).
• Contingent liabilities may be accrued but contingent assets are not accrued.
• Accounting is prudent and conservative to delay the recording of a gain until an asset is actually
received but to record contingent liabilities in advance.
• Even though the contingent assets are not reported, the information still may be important to
investors.

IFRS and Contingencies

• There are very significant differences between U.S. and international standards regarding
contingencies.
• The terms used to refer to situations with unknown outcomes differ.
• In this chapter, we have presented the U.S. standards under which a contingent liability must be
recorded on the balance sheet, if the loss or outflow is “probable” and can be “reasonably
estimated.”
• The meaning of probable is subject to the accountant’s judgment, but the standards indicate it
should mean an event is “likely to occur.”
• If a contingency does not meet the probable and reasonably estimated criteria, it still must be
disclosed in the notes, if the loss or outflow is “reasonably possible.”
• International standards use the term provision for those items that must be recorded on the
balance sheet.
• As in U.S. standards, an item should be recorded if the loss or outflow is probable and can be
reasonably estimated. But the meaning of the term probable is somewhat different. In
international standards, probable means the loss or outflow is “more likely than not” to occur. This
is a lower threshold than in U.S. standards and may cause more items to be recorded as liabilities.
• International standards require the amount recorded as a liability to be “discounted” or recorded
as a present value amount, while U.S. standards do not have a similar requirement.
• In international standards, the term contingent liability is used only for those items that are not
recorded on the balance sheet but are disclosed in the notes that accompany the statements.

Time Value of Money Concepts: Compounding of Interest

• Time value of money: an immediate amount should be preferred over an amount in the future.
• If an amount is received at the present time, it can be invested, and the resulting accumulation
will be larger than if the same amount is received in the future. Thus, there is a time value to cash
receipts and payments.
• The time value concept affects your personal financial decisions, and it affects accounting
valuation decisions.
• The concept of time value of money is probably the most important decision-making tool to
master in preparation for the business world.

Simple Interest
• Simple interest: interest is calculated on the principal amount only.
• If the amount of principal is unchanged from year to year, the interest per year will remain the
same.
• Interest per year can be calculated using the formula: I = Principal Amount × Rate × Time in years

Compound Interest
• Compound interest: interest calculated on the principal plus previous amounts of interest (also
called interest on interest).
• The amount accumulated with compound interest is a higher amount because of the interest-on-
interest feature.
• If compounding is not done annually, you must adjust the interest rate by dividing the annual rate
by the number of compounding periods per year.

Present Value and Future Value: Single Amounts

Future Value of a Single Amount
• Future value of a single amount: amount accumulated at a future time from a single payment or
investment.
• The future amount is always larger than the principal amount (payment) because of the interest
that accumulates.
• The formula to calculate the future value of a single amount is: FV = p (1 + i)n (where p is the
principal amount, i is the interest rate and n is the number of periods of compounding).
• You can also use tables and spreadsheet formulas to calculate the FV.
• The numbers produced by each method may differ by a few dollars because of rounding
differences. Ignore those small differences and concentrate on the methods used to perform the
interest rate calculations.
Present Value of a Single Amount
• Present value of a single amount: the amount at a present time that is equivalent to a payment or
an investment at a future time.
• The formula used to calculate present value is: PV = FV x (1 + i)-n (where i is the interest rate and
n is the number of periods).
• The present value amount is always less than the future payment. This happens because of the
discount factor.
• The present value and future value formulas are the reciprocal of the each other.

Present Value and Future Value of an Annuity

Future Value of an Annuity
• Annuity: a series of payments of equal amounts.
• Future value of an annuity: the amount accumulated in the future when a series of payments is
invested and accrues interest (also called amount of an annuity).
• You can calculate this manually using a time diagram or you can use the tables to calculate this.

Present Value of an Annuity

• Present value of an annuity: the amount at a present time that is equivalent to a series of payments
and interest in the future.
• You can use tables to calculate this by multiplying the principal amount with the factor in the table
corresponding to the required interest rate and number of periods.