Chapter 11
Current Liabilities and Fair Value Accounting
Learning Objectives
1. Dene current liabilities, and identify the concepts underlying them.
2. Identify, compute, and record denitely determinable and estimated current liabilities.
3. Distinguish contingent liabilities from commitments.
4. Identify the valuation approaches to fair value accounting, dene time value of money
and interest, and apply them to present values.
5. Apply the present value concept to simple valuation situations.
6. Use ratio analysis to manage the impact of current liabilities’ impact on liquidity.
Section 1: Concepts
Concepts
Recognition
Valuation
Classication
Disclosure
Lecture Outline
1 Current liabilities are debts and obligations that a company expects to satisfy within one year or its
normal operating cycle.
A. Timing is important in the recognition of liabilities.
1. GAAP requires that a liability be recorded when an obligation occurs.
2. We make adjusting entries to recognize unrecorded liabilities that accrue
during the period, such as salaries payable and interest payable.
3. We also make adjusting entries for other liabilities that can only be estimated,
such as taxes payable.
4. Agreements for future transactions do not have to be recognized.
B. A liability is generally valued at the amount of money needed to pay the debt or at
the fair market value of the goods or services to be delivered.
C. Correct classification distinguishing current and long-term liabilities is important as it affects the
evaluation of a company’s liquidity.
1. Current liabilities – debts and obligations a company expects to satisfy within
one year or within its normal operating cycle, whichever is longer.
2. Long-term liabilities – debts and obligations a company expects to satisfy
beyond one year or beyond its normal operating cycle, whichever is longer.
D. Full disclosure regarding debt structure is required in the nancial statements.
1. Report current liabilities on the balance sheet at fair value.
2. Include additional explanation in the notes to the nancial statements.
3. The disclosure of an unused line of credit helps in assessing a company’s
borrowing power.
Summary
Liabilities are legal obligations requiring either future payment of assets or future
performance of services that result from past transactions. The primary reason for incurring
current liabilities is to meet needs for cash during the operating cycle.
A liability generally should be recorded when an obligation arises, but it is also necessary to
make end-of-period adjustments for accrued and estimated liabilities. Failure to record a
liability often results in an understatement of expense and, therefore, an overstatement of
income. Contracts representing future obligations are not recorded as liabilities until they
become current obligations. Liabilities are valued at the actual or estimated amount due or
at the fair market value of goods or services to be delivered.
Current liabilities are present obligations that are expected to be satised within one year
or within the normal operating cycle, whichever is longer. Payment is expected to be out of
current assets or through the incurrence of another current liability. Long-term liabilities
are obligations that are not expected to be satised within the longer of one year or the
normal operating cycle.
Required disclosures for liabilities include balances, maturity dates, and interest rates of
notes payable, as well as lines of credit and other special credit arrangements.
Relevant Examples and Exhibits
Hershey Foods Note to Financial Statements Regarding Short-Term Debt
Teaching Strategy
Students should be reminded of the denition of a liability—that is, a present obligation for
future payment (of cash or services) based on a past transaction. A reminder of the
denition of current period (the longer of one year or the normal operating cycle) is helpful
in dening current versus long-term liabilities (that is, classication of liabilities).
In the discussion of the recognition of liabilities, point out the di<culty in certain cases of
determining when an obligation occurs (as with a product warranty). In addition, explain why
future commitments may not be liabilities currently.
In the discussion of valuation of liabilities, be sure to mention the di=erence between
denitely determinable amounts and estimated amounts.
Review required disclosures for liabilities.
Short Exercise 1 and Exercise 1A can be used to reinforce the concepts introduced in this
section.
Section 2: Accounting Applications
Accounting Applications
Record denitely determinable current liabilities
Record estimated current liabilities
Account for contingent liabilities
Compute present value
Lecture Outline
I. Current liabilities consists of denitely determinable liabilities and estimated liabilities.
II. Denitely determinable liabilities include:
A. Accounts payable.
B. Notes payable.
1. Journalize entries for notes payable as follows:
a. At issuance, debit Cash and credit Notes Payable for face amount.
b. At maturity, debit Notes Payable, debit Interest Expense, and credit Cash.
C. Bank loans and commercial paper.
D. Accrued liabilities (such as interest payable and salaries payable).
1. Journalize entries for accrued liabilities as follows:
a. Debit Interest Expense and credit Interest Payable
E. Dividends payable.
F. Sales and excise taxes payable.
G. Current portion of long-term debt.
H. Payroll liabilities.
1. Record the payroll, including crediting various payable accounts for employee
withholdings.
2. Record liabilities for employer payroll taxes as a separate entry.
I. Unearned revenues.
1. Recognize a liability for fees received in advance.
2. Recognize revenue only after the commitment has been fullled.
III. Estimated liabilities, which are denite obligations whose exact dollar amount will not
be known until a later date, include:
A. Income taxes payable.
B. Property taxes payable.
C. Promotional costs.
1. Examples include coupons, rebates, and frequent Ayer programs.
2. Usually recorded as a reduction in revenue (contra-sales account).
D. Product warranty liability.
1. Journalize estimated expense with credit to Estimated Warranty Liability.
2. Journalize replacement of product under warranty with debit to Estimated
Warranty Liability.
E. Vacation pay liability.
1. Journalize estimated vacation pay expense with a credit to Estimated Liability
account.
2. Journalize payment of vacation pay with debit to Estimated Liability account.
IV. FASB requires disclosure of contingent liabilities and commitments.
A. Contingent liabilities are potential liabilities that may or may not become
actual liabilities.
1. Examples include:
a. Lawsuits.
b. Income tax disputes.
c. Discounted notes receivable.
d. Guarantees of debt.
e. Failure to follow government regulations.
2. Conditions for when a contingency should be entered in the accounting
records:
a. Liability must be probable.
b. Liability can be reasonably estimated.
B. Commitments are legal obligations that do not meet the conditions for
recognition.
1. Examples include:
a. Purchase agreements.
b. Leases.
V. The concept of fair value applies to some nancial assets, inventories, and some
liabilities, such as notes payable.
A. Fair value is the price for which an asset or liability could be sold.
B. The FASB identies three approaches to measurement at fair value:
1. Market approach:
a. Involves identical or comparable assets or liabilities.
b. Is not possible when a ready market is not as available, as in the case of
special purpose equipment.
2. Income approach:
a. Converts future cash Aows into a single present value.
b. Based on reasonable internally generated information.
3. Cost approach:
a. Based on amount that currently would be required to replace an asset.
b. Example: Inventory usually valued at lower of cost or market.
c. Would take into account a plant asset’s age, condition, depreciation, and
obsolescence.
C. Interest, the time value of money, and future value are related to the income
approach of valuing assets and liabilities.
1. Time value of money is the e=ects of the passage of time on holding or not
holding money.
2. Interest is the cost of using money.
3. Amount of principal plus interest after one or more periods is the future value.
4. Future value may be computed with simple or compound interest.
a. Simple interest – interest is not computed on previously earned interest.
b. Compound interest – interest earned is added to principal on which
interest is computed in future periods.
D. Present value is the amount that must be invested today at a given rate of
interest to produce a given future value.
1. The present value of a single sum due in the future may be computed
manually or with Table 1 in the text.
2. The present value of an ordinary annuity may be computed using Table 2 in
the text.
3. Interest may be compounded for time periods of less than one year.
a. Some savings accounts can record interest quarterly.
b. Most bonds pay interest semiannually.
VI. There are many useful applications for using present value.
A. Valuing an asset at the present value of future benets helps in evaluating a
proposed purchase price.
B. The present value of a deferred payment determines the cost at which an
asset purchase should be recorded.
C. Other applications include:
1. Imputing interest on non-interest-bearing notes.
2. Accounting for installment notes.
3. Valuing a bond.
4. Recording lease obligations.
5. Accounting for pension obligations.
6. Valuing debt.
7. Depreciating property, plant, and equipment.
8. Making capital expenditure decisions.
9. Accounting for any item for which time is a factor.
D. The application of accrual accounting impacts the amounts at which current
liabilities are reported on the nancial statements.