Current Liabilities

When a company buys goods and services on credit or gets loans on a short-term basis, current liabilities are created. A current liability is an amount owed by a business that is expected to be paid normally within one year of the balance sheet date or during the operating cycle, whichever is longer. Examples of current liabilities include accounts payable and short-term loans and notes, which are classified as current liabilities on an organization's balance sheet. Such current liabilities can serve as a source of short-term financing. For example, an invoice from a supplier that is due within 30 days, or allows 30 days to be paid, is tantamount to a loan from the supplier for 30 days.

Other examples of current liabilities are accrued wages, payroll taxes payable, and unearned revenue. These known and certain current liabilities are based on agreements, contracts, or legal obligations and can be measured. A company can determine to whom the amount is owed, for how much, and when the amount is due. These liabilities will be recorded in the accounting records and shown on the company's balance sheet.

For example, an excerpt from Jay Company's balance sheet records the company's current liabilities, which are short-term. Jay Company's current liabilities include accounts payable, accrued wages, payroll taxes payable, unearned revenue, and notes payable.

Often, a business will purchase goods or services from a vendor or a supplier on credit. The amounts bought on credit are accounts payable. The invoice for the goods or services will be paid to the vendor at a later date, such as 30 to 45 days later. Alternatively, the vendor could choose to offer a discount on the goods or services if the business were to pay the invoice sooner. For example, a 2% discount might be offered if the vendor receives payment within 10 days.

For example, Jay Company purchases supplies on credit from Green Company on July 15. Green Company invoices Jay Company for $700, and the payment is due on August 15, which is 30 days later. The $700 is an accounts payable for Jay Company that is payable to Green Company. Now Jay Company has $700 as a current liability on its books on July 15 because it owes Green Company a payment at a future date, which is August 15. This transaction is a known and certain liability because Jay Company knows to whom the amount is owed, how much is owed, and when the amount is due.

Because this accounts payable amount is due within 30 days (which is within the current period of a month), it is reported as a current liability on the balance sheet. The journal entry to set up the current liability would be recorded as a credit to accounts payable. The purchase of supplies is entered as a debit of $700.

Information regarding the amount of liabilities and their duration (short-term or long-term) is important not only to managers for planning purposes and forecasting cash flow, but also to creditors and investors who are interested in learning about a company's debt situation. The status of a company's debt would affect a creditor, which is any entity entitled to receive payment. It is important to segregate short-term debt, which includes obligations due in the short term (current liabilities), from loans that may be long-term debt spanning many years (long-term liabilities).

Some long-term debts, such as mortgages and notes payable that are due in 5 or 10 years, may be payable in a series of monthly or quarterly installments, depending on the terms of the agreement. With such long-term debts, the portion of the principal (original amount without interest) that is due within one year (or operating cycle) is considered as a current liability. It is the current portion of long-term debt, the portion of noncurrent debt due within one year of the balance sheet date, and it is reported under current liabilities on the balance sheet. The remainder of the obligation or debt is classified as a long-term liability on the balance sheet. This tells whoever reviews the company's financial statements what amount is due in the short term and what amount is due in the long term.

For example, Jay Company borrows $400,000 from State Bank in January 2017. Then 50% of the principal is to be repaid on December 1, 2019. The balance of $200,000 is due on December 1, 2020. Jay Company closes its operating cycle on December 31. To record accurate information on its current liabilities, Jay Company must reclassify 50% of its long-term debt as a current liability because that debt is due within a year of its maturity date.

A note payable is a form of borrowed funds or a loan from a financial institution such as a bank. It is a source of financing with an obligation to pay back the amount borrowed (principal) at a future date. For the use of borrowed funds, the bank or any other financial institution will charge interest (the interest expense for the borrower). Loans that are due in the short term, as in 60 to 90 days, are classified as a current liability on the balance sheet. A note payable for such a loan states the amount borrowed, the due date for repayment, and the interest rate associated with the amount borrowed. This transaction is a known and certain liability because the borrower knows to whom the amount is owed, for how much, and when the amount is due.

For example, Jay Company borrows $10,000 from State Bank on June 1 for 6 months at an annual interest rate of 5%. According to the terms of the note payable, Jay Company will pay back the principal plus interest at the end of the 6 months. Jay Company has a liability payable to State Bank not only for the principal, but also for the interest, which is a finance charge. At each month end, Jay Company will need to accrue interest, as this loan is a liability, the amount owed to the bank. Journal entries would be made at each month end.