LESSON ONE

1.0 Current Liabilities

Objectives

After studying this lesson, you should be able to:

1. Define a liability and specify its characteristics
2. Distinguish short-term (current) from long-term liabilities
3. Record transactions that involve such liabilities as short-term notes payable,
product warranty liabilities and unearned revenues
4. Understand the accounting for interest-bearing and non-interest-bearing
current liabilities

1.1 Current Liabilities

1.1.1 Definition of Liability

Liabilities represent obligations that require the future payment of assets or performance
of services. Not every expected future payment is a liability. To qualify as a liability, the
future payment must be a present obligation of the debtor that resulted from a past
transaction. Because liabilities result from past transactions, they normally are
enforceable as legal claims against the enterprise. However, in some circumstances, an
obligation should be recognized as a liability on the debtor’s balance sheet,/SFP even if it
is not legally enforceable as of that date.

The Financial Accounting Standards Board (FASB) has comprehensively defined

liabilities as “probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provided services to other entities in
the future as a result of past transactions or events”. According to this definition, a
liability has three characteristics:
1. There is a present duty to one or more other entities that is expected to be settled
by transfer of assets or provision of services in the future.
2. It is an unavoidable obligation i.e. the duty or responsibility obligates a particular
entity.
3. The transaction or event creating the obligation has already occurred.

When a liability conforming with the definition given above is incurred, it should be
immediately recognized and recorded.

1.1.2 Definition Of Current Liability

American Institute of Certified Public Accountants defined Current (short-term)
liabilities as “obligations whose liquidation is reasonably expected to require the use of
existing resources properly classified as current assets, or the creation of other current
liabilities.” Current assets are those assets that are expected to be converted to cash or
used in normal operations during the operating cycle of the business, or one year from the

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balance sheet date, whichever is longer. The time dimension that applies to current assets
also generally applies to current liabilities. Liabilities that do not conform to this
definition are called long-term, or noncurrent liabilities. Long-term liabilities are
discussed in the next lesson.

Note: The operating cycle is the period elapsing between the acquisitions of goods
In addition, services involved in the manufacturing process and the final cash
realization resulting from sales and subsequent collections.

1.1.3 Types Of Current Liabilities

Current liabilities include accounts payable, notes payable, unearned revenues and
dividends payable. They also include liabilities such as taxes, salaries and wages. They
are discussed below.

(a) Accounts Payable

Accounts payable, usually called traded accounts payable, arise when an entity purchases
goods, supplies, or services in the normal course of business and there is a time lag
between the time of purchase and the time of payment. Since the time lag generally is
short (often lass than 60 days), accounts payable normally are recorded at their face
amount rather than at their present value. Accounts payable can be recorded net of
purchase discounts (cash discounts). Alternately, an allowance for purchase discounts can
be deducted from gross accounts payable in the balance sheet to obtain a proper valuation
of accounts payable. A typical purchase entry for a company that has a perpetual
inventory system and that records accounts payable net of purchase discounts is given
below. We assume a gross purchase price of $100,000 and payment of 2/100, net30. Thus
the net purchase p[rice is $ 98,000:

Inventory 98,000
Accounts payable 98,000

The amount and the due date of an account payable normally are stated in the invoice
from the seller. Usually, accounts payable and purchases are recorded when title passes to
the buyer.

(b) Short-Term (Current) Notes Payable

Notes payable are written promises to pay a certain sum of money on a specified future
date and may arise from sales, financing, or other transactions. In some industries, notes
(often referred to as trade notes payable) are required as part of the sales/purchases
transaction in lieu of the normal extension of open account credit. Notes payable to banks
or loan companies generally arise from cash loans.

(i) Trade notes payable (note given to secure a time extension on

an account)
Trade notes payable current obligations to supplies for which there are written
promissory notes. Trade notes payable typically arisen when the terms of payment

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include a longer payment period than is normal for trade accounts payable. The due date,
the amount of the obligation and the interest rate, if any, are stated in the promissory
note. The generally accepted practice is to report a trade note payable at its face value.

Illustration:
Assume that Hard rock Company cannot pay its past-due Sh 600,000 account with Apex
Company. As an accommodation, Apex Company agrees to accept Hardrock Company’s
60-day, 12%, Sh.600, 000 not in granting an extension on the due date of the debt on
August 23,2000. Hard rock Company records the issuance of the note as follows:

Aug. 23,2000 Accounts payable-Apex Co. 600,000

Notes payable 600,000
( Gave a 60-day, 12%notetoextend the due
Date on the amount owed).

It should be noted that the note does not pay off debt. Rather, the form of the debt is
merely changed from an account payable to a note payable. Apex Co. should prefer
holding the note to the account because, in case of default, the note is a very good written
evidence of the debt’s existence and its amount.

When the note becomes due, Hard rock Company will pay Apex Company Sh.672,
000 and record the payment of the note and its interest with this entry:

Oct.22 Notes Payable 600,000

Interest expense 72,000
Cash 672,000
(Note paid with interest)

(ii) Borrowing from a bank/ loan companies

When lending money, banks/loan companies typically require that the borrower sign a
promissory note. Sometimes, the note states that the signer of the note promises to pay
the principal sum plus interest. If the note is written in this way, the face value of the note
is the principal and the lending transaction is called a loan. This generally involves
interest-bearing notes being issued. An interest-bearing note explicitly states a rate of
interest. This rate is called the stated rate of interest

Alternatively note may be silent regarding interest and simply state that the signer
promises to pay a given amount. In this case, the face amount of the note includes the
amount borrowed plus the interest to be charged and the lending transaction involves
discounting the note. This is a case of zero-interest-bearing note (noninterest-bearing
notes) being issued. Notes designated as noninterest-bearing do not state an explicit
interest rate but, instead, implicitly reflect a rate of interest called the effective rate, or
yield. In other words, regardless of designation, all commercial debt instruments
implicitly or explicitly requires the debtor to pay interest because the cost of using money
over time cannot be avoided. The stated rate determines the amount of cash interest that

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will be paid on the principal amount of the debt. In contrast, the effective rate of interest
is the market interest rate based on the actual cash, or cash equivalent, amount due. The
effective rate is used to discount the future cash payments on a debt to the cash equivalent
borrowed.

Interest-bearing note issued

Interest-bearing notes specify a rate of interest. The debtor receives cash, other assets, or
services and pays back the face amount of the note plus interest at the stated rate on one
or more interest dates. When the stated rate approximately reflects the note’s risk, the
stated and effective interest rates are the same. This is the usual case.

Illustration 1:
Assume that Githurai National Bank agrees to lend $100,000 on March 1, 2002, to Rocky
Co. if Rocky Co. signs a $100,000, 12%, 4-month note. With an interest-bearing note, the
amount of assets received upon issuance of the note generally equals the note’s face
value. Rocky Co. therefore will receive $100,000 cash and will make the following
journal entry:

March 1 Cash 100,000

Notes payable 100,000
(To record the issuance of 12%, 4-month
Note to Rocky Co)

Interest accrues over the life of the note and must be recorded periodically. If Rocky Co.
prepares financial statements semiannually, an adjusting entry is required at June 30 to
recognize interest expense and interest payable of $4,000 ($100,000 x 12% x 4/12). The
formula for computing interest and its application to Rocky Co.’s note are shown below:

Face value X Annual X Time the note has been held in = Interest
of note interest rate terms of one year

$100,000 x 12% x 4/12 = $4,000

The adjusting entry is:

June 30 Interest expense 4,000

Interest payable 4,000
(To accrue interest for 4 months on the
Githurai National Bank note)

In the June 30 financial statements, the current liabilities section of the balance sheet/SFP
will show notes payable $100,000 and interest payable $4,000. In addition, interest
expense of $4,000 will be reported under “other expenses and losses” in the income
statement. If Rocky prepared financial statements monthly, the adjusting entry at the end
of each month would have been &1,000 ($100,000 x 12% x 1/12).

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At maturity (July 1, 2002), Rocky Co. must pay the face value of the note ($100,000) plus
$4,000 interest ($100,000 x 12% x 4/12). The entry to record payment of the note and the
accrued interest is as follows.

July 1 Notes payable 100,000

Interest payable 4,000
Cash 104,000
(To record payment of Githurai National
Bank interest-bearing note and accrued interest at maturity)

Illustration 2:
Assume that on October 1,2002, Sky Company borrows $10,000 cash on a one-year note
with 12% interest payable at the maturity date. The accounting year ends December 31,
and the maturity date of the note is September 30, 2003. This transaction requires the
following accounting and reporting:

Entries during 2002:3 Months oct to Dec.

October 1,2002-Torecord the interest-bearing note at its present value:

Cash 10,000
Note payable 10,000

December31, 2002- Adjusting entry for accrued interest:

Interest expense ($10,000)(0.12)(3/12) 300

Interest payable 300

Reporting at December 31,2002 – Interest-bearing note payable:

Income statement:
Interest expense $300

Balance sheet/SFP:
Current liabilities:
Note payable $10,000
Interest payable 300

Entry at maturity: 9 months jan to sep 2003.

September 30, 2003- payment of face amount plus interest at maturity:

Interest payable..2002 300

Interest expense ($10,000 X0.12X 9/12) 900
Note payable, short-term 10,000
Cash 11,200

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Noninterest-bearing Notes issued (Zero-interest-bearing Note)- discount
The label “noninterest-bearing” is misleading description because such notes do, in fact,
bear interest. The face amount includes both the amount borrowed and interest as a single
amount to be paid back at the maturity date. The borrower receives the difference
between the face amount and the interest on the note. The cash received is the discounted
value of the face amount using the effective interest rate. The difference between the
discounted cash value and the face amount of the note is the interest. The effective
interest rate is determined by reference to market rates for instruments of similar risk
rather than specified on the note.

Illustration 1:
Suppose that on December 11, 2003, XYZ Ltd. discounts at 15% its own $6,000, 60 –
day, noninterest-bearing note payable. The amount of the discount is $150 ($6,000 x 15%
x 60/360 -assume 360 days a year), and the company records the transactions as follows:

Dec. 11 Cash 5,850

Discount on Notes Payable 150
Notes Payable 6,000
(Discounted noninterest-bearing, 60-day note at 15%)

Thus the net liability equals the $5,850 of the cash borrowed ($6,000- $150).

If this company’s accounting period ends on December 31, it needs to recognize 20 days’
interest on this note as an expense of the 2003 accounting period. This amount is $50
[$150 x 20/60]. Therefore the company must make the following adjusting entry on
December 31, 2003:

Dec. 31 Interest expense 50

Discount on notes payable 50
(To record 2003 interest expense)

This adjusting entry records interest expense of $50 in 2003 and removes the same
amount from the discount on notes payable. The $50 then appears on the 2003 income
statement as an expense. The entry also leaves $100 in the discount account until it is
reported as an expense of 2004.

On the December 31, 2003, balance sheet/SFP, the $100 is deducted from the $6,000
nominal balance of the note payable, so that the net liability is shown at the proper
amount of $5,900. If this note is the only one the company has outstanding, the
December 31, 2003, balance sheet/SFP is as follows:

Current liabilities:
Notes payable 6,000
Less discount on note payable 100
(Unamortized discount)
Net liability 5,900

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When the note matures, XYZ Ltd. is required to pay the full-face amount of the note,
$6,000. XYZ Ltd records the payment with this entry:

Feb. 9, 2004 Notes payable 6,000

Cash 6,000
(Paid the discounted note)

In addition, XYZ Ltd. must record the interest expense, as follows:

Feb. 9, 2004 Interest expense ($6000 -5900) 100

Discount on notes payable 100
(To record interest expense)

Illustration 2:
Assume that on October 1, 2001, Goik Ltd. signs an $11,200, one-year, noninterest-
bearing note but receives only $10,000 cash. The effective rate of interest is therefore
12% ($1,200/10,000). The present value of this note is $10,000:
$11,200(PVIF12%,1 year) = $11,200 (0.89286) = $10,000

Accounting entries and reporting

Entries during 2001
October 1, 2001- To record a noninterest-bearing note payable at its gross amount

Cash 10,000
Discount on note payable, short term 1,200
Note payable, short-term 11,200

December 31, 2001- Adjusting entry for accrued interest:

Interest expense (1200 x 3/12) 300
Discount on note payable 300

Reporting at December 31, 2001- Noninterest-bearing note payable:

Income statement:
Interest expense 300

Balance sheet/SFP
Current liabilities:
Note payable 11,200
Less: unamortized discount 900 10,300

Entries at maturity date:

September 30, 2002- payment of the face amount of the note:
Interest expense ($1,200 x 9/12) 900
Note payable 11,200
Discount on note payable 900
Cash 11,200

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Accounting for short-term notes payable having unrealistic stated interest rates
Sometimes a noncash asset is acquired and a note is given with a stated rate of interest
that is less than the current market rate (the effective rate) of interest for the level of risk
involved. When this happens, the stated rate is unrealistic for measuring interest expense.
The correct cost of the asset is the present value of the future cash payments discounted at
the current market rate of interest rather than at the stated interest rate.

Illustration 1:
Assume that a machine is purchased on January 1, 2003, with a one-year, $1,000, 6%
interest-bearing note. The current market rate of interest for obligations with this level of
risk is 12%.

1. Cost of the machine:

($1,000 + $60)( PVIF 12%, 1year) = (1060) (0.89286) = $946.43

2. Entries:

January 1, 2003- acquisition date:

Machine 946.43
Note payable, short-term 946.43

December 31, 2003- payment date:

Note payable, s-tem 946.43

Interest expense (946.43 x 0.12) 113.57
Cash ($1000 + $60) 1,060

The current market interest rate for similar notes with the same risk is used as the
effective rate. If the competitive cash price of the noncash asset received is known, it
could also be used to establish the effective rate of interest.

(c) Unearned Revenues

Cash collected in advance of the delivery of a good or service creates a liability, but it
does not yet qualify for recognition as revenue. Examples of revenues collected in
advance include college tuition, rent, ticket sales and magazine subscriptions. Such
transactions are recorded as a debit to cash and a debit to an appropriately designated
current liability account. This account is often titled unearned revenues.

Subsequently, when the product or service is delivered and the revenue is earned, the
liability account is decreased and the appropriate revenue account is credited. This entry
is typically one of the year-end adjusting entries.

Illustration 1:
Assume that on November 1, 2004, Silib Company collects rent of $6,000 for the next six
months. The accounting period ends December 31. The entries are:

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November 1, 2004- rent collected in advance:
Cash 6,000
Rent revenue collected in advance
(Or unearned rent revenue) 6,000
December 31, 2004- adjusting entry for the portion earned:
Rent revenue collected in advance
(Or unearned rent revenue) 2,000
Rent revenue (6,000 x 2/6) 2,000

The remaining unearned rent revenue of $4,000 is reported as a current liability because
Silib Company has an obligation to provide the space during the following four months.

Illustration 2.
Assume that Kenyatta University sells 10,000 season football tickets at $50 each for its
five-game home schedule. The entry for the sale of season tickets is:

Cash 500,000
Unearned football ticket revenue 500,000
(To record sale of 10,000 season tickets)

As each game is completed, the following entry is made:

Unearned football ticket revenue 500,000

Football ticket revenue 500,000
(To record football ticket revenues earned)

Any balance in an unearned revenue account is reported as a current liability in the

balance sheet. As revenue is earned, a transfer from unearned revenue to earned revenue
occurs.

(d) Dividends Payable

A cash dividend payable is an amount owed by corporation to its stockholders because of
board of directors’ authorization. At the date of declaration, the corporation assumes a
liability that places the stockholders in the position of creditors in the amount of
dividends declared. Because cash dividends are always paid within one year of
declaration, they are classified as current liabilities.

Accumulated but undeclared dividends on cumulative preferred stock are not a

recognized liability because preferred dividends in arrears are not an obligation until the
board of directors authorizing the distribution of earnings takes formal action.
Nevertheless, the amount of cumulative dividends unpaid should be disclosed in a note or
it may be shown parenthetically in the capital stock section.
Dividends payable in the form of additional shares of stock are not recognized as a
liability. Such stock dividends do not require future outlays of assets or services and are
revocable by the board of directors at any time before issuance. Even so, such

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Undistributed stock dividends are generally reported in the stockholders’ equity section
because they represent earnings in the process of transfer to paid-in capital.

(e) Property Taxes Payable

Property taxes based on the assessed value of real and personal property are the primary
source of revenue for most local governments. There are two basic questions in
accounting for property for property taxes:

1. When should the liability for property taxes be recorded on the books of the
taxpayer?
2. When should property tax expense be recognized in the taxpayer’s income
statements?

Two different procedures for accounting for property taxes commonly are found in
practice. Both of these procedures recognize property tax expense over the fiscal year of
the government taxing unit. The two procedures differ with respect to when the liability
for property taxes is recorded. Under the procedure, the property taxes payable account is
credited on the lien date. Under the alternative procedure, property taxes payable are
accrued monthly on the taxpayer’s books during the fiscal year of the government.

Recognition of the entire tax liability on the lien date, which typically precedes the
payment date, results in recording a debit to deferred property tax expense account and a
credit to property tax payable for the unpaid property taxes. The debit to deferred
property tax expense is conceptually troublesome because it implies that unpaid property
taxes are an asset, which, of course, is not the case. On the other hand, accruing property
payable monthly as each month’s property tax expense is recognized avoids recording a
nonexistent asset. Monthly accrual of property taxes payable seems to be preferable and
is illustrated below.

Assume that Jack company’s fiscal year ends on December 31 and that in February Jack
receives its property tax bill for Sh12,000, based on a January 1 assessment. Also assume
that the fiscal year of the government tax unit begins on April 1, which is the lien date for
the property taxes. The property taxes are paid in equal installments on June 1 and
August 1.

If property taxes are accrued monthly, the following entry is made at the end of both
April and May, which are first two months of the property tax year:

Property tax expense 1,000

Property taxes payable 1,000

When the first Sh6000 payment is made on June 1, the following entry is made:

Property tax expense 2,000

Deferred property tax expense 4,000
Cash 6,000

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An asset account, deferred property tax expense, is debited for the excess of the cash
payment over the amount of property taxes payable that were accrued by June 1.
On June 30 and July 31, property tax expense for June and July is recorded with the
entry:

Property tax expense 1,000

Deferred property tax expense 1,000

(f) Bonuses Payable

Bonus payable is another current liability that depends on the company’s results. If
bonuses are based on revenues on units of output, they will be calculated by multiplying
the bonus factor (say one cent per unit of output or per shilling of revenue).

Bonus plans may be formulated in a variety of ways:

Income before bonus expense and before income taxes ( B = b I)

Income after bonus expense but before income taxes [ B = b (I - B ) ]
Income after income taxes but before bonus expense [ B = b (I - T)
Income after bonus expense but after income taxes [ B = b (I - B - T)

Where b = the bonus rate

I = income before bonus and taxes
B = bonus payable
T = taxes payable

Because bonus in a tax allowable expense, T = t(I – B), where t = tax rate.

Example:
Assume that Marufurufu Mingi company operates a bonus plan for its employees based
on income after tax but before bonus expense. Taxes payable is Sh100,000 and the bonus
rate is 2 percent. The tax rate is 30 percent.

Solution
Steps:
1. Construct an equation for the company’s bonus plan
2. Construct an equation for calculating income taxes
3. Substitute known data in the equation and solve unknown
variables Therefore,
B = b(I-T), where T = t(I-B)

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 B = b[I-t(I-B)]
= 0.2[Sh100,000 – 0.3(Sh100,000-B)]
= 0.2(Sh100,000 – Sh30,000 + 0.3B)
= Sh2,000 –
Sh600 + 0.006B
0.994B = Sh1,400
B = Sh1,408.45

The journal entries would be:

Bonus expense 1,408.45
Bonus payable 1,408.45

The bonus expense should appear on the income statement as a

combination with salaries and wages. Bonus payable will be shown on
the balance sheet among the current liabilities.

Review problem
On august 1 2005, McKentany Ltd. (a company that records adjusting
entries only once per year) issued bonds with the following characteristics:
1. Sh.50,000 total face value.
2. 12% stated rate.
3. 16% yield rate.
4. Interest dates are February 1, May 1, August 1, and November 1.
5. Bond date is October 31, 2004.
6. Maturity date is November 1, 2009.
7. Sh.1,000 of bond issue costs were incurred.

Required:
1. Provide all entries required for the bond issue through February 1,
2006, for McKentany using the interest method.
2. On June 1, 2007, McKentany retired Sh.20, 000 of bonds at 98
through open market purchase. Provide the entries to update the bond
issue and to retire the bonds using the interest method.

3. Provide the entries required on August 1, 2007, under the

following methods of discount amortization:
a. Interest method
b. Straight-line method

Solution

1/8/2005- issue bonds and incur issue costs:

Bonds issue cost 1,000
Cash 1,000

Cash 43,917

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 Discount on bonds payable 6,083
Bonds payable 50,000
(50,000 x PVI, 4%,17) + (0.03 x 50,000 x PVA, 4%,17) = 43,917

1/11/2005- interest payment date:

Interest expense 1,757
Discount on bonds payable 257
Cash 1,500
Bonds issue expense 59
Bonds issue cost 59
(1,757 = 43,917*.04.) (1,500 = 50,000*0.03) (59 = 1000/17)

1/12/2005- adjusting entry:

Interest expense 1,178

Discount on bonds payable 178
Interest payable 1,000
Bonds issue expense 39
Bonds issue cost 39
(1,178 = 43,917+257)*0.04*2/3) (1,000 = 1,500*2/3) (39 =

59*2/3) 1/2/2006
Interest expense 589
Interest payable 1,000
Discount on bonds payable 89
Cash 1,500
Bonds issue expense 20
Bonds issue cost 20
(589 = (43,917 + 257)*0.04*1/3) (20 = 59*1/3)
On May 1, 2007, the remaining term of the bond is two and one-half
years, or 10 quarters, and the Sh.20,000 of bonds to be retired have the
following value:
Sh.18,378 = Sh.20,000*PVI, 4%,10 + (Sh.20,000*0.03*PVA, 4%,10)

On May 1, 2007, the remaining discount on the portion of the bonds to

be retired is therefore Sh.1,622 (Sh.20,000-Sh.18,378).

1/6/2007- update relevant bond accounts before retirement:

Interest expense 245
Discount on bonds payable 45
Cash 200
Bonds issue expense 8
Bonds issue cost 8

1/6/2007- removes relevant bond accounts:

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 Bonds payable 20,000
Extraordinary loss, bond extinguishment 1,404
Discount on bonds payable 1,577
Bonds issue cost 227
Cash (0.98*Sh.20,000) 19,600

Sh.245 = 18,378*0.04*1/3; Sh.200 = 20,000*0.03*1/3; Sh.8 =

1,000*1/17/1/3*0.4;
Sh.1,577 = 1,622-45

3. On may 1, 2007, the remaining term of the bonds is two and one-
half years, or 10 quarters, and the remaining Sh.30,000 of bonds have
the following book value:

Sh.27,567 = Sh.30,000*PVI,4%,10 + Sh.30,000*PVA,4%,10.

On May 1, 2007, the remaining discount is therefore Sh.2,433
(Sh.30,000 - Sh.27,567).
a. 1/8/2007- interest payment date.

Interest expense 1,103

Discount on bonds payable 203
Cash 900
Bonds issue expense 35
Bonds issue cost 35
Sh.1,103 = Sh.27,567*0.04; Sh.900 = Sh.30,000*.03; Sh.35 = 0.60*1,000/17.

b. Under SL method, the discount is amortized

Sh.358*6,083/17 per quarter on the entire bond issue.

1/8/2007- interest payment date:

Interest expense 1,115
Discount on bonds payable 215
Cash 900
Bonds issue expense 35
Bonds issue cost 35
Sh.215 = 358*0.6

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