Page 380 - Accounting Principles (A Business Perspective)

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firms), and single proprietorships (corner grocery stores) all have one thing in common—they have liabilities. The
next section discusses some of the current liabilities companies incur.

Current liabilities
Liabilities result from some past transaction and are obligations to pay cash, provide services, or deliver goods

at some future time. This definition includes each of the liabilities discussed in previous chapters and the new
liabilities presented in this chapter. The balance sheet divides liabilities into current liabilities and long-term
liabilities. Current liabilities are obligations that (1) are payable within one year or one operating cycle,
whichever is longer, or (2) will be paid out of current assets or create other current liabilities. Long-term
liabilities are obligations that do not qualify as current liabilities. This chapter focuses on current liabilities and
Chapter 15 describes long-term liabilities.
Note the definition of a current liability uses the term operating cycle. An operating cycle (or cash cycle) is the
time it takes to begin with cash, buy necessary items to produce revenues (such as materials, supplies, labor, and/or
finished goods), sell goods or services, and receive cash by collecting the resulting receivables. For most companies,

this period is no longer than a few months. Service companies generally have the shortest operating cycle, since
they have no cash tied up in inventory. Manufacturing companies generally have the longest cycle because their
cash is tied up in inventory accounts and in accounts receivable before coming back. Even for manufacturing
companies, the cycle is generally less than one year. Thus, as a practical matter, current liabilities are due in one
year or less, and long-term liabilities are due after one year from the balance sheet date.
The operating cycles for various businesses follow:
Type of Business Operating Cycle
Service company selling for cash only Instantaneous
Service company selling on credit Cash -> Accounts Receivable -> Cash
Merchandising company selling for cash Cash -> Inventory -> Cash
Merchandising company selling on credit Cash -> Inventory -> Accounts receivable -> Cash
Manufacturing company selling for cash Cash -> Materials inventory -> Work in process
inventory -> Finished goods inventory ->
Accounts Receivable -> Cash
Current liabilities fall into these three groups:
• Clearly determinable liabilities. The existence of the liability and its amount are certain. Examples
include most of the liabilities discussed previously, such as accounts payable, notes payable, interest payable,
unearned delivery fees, and wages payable. Sales tax payable, federal excise tax payable, current portions of
long-term debt, and payroll liabilities are other examples.
• Estimated liabilities. The existence of the liability is certain, but its amount only can be estimated. An
example is estimated product warranty payable.

• Contingent liabilities. The existence of the liability is uncertain and usually the amount is uncertain
because contingent liabilities depend (or are contingent) on some future event occurring or not occurring.
Examples include liabilities arising from lawsuits, discounted notes receivable, income tax disputes, penalties
that may be assessed because of some past action, and failure of another party to pay a debt that a company
has guaranteed.
The following table summarizes the characteristics of current liabilities:
Is the Is the
Existence Amount
Type of Liability Certain? Certain?
Clearly determinable liabilities Yes Yes

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