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13.1 The Basic Reporting of Liabilities
At the end of this section students should be able to meet the following objectives:
- Define a liability by listing its essential characteristics.
- Differentiate a current liability from a noncurrent liability.
- Explain the significance that current liabilities have for investors and creditors who are studying the financial health and future prospects of an organization.
- Compute the current ratio.
- Identify the appropriate timing for the recognition of a liability.
Current and Noncurrent Liabilities
Question: The June 30, 2011, consolidated balance sheet for The Procter & Gamble Company reports total liabilitiesProbable future sacrifices of economic benefits arising from present obligations; the debts of an organization. of over $70 billion, including current liabilities of approximately $27 billion. In contrast, the business held only $2.8 billion in cash and cash equivalents.
For reporting purposes, Procter & Gamble divided its current liabilitiesDebts that will be satisfied within one year from the date of a balance sheet. into several specific categories:
- Accounts payable ($8.0 billion)
- Accrued and other liabilities ($9.3 billion)
- Debt due within one year ($10.0 billion)
When creating a balance sheet, what is reported as a liability? Why are some of these liabilities shown as current whereas others are not? How does an accountant draw a distinction between liabilities that are labeled as current and those that are reported as noncurrent?
Answer: A liability is an obligation owed to a party outside the reporting organization—a debt that can be stated in monetary terms. Liabilities normally require the payment of cash but might at times be settled by the conveyance of other assets or the delivery of services. Some reported liabilities are for definite amounts, although a significant number are no more than estimations.
The distinction between current and noncurrent liabilitiesDebts that will not be satisfied within one year from the date of a balance sheet. is a function of time. A debt that is expected to be satisfied within one year from the balance sheet date is normally classified as a current liability.In upper-level accounting courses, the definition of a current liability is refined a bit. It refers to any liability that will require the use of a current asset or the creation of another current liability. However, the one-year standard presented in this textbook is sufficient in a vast majority of cases. Amounts owed for rent, insurance, utilities, inventory purchases, and the like usually fall into this category. If payment will not be made until after that one-year interval, the liability is reported as noncurrent. Bonds and notes payable are common examples of noncurrent debts as are liabilities for employee pensions, long-term leases, and deferred income taxes. Current liabilities are listed before noncurrent liabilities on a balance sheet.
The Importance of Information about Liabilities
Question: Figure 13.1 "Liability Section of Balance Sheet, Johnson & Johnson as of January 2, 2011" is the liability section of the balance sheet reported by Johnson & Johnson as of January 2, 2011. Note that additional information about many of these liabilities is available in the notes to the company’s financial statements.
Figure 13.1 Liability Section of Balance Sheet, Johnson & Johnson as of January 2, 2011
Investors and creditors (and other interested parties) who analyze an organization such as Johnson & Johnson usually spend considerable time studying the data that is provided about liabilities, often focusing on current liabilities. Why is information about liabilities, especially the size and composition of current liabilities, considered so important when assessing the financial position and economic health of a business?
Answer: Liabilities represent claims to a company’s assets. Debts must be paid as they come due or the entity risks serious consequences. Missed payments might damage a company’s ability to obtain additional credit in the future. Unfortunately, even bankruptcy can quickly become a possibility if obligations are not met.
To stay viable, organizations have to manage their liabilities carefully. They must be able to generate sufficient cash on an ongoing basis to meet all required payments. Virtually no other goal can be more important, both to company officials and external decision makers.
In general, the larger a liability total is in comparison to the reported amount of assets, the riskier the financial position. The future is always cloudy for a business when the size of its debts begins to approach the total of its assets. The amount reported as current liabilities is especially significant because those debts must be satisfied in the near future. Cash has to be available quickly, often within weeks or months.
Not surprisingly, decision makers become concerned when the reported total for current liabilities is high in comparison with current assets. The essential question is obvious: will the organization be able to meet those obligations as they come due? In a newspaper account about the financial difficulties of Advanced Cell Technology, the following warning was issued: “It reported $17 million in current liabilities, but only $1 million in cash and other current assets, an indication it could be forced to file for bankruptcy protection.”Todd Wallack, “Fame-courting biotech running short of cash,” The Boston Globe, July 17, 2008, A-1.
As mentioned in an earlier chapter, one vital sign monitored by decision makers in judging the present level of risk posed by a company’s liability requirements is the current ratioFormula measuring an organization’s liquidity (the ability to pay debts as they come due); calculated by dividing current assets by current liabilities.: current assets divided by current liabilities. The current ratio is a simple benchmark that can be easily computed using available balance sheet information. Although many theories exist as to an appropriate standard, any current ratio below 1.00 to 1.00 signals that the company’s current liabilities exceed its current assets. Figure 13.2 "Sample of Recent Current Ratios as of January 29, 2011" presents recent current ratios for three well-known companies: Target, Dillard’s, and Aeropostale.
Figure 13.2 Sample of Recent Current Ratios as of January 29, 2011
The Petersen Company currently holds $500,000 in current assets and $200,000 in current liabilities. The company borrows $60,000 cash. However, a question arises as to whether this debt is a current or noncurrent liability. Which of the following statements is true?
- If the liability is noncurrent, the transaction has no impact on the current ratio.
- If the liability is noncurrent, the transaction causes the current ratio to increase.
- If the liability is current, the transaction has no impact on the current ratio.
- If the liability is current, the transaction causes the current ratio to increase.
The correct answer is choice b: If the liability is noncurrent, the transaction causes the current ratio to increase.
If the liability incurred here is noncurrent, the transaction causes current assets to go up by $60,000, but there is no change in current liabilities. Thus, the current ratio (current assets divided by current liabilities) will be higher. If the liability is current, the transaction causes both the current asset total and the current liability total to increase by $60,000. The current ratio is no longer 2.50 to 1.00 ($500,000/$200,000) but will fall to 2.15 to 1.00 ($560,000/$260,000).
Characteristics of a Liability
Question: In the real world of business, organizations are not inclined to report more liabilities than necessary because of potential damage to the image being portrayed. The inclusion of debts usually makes a company look riskier to creditors and investors. Thus, the danger that officials will report an excessive amount of liabilities seems slight. Balance sheets look better to decision makers if fewer obligations are present to drain off financial resources. Consequently, where possible, officials probably have a tendency to limit the debts that are reported. At what point does an entity have to recognize a liability? How does U.S. GAAP ensure that all liabilities are appropriately included on a balance sheet?
Answer: FASB Statement of Financial Accounting Concepts No. 6 defines many of the elements found in a set of financial statements. According to this guideline, a liability should be recognized when all of the following characteristics exist:
- There is a probable future sacrifice
- This sacrifice involves the reporting entity’s assets or services.
- The sacrifice arises from a present obligation that is the result of a past transaction or event.
To understand the reporting of liabilities, several aspects of these characteristics are especially important to note. First, the obligation does not have to be absolute before recognition is required. A future sacrifice only has to be “probable.” This standard leaves open a degree of uncertainty. As might be expected, determination as to whether a potential payment is probable or not can be a point of close scrutiny when independent CPAs audit a set of financial statements. The line between “probable” and “not quite probable” is hardly an easily defined benchmark.
Second, for reporting to be required, a debt must result from a past transaction or event.
- An employee works for a company and is owed a salary. The work previously performed is the past event that creates the obligation.
- A vendor delivers merchandise to a business. Receipt of these purchased goods is the past event that creates the obligation.
Third, the past transaction or event must create a present obligation. In other words, an actual debt must exist and not just a potential debt. Ordering a piece of equipment is a past event but, in most cases, no liability has yet been incurred. In contrast, the delivery of this equipment probably does obligate the buyer and, thus, necessitates the reporting of a debt. Often, in deciding whether a liability should be recognized, the accountant must address two key questions: what event actually obligates the company, and when did that event occur?
Determining all of the liabilities to be included on a balance sheet often takes considerable thought and analysis. Accountants for the reporting company produce a list of debts that meet the characteristics listed above. The independent auditor then spends considerable time and energy searching for any other obligations that might have been omitted, either accidentally or on purpose.
Because of the negative impact on the information being reported, companies prefer not to include liabilities. An excessive debt load, especially in regard to current liabilities, makes a company’s financial affairs appear riskier. Current liabilities typically are those debts that must be satisfied within one year from the balance sheet date. Because a company must be able to meet these debts as they come due, analysts pay close attention to this total. For the same reason, the current ratio (current assets divided by current liabilities) is also watched closely as a sign of financial strength. To prevent misleading financial statements, U.S. GAAP has established guidelines to help ensure the proper inclusion of liabilities. When specified characteristics are met, a liability must be reported. Thus, a liability must be reported to reflect a probable future sacrifice of an entity’s assets or services arising from a present obligation that is the result of a past transaction or event.