Image Alt Text

What are Current Liabilities? – Definition and Example

Try QuickBooks Invoicing & Accounting Software – 30 Days Free Trial 

What are Current Liabilities?

Current liabilities are the obligations of a business due within one operating cycle or a year(whichever is greater). Here, operating cycle means the time it takes to buy or produce inventory, sell the finished products and collect cash for the same.

Now, there are certain capital intensive industries having an operating cycle of more than a year. For instance, companies in liquor and tobacco industries have operating cycles that exceed a year. On the other hand, there are many service and retail businesses having more than two operating cycles within a year.

Furthermore, current liabilities are the obligations that are terminated either by using current assets or creating other current liabilities.

Current Liabilities Example

Following is the balance sheet of Nestle India as on December 31, 2018. Thus, the balance sheet displays current assets, current liabilities, fixed assets, long term debt and capital.

Balance sheet of Nestle India showing what are Current assets

Current Liabilities List

Current Liabilities include:

  • Accounts Payable
  • Notes Payable
  • Current Portion of Long Term Debt
  • Accrued Liabilities
  • Unearned Revenues

1. Accounts Payable

Accounts payable are known as trade payables. These payables are the amounts that a business owes to its suppliers for goods or services purchased on credit. Thus, these amounts arise on account of time difference between receipt of services or acquisition to title of goods and payment for such supplies. And the time period for which such a credit is extended to business typically ranges between 30 – 60 days.

Now, accounts payable are presented under the current liabilities section of the balance sheet. Thus, a business is able to understand the credit challenges faced by a business with its suppliers. This is done by analyzing the accounts payable in relation to the purchases made by an entity.

So, the accounts payable account is credited with the mount of such purchases made once an entity makes a credit purchase. Hence, the creditors ledger accounts have to closed in books of accounts once the payments against such accounts payable are made. This reduces the bills payable balance in the balance sheet.

Nestle Case

Nestle’s trade payables for the year ended December 31, 2018 stood at Rs. 12,403.70 Million. Thus, the company improved on its trade payables as per the annual report. This further resulted in improved net trade working capital.

2. Notes Payable

Notes payable are nothing but the obligation of a company in the form of promissory notes that it owes to its lenders. These are written promises that a company would pay a specific some of money on a particular future date to its creditors. These notes payables arise on account of purchases, financing or other transactions undertaken by a firm.

Furthermore, notes payable can be categorized as short or long term depending upon their maturity period. Thus, notes payable with maturity period of greater than one year are reported as non – current liabilities. Whereas, notes payable with a maturity period of less than a year are represented under current liabilities in balance sheet.

Additionally, notes payable may further be of two types:

Interest Bearing Notes

These represent funds given by lenders to borrowers on which interest accumulates as per the terms of the agreement. The face of such notes payable represents the amount borrowed, maturity along with annual interest to be paid. This interest rate is usually stated as an annual percentage.

Zero Interest Bearing Notes

These notes do not specifically mention the rate of interest on the face of note. However, interest is still charged from the borrower. The borrower, pays the lender an amount on date of maturity. This amount is greater than the cash received by him on the date of issue of such a note.

This means the borrower receives the present value of note in cash. This value is nothing but the face value of note at maturity less the interest charged by the lender for such a note. That is to say that the bank charges a fee in advance rather than charging the same on the date on which such a note matures.

3. Current Portion of Long Term Debt

This refers to the principal amount of debt that is due within one year or one operating cycle (whichever is greater). This long term debt may include bonds, mortgage notes and other long term debts. The balance amount remaining, after considering the current portion of long term debt, is reported as long term debt in the balance sheet.

However, the current portion of long term debt should not be considered as current liability if such a debt is:

  • is paid off using assets accumulated for such a purpose. Provided such assets have not been clearly represented as current assets.
  • refinanced from the amount received by availing new debt
  • transformed into capital stock

This is so because in such situations there is no use of current assets or creation of current liabilities. Thus classifying such current portion of long term debt is not valid. So, to utilize such a debt, a footnote needs to given below financial statements that clearly states such a liability as a current liability.

Liability Due On Demand

Furthermore, there might be situations when a liability is due on demand i.e. callable by a creditor within a year or an operating cycle (whichever is greater). This debt needs to be classified as a current liability. Now, a liability becomes due on demand or callable by creditor when the borrower violates the loan agreement. Say, for instance, a borrower is unable to maintain a given level debt to equity or working capital. Then such a loan agreement stands violated. Due to such a violation, the debt needs to be classified as current liability. This is so because the creditors expect that the existing working capital will be used to pay off such a debt.

However, a liability can also be classified as non – current. This is possible if the borrower proclaims that the violation would be made good within the grace period mentioned in the loan agreement.

4. Accrued Liabilities

Accrued liabilities are also known as accrued expenses. These are the expenses that a business incurs or recognizes in its income statement but are not contractually due.

Thus, the business must recognize such an expense for the benefit received. Although, the cash for such an expense is yet to be paid. These liabilities are the outcome of accrual method of accounting. Under this method, the expenses are recognized as and when they are incurred. This concept relates to the timing and matching principles of accounting.

Say for instance, Kapoor Pvt Ltd is required to pay interest annually of Rs. 1,00,000 on an outstanding bank loan. So, Kapoor Pvt Ltd would recognize Rs. 25,000 out of the total interest expense in its income statement at the end of March 2018. Furthermore, the company will increase the accrued liability of the same amount in its balance sheet. Now, Kapoor Pvt Ltd will stay show the same in its books of accounts although this liability is not actually due until the end of the year.

Examples of accrued liabilities include:

  • Salary and benefits recognized in the appropriate period but actually paid when such a period ends
  • Taxes payable recognized in the income statement but not yet paid
  • Interest payable on loans recognized in the income statement but to be paid on the future date

5. Unearned Revenues

Unearned revenues are also known as unearned income, deferred revenue or deferred income. These revenues refer to the cash collected by a business in advance of providing goods and services. This means that the business receives money for goods or services it is yet to supply.

Hence, this revenue can be thought of as an advance payment of goods or services that a business is expected to produce or supply to the customer. Thus, the seller has a liability equal to an amount of revenue generated in advance till the time actual delivery is made. This is due to the advance payment.

Therefore, cash on the asset side and unearned revenue on the liability side of the balance sheet increase by the same amount on account of advance payment.