Current Liabilities Essay Sample
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Current Liabilities Essay Sample
Current liabilities are defined as: “Debts due to be paid with cash or with goods and services within one year, or within the entity’s operating cycle if the cycle is longer than a year.” (Hongren, Harrison & Oliver, 2012) These liabilities fit into three categories: Current liabilities of known amount; current liabilities that must be estimated; and contingent liabilities. According to the matching principle of accounting, expenses and revenues need to be reported during the same period that they are earned. This can be difficult if the exact amounts are not known. This is the purpose behind estimated and contingent liabilities. In order to provide accurate financial reports companies must record revenues and their associated expenses during the same period so that assets are not overstated and liabilities are not understated. It is imperative that the financial reports are as accurate as possible because decision makers use them to determine the course of action that businesses are to take.(Davis, 2011)
With the accuracy of the reports in mind, the Financial Accounting Standards Board (FASB) has formulated the Generally Accepted Accounting Principles (GAAP) which are procedures and guidelines that “ govern how accounts measure, process, and communicate financial information.” (Hongren et al., 2012) There are many types of current liabilities that have known amounts. Some examples are: payroll expenses, notes payable, and accounts payable. These are some of the most common liabilities that businesses incur. Payroll expenses are the expenses that a company pays to employees including salary, wages and benefits. These expenses are easily calculated and can be predetermined and accounted for ahead of time. Notes payable is the expense that a company pays toward loans. This usually includes interest which must be calculated as well as penalties or discounts for late or early payment. Accounts payable consists of short term credit arrangements such as when supplies are purchased on account and paid for on a monthly basis rather than at the time of purchase. All of these liabilities are of known amounts and must be recorded as liabilities until the point in time when they are paid. Some liabilities, however, have amounts that are not known and must be estimated. One liability that the amount must be estimated is associated with warranties.
Many companies offer warranty coverage of their products. It is important for the potential warranty expenses to be calculated in the same period as the products are sold. This expense is usually estimated as a percentage of sales revenue based on historical data relating to warranty claims. In accordance with the matching principle and GAAP standards, the revenue and warranty expense must be recorded within the same reporting period. This is the only way to ensure that revenues are not overstated and liabilities are not overstated. In this way the financial health of a company can be accurately assessed. Contingent liabilities are another type of liability that must be estimated. Contingent liabilities are potential liabilities that are contingent upon certain circumstances. They are only potentially liabilities, however, they must still be recorded as such in accordance with the matching principle. One example of a contingent liability is a pending lawsuit. If the lawsuit is lost then the company will need to pay, therefore the money must be thought of as already spent until the lawsuit is final. Another example of a contingent liability occurs when one company cosigns on a note for another.
If the second company defaults on the loan then the first company will have to pay. Therefore the money must be recorded as a liability until the note is paid off. There are many different types of liabilities, all of which must be recorded properly in order for a business’ financial statements to accurately reflect its financial wherewithal. Some liabilities have known values while others must be estimated and still others are contingent upon certain courses of events. Regardless of whether or not the amount of a liability is known, it must still be recorded in the same period as the associated revenue is earned. In order to comply with GAAP standards the matching principle must be strictly adhered to in all circumstances. By complying with GAAP standards and the matching principle financial statements will be accurately represented and decision makers will be as informed as possible when deciding what course of action a business should take.
Horngren, C., Harrison W. &Oliver, M. (2012). Accounting (9th ed.). Upper Saddle River, NJ: Pearson Prentice Hall.
Davis, J. (2011). Determining the Appropriate Debt Structure. The RMA Journal, 93(9), 40-44, 11. Retrieved March 10, 2012, from ABI/INFORM Global.