Managing Current Liabilities

Topics: Generally Accepted Accounting Principles, Liability, Balance sheet Pages: 7 (2577 words) Published: June 30, 2012

Managing Current Liabilities:
The Great Balancing Act

One of the most crucial steps in running a major corporation is ensuring that the balance sheet truly reflects the viability of the company. If investors feel that a firm holds too much debt reflecting in poor financial ratios, their stock price may become depressed resulting in angry shareholders. Therefore, why do companies engage in leveraging activities and worry about contingencies? There are many reasons for this and some of these reasons will be outlined in the context of this paper. This paper will attempt to address what exactly is a liability, the different forms it takes, the reasons behind using leveraging techniques, and the impact on financial statements. As the title suggest, it is a balancing act between liabilities and the viability of a company. Too much in liability, especially in the form of debt instruments, could result in having a poor rating by one of the rating agencies that could result in higher borrowing costs. Rating agencies are unbiased firms that analyze companies’ debt and create rating systems that are “designed to indicate the risk associated with a particular security (Mayo, 1997).” In accounting, the term liability signifies an obligation due to another party. A liability is defined as: “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions of events” (Spiceland, Sepe, Tomassini, 2007). Generally Accepted Accounting Principles (GAAP) requires very organized and specific standards when recognizing data. In a classified balance sheet, one way liabilities are managed is by dividing them into two different groups: current and non-current liabilities. A simple definition to describe a current liability is an obligation a company intends to satisfy within a year, or within the operating cycle (whichever is longer). However, a more accurate definition classifies a current liability as an obligation a company intends to satisfy with current assets or with other current liabilities. Although, there are many different types of current liabilities, the most frequent accounts are: accounts payable, notes payable, unearned revenue, commercial paper, income tax liability, dividends payable, accrued liabilities, and the current maturity of long-term debt. One exception to this rule, however, is if a firm has a liability that is due within a year, but intends to refinance it and extend the due date past the year (or operating cycle); this would not be considered a current liability but rather a non-current liability. In the context of this paper, we will focus on notes payable and commercial paper. One example of a current liability, as mentioned before, is called a note. Two of the most common forms of notes that companies engage in are bank loans and lines of credit. Both of these notes are a liability (notes payable) to the borrowing entity and an asset (notes receivable) to the lending entity. In either of these situations, interest is either earned by the lender or paid by the borrower. When a company borrows money from a financial institution, the entity will enter into a loan agreement or promissory note (Spiceland et al., 2011). This promissory note will indicate the terms of the loan such as interest rates and maturity dates. Interest is the amount of money the borrower must pay for the use of the lender’s money. Because notes can be issued for extended periods, interest may be due periodically. Interest is typically calculated by “multiplying the outstanding balance by the annual interest rate by the time to maturity” (Spiceland et al., 2011 p. 695). The first type of note that will be examined is a bank loan. Suppose a company decides to purchase a thirty million dollar asset. In most cases, the...
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