Unearned Revenues

UNDERLYING CONCEPTS

To determine the appropriate classification of specific financial instruments, companies need proper definitions of assets, liabilities, and equities. They often use the conceptual framework definitions as the basis for resolving controversial classification issues.

Because liabilities involve future disbursements of assets or services, one of their most important features is the date on which they are payable. A company must satisfy currently maturing obligations in the ordinary course of business to continue operating. Liabilities with a more distant due date do not, as a rule, represent a claim on the company’s current resources. They are therefore in a slightly different category. This feature gives rise to the basic division of liabilities into (1) current liabilities and (2) long-term debt.

Recall that current assets are cash or other assets that companies reasonably expect to convert into cash, sell, or consume in operations within a single operating cycle or within a year (if completing more than one cycle each year). Current liabilities are “obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets, or the creation of other current liabilities.” [2] This definition has gained wide acceptance because it recognizes operating cycles of varying lengths in different industries. This definition also considers the important relationship between current assets and current liabilities. [3]

The operating cycle is the period of time elapsing between the acquisition of goods and services involved in the manufacturing process and the final cash realization resulting from sales and subsequent collections. Industries that manufacture products requiring an aging process, and certain capital-intensive industries, have an operating cycle of considerably more than one year. On the other hand, most retail and service establishments have several operating cycles within a year.

See the FASB Codification References (pages 708–709).

Here are some typical current liabilities:

  1. Accounts payable.
  2. Notes payable.
  3. Dividends payable.
  4. Customer advances and deposits.
  5. Unearned revenues.
  6. Sales taxes payable.
  7. Income taxes payable.
  8. Employee-related liabilities.
  9. Current maturities of long-term debt.
  10. Short-term obligations expected to be refinanced.

Accounts Payable

Accounts payable, or trade accounts payable, are balances owed to others for goods, supplies, or services purchased on open account. Accounts payable arise because of the time lag between the receipt of services or acquisition of assets and the payment for them. The terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually state this period of extended credit, commonly 30 to 60 days.

Most companies record liabilities for purchases of goods upon receipt of the goods. If control has passed to the purchaser before receipt of the goods, the purchaser should record the transaction at the time of transfer of control. A company must pay special attention to transactions occurring near the end of one accounting period and at the beginning of the next. It needs to ascertain that the record of goods received (the inventory) agrees with the liability (accounts payable), and that it records both in the proper period.

Measuring the amount of an account payable poses no particular difficulty. The invoice received from the creditor specifies the due date and the exact outlay in money that is necessary to settle the account. The only calculation that may be necessary concerns the amount of cash discount. See Chapter 8 for illustrations of entries related to accounts payable and purchase discounts.

Notes Payable

Notes payable are written promises to pay a certain sum of money on a specified future date. They may arise from purchases, financing, or other transactions. Some industries require notes (often referred to as trade notes payable) as part of the sales/purchases transaction in lieu of the normal extension of open account credit. Notes payable to banks or loan companies generally arise from cash loans. Companies classify notes as short-term or long-term, depending on the payment due date. Notes may also be interest-bearing or zero-interest-bearing.

Interest-Bearing Note Issued

Assume that Castle National Bank agrees to lend $100,000 on March 1, 2017, to Landscape Co. if Landscape signs a $100,000, 6 percent, four-month note. Landscape records the cash received on March 1 as follows.

March 1
Cash 100,000
  Notes Payable 100,000
    (To record issuance of 6%, 4-month note to Castle National Bank)

If Landscape prepares financial statements semiannually, it makes the adjusting entry on page 662 to recognize interest expense and interest payable of $2,000 ($100,000×6%×4/12)$2,000 ($100,000×6%×4/12) at June 30.

June 30
Interest Expense 2,000
  Interest Payable 2,000
    (To accrue interest for 4 months on Castle National Bank note)

If Landscape prepares financial statements monthly, its adjusting entry at the end of each month is $500 ($100,000×6%×1/12)$500 ($100,000×6%×1/12).

At maturity (July 1), Landscape must pay the face value of the note ($100,000) plus $2,000 interest ($100,000×6%×4/12)($100,000) plus $2,000 interest ($100,000×6%×4/12). Landscape records payment of the note and accrued interest as follows.

July 1
Notes Payable 100,000
Interest Payable   2,000
  Cash 102,000
    (To record payment of Castle National Bank interest-bearing note and accrued interest at maturity)
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