Current liabilities are the enterprise’s short-term financial obligations that are due within one year or within a normal operating cycle.
These are short term obligations likely to be met by current assets. The operating cycle is also generally known as the cash conversion cycle. This cycle starts with sales to the conversion of cash receipts.
In-depth, it starts from the purchases of raw materials to the conversion of cash from sales. Current liabilities are settled using current assets, which are assets that are to be used up within one year.
Current assets include cash or accounts receivable and other cash equivalents which are received as a result of sales. Examples of current liabilities include:
- Outstanding account payable
- The balance of short-term debt such as bank loans or commercial paper issued to fund operations
- The balance of dividends payable
- Notes payable—the principal portion of outstanding debt
- Current portion of deferred revenue that recognise in the balance sheet, such as prepayments by customers for work not completed or earned yet
Accounts payable form the largest portion of the current liability section on the company’s financial statements. It represents the purchases that are unpaid by the enterprise.
In the cash conversion cycle, companies match the payment dates with accounts receivables making sure that receipts are made before making the payments to the suppliers.
Lower the accounts payable days the better. It reflects that the company is able to realize the cash in good fashion.
An example would be: The Bold Fashions Ltd bought textile garments from Sri Textile traders as raw materials on credit. The Bold Fashions here got the inventory as a current asset while creating a short-term obligation on the other hand.
Accounting treatment in Financial Statements
Accounts payable fall under current liabilities section which falls under liabilities part of the Balance sheet as shown below:
|Liabilities and capital||Amount ($)||Assets||Amount ($)|
|Shareholders’ equity||X||Non – current Assets||X|
|Other current Liabilities||X|
Why are accounts payable a current Liability?
When the company determines the economic benefits must be paid within a year, it should immediately record credit entry for current liability.
Reflecting on the circumstances of the received benefit, the accountants shall classify it as either asset or expense, that assumes the debit side of the entry. As the credit side is emphasized, it is a current liability.
The nature of accounts payable is short term obligation. The company is generally expected to pay for the purchases within 30-180 days in the general business scenario.
When the accounts payable age is greater than 180 days, serious doubts arise on the liquidity and stability of the company to meet its short-term obligations.
The common characteristics below conclude why accounts payable is within current liability:
- Both are short term obligations to meet within the year.
- Accounts payable is a subset of current liability.
- The significant portion of working capital requires the management of accounts receivable and accounts payable, both contributing to a healthy cash conversion cycle and so does current liabilities as a whole.
- Both accounts payable and current liabilities are the results of a past transaction that obligates the entity.