Chapter 11—Accounting for Current Liabilities



LECTURE NOTES—Accounting for Current Liabilities

Chapter Objectives:

Explain a current liability, and identify the major types of current liabilities.

Describe the accounting for notes payable.

Explain the accounting for other current liabilities.

Explain the financial statement presentation and analysis of current liabilities.

Describe the accounting and disclosure requirements for contingent liabilities.

Compute and record the payroll for a pay period.

Describe and record employer payroll taxes.

Discuss the objectives of internal control for payroll.

I. Introduction: Current Liabilities are debts:

A. 2 Key Features:

1. It can reasonably be expected to be paid from existing current assets or through the creation of other current liabilities; and

2. It will be paid within one year or the operating cycle, whichever is longer.

B. Types of Current Liabilities:

1. NOTES PAYABLE—INTEREST BEARING NOTES: Promissory Notes are written promises to pay a sum of money at a definite time in the future. Notes give the creditor more legal security than open accounts. Notes payable arise when money is borrowed.   Interest expense (the charge for credit the company will pay for the cost of borrowing) is a nonoperating expense and will be located in the Other Expense section on the Income Statement. The use of credit plays a major role in our nation's economy.

a) Credit: The allowance of cash, goods, or services in the present, with payment expected in the future.

b) Interest (I): the charge for credit and appears on the Income Statement; calculated as principal (P) or face amount of the note x annual rate (R) x time (T). Calculating Interest on a Note:  I = P x R x T (since the quoted rate given for a note is an annual rate of interest, then the time (T) must be annualized so if in years, the Time (T) will be a whole number for the number of years.  If the note is in months, the Time (T) must be converted to months by using a fraction where 12 in the denominator for the number of months in a year (for example a 3-month note will have T = 3/12). Some INTEREST BEARING NOTES, have time in terms on month where the months involved are divided by 12 (months in a year). Bankers’ interest uses a 360-day year. If the note is in days, then the ordinary interest method will be used or banker's or commercial year where the denominator will be 360 days (for example a 90-day note will have T = 90/360).  Therefore for using days, the numerator will have "exact" days in the period and the denominator will use ordinary days or 360.

1) If the note due date extends beyond the fiscal year, then an adjusting entry (to properly match revenues and expenses in the same accounting period) must be made to accrue interest up to the last day of the year.

2) Determining the Due Date of a Note (date at which a note must be paid) depends on whether the note is in months or days. If the note is in months, you simply count ahead the proper number of months. If the note is in days, you must know the days in each month to calculate the exact number of days. Count days after the date of the note up to and including the date of maturity. The poem helps: Thirty days has September, April, June, and November. All the rest has 31 except for February (where for purposes of this course, we will consider it to be 28). There is also the knuckle method where you make a fist out of both hands and beginning with your left hand, the knuckles have 31 days and the valley between the knuckles has 30 days or in the case of February 28 days. So with the left hand, it begins with a knuckle which is January (31 days), February (28 days), then March (31), April (30), May (31), June (30) July (31 which ends the left hand). Then your right hand begins with a knuckle which is August (31), September (30), October (31), November (30), December (31). TO CALCULATE THE DUE DATE OF A NOTE, USE THE METHOD BELOW (Example used: 90 days after June 20):

|Last day of month that note is dated =  June | 30 |June has 30 days |

|- Date of the note                               =   |-20 |Note is dated June 20 |

|June | | |

|= Days in the first month                   =   June |10 |Subtract for days in first month |

|+ Days in the following month           =   July |31 |Number of days in July |

|+ Days in the next month                  =   August |31 |Number of days in August |

|+ Days needed in the next month     =   September |18 |DUE DATE OF NOTE |

|Total of all the days in the months to length of note |90 |Number of days of the note |

Example of 90 days after March 11:

|March | 31 |Number of days in March (the month the note was dated) |

|March |-11 |Subtract the date of the note |

|March |20 |Number of days to count for March |

|April |30 |Number of days in April |

|May |31 |Number of days in May |

|June | 9 |Number of days needed in June to reach 90 days=DUE DATE OF NOTE |

|Total |90 |Total "exact" days of the note |

|Determine Due Dates of Notes: |

| | | | | |(a) |90 days from May 8: |

|Begin with last day of month that the note was dated |May |31 | |

|Subtract the date of the note |May |-8 | |

|Days in the first month |May | | |

| | |23 | |

| | | | |

|Add the total days in the following month |June |30 |84 days |

|Add the total days in the following month |July |31 | |

|Days needed in the next month for a total of 90 days |Aug. |6 |Due Date of Note |

| | | |Total days of note |90 | |

| | | | | |(b) |60 days from Aug. 24: |

|Begin with last day of month the note was dated |Aug. |31 | |

|Subtract the date of the note |Aug. |-24 | |

|Days in the first month |Aug. | 7 |37 days |

| | | | |

|Add the total days in the following month |Sept |30 | |

|Days needed in the next month for a total of 60 days |Oct. |23 |Due Date of Note |

| | | |Total days of note |60 | |

| | | | | |(c ) |5 months from Oct. 7: |

|Count 5 months beginning with October 7 |Mar. |7 |Due Date of Note |

| | | | | | | | |

| | | | | |(d) |180 days from March 22: |

|Begin with last day of month that the note was dated |Mar. |31 | |

|Subtract the date of the note |Mar. |-22 | |

|Days in the first month |Mar. | | |

| | |9 | |

| | | | |

|Add the total days in the following month |Apr. |30 | |

|Add the total days in the following month |May |31 |162 days |

|Add the total days in the following month |June |30 | |

|Add the total days in the following month |July |31 | |

|Add the total days in the following month |Aug. |31 | |

|Days needed in the next month for a total of 180 days |Sept. |18 |Due Date of Note |

| | | |Total days of note |180 | |

| | | | | | | | |

| | | | | |(e) |120 days from July 31: |

|Begin with last day of month that the note was dated |July |31 | |

|Subtract the date of the note |July |-31 | |

|Days in the first month |July | | |

| | |0 | |

| | | | |

|Add the total days in the following month |Aug. |31 |92 days |

|Add the total days in the following month |Sept. |30 | |

|Add the total days in the following month |Oct. |31 | |

|Days needed in the next month for a total of 120 days |Nov. |28 |Due Date of Note |

| | | |Total days of note |120 | |

| | | | | | | | |

| | | | | |(f) |3 months from August 31: |

|Count 3 months beginning with August 31 to Nov. w/30 |Nov. |30 |Due Date of Note |

2. SALES TAX PAYABLE—Sales tax is expressed as a percentage of the sales price and is recorded in a separate account as it must be remitted to a taxing authority as the merchandising firm serves only as a collection agent for the taxing authority. If sales and sales tax are not rung up separately, they must be extracted from the total receipts as follows:

|Total Receipts |÷ |100% + Sales Tax % |= |Sales Amount |

|$10,600 |÷ |1.06 |= |$10,000 |

3. UNEARNED REVENUES (deferred) revenue are current liabilities that will not have the word, "payable," with the name of the account but it is a liability (a debt owed by the company) as it originates from receiving cash in advance before a revenue (income earned from carrying out the activities of a firm) is performed. Example: April 1, a company, Hess Publishing Company, receives $82,000 cash for subscriptions covering two years and records them originally as a debit to Cash and as a credit to Unearned Subscriptions which is a liability account as the company needs to perform the service (send out magazines every month) to earn the revenue. On December 31, an adjusting entry needs to be made for the amount of revenue that has been earned to properly match revenues and expenses in the same accounting period. At the end of the year, Hess finds that $30,750 of the subscriptions have been earned and the adjusting entry reflects this amount. The following reflects both entries:

|Assets |= |

|Date |Account Title |P.R |Debit |Credit |

|20-- |Adjusting Entries | | | |

|Dec |31 |Warranty Expense | | | |

| | | Estimated Warranty Liability | | | |

| | | | | | |

C. DISCLOSURE OF CONTINGENT LIABILITIES

1. When it is probable that a contingent liability will be incurred but the amount cannot be reasonably estimated, or when the contingent liability is only reasonably possible, only disclosure of the contingency is required.

2. The disclosure should identify the nature of the item and, if known, the amount of the contingency and expected outcome of the future event.

II. PAYROLL ACCOUNTING

A. INTERNAL CONTROL—the objectives are:

1. to safeguard company assets against unauthorized payments of payroll, and

2. to ensure the accuracy of the accounting records pertaining to payrolls.

B. RECORD THE PAYROLL FOR A PAY PERIOD

1. The first step to recording payroll is to properly calculate the gross earnings (total compensation earned by the employee); all of the proper deductions; and net pay (gross earnings minus deductions).

a) Gross earnings = Regular earnings + Overtime earnings

b) Overtime rate/hour = Regular rate x 1½ times regular rate.

2. Payroll Deductions—do not result in a payroll tax expense to the employer.

a) Mandatory deductions are required by law:

1) FICA taxes = social security taxes (OASDI) (6.2%) + Medicare taxes (1.45%)

2) Income taxes depend on:

a. Employee’s gross earnings

b. Number of allowances claimed (on W-4)

c. Length of the pay period

b) Voluntary deductions at the option of the employee:

1) Charitable such as to United Fund;

2) Retirement such as savings bonds and pension plans;

3) Other purposes such as union dues, health and life insurance, etc.

3. Recording the Payroll:

a) A payroll register (a payroll record that accumulates the gross earnings, deductions, and net pay by employee for each pay period) is prepared.

b) A payroll entry for the pay period is recording in a journal:

|General Journal |Page 1 |

|Date |Account Title |P.R. |Debit |Credit |

|20-- | | | | |

|Jan. |14 |Wages and/or Salaries Expense (gross pay) | | | |

| | |Mandatory deductions (FICA,FIT,SIT) | | | |

| | |Voluntary deductions | | | |

| | |Wages and/or Salaries Payable (net pay) | | | |

c) Record the payment of the payroll.

C. RECORD EMPLOYER PAYROLL TAXES levied on employers:

1. Type of taxes:

a) FICA at 7.65% matching the employee’s FICA contribution.

b) Federal Unemployment Taxes (FUTA) at 6.2% with a credit of 5.4% allowed for payment to state unemployment making the FUTA rate .8%.

c) State Unemployment Taxes (SUTA) where the rate depends on the state and the employer’s experience rating: Companies with a history of unstable employment may pay more than the basic state rate.

2. Recording Employer Payroll Taxes.: Payroll Tax Expense is debited for all three taxes and all three taxes are separately credited.

D. ADDITONAL FRINGE BENEFITS

1. Paid Absences—if employees are given rights to receive compensation for absences when certain conditions are met.

a) Examples—paid vacations, sick pay benefits, and paid holidays.

b) When the payment for such absences is probable and reasonable estimated, a liability needs to be accrued (required by the matching principle) for paid future absences.

2. Postretirement Benefits

a) Postretirement Health Care and Life Insurance Benefits

1) The FASB now requires the accrual method of accounting for these costs.

2) Therefore, the cost of these benefits must be expensed during the working years of the employees and recognize a liability to the extent that these obligations are unfunded, (matching principle of accounting).

b) Pension Plan:

1) An agreement whereby an employer provides benefits to employees after they retire.

2) Three parties involved:

a. Employer (company) sponsors the plan

b. Plan administrator receives the contributions from the employer, invests the pension assets; and makes the benefit payments to …

c. The pension recipients (retired employees).

3) A liability is recognized when the pension expense to date is more than the company’s contributions to date.

4) An asset is recognized when the pension expense to date is less than the company’s contributions to date.

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