Chapter 11: Current Liabilities and Payroll – Study Notes

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Chapter 11: Current Liabilities and Payroll

Introduction

This chapter explores the accounting for current liabilities, payroll, estimated and contingent liabilities, and the use of the times-interest-earned ratio to evaluate business performance. Understanding these concepts is essential for accurate financial reporting and effective business management.

Current Liabilities of Known Amount

Definition and Characteristics

Liabilities are debts owed to creditors, arising from past transactions or events.
They create a present obligation for future payment of cash or services.
They are unavoidable obligations.

Classification of Liabilities

Current liabilities: Must be paid with cash, goods, or services within one year or the entity’s operating cycle.
Long-term liabilities: Do not need to be paid within one year or the operating cycle.

Examples of Current Liabilities

Accounts Payable
Sales Tax Payable
Unearned Revenue

Examples of long-term liabilities include Notes Payable, Mortgage Payable, and Bonds Payable.

Sales Tax Payable

Sales tax collected from customers is a current liability, not an expense.
It is forwarded to the state at regular intervals.
Example: If taxable sales are $10,000 and the sales tax rate is 6%, the company collects $600 in sales tax.

Income Tax Payable

Federal income tax payable is a current liability until paid.
Example: If income tax payable is $3,780, the liability is removed when the tax is paid.

Unearned Revenue

Arises when cash is received before goods or services are provided (also called deferred revenue).
As the work is performed, revenue is recognized, and the liability decreases.
Example: $900 received in advance; after one-third of the work is completed, $300 is recognized as revenue.

Short-Term Notes Payable

Written promises to pay a debt, usually with interest, within one year or less.
May arise from purchases or borrowing from banks.
Interest must be accrued at year-end if not yet paid.
Example: $8,000 inventory purchase with a 10%, 90-day note; $10,000 borrowed at 6% for five months.

Current Portion of Long-Term Notes Payable

Long-term notes payable are split into current and long-term portions on the balance sheet.
The portion due within one year is classified as a current liability.

Payroll Accounting

Payroll Transactions

Payroll (employee compensation) is a major expense and liability for businesses.
Forms of pay include salary, wages, commission, bonus, and benefits.

Gross Pay vs. Net Pay

Gross pay: Total earnings before deductions.
Net pay: Take-home pay after all deductions.

Payroll Deductions

Required deductions: Federal and state income tax, Social Security (FICA), other legal deductions.
Optional deductions: Insurance, retirement contributions, charitable donations.

Income Tax Withholding

Amount withheld depends on gross pay and allowances claimed (e.g., marital status, dependents).
Employees complete a W-4 form to determine withholding.

Social Security Tax (FICA)

Mandated by the Federal Insurance Contributions Act (FICA).
Includes OASDI (Old Age, Survivors, and Disability Insurance) and Medicare.
Both employee and employer contribute.

Optional Withholding Deductions

May include health insurance, retirement savings, union dues, and charitable contributions.
Employers remit these amounts to the appropriate organizations.

Payroll Register

Summarizes earnings, withholdings, and net pay for each employee.
Used to prepare payroll journal entries.

Employer Payroll Taxes

Employers pay payroll taxes not withheld from employees, including:
- Employer FICA tax
- State Unemployment Tax (SUTA)
- Federal Unemployment Tax (FUTA)
These taxes fund Social Security, Medicare, and unemployment benefits.

Internal Control Over Payroll

Efficiency controls: Automation of payroll processing.
Safeguarding controls: Employee identification, separation of duties, use of time clocks, and direct deposit.

Estimated Liabilities

Definition and Examples

Liabilities that exist but must be estimated for reporting purposes.
Common examples: Bonus plans, vacation pay, health and pension benefits, warranties.

Bonus Plans

Bonuses are often based on net income after deducting the bonus itself.
Example: 5% bonus on $315,000 net income before bonus; the liability is recorded even if payment is made in the next year.

Vacation, Health, and Pension Benefits

Estimated costs for employee benefits are accrued as liabilities.
Example: Vacation benefits estimated at $1,000 per month.

Warranties

Corporations guarantee products under warranty agreements.
The matching principle requires warranty expense to be recorded in the same period as related sales revenue.
Example: $50,000 in sales with estimated warranty costs of 3% ($1,500); actual warranty claims of $800 are recorded as they occur.

Contingent Liabilities

Definition and Accounting Treatment

A contingent liability is a potential liability dependent on a future event.
Accounting treatment depends on the likelihood of the event:
- Remote: Disclosure not required.
- Reasonably possible: Disclose in notes to financial statements.
- Probable: If the amount can be estimated, record a liability; otherwise, disclose in notes.

Times-Interest-Earned Ratio

Definition and Application

Measures a company’s ability to pay interest expense from operating income.
Also called the interest-coverage ratio.
A higher ratio indicates greater ease in meeting interest obligations.

Formula:

Example: If a company has net income of $100,000, income tax expense of $20,000, and interest expense of $10,000, the ratio is: