nobles fin5 ppt_11

Chapter 11Current

Liabilities and Payroll

Learning Objectives

1. Account for current liabilities of known amount

2. Calculate and journalize basic payroll transactions

3. Account for current liabilities that must be estimated

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Learning Objectives

4. Account for contingent liabilities

5. Use the times-interest-earned ratio to evaluate business performance

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Learning Objective 1

Account for current liabilities of known amount

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How Are Current Liabilities of Known Amounts Accounted For?

• Liabilities are debts that are owed to creditors.

• Liabilities have three main characteristics:1. They occur as a result of a past transaction or

event.2. They create a present obligation for future

payments of cash or services.3. They are an unavoidable obligation.

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How Are Current Liabilities of Known Amounts Accounted For?

• Current liabilities must be paid either with cash or with goods and services within one year or within the entity’s operating cycle.

• Long-term liabilities do not need to be paid within one year or within the entity’s operating cycle.

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How Are Current Liabilities of Known Amounts Accounted For?

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Current liabilities

Accounts Payable

Sales Tax Payable

Unearned Revenue

Long-term liabilities

Notes Payable

Mortgage Payable

Bonds Payable

Sales Tax Payable

• December’s taxable sales for Smart Touch Learning totaled $10,000. The company collected an additional 6% sales tax, which would equal $600 ($10,000 × 0.06).

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Sales Tax Payable

• Sales tax is not an expense of the business. It is a current liability. Companies collect the sales tax and then forward it to the state at regular intervals.

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Income Tax Payable

• Assume that Smart Touch Learning incurred federal income tax payable of $3,780.

• When Smart Touch Learning pays the tax, it will record the following:

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Unearned Revenues

• Suppose Smart Touch Learning received $900 in advance on May 21 for a month’s work beginning on that date.

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Unearned Revenue

• During May, Smart Touch Learning delivered one-third of the work and earned $300 ($900 × 1/3) of the revenue. On May 31, the accounting clerk would record the following entry:

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Short-Term Notes Payable

• Assume on May 1, Smart Touch Learning purchased merchandise inventory with a 10%, 90-day note payable, for $8,000. The company uses the perpetual inventory system.

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Short-Term Notes Payable

• On July 30, when the note is due, Smart Touch Learning will pay the note plus interest.

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Current Portion of Long-Term Notes Payable

• Long-term notes payable are typically reported in the long-term liability section of the balance sheet.

• When the long-term debt is paid in installments, the business reports the current portion of notes payable as a current liability.

• The remainder is classified as long-term.

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Learning Objective 2

Calculate and journalize basic payroll transactions

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How Do Companies Account for and Record Payroll?

• Payroll, also called employee compensation, creates liabilities for a business.

• For service organizations, payroll is the major expense.

• There are numerous ways to label an employee’s pay:• Salary• Compensation• Commission• Bonus • Benefits

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Gross Pay and Net (Take-Home) Pay

• Two pay amounts are important for accounting purposes:– Gross pay is the total amount of salary, wages,

commissions, and bonuses earned by the employee during the pay period.

– Net pay is the amount the employee gets to keep. Net pay is also called take-home pay.

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Employee Payroll Withholding Deductions

Required Deductions

• Federal and state income tax

• Social Security tax• Other deductions

required by federal, state, or local law

Optional Deductions

• Insurance premiums

• Retirement plan contributions

• Charitable contributions

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Withholding for Employee Income Tax

• The income tax deducted from gross pay is called income tax withholding.

• The amount withheld depends on the employee’s gross pay and the number of withholding allowances claimed. – Unmarried taxpayers usually claim one

allowance. – A childless married couple usually claims two

allowances.

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Withholding for Employee Income Tax

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Withholding for Employee Social Security Tax (FICA)

• The Federal Insurance Contributions Act (FICA), also known as the Social Security Act, created the Social Security tax.

• The law requires employers to withhold Social Security (FICA) tax from employees’ paychecks.

• FICA has two components:– OASDI (old age, survivors, and disability

insurance)– Medicare (medical benefits)

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Payroll Register

• Many companies use a payroll register to help summarize the earnings, withholdings, and net pay for each employee.

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Journalizing Employee Payroll

• The payroll register is used to record the payroll journal entry.

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Employer Payroll Taxes

• Employers must pay at least three payroll taxes, two of which are unemployment compensation taxes.

• These taxes are not withheld from employees’ gross earnings but instead are paid by the employer:– Employer FICA tax (OASDI and Medicare)– State unemployment compensation tax (SUTA)– Federal unemployment compensation tax

(FUTA)

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Employer Payroll Taxes

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Journalizing Employer Payroll Taxes

• Smart Touch Learning records the employer’s payroll tax expense as a debit to Payroll Tax Expense and a credit to the various payable accounts.

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Internal Control Over Payroll

• There are two main controls for payroll: – Controls for efficiency:

• Payroll is usually automated rather than prepared by hand.

– Controls to safeguard payroll disbursements:• Employees sign for checks or present IDs.• Hiring and firing is separated from payroll

preparation.• Time clocks and direct deposit are also used.

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Learning Objective 3

Account for current liabilities that must be estimated

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How Are Current Liabilities That Must Be Estimated Accounted For?

• A business may know that a liability exists but not know the exact amount.

• It must estimate the amount of the liability and report it on the balance sheet.

• Common examples of estimated liabilities:• Bonus plans• Vacation pay• Health and pension

expense benefits• Warranties

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Bonus Plans

• Assume Smart Touch Learning estimates that it will pay a 5% bonus on annual net income after deducting the bonus. The company reports net income of $315,000 before the calculation of the bonus.

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Vacation, Health, and Pension Benefits

• Businesses typically offer vacation, health, and pension benefits to employees. – A pension plan provides benefits to retired

employees.

• Smart Touch Learning estimates the cost of providing vacation benefits is $1,000 per month.

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Warranties

• Many corporations guarantee their products against defects under warranty agreements.

• The time period of warranties varies by product and company.

• The matching principle requires businesses to record Warranty Expense in the same period that the company records the revenue related to the warranty.

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Warranties

• Assume that Smart Touch Learning made sales on account of $50,000, costing $35,000 subject to warranties on June 10, and estimates warranties at 3% of sales.

• The journal entry to record this transaction is shown on the next slide.

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Warranties

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Warranties

• Assume that some of Smart Touch Learning’s customers make claims that must be honored through the warranty offered by the company. The warranty costs total $800 and are made on June 27 as follows:

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Learning Objective 4

Account for contingent liabilities

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How Are Contingent Liabilities Accounted For?

• A contingent liability is a potential liability that depends on a future event.

• For a contingent liability to be paid, some event must happen in the future.

• How businesses record contingent liabilities is based on the likelihood of events occurring in the future: • Remote• Reasonably possible• Probable

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How Are Contingent Liabilities Accounted For?

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Learning Objective 5

Use the times-interest-earned ratio to evaluate business performance

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How Do We Use the Times-Interest-Earned Ratio to Evaluate Business

Performance?• Investors can use the times-interest-

earned ratio to evaluate a business’s ability to pay interest expense.

• A high interest coverage ratio indicates a business’s ease in paying interest expense.

• The formula is:

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