Prepared by: C. Douglas Cloud Professor Emeritus of AccountingPepperdine University

Current Liabilities and Payroll

Chapter 10

Learning Objectives1. Describe and illustrate current

liabilities related to accounts payable, current portion of long-term debt, and notes payable.

2. Determine employer liabilities for payroll, including liabilities arising from employee earnings and deductions from earnings.

3. Describe payroll accounting systems that use a payroll register, employee earnings records, and a general journal.

Learning Objectives4. Journalize entries for employee fringe

benefits, including vacation pay and pensions.5. Describe the accounting treatment for

contingent liabilities and journalize entries for product warranties.

6. Describe and illustrate the use of the quick ratio in analyzing a company’s ability to pay its current liabilities.

Learning Objective 1

Describe and illustrate current liabilities

related to accounts payable, current

portion of long-term debt, and notes

payable.

Current Liabilities

When a company or a bank advances credit, it is making a loan.

The company or bank is called a creditor (or lender).

The individuals or companies receiving the loans are called debtors (or borrowers).

Long-term liabilities are debts due beyond one year.

Current liabilities are debts that will be paid out of current assets and are due within one year.

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Accounts PayableLO 1LO 1

Accounts payable transactions arise from purchasing goods or services for use in a company’s operations or from purchasing merchandise for resale.

Current Portion of Long-Term Debt Long-term liabilities are often paid

back in periodic payments, called installments. Installments that are due within the coming year must be classified as a current liability. The installments due after the coming year are classified as a long-term liability.

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Short-Term Notes PayableNature’s Sunshine Company issues a 90-day, 12% note for $1,000, dated August 1, 2011 to Murray Co. for a $1,000 overdue account.

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Short-Term Notes PayableWhen the note matures, the entry to record the payment of $1,000 plus $30 interest ($1,000 x 12% x 90/360) is as follows:

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Interest Expense Interest Expense appears on the income appears on the income statement as an “Other statement as an “Other

Expense.”Expense.”

Description Debit Credit

Bowden Co. (Borrower)

Mdse. Inventory 10,000Accounts Payable 10,000

Coker Co. (Creditor)Description Debit Credit

Accounts Receivable10,000Sales

10,000Cost of Mdse. Sold 7,500

Mdse. Inventory 7,500

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On May 1, Bowden Co. (borrower) purchased merchandise on account from Coker Co. (creditor), $10,000, 2/10, n/30. The merchandise cost Coker Co. $7,500.

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Accounts Payable10,000Notes Payable 10,000

Description Debit Credit

Bowden Co. (Borrower)

Notes Receivable 10,000Accounts Receivable

10,000

Coker Co. (Creditor)Description Debit Credit

On May 31, Bowden Co. issued a 60-day, 12% note for $10,000 to Coker Co. on account.

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Notes Payable 10,000Interest Expense 200

Cash 10,200

Description Debit Credit

Bowden Co. (Borrower)

Cash 10,200Interest Revenue 200Notes Receivable 10,000

Coker Co. (Creditor)Description Debit Credit

On July 30, Bowden Co. paid Coker Co. the amount due on the note of May 31, the face amount of $10,000 plus interest of $200 ($10,000 x 12% x 60/360).

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On September 19, Iceburg Company borrowed cash from First National Bank by issuing a $4,000, 90-day, 15% note to the bank.

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On December 18, Iceburg Company paid First National Bank $4,000 plus interest of $150 ($4,000 x 15% x 90/360).

Short-Term Notes Payable A discounted note has the following

characteristics:1. The interest rate on the note is called the

discount rate.2. The amount of interest on the note, called the

discount, is computed by multiplying the discount rate times the face amount of the note.

The debtor (borrower) receives the face amount of the note less the discount, called the proceeds.

The debtor must repay the face amount of the note on the due date.

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On August 10, Cary Company issues a $20,000, 90-day discounted note to Western National Bank. The discount rate is 15%, and the amount of the discount is $750 ($20,000 x 15% x 90/360).

proceeds

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The entry when Cary Company pays the discounted note on November 8 is as follows:

Learning Objective 2

Determine employer liabilities for payroll,

including liabilities arising from employee earnings

and deductions from earnings.

Payroll and Payroll Taxes In accounting, payroll refers to the

amount paid to employees for services they provided during the period. A company’s payroll is important for the following reasons: Payroll and related payroll taxes significantly

affect the net income of most companies. Payroll is subject to federal and state

regulations. Good employee morale requires payroll to be

paid timely and accurately.

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Liability for Employee Earnings Salary usually refers to payment for

managerial and administrative services. Salary is normally expressed in terms of a month or a year.

Wages usually refers to payment for employee manual labor. The rate of wages is normally stated on an hourly or weekly basis.

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Liability for Employee EarningsJohn T. McGrath is employed by McDermott Supply Co. at the rate of $34 per hour, plus 1.5 times the normal hourly rate for hours over 40 per week. For the week ended December 27, McGrath worked 42 hours. His earnings are computed as follows:

Earnings at regular rate (40 x $34) $1,360Earnings at overtime rate (2 x $51) 102Total earnings $1,462

Deductions from Employee Earnings The total earnings of an employee for

a payroll period, including any overtime pay, are called gross pay.

From this amount is subtracted one or more deductions to arrive at the net pay.

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Deductions from Employee Earnings

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Deductions from Employee Earnings

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John T. McGrath made $1,462 for the week ending December 27. McGrath’s W-4 (previous slide) claims one withholding allowance of $70. Thus, the wages used to determine McGrath’s withholding bracket in Exhibit 3 (next slide) are $1,392 ($1,462 – $70).

Deductions from Employee Earnings

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Deductions from Employee Earnings The Federal Insurance Contributions

Act (FICA) tax withheld contributes to the following two federal programs. Social security, which provides payments

for retirees, survivors, and disability insurance. (Assume 6% on all earnings.)

Medicare, which provides health insurance benefits for senior citizens. (Assume 1.5% on all earnings.)

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LO 2LO 2Deductions from Employee Earnings

John T. McGrath’s earnings for the week ending December 27 are $1,462. Total FICA tax to be withheld is calculated as follows:

Earnings subject to 6% social security tax $1,462Social security tax rate x 6%

Social security tax $ 87.72Earnings subject to 1.5% Medicare tax $1,462Medicare tax rate x 1.5%Medicare tax 21.93

Total FICA tax $109.65

John T. McGrath’s Net Pay:Gross earnings for the week $1,462.00 Deductions:

Social security tax $ 87.72Medicare tax 21.93Federal income tax 258.90Retirement savings 20.00United Fund 5.00 Total deductions 393.55

Net pay $1,068.45

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Liability for Employer’s Payroll Taxes Employers are subject to the

following payroll taxes for amounts paid their employees: FICA Tax Federal Unemployment Compensation Tax

(FUTA) State Unemployment Compensation Tax

(SUTA)

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Liability for Employer’s Payroll Taxes

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Learning Objective 3

Describe payroll accounting systems

that use a payroll register, employee

earnings records, and a general journal.

Accounting Systems for Payroll and Payroll Taxes

Payroll systems should be designed to: Pay employees accurately and timely. Meet regulatory requirements of federal,

state, and local agencies. Provide useful data for management

decision-making needs.

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Payroll Register The payroll register is a multicolumn

report used for summarizing the data for each payroll period. Exhibit 5 illustrates a payroll register for McDermott Supply Co.

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Payroll RegisterLO 3LO 3

(left side, continued)

Payroll RegisterLO 3LO 3

(right side)

Recording Employees’ Earnings

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Recording and Paying Payroll Taxes

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Employers must match the employee’s social security and Medicare tax contributions. In addition, the employer must pay SUTA tax of 5.4% and FUTA tax of 0.8% (assume on $2,710). For McDermott Supply’s payroll of December 27, these payroll taxes are computed as follows:

Social security tax $ 834.12 ($13,902 x 6%)Medicare tax 208.53 ($13,902 x 1.5%)SUTA 146.34 ($2,710 x 5.4%)FUTA 21.68 ($2,710 x 0.8%) Total payroll taxes $1,210.67

Recording and Paying Payroll Taxes

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The entry to journalize the payroll tax expense for Exhibit 5 is shown below.

Employee’s Earnings Record A detailed payroll record must be

kept for each employee. This record is called an employee’s earnings record. Exhibit 6 (next two slides) shows a portion of John T. McGrath’s employee’s earnings record.

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(continued)

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Employee’s Earnings RecordLO 3LO 3

Payroll Checks At the end of each payroll period,

payroll checks are prepared. Each check includes a detachable statement showing the details of how the net pay was computed.

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Payroll Checks

Payroll System Design The inputs into a payroll system may

be classified as: Constants, which are data that remain

unchanged from payroll to payroll.• Employee names• Social security numbers

Variables, which are data that change from payroll to payroll.• Number of hours or days worked• Accrued sick leave

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Internal Controls for Payroll Systems Some examples of payroll controls include:

If a check-signing machine is used, blank payroll checks and access to the machine should be restricted to prevent their theft or misuse.

The hiring and firing of employees should be properly authorized and approved in writing.

All changes in pay rates should be properly authorized and approved in writing.

Employees should be observed when arriving for work to verify that employees are “checking in” for work only once and only for themselves.

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Internal Controls for Payroll Systems

Payroll checks should be distributed by someone other than employee supervisors.

A special payroll bank account should be used.

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Learning Objective 4

Journalize entries for employee fringe

benefits, including vacation pay and

pensions.

Employees’ Fringe Benefits Many companies provide their

employees benefits in addition to salary and wages earned. Such fringe benefits may include: Vacation pay (sometimes called

compensated absences) Medical benefits Retirement benefits

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Vacation Pay

Assume that employees earn one day of vacation for each month worked. The estimated vacation pay for the year ending December 31 is $325,000. The adjusting entry for the accrued vacation is shown below.

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Pensions A pension is a cash payment to

retired employees. Pension rights are accrued by employees as they work, based on the employer’s pension plan. Two types of pension plans are:

Defined contribution plan Defined benefit plan

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PensionsLO 4LO 4

In a defined contribution plan, the company invests contributions on behalf of the employee during the employee’s working years. Normally, the employee and employer

contribute to the plan. The employee’s pension depends on the

total contributions and the investment returns earned on those contributions.

Heaven Scent Perfumes Company contributes 10% of employee monthly salaries to an employee 401K plan. Assuming $500,000 of monthly salaries, the journal entry to record the monthly contribution is shown below.

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In a defined benefit plan, the employer is obligated to pay for (fund) the employee’s future pension benefits. Many companies are replacing their

defined benefit plans with defined contribution plans.

A retired employee receives a specific amount based on his or her salary history and years of service.

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The defined benefit plan of Hinkle Co. requires an annual pension cost of $80,000. The annual contribution is based on estimates of Hinkle’s future pension liability. On December 31, Hinkle Co. pays $60,000 to the pension fund. The entry to record the payment and unfunded liability is shown below.

Pensions

Postretirement Benefits Other than Pensions

Employees may earn rights to other postretirement benefits, such as dental care, eye care, medical care, life insurance, tuition assistance, tax services, and legal services.

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Current Liabilities on the Balance Sheet

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Learning Objective 5

Describe the accounting treatment

for contingent liabilities and

journalize entries for product warranties.

Contingent Liabilities Some liabilities may arise from past

transactions if certain events occur in the future. These potential obligations are called contingent liabilities. The accounting for contingent liabilities depends on the following two factors:1. Likelihood of occurring: probable,

reasonably possible, or remote2. Measurement: estimable or not

estimable

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Contingent LiabilitiesLO 5LO 5

During June, a company sold a product for $60,000 that includes a 36-month warranty for repairs. The average cost of repairs over the warranty period is 5% of the sales price. The entry to record the estimated product warranty expense for June is shown below.

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If a $200 part is replaced under warranty on August 16, the entry is as follows:

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Learning Objective 6

Describe and illustrate the use of the quick ratio in analyzing a company’s ability to

pay its current liabilities.

Quick Ratio Current position analysis helps

creditors evaluate a company’s ability to pay its current liabilities. It is based on: Working capital, the excess of current

assets over current liabilities Current ratio, determined by dividing the

current assets by the current liabilities Quick ratio, an indicator of a company’s

short-term liquidity

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Quick RatioThe quick ratio measures the

“instant” debt-paying ability of a company and is computed as follows:

Quick Ratio =Quick Assets

Current Liabilities

Quick assets are cash and other current assets that can be easily converted to cash.

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