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Chapter 11 Current Liabilities and Payroll

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Chapter 11Current

Liabilities and Payroll

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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

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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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