Chapter Nine Accounting for Current Liabilities and Payroll McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

LO 1 Show how notes payable and related interest expense affect financial statements. 9-1

Notes Payable In previous chapters, we have examined promissory notes from the perspective of the lender. We will now look at how a company accounts for notes as a borrower, or maker. 9-2

Notes Payable and the Going Concern Assumption Do companies estimate the amount of payables that they are going to pay? Under the going concern assumption, companies expect to pay their obligations in full. 9-3

On September 1, 2013, Herrera Supply Company (HSC) borrowed $90,000 from the National Bank. 1.Increase assets (cash). 2.Increase liabilities (notes payable). 9-4

On December 31, 2013, HSC must accrue (recognize) four months of interest expense. 1.Increase liabilities (interest payable). 2.Decrease equity (interest expense). 9-5

On August 31, 2014, the maturity date of the note, three events are recognized. First, $5,400 of interest expense has accrued since January 1, Increase liabilities (interest payable). 2.Decrease stockholders’ equity (retained earnings). 9-6

Second, cash is paid for $8,100, the total amount of interest due on the note. 1.Decrease assets (cash). 2.Decrease liabilities (interest payable). 9-7

Third, HSC must recognize the repayment of the $90,000 principal of the note. 1.Decrease assets (cash). 2.Decrease liabilities (notes payable). 9-8

LO 2 Show how sales tax liabilities affect financial statements. 9-9

Sales Tax Most states require retailers to collect sales tax on goods sold to their customers. Retailers collect the tax from customers and remit the tax to the state at regular intervals. 9-10

Collecting Sales Tax Event 1: Herrera Supply Company (HSC) sells merchandise to a customer for $2,000 cash in a state where the sales tax rate is 6 percent. 9-11

Remitting Sales Tax Event 2: Herrera remits the tax due to the state taxing authority. 9-12

Define contingent liabilities and explain how they are reported in financial statements. LO

Contingent Liabilities A contingent liability is a potential obligation arising from a past event. The amount or existence of the obligation depends on some future event. A pending lawsuit, for example, is a contingent liability. Accounting standards require companies to classify contingent liabilities into one of three categories. 9-14

9-15

LO 4 Explain how warranty obligations affect financial statements. 9-16

Warranty Obligations Generally within the warranty period, the seller promises to replace or repair defective products without charge to the customer. Event 1 Sale of Merchandise HSC sells $7,000 of merchandise for cash. The merchandise had cost the company $4,

Warranty Obligations Event 2 Recognition of Warranty Expense The company estimates that warranty expense associated with the current sale will be $

Warranty Obligations Event 3 Settlement of Warranty Obligation The company pays $40 cash to repair defective merchandise returned by a customer. 9-19

General Ledger T-Accounts 9-20

Financial Statements Panel C Financial Statements for

Determine payroll taxes and explain how they affect financial statements. LO

Identifying Employees People who perform work for your business are employees. Correct? Not necessarily. When a business supervises, directs, and controls an individual’s work, the individual is an employee of the business. When a business pays an individual for specific services, but the individual supervises and controls the work, then that individual is an independent contractor. 9-23

Social Security and Medicare (FICA) Taxes The Federal Insurance Contributions Act (FICA) provided funding for Social Security and Medicare programs. Approximately 7 ½% of each employee’s gross pay is withheld for FICA tax, and the employer pays an additional 7 ½ %. 9-24

Payroll Taxes Payroll taxes only apply to employees. Companies are not required to withhold taxes from or pay taxes on work done by independent contractors. Employers withhold federal, state, and sometimes local income taxes, as well as FICA (Social Security and Medicare) taxes from employees, and then remit those taxes to the taxing authorities. They also pay unemployment taxes and the employer portion of FICA taxes. 9-25

Deductions from Gross Earnings Gross monthly salary $6,000 Deductions Federal income taxes $450 FICA Tax—Social Security ($6,000 X 6%) 360 FICA Tax—Medicare ($6,000 X 1.5%) 90 Medical insurance premiums 320 American Cancer Society 25 Total deductions 1,245 Net pay $4,

Withholding Allowances 9-27

Form W

Recording Payroll Account TitleDebitCredit Salary Expense 6,000 Employee Income Tax Payable 450 FICA Tax - Social Security Payable 360 FICA Tax - Medicare Payable 90 Medical Insurance Premiums Payable 320 American Cancer Society Payable 25 Cash 4,

Payroll Tax Expense FICA tax expense—Social Security ($6,000 X 6%) $360 FICA tax expense—Medicare ($6,000 X 1.5%) 90 Federal unemployment tax expense ($1,000 X.8%) 8 State unemployment tax expense ($1,000 X 5.4%) 54 Total payroll tax expense $

Fringe Benefits Account TitleDebitCredit Vacation Pay Expense 200 Employee Medical Insurance Expense 250 Employee Pension Expense 150 Vacation Pay Payable 200 Employee Medical Insurance Payable 250 Employee Pension Liability

Prepare a classified balance sheet. LO

Current Versus Noncurrent Current assets are expected to be converted to cash or consumed within one year or an operating cycle, whichever is longer. Current assets include: CashCash Marketable SecuritiesMarketable Securities Accounts ReceivableAccounts Receivable Short-Term Notes ReceivableShort-Term Notes Receivable Interest ReceivableInterest Receivable InventoryInventory SuppliesSupplies PrepaidsPrepaids CashCash Marketable SecuritiesMarketable Securities Accounts ReceivableAccounts Receivable Short-Term Notes ReceivableShort-Term Notes Receivable Interest ReceivableInterest Receivable InventoryInventory SuppliesSupplies PrepaidsPrepaids 9-33

Current Versus Noncurrent Current liabilities are due within one year or an operating cycle, whichever is longer. Current liabilities include: Accounts PayableAccounts Payable Short-Term Notes PayableShort-Term Notes Payable Wages PayableWages Payable Taxes PayableTaxes Payable Interest PayableInterest Payable Accounts PayableAccounts Payable Short-Term Notes PayableShort-Term Notes Payable Wages PayableWages Payable Taxes PayableTaxes Payable Interest PayableInterest Payable 9-34

9-35

Use the current ratio to assess the level of liquidity. LO

Current Ratio = Current Asset Current Liabilities For Limbaugh Company the current ratio is: Current Ratio = $288,600 $193, :1 = 1.49:1 9-37

Liquidity vs. Solvency Liquidity describes the ability to generate sufficient short-term cash flows to pay obligations as they come due. Solvency is the ability to repay liabilities in the long run. Liquidity is often measured by the current ratio. Solvency is often measured by the debt to assets ratio. 9-38

Liquidity vs. Solvency 9-39

Show how discount notes and related interest charges affect financial statements. (Appendix) LO

Discount Notes Discount notes are ones in which the interest is withheld from the proceeds when the note is issued. The face value of the note is the amount that will be repaid at maturity. 9-41

Issuing a Discount Note Beacon Management Services was started when it issued a $10,000 face value discount note to State Bank on March 1, The one-year note carried a 9% discount rate. Face value of the note $10,000 Less discount ($10,000 x.09 x 1) (900) Proceeds (amount borrowed) $ 9,

Issuing a Discount Note Account TitleDebitCredit Cash 9,100 Discount on Notes Payable 900 Notes Payable 10,

Recognizing Interest on a Discount Note On December 31, 2013, Beacon recorded an adjusting entry to recognize interest accrued since March 1. $900 Discount/12 months = $75 $75 x 10 months = $750 Account TitleDebitCredit Interest Expense 750 Discount on Notes Payable

Repaying a Discount Note Beacon repaid the face value of the discount note on March 1, $900 Discount/12 months = $75 $75 x 2 months = $150 Account TitleDebitCredit Interest Expense 150 Discount on notes Ppayable

Repaying a Discount Note Beacon repaid the face value of the discount note on March 1, Account TitleDebitCredit Notes Payable 10,000 Cash 10,

End of Chapter Nine 9-47