Completing the Operating Cycle Completing the Operating Cycle C H A P T E R 8

Learning Objective 1 Account for the various components of employee compensation expense.

Describe the Employee Compensation Time Line Time Payroll Compen- sated Absences Stock Options and Bonuses Post- employ- ment Benefits Pensions and Post- retiremen t Benefits Other than Pensions

u Salaries and wages earned by employees in the current period. What are the correct journal entries? u Accounting for salaries of $2,700: u When employees work: Payroll Salaries Expense ,700 Salaries Payable ,700 Salaries Payable ,700 Cash ,700 u When wages are paid: u However, accounting for salaries and related payroll taxes is never this simple. Recording the payment of this payable is similar to journal entry to record payment of every payable. The payable is debited and cash is credited.

Withholdings Which taxes must employers withhold from employees’ salaries and wages? Federal and state income taxes. Social Security (FICA) taxes. Voluntary or contractual withholdings (union dues, medical insurance premiums, and charitable donations). They are not additional expenses to the employer since the employee pays the taxes. The business acts as agent to assist in the collection of funds for the government or organization.

Salaries Expense Entry Salaries Expense ,700 FICA Taxes Payable, Employee Federal Withholding Taxes Payable State Withholding Taxes Payable Union Dues Payable Salaries Payable To record Sally Wage’s salary. Sally Wage works for you and earns $32,400 annually. Make the appropriate journal entry for Sally’s January salary.

Payroll Tax Expense Entry Payroll Tax Expense FICA Taxes Payable, Employer Federal Unemployment Taxes Payable. 30 State Unemployment Taxes Payable...68 To record liabilities associated with Sally Wage’s salary. Now that the appropriate journal entry is made for Sally’s wages, make the entry to record your company’s portion.

Compensated Absences ç Matching principle u The expense associated with the compensated absence must be accounted for in the period in which it is earned by the employee. ç Therefore, the expense is estimated. Salaries Expense Sick Days Payable To recognize accrued sick pay. ç Journal entry when the sick day is actually taken: Sick Days Payable Various Taxes Payables Cash To record payment of sick day net of FICA, federal, and state taxes.

Describe Bonuses and Stock Options l Employees, generally top management, may have the option to purchase stock in the future at a price specified today. l Generally, the stock is presently selling at an amount below the option price. l The objective is to provide management with an incentive to effectively run the company in such a way that the stock price increases.

Bonuses and Stock Options Salaries Expense ,000 Various Taxes Payables ,000 Bonus Payable ,000 To record bonus earned by Mr. Will Fences. Your firm met its target goals this year. Your President, Mr. Will Fences, is therefore entitled to a bonus. His annual salary is $1 million and his bonus is 15 percent, payable at the end of the year. Make the appropriate December 31 journal entry for the bonus.

Post-employment Benefits t Those benefits incurred after an employee has ceased to work for an employer but before that employee retires. t Examples: severance packages, retraining costs, education costs. t Journal entry when estimated salaries are $2,000: Salaries Expense ,000 Benefits Payable ,000 To record post-employment benefits for laid-off employees. t When paid, a journal entry is made to reduce the payable and to record the cash outflow.

Define Pensions l Compensation received by an employee after retirement. l Defined contribution plan. l Employer sets aside money to be paid following retirement. l Employee gets what was contributed plus the earnings. l Defined benefit plan. l Benefits based on number of years worked. l Employee gets whatever benefit is defined in the plan. l Company attempts to determine costs to be paid in the future and records an estimate in the current period.

Learning Objective 2 Compute income tax expense including appropriate consideration of deferred tax items.

Taxes on Operations What other taxes are companies responsible to pay? Sales Taxes Property Taxes Income Taxes

Michael’s Mowers sold a lawnmower for $340. What is the journal entry assuming the state charges a 5 percent sales tax? Example: Sales Taxes Cash Sales Revenue Sales Tax Payable From sale of lawnmower, including 5% sales tax.

Example: Property Taxes 12/31/03Property Tax Expense ,200 Property Tax Payable.....6,200 To record property tax expense and liability to Greenlawn City. The City of Greenlawn assesses property taxes on land and buildings. Michael’s Mowers pays its property taxes on a calendar-year basis and owes Greenlawn $6,200 for Make Michael’s appropriate journal entry.

Example: Income Taxes Michael’s Mowers pretax income is $385,000. Its income tax rate for 2003 for both federal and state is 30 percent. Prepare an adjusting entry at year-end showing the company’s tax expense. 12/31/03Income Tax Expense ,500 Income Tax Payable ,500 To record income tax expense and tax liability on $385,000 pretax income for 2001 using a 30 percent effective tax rate.

Learning Objective 3 Distinguish between contingent items that should be recognized in the financial statements and those that should be merely disclosed in the financial statement notes.

Contingencies t Contingency: An event that may or may not occur. t Accounting standard setters say proper disclosure depends upon the assessed outcome. t Terms used to describe contingencies: probable, reasonably possible, and remote. t A firm must obtain objective assessments and then account for those events based on that assessment.

Contingent Liabilities TermDefinitionAccounting ReasonablyThe chance of the futureProvide detailed possibleevent occurring is moredisclosure of the than remote but less thanpossible liability in likely.the notes. Probable The future event is likely Estimate the amount to occur. of the contingency and make the appropriate journal entry; provide detailed disclosure in the notes. RemoteThe chance of the futureNo disclosure event occurring is slight.required.

Learning Objective 4 Understand when an expenditure should be recorded as an asset and when it should be recorded as an expense.

Describe the Expense/Asset Continuum ExpenseAsset Land and Building Research and Development Repairs Office Supplies Used

Michael’s builds a new $1 million store. Should it simply show this as an expense or capitalize it as an asset? Expense or Capitalize? Why the Debate? u If Michael’s chooses not to capitalize, the company’s financial statements will be misstated. u The income statement in Year 1 will have too much expense. u The income statements for Years 2 through 20 will contain too little expense. u Potential investors may invest elsewhere because of the low net income figure resulting from the large expense. u The balance sheet will not show an item that is expected to benefit future periods. u Bad resource allocation decisions could result.

Learning Objective 5 Prepare an income statement summarizing operating activities as well as other revenues and expenses, extraordinary items, and earnings per share.

Income Statement Put these major components of an Income Statement in correct order: u Net sales revenue u Net income u Sales revenue u Cost of goods sold u Operating expenses u Operating income

Revenues –Cost of goods sold = Gross margin –Selling expenses –General and administrative expenses = Operating income +/–Other revenues and expenses = Income before taxes –Income tax = Income after taxes +/–Extraordinary items = Net income Income Statement Format

Define Other Revenue and Expenses Those items incurred or earned from activities that are outside of, or peripheral to, the normal operations of a firm. For example, Michael’s Mowers sponsored a local little league team. Its expense for uniforms may be shown under “Other Revenues and Expenses.”

Define Extraordinary Items n Reserved for reporting special non-operating gains and losses. n Restrictive and includes only those items that are: u unusual in nature u infrequent in occurrence u material in amount n Separate so financial statement users can know they are one-time or nonrecurring events. n Examples: losses from floods, fires, earthquakes.

Define Earnings per Share n EPS is required on the income statement. n If extraordinary items are included, EPS figures are reported u on income before extraordinary items, u on extraordinary items, and u on net income. n Allows potential investors to compare profitability across firms of different sizes. n How do you do the calculation? Net income Average number of shares outstanding