Current Liabilities and Payroll Chapter 11 Current Liabilities and Payroll

Liabilities that are to be paid out of current assets and are due within a short time, usually within one year, are called current liabilities. Accounts payable Current portion of long-term debt Notes payable

Accounts payable arise from purchasing goods or services for use in a company’s operations or for 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 total amount of the installments due after the coming year is classified as a long-term liability.

Short-Term Notes Payable A firm issues a 90-day, 12% note for $1,000, dated August 1, 2008 to Murray Co. for a $1,000 overdue account.

On October 30, when the note matures, the firm pays the $1,000 principal plus $30 interest ($1,000 × 12% × 90/360). Interest Expense appears on the income statement as an “Other Expense.”

On September 19, Iceburg Company issues a $4,000, 90-day, 15% note to First National Bank.

On the due date of the note (December 18), Iceburg Company owes $4,000 plus interest of $150 ($4,000 × 15% × 90/360).

Discounting a Note A discounted note has the following characteristics: The creditor (lender) requires an interest rate, called the discount rate. Interest, called the discount, is computed on the face amount of the note. The debtor (borrower) receives the face amount of the note less the discount, called the proceeds. The debtor pays the face amount of the note on the due date.

On August 10, Cary Company issues a $20,000, 90-day note to Rock Company in exchange for inventory. Rock discounts the note at 15%. Proceeds Discount: $20,000 × .15 × 90/360 Discount rate

On November 8 the note is paid in full. The amount paid is the face amount of the note.

Proceeds from Notes Payable Example Exercise 11-1 Proceeds from Notes Payable On July 1, Bella Salon Company issued a 60-day note with a face amount of $60,000 to Delilah Hair Product Company for merchandise inventory. Determine the proceeds of the note, assuming the note carries an interest rate of 6%. Determine the proceeds of the note, assuming the note is discounted at 6%. a. $60,000 b. $59,400 [$60,000 – ($60,000 × 6% × 60/360)]

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: Likelihood of occurring: Probable, reasonably possible, or remote. Measurement: Estimable or not estimable.

Recording Contingent Liabilities During June, a company sells a product for $60,000 on which there is a 36-month warranty. Past experience indicates that the average cost to repair defects is 5% of the sales price over the warranty period.

If a customer required a $200 part replacement on August 16, the entry would be:

Exhibit 10 Accounting Treatment of Contingent Liabilities

Problem 11-1B Apr 21: Borrowed $60,000; issued a 45-day, 6% note Cash 60,000 Notes Payable 60,000 Apr 26: Purchased equipment issued a $160,000 180-day note at a discount of 8% Equipment 153,600 Int Exp (160,000 x 180/360 x 8%) 6,400 Notes Payable 160,000

11-1B continued May 16 Pd interest due on note of April 1 and renewed loan by issuing 30-day 10% note Notes Payable 60,000 Int Exp (60000 x 45/360 x 6%) 450 Notes Payable 60,000 Cash 450

11-1B continued Nov 10 Purchased equip for $200,000; paid $60,000 and issued 7 9% notes for $20,000 each coming due at 30-day intervals Equipment 200,000 Cash 60,000 Notes Payable 140,000

11-1B continued Dec 10 Paid the amount due on the first note in the series issued on Nov 10 Notes Payable 20,000 Int Exp (20, 000 x 30/360 x 9%) 150 Cash 20,150

11-1B continued 2. b. Adjusting entry for the 6 remaining notes owed from the Nov 10 transaction Interest Expense 1530 Interest Payable 1530 (20000 x 9% x 51/360 x 6 notes)

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

Payroll refers to the amount paid to employees for the services they provide during a period. A company’s payroll is important for the following reasons: Employees are sensitive to payroll errors and irregularities. Good employee morale requires payroll to be paid timely and accurately. Payroll is subject to various federal and state regulations. Payroll and related payroll taxes significantly affect the net income of most companies.

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

Computing Employee’s Earnings John 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. Earnings at regular rate (40 × $34) $1,360 Earnings at overtime rate (2 × $51) 102 Total earnings $1,462

The total earnings of an employee for a payroll period are called gross pay. From this is subtracted one or more deductions to arrive at the net pay. Net pay is the amount that the employer must pay the employee.

Deductions from Employee’s Earnings: McGrath Example McGrath made $1,462 for the week ending December 27. Since McGrath’s W-4 claims one withholding allowance, $67 (the assumed standard withholding allowance) is deducted from his gross pay to arrive at $1,395 ($1,462 – $67).

Wage Bracket Withholding Table Exhibit 3 Wage Bracket Withholding Table Source: Publication 15, Employer’s Tax Guide, Internal Revenue Service, 2008

McGrath Example (continued) Initial withholding (Slide 30) $ 82.95 Plus [25% × ($1,395 – $653)] 185.50 Total federal income taxes withheld $268.45

Federal Income Tax Withholding Example Exercise 11-2 Federal Income Tax Withholding Karen Dunn’s weekly gross earnings for the present week were $2,250. Dunn has two exemptions. Using the wage bracket withholding table in Exhibit 3 (Slide 30) with a $67 standard withholding allowance for each exemption, what is Dunn’s federal income tax withholding?

One allowance (provided by IRS) $67 Example Exercise 11-2 (continued) Total wage payment $2,250 One allowance (provided by IRS) $67 Multiplied by allowances claimed on W-4 × 2 134 Amount subject to withholding $2,116 Initial withholding from wage bracket in Exh. 3 $302.96 Plus additional withholding: 28% of excess over $1,533 163.24* Federal income tax withholding $466.20 *28% × ($2,116 – $1,533)

FICA Tax The amount of FICA tax withheld is the employees’ contribution to two federal programs. The first program, called social security, is for old age, survivors, and disability insurance (OASDI). The second program, called Medicare, provides health insurance for senior citizens.

John T. McGrath’s FICA Tax John T. Mcgrath’s annual earnings prior to the payroll period ending on December 27 total $99,038. Earnings subject to 6% social security tax ($100,000 – $99,038) $ 962 Social security tax rate × 6% Social security tax $57.72 Earnings subject to 1.5% Medicare tax $1,462 Medicare tax rate × 1.5% Medicare tax 21.93 Total FICA tax $79.65

John T. McGrath’s Net Pay Gross earnings for the week $1,462.00 Deductions: Social security tax (Slide 35) $ 57.72 Medicare tax (Slide 35) 21.93 Federal income tax (Slide 31) 268.45 Retirement savings 20.00 United Way 5.00 Total deductions 373.10 Net pay $1,088.90

Example Exercise 11-3 Employee Net Pay Karen Dunn’s weekly gross earnings for the week ending Dec. 3rd were $2,250, and her federal income tax withholding was $466.19. Prior to this week Dunn had earned $98,000 for the year. Assuming the social security rate is 6% on the first $100,000 of annual earnings and Medicare is 1.5% of all earnings, what is Dunn’s net pay?

Less: Federal income tax withholding 466.19 Example Exercise 11-3 (continued) Total wage payment $2,250.00 Less: Federal income tax withholding 466.19 Earnings subject to social security tax ($100,000 – $98,000) $2,000 Social security tax rate × 6% Social security tax 120.00 Medicare tax ($2,250 × 1.5%) 33.75 Net pay $1,630.06

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)

Employer’s Federal Payroll Taxes Employers are required to contribute to the social security and Medicare programs for each employee. The employer must match the employee’s contribution to each program.

Employer’s Federal Unemployment Taxes A FUTA tax of 6.2% is levied on employers only to provide for temporary unemployment to those who become unemployed as a result of layoffs due to economic causes beyond their control. This tax applies to only the first $7,000 of the earnings of each covered employee during a calendar year.

Employer’s State Unemployment Taxes This employer tax also provides temporary payments to those who become unemployed. The FUTA and SUTA programs are closely coordinated, with the states distributing the unemployment checks. SUTA tax rates and earnings subject to tax vary by state.

Exhibit 4 Responsibility for Tax Payments

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

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.

Payroll Register The payroll register is a multicolumn report used for summarizing the data for each payroll period. The right hand columns of the payroll register indicate the accounts debited for the payroll expense. These columns are often referred to as the payroll distribution.

Journalize Period Payroll Example Exercise 11-4 Journalize Period Payroll The payroll register of Chen Engineering Services indicates $900 of social security withheld and $225 of Medicare tax withheld on total salaries of $15,000 for the period. Federal withholding for the period totaled $2,925. Provide the journal entry for the period’s payroll. Salaries Expense……………………………… 15,000 Social Security Tax Payable………........ 900 Medicare Tax Payable………………….... 225 Federal Withholding Tax Payable……… 2,925 Salaries Payable………………………….. 10,950

Employee’s Earnings Record A detailed payroll record is maintained for each employee. This record is called an employee’s earnings record. At the end of each pay period, payroll checks are prepared. Each check includes a detachable statement showing the details of how the net pay was computed.

Exhibit 8 Flow of Data in a Payroll System

Internal Controls for Payroll Systems If a check-signing machine is used, blank payroll checks and access to the machine should be restricted to prevent their theft. 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. (continued)

Employees should be observed when arriving for work to verify they are “checking in” for work only once and only for themselves. Payroll checks should be distributed by someone other than employee supervisors. A special payroll bank account should be used.

Objective 4 Journalize entries for employee fringe benefits, including vacation pay, and pensions.

Many companies provide their employees a variety of benefits in addition to salary and wages earned. Such fringe benefits may take many forms, including vacations, medical, and retirement benefits.

Vacation Pay Most employers grant vacation rights, sometimes called compensated absences, to their employees. The estimated vacation pay for the year ending December 31 is $325,000.

Pension A pension represents a cash payment to retired employees. Rights to pension payments are earned by employees during their working years, based on the pension plan established by the employer.

Defined Contribution Plan In a defined contribution plan, a fixed amount of money is invested on the employee’s behalf during the employee’s working years.

Defined Benefit Plan In a defined benefit plan, employers promise employees a fixed annual pension benefit at retirement, based on years of service and compensation levels.

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.

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: Likelihood of occurring: Probable, reasonably possible, or remote. Measurement: Estimable or not estimable.

Recording Contingent Liabilities During June, a company sells a product for $60,000 on which there is a 36-month warranty. Past experience indicates that the average cost to repair defects is 5% of the sales price over the warranty period.

If a customer required a $200 part replacement on August 16, the entry would be:

Exhibit 10 Accounting Treatment of Contingent Liabilities

Quick Ratio Noble Co. Hart Co. Quick assets: Cash $147,000 $120,000 Accounts receivable (net) 84,000 472,000 Total quick assets $231,000 $592,000 Current liabilities $220,000 $740,000 Quick assets Current liabilities Quick Ratio = The quick ratio or acid-test ratio can be used to evaluate a firm’s ability to pay its current liabilities within a short period of time.

Quick Ratio Noble Co. Hart Co. Quick assets: Cash $147,000 $120,000 Accounts receivable (net) 84,000 472,000 Total quick assets $231,000 $592,000 Current liabilities $220,000 $740,000 Quick assets Current liabilities Quick Ratio = Noble Company = $231,000 $220,000 = 1.05

Quick Ratio Noble Co. Hart Co. Quick assets: Cash $147,000 $120,000 Accounts receivable (net) 84,000 472,000 Total quick assets $231,000 $592,000 Current liabilities $220,000 $740,000 Quick assets Current liabilities Quick Ratio = Hart Company = $592,000 $740,000 = 0.80

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