Chapter 12 Current Liabilities Employer Obligations Learning Goals
Chapter 12 Current Liabilities & Employer Obligations
Learning Goals �The nature and recording of typical current liabilities �Accounting for notes payable �The criteria for recognition and/or disclosure of contingent liabilities �Basic accounting for payroll and payroll related taxes �Other components of employee compensation 2
Current Liabilities �Debts that are due to be paid within one year or the operating cycle, whichever is longer � Typically involve: Use of current assets, � Creation of another current liability, or � Providing of some service � 3
The Operating Cycle �The length of time it takes to turn cash back into cash � Ex) A business starts with cash, buys inventory, sells goods, and eventually collects the sales proceeds in cash �For most businesses, the operating cycle is less than one year, but not always 4
Accounts Payable �Amounts due to suppliers relating to the purchase of goods and services �May be supported by a written agreement � Typically based on an informal working relationship 5
Current Portion of Long-Term Debt �Debt of long duration is reported as a long-term liability �However, the amount of principal to be paid within one year or the operating cycle, whichever is longer, should be separated and classified as a current liability �Ex) A $100, 000 long-term note is to be paid in equal annual increments of $10, 000, plus accrued interest � At the end of any given year, the $10, 000 principal due during the following year should be reported as a current liability � The remaining balance should be shown as a long-term liability � The accrued interest would also be reported as a current liability 6
Accrued Liabilities �Expenses that accumulate with the passage of time, but will be paid in one lump-sum amount � Ex) Employee wages accrue gradually with time The amount that employees have earned but not been paid is termed accrued salaries � Reported as a current liability � Other examples include accrued taxes and interest � 7
Prepayments by Customers �When customers deposit money in advance of receiving the expected goods or services �Represent an obligation to either return the money or deliver a service in the future �Reported as “unearned revenue” in the current liability section � Removed and revenue recognized as goods and services are provided �Ex) Selling magazine subscriptions in advance, selling gift cards, selling tickets well before a scheduled event, etc. 8
Collections for Third Parties �The recipient of some payment is not the beneficiary of the payment � The recipient has an obligation to turn the money over to another entity � Reported as current liabilities until funds are remitted � Ex) Sales tax collected by merchants to be passed along to taxing entities 9
Obligations to be Refinanced �Sometimes companies renew long-term obligations by borrowing money to repay maturing notes �A currently maturing long-term obligation is to be shown as a current liability unless: � The company intends to renew the debt on a long-term basis, and � The company has the ability to do so � Usually evidenced by a agreement with a competent lender 10
Notes Payable � Formal short-term borrowings � Usually evidenced by a specific written promise to pay � The party who agrees to pay is termed the “maker” � Negotiable instruments � Enable transfer to other parties � Typically involve interest � Vary in duration � Ex) Bank borrowings, equipment purchases, and some credit purchases from suppliers 11
Notes Payable - Example �Oliva has agreed to pay to Banc. Zone $10, 000 plus interest of $400 on June 30, 20 X 8 � The interest represents 8% of $10, 000 for half of a year (January 1 through June 30) �A correct legal form would typically be more expansive and cover things like what happens in the event of default, who pays legal fees if there is a dispute, requirements of demand notice, etc. 12
Notes Payable - Example 13
Notes Payable - Example �The amount borrowed is recorded by debiting Cash and crediting Notes Payable: 14
Notes Payable - Example �When the note is repaid, difference between the carrying amount of the note and the cash to repay that note is reported as interest expense 15
Notes Payable - Example �Entries if the note had been created on October 1: 16
Notes Payable - Example �Interest for three months was accrued at December 31, representing accumulated interest to be paid at maturity on March 31, 20 X 9 �On March 31, another three months of interest was charged to expense �The cash payment included $400 for interest, half relating to the amount previously accrued in 20 X 8 and half relating to 20 X 9 17
Notes Payable - Example � The current liabilities section on December 31, 20 X 8 would appear as follows: The order may be according to due dates, from earliest to latest An alternative is to list by maturity value, from largest to smallest 18
Interest Calculations �Some short-term borrowing agreements may stipulate that a year is assumed to have 360 days � Justified in the past to ease calculations �Lenders may use to prey on borrowers � Ex) Interest on a $100, 000, 8% loan for 180 days � $4, 000 � $100, 000 X. 08 X 180/360 � Only � assuming a 360 -day year $3, 945 based on the more correct 365 -day year $100, 000 X. 08 X 180/365 19
Rule of 78 s � Based on the notion that a year has 12 months, and 12 + 11 + 10 + 9 +. . . + 1 = 78 � 12/78 of the total interest is attributable to the first month, 11/78 to the next, etc. � Ex) $100, 000 borrowed with 8% interest for 12 months would have annual interest of $8, 000 � Suppose the borrower prepaid the loan after two months: � Under the rule of 78 s, interest due would be $2, 359 � � (12+11)/78 X $8, 000 Based simply on 2 of 12 months, the interest due would be $1, 333 � 2/12 X $8, 000 20
Simple vs. Compounding �Simple Interest = Loan X Interest Rate X Time �Compound interest assumes accumulated interest will also start to accrue interest (“interest on interest”) � Compounding can occur annually, quarterly, monthly, daily, and even continuously � The narrower the frequency, the greater the amount of total interest that will be calculated 21
Interest Up Front �A note may be issued with interest included in the face value � Also known as a note issued at a discount �Ex) $9, 000 is borrowed, but a $10, 000 note is established �At maturity, $10, 000 is repaid � $9, 000 repayment of borrowed amounts and $1, 000 interest �The interest rate may appear to be 10% (1, 000/10, 000), but the effective rate is much higher (1, 000/9, 000 = 11. 11%) 22
Interest Up Front �The entry to record the note: 23
Interest Up Front �The $1, 000 difference is initially recorded as a discount on note payable � Reported as contra liability � Results in a $9, 000 net liability �Discount amortization transfers the discount to interest expense over the life of the loan � The $1, 000 discount should be recorded as interest expense by debiting Interest Expense and crediting Discount on Note Payable � This amount would need to be recorded partially in one period and partially in another if the maturity date was not the end of the year 24
Interest Up Front �The entries at maturity: 25
Truth In Lending �Lenders can use unique interest calculations to tilt the benefit of a bargain to their advantage �Statues have increasingly required fuller disclosure or even limited certain practiced �Lenders who overcharge interest or violate laws may lose the right to collect amounts loaned 26
Contingent Liabilities �Uncertain or potential obligations that may give rise to liabilities, but the timing and amounts are not sure � Ex) Legal disputes, environmental contamination, product warranties, etc. (“firm specific risks”) �Different from general business risks, such as war, storms, etc. , where no specific accounting can be made in advance 27
Contingent Liabilities 28
Contingent Liabilities �Recorded in the accounts it is: �Probable that the future event will occur and �The amount of the liability can be reasonably estimated �A loss recorded (debit) and liability established (credit) �If the estimated loss can only be defined as a range of outcomes the recorded amount is generally: �The low end of the range under USA standards �The midpoint of the estimated outcomes under international accounting standards 29
Contingent Liabilities �If it is only reasonably possible that the contingent liability will become a real liability, a note to the financial statements is required � Similar treatment when it is probable a loss has occurred but the amount cannot be estimated �Normally, accounting tends to be very conservative, but this is not the case for contingent liabilities 30
Contingent Liabilities �Remote risks do not need to be disclosed � Viewed as needless clutter � Ex) Frivolous lawsuits �Disclosures of business decisions risks are not required, but not discouraged � Ex) Deciding to reduce insurance coverage due to high insurance premiums �Contingent assets/gains are almost never recognized before payments are actually received � Ex) Company’s claim against another for patent infringement 31
Timing of Events �If a customer was injured by a defective product in Year 1, but the company did not receive notice of the event until Year 2 (but before issuing Year 1’s financial statements), the event would nevertheless impact Year 1 financial statements � The event (“the injury itself”) giving rise to the loss arose in Year 1 32
Timing of Events �Conversely, if the injury on the preceding slide occurred in Year 2, Year 1’s financial statements would not be adjusted no matter how bad the financial effect � A note in the financial statements may be needed to explain that a material adverse event arising subsequent to year end has occurred 33
Warranty Liability �When goods are sold, an estimate of the amount of warranty costs to be incurred on the goods should be recorded as expense � The offsetting credit goes to a Warranty Liability account �As warranty work is performed, the Warranty Liability is reduced and Cash (or other resources) is credited �This method follows the matching principle 34
Warranty Liability - Example �Zeff Company had a beginning-of-year Warranty Liability account balance of $25, 000 �During the year Zeff sells $3, 500, 000 of goods, eventually expecting to incur warranty costs equal to 2% of sales � The 2% rate is just an estimate based on the best information available to Zeff �$80, 000 was actually spent on warranty work 35
Warranty Liability - Example 36
Warranty Liability - Example 37
Costs Similar to Warranties �Estimated liabilities should be established with similar procedures as warranty costs for items such as: � Coupons � Prizes � Rebates � Air-miles � Free hotel stays � Free rentals � Other items associated with sales activity 38
Payroll �Payroll tax and record keeping requirements differ for independent contractors and employees � An independent contractor performs a designated task or service for a company � The company has the right to control or direct only the result of the work done by an independent contractor � An employee works for a specific business and performs activities as directed by that business � The business controls what will be done and how it will be done 39
Payroll �Amounts paid to independent contractors generally do not involve any tax withholdings by the payer �The payer may need to report the amount paid to the Internal Revenue Service (IRS) on a Form 1099, with a copy to the independent contractor �The obligation for paying taxes rests with the independent contractor 40
Payroll �Paychecks are usually reduced by a variety of taxes and other reductions may also occur �Employers may also pay costs related to such deductions �Gross Pay: Total earnings of an employee �Hourly employees: Number of hours worked X hourly rate �Salaried employees: Flat amount for the period �Overtime rules may increase pay �Net Pay: Gross earnings less applicable deductions 41
Income Taxes � Income taxes are required to be withheld by federal and sometimes state and/or city governments � Withheld amounts must be remitted periodically to the government by the employer � The employer becomes an agent to collect amounts � Carried as a current liability on the employer’s books � The level of withholdings are based on the employee’s level of income, the frequency of pay, marital status, and the number of withholding allowances claimed � Employees claim withholding allowances by filing a form W-4 with their employer 42
Social Security and Medicare Taxes �Social Security/Medicare Taxes are also known as FICA, Federal Insurance Contributions Act �Tax transfers money to retirees and certain other persons not fully able to provide for themselves � Social security provides a modest income stream to the beneficiaries � Medicare provides support for health care costs of beneficiaries 43
Social Security and Medicare Taxes �The social security tax is a designated percentage of income, up to a certain maximum level of annual income per employee � If an employee’s income exceeds the annual limit, the tax ceases to be withheld from that employee for the remainder of the calendar year �The medicare/medicaid tax is also a designated percentage of income, but has no annual maximum �The employee’s amount for both taxes must be matched by the employer 44
Other Employee Deductions �Other deductions may include: � Cost sharing in health care insurance programs � Contributions to various retirement or other savings plans � Charitable contributions � Contributions to tax-advantaged health and child care savings programs �The employer collects amounts from the employees and has a duty to remit amounts to other entities 45
Payroll - Illustration 46
Payroll - Illustration � I. M. Fictitious earned $3, 000, but “took home” only $1, 819 47
Payroll - Illustration � I. M. Fictitious’s pay would be recorded as follows: 48
Employer Payroll �Social security and medicare/medicaid tax amounts must be matched by employers �Employers are also subject to unemployment taxes � FUTA: Federal Unemployment Tax � SUTA: State Unemployment Tax � Taxes provide funds that are paid to workers who are temporarily unable to find employment � Rates vary by state and employer history � Employers who rarely release employees generally get more favorable rates � Tax stops each year once a maximum income level is reached 49
Employer Payroll �Employers may carry workers compensation insurance � Provides payments to workers who sustain on-the-job injuries, and shields the employer from additional claims �Employers may provide health care insurance and retirement plan contributions �Obviously, the employer’s cost of an employee goes well beyond the amount reported on the paycheck 50
Payroll - Illustration � The following entry records the additional costs for I. M. Fictitious It was assumed that FUTA and SUTA bases had already been exceeded, the employer exactly matched insurance and retirement program contributions, and the employer incurred workers’ compensation insurance of $300. 51
Additional Reports �Shortly after the conclusion of a calendar year, an employer must review its employee records and prepare a summary wage and tax statement, commonly called a W-2 � Information is furnished to each employee and the government � Helps employees accurately prepare their own annual federal and state income tax returns � Allows the government to verify amounts reported by those individual taxpayers 52
Accurate Payroll Systems �Accuracy is vital in payroll accounting �A business may hire an outside firm that specializes in payroll management and accounting � The outside firm manages the payroll, recordkeeping, government compliance, processing of tax deposits, etc. �Most firms will set up a separate payroll journal or database that tracks information about each employee, as well as in the aggregate � A separate payroll bank account may be established into which the gross pay is transferred and from which paychecks and tax payments are disbursed 53
Accurate Payroll Systems �Employers who fail to make timely remittances are subject to harsh penalties �The government has made it very simple for employers to remit withheld amounts � Most commercial banks are approved to accept such amounts from employers � Online systems also allow easy funds transfer �The frequency of the required remittance is dependent upon the size of the employer and the total payroll 54
Compensated Absences �Paid time off �May include sick leave, holidays, family emergency time, jury duty time, vacations, etc. �Often accumulate with the passage of time �Companies expense and provide a liability for such accumulated costs when the accumulated benefit: � Relates to services already rendered, � Is a right that vests or accumulates, � Is probable to be paid, and � Can be reasonably estimated 55
Pension Plans – Defined Contribution �With defined contribution plans, an employer promises to make a periodic contribution into a separate pension fund account � The funds might be invested in stocks, bonds, or other approved investments � After a minimum vesting period, the funds become the property of the employee for their benefit once they enter retirement 56
Pension Plans – Defined Contribution �The company simply expenses the required periodic contribution as incurred � The pension assets and obligations are effectively transferred to a separate pension trust, greatly simplifying the recordkeeping of the employer 57
Pension Plans – Defined Benefit �In defined benefit plans, an employer’s promise become more uncertain �Benefits are a function of factors such as age, years of service, and annual service �Actuaries are trained to make assessments about life expectancy and work force trends �Prepare estimates to calculate annual pension expense �Funds are invested and eventually disbursed to retirees 58
Pension Plans – Defined Benefit �The company remains obligated for any shortfalls in the pension trust �If the pension fund is “underfunded” relative to outstanding pension promises made, a pension liability is reported �The pension assets and obligations are carried on the books of the separate pension trust fund 59
Other Post-Retirement Benefits �Some companies provide retirees with health care coverage, prescription benefits, and life insurance �Costs are expensed during the period of time during which the employee is actively working to have these rights vest � Offsetting liabilities are reported 60
Key Terms � Accounts payable Amounts due to suppliers relating to the purchase of goods and services on credit � Compensated absences Term to describe paid time off; vacations, sick leave, etc. � Contingent liabilities Events that may or may not give rise to an actual liability because the outcome is uncertain; examples include lawsuits, environmental damage issues, and so forth � Defined benefit plan A type of pension plan where the benefits are a function of years of service, pay, and age; the ultimate employer cost is not known in advance � Defined contribution plan A type of pension plan where the benefits are based on amounts in trust for the benefit of the employee; employer contributions are usually a fixed percentage of pay 61
Key Terms � Employee A person who works for a specific business and whose activities are directed by that business � FICA Federal Insurance Contributions Act (also known as social security and Medicare); establishes a tax that employers must withhold and match for governmentbased retiree benefit � Form 1099 A form required to be issued to an independent contractor reporting amounts paid; to assist with tax compliance issues (this form used to report other payments like interest, etc. ) � FUTA Federal Unemployment Tax levied on employer to provide funds for unemployed workers; rate is dependent on existence of SUTA and employer history of layoffs, etc. � Gross pay Also known as gross earnings; this it is the total amount earned by an employee before any deductions 62
Key Terms � Income taxes Taxes that are based on the amount income; for employees such amounts must be withheld by employers and remitted to the government � Independent contractor One who performs a designated task or service for a company, and the company has the right to control or direct only the result of the work done � Net pay Also known as net earnings; this is the gross pay less all applicable deductions ("take home pay") � Notes payable Formal short-term borrowings usually evidenced by a specific written promise to pay � Pension plan A general term to describe some form of arrangement for continuing payments to retirees 63
Key Terms � SUTA State Unemployment Tax levied on employer to provide funds for unemployed workers; rate is adjusted for employer history of layoffs, etc. � W-2 An annual statement provided to employees stating the amount of earnings and withholdings; assists employee in preparing their own tax returns � W-4 A form filled out by an employee stating the amount of exemptions to which they are entitled for tax purposes; such exemptions bear on the amount of income tax withholdings � Warranty liability A liability that is recorded for the future costs of claims that are anticipated because of product warranty agreements � Workers compensation insurance Insurance paid by the employer to cover work related injuries sustained by employees 64
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