Chapter 12 Current Liabilities Multimedia Slides by Gail
Chapter 12 Current Liabilities Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University
Learning Objectives 1. Identify the management issues related to recognition, valuation, classification, and disclosure of current liabilities. 2. Identify, compute, and record definitely determinable and estimated current liabilities. 3. Distinguish contingent liabilities from commitments. Copyright © Houghton Mifflin Company. All rights reserved. 2
Supplemental Objective 4. Compute and record the liabilities associated with payroll accounting. Copyright © Houghton Mifflin Company. All rights reserved. 3
Management Issues Related to Accounting for Current Liabilities • Objective 1 – Identify the management issues related to recognition, valuation, classification, and disclosure of current liabilities Copyright © Houghton Mifflin Company. All rights reserved. 4
Current Liabilities … are incurred to meet cash needs during the operating cycle • The proper identification and management of current liabilities requires an understanding of how they are – – Recognized Valued Classified Disclosed Copyright © Houghton Mifflin Company. All rights reserved. Current liabilities typically equal from 25 to 50 percent of total assets 5
Management Issues Related to Accounting for Current Liabilities • Managing liquidity and cash flows • Recognition of liabilities • Valuation of liabilities • Classification of liabilities • Disclosure of liabilities Copyright © Houghton Mifflin Company. All rights reserved. 6
Managing Liquidity and Cash Flows • The operating cycle converts cash to purchases, to sales, to accounts receivable, and back to cash – Most current liabilities support this cycle • Failure to manage related cash flows can have serious consequences – If suppliers are not paid, they may not ship – A continued inability to meet payments when due can lead to bankruptcy Copyright © Houghton Mifflin Company. All rights reserved. 7
Managing Liquidity and Cash Flows (cont’d) • Factors to consider – Ability to pay current liabilities • Evaluate using three measures of liquidity – Working capital – Current ratio – Quick ratio Current liabilities are a key component in each of these three measures – Amount of time creditors are willing to give a company to pay its accounts payable • Common measures of this time – Payables turnover – Average days’ payable Copyright © Houghton Mifflin Company. All rights reserved. 8
Working Capital U. S. Airways’ short-term liquidity as measured by working capital was negative in 2000 and 2001 • Low or negative working capital is common for airline companies because unearned ticket revenue is a current liability • Assuming only a small percentage of unearned ticket revenues will be repaid to customers, unearned ticket revenues might be excluded for current liabilities for the purpose of analysis Copyright © Houghton Mifflin Company. All rights reserved. 9
Payables Turnover Radio. Shack Corp. had accounts payable of $312. 6 million in 2002 and $206. 7 million in 2001. Its cost of goods sold in 2002 was $2, 338. 9 million and its inventory increased by $21. 4 million This means that, on average, Radio. Shack’s accounts payable are paid 9. 1 times during the accounting period Copyright © Houghton Mifflin Company. All rights reserved. 10
Payables Turnover for Selected Industries Copyright © Houghton Mifflin Company. All rights reserved. 11
Average Days’ Payable Knowing that Radio. Shack Corporation’s payables turnover is 9. 1 times, its average days’ payable can be computed This means that, on average, Radio. Shack Corporation takes 40. 1 days to pay its accounts payable Copyright © Houghton Mifflin Company. All rights reserved. 12
Recognition of Liabilities • A liability is recorded when an obligation exists – A transaction obligates a company to make future payments – Current liabilities often are not represented by a direct transaction • Record adjusting entries to recognize unrecorded liabilities – Known amounts such as salaries payable – Estimated amounts such as taxes payable • Transactions or commitments where no current obligation exists are not recognized as liabilities Copyright © Houghton Mifflin Company. All rights reserved. 13
Valuation of Liabilities • On the balance sheet, liabilities are generally valued at – The amount of money needed to pay the debt, or – The fair market value of goods or services to be delivered • Sometimes the amount must be estimated – Estimates are based on past experience and anticipated changes in the business environment • Service warranties on cars • Additional financial statement disclosure may be required Copyright © Houghton Mifflin Company. All rights reserved. 14
Classification of Liabilities … directly matches the classification of assets • Current liabilities – Expected to be satisfied within one year or within the normal operating cycle, whichever is longer – Paid out of current assets or with cash generated from operations • Long-term liabilities – Due beyond one year or beyond the normal operating cycle – Used to finance long-term assets It is important to distinguish between current and long -term liabilities because of the effect on liquidity Copyright © Houghton Mifflin Company. All rights reserved. 15
Disclosure of Liabilities • Supplemental disclosure may be required in the notes to the financial statements – Large amount of notes payable – Special credit arrangements – Commercial paper – Lines of credit Copyright © Houghton Mifflin Company. All rights reserved. 16
Discussion Q. What is the rule for classifying a liability as current? A. A liability is current if the obligation will be satisfied within one year or within the normal operating cycle, whichever is longer Copyright © Houghton Mifflin Company. All rights reserved. 17
Common Categories of Current Liabilities • Objective 2 – Identify, compute, and record definitely determinable and estimated current liabilities Copyright © Houghton Mifflin Company. All rights reserved. 18
Common Categories of Current Liabilities • Two major groups of current liabilities – Definitely determinable liabilities • Set by contract or by statute and can be measured exactly – Estimated liabilities • Definite debts or obligations of which the exact dollar amount cannot be known until a later date Copyright © Houghton Mifflin Company. All rights reserved. 19
Types of Definitely Determinable Liabilities • Accounts payable • Bank loans and commercial paper • Notes payable • Accrued liabilities • Dividends payable • Sales and excise taxes payable • Current portions of long-term debt • Payroll liabilities • Unearned or deferred revenues Copyright © Houghton Mifflin Company. All rights reserved. 20
Accounts Payable … are short-term obligations to suppliers for goods and services • Also called trade accounts payable • Amount in Accounts Payable account in the general ledger is generally supported by an Accounts Payable subsidiary ledger – Accounts Payable subsidiary ledger contains an individual account for each person or company to which money is owed Copyright © Houghton Mifflin Company. All rights reserved. 21
Bank Loans • A line of credit may be established with a bank – Allows a company to borrow funds when needed to finance current operations • The bank may require the company to meet certain financial goals – Maintain specific profit margins – Maintain current ratios – Maintain debt to equity ratios Copyright © Houghton Mifflin Company. All rights reserved. 22
Commercial Paper … is a way of borrowing money by using unsecured short-term loans sold directly to the public • The portion of the line of credit borrowed and the amount of commercial paper issued are usually combined with notes payable in the current liabilities section of the balance sheet • Details are disclosed in a note to the financial statements Copyright © Houghton Mifflin Company. All rights reserved. 23
Short-Term Notes Payable. . . are obligations represented by promissory notes • Can be used to – Secure bank loans – Pay suppliers – Obtain other credit • Interest may be – Stated separately on the face of the note – Deducted in advance by discounting it from the face value of the note Copyright © Houghton Mifflin Company. All rights reserved. 24
Two Promissory Notes: One with Interest Stated Separately; One with Interest in Face Amount Copyright © Houghton Mifflin Company. All rights reserved. 25
Recording Notes Payable Interest Stated Separately on Face of Note Aug. 31: Issued a 60 -day, 12 percent promissory note with interest stated separately Oct. 30: Note is paid with interest Copyright © Houghton Mifflin Company. All rights reserved. 26
Recording Notes Payable Interest Deducted in Advance This is called discounting Aug. 31: Issued a 60 -day, 12 percent promissory note with interest deducted in advance Oct. 30: Note is paid Copyright © Houghton Mifflin Company. All rights reserved. 27
Accrued Liabilities … are existing liabilities that have not yet been recorded • Include – Interest payable – Wages payable Accrued liabilities can include estimated liabilities – Income taxes payable • Adjusting entries are required to recognize and record accrued liabilities Copyright © Houghton Mifflin Company. All rights reserved. 28
Recording Interest Payable Sep. 30: Record interest expense for 30 days on 60 -day, 12 percent promissory note issued August 31 Interest Stated Separately on Face of Note Interest Included in Face Amount Discount on Notes Payable will have a debit balance of $50 which will become interest expense during the next 30 days Copyright © Houghton Mifflin Company. All rights reserved. 29
Dividends Payable … are dividends that have been declared but not yet paid • Cash dividends are a distribution of earnings by a corporation • During the time between the date of declaration and the date of payment, dividends are a current liability • There is no liability until the board declares a dividend • The decision to pay dividends is solely up to the board of directors Copyright © Houghton Mifflin Company. All rights reserved. 30
Sales and Excise Taxes Payable … are taxes collected by businesses that must be forwarded to the appropriate government agencies • Most states and many cities levy a sales tax on retail transactions • The amount of tax collected is a current liability until remitted to the government Copyright © Houghton Mifflin Company. All rights reserved. 31
Recording Sales and Excise Taxes Payable June 1: Sold merchandise for $100; subject to 5 percent sales tax and 10 percent excise tax The taxes are collected and recorded as liabilities to be remitted at the proper times to the appropriate government agencies Copyright © Houghton Mifflin Company. All rights reserved. 32
Current Portions of Long-Term Debt … include the portions of long-term debt that are due within the next year and are to be paid from current assets • Are classified as current liabilities • No journal entry is required – Debt is reclassified when financial statements are prepared Copyright © Houghton Mifflin Company. All rights reserved. 33
Payroll Liabilities … include the cost of labor and related taxes for a company • The employer is liable to employees for wages and salaries – Wages • Payment for the services of employees at an hourly rate – Salaries • Compensation of employees who are paid at a monthly or yearly rate Copyright © Houghton Mifflin Company. All rights reserved. 34
Payroll Liabilities (cont’d) • Payroll accounting is important because complex laws and significant liabilities are involved • The employer is responsible to various government and other agencies for amounts withheld and related taxes • It is important to distinguish between employees and independent contractors • The journal entry to record payroll is lengthy Copyright © Houghton Mifflin Company. All rights reserved. 35
Illustration of Payroll Liabilities
Recording Payroll Feb 15: Record payroll, total employee wages, $32, 500 Note that employees earned $32, 500 but take home pay was $21, 214 Feb 15: Record payroll taxes Payroll taxes and benefits increase the total cost of payroll to $41, 901 ($32, 500 + $9, 401) Copyright © Houghton Mifflin Company. All rights reserved. 37
Unearned Revenues … are obligations for goods or services that the company must provide or deliver in a future accounting period in return for an advance payment from a customer • Deposits received in advance are also considered current liabilities Copyright © Houghton Mifflin Company. All rights reserved. 38
Recording Unearned Revenues Received annual subscriptions totaling $240 The publisher now has a liability that will be reduced gradually as monthly issues of magazines are mailed Monthly issue of magazines mailed Copyright © Houghton Mifflin Company. All rights reserved. 39
Estimated Liabilities … are definite debts or obligations of which the exact dollar amount cannot be known until a later date • There is no doubt about the existence of the legal obligation • The primary accounting problem is to estimate and record the amount of the liability Copyright © Houghton Mifflin Company. All rights reserved. 40
Types of Estimated Liabilities • Income taxes • Property taxes • Product warranties • Vacation pay Copyright © Houghton Mifflin Company. All rights reserved. 41
Income Taxes • The amount of income taxes liability depends on the results of operations • The amount may not be known until after the end of the year • Sole proprietorships and partnerships do not pay income taxes – Their owners pay on their individual returns • An adjusting entry records the estimated tax liability Copyright © Houghton Mifflin Company. All rights reserved. 42
Property Tax Payable • Property taxes are levied on real and personal property • They are assessed annually, but the government unit’s fiscal year and the company’s may not correspond • The company must estimate the amount of property tax that applies to each month of the year Copyright © Houghton Mifflin Company. All rights reserved. 43
Product Warranty Liability • A liability exists for the length of time specified in the terms of the warranty • A company can estimate the future cost of the liability – Based on past experience with claims for the product or services – An average cost is usually used • The estimated cost of the warranty is debited to an expense account in the period of sale Copyright © Houghton Mifflin Company. All rights reserved. 44
Computation of Product Warranty Liability During July, 350 mufflers were sold for $50 each. In the past, 6 percent of mufflers were returned for replacement under warranty Copyright © Houghton Mifflin Company. All rights reserved. 45
Computation of Product Warranty Liability (cont’d) Dec 5: A customer returns, under warranty, a defective muffler that cost $40 and pays a $20 service fee for the replacement Copyright © Houghton Mifflin Company. All rights reserved. 46
Vacation Pay Liability • Employees accrue vacation pay as they work during the year • The cost should be allocated over the entire year so that month-to-month costs will not be distorted • The treatment of vacation pay also applies to other payroll costs – Bonus plans – Contributions to pension plans Copyright © Houghton Mifflin Company. All rights reserved. 47
Vacation Pay Liability (cont’d) April 20: Record estimated vacation pay liability. Employees earn two weeks paid vacation for every 50 weeks worked, and it is assumed only 75 percent of employees will ultimately collect vacation pay. The weekly payroll was $21, 000, of which $1, 000 was paid to employees on vacation. The computation of vacation pay expense is based on the payroll of employees not on vacation Copyright © Houghton Mifflin Company. All rights reserved. 48
Discussion Q. Indicate whether each of the following is (a) A definitely determinable liability (b) An estimated liability 1. 2. 3. 4. Dividends payable Income taxes payable Current portion of long-term debt Vacation pay liability Copyright © Houghton Mifflin Company. All rights reserved. 1. 2. 3. 4. a b 49
Contingent Liabilities and Commitments • Objective 3 – Distinguish contingent liabilities from commitments Copyright © Houghton Mifflin Company. All rights reserved. 50
Contingent Liabilities … are potential liabilities that depend on future events arising out of past transactions Past transaction – building of a bridge Future event – outcome of a lawsuit • Two conditions for determining when a contingency should be entered in the accounting records 1. The liability must be probable 2. It can be reasonably estimated • Vacation pay, income taxes, and warranty liability Copyright © Houghton Mifflin Company. All rights reserved. 51
Commitments … are legal obligations that do not meet the technical requirements for recognition as a liability • Common examples – Purchase agreements – Leases Copyright © Houghton Mifflin Company. All rights reserved. 52
Discussion Q. What is a contingent liability, and how does it differ from an estimated liability? A. A contingent liability is a potential liability that depends on a future event arising out of a past transaction It differs from an estimated liability in that an estimated liability is not a potential liability but a current liability for which the amount is uncertain and must be estimated Copyright © Houghton Mifflin Company. All rights reserved. 53
Payroll Accounting Illustrated • Supplemental Objective 4 – Compute and record the liabilities associated with payroll accounting Copyright © Houghton Mifflin Company. All rights reserved. 54
Computation of an Employee’s Take-Home Pay Copyright © Houghton Mifflin Company. All rights reserved. 55
Regular Time • Hours worked up to 40 hours per week or 8 hours per day The Fair Labor Standards Act requires employers to pay a minimum wage • For employers taking part in interstate commerce, employees who work beyond regular time must be paid overtime Copyright © Houghton Mifflin Company. All rights reserved. 56
Overtime • Regulated by the federal Fair Standards Act • Overtime pay must be at least one and one-half times the regular rate • Work on Saturdays, Sundays, and holidays may also call for overtime pay or some sort of premium pay Overtime pay under union or other employment contracts may exceed these minimums Copyright © Houghton Mifflin Company. All rights reserved. 57
Calculating Total Wages Robert Jones earns a regular wage of $8 an hour, one and one-half times the regular rate for work over eight hours in any weekday, and twice the regular rate for work on Saturdays, Sundays, and holidays Jones works the following days and hours during the week of January 18, 20 xx Copyright © Houghton Mifflin Company. All rights reserved. 58
Calculating Total Wages (cont’d) Jones’s wages would be calculated as follows Copyright © Houghton Mifflin Company. All rights reserved. 59
Calculating Net (Take-Home) Pay • Once total wages have been calculated, total deductions must be determined • Deductions include – – – Federal income taxes withheld Social security tax Medicare tax Medical insurance Life insurance Other deductions Copyright © Houghton Mifflin Company. All rights reserved. 60
Social Security and Medicare Taxes • Social security tax – 6. 2% (if total wages earned ≤ $87, 000) • Medicare tax – 1. 45% Copyright © Houghton Mifflin Company. All rights reserved. 61
Federal Income Taxes • Based on earnings and number of exemptions claimed • W-4 – Employee’s Withholding Exemption Certificate – One exemption each may be claimed for the employee and his or her dependents • Amount of withholding is determined by referring to a withholding table provided by the IRS – Based on the information on the W-4 Copyright © Houghton Mifflin Company. All rights reserved. 62
Sample Withholding Table Jones is a married employee who has a total of four exemptions and is paid weekly The withholding on total wages of $412 is $31 Copyright © Houghton Mifflin Company. All rights reserved. Actual withholding tables change periodically to reflect changes in tax laws and regulations 63
Net (Take-Home) Pay Jones’s union dues are $2. 00, his medical insurance premiums are $7. 60, his life insurance premium is $6. 00, he places $15. 00 per week in savings bonds, and he contributes $1. 00 per week to United Charities Copyright © Houghton Mifflin Company. All rights reserved. 64
Payroll Register • A detailed listing of a company’s total payroll • Is prepared each pay period • Columns in the register help employers record payroll in the accounting records and meet legal reporting requirements Copyright © Houghton Mifflin Company. All rights reserved. 65
Payroll Register (cont’d) • Note that the name, hours, earnings, deductions, and net pay are listed for each employee The last two columns are needed to divide the expenses in the accounting records into selling and administrative categories Copyright © Houghton Mifflin Company. All rights reserved. 12– 66
Payroll Register (cont’d) • The journal entry for recording the payroll is based on the column totals from the payroll register Copyright © Houghton Mifflin Company. All rights reserved. 12– 67
Payroll Register (cont’d) 12– 68
Employee Earnings Record • Each employer must keep a record of earnings and withholdings for each employee • Most companies use computers for this purpose, but a manual record, such as the one above, may still be used Copyright © Houghton Mifflin Company. All rights reserved. 69
Employee Earnings Record (cont’d) • This form is designed to help employers meet legal reporting requirements – – Each deduction must be shown to have been paid to the proper agency The employee must receive a report of the deductions each year Copyright © Houghton Mifflin Company. All rights reserved. 70
Employee Earnings Record (cont’d) • Most of the columns are self-explanatory • Cumulative Gross Earnings column – Total earnings to date – Helps employer comply with rules of applying social security and unemployment taxes up to the minimum wage levels Copyright © Houghton Mifflin Company. All rights reserved. 71
Employee Earnings Record (cont’d) • Cumulative Gross Earnings column (cont’d) – At year end, the employer reports total earnings and deductions on Form W-2 to the employee • – Used by employee to complete the individual tax return A copy is sent to the IRS • Used to check whether employee has reported correct amounts on his or her individual tax return Copyright © Houghton Mifflin Company. All rights reserved. 72
Recording Payroll Taxes Copyright © Houghton Mifflin Company. All rights reserved. 12– 73
Payment of Payroll The company has a liability for wages payable of $1, 334. 40 after recording payroll for the week ended January 18 • If a special payroll account is used 1. A check for regular net earnings must be drawn on the regular account and deposited in the special payroll account 2. Checks are issued to employees from the special payroll account Copyright © Houghton Mifflin Company. All rights reserved. 12– 74
Payment of Payroll (cont’d) • If a voucher system is combined with a payroll account – A voucher for the total wages payable is prepared and recorded in the voucher register Copyright © Houghton Mifflin Company. All rights reserved. 12– 75
Payment of Payroll (cont’d) • Social security and Medicare taxes must be paid at least quarterly – This includes both the employees’ and employer’s shares • Federal income taxes must also be paid at least quarterly • More frequent payments are required when the total liability exceeds $500 Copyright © Houghton Mifflin Company. All rights reserved. 12– 76
Payment of Payroll (cont’d) • Federal unemployment insurance tax is paid yearly if the amount due is less than $100 • If the amount due is more than $100 at the end of any quarter, a payment is necessary • Payment dates vary among states Copyright © Houghton Mifflin Company. All rights reserved. 12– 77
Payment of Payroll (cont’d) • Other payroll deductions must be paid in accordance with the particular contracts or agreements involved Copyright © Houghton Mifflin Company. All rights reserved. 12– 78
Discussion Q. Are the amounts recorded for wages expense and wages payable for a pay period always the same? A. No. The amount recorded for wages expense is equal to the gross earnings of employees for the pay period. The amount recorded for wages payable is equal to the employees net earnings, which is gross earnings less any deductions for taxes, union dues, insurance premiums, etc. Copyright © Houghton Mifflin Company. All rights reserved. 12– 79
Time for Review 1. Identify the management issues related to recognition, valuation, classification, and disclosure of current liabilities 2. Identify, compute, and record definitely determinable and estimated current liabilities 3. Distinguish contingent liabilities from commitments Copyright © Houghton Mifflin Company. All rights reserved. 80
And Finally… 4. Compute and record the liabilities associated with payroll accounting Copyright © Houghton Mifflin Company. All rights reserved. 81
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