1. Chapter 11 Current Liabilities and Payroll

2. Learning Objectives Account for current liabilities of known amount
Calculate and journalize basic payroll transactions
Account for current liabilities that must be estimated

3. Learning Objectives Account for contingent liabilities
Use the times-interest-earned ratio to evaluate business performance

4. Learning Objective 1
Account for current liabilities of known amount

5. How Are Current Liabilities of Known Amounts Accounted For?
Liabilities are debts that are owed to creditors.
Liabilities have three main characteristics:
They occur as a result of a past transaction or event.
They create a present obligation for future payments of cash or services.
They are an unavoidable obligation.
Up to this point, we’ve been focusing on all the assets a corporation owns. But what about the bills a business owes? A business needs to know what it owes (liabilities) and by what date the liabilities have to be paid. Liabilities are debts that are owed to creditors. Liabilities have three main characteristics:
They occur as a result of a past transaction or event.
They create a present obligation for future payments.
They are an unavoidable obligation.

6. How Are Current Liabilities of Known Amounts Accounted For?
Current liabilities must be paid either with cash or with goods and services within one year or within the entity’s operating cycle.
Long-term liabilities do not need to be paid within one year or within the entity’s operating cycle.
Liabilities can be split into two main categories: current and long-term. A current liability is a liability that must be paid with cash or with goods and services within one year or within the entity’s operating cycle if the cycle is longer than a year. A long-term liability is a liability that does not need to be paid within one year or within the entity’s operating cycle, whichever is longer.

7. How Are Current Liabilities of Known Amounts Accounted For?
Accounts Payable
Sales Tax Payable
Unearned Revenue
Long-term liabilities
Notes Payable
Mortgage Payable
Bonds Payable
Examples of current liabilities include:
Accounts Payable: Amounts owed for products or services on account are accounts payable. Because these are typically due in 30 days, they are current liabilities.
Sales Tax Payable: Most states assess sales tax on retail sales. Retailers collect the sales tax in addition to the price of the item sold. Sales Tax Payable is a current liability because the retailer must pay the state in less than a year.
Unearned Revenues: Unearned revenue is also called deferred revenue. Unearned revenue arises when a business has received cash in advance of providing goods or performing work and, therefore, has an obligation to provide goods or services to customers in the future.
Examples of long-term liabilities include Notes Payable, Mortgage Payable, and Bonds Payable.

8. Sales Tax Payable
December’s taxable sales for Smart Touch Learning totaled $10,000. The company collected an additional 6% sales tax, which would equal $600 ($10,000 × 0.06).
Sales tax is usually calculated as a percentage of the amount of the sale. For example, suppose December’s taxable sales for Smart Touch Learning totaled $10,000. The company collected an additional 6% sales tax, which would equal $600 ($10,000 x 0.06). The entry will require a debit to Accounts Receivable for $10,600, the amount of the sale and the amount of the related sales tax. In addition, there will be credit to Sales for $10,000 and a credit to Sales Taxes Payable for $600.

9. Sales Tax Payable
Sales tax is not an expense of the business. It is a current liability. Companies collect the sales tax and then forward it to the state at regular intervals.
Sales tax is not an expense of the business. It is a current liability. Companies collect the sales tax and then forward it to the state at regular intervals. They normally submit it monthly, but they could file it at other intervals, depending on the state and the amount of the tax. To pay the tax, the company debits Sales Tax Payable and credits Cash for $600.

10. Income Tax Payable
Assume that Smart Touch Learning incurred federal income tax payable of $3,780.
When Smart Touch Learning pays the tax, it will record the following:
The federal government and many state governments require corporations to pay income tax on their net income. Federal income taxes are calculated on a corporate tax return, referred to as Form The amount of taxes that the corporation owes but has not yet paid is classified as Income Tax Payable and is reported as a current liability on the balance sheet.

11. Unearned Revenues
Suppose Smart Touch Learning received $900 in advance on May 21 for a month’s work beginning on that date.
Unearned revenue is also called deferred revenue. Unearned revenue arises when a business has received cash in advance of providing goods or performing work and, therefore, has an obligation to provide goods or services to the customer in the future. Unearned revenues are current liabilities until they are earned.
Suppose Smart Touch Learning received $900 in advance on May 21 for a month’s work beginning on that date. On May 21, because it received cash before earning the revenue, the company has a liability to perform work for the client. The liability is called Unearned Revenue.

12. Unearned Revenue
During May, Smart Touch Learning delivered one-third of the work and earned $300 ($900 × 1/3) of the revenue. On May 31, the accounting clerk would record the following entry:
During May, Smart Touch Learning delivered one-third of the work and earned $300 ($900 × 1/3) of the revenue. On May 31, the accounting clerk would record a debit to Unearned Revenue of $300 and a credit to Service Revenue of $300 to show that some of the work had been completed and some revenues had now been earned.

13. Short-Term Notes Payable
Assume on May 1, Smart Touch Learning purchased merchandise inventory with a 10%, 90-day note payable, for $8,000. The company uses the perpetual inventory system.
Short-term notes payable are a common form of financing. A short-term note payable represents a written promise by the business to pay a debt, usually involving interest, within one year or less.
Assume on May 1, Smart Touch Learning purchased merchandise inventory with a 10%, 90-day note payable, for $8,000. The company uses the perpetual inventory system. The entry includes a debit to Merchandise Inventory for $8,000 and a credit to Notes Payable of $8,000.

14. Short-Term Notes Payable
On July 30, when the note is due, Smart Touch Learning will pay the note plus interest.
On July 30, when the note is due, Smart Touch Learning will pay the note plus interest. Notes Payable will be debited $8,000, Interest Expense will be debited $200 ($8,000 × 0.10 × 90/360), and Cash is credited $8,200 for the principal and interest associated with the note.

15. Current Portion of Long-Term Notes Payable
Long-term notes payable are typically reported in the long-term liability section of the balance sheet.
When the long-term debt is paid in installments, the business reports the current portion of notes payable as a current liability.
The remainder is classified as long-term.
Long-term notes payable are typically reported in the long-term liability section of the balance sheet. If, however, the long-term debt is paid in installments, the business will report the current portion of notes payable (also called maturity) as a current liability. The current portion of notes payable is the amount of the principal that is payable within one year. The remaining portion of the note will be classified as long-term.

16. Learning Objective 2
Calculate and journalize basic payroll transactions

17. How Do Companies Account for and Record Payroll?
Payroll, also called employee compensation, creates liabilities for a business.
For service organizations, payroll is the major expense.
There are numerous ways to label an employee’s pay:
Salary
Compensation
Commission
Bonus
Benefits
Payroll, also called employee compensation, also creates liabilities for a business. For service organizations—such as CPA firms and travel agencies—payroll is the major expense. Labor cost is so important that most businesses develop a special payroll system.
There are numerous ways to label an employee’s pay:
Salary is pay stated at an annual, monthly, or weekly rate, such as $62,400 per year, $5,200 per month, or $1,200 per week.
Wages are pay amounts stated at an hourly rate, such as $15 per hour.
Commission is pay stated as a percentage of a sales amount, such as a 5% commission on a sale. A realtor who earns 5% commission, for example, earns $5,000 on a $100,000 sale of real estate ($100,000 × 5%).
Bonus is pay over and above base salary (or wage commission). A bonus is usually paid for exceptional performance—in a single amount after year-end.
Benefits are extra compensation—items that are not paid directly to the employee. Benefits cover health, life, and disability insurance.

18. Gross Pay and Net (Take-Home) Pay
Two pay amounts are important for accounting purposes:
Gross pay is the total amount of salary, wages, commissions, and bonuses earned by the employee during the pay period.
Net pay is the amount the employee gets to keep. Net pay is also called take-home pay.
Two pay amounts are important for accounting purposes. Gross pay is the total amount of salary, wages, commissions, and any other employee compensation before taxes and other deductions. Net pay is gross pay minus all deductions. It is the amount of compensation that the employee actually takes home.

19. Employee Payroll Withholding Deductions
Required Deductions
Federal and state income tax
Social Security tax
Other deductions required by federal, state, or local law
Optional Deductions
Insurance premiums
Retirement plan contributions
Charitable contributions
The federal government, most states, and many municipalities require employers to deduct taxes from employee paychecks. Insurance companies may also get some of the employee’s gross pay. Amounts withheld from paychecks are called withholding deductions. Payroll withholding deductions are the difference between gross pay and take-home pay. These deductions are withheld from paychecks and sent directly to the government, to insurance companies, or to other entities. Payroll deductions fall into two categories: required deductions and optional deductions.
Required deductions include items such as employee federal and state income tax, Social Security tax, and other deductions required by federal, state, or local laws. For example, employees pay their income tax and Social Security tax through payroll deductions.
Optional deductions include insurance premiums, retirement plan contributions, charitable contributions, and other amounts that are withheld at the employee’s request.

20. Withholding for Employee Income Tax
The income tax deducted from gross pay is called income tax withholding.
The amount withheld depends on the employee’s gross pay and the number of withholding allowances claimed.
Unmarried taxpayers usually claim one allowance.
A childless married couple usually claims two allowances.
U.S. law and some states, cities, and counties require companies to withhold income tax from employee paychecks. The income tax deducted from gross pay is called income tax withholding. The amount withheld depends on the employee’s gross pay and on the number of withholding allowances he or she claims.
For federal withholding, an employee files form W-4 with his or her employer to indicate the number of allowances claimed for income tax withholding. Each allowance lowers the amount of tax withheld.

21. Withholding for Employee Income Tax
Exhibit 11-1 shows a W-4 for Ryan Park, who claims married with three allowances (see lines 3 and 5).

22. Withholding for Employee Social Security Tax (FICA)
The Federal Insurance Contributions Act (FICA), also known as the Social Security Act, created the Social Security tax.
The law requires employers to withhold Social Security (FICA) tax from employees’ paychecks.
FICA has two components:
OASDI (old age, survivors, and disability insurance)
Medicare (medical benefits)
The Federal Insurance Contributions Act (FICA), also known as the Social Security Act, created the Social Security tax. The Social Security program provides retirement, disability, and medical benefits. The law requires employers to withhold Social Security (FICA) tax from employees’ paychecks. The FICA tax has two components:
OASDI (old age, survivors, and disability insurance)
Medicare (medical benefits)
OASDI provides retirement benefits to individuals based on age, benefits to survivors of qualified individuals, and disability insurance to individuals who cannot work because of a medical condition. The Medicare portion of the FICA tax provides health insurance to individuals based on age or disability. Medicare applies to all employees earnings, which means there is no maximum tax.

23. Payroll Register
Many companies use a payroll register to help summarize the earnings, withholdings, and net pay for each employee.
Many companies use a payroll register to help summarize the earnings, withholdings, and net pay for each employee. Exhibit 11-2 shows an example.

24. Journalizing Employee Payroll
The payroll register is used to record the payroll journal entry.
The payroll register is used to record the payroll journal entry. Payroll and payroll withholdings are recorded as liabilities until the amounts are paid. The totals from the payroll register will be used to create the journal entry for Smart Touch Learning.

25. Employer Payroll Taxes
Employers must pay at least three payroll taxes, two of which are unemployment compensation taxes.
These taxes are not withheld from employees’ gross earnings but instead are paid by the employer:
Employer FICA tax (OASDI and Medicare)
State unemployment compensation tax (SUTA)
Federal unemployment compensation tax (FUTA)
In addition to income tax and FICA tax, which are withheld from employee paychecks, employers must pay at least three payroll taxes. These taxes are not withheld from employees’ gross earnings but instead are paid by the employer:
Employer FICA tax (OASDI and Medicare)
State unemployment compensation tax (SUTA)
Federal unemployment compensation tax (FUTA)
Unemployment compensation tax is a payroll tax paid by employers to the government, which uses the cash to pay unemployment benefits to people who are out of work.

26. Employer Payroll Taxes
Exhibit 11-3 shows the distribution of payroll for an employee who earns $1,000, assuming the employee has not reached the payroll tax limits.

27. Journalizing Employer Payroll Taxes
Smart Touch Learning records the employer’s payroll tax expense as a debit to Payroll Tax Expense and a credit to the various payable accounts.
As with employee contributions, the federal FICA—OASDI is determined as 6.2% on the first $117,000 earned by each employee. Smart Touch Learning must pay OASDI tax on all employees; however, the amount paid on James Kolen’s earnings is limited to the first $117,000 [($117,000 ‒ $112,700) × 6.2% = $267]. FICA—Medicare applies to all earnings at a rate of 1.45%.
FUTA (0.6%) and SUTA (5.4%) tax is paid on only the first $7,000 of each employee’s earnings. Smart Touch Learning will only pay unemployment taxes on Lisa Smart because all other employees have earned more than $7,000 to date.
Smart Touch Learning records the employer’s payroll tax expense as a debit to Payroll Tax Expense and a credit to the various payable accounts.

28. Internal Control Over Payroll
There are two main controls for payroll:
Controls for efficiency:
Payroll is usually automated rather than prepared by hand.
Controls to safeguard payroll disbursements:
Employees sign for checks or present IDs.
Hiring and firing is separated from payroll preparation.
Time clocks and direct deposit are also used.
There are two main controls for payroll: controls for efficiency and controls to safeguard payroll disbursements.
Payroll transactions are ideal for computer processing. The payroll data are stored in a file, and the computer makes the calculations, prints paychecks, and updates all records electronically. In addition, companies may require direct deposits for employees’ pay so that paper checks do not have to be written to each employee. Direct deposit also increases efficiency by reducing the amount of reconciling needed on outstanding checks.
A controller of a small business can monitor his or her payroll through personal contact with employees. Large companies cannot. A particular risk is that a paycheck may be written to a fictitious person and cashed by a dishonest employee. To guard against this, large businesses adopt strict internal controls for payroll.

29. Learning Objective 3
Account for current liabilities that must be estimated

30. How Are Current Liabilities That Must Be Estimated Accounted For?
A business may know that a liability exists but not know the exact amount.
It must estimate the amount of the liability and report it on the balance sheet.
Common examples of estimated liabilities:
Bonus plans
Vacation pay
Health and pension expense benefits
Warranties
A business may know that a liability exists but not know the exact amount. The business cannot simply ignore the liability. It must estimate the amount of the liability and report it on the balance sheet. Common examples of liabilities that are often estimated are bonus plans, vacation pay, health and pension benefits, and warranties.

31. Bonus Plans
Assume Smart Touch Learning estimates that it will pay a 5% bonus on annual net income after deducting the bonus. The company reports net income of $315,000 before the calculation of the bonus.
Many companies give bonuses to their employees in addition to their regular wages. These bonuses are often based on meeting a specific goal, such as the employee meeting an expected sales goal or the business achieving a target profit. Usually a company does not know the amount of the year-end bonus at year-end; the company instead estimates the amount of the bonus based on a set percentage.
For example, assume Smart Touch Learning estimates that it will pay a 5% bonus on annual net income after deducting the bonus. Assume the company reports net income of $315,000 before the calculation of the bonus. The accounting department will calculate the bonus as follows: (Bonus % × net income before bonus) / (1 + Bonus %), so (0.05 × $315,000) / ( ) = $15,000. This formula allows you to back into the bonus amount.

32. Vacation, Health, and Pension Benefits
Businesses typically offer vacation, health, and pension benefits to employees.
A pension plan provides benefits to retired employees.
Smart Touch Learning estimates the cost of providing vacation benefits is $1,000 per month.
Businesses typically offer vacation, health, and pension benefits to employees. A pension plan is a plan that provides benefits to retired employees. Vacation, health, and pension benefits must be estimated and recorded as a liability.
Suppose Smart Touch Learning employees earn two weeks of vacation throughout the year. The company estimates that the cost of providing vacation benefits is $1,000 per month. When an employee takes paid vacation, Smart Touch Learning will reduce the liability, Vacation Benefits Payable, with a debit and credit Cash. Other benefits, such as health and pension benefits, are recorded in the same manner.

33. Warranties
Many corporations guarantee their products against defects under warranty agreements.
The time period of warranties varies by product and company.
The matching principle requires businesses to record Warranty Expense in the same period that the company records the revenue related to the warranty.
Many corporations guarantee their products against defects under warranty agreements. The time period of warranty agreements varies. A warranty is an agreement that guarantees a company’s product against defects. The matching principle requires businesses to record Warranty Expense in the same period that the company records the revenue related to that warranty. The expense, therefore, is incurred when the company makes a sale, not when the company pays the warranty claims. At the time of the sale, the company does not know the exact amount of warranty expense but can estimate it.

34. Warranties
Assume that Smart Touch Learning made sales on account of $50,000, costing $35,000 subject to warranties on June 10, and estimates warranties at 3% of sales.
The journal entry to record this transaction is shown on the next slide.
Assume that Smart Touch Learning made sales on account of $50,000 (cost of merchandise inventory sold, $35,000) subject to product warranties on June 10 and estimates the warranty cost will be 3% of sales.

35. Warranties
Smart Touch Learning estimates the Warranty Expense at $1,500 ($50,000 × .03). A debit to Warranty Expense of $1,500 is recorded and follows the matching principle, and a credit of $1,500 is posted to Estimated Warranty Payable.

36. Warranties
Assume that some of Smart Touch Learning’s customers make claims that must be honored through the warranty offered by the company. The warranty costs total $800 and are made on June 27 as follows:
Assume that some of Smart Touch Learning’s customers make claims that must be honored through the warranty offered by the company. The warranty costs total $800 and are made on June 27. The company replaces the defective goods and records a debit to Estimated Warranty Payable for the $800 of warranty costs and a credit to Merchandise Inventory for $800.
Smart Touch Learning’s expense on the income statement is $1,500, the estimated amount, not the $800 actually honored. After honoring these warranties, the company’s liability account has a credit balance of $700. This $700 balance represents warranty claims Smart Touch Learning expects to honor in the future based on its estimates; therefore, the $700 is a liability to Smart Touch Learning.

37. Learning Objective 4
Account for contingent liabilities

38. How Are Contingent Liabilities Accounted For?
A contingent liability is a potential liability that depends on a future event.
For a contingent liability to be paid, some event must happen in the future.
How businesses record contingent liabilities is based on the likelihood of events occurring in the future:
Remote
Reasonably possible
Probable
A contingent liability is a potential liability that depends on some future event. A contingent liability is a potential, rather than an actual, liability because it depends on a future event. For a contingent liability to be paid, some event (the contingency) must happen in the future. How businesses record or don’t record contingent liabilities is based on the likelihood of the event occurring in the future: remote, reasonably possible, or probable.
A contingency that is remote has little chance of the event occurring in the future. If a contingency is remote, the company does not need to record a liability and does not need to disclose it in the notes to the financial statements.
Contingencies that are reasonably possible have a greater chance of occurring but are not likely. A reasonably possible contingency should be described in the notes to the financial statements.
If a contingency is probable, it means that the future event is likely to occur. Only contingencies that are probable and can be estimated are recorded as a liability and have an expense accrued.

39. How Are Contingent Liabilities Accounted For?
Exhibit 11-4 summarizes the rules for contingent liabilities.

40. Learning Objective 5
Use the times-interest-earned ratio to evaluate business performance

41. How Do We Use the Times-Interest-Earned Ratio to Evaluate Business Performance?
Investors can use the times-interest-earned ratio to evaluate a business’s ability to pay interest expense.
A high interest coverage ratio indicates a business’s ease in paying interest expense.
The formula is:
Investors can use the times-interest-earned ratio to evaluate a business’s ability to pay interest expense. This ratio measures the number of times earnings before interest and taxes (EBIT) can cover (pay) interest expense. The times-interest-earned ratio is also called the interest-coverage ratio. A high interest-coverage ratio indicates a business’s ease in paying interest expense; a low ratio suggests difficulty. The times-interest-earned ratio is calculated as EBIT (Net income + Income tax expense + Interest expense) divided by Interest expense.