Chapter 11 Current Liabilities and Payroll

Chapter 11 Current Liabilities and Payroll

Chapter 11 Learning Objectives
Account for current liabilities of known amount Calculate and journalize basic payroll transactions Account for current liabilities that must be estimated © 2018 Pearson Education, Inc.

Chapter 11 Learning Objectives
Account for contingent liabilities Use the times-interest-earned ratio to evaluate business performance © 2018 Pearson Education, Inc.

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 payment 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 because of a past transaction or event. They create a present obligation for future payment of cash or services. They are an unavoidable obligation. © 2018 Pearson Education, Inc.

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. © 2018 Pearson Education, Inc.

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 before 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. © 2018 Pearson Education, Inc.

Sales Tax Payable December’s taxable sales for Smart Touch Learning total $10,000. The company collects an additional 6% sales tax, which equals $600 ($10,000 × 0.06). Sales tax is usually calculated as a percentage of the amount of the sale. For example, suppose that December’s taxable sales for Smart Touch Learning total $10,000. The company collects an additional 6% sales tax, which equals $600 ($10,000 × 0.06). The entry requires a debit to Cash for $10,600, the amount of the sale plus the amount of the related sales tax. In addition, there is credit to Sales Revenue for $10,000 and a credit to Sales Taxes Payable for $600. © 2018 Pearson Education, Inc.

Sales Tax Payable Sales tax is not an expense of the business. It is a current liability. Companies collect sales tax and then forward it to the state at regular intervals. When Smart Touch Learning pays the tax, it records the following: Sales tax is not an expense of the business. It is a current liability. Companies collect 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 for $600 and credits Cash for $600. © 2018 Pearson Education, Inc.

Income Tax Payable Smart Touch Learning incurs federal income tax payable of $3,780. When Smart Touch Learning pays the tax, it records 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. © 2018 Pearson Education, Inc.

Unearned Revenues Unearned revenue arises when a business has received cash before providing goods or performing work. Smart Touch Learning receives $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 receives $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. © 2018 Pearson Education, Inc.

Unearned Revenues During May, Smart Touch Learning delivers one-third of the work and earns $300 ($900 × 1/3) of the revenue. On May 31, the accounting clerk records the following entry: During May, Smart Touch Learning delivers one-third of the work and earns $300 ($900 × 1/3) of the revenue. On May 31, the accounting clerk records a debit to Unearned Revenue of $300 and a credit to Service Revenue of $300 to show that some of the work has been completed and some revenues have now been earned. © 2018 Pearson Education, Inc.

Short-term Notes Payable
A short-term note payable represents a written promise by a business to pay a debt, usually involving interest, within one year or less. On May 1, Smart Touch Learning purchases merchandise inventory with a 10%, 90-day note payable, for $8,000. Assume a 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 that on May 1, Smart Touch Learning purchases 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 for $8,000. © 2018 Pearson Education, Inc.

On July 30, when the note is due, Smart Touch Learning pays the note plus interest. On July 30, when the note is due, Smart Touch Learning pays the note plus interest. It then debits Notes Payable for $8,000 and Interest Expense for $197 ($8,000 × 0.10 × 90/365). It credits Cash for $8,197 for the principal and interest associated with the note. © 2018 Pearson Education, Inc.

Businesses occasionally borrow cash from banks. A bank requires a business to sign a promissory note stating that the business will pay the principal plus interest at a specified maturity date. Businesses occasionally borrow cash from banks. A bank requires a business to sign a promissory note stating that the business will pay the principal plus interest at a specified maturity date. © 2018 Pearson Education, Inc.

On November 1, 2018, Smart Touch Learning borrows $10,000 from First Street Bank at 6% for five months. On November 1, the accounting clerk records the following entry: On November 1, 2018, Smart Touch Learning borrows $10,000 from First Street Bank at 6% for five months. On November 1, the accounting clerk records the transaction with a debit to Cash and a credit to Notes Payable for $10,000. © 2018 Pearson Education, Inc.

At year-end, the matching principle requires the business to accrue interest expense for November and December as follows: The interest accrual at December 31, 2018, allocates $100 of the interest on this note to 2018. © 2018 Pearson Education, Inc.

During 2019, the interest on this note for the three remaining months is $150. During 2019, the interest on this note for the three remaining months is $150. When Smart Touch Learning records payment for the note, it records the remaining interest expense and also removes the interest payable and note payable from the books. © 2018 Pearson Education, Inc.

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 a 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, a long-term debt is paid in installments, the business reports the current portion of notes payable (also called current 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 is classified as long-term. Consider a $20,000 note payable that is paid in $5,000 installments over four years. The portion that must be paid within one year, $5,000, is current. The remaining $15,000 is classified as long-term. No journal entry is needed to reclassify the current portion. It is, instead, only classified as current or long-term for reporting purposes on the balance sheet. Notice that the reclassification does not change the total amount of debt. It only reclassifies $5,000 of the total debt from long-term to current. © 2018 Pearson Education, Inc.

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, 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 include health, life, and disability insurance. © 2018 Pearson Education, Inc.

HOW DO COMPANIES ACCOUNT FOR AND RECORD PAYROLL?
Ryan Park was hired to work for Smart Touch Learning. Ryan earns wages of $15 per hour for straight time (40 hours). The company pays time-and-a-half for overtime. Thus, Ryan earns $22.50 per hour of overtime ($15.00 × 1.5). For a 42-hour work week, Ryan’s gross pay is: Businesses pay employees at a base rate for a set period—called straight time. For additional hours—overtime—the employee may get a higher pay rate, depending on the job classification and wage and hour laws. © 2018 Pearson Education, Inc.

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 an employee during a pay period. Net pay is the amount an 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 an employee actually takes home. © 2018 Pearson Education, Inc.

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. © 2018 Pearson Education, Inc.

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. An unmarried taxpayer usually claims one allowance. A childless married couple usually claims two allowances. A married couple with one child usually claims three 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. © 2018 Pearson Education, Inc.

Withholding for Employee Income Tax
Ryan Park claims married with three allowances. Exhibit 11-1 shows a W-4 for Ryan Park, who claims married with three allowances (see lines 3 and 5). © 2018 Pearson Education, Inc.

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 amount of tax withheld varies from year to year because the wage base is subject to OASDI tax changes each year. For 2016, the OASDI tax applies to the first $118,500 of employee earnings in a year. The taxable amount of earnings is usually adjusted annually. The OASDI tax rate for employees at the time of this writing is 6.2%. Therefore, the maximum OASDI tax that an employee paid in 2016 was $7,347 ($118,500 × 0.062). 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. At the time of this writing, this tax rate is 1.45% for earnings up to $200,000. Earnings over $200,000 are taxed an additional 0.9%, for a total of 2.35%. Therefore, an employee pays a combined FICA tax rate of 7.65% (6.2% %) of the first $118,500 of annual earnings, plus 1.45% of earnings above $118,500 up to $200,000, and 2.35% on earnings above $200,000. © 2018 Pearson Education, Inc.

Withholding for Employee Social Security Tax (FICA)
James Kolen, an employee of Smart Touch Learning, earned $114,200 prior to December. Kolen’s salary for December is $10,000. Kolen’s FICA tax withheld from his paycheck is calculated as follows: Notice that only $4,300 of Kolen’s $10,000 salary is subject to OASDI tax. This is because in December, Kolen reaches the maximum amount of earnings subject to OASDI. Once an employee has earned $118,500, no further earnings are taxed for OASDI in that year. Medicare tax, on the other hand, has no maximum. All earnings are subject to the tax. Kolen pays Medicare tax on the entire $10,000 earned in December. © 2018 Pearson Education, Inc.

Optional Withholding Deductions
Some companies withhold payroll deductions and then pay designated organizations according to employee instructions. Examples include: Insurance premiums Retirement savings Union dues Gifts to charities Some companies withhold payroll deductions and then pay designated organizations according to employee instructions. Examples include insurance premiums, retirement savings, union dues, and gifts to charities. © 2018 Pearson Education, Inc.

Optional Withholding Deductions
James Kolen’s final pay period on December 31 assumes that he authorized a $180 payment for health insurance and a $20 contribution to United Way. Employee income tax is assumed to be 20% of gross pay. This slide illustrates the net (take-home) pay that occurs once withholding deductions are subtracted from gross pay. © 2018 Pearson Education, Inc.

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 of a payroll register. © 2018 Pearson Education, Inc.

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 are used to create the journal entry for Smart Touch Learning. In the journal entry, Salaries and Wages Expense ($28,580) represents the gross pay for all employees. Gross pay includes both the amount owed for salaries and wages ($19,727) and payroll withholdings ($1,419 + $414 + $6,315 + $645 + $60). © 2018 Pearson Education, Inc.

Journalizing Employee Payroll
On payday, Smart Touch Learning makes payment of $19,727 to its employees and records the following journal entry: The other payable accounts, FICA, Income Taxes Payable, Health Insurance, and any charitable contributions, are removed from the books when payments are made on those specific payables with debits to the liability accounts and a credit to Cash. © 2018 Pearson Education, Inc.

Employer Payroll Taxes
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) Unemployment compensation taxes: 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. © 2018 Pearson Education, Inc.

Employer Payroll Taxes
Exhibit 11-3 shows the distribution of payroll for an employee who earns $1,000, assuming that the employee has not reached the payroll tax limits. Exhibit 11-3 shows the distribution of payroll for an employee who earns $1,000, assuming that the employee has not reached the payroll tax limits. © 2018 Pearson Education, Inc.

Journalizing Employer Payroll Taxes
Smart Touch Learning’s employer payroll taxes for December are calculated as follows: As with employee contributions, the federal OASDI is determined as 6.2% on the first $118,500 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 $118,500 [($118,500 – $114,200) × 6.2% = $267]. Medicare applies to all earnings at a rate of 1.45%. FUTA (0.6%) and SUTA (5.4%) tax are only paid on the first $7,000 of each employee’s earnings. Smart Touch Learning only pays unemployment taxes on Lisa Smart because all other employees have earned more than $7,000 prior to the December pay period. © 2018 Pearson Education, Inc.

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. 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. © 2018 Pearson Education, Inc.

Payment of Employer Payroll Taxes and Employees’ Withholdings
On January 15, Smart Touch Learning makes payments for its tax obligations and the employees’ withholdings. On payday, or shortly thereafter, Smart Touch Learning makes payments to the various government agencies and other designated organizations for the employees’ withholdings and Smart Touch Learning’s tax obligations. The information for the payment comes from the journal entries to record employee payroll and employer payroll taxes. Notice that FICA––OASDI Taxes Payable and FICA––Medicare Taxes Payable are included in the journal entry to record employee payroll and the journal entry to record employer payroll taxes. That is because the FICA taxes are obligations of both the employee and the employer. Smart Touch Learning combines those amounts when recording the payments. © 2018 Pearson Education, Inc.

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 are 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. © 2018 Pearson Education, Inc.

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. © 2018 Pearson Education, Inc.

Bonus Plans 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 that the company reports net income of $315,000 before the calculation of the bonus. The accounting department calculates 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. © 2018 Pearson Education, Inc.

Bonus Plans Assuming that Smart Touch Learning will not make payment until the next year, it must record a liability for the bonus due to its employees. Assuming that Smart Touch Learning will not make payment until the next year, it must record a liability for the bonus due to its employees. The entry debits Employee Bonus Expense and credits Employee Payable for $15,000. © 2018 Pearson Education, Inc.

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 reduces the liability, Vacation Benefits Payable, with a debit and credits Cash. Other benefits, such as health and pension benefits, are recorded in the same manner. © 2018 Pearson Education, Inc.

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. © 2018 Pearson Education, Inc.

Warranties 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 that warranty costs will be 3% of sales. Assume that Smart Touch Learning makes sales on account of $50,000 (cost of merchandise inventory sold, $35,000) subject to product warranties on June 10, and estimates the warranty costs at 3% of sales. © 2018 Pearson Education, Inc.

Warranties 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 makes the following journal entry: 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. © 2018 Pearson Education, Inc.

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, the future event is likely to occur. Only contingencies that are probable and can be estimated are recorded as liabilities and have expenses accrued. © 2018 Pearson Education, Inc.

HOW ARE CONTINGENT LIABILITIES ACCOUNTED FOR?
Exhibit 11-4 summarizes the rules for contingent liabilities. © 2018 Pearson Education, Inc.

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. 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. 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. © 2018 Pearson Education, Inc.

HOW DO WE USE THE TIMES-INTEREST-EARNED RATIO TO EVALUATE BUSINESS PERFORMANCE? The following amounts (in millions) are taken from Kohl’s Corporation’s income statement. This slide provides key account totals from Kohl’s Corporation’s income statement that will be used in computing the ratios on the following slides. © 2018 Pearson Education, Inc.

HOW DO WE USE THE TIMES-INTEREST-EARNED RATIO TO EVALUATE BUSINESS PERFORMANCE? Kohl’s times-interest-earned ratio for the year ended January 30, 2016 (2015 fiscal year): Kohl’s times-interest-earned ratio for the year ended January 30, 2015 (2014 fiscal year): Notice that from 2014 to 2015, Kohl’s experienced a decrease in its times-interest-earned ratio. This is because Kohl’s incurred slightly less interest expense but had a much larger decrease in net income to cover it. This decrease in net income decreases Kohl’s times-interest-earned ratio from 4.97 times to 4.23 times. However, it appears that Kohl’s can still cover its interest expense. © 2018 Pearson Education, Inc.

Chapter 11 Current Liabilities and Payroll

Similar presentations

Presentation on theme: "Chapter 11 Current Liabilities and Payroll"— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

Chapter 11 Current Liabilities and Payroll

Similar presentations

Presentation on theme: "Chapter 11 Current Liabilities and Payroll"— Presentation transcript:

Similar presentations

About project

Feedback