ACCT 2301 CH11 Current Liabilities and Payroll
The Social Security system is funded by
contributions from both the employer and employee.
Payroll and employee benefits are reported as
current liabilities on the balance sheet until the company makes payment.
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.
Net Pay
Gross pay minus all deductions. The amount of compensation that the employee actually takes home. Net pay is also called *take-home pay*. Net pay equals gross pay minus all deductions such as income tax withheld. The employer either writes a paycheck to each employee for his or her take-home pay or directly deposits the employee's take-home pay into the employee's bank account.
Under IFRS, "probable" is defined more broadly as
"more likely than not" that the future event will result in a liability. "More likely than not" means more than a 50% chance.
Payroll Register - fields
1. Employee Name 2. Beginning cumulative earnings—the amount the employee has earned through the last pay period. 3. Current period earnings—earnings for the current period (includes regular and overtime earnings, commissions, and bonuses). 4. Ending cumulative earnings—beginning cumulative earnings plus current period earnings. 5. OASDI—6.2% tax on the first $118,500 earnings. 6. Medicare—1.45% tax on the first $200,000; 2.35% on earnings over $200,000.
Contingent Liabilities - Table
4 scenarios
Payroll Register - fields (cont)
7. Income Tax—includes federal, state, and any local government income tax withheld; varies depending on filing status and number of withholding allowances. 8.Health Insurance—withholdings made for employee-paid health care coverage. 9. Other—employees' voluntary withholdings such as charitable contributions and union dues. 10. Total Withholdings—total of all withholdings. 11. Net Pay—current period earnings less total withholdings. This is the amount that is paid to each employee. 12. Check No.—the check number used to make payment for earnings. 13. Salaries and Wages Expense—the amount debited to Salaries and Wages Expense for the current pay period.
Remote Contingent Liability
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. An example of a remote contingency would be a frivolous lawsuit.
Controls to Safeguard Payroll Disbursements
A controller of a small business can monitor his or her payroll by 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. • Hiring and firing employees should be separated from accounting and from passing out paychecks. • Photo IDs ensure that only actual employees are paid. • Employees clock in at the start and clock out at the end of the workday to prove their attendance and hours worked.
Long-term Liability
A liability that does not need to be paid within one year or within the entity's operating cycle, whichever is longer.
Current Liability
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.
Pension Plan
A plan that provides benefits to retired employees.
Contingent Liability
A potential liability that depends on some future event. For a contingent liability to be paid, some event (the contingency) must happen in the future.
Payroll Register
A schedule that summarizes the earnings, withholdings, and net pay for each employee.
Short-term Note Payable
A written promise made by the business to pay a debt, usually involving interest, within one year or less. a common form of financing
Accounts Payable
Amounts owed for products or services purchased on account are accounts payable. Because these are typically due in 30 days, they are current liabilities. Accounts payable occur because the business receives the goods or services before payment has been made.
withholding deductions
Amounts withheld from paychecks These deductions are withheld from paychecks and sent directly to the government, to insurance companies, or to other entities.
Warranty
An agreement that guarantees a company's product against defects. The time period of warranty agreements varies.
Optional Withholding Deductions
As a convenience to employees, some companies withhold payroll deductions and then pay designated organizations according to employee instructions. Insurance premiums, retirement savings, union dues, and gifts to charities are examples.
Journalizing Employer Payroll Taxes Smart Touch Learning's employer payroll taxes for December will be calculated as follows:
As with employee contributions, the federal FICA—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]. FICA—Medicare applies to all earnings at a rate of 1.45%. FUTA (0.6%) and SUTA (5.4%) tax is only paid on 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 prior to the December pay period.
Bonus Plans - example 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 = (Bonus % x Net income before bonus) / (1 + Bonus %) = (0.05 x $315K) / (1 + 0.05) = $15K
There are numerous ways to label an employee's pay: (continued)
Benefits are extra compensation—items that are not paid directly to the employee. Benefits cover health, life, and disability insurance. The employer pays the insurance company, which then provides coverage for the employee. Another type of benefit, retirement, sets aside money for the employee for his or her future retirement.
Short-term Note Payable - cash example
Businesses occasionally borrow cash from banks. The bank requires the business to sign a promissory note that states that the business will pay the principal plus interest at a specified maturity date. 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, allocated $100 of the interest on this note to 2018. During 2019, the interest on this note for the three remaining months is $150. When Smart Touch Learning records payment for the note, it will record the remaining interest expense and also remove the interest payable and note payable from the books as shown:
Vacation, Health, and Pension Benefits
Businesses typically offer vacation, health, and pension benefits to its employees.
Reasonably Possible Contingent Liability
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. For example, consider a company that is the defendant in a significant lawsuit. If the company has been advised by legal counsel that it is reasonably possible that it will lose the lawsuit, then it should report the lawsuit in its notes to the financial statements.
Liabilities
Debts that are owed to creditors Liabilities have three main characteristics: 1. They occur because of a past transaction or event. 2. They create a present obligation for future payment of cash or services. 3. They are an unavoidable obligation.
Unearned revenue - example
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 adjusting entry to show that some work had been completed and some revenue had now been earned:
The times-interest-earned ratio is calculated as
EBIT (Net income +Income tax expense+Interest expense) divided by Interest expense.
Times-Interest-Earned Ratio
Evaluates 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.
Sales tax payable journal entry
Example 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). Accounts: Cash Sales Revenue Sales Tax Payable Notation: To record cash sales and the related sales tax
Probable Contingent Liability
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 an expense is accrued. An example of an estimable probable contingency is a warranty.
Unemployment Compensation Taxes (continued)
In recent years, employers have paid a combined tax of 6.0% *on the first $7,000* of each employee's annual earnings for unemployment tax. The proportion paid to the state depends on the individual state, but for many it is 5.4% to the state plus 0.6% to the federal government. For this payroll tax, the employer uses two liability accounts: • Federal Unemployment Taxes Payable (FUTA Payable) @ 0.6% • State Unemployment Taxes Payable (SUTA Payable) @ 5.4%
Withholding for Employee Income Tax
Income tax deducted from an employee's gross pay. U.S. law and some states, cities, and counties require companies to withhold income tax from employee paychecks. The amount withheld depends on the employee's gross pay and on the number of withholding allowances he or she claims.
Current Portion of Long-term Notes Payable - example
Let's 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 will be 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.
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.
Matching + Employer only taxes
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. Sales tax is usually calculated as a percentage of the amount of the sale.
Journalizing Employee Payroll (continued)
On payday, Smart Touch Learning will make payment of $19,727 to its employees and record the following journal entry: The other payable accounts, FICA, Income Taxes Payable, Health Insurance, and any charitable contributions, will be removed from the books when payments are made on those specific payables with debits to the liability accounts and a credit to Cash.
Journalizing Employee Payroll The information from 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. In the above 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).
Unemployment Compensation Taxes
Payroll tax paid by employers to the government, which uses the cash to pay unemployment benefits to people who are out of work. • The Federal Unemployment Tax Act (FUTA) • State Unemployment Tax Act (SUTA Paid by the employer; they are not deducted from employees' gross pay. (Some states require employees to contribute to SUTA.
Warranty (example - T Account)
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.
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. The accounting clerk will record the following journal entry monthly: 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.
Bonus Plans - example Assuming Smart Touch Learning will not make payment until the next year, it must record a liability for the bonus due to its employees.
The accounting clerk will record the following entry: When Smart Touch Learning makes payment, it will debit Employee Bonus Payable and credit Cash.
Current Portion of Long-term Notes Payable
The amount of the principal that is payable within one year of the balance sheet date. 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 current maturity) as a current liability. The remaining portion of the note will be classified as long-term.
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.
Another contingent liability arises when a company co-signs a note payable for another entity.
The company co-signing has a contingent liability until the note comes due and is paid by the other entity. If the other company pays off the note, the contingent liability vanishes. If the other company doesn't pay off the note, the co-signing company must pay the debt for the other entity.
Warranty (example - sale) 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 that warranty costs will be 3% of sales.
The company would record the sales revenue, cost of goods sold, and estimated warranty expense as follows:
Contingent Liability - example For example, suppose Smart Touch Learning is sued because of alleged patent infringement on one of its online learning videos.
The company, therefore, faces a contingent liability, which may or may not become an actual liability. If the outcome of this lawsuit is unfavorable, it could hurt Smart Touch Learning by increasing its liabilities. Therefore, it would be unethical to withhold knowledge of the lawsuit from investors and creditors.
Employer FICA Tax
The employer portion of OASDI is 6.2% on the first $118,500 of each employee's annual earnings. The employer's tax rate for Medicare is 1.45% on all earnings. *(The employer does not pay the additional 0.9% Medicare tax on earnings above $200,000.)*
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.
Income tax payable
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 a Form 1120. 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. Journal Accounts: Income Tax Expense Income Tax Payable Notation: To record income tax expense incurred
On payday, or shortly thereafter, Smart Touch Learning will make 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 will combine those amounts when recording the payments. Assuming the payments are made on January 15, the journal entry is:
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).
Gross Pay
The total amount of salary, wages, commissions, and any other employee compensation *before* taxes and other deductions. Gross pay is an expense to the employer.
Warranty (example - claim) 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 makes the following journal entry:
Bonus Plans 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.
Employer Payroll Taxes 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)
Sales tax payable journal entry - payment
To pay the tax, the company debits Sales Tax Payable and credits Cash. Accounts Sales Tax Payable Cash Notation: To record cash payment for sales tax payable
Income tax payable - payment
When Smart Touch Learning files its Form 1120 corporate tax return and makes payment, the corporation will record the following entry: Account: Income Tax Payable Cash Notation To record cash payment for income tax payable
The foundation of internal control is the separation of duties. This is why
all but the smallest companies have separate departments for the following activities: • The Human Resources Department hires and fires workers. • The Payroll Department maintains employee earnings records. • The Accounting Department records all transactions. • The Treasurer distributes paychecks to employees.
Unearned revenue
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.
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.
Federal Insurance Contributions Act (FICA)
also known as the Social Security Act, The federal act that created the Social Security tax that 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)
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.
Contingencies that are probable but cannot be estimated are
disclosed in the notes to the financial statements. A liability is not recorded because the amount of the contingency cannot be estimated.
The Medicare portion of the FICA tax provides
health insurance to individuals based on age or disability. Medicare applies to all employee earnings—*that 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% + 1.45%) 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.
For federal tax withholdings, 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: • 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, and so on.
OASDI provides retirement benefits to
individuals based upon 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.
Once an employee has earned $118,500,
no further earnings are taxed for OASDI in that year. Assume that James Kolen, another 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:
Short-term Note Payable - merchandise example
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 to record the note and purchase of inventory follows: On July 30, when the note is due, Smart Touch Learning will pay the note plus interest and record the following entry:
After being withheld, payroll deductions become
the liability of the employer, who then pays the outside parties—taxes to the government and contributions to charitable organizations, for example.
Current liabilities are listed on the balance sheet in
the order in which they are due
IFRS defines current and long-term liabilities in
the same manner as GAAP.
Internal Control Over Payroll There are two main controls for payroll:
• Controls for efficiency • Controls to safeguard payroll disbursements
Controls for Efficiency
• 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 deposits also increase efficiency by reducing the amount of reconciling needed on outstanding checks.
How businesses record or don't record contingent liabilities is based on one of three likelihoods of the event occurring in the future:
• Remote • Reasonably possible • Probable
Payroll withholding deductions fall into two categories:
• Required deductions, 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, including insurance premiums, retirement plan contributions, charitable contributions, and other amounts that are withheld at the employee's request.
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 sale 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 or commission). A bonus is usually paid for exceptional performance—in a single amount after year-end.
Liabilities can be split into two main categories:
• current • long-term
Current Liabilities - examples
•Accounts Payable •Notes Payable due w/in 1 year •Salaries Payable •Interest Payable •Unearned Revenue •Income Tax Payable •Any portion of a long-term liability that is due within the next year is also reported as a current liability.
