Chapter 10 Financial accounting PDF

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Current Liabilities and Payroll SMART TOUCH LEARNING Balance Sheet May 31, 2013

Assets

This amount must be paid in one year or the business’s operating cycle, whichever is longer.

Liabilities

Current assets: Cash Accounts receivable

$ 4,800 2,600

Inventory

30,500

Supplies

600

Prepaid rent

2,000

Total current assets Plant assets:

Current liabilities: Accounts payable Salary payable Interest payable Unearned service revenue

$ 48,700 900 100 400

Total current liabilities

50,100

$ 40,500 Long-term liabilities: Notes payable

Furniture

$18,000

Less: Accumulated depreciation— furniture Building

300

20,000

Total l iabilities

70,100

17,700

48,000

Less: Accumulated depreciation— building

200

47,800

Total plant assets Total assets

Owner’s Equity 65,500 Bright, capital $106,000 Total liabilities and owner’s equity

35,900 $106,000

Learning Objectives 1

Account for current liabilities of known amount

3

Calculate payroll and payroll tax amounts

2

Account for current liabilities that must be estimated

4

Journalize basic payroll transactions

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p to this point, we’ve been focusing on all the assets a business owns. But what about the bills a business owes? As a business owner or manager, you have to

know what you owe (your liabilities) and what date you have to pay them. Why? To be sure you have cash on hand to pay these bills. In this chapter, we’ll focus on some common current liabilities a business may owe. As with other chapters, we’ll continue to focus on Smart Touch Learning and see how it manages its current liabilities.

496

Current Liabilities and Payroll

497

Current Liabilities of Known Amount The amounts of most liabilities are known. Recall that current liabilities are those debts due to be paid within one year, or within the entity’s operating cycle if that cycle is longer than a year. Let’s begin with current liabilities of a known amount.

1

Account for current liabilities of known amount

Accounts Payable Amounts owed for products or services purchased on account are accounts payable. Since these are due on average in 30 days, they are current liabilities. We have seen many accounts payable illustrations in preceding chapters. Consider the balance sheet for May 31, 2013, prepared in Chapter 4 for Smart Touch Learning and reproduced as follows: Classified Balance Sheet in Account Form (Reproduced from Exhibit 4-12)

EXHIBIT 10-1

SMART TOUCH LEARNING Balance Sheet May 31, 2013 Assets

Liabilities

Current assets: Cash

Current liabilities: Accounts payable

$ 4,800

Accounts receivable

Salary payable

2,600 600 2,000

Supplies Prepaid rent Total current assets

Interest payable Unearned service revenue Total current liabilities

$10,000

Plant assets: Furniture Less: Accumulated depreciation—furniture

$18,000 300

17,700

Building Less: Accumulated depreciation—building

48,000 200

47,800

Total plant assets

Long-term liabilities: Notes payable Total liabilities

$75,500

Bright, capital Total liabilities and owner’s equity

Notice that the balance on May 31, 2013, for Accounts payable is $18,200. As we learned in Chapter 5, one of Smart Touch’s common transactions is the credit purchase of inventory. With accounts payable and inventory systems integrated, Smart Touch records the purchase of inventory on account, using the perpetual system. A reproduction of the Chapter 5 entry that Smart Touch made on June 3 to purchase $700 of inventory on account follows: Jun 3

Inventory

(A+)

Accounts payable

700 (L+)

700

Purchase on account.

Then, when Smart Touch paid the liability and took advantage of the purchase discount on June 15, the entry was as follows: Jun 15

Accounts payable (L–) Cash (A–) Inventory (A–) Paid on account within discount period.

900 100 400 19,600 20,000 39,600

Owner’s Equity 65,500

Total assets

$18,200

700 679 21

35,900 $75,500

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Keep in mind that Smart Touch purchased more inventory in other transactions in June.

Short-Term Notes Payable Short-term notes payable are a common form of financing. Short-term notes payable are promissory notes that must be paid within one year. Consider how the entry on June 3 would change if Smart Touch had purchased the inventory with a 10%, oneyear note payable. The modified June 3 purchase entry follows: 2013 Jun 3

Inventory (A+) Short-term notes payable

700 (L+)

700

A

Purchased inventory on a one-year, 10% note.

At year-end it is necessary to accrue interest expense for the seven months from June to December (do not adjust interest for the three days in June) as follows: 2013 Dec 31

Interest expense ($700 ⫻ 0.10 ⫻ 7/12) Interest payable (L+)

(E+)

41 41

B

Accrued interest expense at year-end.

The interest accrual at December 31, 2013, allocated $41 of the interest on this note to 2013. During 2014, the interest on this note for the five remaining months is $29, as shown in the following entry for the payment of the note in 2014: 2014 Jun 3

Short-term notes payable Interest payable

700 41

(L–)

(L–)

Interest expense ($700 ⫻ 0.10 ⫻ 5/12) Cash (A–) Paid note and interest at maturity.

(E+)

29 770

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 collected is owed to the state. Let’s apply this to Smart Touch. Suppose December’s taxable sales for Smart Touch totaled $10,000. Smart Touch collected an additional 6% sales tax, which would equal $600 ($10,000 ⫻ 0.06). Smart Touch would record that month’s sales as follows: 2013 Dec 31

Cash ($10,000 ⫻ 1.06)

(A+)

Sales revenue (R+) Sales tax payable ($10,000 ⫻ 0.06) (L+) To record cash sales and the related sales tax.

10,600 10,000 600

As noted above, Sales tax payable is a current liability. Notice how it shows as an obligation (credit balance) in the Sales tax payable T-account, just after the sale.

* The red colored boxes throughout the chapter reference Exhibit 11-5 in Chapter 11 on page 547.

C

*

Current Liabilities and Payroll

Sales tax payable 600

Companies forward the sales tax 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. 2014 Jan 20

Sales tax payable (L–) Cash (A–)

600 600

Current Portion of Long-Term Notes Payable Most long-term notes payable are paid in installments. The current portion of notes payable (also called current maturity) is the principal amount that will be paid within one year—a current liability. The current portion of notes payable is equal to this year’s principal payments. The remaining portion is long-term. Let’s consider the $20,000 notes payable that Smart Touch signed on May 1, 2013 (refer to Exhibit 10-1). The note bears interest at 6%. If the note will be paid over four years with payments of $5,000 plus interest due each May 1, what portion of the note is current? The portion that must be paid within one year, $5,000, is current. At the inception of the note, the company recorded the entire note as long term. A second entry to the account for the $5,000 principal that is current will need to be made on May 1, 2013. 2013 May 1

May 1

May 1 2013

Cash

(A+) Long-term notes payable

20,000 (L+)

20,000

Long-term notes payable (L–) Current portion of long-term notes payable

5,000 (L+)

E

E

5,000

May 1 2014

May 1 2015

May 1 2016

May 1 2017

$5,000 principal + interest

$5,000 principal + interest

$5,000 principal + interest

$5,000 principal + interest

Borrow $20,000

Notice that the reclassification entry on May 1 does not change the total amount of debt. It only reclassifies $5,000 of the total debt from long-term to current. Interest would still accrue (see the next section). We focus on the current portion classification in this chapter. In Chapter 11, we’ll focus on the long-term portion and the yearly payments on the note.

Accrued Liabilities In Chapter 3, we learned that an accrued expense is any expense that has been incurred but has not yet been paid. When an expense is accrued (debited), it often has a related unpaid bill, or an accrued liability (credited). Accrued liabilities typically occur with the passage of time, such as interest on a note payable. Refer to Exhibit 10-1, Smart Touch’s May 31, 2013, balance sheet. Like most other companies, Smart Touch has accrued liabilities for salaries payable and interest

D

499

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Chapter 10

payable. Smart Touch has already accrued one month of interest on the $20,000 note (20,000 ⫻ 6% ⫻ 1/12); $100 interest for the month of May 2013, as shown in Exhibit 10-1. Now, at December 31, Smart Touch still needs to accrue interest from May 31 to December 31, or seven more month’s interest on the $20,000 note: Dec 31

Interest expense (20,000 ⫻ 6% ⫻ 7/12) Interest payable (L+)

(E+)

700 700

Unearned Revenues

Key Takeaway A current liability must be paid in a year or less. For some current liabilities, the exact amount is known or can easily be calculated, such as the amount of sales tax payable, interest owed (payable) on a note, or the amount of work still owed to a customer who paid in advance (unearned revenue). For some, the current liability is known based on a contract, such as with the current portion of long-term notes payable. Still others must be accrued and are known based on a bill received or hours worked, such as accounts payable or salaries payable. The key to all of these is the current liability amount is known, not estimated.

Unearned revenue is also called deferred revenue. Unearned revenue arises when a business has received cash in advance of performing work and, therefore, has an obligation to provide goods or services to the customer in the future. If you receive cash before you do the work, you owe the work (unearned service revenue).Let’s consider an example using Smart Touch’s May 31, 2013, balance sheet. Smart Touch received $600 in advance on May 21 for a month’s work beginning on that date. On May 31, because it received cash before earning the revenue, Smart Touch has a liability to perform 20 more days of work for the client. The liability is called Unearned service revenue. The entry made by Smart Touch on May 21, 2013, follows: 2013 May 21

Cash

(A+) Unearned service revenue

600 (L+)

600

During May, Smart Touch delivered one-third of the work and earned $200 ($600 ⫻ 1/3) of the revenue. The May 31, 2013, adjusting entry made by Smart Touch decreased the liability and increased the revenue as follows: 2013 May 31

Unearned service revenue (L–) Service revenue (R+)

200 200

At this point, Smart Touch has earned $200 of the revenue and still owes $400 of work to the customer, as follows (and as in Exhibit 10-1): Service revenue May 31

Unearned service revenue 200

May 31

200 May 21

600

Bal

400

F

Current Liabilities that Must Be Estimated 2

Account for current liabilities that must be estimated

A business may know that a liability exists, but not know the exact amount. The business cannot simply ignore the liability. It must report it on the balance sheet. A prime example is Estimated warranty payable, which is common for manufacturing companies like Dell and Sony.

Estimated Warranty Payable Many companies guarantee their products a gainst defects under warranty agreements. Both 90-day and one-year warranties are common. The matching principle says to record the 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

B

Current Liabilities and Payroll

501

warranty claims. At the time of the sale, the company does not know the exact amount of warranty expense, but can estimate it. Assume that Smart Touch made sales on account of $50,000 subject to product warranties on June 10, 2013. Smart Touch estimates that 3% of its products may require warranty repairs. The company would record the sales and the estimated warranty expense in the same period, as follows: 2013 Jun 10

Jun 10

Jun 10

Accounts receivable Sales revenue Sales on account.

50,000

(A+) (R+)

50,000

21,000

COGS (E+) Inventory (A–) To record cost of inventory sold.

21,000

Warranty expense ($50,000 ⫻ 0.03) (E+) Estimated warranty payable (L+) To accrue warranty payable.

1,500 1,500

Assume that some of Smart Touch’s customers make claims that must be honored through the warranty offered by the company. The warranty payments total $800 and are made on June 27, 2013. Smart Touch repairs the defective goods and makes the following journal entry: 2013 Jun 27

Estimated warranty payable Cash (A–) To pay warranty claims.

(L–)

800 800

Connect To: Ethics

Smart Touch’s expense on the income statement is $1,500, the estimated amount, not the $800 actually paid. After paying for these warranties, Smart Touch’s liability account has a credit balance of $700. This $700 balance represents warranty claims Smart Touch expects to pay in the future based on its estimates; therefore, the $700 is a liability to Smart Touch. Estimated warranty payable 800

1,500 Bal

700

G

Contingent Liabilities A contingent liability is a potential, rather than an actual, liability because it depends on a future event. Some event must happen (the contingency) for a contingent liability to have to be paid. For example, suppose Smart Touch is sued because of alleged patent infringement on one of its learning DVDs. Smart Touch, 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 by increasing its liabilities. Therefore, it would be unethical to withhold knowledge of the lawsuit from investors and creditors. Another contingent liability arises when you co-sign a note payable for another entity. An example of this would occur if Greg’s Tunes were to co-sign Smart Touch’s note payable. The company co-signing (Greg’s Tunes) has a contingent liability until the note comes due and is paid by the other entity (Smart Touch). If the other company (Smart Touch) pays off the note, the contingent liability vanishes (for Greg’s Tunes). If not, the co-signing company (Greg’s Tunes) must pay the debt for the other entity (Smart Touch).

Accounting for liabilities poses an ethical challenge. Businesses like to show high levels of net income because that makes them look successful. As a result, owners and managers may be tempted to overlook some expenses and liabilities at the end of the accounting period. For example, a company can fail to accrue warranty expense. This will cause total expenses to be understated, net income to be overstated, and total liabilities to be understated. Contingent liabilities also pose an ethical challenge. Because contingencies are potential, rather than actual, liabilities, they are easier to overlook. But a contingency can turn into an actual liability and can significantly change the company’s financial position. Successful people do not play games with their accounting. Falsifying financial statements can land a person in prison.

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As shown in Exhibit 10-2, the accounting profession divides contingent liabilities into three categories—remote, reasonably possible, and probable—based on the likelihood of an actual loss. EXHIBIT 10-2

Contingent Liabilities: Three Categories

Likelihood of an Actual Loss Remote Reasonably possible

Probable, and the amount of the loss can be reasonably estimated

Key Takeaway Estimated current liabilities are owed, but the amount owed is based on an educated guess, not an exact known amount. So, for example, estimated warranty claims are recorded as a liability at the time a sale is made. The estimated expense and liability are journalized at the time of sale because of the matching principle. So the sales revenue and its related expense (estimated warranty claims) are reported (matched) in the same time period on the income statement.

How to Report the Contingency Do not disclose. Example: A frivolous lawsuit. Describe the situation in a note to the financial statements. Example: The company is the defendant in a significant lawsuit and the outcome is unknown. Record an expense and an actual liability, based on estimated amounts. Example: Warranty expense, as illustrated in the preceding section.

Codification Section: 450-20-55

Stop and review what you have learned by studying the Decision Guidelines on the next page.

Stop

Think...

Do you ever guess how much money you will need to pay your tuition each semester? If you do, you are making an informal sort of accounting estimate. Estimations can be formal or informal, but we all make accounting estimates. The key to why we estimate is so that we can accurately measure income. In the case of estimating your tuition, it might be just so you are sure you have enough cash on hand to pay it. Journalizing an estimate, such as for your tuition, is an example of an accrued liability.

Current Liabilities and Payroll

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Decision Guidelines 10-1 ACCOUNTING FOR CURRENT LIABILITIES Suppose you are in charge of accounting for a large construction company. The company needs to borrow $10,000 for materials for an upcoming construction job. The bank wants to see the company’s balance sheet. These Decision Guidelines will help you report current liabilities accurately.

Decision ●

●

What are the two main issues in accounting for current liabilities? What are the two basic categories of current liabilities?

Guidelines ● ●