CHAPTER

III Current Liabilities and

Payroll

Accounting
27e

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Warren
Reeve
Duchac
 Liabilities
Liabilities

Current Liabilities Non-Current Liabilities

Notes payable Bond basics

Sales taxes payable Accounting for bond issues
Unearned revenues Accounting for bond
Current maturities of long- retirements
term debt Accounting for long-term
Statement presentation notes payable
and analysis Statement presentation and
analysis
Section 1 Current Liabilities
What
What is
is aa Current
Current Liability?
Liability?

Current liability is debt with two key features:

1. Company expects to pay the debt from existing
current assets or through the creation of other current
liabilities.
2. Company will pay the debt within one year or the
operating cycle, whichever is longer.

Current liabilities include notes payable, accounts payable, unearned

revenues, and accrued liabilities such as taxes payable, salaries payable,
and interest payable.
SO 1 Explain a current liability, and identify the
major types of current liabilities.
Current Liabilities

• When a company or a bank advances

credit, it is making a loan.
• The company or bank is called a creditor
(or lender).
• The individuals or companies receiving the
loans are called debtors (or borrowers).
• Debt is recorded as a liability by the
debtor.
o Long-term liabilities are debts due beyond one
year.
o Current liabilities are debts that will be paid out
of current assets and are due within one year.
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Accounts Payable

• Accounts payable transactions involve a

variety of purchases on account, including
the purchase of merchandise and supplies.
• For most companies, accounts payable is
the largest current liability.

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What
What is
is aa Current
Current Liability?
Liability?

Notes Payable
Written promissory note.
Require the borrower to pay interest.
Issued for varying periods.

SO 2 Describe the accounting for notes payable.

What
What is
is aa Current
Current Liability?
Liability?

Illustration: On March 1, 2011, Cole Williams borrows

$100,000 from First National Bank on a 4-month, 12% note.
Instructions
a) Prepare the entry on March 1.
b) Prepare the adjusting entry on June 30, assuming
monthly adjusting entries have not been made.
c) Prepare the entry at maturity (July 1).

SO 2 Describe the accounting for notes payable.

What
What is
is aa Current
Current Liability?
Liability?

Illustration: On March 1, 2011, Cole Williams borrows

$100,000 from First National Bank on a 4-month, 12% note.
a) Prepare the entry on March 1.
Cash 100,000
Notes payable

b) Prepare100,000
the adjusting entry on June 30.
$100,000 x 12% x 4/12 = $4,000

Interest expense 4,000

Interest payable

4,000 SO 2 Describe the accounting for notes payable.

What
What is
is aa Current
Current Liability?
Liability?

Sales Tax Payable

Sales taxes are expressed as a stated percentage of
the sales price.

Either rung up separately or included in total

receipts.

Retailer collects tax from the customer.

Retailer remits the collections to the state’s

department of revenue.

SO 3 Explain the accounting for other current liabilities.

What
What is
is aa Current
Current Liability?
Liability?

Illustration: The March 25 cash register reading for Cooley

Grocery shows sales of $10,000 and sales taxes of $600 (sales
tax rate of 6%), the journal entry is:

Cash 10,600
Sales
Sales tax payable
10,000
600

SO 3 Explain the accounting for other current liabilities.

What
What is
is aa Current
Current Liability?
Liability?

Unearned Revenue
Revenues that are received before the company delivers
goods or provides services.
1. Company debits Cash, and credits
a current liability
account (unearned revenue).
2. When the company earns the
revenue, it debits the
Unearned Revenue account,
and credits a revenue account.

SO 3 Explain the accounting for other current liabilities.

What
What is
is aa Current
Current Liability?
Liability?

Illustration: Assume that Superior University sells 10,000

season football tickets at $50 each for its five-game home
schedule. The university makes the following entry for the sale
of season tickets:
Aug. 6 Cash 500,000
Unearned revenue

500,000 each of the five home games, it would

As the school completes
record the revenue earned.

Sept. 7 Unearned revenue 100,000

Ticket revenue

100,000
SO 3 Explain the accounting for other current liabilities.
Current Portion of Long-Term Debt

• Long-term liabilities are often paid back in

periodic payments, called installments.
o Such installments that are due within the
coming year are classified as a current liability.
o The installments due after the coming year are
classified as a long-term liability.

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Short-Term Notes Payable
(slide 1 of 2)

• Notes may be issued to purchase

merchandise or other assets. Notes may
also be issued to creditors to satisfy an
account payable created earlier.
o The entry to record the issuance of the note
debits Accounts Payable and credits Notes
Payable.

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Short-Term Notes Payable
(slide 2 of 2)

• A company may also borrow from a bank by

issuing a note.
• In some cases, a discounted note may be issued
rather than an interest-bearing note.
• A discounted note has the following
characteristics:
o The interest rate on the note is called the discount rate.
o The amount of interest on the note, called the discount,
is computed by multiplying the discount rate times the
face amount of the note.
o The debtor (borrower) receives the face amount of the
note less the discount, called the proceeds.
o The debtor must repay the face amount of the note on
the due date.

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Payroll and Payroll Taxes

• In accounting, payroll refers to the

amount paid to employees for services
they provided during the period.
• A company’s payroll is important for the
following reasons:
o Payroll and related payroll taxes significantly
affect the net income of most companies.
o Payroll is subject to federal and state
regulations.
o Good employee morale requires payroll to be
paid timely and accurately.

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Liability for Employee Earnings
(slide 1 of 2)

• Salary usually refers to payment for

managerial and administrative services.
o Salary is normally expressed in terms of a
month or a year.
• Wages usually refers to payment for
employee manual labor.
o The rate of wages is normally stated on an
hourly or weekly basis.
• The salary or wage of an employee may
be increased by bonuses, commissions,
profit sharing, or cost-of-living
adjustments.
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Liability for Employee Earnings
(slide 2 of 2)

• Companies engaged in interstate

commerce must follow the Fair Labor
Standards Act. This act, sometimes called
the Federal Wage and Hour Law, requires
employers to pay a minimum rate of 1½
times the regular rate for all hours worked
in excess of 40 hours per week.

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Deductions from Employee Earnings

• The total earnings of an employee for a

payroll period, including any overtime pay,
are called gross pay.
• From this amount is subtracted one or
more deductions to arrive at the net pay.
o Net pay is the amount paid the employee.
o The deductions normally include the following:
 Federal income taxes
 State income taxes
 Local income taxes
 Medical insurance
 Pension contributions

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Income Taxes
(slide 1 of 4)

• Employers normally withhold a portion of

employee earnings for payment of the
employees’ federal income tax.
• Each employee authorizes the amount to
be withheld by completing an “Employee’s
Withholding Allowance Certificate,” called
a W-4.

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Income Taxes
(slide 2 of 4)

• On the W-4, an employee indicates marital

status and the number of withholding
allowances.
o A single employee may claim one withholding
allowance.
o A married employee may claim an additional
allowance for a spouse.
o An employee may also claim an allowance for
each dependent other than a spouse.
• Each allowance reduces the federal
income tax withheld from the employee’s
pay.
o The federal income tax withheld depends on
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Income Taxes
(slide 3 of 4)

• Withholding tables issued by the Internal

Revenue Service (IRS) are used to
determine amounts to withhold.
• Each year, the amount of standard
withholding allowance is determined by
the IRS.
o For ease of computation and because this
amount changes each year, we assume that
the standard withholding allowance to be
deducted for a single person paid weekly is
$75.

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Income Taxes
(slide 4 of 4)

• After the person’s withholding wage

bracket has been computed, the federal
income tax to be withheld is determined as
follows:
o Step 1. Locate the proper withholding wage
bracket in the withholding tables issued by the
IRS.
o Step 2. Compute the withholding for the proper
wage bracket using the directions in the two-
right columns of the withholding table.

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FICA Tax
(slide 1 of 2)

• Employers are required by the Federal

Insurance Contributions Act (FICA) to
withhold a portion of the earnings of each
employee.
• The FICA tax withheld contributes to the
following two federal programs:
o Social security, which provides payments for
retirees, survivors, and disability insurance.
o Medicare, which provides health insurance for
senior citizens.

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FICA Tax
(slide 2 of 2)

• The amount withheld from each employee

is based on the employee’s earnings paid
in the calendar year.
• The withholding tax rates and maximum
earnings subject to tax are often revised
by Congress.
o To simplify, this chapter assumes the following
rates and earnings subject to tax:
 Social security: 6% on all earnings
 Medicare: 1.5% on all earnings

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Other Deductions

• Employees may choose to have additional

amounts deducted from their gross pay,
such as deductions for:
o Retirement savings
o Charitable contributions
o Life insurance

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Computing Employee Net Pay

• Gross earnings less payroll deductions

equals net pay.
• Net pay is sometimes called take-home
pay.

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Liability for Employer’s Payroll Taxes

• Employers are subject to the following

payroll taxes for amounts paid their
employees:
o FICA Tax
 Employers must match the employee’s FICA tax
contribution.
o Federal Unemployment Compensation Tax
(FUTA)
 This employer tax provides for temporary payments
to those who become unemployed.
o State Unemployment Compensation Tax (SUTA)
 This employer tax provides temporary payments to
those who become unemployed.

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Accounting Systems for
Payroll and Payroll Taxes (slide 1 of 2)

• Payroll systems should be designed to:

o Pay employees accurately and timely.
o Meet regulatory requirements of federal, state,
and local agencies.
o Provide useful data for management decision-
making needs.
• Although payroll systems differ among
companies, the major elements of most
payroll systems are:
o Payroll register
o Employee’s earnings record
o Payroll checks
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Accounting Systems for
Payroll and Payroll Taxes (slide 2 of 2)
• The payroll register is a multicolumn report
used for summarizing the data for each payroll
period.
• Although payroll registers vary by company, a
• payroll
Employee register
name normally includes
• Federalthe following
income tax
• columns:
Total hours worked withheld
• Regular earnings • Retirement savings
• Overtime earnings withheld
• Total gross earnings • Miscellaneous items
• Social security tax withheld withheld
• Medicare tax withheld • Total withholdings
• Net pay
• Check number of payroll
check issued
• Accounts debited for
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payroll expense
Recording and Paying Payroll Taxes

• Payroll taxes are recorded as liabilities

when the payroll is paid to employees.
• In addition, employers compute and report
payroll taxes on a calendar-year basis,
which may differ from the company’s fiscal
year.
• Employers must match the employees’
social security and Medicare tax
contributions.
• In addition, the employer must pay state
unemployment compensation tax (SUTA)
of 5.4% and federal unemployment
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Employee’s Earnings Record

• Each employee’s earnings to date must be

determined at the end of each payroll
period. This total is necessary for
computing the employee’s social security
tax withholding and the employer’s payroll
taxes.
• Thus, detailed payroll records must be
kept for each employee. This record is
called an employee’s earnings record.

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Payroll Checks
(slide 1 of 2)

• Companies pay employees either by

electronic funds transfer or by issuing
payroll checks.
o With electronic funds transfers, the employee’s
net pay is electronically deposited into their
bank account each period. Later, the
employees receive a payroll statement
summarizing how the net pay was computed.
o Each payroll check includes a detachable
statement showing how the net pay was
computed, which is typically identical to the
payroll statement accompanying electronic
funds transfers (EFTs).
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Payroll Checks
(slide 2 of 2)

• Most companies use a special payroll bank

account to disburse payroll.
o An advantage of using a separate payroll bank
account is that reconciling the bank
statements is simplified.
o In addition, a payroll bank account establishes
control over payroll checks and, thus, prevents
their theft or misuse.

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Computerized Payroll System

• The inputs into a payroll system may be

classified as:
o Constants: Data that remain unchanged from
payroll to payroll. Examples include:
 Employee names
 Social security numbers
 Marital status
 Rates of pay
 Tax rates
o Variables: Data that change from payroll to
payroll. Examples include:
 Number of hours or days worked for each employee
 Accrued days of sick leave
 Total earnings to date
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Internal Controls for Payroll Systems

• Some examples of payroll controls include the

following:
o If a check-signing machine is used, blank payroll checks
and access to the machine should be restricted to
prevent their theft or misuse.
o The hiring and firing of employees should be properly
authorized and approved in writing.
o All changes in pay rates should be properly authorized
and approved in writing.
o Employees should be observed when arriving for work to
verify that employees are “checking in” for work only
once and only for themselves. Employees may “check
in” for work by using a time card or by swiping their
employee ID card.
o Payroll checks should be distributed by someone other
than employee supervisors.
o A special payroll bank account should be used.
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Employees’ Fringe Benefits

• Many companies provide their employees

benefits in addition to salary and wages
earned. Such fringe benefits may
include:
o Vacation pay
o Medical benefits
o Retirement benefits
• The cost of employee fringe benefits is
recorded as an expense by the employer.

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Vacation Pay

• The liability to pay for employee vacations could be accrued

as a liability at the end of each pay period. However, many
companies wait and record an adjusting entry for accrued
vacation at the end of the year.
• If employees are required to take all their vacation time
within one year, the vacation pay payable is reported as a
current liability on the balance sheet.
• If employees are allowed to accumulate their vacation pay,
the estimated vacation pay payable that will not be taken
within a year is reported as a long-term liability.
• When employees take vacation, the liability for vacation
pay is decreased by debiting Vacation Pay Payable. Salaries
or Wages Payable and the other related payroll accounts for
taxes and withholdings are credited.

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Pensions

• A pension is a cash payment to retired

employees.
• Pension rights are accrued by employees
as they work, based on the employer’s
pension plan.
• Two basic types of pension plans are:
o Defined contribution plan
o Defined benefit plan

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Defined Contribution Plans
(slide 1 of 2)

• In a defined contribution plan, the

company invests contributions on behalf
of the employee during the employee’s
working years.
o Normally, the employee and employer
contribute to the plan.
o The employee’s pension depends on the total
contributions and the investment returns
earned on those contributions.

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Defined Contribution Plans
(slide 2 of 2)

• One of the more popular defined

contribution plans is the 401K plan.
o Under this plan, employees contribute a
portion of their gross pay before taxes to
investments.
o A 401k plan offers employees two advantages:
 The employee contribution is deducted before taxes.
 The contributions and related earnings are not taxed
until withdrawn at retirement.
• In most cases, the employer matches
some portion of the employee’s
contribution.
• The employer’s cost is debited to Pension
Expense.
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Defined Benefit Plans
(slide 1 of 2)

• In a defined benefit plan, the company

pays the employee a fixed annual pension
based on a formula. The formula is
normally based on such factors as the
employee’s years of service, age, and past
salary.

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Defined Benefit Plans
(slide 2 of 2)

• In a defined benefit plan, the employer is

obligated to pay for (fund) the employee’s future
pension benefits.
• The pension cost of a defined benefit plan is
debited to Pension Expense. Cash is credited for
the amount contributed (funded) by the
employer, and any unfunded amount is credited
to Unfunded Pension Liability.
• If the unfunded pension liability is to be paid
within one year, it is reported as a current liability
on the balance sheet.
• Any portion of the unfunded pension liability that
will be paid beyond one year is a long-term
liability.
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Postretirement Benefits Other than Pensions
(slide 1 of 3)

• Employees may earn rights to other

postretirement benefits from their
employer. Such benefits may include the
following:
o Dental care
o Eye care
o Medical care
o Life insurance
o Tuition assistance
o Tax services
o Legal services

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Postretirement Benefits Other than Pensions
(slide 2 of 3)

• The estimate of the annual benefits

expense is recorded by debiting
Postretirement Benefits Expense. If the
benefits are fully funded, Cash is credited
for the same amount. If the benefits are
not fully funded, a postretirement benefits
plan liability account is also credited.

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Postretirement Benefits Other than Pensions
(slide 3 of 3)

• The nature of postretirement benefit

liabilities should be disclosed on the
financial statements. These disclosures are
usually included as notes to the financial
statements.

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Contingent Liabilities

• Some liabilities may arise from past

transactions only if certain events occur in
the future. These potential obligations are
called contingent liabilities.
• The accounting for contingent liabilities
depends on the following two factors:
o Likelihood of occurring
 The likelihood that the event creating the liability
occurring is classified as probable, reasonably
possible, or remote.
o Measurement
 The ability to estimate the potential liability is
classified as estimable or not estimable.
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Probable and Estimable

• If a contingent liability is probable and the

amount of the liability can be reasonably
estimated, it is recorded and disclosed.
• The liability is recorded by debiting an
expense and crediting a liability.
• If the product is repaired under warranty,
the repair costs are recorded by debiting
Product Warranty Payable and crediting
Cash, Supplies, Wages Payable, or other
accounts.

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Probable and Not Estimable

• A contingent liability whose occurrence is

probable but not estimable is disclosed in
the notes to the financial statements.

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Reasonably Possible

• A contingent liability whose occurrence is

reasonably possible is disclosed in the
notes to the financial statements.

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Remote

• No disclosure needs to be made in the

notes to the financial statements for a
contingent liability whose occurrence is
remote.

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Financial Analysis and Interpretation:
Quick Ratio (slide 1 of 3)

• Current position analysis helps

creditors evaluate a company’s ability to
pay its current liabilities. This analysis is
based on:
o Working capital
o Current ratio
o Quick ratio

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Financial Analysis and Interpretation:
Quick Ratio (slide 2 of 3)

• Working capital is computed as follows:

Working Capital = Current Assets – Current
Liabilities
• The current ratio is computed as follows:
Current Assets
Current
Current
Ratio =
• While these Liabilities
two measures
used to can be
a company’s ability to pay its current
liabilities, they do not provide insight into
the company’s ability to pay these
liabilities within a short period of time.
o This is because some current assets cannot be
converted into cash as quickly as other current
assets.
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Financial Analysis and Interpretation:
Quick Ratio (slide 3 of 3)

• The quick ratio overcomes this limitation

by measuring the “instant” debt-paying
ability of a company.
• It is computed as follows:
Quick Assets
Quick Ratio
Current
=
Liabilities

• Quick assets are cash and other current

assets that can be easily be converted to
cash.
• A quick ratio below 1.0 indicates that the
company does not have enough quick
assets to cover its current liabilities.
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