What would you do if you had a great idea for a new product but couldn't come up with the cash to get the business off the ground? Small businesses often cannot attract investors. Nor can they obtain traditional debt financing through bank loans or bond issuances. Instead, they often resort to unusual, and costly, forms of nontraditional financing.
Such was the case for Wilbert Murdock. Murdock grew up in a New York housing project and always had great ambitions. This ambitious spirit led him into some business ventures that failed: a medical diagnostic tool, a device to eliminate carpal tunnel syndrome, custom-designed sneakers, and a device to keep people from falling asleep while driving.
Another idea was computerized golf clubs that analyze a golfer's swing and provide immediate feedback. Murdock saw great potential in the idea. Many golfers are willing to shell out considerable sums of money for devices that might improve their game. But Murdock had no cash to develop his product, and banks and other lenders had shied away. Rather than give up, Murdock resorted to credit cards—in a big way. He quickly owed $25,000 to credit card companies.
While funding a business with credit cards might sound unusual, it isn't. A recent study found that one-third of businesses with fewer than 20 employees financed at least part of their operations with credit cards. As Murdock explained, credit cards are an appealing way to finance a start-up because “credit-card companies don't care how the money is spent.” However, they do care how they are paid. And so Murdock faced high interest charges and a barrage of credit card collection letters.
Murdock's debt forced him to sacrifice nearly everything in order to keep his business afloat. His car stopped running, he barely had enough money to buy food, and he lived and worked out of a dimly lit apartment in his mother's basement. Through it all he tried to maintain a positive spirit, joking that, if he becomes successful, he might some day get to appear in an American Express commercial.
Source: Rodney Ho, “Banking on Plastic: To Finance a Dream, Many Entrepreneurs Binge on Credit Cards,” Wall Street Journal (March 9, 1998), p. A1.
Preview of Chapter 11
Inventor-entrepreneur Wilbert Murdock, as you can tell from the Feature Story, had to use multiple credit cards to finance his business ventures. Murdock's credit card debts would be classified as current liabilities because they are due every month. Yet, by making minimal payments and paying high interest each month, Murdock used this credit source long-term. Some credit card balances remain outstanding for years as they accumulate interest.
Earlier, we defined liabilities as creditors’ claims on total assets and as existing debts and obligations. These claims, debts, and obligations must be settled or paid at some time in the future by the transfer of assets or services. The future date on which they are due or payable (maturity date) is a significant feature of liabilities. This “future date” feature gives rise to two basic classifications of liabilities: (1) current liabilities and (2) long-term liabilities. We will explain current liabilities, along with payroll accounting, in this chapter. We will explain long-term liabilities in Chapter 15.
The content and organization of Chapter 11 are as follows.
Explain a current liability, and identify the major types of current liabilities.
As explained in Chapter 4, a current liability is a debt that a company expects to pay within one year or the operating cycle, whichever is longer. Debts that do not meet this criterion are classified as long-term liabilities.
Companies must carefully monitor the relationship of current liabilities to current assets. This relationship is critical in evaluating a company's short-term debt-paying ability. A company that has more current liabilities than current assets may not be able to meet its current obligations when they become due.
Current liabilities include notes payable, accounts payable, and unearned revenues. They also include accrued liabilities such as taxes, salaries and wages, and interest payable. In the sections that follow, we discuss a few of the common types of current liabilities.
Companies record obligations in the form of written notes as notes payable. Notes payable are often used instead of accounts payable because they give the lender formal proof of the obligation in case legal remedies are needed to collect the debt. Companies frequently issue notes payable to meet short-term financing needs. Notes payable usually require the borrower to pay interest.
Notes are issued for varying periods of time. Those due for payment within one year of the balance sheet date are usually classified as current liabilities.
To illustrate the accounting for notes payable, assume that First National Bank agrees to lend $100,000 on September 1, 2014, if Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1. When a company issues an interest-bearing note, the amount of assets it receives upon issuance of the note generally equals the note's face value. Cole Williams Co. therefore will receive $100,000 cash and will make the following journal entry.
Interest accrues over the life of the note, and the company must periodically record that accrual. If Cole Williams Co. prepares financial statements annually, it makes an adjusting entry at December 31 to recognize interest expense and interest payable of $4,000 ($100,000 × 12% × 4/12). Illustration 11-1 shows the formula for computing interest and its application to Cole Williams Co.'s note.
Cole Williams makes an adjusting entry as follows.
In the December 31 financial statements, the current liabilities section of the balance sheet will show notes payable $100,000 and interest payable $4,000. In addition, the company will report interest expense of $4,000 under “Other expenses and losses” in the income statement. If Cole Williams Co. prepared financial statements monthly, the adjusting entry at the end of each month would be $1,000 ($100,000 × 12% × 1/12).
At maturity (January 1, 2015), Cole Williams Co. must pay the face value of the note ($100,000) plus $4,000 interest ($100,000 × 12% × 4/12). It records payment of the note and accrued interest as follows.
As a consumer, you know that many of the products you purchase at retail stores are subject to sales taxes. Many states also are now collecting sales taxes on purchases made on the Internet as well. Sales taxes are expressed as a percentage of the sales price. The selling company collects the tax from the customer when the sale occurs. Periodically (usually monthly), the retailer remits the collections to the state's department of revenue. Collecting sales taxes is important. For example, the state of New York recently sued Sprint Corporation for $300 million for its alleged failure to collect sales taxes on phone calls.
Under most state sales tax laws, the selling company must enter separately in the cash register the amount of the sale and the amount of the sales tax collected. (Gasoline sales are a major exception.) The company then uses the cash register readings to credit Sales Revenue and Sales Taxes Payable. For example, if 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:
When the company remits the taxes to the taxing agency, it debits Sales Taxes Payable and credits Cash. The company does not report sales taxes as an expense. It simply forwards to the government the amount paid by the customers. Thus, Cooley Grocery serves only as a collection agent for the taxing authority.
Sometimes companies do not enter sales taxes separately in the cash register. To determine the amount of sales in such cases, divide total receipts by 100% plus the sales tax percentage. To illustrate, assume that in the above example Cooley Grocery enters total receipts of $10,600. The receipts from the sales are equal to the sales price (100%) plus the tax percentage (6% of sales), or 1.06 times the sales total. We can compute the sales amount as follows.
$10,600 ÷ 1.06 = $10,000
Helpful Hint Alternatively, Cooley could find the tax by multiplying sales by the sales tax rate ($10,000 × .06).
Thus, Cooley Grocery could find the sales tax amount it must remit to the state ($600) by subtracting sales from total receipts ($10,600 − $10,000).
A magazine publisher, such as Sports Illustrated, receives customers’ checks when they order magazines. An airline company, such as American Airlines, often receives cash when it sells tickets for future flights. Season tickets for concerts, sporting events, and theater programs are also paid for in advance. How do companies account for unearned revenues that are received before goods are delivered or services are performed?
1. When a company receives the advance payment, it debits Cash, and credits a current liability account identifying the source of the unearned revenue.
2. When the company recognizes revenue, it debits an unearned revenue account, and credits a revenue account.
To illustrate, 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.
As each game is completed, Superior records the recognition of revenue with the following entry.
The account Unearned Ticket Revenue represents unearned revenue, and Superior reports it as a current liability. As the school recognizes revenue, it reclassifies the amount from unearned revenue to Ticket Revenue. Unearned revenue is material for some companies. In the airline industry, for example, tickets sold for future flights represent almost 50% of total current liabilities. At United Air Lines, unearned ticket revenue is its largest current liability, recently amounting to over $1 billion.
Illustration 11-2 shows specific unearned revenue and revenue accounts used in selected types of businesses.
Companies often have a portion of long-term debt that comes due in the current year. That amount is considered a current liability. As an example, assume that Wendy Construction issues a five-year, interest-bearing $25,000 note on January 1, 2013. This note specifies that each January 1, starting January 1, 2014, Wendy should pay $5,000 of the note. When the company prepares financial statements on December 31, 2013, it should report $5,000 as a current liability and $20,000 as a long-term liability. (The $5,000 amount is the portion of the note that is due to be paid within the next 12 months.) Companies often identify current maturities of long-term debt on the balance sheet as long-term debt due within one year.
It is not necessary to prepare an adjusting entry to recognize the current maturity of long-term debt. At the balance sheet date, all obligations due within one year are classified as current, and all other obligations as long-term.
Current Liabilities
You and several classmates are studying for the next accounting examination. They ask you to answer the following questions.
1. If cash is borrowed on a $50,000, 6-month, 12% note on September 1, how much interest expense would be incurred by December 31?
2. How is the sales tax amount determined when the cash register total includes sales taxes?
3. If $15,000 is collected in advance on November 1 for 3 months’ rent, what amount of rent revenue should be recognized by December 31?
Action Plan
Use the interest formula: Face value of note × Annual interest rate × Time in terms of one year.
Divide total receipts by 100% plus the tax rate to determine sales revenue; then subtract sales revenue from the total receipts.
Determine what fraction of the total unearned rent should be recognized this year.
Solution
1. $50,000 × 12% × 4/12 = $2,000
2. First, divide the total cash register receipts by 100% plus the sales tax percentage to find the sales revenue amount. Second, subtract the sales revenue amount from the total cash register receipts to determine the sales taxes.
3. $15,000 × 2/3 = $10,000
Related exercise material: BE11-2, BE11-3, BE11-4, E11-1, E11-2, E11-3, E11-4, and DO IT! 11-1.
Explain the financial statement presentation and analysis of current liabilities.
As indicated in Chapter 4, current liabilities are the first category under liabilities on the balance sheet. Each of the principal types of current liabilities is listed separately. In addition, companies disclose the terms of notes payable and other key information about the individual items in the notes to the financial statements.
Companies seldom list current liabilities in the order of liquidity. The reason is that varying maturity dates may exist for specific obligations such as notes payable. A more common method of presenting current liabilities is to list them by order of magnitude, with the largest ones first. Or, as a matter of custom, many companies show notes payable first, and then accounts payable, regardless of amount. Then the remaining current liabilities are listed by magnitude. (Use this approach in your homework.) Illustration 11-3 (page 528) provides an adapted excerpt from Caterpillar Inc.'s balance sheet, which illustrates its order of presentation.
Use of current and noncurrent classifications makes it possible to analyze a company's liquidity. Liquidity refers to the ability to pay maturing obligations and meet unexpected needs for cash. The relationship of current assets to current liabilities is critical in analyzing liquidity. We can express this relationship as a dollar amount (working capital) and as a ratio (the current ratio).
Helpful Hint For other examples of current liabilities sections, refer to the PepsiCo and Coca-Cola balance sheets in Appendices B and C.
The excess of current assets over current liabilities is working capital. Illustration 11-4 shows the formula for the computation of Caterpillar's working capital (dollar amounts in millions).
As an absolute dollar amount, working capital offers limited informational value. For example, $1 million of working capital may be more than needed for a small company but inadequate for a large corporation. Also, $1 million of working capital may be adequate for a company at one time but inadequate at another time.
The current ratio permits us to compare the liquidity of different-sized companies and of a single company at different times. The current ratio is calculated as current assets divided by current liabilities. Illustration 11-5 shows the formula for this ratio, along with its computation using Caterpillar's current asset and current liability data (dollar amounts in millions).
Historically, companies and analysts considered a current ratio of 2:1 to be the standard for a good credit rating. In recent years, however, many healthy companies have maintained ratios well below 2:1 by improving management of their current assets and liabilities. Caterpillar's ratio of 1.33:1 is adequate but certainly below the standard of 2:1.
Describe the accounting and disclosure requirements for contingent liabilities.
With notes payable, interest payable, accounts payable, and sales taxes payable, we know that an obligation to make a payment exists. But, suppose that your company is involved in a dispute with the Internal Revenue Service (IRS) over the amount of its income tax liability. Should you report the disputed amount as a liability on the balance sheet? Or, suppose your company is involved in a law-suit which, if you lose, might result in bankruptcy. How should you report this major contingency? The answers to these questions are difficult because these liabilities are dependent—contingent—upon some future event. In other words, a contingent liability is a potential liability that may become an actual liability in the future.
How should companies report contingent liabilities? They use the following guidelines:
1. If the contingency is probable (if it is likely to occur) and the amount can be reasonably estimated, the liability should be recorded in the accounts.
2. If the contingency is only reasonably possible (if it could happen), then it needs to be disclosed only in the notes that accompany the financial statements.
3. If the contingency is remote (if it is unlikely to occur), it need not be recorded or disclosed.
ACCOUNTING ACROSS THE ORGANIZATION
Contingencies: How Big Are They?
Contingent liabilities abound in the real world. Consider the following. Manville Corp. filed for bankruptcy when it was hit by billions of dollars in asbestos product-liability claims. Companies having multiple toxic waste sites are faced with cleanup costs that average $10 to $30 million and can reach as high as $500 million depending on the type of waste. For life and health insurance companies and their stockholders, the cost of diseases such as diabetes, Alzheimer's, and AIDS is like an iceberg: Everyone wonders how big such costs really are and what damage they might do in the future. And frequent-flyer programs are so popular that airlines at one time owed participants more than 3 million round-trip domestic tickets. That's enough to fly at least 5.4 billion miles—free for the passengers, but at what future cost to the airlines?
Why do you think most companies disclose, but do not record, contingent liabilities? (See page 563.)
Product warranties are an example of a contingent liability that companies should record in the accounts. Warranty contracts result in future costs that companies may incur in replacing defective units or repairing malfunctioning units. Generally, a manufacturer, such as Stanley Black & Decker, knows that it will incur some warranty costs. From prior experience with the product, the company usually can reasonably estimate the anticipated cost of servicing (honoring) the warranty.
The accounting for warranty costs is based on the expense recognition principle. The estimated cost of honoring product warranty contracts should be recognized as an expense in the period in which the sale occurs. To illustrate, assume that in 2014 Denson Manufacturing Company sells 10,000 washers and dryers at an average price of $600 each. The selling price includes a one-year warranty on parts. Denson expects that 500 units (5%) will be defective and that warranty repair costs will average $80 per unit. In 2014, the company honors warranty contracts on 300 units, at a total cost of $24,000.
At December 31, it is necessary to accrue the estimated warranty costs on the 2014 sales. Denson computes the estimated warranty liability as follows.
The company makes the following adjusting entry.
Denson records those repair costs incurred in 2014 to honor warranty contracts on 2014 sales as shown below.
The company reports warranty expense of $40,000 under selling expenses in the income statement. It classifies warranty liability of $16,000 ($40,000 − $24,000) as a current liability on the balance sheet.
In the following year, Denson should debit to Warranty Liability all expenses incurred in honoring warranty contracts on 2014 sales. To illustrate, assume that the company replaces 20 defective units in January 2015, at an average cost of $80 in parts and labor. The summary entry for the month of January 2015 is:
When it is probable that a company will incur a contingent liability but it cannot reasonably estimate the amount, or when the contingent liability is only reasonably possible, only disclosure of the contingency is required. Examples of contingencies that may require disclosure are pending or threatened lawsuits and assessment of additional income taxes pending an IRS audit of the tax return.
The disclosure should identify the nature of the item and, if known, the amount of the contingency and the expected outcome of the future event. Disclosure is usually accomplished through a note to the financial statements, as shown in Illustration 11-7.
The required disclosure for contingencies is a good example of the use of the full-disclosure principle. The full-disclosure principle requires that companies disclose all circumstances and events that would make a difference to financial statement users. Some important financial information, such as contingencies, is not easily reported in the financial statements. Reporting information on contingencies in the notes to the financial statements will help investors be aware of events that can affect the financial health of a company.
DO IT!
Current Liabilities
Lepid Company has the following account balances at December 31, 2014.
Notes payable ($80,000 due after 12/31/15) | $200,000 |
Unearned service revenue | 75,000 |
Other long-term debt ($30,000 due in 2015) | 150,000 |
Salaries and wages payable | 22,000 |
Other accrued expenses | 15,000 |
Accounts payable | 100,000 |
In addition, Lepid is involved in a lawsuit. Legal counsel feels it is probable Lepid will pay damages of $38,000 in 2015.
(a) Prepare the current liability section of Lepid's December 31, 2014, balance sheet.
(b) Lepid's current assets are $504,000. Compute Lepid's working capital and current ratio.
Action Plan
Determine which liabilities will be paid within one year or the operating cycle and include those as current liabilities.
If the contingent liability is probable and reasonably estimable, include it as a current liability.
Use the formula for working capital: Current assets − Current liabilities.
Use the formula for the current ratio: Current assets ÷ Current liabilities.
Solution
(b) Working capital = Current assets − Current liabilities = $504,000 − $400,000 = $104,000
Current ratio = Current assets ÷ Current liabilities = $504,000 ÷ $400,000 = 1.26:1
Related exercise material: BE11-5, E11-7, E11-8, E11-9, and DO IT! 11-2.
Payroll and related fringe benefits often make up a large percentage of current liabilities. Employee compensation is often the most significant expense that a company incurs. For example, Costco recently reported total employees of 103,000 and labor and fringe benefits costs which approximated 70% of the company's total cost of operations.
Payroll accounting involves more than paying employees’ wages. Companies are required by law to maintain payroll records for each employee, to file and pay payroll taxes, and to comply with state and federal tax laws related to employee compensation.
The term “payroll” pertains to both salaries and wages of employees. Managerial, administrative, and sales personnel are generally paid salaries. Salaries are often expressed in terms of a specified amount per month or per year rather than an hourly rate. Store clerks, factory employees, and manual laborers are normally paid wages. Wages are based on a rate per hour or on a piecework basis (such as per unit of product). Frequently, people use the terms “salaries” and “wages” interchangeably.
The term “payroll” does not apply to payments made for services of professionals such as certified public accountants, attorneys, and architects. Such professionals are independent contractors rather than salaried employees. Payments to them are called fees. This distinction is important because government regulations relating to the payment and reporting of payroll taxes apply only to employees.
Determining the payroll involves computing three amounts: (1) gross earnings, (2) payroll deductions, and (3) net pay.
Gross earnings is the total compensation earned by an employee. It consists of wages or salaries, plus any bonuses and commissions.
Companies determine total wages for an employee by multiplying the hours worked by the hourly rate of pay. In addition to the hourly pay rate, most companies are required by law to pay hourly workers a minimum of 1½ times the regular hourly rate for overtime work in excess of eight hours per day or 40 hours per week. In addition, many employers pay overtime rates for work done at night, on weekends, and on holidays.
For example, assume that Michael Jordan, an employee of Academy Company, worked 44 hours for the weekly pay period ending January 14. His regular wage is $12 per hour. For any hours in excess of 40, the company pays at one-and-a-half times the regular rate. Academy computes Jordan's gross earnings (total wages) as follows.
This computation assumes that Jordan receives 1½ times his regular hourly rate ($12 × 1.5) for his overtime hours. Union contracts often require that overtime rates be as much as twice the regular rates.
An employee's salary is generally based on a monthly or yearly rate. The company then prorates these rates to its payroll periods (e.g., biweekly or monthly). Most executive and administrative positions are salaried. Federal law does not require overtime pay for employees in such positions.
Many companies have bonus agreements for employees. One survey found that over 94% of the largest U.S. manufacturing companies offer annual bonuses to key executives. Bonus arrangements may be based on such factors as increased sales or net income. Companies may pay bonuses in cash and/or by granting employees the opportunity to acquire shares of company stock at favorable prices (called stock option plans).
Ethics Note
Bonuses often reward outstanding individual performance, but successful corporations also need considerable teamwork. A challenge is to motivate individuals while preventing an unethical employee from taking another's idea for his or her own advantage.
As anyone who has received a paycheck knows, gross earnings are usually very different from the amount actually received. The difference is due to payroll deductions.
Payroll deductions may be mandatory or voluntary. Mandatory deductions are required by law and consist of FICA taxes and income taxes. Voluntary deductions are at the option of the employee. Illustration 11-9 summarizes common types of payroll deductions. Such deductions do not result in payroll tax expense to the employer. The employer is merely a collection agent, and subsequently transfers the deducted amounts to the government and designated recipients.
FICA TAXES In 1937, Congress enacted the Federal Insurance Contribution Act (FICA). FICA taxes are designed to provide workers with supplemental retirement, employment disability, and medical benefits. In 1965, Congress extended benefits to include Medicare for individuals over 65 years of age. The benefits are financed by a tax levied on employees’ earnings.
FICA taxes consist of a Social Security tax and a Medicare tax. They are paid by both employee and employer.1 The FICA tax rate is 7.65% (6.2% Social Security tax plus 1.45%) on the first $110,100 of salary and wages for each employee. In addition, the Medicare tax of 1.45% continues for an employee's salary and wages in excess of $110,100. These tax rate and tax base requirements are shown in Illustration 11-10.
To illustrate the computation of FICA taxes, assume that Mario Ruez has total wages for the year of $100,000. In this case, Mario pays FICA taxes of $7,650 ($100,000 × 7.65%). If Mario has total wages of $114,000, Mario pays FICA taxes of $8,479.20, as shown in Illustration 11-11.
Mario's employer is also required to pay $8,479.20.
INCOME TAXES Under the U.S. pay-as-you-go system of federal income taxes, employers are required to withhold income taxes from employees each pay period. Three variables determine the amount to be withheld: (1) the employee's gross earnings, (2) the number of allowances claimed by the employee, and (3) the length of the pay period. The number of allowances claimed typically includes the employee, his or her spouse, and other dependents.
Withholding tables furnished by the Internal Revenue Service indicate the amount of income tax to be withheld. Withholding amounts are based on gross wages and the number of allowances claimed. Separate tables are provided for weekly, biweekly, semimonthly, and monthly pay periods. Illustration 11-12 shows the withholding tax table for Michael Jordan (assuming he earns $552 per week and claims two allowances). For a weekly salary of $552 with two allowances, the income tax to be withheld is $49 (highlighted in red).
In addition, most states (and some cities) require employers to withhold income taxes from employees’ earnings. As a rule, the amounts withheld are a percentage (specified in the state revenue code) of the amount withheld for the federal income tax. Or they may be a specified percentage of the employee's earnings. For the sake of simplicity, we have assumed that Jordan's wages are subject to state income taxes of 2%, or $11.04 (2% × $552) per week.
There is no limit on the amount of gross earnings subject to income tax withholdings. In fact, under our progressive system of taxation, the higher the earnings, the higher the percentage of income withheld for taxes.
OTHER DEDUCTIONS Employees may voluntarily authorize withholdings for charitable organizations, retirement, and other purposes. All voluntary deductions from gross earnings should be authorized in writing by the employee. The authorization(s) may be made individually or as part of a group plan. Deductions for charitable organizations, such as the United Fund, or for financial arrangements, such as U.S. savings bonds and repayment of loans from company credit unions, are made individually. Deductions for union dues, health and life insurance, and pension plans are often made on a group basis. We will assume that Jordan has weekly voluntary deductions of $10 for the United Fund and $5 for union dues.
Academy Company determines net pay by subtracting payroll deductions from gross earnings. Illustration 11-13 shows the computation of Jordan's net pay for the pay period.
Alternative Terminology
Net pay is also called take-home pay.
Assuming that Michael Jordan's wages for each week during the year are $552, total wages for the year are $28,704 (52 × $552). Thus, all of Jordan's wages are subject to FICA tax during the year. In comparison, let's assume that Jordan's department head earns $2,200 per week, or $114,400 for the year. Since only the first $110,100 is subject to FICA taxes, the maximum FICA withholdings on the department head's earnings would be $8,485 [($110,100 × 6.20%) + ($114,400 × 1.45%)].
Recording the payroll involves maintaining payroll department records, recognizing payroll expenses and liabilities, and recording payment of the payroll.
To comply with state and federal laws, an employer must keep a cumulative record of each employee's gross earnings, deductions, and net pay during the year. The record that provides this information is the employee earnings record. Illustration 11-14 shows Michael Jordan's employee earnings record.
Companies keep a separate earnings record for each employee and update these records after each pay period. The employer uses the cumulative payroll data on the earnings record to: (1) determine when an employee has earned the maximum earnings subject to FICA taxes, (2) file state and federal payroll tax returns (as explained later), and (3) provide each employee with a statement of gross earnings and tax withholdings for the year. Illustration 11-18 on page 542 shows this statement.
In addition to employee earnings records, many companies find it useful to prepare a payroll register. This record accumulates the gross earnings, deductions, and net pay by employee for each pay period. Illustration 11-15 presents Academy Company's payroll register. It provides the documentation for preparing a paycheck for each employee. For example, it shows the data for Michael Jordan in the wages section. In this example, Academy Company's total weekly payroll is $17,210, as shown in the gross earnings column (column E, row 24).
Note that this record is a listing of each employee's payroll data for the pay period. In some companies, a payroll register is a journal or book of original entry. Postings are made from it directly to ledger accounts. In other companies, the payroll register is a memorandum record that provides the data for a general journal entry and subsequent posting to the ledger accounts. At Academy Company, the latter procedure is followed.
From the payroll register in Illustration 11-15, Academy Company makes a journal entry to record the payroll. For the week ending January 14, the entry is:
The company credits specific liability accounts for the mandatory and voluntary deductions made during the pay period. In the example, Academy debits Salaries and Wages Expense for the gross earnings of its employees. The amount credited to Salaries and Wages Payable is the sum of the individual checks the employees will receive.
A company makes payments by check (or electronic funds transfer) either from its regular bank account or a payroll bank account. Each paycheck is usually accompanied by a detachable statement of earnings document. This shows the employee's gross earnings, payroll deductions, and net pay, both for the period and for the year-to-date. Academy Company uses its regular bank account for payroll checks. Illustration 11-16 (page 538) shows the paycheck and statement of earnings for Michael Jordan.
Helpful Hint Do any of the income tax liabilities result in payroll tax expense for the employer?
Answer: No. The employer is acting only as a collection agent for the government.
Following payment of the payroll, the company enters the check numbers in the payroll register. Academy Company records payment of the payroll as follows.
Many medium- and large-size companies use a payroll processing center that performs payroll recordkeeping services. Companies send the center payroll information about employee pay rates and hours worked. The center maintains the payroll records and prepares the payroll checks. In most cases, it costs less to process the payroll through the center (outsource) than if the company did so internally.
DO IT!
Payroll
In January, gross earnings in Ramirez Company were $40,000. All earnings are subject to 7.65% FICA taxes. Federal income tax withheld was $9,000, and state income tax withheld was $1,000. (a) Calculate net pay for January, and (b) record the payroll.
Action Plan
Determine net pay by subtracting payroll deductions from gross earnings.
Record gross earnings as Salaries and Wages Expense, record payroll deductions as liabilities, and record net pay as Salaries and Wages Payable.
Solution
(a) Net pay: $40,000 − (7.65% × $40,000) − $9,000 − $1,000 = $26,940
(b) Salaries and Wages Expense 40,000
FICA Taxes Payable | 3,060 |
Federal Income Taxes Payable | 9,000 |
State Income Taxes Payable | 1,000 |
Salaries and Wages Payable | 26,940 |
(To record payroll) |
Related exercise material: BE11-7, BE11-8, E11-10, E11-11, E11-12, E11-13, and DO IT! 11-3.
Payroll tax expense for businesses results from three taxes that governmental agencies levy on employers. These taxes are (1) FICA, (2) federal unemployment tax, and (3) state unemployment tax. These taxes plus such items as paid vacations and pensions (discussed in the appendix to this chapter) are collectively referred to as fringe benefits. As indicated earlier, the cost of fringe benefits in many companies is substantial.
Each employee must pay FICA taxes. In addition, employers must match each employee's FICA contribution. This means the employer must remit to the federal government 12.4% of each employee's first $110,100 of taxable earnings, plus 2.9% of each employee's earnings, regardless of amount. The matching contribution results in payroll tax expense to the employer. The employer's tax is subject to the same rate and maximum earnings as the employee's. The company uses the same account, FICA Taxes Payable, to record both the employee's and the employer's FICA contributions. For the January 14 payroll, Academy Company's FICA tax contribution is $1,316.57 ($17,210.00 × 7.65%).
The Federal Unemployment Tax Act (FUTA) is another feature of the federal Social Security program. Federal unemployment taxes provide benefits for a limited period of time to employees who lose their jobs through no fault of their own. The FUTA tax rate is 6.2% of taxable wages. The taxable wage base is the first $7,000 of wages paid to each employee in a calendar year. Employers who pay the state unemployment tax on a timely basis will receive an offset credit of up to 5.4%. Therefore, the net federal tax rate is generally 0.8% (6.2% − 5.4%). This rate would equate to a maximum of $56 of federal tax per employee per year (0.8% × $7,000). State tax rates are based on state law.
Helpful Hint Both the employer and employee pay FICA taxes. Federal unemployment taxes and (in most states) the state unemployment taxes are borne entirely by the employer.
The employer bears the entire federal unemployment tax. There is no deduction or withholding from employees. Companies use the account Federal Unemployment Taxes Payable to recognize this liability. The federal unemployment tax for Academy Company for the January 14 payroll is $137.68 ($17,210.00 × 0.8%).
All states have unemployment compensation programs under state unemployment tax acts (SUTA). Like federal unemployment taxes, state unemployment taxes provide benefits to employees who lose their jobs. These taxes are levied on employers.2 The basic rate is usually 5.4% on the first $7,000 of wages paid to an employee during the year. The state adjusts the basic rate according to the employer's experience rating: Companies with a history of stable employment may pay less than 5.4%. Companies with a history of unstable employment may pay more than the basic rate. Regardless of the rate paid, the company's credit on the federal unemployment tax is still 5.4%.
Companies use the account State Unemployment Taxes Payable for this liability. The state unemployment tax for Academy Company for the January 14 payroll is $929.34 ($17,210.00 × 5.4%). Illustration 11-17 (page 540) summarizes the types of employer payroll taxes.
Companies usually record employer payroll taxes at the same time they record the payroll. The entire amount of gross pay ($17,210.00) shown in the payroll register in Illustration 11-15 is subject to each of the three taxes mentioned above.
Accordingly, Academy records the payroll tax expense associated with the January 14 payroll with the following entry.
Note that Academy uses separate liability accounts instead of a single credit to Payroll Taxes Payable. Why? Because these liabilities are payable to different taxing authorities at different dates. Companies classify the liability accounts in the balance sheet as current liabilities since they will be paid within the next year. They classify Payroll Tax Expense on the income statement as an operating expense.
ACCOUNTING ACROSS THE ORGANIZATION
It Costs $74,000 to Put $44,000 in Sally's Pocket
Sally works for Bogan Communications, a small company in New Jersey that provides audio systems. She makes $59,000 a year but only nets $44,000. What happened to the other $15,000? Well, $2,376 goes for Sally's share of the medical and dental insurance that Bogan provides, $126 for state unemployment insurance, $149 for disability insurance, and $856 for Medicare. New Jersey takes $1,893 in income taxes, and the federal government gets $3,658 for Social Security and another $6,250 for income tax withholding. All of this adds up to some 22% of Sally's gross pay going to Washington or Trenton.
Employing Sally costs Bogan plenty too. Bogan has to write checks for $74,000 so Sally can receive her $59,000 in base pay. Health insurance is the biggest cost: While Sally pays nearly $2,400 for coverage, Bogan pays the rest—$9,561. Then, the federal and state governments take $56 for federal unemployment coverage, $149 for disability insurance, $300 for workers’ comp, and $505 for state unemployment insurance. Finally, the government requires Bogan to pay $856 for Sally's Medicare and $3,658 for her Social Security.
When you add it all up, it costs $74,000 to put $44,000 in Sally's pocket and to give her $12,000 in benefits.
Source: Michael P. Fleischer, “Why I'm Not Hiring,” Wall Street Journal (August 9, 2010), p. A17.
How are the Social Security and Medicare taxes computed for Sally's salary? (See page 563.)
Employer's Payroll Taxes
In January, the payroll supervisor determines that gross earnings for Halo Company are $70,000. All earnings are subject to 7.65% FICA taxes, 5.4% state unemployment taxes, and 0.8% federal unemployment taxes. Halo asks you to record the employer's payroll taxes.
Action Plan
Compute the employer's payroll taxes on the period's gross earnings.
Identify the expense account(s) to be debited.
Identify the liability account(s) to be credited.
Solution
The entry to record the employer's payroll taxes is:
Related exercise material: BE11-9, E11-12, E11-14, and DO IT! 11-4.
Preparation of payroll tax returns is the responsibility of the payroll department. The treasurer's department makes the tax payment. Much of the information for the returns is obtained from employee earnings records.
For purposes of reporting and remitting to the IRS, the company combines the FICA taxes and federal income taxes that it withheld. Companies must report the taxes quarterly, no later than one month following the close of each quarter. The remitting requirements depend on the amount of taxes withheld and the length of the pay period. Companies remit funds through deposits in either a Federal Reserve bank or an authorized commercial bank.
Companies generally file and remit federal unemployment taxes annually on or before January 31 of the subsequent year. Earlier payments are required when the tax exceeds a specified amount. Companies usually must file and pay state unemployment taxes by the end of the month following each quarter. When payroll taxes are paid, companies debit payroll liability accounts, and credit Cash.
ANATOMY OF A FRAUD
Art was a custodial supervisor for a large school district. The district was supposed to employ between 35 and 40 regular custodians, as well as 3 or 4 substitute custodians to fill in when regular custodians were missing. Instead, in addition to the regular custodians, Art “hired” 77 substitutes. In fact, almost none of these people worked for the district. Instead, Art submitted time cards for these people, collected their checks at the district office, and personally distributed the checks to the “employees.” If a substitute's check was for $1,200, that person would cash the check, keep $200, and pay Art $1,000.
Total take: $150,000
The Missing Controls
Human Resource Controls. Thorough background checks should be performed. No employees should begin work until they have been approved by the Board of Education and entered into the payroll system. No employees should be entered into the payroll system until they have been approved by a supervisor. All paychecks should be distributed directly to employees at the official school locations by designated employees.
Independent internal verification. Budgets should be reviewed monthly to identify situations where actual costs significantly exceed budgeted amounts.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 164–171.
Employers also must provide each employee with a Wage and Tax Statement (Form W-2) by January 31 following the end of a calendar year. This statement shows gross earnings, FICA taxes withheld, and income taxes withheld for the year. The required W-2 form for Michael Jordan, using assumed annual data, is shown in Illustration 11-18. The employer must send a copy of each employee's Wage and Tax Statement (Form W-2) to the Social Security Administration. This agency subsequently furnishes the Internal Revenue Service with the income data required.
Chapter 8 introduced internal control. As applied to payrolls, the objectives of internal control are (1) to safeguard company assets against unauthorized payments of payrolls, and (2) to ensure the accuracy and reliability of the accounting records pertaining to payrolls.
Irregularities often result if internal control is lax. Frauds involving payroll include overstating hours, using unauthorized pay rates, adding fictitious employees to the payroll, continuing terminated employees on the payroll, and distributing duplicate payroll checks. Moreover, inaccurate records will result in incorrect paychecks, financial statements, and payroll tax returns.
Payroll activities involve four functions: hiring employees, timekeeping, preparing the payroll, and paying the payroll. For effective internal control, companies should assign these four functions to different departments or individuals. Illustration 11-19 highlights these functions and illustrates their internal control features.
Indiana Jones Company had the following selected transactions.
Feb. | 1 | Signs a $50,000, 6-month, 9%-interest-bearing note payable to CitiBank and receives $50,000 in cash. |
10 | Cash register sales total $43,200, which includes an 8% sales tax. | |
28 | The payroll for the month consists of salaries and wages of $50,000. All wages are subject to 7.65% FICA taxes. A total of $8,900 federal income taxes are withheld. The salaries are paid on March 1. | |
28 | The company develops the following adjustment data. 1. Interest expense of $375 has been incurred on the note. 2. Employer payroll taxes include 7.65% FICA taxes, a 5.4% state unemployment tax, and a 0.8% federal unemployment tax. 3. Some sales were made under warranty. Of the units sold under warranty, 350 are expected to become defective. Repair costs are estimated to be $40 per unit. |
Instructions
(a) Journalize the February transactions.
(b) Journalize the adjusting entries at February 28.
Action Plan
To determine sales revenue, divide the cash register total by 100% plus the sales tax percentage.
Base payroll taxes on gross earnings.
Expense warranty costs in the period in which the sale occurs.
Solution to Comprehensive DO IT!
1 Explain a current liability, and identify the major types of current liabilities. A current liability is a debt that a company expects to pay within one year or the operating cycle, whichever is longer. The major types of current liabilities are notes payable, accounts payable, sales taxes payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest payable.
2 Describe the accounting for notes payable. When a promissory note is interest-bearing, the amount of assets received upon the issuance of the note is generally equal to the face value of the note. Interest expense accrues over the life of the note. At maturity, the amount paid equals the face value of the note plus accrued interest.
3 Explain the accounting for other current liabilities. Companies record sales taxes payable at the time the related sales occur. The company serves as a collection agent for the taxing authority. Sales taxes are not an expense to the company. Companies initially record unearned revenues in an Unearned Revenue account. As a company recognizes revenue, a transfer from unearned revenue to revenue occurs. Companies report the current maturities of long-term debt as a current liability in the balance sheet.
4 Explain the financial statement presentation and analysis of current liabilities. Companies should report the nature and amount of each current liability in the balance sheet or in schedules in the notes accompanying the statements. The liquidity of a company may be analyzed by computing working capital and the current ratio.
5 Describe the accounting and disclosure requirements for contingent liabilities. If the contingency is probable (likely to occur) and the amount is reasonably estimable, the company should record the liability in the accounts. If the contingency is only reasonably possible (it could happen), then it should be disclosed only in the notes to the financial statements. If the possibility that the contingency will happen is remote (unlikely to occur), it need not be recorded or disclosed.
6 Compute and record the payroll for a pay period. The computation of the payroll involves gross earnings, payroll deductions, and net pay. In recording the payroll, companies debit Salaries and Wages Expense for gross earnings, credit individual tax and other liability accounts for payroll deductions, and credit Salaries and Wages Payable for net pay. When the payroll is paid, companies debit Salaries and Wages Payable and credit Cash.
7 Describe and record employer payroll taxes. Employer payroll taxes consist of FICA, federal unemployment taxes, and state unemployment taxes. The taxes are usually accrued at the time the company records the payroll, by debiting Payroll Tax Expense and crediting separate liability accounts for each type of tax.
8 Discuss the objectives of internal control for payroll. The objectives of internal control for payroll are (1) to safeguard company assets against unauthorized payments of payrolls, and (2) to ensure the accuracy of the accounting records pertaining to payrolls.
Bonus Compensation to management and other personnel, based on factors such as increased sales or the amount of net income. (p. 533).
Contingent liability A potential liability that may become an actual liability in the future. (p. 529).
Current ratio A measure of a company's liquidity; computed as current assets divided by current liabilities. (p. 528).
Employee earnings record A cumulative record of each employee's gross earnings, deductions, and net pay during the year. (p. 536).
Federal unemployment taxes Taxes imposed on the employer by the federal government that provide benefits for a limited time period to employees who lose their jobs through no fault of their own. (p. 539).
Fees Payments made for the services of professionals. (p. 532).
FICA taxes Taxes designed to provide workers with supplemental retirement, employment disability, and medical benefits. (p. 533).
Full-disclosure principle Requires that companies disclose all circumstances and events that would make a difference to financial statement users. (p. 531).
Gross earnings Total compensation earned by an employee. (p. 532).
Net pay Gross earnings less payroll deductions. (p. 535).
Notes payable Obligations in the form of written notes. (p. 524).
Payroll deductions Deductions from gross earnings to determine the amount of a paycheck. (p. 533).
Payroll register A payroll record that accumulates the gross earnings, deductions, and net pay by employee for each pay period. (p. 536).
Salaries Employee pay based on a specified amount rather than an hourly rate. (p. 532).
Statement of earnings A document attached to a paycheck that indicates the employee's gross earnings, payroll deductions, and net pay. (p. 537).
State unemployment taxes Taxes imposed on the employer by states that provide benefits to employees who lose their jobs. (p. 539).
Wage and Tax Statement (Form W-2) A form showing gross earnings, FICA taxes withheld, and income taxes withheld, prepared annually by an employer for each employee. (p. 542).
Wages Amounts paid to employees based on a rate per hour or on a piecework basis. (p. 532).
Working capital A measure of a company's liquidity; computed as current assets minus current liabilities.(p. 528).
In addition to the traditional payroll-tax fringe benefits (Social Security taxes, Medicare taxes, and state and federal unemployment taxes), employers incur other substantial fringe benefit costs. Two of the most important are paid absences and postretirement benefits.
Employees often are given rights to receive compensation for absences when they meet certain conditions of employment. The compensation may be for paid vacations, sick pay benefits, and paid holidays. When the payment for such absences is probable and the amount can be reasonably estimated, the company should accrue a liability for paid future absences. When the amount cannot be reasonably estimated, the company should instead disclose the potential liability. Ordinarily, vacation pay is the only paid absence that is accrued. The other types of paid absences are only disclosed.
To illustrate, assume that Academy Company employees are entitled to one day's vacation for each month worked. If 30 employees earn an average of $110 per day in a given month, the accrual for vacation benefits in one month is $3,300. Academy records the liability at the end of the month by the following adjusting entry.
This accrual is required by the expense recognition principle. Academy would report Vacation Benefits Expense as an operating expense in the income statement, and Vacation Benefits Payable as a current liability in the balance sheet.
Later, when Academy pays vacation benefits, it debits Vacation Benefits Payable and credits Cash. For example, if employees take 10 days of vacation in July, the entry is:
The magnitude of unpaid absences has gained employers’ attention. Consider the case of an assistant superintendent of schools who worked for 20 years and rarely took a vacation or sick day. A month or so before she retired, the school district discovered that she was due nearly $30,000 in accrued benefits. Yet the school district had never accrued the liability.
Postretirement benefits are benefits that employers provide to retired employees for (1) pensions and (2) health care and life insurance. Companies account for both types of postretirement benefits on the accrual basis. The cost of postretirement benefits is getting steep. For example, states and localities must deal with a $1 trillion deficit in public employees’ retirement benefit funds. This shortfall amounts to more than $8,800 for every household in the nation.
The average American has debt of approximately $10,000 (not counting the mortgage on their home) and has little in the way of savings. What will happen at retirement for these people? The picture is not pretty—people are living longer, the future of Social Security is unclear, and companies are cutting back on postretirement benefits. This situation may lead to one of the great social and moral dilemmas this country faces in the next 40 years. The more you know about postretirement benefits, the better you will understand the issues involved in this dilemma.
Providing medical and related health-care benefits for retirees was at one time an inexpensive and highly effective way of generating employee goodwill. This practice has now turned into one of corporate America's most worrisome financial problems. Runaway medical costs, early retirement, and increased longevity are sending the liability for retiree health plans through the roof.
Companies estimate and expense postretirement costs during the working years of the employee because the company benefits from the employee's services during this period. However, the company rarely sets up funds to meet the cost of the future benefits. It follows a pay-as-you-go basis for these costs. The major reason is that the company does not receive a tax deduction until it actually pays the medical bill.
A pension plan is an agreement whereby an employer provides benefits (payments) to employees after they retire. The need for good accounting for pension plans becomes apparent when we consider the size of existing pension funds. Over 50 million workers currently participate in pension plans in the United States. Most pension plans are subject to the provisions of ERISA (Employee Retirement Income Security Act), a law enacted to curb abuses in the administration and funding of such plans.
Three parties are generally involved in a pension plan. The employer (company) sponsors the pension plan. The plan administrator receives the contributionsfrom the employer, invests the pension assets, and makes the benefit payments to the pension recipients (retired employees). Illustration 11A-1 indicates the flow of cash among the three parties involved in a pension plan.
An employer-financed pension is part of the employees’ compensation. ERISA establishes the minimum contribution that a company must make each year toward employee pensions. The most popular type of pension plan used is the 401(k) plan. A 401(k) plan works as follows. As an employee, you can contribute up to a certain percentage of your pay into a 401(k) plan, and your employer will match a percentage of your contribution. These contributions are then generally invested in stocks and bonds through mutual funds. These funds will grow without being taxed and can be withdrawn beginning at age 59-1/2. If you must access the funds earlier, you may be able to do so, but a penalty usually occurs along with a payment of tax on the proceeds. Any time you have the opportunity to be involved in a 401(k) plan, you should avail yourself of this benefit!
Companies record pension costs as an expense while the employees are working because that is when the company receives benefits from the employees’ services. Generally, the pension expense is reported as an operating expense in the company's income statement. Frequently, the amount contributed by the company to the pension plan is different from the amount of the pension expense. A liability is recognized when the pension expense to date is more than the company's contributions to date. An asset is recognized when the pension expense to date is less than the company's contributions to date. Further consideration of the accounting for pension plans is left for more advanced courses.
The two most common types of pension arrangements for providing benefits to employees after they retire are defined-contribution plans and defined-benefit plans.
DEFINED-CONTRIBUTION PLAN In a defined-contribution plan, the plan defines the employer's contribution but not the benefit that the employee will receive at retirement. That is, the employer agrees to contribute a certain sum each period based on a formula. A 401(k) plan is typically a defined-contribution plan.
The accounting for a defined-contribution plan is straightforward. The employer simply makes a contribution each year based on the formula established in the plan. As a result, the employer's obligation is easily determined. It follows that the company reports the amount of the contribution required each period as pension expense. The employer reports a liability only if it has not made the contribution in full.
To illustrate, assume that Alba Office Interiors has a defined-contribution plan in which it contributes $200,000 each year to the pension fund for its employees. The entry to record this transaction is:
__________
1Congress sets the tax rate and the tax base for FICA taxes. For example, in 2011 the tax rate on gross earnings subject to Social Security taxes for employees was lowered to 4.2% to provide more spendable income to stimulate the economy.
2In a few states, the employee is also required to make a contribution. In this textbook, including the homework, we will assume that the tax is only on the employer.