Current Liabilities

1. Current Liabilities

Figure 12.1 Summer Eatery. Proper management of short-term obligations can lead to long-term business success.

Willow knew from a young age that she had a future in food. She has just transformed her passion into a thriving business venture as the owner of a small restaurant called Summer Eatery.

To grow her business, Willow has decided to provide both restaurant dining and catering services. When Summer Eatery accepts catering orders, it requires a client deposit equal to 50% of the total order. Since Summer Eatery has not yet provided the catering services at the time of deposit, the deposit amount is recognized as unearned revenue. Once the catering services have been provided, this liability to the client is reclassified as revenue for the restaurant.

The catering service is a success, and Summer Eatery’s income increases twofold. The increase in business has allowed Willow to form a strong relationship with her vendors (suppliers). Because of this relationship, some suppliers will deliver the food and equipment she needs and allow the restaurant to defer payment until a later date. This helps Summer Eatery because it does not yet have enough cash on hand to pay for the food and equipment. Rather than incur more debt, or have to delay ordering, this arrangement allows Willow to grow and still meet her current obligations.

It takes more than an idea to make a business grow, and Willow will continue to experience the ebb and flow of running a restaurant and catering service. Her management of short-term obligations will be one of the keys to Summer Eatery’s future success.

Source: https://openstax.org/books/principles-financial-accounting/pages/12-why-it-matters
This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 License.

1.1. Identify and Describe Current Liabilities

1.2. Analyze, Journalize, and Report Current Liabilities

To illustrate current liability entries, we use transaction information from Sierra Sports (see Figure 12.6). Sierra Sports owns and operates a sporting goods store in the Southwest specializing in sports apparel and equipment. The company engages in regular business activities with suppliers, creditors, customers, and employees.

Figure 12.6 Sierra Sports Logo. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Accounts Payable

On August 1, Sierra Sports purchases $12,000 of soccer equipment from a manufacturer (supplier) on credit. Assume for the following examples that Sierra Sports uses the perpetual inventory method, which uses the Inventory account when the company buys, sells, or adjusts the inventory balance, such as in the following example where they qualified for a discount. In the current transaction, credit terms are 2/10, n/30, the invoice date is August 1, and shipping charges are FOB shipping point (which is included in the purchase cost).

Recall from Merchandising Transactions, that credit terms of 2/10, n/30 signal the payment terms and discount, and FOB shipping point establishes the point of merchandise ownership, the responsibility during transit, and which entity pays shipping charges. Therefore, 2/10, n/30 means Sierra Sports has ten days to pay its balance due to receive a 2% discount, otherwise Sierra Sports has net thirty days, in this case August 31, to pay in full but not receive a discount. FOB shipping point signals that since Sierra Sports takes ownership of the merchandise when it leaves the manufacturer, it takes responsibility for the merchandise in transit and will pay the shipping charges.

Sierra Sports would make the following journal entry on August 1.

The merchandise is purchased from the supplier on credit. In this case, Accounts Payable would increase (a credit) for the full amount due. Inventory, the asset account, would increase (a debit) for the purchase price of the merchandise.

If Sierra Sports pays the full amount owed on August 10, it qualifies for the discount, and the following entry would occur.

Assume that the payment to the manufacturer occurs within the discount period of ten days (2/10, n/30) and is recognized in the entry. Accounts Payable decreases (debit) for the original amount due, Inventory decreases (credit) for the discount amount of $240 ($12,000 × 2%), and Cash decreases (credit) for the remaining balance due after discount.

Note that Inventory is decreased in this entry because the value of the merchandise (soccer equipment) is reduced. When applying the perpetual inventory method, this reduction is required by generally accepted accounting principles (GAAP) (under the cost principle) to reflect the actual cost of the merchandise.

A second possibility is that Sierra will return part of the purchase before the ten-day discount window has expired. Assume in this example that $1,000 of the $12,000 purchase was returned to the seller on August 8 and the remaining account payable due was paid by Sierra to the seller on August 10, which means that Sierra qualified for the remaining eligible discount. The following two journal entries represent the return of inventory and the subsequent payment for the remaining account payable owed. The initial journal entry from August 1 will still apply, because we assume that Sierra intended to keep the full $12,000 of inventory when the purchase was made.

When the $1,000 in inventory was returned on August 8, the accounts payable account and the inventory accounts should be reduced by $1,000 as demonstrated in this journal entry.

After this transaction, Sierra still owed $11,000 and still had $11,000 in inventory from the purchase, assuming that Sierra had not sold any of it yet.

When Sierra paid the remaining balance on August 10, the company qualified for the discount. However, since Sierra only owed a remaining balance of $11,000 and not the original $12,000, the discount received was 2% of $11,000, or $220, as demonstrated in this journal entry. Since Sierra owed $11,000 and received a discount of $220, the supplier was paid $10,780. This second journal entry is the same as the one that would have recognized an original purchase of $11,000 that qualified for a discount.

Remember that since we are assuming that Sierra was using the perpetual inventory method, purchases, payments, and adjustments in goods available for sale are reflected in the company’s Inventory account. In our example, one of the potential adjustments is that discounts received are recorded as reductions to the Inventory account.

To demonstrate this concept, after buying $12,000 in inventory, returning $1,000 in inventory, and then paying for the remaining balance and qualifying for the discount, Sierra’s Inventory balance increased by $10,780, as shown.

If Sierra had bought $11,000 of inventory on August 1 and paid cash and taken the discount, after taking the $220 discount, the increase of Inventory on their balance sheet would have been $10,780, as it finally ended up being in our more complicated set of transactions on three different days. The important factor is that the company qualified for a 2% discount on inventory that had a retail price before discounts of $11,000.

In a final possible scenario, assume that Sierra Sports remitted payment outside of the discount window on August 28, but inside of thirty days. In this case, they did not qualify for the discount, and assuming that they made no returns they paid the full, undiscounted balance of $12,000.

If this occurred, both Accounts Payable and Cash decreased by $12,000. Inventory is not affected in this instance because the full cost of the merchandise was paid; so, the increase in value for the inventory was $12,000, and not the $11,760 value determined in our beginning transactions where they qualified for the discount.

Your Turn

Accounting for Advance Payments

You are the owner of a catering company and require advance payments from clients before providing catering services. You receive an order from the Coopers, who would like you to cater their wedding on June 10. The Coopers pay you $5,500 cash on March 25. Record your journal entries for the initial payment from the Coopers, and when the catering service has been provided on June 10.

Solution

Unearned Revenue

Sierra Sports has contracted with a local youth football league to provide all uniforms for participating teams. The league pays for the uniforms in advance, and Sierra Sports provides the customized uniforms shortly after purchase. The following situation shows the journal entry for the initial purchase with cash. Assume the league pays Sierra Sports for twenty uniforms (cost per uniform is $30, for a total of $600) on April 3.

Sierra Sports would see an increase to Cash (debit) for the payment made from the football league. The revenue from the sale of the uniforms is $600 (20 uniforms × $30 per uniform). Unearned Uniform Revenue accounts reflect the prepayment from the league, which cannot be recognized as earned revenue until the uniforms are provided. Unearned Uniform Revenue is a current liability account that increases (credit) with the increase in outstanding product debt.

Sierra provides the uniforms on May 6 and records the following entry.

Now that Sierra has provided all of the uniforms, the unearned revenue can be recognized as earned. This satisfies the revenue recognition principle. Therefore, Unearned Uniform Revenue would decrease (debit), and Uniform Revenue would increase (credit) for the total amount.

Let’s say that Sierra only provides half the uniforms on May 6 and supplies the rest of the order on June 2. The company may not recognize revenue until a product (or a portion of a product) has been provided. This means only half the revenue can be recognized on May 6 ($300) because only half of the uniforms were provided. The rest of the revenue recognition will have to wait until June 2. Since only half of the uniforms were delivered on May 6, only half of the costs of goods sold would be recognized on May 6. The other half of the costs of goods sold would be recognized on June 2 when the other half of the uniforms were delivered. The following entries show the separate entries for partial revenue recognition.

In another scenario using the same cost information, assume that on April 3, the league contracted for the production of the uniforms on credit with terms 5/10, n/30. They signed a contract for the production of the uniforms, so an account receivable was created for Sierra, as shown.

Sierra and the league have worked out credit terms and a discount agreement. As such, the league can delay cash payment for ten days and receive a discount, or for thirty days with no discount assessed. Instead of cash increasing for Sierra, Accounts Receivable increases (debit) for the amount the football league owes.

The league pays for the uniforms on April 15, and Sierra provides all uniforms on May 6. The following entry shows the payment on credit.

The football league made payment outside of the discount period, since April 15 is more than ten days from the invoice date. Thus, they do not receive the 5% discount. Cash increases (debit) for the $600 paid by the football league, and Accounts Receivable decreases (credit).

In the next example, let’s assume that the league made payment within the discount window, on April 13. The following entry occurs.

In this case, Accounts Receivable decreases (credit) for the original amount owed, Sales Discount increases (debit) for the discount amount of $30 ($600 × 5%), and Cash increases (debit) for the $570 paid by the football league less discount.

When the company provides the uniforms on May 6, Unearned Uniform Revenue decreases (debit) and Uniform Revenue increases (credit) for $600.

Ethical Considerations

Stock Options and Unearned Revenue Manipulation

The anticipated income of public companies is projected by stock market analysts through whisper-earnings, or forecasted earnings. It can be advantageous for a company to have its stock beat the stock market’s expectation of earnings. Likewise, falling below the market’s expectation can be a disadvantage. If a company’s whisper-earnings are not going to be met, there could be pressure on the chief financial officer to misrepresent earnings through manipulation of unearned revenue accounts to better match the stock market’s expectation.

Because many executives, other top management, and even employees have stock options, this can also provide incentive to manipulate earnings. A stock option sets a minimum price for the stock on a certain date. This is the date the option vests, at what is commonly called the strike price. Options are worthless if the stock price on the vesting date is lower than the price at which they were granted. This could result in a loss of income, potentially incentivizing earnings manipulation to meet the stock market’s expectations and exceed the vested stock price in the option.

Researchers have found that when executive options are about to vest, companies are more likely to present financial statements that meet or slightly beat the earnings forecasts of analysts. The proximity of the actual earnings to earnings forecasts suggests they were manipulated because of the vesting. As Douglas R. Carmichael points out, "public companies that fail to report quarterly earnings which meet or exceed analysts’ expectations often experience a drop in their stock prices. This can lead to practices that sometimes include fraudulent overstatement of quarterly revenue". If earnings meet or exceed expectations, a stock price can hit or surpass the vested stock price in the option. For company members with stock options, this could result in higher income. Thus, financial statements that align closely with analysts’ estimates, rather than showing large projections above or below whisper-earnings, could indicate that accounting information has possibly been adjusted to meet the expected numbers. Such manipulations can be made in unearned revenue accounts.

In November 1998, the Securities and Exchange Commission (SEC) issued Practice Alert 98-3, Revenue Recognition Issues, SEC Practice Section Professional Issues Task Force, recognizing and discussing the manipulation of earnings used to exceed stock market and analysts’ expectations. Accountants should watch for revenue recognition related issues in preparing the financial statements of their company or client, especially when employees’ or management’s stock options are about to vest.

Current Portion of a Noncurrent Note Payable

Sierra Sports takes out a bank loan on January 1, 2017 to cover expansion costs for a new store. The note amount is $360,000. The note has terms of repayment that include equal principal payments annually over the next twenty years. The annual interest rate on the loan is 9%. Interest accumulates each month based on the standard interest rate formula discussed previously, and on the current outstanding principal balance of the loan. Sierra records interest accumulation every three months, at the end of each third month. The initial loan (note) entry follows.

Notes Payable increases (credit) for the full loan principal amount. Cash increases (debit) as well. On March 31, the end of the first three months, Sierra records their first interest accumulation.

Interest Expense increases (debit) as does Interest Payable (credit) for the amount of interest accumulated but unpaid at the end of the three-month period. The amount $8,100 is found by using the interest formula, where the outstanding principal balance is $360,000, interest rate of 9%, and the part of the year being three out of twelve months: $360,000 × 9% × (3/12).

The same entry for interest will occur every three months until year-end. When accumulated interest is paid on January 1 of the following year, Sierra would record this entry.

Both Interest Payable and Cash decrease for the total interest amount accumulated during 2017. This is calculated by taking each three-month interest accumulation of $8,100 and multiplying by the four recorded interest entries for the periods. You could also compute this by taking the original principal balance and multiplying by 9%.

On December 31, 2017, the first principal payment is due. The following entry occurs to show payment of this principal amount due in the current period.

Notes Payable decreases (debit), as does Cash (credit), for the amount of the noncurrent note payable due in the current period. This amount is calculated by dividing the original principal amount ($360,000) by twenty years to get an annual current principal payment of $18,000 ($360,000/20).

While the accounts used to record a reduction in Notes Payable are the same as the accounts used for a noncurrent note, the reporting on the balance sheet is classified in a different area. The current portion of the noncurrent note payable ($18,000) is reported under Current Liabilities, and the remaining noncurrent balance of $342,000 ($360,000 – $18,000) is classified and displayed under noncurrent liabilities, as shown in Figure 12.7.

Figure 12.7 Sierra Sports Balance Sheet. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Taxes Payable

Let’s consider our previous example where Sierra Sports purchased $12,000 of soccer equipment in August. Sierra now sells the soccer equipment to a local soccer league for $18,000 cash on August 20. The sales tax rate is 6%. The following revenue entry would occur.

Cash increases (debit) for the sales amount plus sales tax. Sales Tax Payable increases (credit) for the 6% tax rate ($18,000 × 6%). Sierra’s tax liability is owed to the State Tax Board. Sales increases (credit) for the original amount of the sale, not including sales tax. If Sierra’s customer pays on credit, Accounts Receivable would increase (debit) for $19,080 rather than Cash.

When Sierra remits payment to the State Tax Board on October 1, the following entry occurs.

Sales Tax Payable and Cash decrease for the payment amount of $1,080. Sales tax is not an expense to the business because the company is holding it on account for another entity.

Sierra Sports payroll tax journal entries will appear in Record Transactions Incurred in Preparing Payroll.

Your Turn

Accounting for Purchase Discounts

You own a shipping and packaging facility and provide shipping services to customers. You have worked out a contract with a local supplier to provide your business with packing materials on an ongoing basis. Terms of your agreement allow for delayed payment of up to thirty days from the invoice date, with an incentive to pay within ten days to receive a 5% discount on the packing materials. On April 3, you purchase 1,000 boxes (Box Inventory) from this supplier at a cost per box of $1.25. You pay the amount due to the supplier on April 11. Record the journal entries to recognize the initial purchase on April 3, and payment of the amount due on April 11.

Solution

1.3. Define and Apply Accounting Treatment for Contingent Liabilities

What happens if your business anticipates incurring a loss or debt? Do you need to report this if you are uncertain it will occur? What if you know the loss or debt will occur but it has not happened yet? Do you have to report this event now, or in the future? These are questions businesses must ask themselves when exploring contingencies and their effect on liabilities.

A contingency occurs when a current situation has an outcome that is unknown or uncertain and will not be resolved until a future point in time. The outcome could be positive or negative. A contingent liability can produce a future debt or negative obligation for the company. Some examples of contingent liabilities include pending litigation (legal action), warranties, customer insurance claims, and bankruptcy.

While a contingency may be positive or negative, we only focus on outcomes that may produce a liability for the company (negative outcome), since these might lead to adjustments in the financial statements in certain cases. Positive contingencies do not require or allow the same types of adjustments to the company’s financial statements as do negative contingencies, since accounting standards do not permit positive contingencies to be recorded.

Pending litigation involves legal claims against the business that may be resolved at a future point in time. The outcome of the lawsuit has yet to be determined but could have a negative future impact on the business.

Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8). It is unclear if a customer will need to use a warranty, and when, but this is a possibility for each product or service sold that includes a warranty. The same idea applies to insurance claims (car, life, and fire, for example), and bankruptcy. There is an uncertainty that a claim will transpire, or bankruptcy will occur. If the contingencies do occur, it may still be uncertain when they will come to fruition, or the financial implications.

Figure 12.8 One-Year Warranty. Companies may offer product or service warranties. (credit: modification of "Seal Guaranteed" by "harshahars"/Pixabay, CC0)

The answer to whether or not uncertainties must be reported comes from Financial Accounting Standards Board (FASB) pronouncements.

Two Financial Accounting Standards Board (FASB) Requirements for Recognition of a Contingent Liability

There are two requirements for contingent liability recognition:

1. There is a likelihood of occurrence.
2. Measurement of the occurrence is classified as either estimable or inestimable.

Application of Likelihood of Occurrence Requirement

Let’s explore the likelihood of occurrence requirement in more detail.

According to the FASB, if there is a probable liability determination before the preparation of financial statements has occurred, there is a likelihood of occurrence, and the liability must be disclosed and recognized. This financial recognition and disclosure are recognized in the current financial statements. The income statement and balance sheet are typically impacted by contingent liabilities.

For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. The warranty is good for one year. Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have already sold goals with this problem to customers. There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced. Not only does the contingent liability meet the probability requirement, it also meets the measurement requirement.

Application of Measurement Requirement

The measurement requirement refers to the company’s ability to reasonably estimate the amount of loss. Even though a reasonable estimate is the company’s best guess, it should not be a frivolous number. For a financial figure to be reasonably estimated, it could be based on past experience or industry standards (see Figure 12.9). It could also be determined by the potential future, known financial outcome.

Figure 12.9 Contingent Liabilities Estimation Checklist. These are possible ways to determine a contingent liability financial estimate. (credit: modification of "Checklist" by Alan Cleaver/Flickr, CC BY 2.0)

Let’s continue to use Sierra Sports’ soccer goal warranty as our example. If the warranties are honored, the company should know how much each screw costs, labor cost required, time commitment, and any overhead costs incurred. This amount could be a reasonable estimate for the parts repair cost per soccer goal. Since not all warranties may be honored (warranty expired), the company needs to make a reasonable determination for the amount of honored warranties to get a more accurate figure.

Another way to establish the warranty liability could be an estimation of honored warranties as a percentage of sales. In this instance, Sierra could estimate warranty claims at 10% of its soccer goal sales.

When determining if the contingent liability should be recognized, there are four potential treatments to consider.

Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses. To begin, in many ways a warranty expense works similarly to the bad debt expense concept covered in Accounting for Receivables in that the anticipated expense is determined by examining past period expense experiences and then basing the current expense on current sales data. Also, as with bad debts, the warranty repairs typically are made in an accounting period sometimes months or even years after the initial sale of the product, which means that we need to estimate future costs to comply with the revenue recognition and matching principles of generally accepted accounting principles (GAAP).

Some industries have such a large number of transactions and a vast data bank of past warranty claims that they have an easier time estimating potential warranty claims, while other companies have a harder time estimating future claims. In our case, we make assumptions about Sierra Sports and build our discussion on the estimated experiences.

For our purposes, assume that Sierra Sports has a line of soccer goals that sell for $800, and the company anticipates selling 500 goals this year (2019). Past experience for the goals that the company has sold is that 5% of them will need to be repaired under their three-year warranty program, and the cost of the average repair is $200. To simplify our example, we concentrate strictly on the journal entries for the warranty expense recognition and the application of the warranty repair pool. If the company sells 500 goals in 2019 and 5% need to be repaired, then 25 goals will be repaired at an average cost of $200. The average cost of $200 × 25 goals gives an anticipated future repair cost of $5,000 for 2019. Assume for the sake of our example that in 2020 Sierra Sports made repairs that cost $2,800. Following are the necessary journal entries to record the expense in 2019 and the repairs in 2020. The resources used in the warranty repair work could have included several options, such as parts and labor, but to keep it simple we allocated all of the expenses to repair parts inventory. Since the company’s inventory of supply parts (an asset) went down by $2,800, the reduction is reflected with a credit entry to repair parts inventory. First, following is the necessary journal entry to record the expense in 2019.

Next, here is the journal entry to record the repairs in 2020.

Before we finish, we need to address one more issue. Our example only covered the warranty expenses anticipated from the 2019 sales. Since the company has a three-year warranty, and it estimated repair costs of $5,000 for the goals sold in 2019, there is still a balance of $2,200 left from the original $5,000. However, its actual experiences could be more, the same, or less than $2,200. If it is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward. If it is determined that not enough is being accumulated, then the warranty expense allowance can be increased.

Since this warranty expense allocation will probably be carried on for many years, adjustments in the estimated warranty expenses can be made to reflect actual experiences. Also, sales for 2020, 2021, 2022, and all subsequent years will need to reflect the same types of journal entries for their sales. In essence, as long as Sierra Sports sells the goals or other equipment and provides a warranty, it will need to account for the warranty expenses in a manner similar to the one we demonstrated.

Think It Through

Product Recalls: Contingent Liabilities?

Consider the following scenario: A hoverboard is a self-balancing scooter that uses body position and weight transfer to control the device. Hoverboards use a lithium-ion battery pack, which was found to overheat causing an increased risk for the product to catch fire or explode. Several people were badly injured from these fires and explosions. As a result, a recall was issued in mid-2016 on most hoverboard models. Customers were asked to return the product to the original point of sale (the retailer). Retailers were required to accept returns and provide repair when available. In some cases, retailers were held accountable by consumers, and not the manufacturer of the hoverboards. You are the retailer in this situation and must decide if the hoverboard scenario creates any contingent liabilities. If so, what are the contingent liabilities? Do the conditions meet FASB requirements for contingent liability reporting? Which of the four possible treatments are best suited for the potential liabilities identified? Are there any journal entries or note disclosures necessary?

Four Potential Treatments for Contingent Liabilities

If the contingency is probable and estimable, it is likely to occur and can be reasonably estimated. In this case, the liability and associated expense must be journalized and included in the current period’s financial statements (balance sheet and income statement) along with note disclosures explaining the reason for recognition. The note disclosures are a GAAP requirement pertaining to the full disclosure principle, as detailed in Analyzing and Recording Transactions.

If the contingent liability is probable and inestimable, it is likely to occur but cannot be reasonably estimated. In this case, a note disclosure is required in financial statements, but a journal entry and financial recognition should not occur until a reasonable estimate is possible.

If the contingency is reasonably possible, it could occur but is not probable. The amount may or may not be estimable. Since this condition does not meet the requirement of likelihood, it should not be journalized or financially represented within the financial statements. Rather, it is disclosed in the notes only with any available details, financial or otherwise.

If the contingent liability is considered remote, it is unlikely to occur and may or may not be estimable. This does not meet the likelihood requirement, and the possibility of actualization is minimal. In this situation, no journal entry or note disclosure in financial statements is necessary.

Financial Statement Treatments

Table 12.2 Four Treatments of Contingent Liabilities. Proper recognition of the four contingent liability treatments.

Link to Learning

Google, a subsidiary of Alphabet Inc., has expanded from a search engine to a global brand with a variety of product and service offerings. Like many other companies, contingent liabilities are carried on Google’s balance sheet, report expenses related to these contingencies on its income statement, and note disclosures are provided to explain its contingent liability treatments. Check out Google’s contingent liability considerations in this press release for Alphabet Inc.’s First Quarter 2017 Results to see a financial statement package, including note disclosures.

Let’s review some contingent liability treatment examples as they relate to our fictitious company, Sierra Sports.

Probable and Estimable

If Sierra Sports determines the cost of the soccer goal screws are $30, the labor requirement is one hour at a rate of $40 per hour, and there is no extra overhead applied, then the total estimated warranty repair cost would be $70 per goal: $30 + (1 hour × $40 per hour). Sierra Sports sold ten goals before it discovered the rusty screw issue. The company believes that only six of those goals will have their warranties honored, based on past experience. This means Sierra will incur a warranty liability of $420 ($70 × 6 goals). The $420 is considered probable and estimable and is recorded in Warranty Liability and Warranty Expense accounts during the period of discovery (current period).

An example of determining a warranty liability based on a percentage of sales follows. The sales price per soccer goal is $1,200, and Sierra Sports believes 10% of sales will result in honored warranties. The company would record this warranty liability of $120 ($1,200 × 10%) to Warranty Liability and Warranty Expense accounts.

When the warranty is honored, this would reduce the Warranty Liability account and decrease the asset used for repair (Parts: Screws account) or Cash, if applicable. The recognition would happen as soon as the warranty is honored. This first entry shown is to recognize honored warranties for all six goals.

This second entry recognizes an honored warranty for a soccer goal based on 10% of sales from the period.

As you’ve learned, not only are warranty expense and warranty liability journalized, but they are also recognized on the income statement and balance sheet. The following examples show recognition of Warranty Expense on the income statement Figure 12.10 and Warranty Liability on the balance sheet Figure 12.11 for Sierra Sports.

Figure 12.10 Sierra Sports’ Income Statement. Warranty Expense is recognized on the income statement. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Figure 12.11 Sierra Sports’ Balance Sheet. Warranty Liability is recognized on the balance sheet. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Probable and Not Estimable

Assume that Sierra Sports is sued by one of the customers who purchased the faulty soccer goals. A settlement of responsibility in the case has been reached, but the actual damages have not been determined and cannot be reasonably estimated. This is considered probable but inestimable, because the lawsuit is very likely to occur (given a settlement is agreed upon) but the actual damages are unknown. No journal entry or financial adjustment in the financial statements will occur. Instead, Sierra Sports will include a note describing any details available about the lawsuit. When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate.

Sierra Sports could say the following in its financial statement disclosures: "There is pending litigation against our company with the likelihood of settlement probable. Detailed terms and damages have not yet reached agreement, and a reasonable assessment of financial impact is currently unknown".

Reasonably Possible

Sierra Sports may have more litigation in the future surrounding the soccer goals. These lawsuits have not yet been filed or are in the very early stages of the litigation process. Since there is a past precedent for lawsuits of this nature but no establishment of guilt or formal arrangement of damages or timeline, the likelihood of occurrence is reasonably possible. The outcome is not probable but is not remote either. Since the outcome is possible, the contingent liability is disclosed in Sierra Sports’ financial statement notes.

Sierra Sports could say the following in their financial statement disclosures: "We anticipate more claimants filing legal action against our company with the likelihood of settlement reasonably possible. Assignment of guilt, detailed terms, and potential damages have not been established. A reasonable assessment of financial impact is currently unknown".

Remote

Sierra Sports worries that as a result of pending litigation and losses associated with the faulty soccer goals, the company might have to file for bankruptcy. After consulting with a financial advisor, the company is pretty certain it can continue operating in the long term without restructuring. The chances are remote that a bankruptcy would occur. Sierra Sports would not recognize this remote occurrence on the financial statements or provide a note disclosure.

IFRS Connection

Current Liabilities

US GAAP and International Financial Reporting Standards (IFRS) define "current liabilities" similarly and use the same reporting criteria for most all types of current liabilities. However, two primary differences exist between US GAAP and IFRS: the reporting of (1) debt due on demand and (2) contingencies.

Liquidity and solvency are measures of a company’s ability to pay debts as they come due. Liquidity measures evaluate a company’s ability to pay current debts as they come due, while solvency measures evaluate the ability to pay debts long term. One common liquidity measure is the current ratio, and a higher ratio is preferred over a lower one. This ratio—current assets divided by current liabilities—is lowered by an increase in current liabilities (the denominator increases while we assume that the numerator remains the same). When lenders arrange loans with their corporate customers, limits are typically set on how low certain liquidity ratios (such as the current ratio) can go before the bank can demand that the loan be repaid immediately.

In theory, debt that has not been paid and that has become "on demand" would be considered a current liability. However, in determining how to report a loan that has become "on-demand", US GAAP and IFRS differ:

• Under US GAAP, debts on which payment has been demanded because of violations of the contractual agreement between the lender and creditor are only included in current liabilities if, by the financial statement presentation date, there have been no arrangements made to pay off or restructure the debt. This allows companies time between the end of the fiscal year and the actual publication of the financial statements (typically two months) to make arrangements for repayment of the loan. Most often these loans are refinanced.
• Under IFRS, any payment or refinancing arrangements must be made by the fiscal year-end of the debtor. This difference means that companies reporting under IFRS must be proactive in assessing whether their debt agreements will be violated and make appropriate arrangements for refinancing or differing payment options prior to final year-end numbers being reported.

A second set of differences exist regarding reporting contingencies. Where US GAAP uses the term "contingencies", IFRS uses "provisions". In both cases, gain contingencies are not recorded until they are essentially realized. Both systems want to avoid prematurely recording or overstating gains based on the principles of conservatism. Loss contingencies are recorded (accrued) if certain conditions are met:

• Under US GAAP, loss contingencies are accrued if they are probable and can be estimated. Probable means "likely" to occur and is often assessed as an 80% likelihood by practitioners.
• Under IFRS, probable is defined as "more likely than not" and is typically assessed at 50% by practitioners.

The determination of whether a contingency is probable is based on the judgment of auditors and management in both situations. This means a contingent situation such as a lawsuit might be accrued under IFRS but not accrued under US GAAP. Finally, how a loss contingency is measured varies between the two options as well. For example, if a company is told it will be probable that it will lose an active lawsuit, and the legal team gives a range of the dollar value of that loss, under IFRS, the discounted midpoint of that range would be accrued, and the range disclosed. Under US GAAP, the low end of the range would be accrued, and the range disclosed.

1.4. Prepare Journal Entries to Record Short-Term Notes Payable

If you have ever taken out a payday loan, you may have experienced a situation where your living expenses temporarily exceeded your assets. You need enough money to cover your expenses until you get your next paycheck. Once you receive that paycheck, you can repay the lender the amount you borrowed, plus a little extra for the lender’s assistance.

There is an ebb and flow to business that can sometimes produce this same situation, where business expenses temporarily exceed revenues. Even if a company finds itself in this situation, bills still need to be paid. The company may consider a short-term note payable to cover the difference.

A short-term note payable is a debt created and due within a company’s operating period (less than a year). Some key characteristics of this written promise to pay (see Figure 12.12) include an established date for repayment, a specific payable amount, interest terms, and the possibility of debt resale to another party. A short-term note is classified as a current liability because it is wholly honored within a company’s operating period. This payable account would appear on the balance sheet under Current Liabilities.

Figure 12.12 Short-Term Promissory Note. A promissory note includes terms of repayment, such as the date and interest rate. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Debt sale to a third party is a possibility with any loan, which includes a short-term note payable. The terms of the agreement will state this resale possibility, and the new debt owner honors the agreement terms of the original parties. A lender may choose this option to collect cash quickly and reduce the overall outstanding debt.

We now consider two short-term notes payable situations; one is created by a purchase, and the other is created by a loan.

Think It Through

Promissory Notes: Time to Issue More Debt?

A common practice for government entities, particularly schools, is to issue short-term (promissory) notes to cover daily expenditures until revenues are received from tax collection, lottery funds, and other sources. School boards approve the note issuances, with repayments of principal and interest typically met within a few months.

The goal is to fully cover all expenses until revenues are distributed from the state. However, revenues distributed fluctuate due to changes in collection expectations, and schools may not be able to cover their expenditures in the current period. This leads to a dilemma—whether or not to issue more short-term notes to cover the deficit.

Short-term debt may be preferred over long-term debt when the entity does not want to devote resources to pay interest over an extended period of time. In many cases, the interest rate is lower than long-term debt, because the loan is considered less risky with the shorter payback period. This shorter payback period is also beneficial with amortization expenses; short-term debt typically does not amortize, unlike long-term debt.

What would you do if you found your school in this situation? Would you issue more debt? Are there alternatives? What are some positives and negatives to the promissory note practice?

Recording Short-Term Notes Payable Created by a Purchase

A short-term notes payable created by a purchase typically occurs when a payment to a supplier does not occur within the established time frame. The supplier might require a new agreement that converts the overdue accounts payable into a short-term note payable (see Figure 12.13), with interest added. This gives the company more time to make good on outstanding debt and gives the supplier an incentive for delaying payment. Also, the creation of the note payable creates a stronger legal position for the owner of the note, since the note is a negotiable legal instrument that can be more easily enforced in court actions.

Figure 12.13 Accounts Payable Conversion. Accounts Payable may be converted into a short-term notes payable, if there is a default on payment. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

To illustrate, let’s revisit Sierra Sports’ purchase of soccer equipment on August 1. Sierra Sports purchased $12,000 of soccer equipment from a supplier on credit. Credit terms were 2/10, n/30, invoice date August 1. Let’s assume that Sierra Sports was unable to make the payment due within 30 days. On August 31, the supplier renegotiates terms with Sierra and converts the accounts payable into a written note, requiring full payment in two months, beginning September 1. Interest is now included as part of the payment terms at an annual rate of 10%. The conversion entry from an account payable to a Short-Term Note Payable in Sierra’s journal is shown.

Accounts Payable decreases (debit) and Short-Term Notes Payable increases (credit) for the original amount owed of $12,000. When Sierra pays cash for the full amount due, including interest, on October 31, the following entry occurs.

Since Sierra paid the full amount due, Short-Term Notes Payable decreases (debit) for the principal amount of the debt. Interest Expense increases (debit) for two months of interest accumulation. Interest Expense is found from our earlier equation, where Interest = Principal × Annual interest rate × Part of year ($12,000 × 10% × [2/12]), which is $200. Cash decreases (credit) for $12,200, which is the principal plus the interest due.

The other short-term note scenario is created by a loan.

Recording Short-Term Notes Payable Created by a Loan

A short-term notes payable created by a loan transpires when a business incurs debt with a lender Figure 12.14. A business may choose this path when it does not have enough cash on hand to finance a capital expenditure immediately but does not need long-term financing. The business may also require an influx of cash to cover expenses temporarily. There is a written promise to pay the principal balance and interest due on or before a specific date. This payment period is within a company’s operating period (less than a year). Consider a short-term notes payable scenario for Sierra Sports.

Figure 12.14 Bank Loan. A short-term note can be created from a loan. (credit: "Business Paperwork Deal" by "rawpixel"/Pixabay, CC0)

Sierra Sports requires a new apparel printing machine after experiencing an increase in custom uniform orders. Sierra does not have enough cash on hand currently to pay for the machine, but the company does not need long-term financing. Sierra borrows $150,000 from the bank on October 1, with payment due within three months (December 31), at a 12% annual interest rate. The following entry occurs when Sierra initially takes out the loan.

Cash increases (debit) as does Short-Term Notes Payable (credit) for the principal amount of the loan, which is $150,000. When Sierra pays in full on December 31, the following entry occurs.

Short-Term Notes Payable decreases (a debit) for the principal amount of the loan ($150,000). Interest Expense increases (a debit) for $4,500 (calculated as $150,000 principal × 12% annual interest rate × [3/12 months]). Cash decreases (a credit) for the principal amount plus interest due.

Link to Learning

Loan calculators can help businesses determine the amount they are able to borrow from a lender given certain factors, such as loan amount, terms, interest rate, and payback categorization (payback periodically or at the end of the loan, for example). A group of information technology professionals provides one such loan calculator with definitions and additional information and tools to provide more information.

1.5. Record Transactions Incurred in Preparing Payroll

Have you ever looked at your paycheck and wondered where all the money went? Well, it did not disappear; the money was used to contribute required and optional financial payments to various entities.

Payroll can be one of the largest expenses and potential liabilities for a business. Payroll liabilities include employee salaries and wages, and deductions for taxes, benefits, and employer contributions. In this section, we explain these elements of payroll and the required journal entries.

Employee Compensation and Deductions

As an employee working in a business, you receive compensation for your work. This pay could be a monthly salary or hourly wages paid periodically. The amount earned by the employee before any reductions in pay occur is considered gross income (pay). These reductions include involuntary and voluntary deductions. The remaining balance after deductions is considered net income (pay), or "take-home-pay". The take-home-pay is what employees receive and deposit in their bank accounts.

Involuntary Deductions

Involuntary deductions are withholdings that neither the employer nor the employee have control over and are required by law.

Federal, state, and local income taxes are considered involuntary deductions. Income taxes imposed are different for every employee and are based on their W-4 Form, the Employee’s Withholding Allowance Certificate. An employee will fill in his or her marital status, number of allowances requested, and any additional reduction amounts. The employer will use this information to determine the federal income tax withholding amount from each paycheck. State income tax withholding may also use W-4 information or the state’s withholdings certificate. The federal income tax withholding and state income tax withholding amounts can be established with tax tables published annually by the Internal Revenue Service (IRS) (see Figure 12.15) and state government offices, respectively. Some states though do not require an income tax withholding, since they do not impose a state income tax. Federal and state income liabilities are held in payable accounts until disbursement to the governmental bodies that administer the tax compliance process for their particular governmental entity.

Figure 12.15 Wage Bracket Tax Withholding Table: Single Persons (2017). These are the monthly tax withholding amounts recommended by the IRS for wages earned by single persons in 2017. (credit: "Employer’s Tax Guide" by Department of the Treasury Internal Revenue Service, Public Domain)

While not a common occurrence, local income tax withholding is applied to those living or working within a jurisdiction to cover schooling, social services, park maintenance, and law enforcement. If local income taxes are withheld, these remain current liabilities until paid.

Other involuntary deductions involve Federal Insurance Contribution Act (FICA) taxes for Social Security and Medicare. FICA mandates employers to withhold taxes from employee wages "to provide benefits for retirees, the disabled, and children". The Social Security tax rate is 6.2% of employee gross wages. As of 2017, there is a maximum taxable earnings amount of $127,200. Meaning, only the first $127,200 of each employee’s gross wages has the Social Security tax applied. In 2018, the maximum taxable earnings amount increased to $128,400. The Medicare tax rate is 1.45% of employee gross income. There is no taxable earnings cap for Medicare tax. The two taxes combined equal 7.65% (6.2% + 1.45%). Both the employer and the employee pay the two taxes on behalf of the employee.

More recent health-care legislation, the Affordable Care Act (ACA), requires an additional medicare tax withholding from employee pay of 0.9% for individuals who exceed an income threshold based on their filing status (married, single, or head of household, for example). This Additional Medicare Tax withholding is only applied to employee payroll.

Figure 12.16 FICA Social Security and FICA Medicare Taxes. Deductions to payroll include FICA Social Security and FICA Medicare taxes. (credit: modification of work by California Tax Service Center, State of California/CA.gov, Public Domain)

Last, involuntary deductions may also include child support payments, IRS federal tax levies, court-ordered wage garnishments, and bankruptcy judgments. All involuntary deductions are an employer’s liability until they are paid.

Voluntary Deductions

In addition to involuntary deductions, employers may withhold certain voluntary deductions from employee wages. Voluntary deductions are not required to be removed from employee pay unless the employee designates reduction of these amounts. Voluntary deductions may include, but are not limited to, health-care coverage, life insurance, retirement contributions, charitable contributions, pension funds, and union dues. Employees can cover the full cost of these benefits or they may cost-share with the employer.

Health-care coverage is a requirement for many businesses to provide as a result of the ACA. Employers may provide partial benefit coverage and request the employee to pay the remainder. For example, the employer would cover 30% of health-care cost, and 70% would be the employee’s responsibility.

Retirement contributions may include those made to an employer-sponsored plan, such as a defined contribution plan, which "shelters" the income in a 401(k) or a 403(b). In simple terms, a defined contribution plan allows an employee to voluntarily contribute a specified amount or percentage of his or her pretax wages to a special account in order to defer the tax on those earnings. Usually, a portion of the employee’s contribution is matched by his or her employer; employers often use this as an incentive to attract and keep highly skilled and valuable employees. Only when the employee eventually withdraws funds from the plan will he or she be required to pay the tax on those earnings. Because the amount contributed to the plan is not immediately taxed by the IRS, it enables the employee to accumulate funds for his or her retirement. This deferred income may be excluded from the employee’s current federal taxable income but not FICA taxes. All voluntary deductions are considered employer liabilities until remitted. For more in-depth information on retirement planning, and using a 401(k) or a 403(b), refer to Appendix C.

Figure 12.17 Retirement Savings. Defined contribution plans can help you save for retirement. (credit: modification of "Money Coin Investment" by "nattanan23"/Pixabay, CC0)

As with involuntary deductions, voluntary deductions are held as a current liability until paid. When payroll is disbursed, journal entries are required.

Concepts In Practice

Should You Start Saving for Retirement?

Should you save for retirement now or wait? As a student, you may be inclined to put off saving for retirement for many reasons. You may not be in a financial position to do so, you believe Social Security will be enough to cover your needs, or you may not have even thought about it up to this point.

According to a 2012 survey from the Bureau of Labor Statistics, of those who had access to a defined contribution plan, only 68% of employees contributed to their retirement plan. Many employees wait until their mid-thirties or forties to begin saving, and this can delay retirement, or may leave the retiree unable to cover his or her annual expenses. Some pitfalls contributing to this lack of saving are short-term negative spending practices such as high-interest loan debt, credit card purchases, and discretionary spending (optional expenses such as eating out or entertainment). To avoid these hazards, you should

1. Analyze your spending habits and make changes where possible.
2. Develop a financial plan with the help of a finance specialist.
3. Join a defined contribution plan and stick with the plan (do not withdraw funds early).
4. Try to contribute at least as much as your employer is willing to match.
5. Consider other short-term savings options like bonds, or high-interest bank accounts.
6. Have a specific savings goal for your retirement account. For example, many financial advisors recommend saving at least 15% of your monthly income for retirement. However, they usually include both the employee’s contribution and the employer’s. For example, assume that the company matches each dollar invested by the employee with a $0.50 contribution from the employer, up to 8% for the employee. In this case, if the employee contributes 8% and the company provides 4%, that takes the employee to 80% of the recommended goal (12% of the recommended 15%).

Remember, the longer you wait to begin investing, the more you will have to save later on to have enough for retirement.

Journal Entries to Report Employee Compensation and Deductions

We continue to use Sierra Sports as our example company to prepare journal entries.

Sierra Sports employs several people, but our focus is on one specific employee for this example. Billie Sanders works for Sierra Sports and earns a salary each month of $2,000. She claims two withholdings allowances (see Figure 12.15). This amount is paid on the first of the following month. Withholdings for federal and state income taxes are assessed in the amount of $102 and $25, respectively. FICA Social Security is taxed at the 6.2% rate, and FICA Medicare is taxed at the 1.45% rate. Billie has voluntary deductions for health insurance and a 401(k) retirement contribution. She is responsible for 40% of her $500 health-care insurance premium; Sierra Sports pays the remaining 60% (as explained in employer payroll). The 401(k) contributions total $150. The first entry records the salaries liability during the month of August.

Salaries Expense is an equity account used to recognize the accumulated (accrued) expense to the business during August (increase on the debit side). Salaries Expense represents the employee’s gross income (pay) before any deductions. Each deduction liability is listed in its own account; this will help for ease of payment to the different entities. Note that Health Insurance Payable is in the amount of $200, which is 40% of the employee’s responsibility for the premium ($500 × 0.40 = $200). Salaries Payable represents net income (pay) or the "take-home pay" for Billie. Salaries Payable is $1,370, which is found by taking gross income and subtracting the sum of the liabilities ($2,000 – $630 = $1,370). Since salaries are not paid until the first of the following month, this liability will remain during the month of August. All liabilities (payables) increase due to the company’s outstanding debt (increase on the credit side).

The second entry records cash payment of accumulated salaries on September 1.

Payment to Billie Sanders occurs on September 1. The payment is for salaries accumulated from the month of August. The payment decreases Salaries Payable (debit side) since the liability was paid and decreases Cash (credit side), because cash is the asset used for payment.

Link to Learning

The IRS has developed a simulation database with twenty different taxpayer simulations to help taxpayers understand their tax returns and withholdings.

Employer Compensation and Deductions

At this point you might be asking yourself, "why am I having to pay all of this money and my employer isn’t?" Your employer also has a fiscal and legal responsibility to contribute and match funds to certain payroll liability accounts.

Involuntary Payroll Taxes

Employers must match employee contributions to FICA Social Security (6.2% rate) on the first $127,200 of employee wages for 2017, and FICA Medicare (1.45% rate) on all employee earnings. Withholdings for these taxes are forwarded to the same place as employee contributions; thus, the same accounts are used when recording journal entries.

Employers are required by law to pay into an unemployment insurance system that covers employees in case of job disruption due to factors outside of their control (job elimination from company bankruptcy, for example). The tax recognizing this required payment is the Federal Unemployment Tax Act (FUTA). FUTA is at a rate of 6%. This tax applies to the initial $7,000 of each employee’s wages earned during the year. This rate may be reduced by as much as 5.4% as a credit for paying into state unemployment on time, producing a lower rate of 0.6%. The State Unemployment Tax Act (SUTA) is similar to the FUTA process, but tax rates and minimum taxable earnings vary by state.

Figure 12.18 Unemployment Support. Two common employer payroll deductions are federal and state unemployment taxes. (credit: "Laptop" by Unknown/pxhere, CC0)

Voluntary Benefits Provided by the Employer

Employers offer competitive advantages (benefits) to employees in an effort to improve job satisfaction and increase employee morale. There is no statute mandating the employer cover these benefits financially. Some possible benefits are health-care coverage, life insurance, contributions to retirement plans, paid sick leave, paid maternity/paternity leave, and vacation compensation.

Paid sick leave, paid maternity/paternity leave, and vacation compensation help employees take time off when needed or required by providing a stipend while the employee is away. This compensation is often comparable to the wages or salary for the covered period. Some companies have policies that require vacation and paid sick leave to be used within the year or the employee risks losing that benefit in the current period. These benefits are considered estimated liabilities since it is not clear when, if, or how much the employee will use them. Let’s now see the process for journalizing employer compensation and deductions.

Figure 12.19 Employer-Provided Benefit. Providing employees with vacation benefits can increase job satisfaction. (credit: "Ellie relaxes by the palm tree" Darren Foreman/Flickr, CC BY 2.0)

Journal Entries to Report Employer Compensation and Deductions

In addition to the employee payroll entries for Billie Sanders, Sierra Sports has an obligation to contribute taxes to federal unemployment, state unemployment, FICA Social Security, and FICA Medicare. They are also responsible for 60% of Billie’s health insurance premium payment. Assume Sierra Sports receives the FUTA credit and is only taxed at the rate of 0.6%, and SUTA taxes are $100. August is Billie Sanders’ first month of pay for the year. The following entry represents the employer payroll liabilities and expense for the month of August. The second entry records the health insurance premium liability.

Employer Payroll Tax Expense is the equity account used to recognize payroll expenses during the period (increases on the debit side). The amount of $265 is the sum of all liabilities from that period. Notice that FICA Social Security Tax Payable and FICA Medicare Tax Payable were used in the employee payroll entry earlier and again here in the employer payroll. You only need to use one account if the payments are for the same recipient and purpose. The amounts of Social Security ($124) and Medicare ($29) taxes withheld match the amounts withheld from employee payroll. Federal Unemployment Tax Payable and State Unemployment Tax Payable recognize the liabilities for federal and state unemployment deductions, respectively. The federal unemployment tax ($12) is computed by multiplying the federal unemployment tax rate of 0.6% by $2,000. These liability accounts increase (credit side) when the amount owed increases.

The second entry recognizes the liability created from providing the voluntary benefit, health insurance coverage. Voluntary and involuntary employer payroll items should be separated. It is also important to separate estimated liabilities from certain voluntary benefits due to their uncertainty. Benefits Expense recognizes the health insurance expense from August. Health Insurance Payable recognizes the outstanding liability for health-care coverage covered by the employer ($500 × 60% = $300).

The following entries represent payment of the employer payroll and benefit liabilities in the following period.

When payment occurs, all payable accounts decrease (debit) because the company paid all taxes and benefits owed for those liabilities. Cash is the accepted form of payment at the payee organizations (Social Security Administration, and health plan administrator, for example).

Link to Learning

The IRS oversees all tax-related activities on behalf of the US Department of the Treasury. In an effort to assist taxpayers with determining amounts they may owe, the IRS has established a withholdings calculator that can let an employee know if he or she needs to submit a new W-4 form to the employer based on the results.

1.6. Key Terms

account payable

account for financial obligations to suppliers after purchasing products or services on credit

Additional Medicare Tax

requirement for employers to withhold 0.9% from employee pay for individuals who exceed an income threshold based on their filing status

contingency

current situation, where the outcome is unknown or uncertain and will not be resolved until a future point in time

contingent liability

uncertain outcome to a current condition that could produce a future debt or negative obligation for the company

current liability

debt or obligation due within one year or, in rare cases, a company’s standard operating cycle, whichever is greater

current portion of a note payable

portion of a long-term note due during the company’s current operating period

defined contribution plans

money set aside and held in account for employee’s retirement with possible contribution from employers

federal income tax withholding

amount withheld from employee pay based on employee responses given on Form W-4

Federal Insurance Contribution Act (FICA) tax

involuntary tax mandated by FICA that requires employers to withhold taxes from employee wages "to provide benefits for retirees, the disabled, and children"

Federal Unemployment Tax Act (FUTA)

response to a law requiring employers to pay into a federal unemployment insurance system that covers employees in case of job disruption due to factors outside of their control

gross income (pay)

amount earned by the employee before any reductions in pay occur due to involuntary and voluntary deductions

interest

monetary incentive to the lender, which justifies loan risk; interest is paid to the lender by the borrower

involuntary deduction

withholding that neither the employer nor the employee have control over, and is required by law

likelihood of occurrence

contingent liability must be recognized and disclosed if there is a probable liability determination before the preparation of financial statements has occurred

local income tax withholding

applied to those living or working within a jurisdiction to cover schooling, social services, park maintenance, and law enforcement

measurement requirement

company’s ability to reasonably estimate the amount of loss

Medicare tax rate

currently 1.45% of employee gross income with no taxable earnings cap

net income (pay)

(also, take home pay) remaining employee earnings balance after involuntary and voluntary deductions from employee pay

note payable

legal document between a borrower and a lender specifying terms of a financial arrangement; in most situations, the debt is long-term

principal

initial borrowed amount of a loan, not including interest; also, face value or maturity value of a bond (the amount to be paid at maturity)

probable and estimable

contingent liability is likely to occur and can be reasonably estimated

probable and inestimable

contingent liability is likely to occur but cannot be reasonably estimated

reasonably possible

contingent liability could occur but is not probable

remote

contingent liability is unlikely to occur

short-term note payable

debt created and due within a company’s operating period (less than a year)

Social Security tax rate

currently 6.2% of employees gross wage earnings with a maximum taxable earnings amount of $127,200 in 2017 and $128,400 in 2018

state income tax withholding

reduction to employee pay determined by responses given on Form W-4, or on a state withholdings certificate

State Unemployment Tax Act (SUTA)

response to a law requiring employers to pay into a state unemployment insurance system that covers employees in case of job disruption due to factors outside of their control

taxes payable

liability created when a company collects taxes on behalf of employees and customers

unearned revenue

advance payment for a product or service that has yet to be provided by the company; the transaction is a liability until the product or service is provided

vacation compensation

stipend provided by the employer to employees when they take time off for vacation

voluntary deduction

not required to be removed from employee pay unless the employee designates reduction of this amount 

1.7. Summary

12.1 Identify and Describe Current Liabilities

• Current liabilities are debts or obligations that arise from past business activities and are due for payment within a company’s operating period (one year). Common examples of current liabilities include accounts payable, unearned revenue, the current portion of a noncurrent note payable, and taxes payable.
• Accounts payable is used to record purchases from suppliers on credit. Accounts payable typically does not include interest payments.
• Unearned revenue is recorded when customers pay in advance for products or services before receiving their benefits. The company maintains the liability until services or products are rendered.
• Notes payable is a debt to a lender with specific repayment terms, which can include principal and interest. Interest accrued can be computed with the annual interest rate, principal loan amount, and portion of the year accrued.
• Employers withhold taxes from employees and customers for payment to government agencies at a later date, but within the business operating period. Common taxes are sales tax and federal, state, and local income taxes.

12.2 Analyze, Journalize, and Report Current Liabilities

• When the merchandiser initially pays the supplier on credit, it increases both Accounts Payable (a credit) and the appropriate merchandise Inventory account (a debit). When the amount due is later paid, it decreases both Accounts Payable (a debit) and Cash (a credit).
• When the company collects payment from a customer in advance of providing a product or service, it increases both Unearned Revenue (a credit) and Cash (a debit). When the company provides the product or service, Unearned Revenue decreases (a debit), and Revenue increases (a credit) to realize the amount earned.
• To recognize payment of the current portion of a noncurrent note payable, both Notes Payable and Cash would decrease, resulting in a debit and a credit, respectively. To recognize interest accumulation, both Interest Expense and Interest Payable would increase, resulting in a debit and a credit, respectively.
• To recognize sales tax in the initial sale to a customer, Cash or Accounts Receivable increases (a debit), and Sales Tax Payable increases (a credit), as does Sales (a credit). When the company remits the sales tax payment to the governing body, Sales Tax Payable decreases (a debit), as does Cash (a credit).

12.3 Define and Apply Accounting Treatment for Contingent Liabilities

• Contingent liabilities arise from a current situation with an uncertain outcome that may occur in the future. Contingent liabilities may include litigation, warranties, insurance claims, and bankruptcy.
• Two FASB recognition requirements must be met before declaring a contingent liability. There must be a probable likelihood of occurrence, and the loss amount is reasonably estimated.
• The four contingent liability treatments are probable and estimable, probable and inestimable, reasonably possible, and remote.
• Recognition in financial statements, as well as a note disclosure, occurs when the outcome is probable and estimable. Probable and not estimable and reasonably possible outcomes require note disclosures only. There is no recognition or note disclosure for a remote outcome.

12.4 Prepare Journal Entries to Record Short-Term Notes Payable

• Short-term notes payable is a debt created and due within a company’s operating period (less than a year). This debt includes a written promise to pay principal and interest.
• If a company does not pay for its purchases within a specified time frame, a supplier will convert the accounts payable into a short-term note payable with interest. When the company pays the amount owed, short-term notes payable and Cash will decrease, while interest expense increases.
• A company may borrow from a bank because it does not have enough cash on hand to pay for a capital expenditure or cover temporary expenses. The loan will consist of short-term repayment with interest, affecting short-term notes payable, cash, and interest expense.

12.5 Record Transactions Incurred in Preparing Payroll

• An employee’s net income (pay) results from gross income (pay) minus any involuntary and voluntary deductions. Employee payroll deductions may include federal, state, and local income taxes; FICA Social Security; FICA Medicare; and voluntary deductions such as health insurance, retirement plan contributions, and union dues.
• When recording employee payroll liabilities, Salaries Expense, Salaries Payable, and all payables for income taxes, Social Security, Medicare, and voluntary deductions, are reported. When the company pays the accrued salaries, Salaries Payable is reduced, as is cash.
• Employers are required to match employee withholdings for Social Security and Medicare. They must also remit FUTA and SUTA taxes, as well as voluntary deductions and benefits provided to employees.
• When recording employer payroll liabilities, Employer Payroll Taxes Expense and all payables associated with FUTA, SUTA, Social Security, Medicare, and voluntary deductions are required. When the company pays all employer liabilities, each payable and cash account decreases.