10A-1 Current Liabilities liabilities economic claims against the assets of a company, a firm?s future economic obligations current liabilities liabilities that a firm must satisfy within one year/one operating cycle Types of Current Liabilities Accounts Payable Short-Term Notes Payable Short-Term Interest Payable Salaries and Wages Payable Taxes Payable Prepayments (Unearned Revenue) and Deposits Current portions (or maturities) of long-term debt Accounts Payable very short-term obligations that arise from the day-to-day business of the firm, a.k.a. trade accounts payable Short-Term Notes Payable formal arrangements acknowledging a liability. Short-term notes are those which are due within one year/one operating cycle. Short-Term Interest Payable interest payable is an accrued expense that reflects interest on notes owed as of the end of an accounting period. Short-term interest payable is the amount that is to be paid within one year/one operating cycle. Salaries and Wages Payable the amount owed to employees for work that they have completed but for which they have not yet been paid Taxes Payable taxes which have been incurred but have not yet been paid. Also includes sales taxes which are collected for the government at the time the sale was made, but have not yet been sent to the government. Prepayments (Unearned Revenue) and Deposits prepayments occur when customers pay for services which will be delivered over a period of time. The service provider incurs an obligation to deliver the service in the future, and as this service is provided, the obligation is reduced and service revenue is increased. (Ex: apartment rent, magazine subscriptions, insurance fees). Deposits are the same in that the seller incurs a liability to either return the deposit or deliver the service. Current portions (or maturities) of long-term debt the part of a debt that is due within one year/one operating cycle. Serious considerations for investors and creditors because they must be paid using current assets. Two circumstances in which the current portion of long-term debt does not need to be classified as current: the current portion of the debt will be paid by either using noncurrent assets or by issuing stock the current amounts are expected to be refinanced on a long-term basis (the debt will be renegotiated) Discounted Short-Term Notes banks often loan the principle amount and all the interest to a customer up front then the bank subtracts the interest payment from the cash they actually give to a customer by doing this, the customer has actually paid the interest in advance banks benefit from this because the customer actually ends up paying more than the quoted interest rate Example: On November 1, a bank lends $100,000 to a customer at a stated annual interest rate of 12% for 6 months. Interest = Principal x Annual Interest Rate x Time (in years) Interest = $100,000 x 12% x 6/12 Interest = $6,000 Interest is calculated by the bank to be $6,000, so the bank takes the interest immediately and gives the customer $94,000. In 6 months, when the customer pays off the loan, the amount required will be $100,000. However, the customer only actually collected $94,000 from the bank, so they were really charged $6000 interest on a $94,000 loan. $6000 = $94,000 x Annual Interest Rate x 6/12 Annual Interest Rate = 12.77% The real interest rate was actually 12.77%, not the 12% quoted by the bank. The true amount the customer is paying in interest is called the effective interest rate. The customer doesn?t realize that they are being charged a higher interest rate because they view the $6,000 interest the bank prepaid as a discount on a note payable. This discount accounts for the fact that they only received $94,000 from the bank yet they owed $100,000. The customer records the transaction as: Discount on Note Payable is a contra account to Note Payable. The book value of the loan is determined by subtracting the discount account from the note payable account. On December 31, when the customer closes its books, an adjusting entry needs to be made. Two months of the six month loan have passed, so 2/6 or $2,000 of the interest is now owed to the bank. The Discount on Note Payable account is credited to acknowledge the fact that $2,000 of this discount has been used. Also, the Interest Expense account is debited to acknowledge the fact that over the two month period a $2,000 interest expense was incurred. Several Different Types of Employee Compensation Commissions bonus and incentive payments given to sales personnel Wages earnings of employees with a compensation stated in hourly terms Salary earnings of employees stated in monthly or yearly amounts Overtime Pay the higher hourly wages paid to employees for working more than 40 hours per week Fringe Benefits other types of compensation given to employees, such as sick leave and vacation pay Employer Payments 3 Different Classifications of Employer Payments those paid from the employees earnings those paid by the employer to governmental agencies which are required by law and are designed to benefit the employee fringe benefits paid by the employer for goods and services which will be provided to the employee Payments From the Employee?s Earnings state and federal income tax withholdings and social security taxes income taxes represent a legally required estimate of how much income tax an employee will have to pay from present earnings social security taxes are required by the Federal Insurance Contributions Act (FICA) for the purposes of retirement, disability, and medical benefits Example: Nataliya earns a total of $4,000 a month while working for YOUTH Inc. Every month a total of $550 is withheld for federal taxes and $110 for state taxes. FICA requires a 7.65% reduction from earnings, so every month $306 is withheld. Nataliya has also asked her employer to withhold $50 from her paycheck every month and send it to United Way. Nataliya also asked her employer to withhold $30 every month for life insurance. At the end of the month, YOUTH Inc. makes the following journal entry to record the salary expense incurred for Nataliya. Salary Expense 4,000 Federal Tax Payable 550 State Tax Payable 110 FICA Tax Payable 306 Payable to United Way 50 Insurance Premium Payable 30 Salary Payable to Nataliya 2,954 Nataliya?s salary and payables. Required Payments by the Employer payments charged directly to the employer which benefit the employee are called payroll taxes the first payroll tax is the employer?s share of FICA insurance, the employer must pay the same amount to the federal government that the employee does the second payroll tax is required by the Federal Unemployment Tax Act (FUTA). It is used to make predetermined payments to people previously employed but presently out of work Example: YOUTH Inc. must pay $306 to FICA to match the $306 Nataliya paid The FUTA tax rate is 5.4% of employee gross earnings to the state and 0.8% to the federal government. At the end of the month, YOUTH Inc. makes the following journal entries to record these obligations. Payroll tax expense 554 FICA tax payable 306 Federal unemployment tax payable 32 State unemployment tax payable 216 FICA, FUTA, and state unemployment paid for Nataliya. Fringe Benefits benefits paid for by the employer that provide a direct benefit to the employee Example: YOUTH Inc. pays Nataliya?s entire $100 health insurance bill and they put $250 into her retirement fund each month. At the end of the month they record the following journal entry. Employee fringe benefit expense 350 Health Insurance payable 100 Pension Plan payable 250 Fringe benefits for Nataliya. Estimated Liabilities a liability that the company incurs, but they are not yet sure of the size or magnitude Ex: warranties, guarantees, frequent flyer miles In order to record these liabilities, companies use a historical percentage that averages the amount from past years Example: LOCAL grocery store sells 500 pumpkins for $1 each during Halloween With each sale, LOCAL promised a money-back guarantee In terms of the matching concept, the obligation to take back the pumpkins creates a liability at the time of the sale, however LOCAL is not yet sure exactly how big this liability is From past years, they believe approximately 2% of all sales will be returned 2% x $500 = $10 From a historical standpoint, approximately 10 pumpkins will be returned On October 31, LOCAL prepares their financial statements are records the liability from the guarantee as follows. On November 3, a customer returns 2 pumpkins and LOCAL refunds the purchase price. The entry would be as follows. Accounting for guarantees this way, no expense was charged this period. The expense was incurred in the last period, by estimation means, when the revenue was earned. Contingent Liabilities Result from a past transaction or promise which will only occur in the future if some other event takes place Ex: with lawsuits (if the company will lose the case, they will incur the liability) If there is a likelihood that the company will lose, this information must be divulged on the financial statement 3 Levels of requirements for such disclosure: the firm believes that having to pay anything is remote, and the lawsuit does not need to be divulged the firm thinks it is reasonably possible they will have to pay something, and a footnote to the financial statement must be added explaining the lawsuit, however nothing is recorded the firm thinks it is likely or probable that they will have to pay something to this person, and whatever they believe they will have to pay must be recorded Example: BUTTERFINGERS Inc. performs hair transplants A balding, unhappy customer files a $10,000,000 lawsuit against them BUTTERFINGERS believes there is a pretty good chance they will lose the lawsuit and have to pay $1,000,000 to the customer Contingent liabilities are the only exception to the conservatism concept. If BUTTERFINGERS believes it will have to pay anywhere between 1 and 5 million, they record the lower amount of the numbers. The higher amount is then put in a footnote on the financial statement. When contingent liabilities are ultimately paid, they are treated just like estimated liabilities. Cash 94,000 Note Payable 100,000 Discount on Note Payable 6,000 Cash 94,000 Note Payable 100,000 Discount on Note Payable 6,000 2,000 bal 4,000 Interest Expense 2,000 Cash Estimated Guarantee Payable 10 (10/31) Guarantee Expense (10/31) 10 Cash 2 (11/3) Estimated Guarantee Payable 10 (10/31) (11/3) 2 8 bal Lawsuit Expense 1,000,000 Contingent Legal Liability 1,000,000
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