April 20, 2015

Liabilities and Interest - Review Notes

Review Notes

Current Liabilities

A current liability is one which is expected to be paid out of current assets within one year or the operating cycle of the business, whichever is longer.

Accounts Payable

Notes Payable

Sales Taxes Payable

Unearned Revenues

Current Maturities of Long Term Debt

Contingent Liabilities

Payroll Liabilities

Additional Fringe Benefits

Notes Payable

The accounting procedure for Notes Payable:  Johnson Company borrows $100,000 on March 1 for four months at 12% interest. The interest amount for the four month period would be $100,000 * .12 * 4/12 = $4000.

A debit to Cash account and credit to Notes Payable account is to be recorded when cash come into the company on 1 March.

If the company closes its books monthly, an adjustment entry needs to be made at the end of each month for interest accrued. For example, at the end of March, one month has elapsed, and $1,000 of interest expense ($100,000 * .12 * 1/12) is accrued:

After four months, the Interest Payable would amount to $4,000, and the entry to record payment of interest and principal amount would require a debit to Interest Payable for $4,000, a debit to Notes Payable for $100,000, and a credit to Cash for $104,000..

Sales Taxes Payable

Many states levy a sales tax on certain items.  The  retailer is in a position to collect the tax at the moment of sale.  After collection, the tax becomes a liability for the retailer. Therefore, the retailer is not incurring a sales tax expense; rather, the retailer is acting only as a collection agent.  Periodically, the retailer is required, by state law, to remit the taxes collected to the state.

If sales taxes are not accounted for separately, the retailer may have to determine the amount of sales tax rung up.  For example, if $1,000 was taken in, how much of the $1,000 is sales tax, if the sales tax rate is 6%? The approach is to use algebra and calculate the amount. Let S = sales for the day. S + .06S = 1000; or, 1.06S = 1000; S = 943.40. The sales tax liability = 943.40 * .06 = 56.60.

Unearned Revenues

An Unearned Revenue occurs when someone pays us for services that we will provide in the future. If cash comes in before we perform the service, debit Cash and credit Unearned Revenue. Unearned Revenue is a current liability and is reported on the balance sheet.

When we perform the service for which the advance payment was made, we debit Unearned Revenue and credit Fees Earned. Some typical examples where Unearned Revenues occur include: purchase of season tickets for entertainment programs spread over a month, and payment of a lawyer's retainer for the full period of the case. In both cases, the party who will provide the product receives cash before earning the revenue.

Current Portion of Long Term Debt

If a company has purchased real estate, such as a building, the debt incurred for the asset’s purchase will be in the form of a mortgage payable. Although,  a mortgage as a long term liability, payments are made each month from the start of the mortgage. The debt to be paid off within one year is considered a current liability, and is reported separately from the remainder of the mortgage.

Example: A company purchased an office for $100,000 and signed a mortgage payable for that amount. In addition to the interest, the principal of the note will be reduced by $6,000. The $6,000 would be reported as a current liability; the remainder of the debt ($94,000) would be reported as Mortgage Payable in the Long Term Liabilities section of the balance sheet.

Contingent Liabilities

As the name implies, a Contingent Liability is one which may or may not result in an obligation to pay. Contingent liabilities result from lawsuits, misunderstandings or differences of opinion with the Internal Revenue Service, or other claims. The question is: should a liability be recorded on the books? According to GAAP, a liability should be recorded if the contingent event is probable and can be reasonably estimated.

If the contingent liability is only reasonably possible, disclosure of the item should be made in the notes to the financial statements.

If the contingent liability is only remotely possible, it need not be recorded or disclosed.

This discussion of contingent liabilities is important because warranties are so prevalent with merchanisers.  Warranty expenses are recorded as current liabilities even if customers have not returned the faulty merchandise as yet.  In fact, the incurrence of the warranty liability occurs at the moment of sale. The only requirement is that the warranty costs must be probable and estimable. Like depreciation, warranty costs are estimated, and the estimate can be altered over time.

Warranty Expenses

One example of a type of contingent liability that is usually recorded as an actual liability is that of Warranty Expenses arising from sale of a product. If the requirements shown above are met, (that warranty costs are probable for the product and can be estimated), then a liability is recorded. The journal entry would be a debit to Warranty Expense, and a credit to Estimated Warranty Liability. If a customer brings back a defective product and insists on a refund, a debit is made to Estimated Warranty Liability, and a credit is made to Cash.

Payroll Liabilities

Employee Payroll Entry

Similar to Sales Taxes, a business may act as an agent of a governmental unit by deducting amounts from the earnings of employees and depositing these amounts with the proper authorities. The deductions include FICA taxes, Federal Income tax, and various voluntary deductions. Here is a general model you might use for the employees' payroll entries:

Date Salaries Expense xxxxx
     FICA Taxes Payable xxxxx
     Federal Income Tax Payable xxxxx
     State Income Tax Payable xxxxx
     Salaries Payable xxxxx
The cumulative earnings of employees represent an expense of the business, in this case, Salaries Expense or Wages Expense. Not all of that amount, however, is paid out to employees. Various deductions are made, resulting in liabilities (FICA Taxes Payable, Federal Income Tax Payable, etc.). The balance becomes Salaries and Wages Payable, which will be paid out as checks to employees. Keep in mind that there are many opportunities for error in recording payroll; it is the wise employee who checks payroll stubs and questions calculations that are not understood.

Employer’s Payroll Tax Entry

In addition to employee contributions to various taxing authorities, there are some taxes (Payroll Tax Expenses) levied solely on employers. Generally, such taxes include:

FICA Tax Payable (Social Security taxes);

FUTA Tax Payable (Federal Unemployment taxes);

SUTA Tax Payable (State Unemployment taxes).

When it comes to unemployment taxes, employers alone are responsible. The majority of unemployment taxes are levied at the state level (SUTA). A small amount is levied at the Federal level (FUTA).

Here is a model entry to construct the Payroll Tax entry:

Date Payroll Tax Expense xxxxx
     FICA Taxes Payable xxxxx
     State Unemployment Tax Payable xxxxx
     Federal Unemployment Tax Payable xxxxx

Note that both payroll entries require payment of FICA tax.  This is because FICA is levied on both the employee and the employer.  Notice also, that the employee does not pay unemployment; in the U.S., unemployment taxes are the responsibility of employers.

Additional Fringe Benefits

Fringe benefits often take the form of a health insurance plan and a retirement plan. The entry for such benefits requires a debit to each benefit as an expense to the employer, and a credit to Employee Benefits Payable.

Current Liabilities

Long Term Liabilities

Present Value - Future Value concepts

Presentation slides


More detailed note on accounting for long-term liabilites

Updated  20 April 2015,  8 December 2011

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