Financial Accounting Notes Current Liabilities I. Managing Issues Related to Accounting for Current Liabilities A company operating cycle is the process of converting cash to purchases, to sales, to accounts receivable and back to cash. Most current liabilities are incurred in support of the cycle. Short-term debt is used to raise cash during periods of inventory buildup or while waiting for collection of receivables. A key consideration with managing a company s liquidity position and cash flows is the amount of time its creditors are willing to give to pay its accounts payable. Common measures of current liabilities are payable turnover and the average days payable. Payable turnover = Cost of Good Sold +Change of Merchandise Inventory Average Accounts Payable $2,042.7 50.7 (234.8 +206.4)/2 $1992 $220.6 9.0 times 9.0 means the number of times accounts payable were paid. Average Day Payable = 365 DAYS Payable Turnover 40.6 How long, on the average, a company takes to pay its accounts payable? In-class Exercise SE2 A. Recognition of Liabilities. As in other accounts timing is very important when recording a liability. Failure to record liabilities properly may understate expenses and overstate income. When should liabilities be recorded? When obligations occur. However, some liabilities do not occur in the process of increasing inventory, some occur at month end such as wages payable or tax 1
liability. Adjusting entries at the end of the month should true up the correct value of Accounts Payable. B. Valuation of Liabilities Most liabilities are value at the face value of a loan. A few liabilities, however, need to be estimated, i.e. repair warranty. C. Classification of Liabilities Current liability less than one year or within the operating cycle of the business whichever is longer. Current liabilities are typically paid out of current assets with cash generated from operations. D. Disclosure of Liabilities Some accounts may need to be explained as notes in the financial statements. The disclosure may consist on amount, timing etc. In-class Exercise SE3 II. Common Categories of Current Liabilities Determinable Liabilities Estimated Liabilities A. Determinable Liabilities Accounts Payable Short-term obligations to suppliers for goods and services Bank Loan and Commercial Paper Line of credit a firm establishes with other organizations, such as banks, to cover payroll, or to have instant cash, vendors, to buy supplies etc. Banks may required to fulfill certain company financial goals, such as maintaining specific profit margins, current ratio or debt to equity ratio in order to maintain the line of credit. Notes Payable Short term notes payable, are obligations represented by promissory notes. These notes may be used to secure bank loans, to pay suppliers for goods and services etc. Receipt of Note: Example 1: Interest Stated Separately a) Cash 5,000 Notes Payable 5,000 Cash a) 5,000 b) 5,100 b) 5,000 Note Payable a) 5,000 2
Payment of Note: Example 1: b) Notes Payable 5,000 Interest Expense 100 Cash 5,100 b) 100 Interest Expense Loan is calculated using simple interest. Principle x rate x time. Example Principle = $5,000, Rate = 12$, for 2 months Calculation $5,000 * 12% * 60 = $100 for 60 days 360 days In-class Exercise SE4 Accrued Liabilities Recognizing Liabilities that are not in the accounting records. Interest accrued from any type of payable should be recorded at the end of the accounting cycle. Example 1: Interest Expense 50 Interest payable 50 Example 2: Interest Expense 50 Discount on notes payable 50 Dividend Payable When the board of directors approves a dividend it becomes a liability until the date paid. Sales and Excise Taxes Payable Taxes Excise to a business is a liability until paid. These must be accrued at the end of the business cycle. Current Portion of Long-Term Debt The portion of a long-term debt that is due within the next year and is to be paid from current assets is classified as a current liability. E.I. A 5-year debt to be paid annually, the installment for that year is classified as a current. 3
Payroll Liabilities Cost of payroll and related payroll taxes is a major expense. In some industries payroll may represent almost 50% of their total expenses. Wages refers to payment for services to hourly employees. Salaries refer compensation to bi-weekly, monthly or annual rates. Payroll Liabilities 6.2% of first $87,000 for both employee and employer 1.4% of gross income for both employee and employer FUTA, Federal Unemployment Taxes Paid by employers only. 6.2% of the first $7,000 earned by an employee. But this tax is offset by a credit of what is paid to the State, 4
Recording Payroll: Feb. 15 Wages Expense 32,500 Employee s federal Income Taxes Payable 5,400 Employee s State Income Taxes Payable 1,200 Social Security Tax Payable 2,015 Medicare Tax Payable 471 Medial Insurance payable 900 Pension Contributions Payable 1,300 Wages Payable 21,214 To record Payroll for February 2002 Feb. 15 Payroll Taxes and Benefits Expense 9,401 Social Security Tax Payable 2,015 Medicare Tax Payable 471 Medical Insurance Payable 3,600 Pension Contributions Payable 1,300 Federal Unemployment Tax Payable 260 State Unemployment Tax Payable 1,750 To record payroll taxes and other costs. In-class Exercise SE5 Unearned Revenue: Represents obligations for goods or services that the company must provide or deliver in a future accounting period. Example; Magazine subscriptions, Tickets to a game or concert. Journal Entry: Received Payment for annual subscriptions Cash 240 Unearned subscriptions 240 The publisher has a liability of $240 this amount will be reduced monthly as the obligation to send a monthly magazine. As the obligation declines the revenue is earned. Unearned Subscriptions 20 Subscriptions Revenue 20 5
Estimated Liabilities: When no exact dollar amount is known an estimate of the obligation must be recorded. Example; Income taxes, property taxes, product warranties and vacation paid. Income Taxes: Because the amount of income taxes paid depends on result of operations this liability must be estimated because taxes are due on the period income is earned, but they may be paid later. Example is taxes are due April 2003 for the amounts earned in 2002. Dec. 31 Income tax Expense 53,000 Estimated Income Tax Payable 53,000 To record estimated federal income taxes Property Tax Payable: Property tax consists on Building, land, personal property such as inventory and equipment. Because the tax assessment is received after the year-end an estimate is recorded. Product Warranty Liability: When a firm places a warranty on its product at the time of sale, a liability exists for the length of the warranty. Usually history is used to calculate the estimated liability. Here the conservatism principle is used. Jul 31. Product Warranty Expense 525 Estimated Product Warranty Liability 525 To record estimated product warranty expense In-Class Exercise: SE6 Vacation Pay Liability; Employees earn the right to paid vacation. Theoretically the cost of the vacation should be allocated as an expense for the whole year so that month-to-month cost will not be distorted. That is because when an employee resigns from the firm they received whatever it was accrued in vacation paid. Apr.20 Vacation Pay Expense 600 Estimated Liability for Vacation Pay 600 To Recorded estimated vacation pay expense 6
Aug. 31 Estimated Liability for Vacation Pay 1,000 Cash 1,000 Sales Tax Business collect sales tax from customers at a rate established by the state of residency. In California, business send the sales tax collected to the Board of Equalization. Example: John Auto Parts had cash sales of $20,000 for the month of April. Sales are subject to a 8.75% sales tax. Recording the cash sales and collection of sales tax: April 30 Cash 21,750 Sales 20,000 Sales Taxes 1,750 ($20,000 x 8.75% = $1,750) Contingent Liabilities: A contingent liability is not an existing liability but a potential liability. Most of these liabilities are incurred because of potential legal action against the company. Two conditions may exists: 1. The liability must be probable 2. It must be reasonably estimated Note to student: Pages 440 through 450 Time Value of Money will be covered in Chapter 10 Homework Exercises for : E4, E5, E6, E7, E8. 7