# Lesson 11--Current Liabilities

## Current Liabilities and Payroll Accounting

In the first Accounting course, current liabilities are portrayed as consisting almost solely of Accounts Payable and Notes Payable. In practice, there are other categories of current liabilities, which are explored in this chapter.

## Learning Objectives

This chapter covers the following topics:

1.      Short Term Notes Payable

2.      Accounts Payable

3.      Current Maturities of Long Term Debt

4.      Contingent Liabilities

5.      Payroll 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. Current liabilities are paid using current assets. Financial professionals look at the relationship of current assets versus current liabilities in measuring the liquidity of the company.

## Notes Payable

The text begins with the accounting procedure for Notes Payable: Suppose you borrow \$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. The formula for interest calculation is Interest = Principal times Rate times Time, with the time expressed in years or a fraction of a year.  Always take care in your calculation of time.  In this example, interest needs to be calculated for March, as well as April, May, and June -- because the money is borrowed on March 1.

In determining the maturity date for the note, we count forward from March 1. Because the maturity date is specified in months, we count forward, month by month. The maturity date is therefore July1. If the note is quoted in years, we would count forward using the same date next year. If this note were a one-year note, the maturity date would be March 1 next year. The most complicated situation is when the note is quoted in days, because you need to count the days. For example, if this note was a 60-day note dated March 1, you would calculate the days left in March (30), plus 30 days in April, resulting in a maturity date of April 30. If you have not memorized the number of days in each month, this would be a good opportunity to do so.

If the company closes its books monthly, an adjustment would 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:

The same entry would be made at the end of April, May and June, resulting in Interest Payable of \$4,000 after four months. (Note that the \$1,000 of interest expense would be closed at the end of each month.) At maturity, the following entry would be made when we pay off the liability:

 Date Accounts Debit Credit July 1 Note Payable 100,000 Interest Payable 4,000 Cash 104,000

After four months, the Interest Payable would amount to \$4,000. Note that the borrower must pay off the original principal, plus interest, at the maturity date.

If the company closes its books annually, the entry to pay off the note would look like this:

 Date Accounts Debit Credit July 1 Note Payable 100,000 Interest Expense 4,000 Cash 104,000

A short term note payable, such as the one above, is an example of a negotiable instrument--meaning that the lender may wait until maturity to get payment--or, sign the note over to a bank to get the money earlier.

If we calculate the effective interest of the note, given the terms above, we paid \$4,000 to use \$100,000 for four months. Dividing \$4,000 by \$100,000 yields 4% interest for 1/3 year. To get an annual rate of interest, multiply by 3, and the effective interest rate is 12%.

## A Discounted Note

Your textbook discusses another type of note called a discounted note. Let us say that you sign a note similar to the one discussed earlier, only with one difference in the terms. You sign a note payable for \$100,000, with interest at 12% for four months, but this time the note is discounted. In this case, the lender takes out the interest prior to giving you the money. The interest, as before, will be 100,000 * .12 * 4/12 = \$4,000. And, although you signed a note for \$100,000, you only receive \$96,000. Why? Because the interest is being taken out before you receive the proceeds. Note that you must pay back the full \$100,000 at maturity.

So, here's the question: are you paying 12% for your loan? Let's consider this question. We pay \$4,000 to borrow \$96,000. Compute \$4,000/\$96,000 = .04166 = 4.166% interest. But that 4.166% is for four months, 1/3 of a year. If we annualize the interest rate (multiplying by 3), that annual rate is 12.5%. In the earlier example, we paid \$4,000 to borrow \$100,000, which equates to a 12% loan. Clearly, a discounted note is not as favorable to the borrower.

## Current Portion of Long Term Debt

If a company has purchased real estate, such as a building, the debt incurred for the asset purchase will be in the form of a mortgage payable. Although we think of a mortgage as a long term liability, payments are made each month. 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: Our company purchased an office for \$100,000 and signed a mortgage payable for that amount. In addition to the interest that we will pay this year, 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.

This is a case in which the Mortgage Payable has a balance of \$100,000, but on the balance sheet, we report \$6,000 as a current liability, and the remaining \$94,000 as a long term liability.

## 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.

## Warranty Liabilities

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 interesting thing about warranty liabilities is that the liability arises from selling the product. If you sell your product and the product has a warranty, the cause of the liability is the sale. So the company selling the product makes an adjusting entry when the sale is made, consisting of a debit to Warranty Expense and a credit to Warranty Payable. If a customer brings back the product, a debit is made to Warranty Payable, and Cash (or Inventory) is credited.

## Payroll Liabilities

You should focus on three types of payroll entries that are made by an employer: the entry for the employee payroll, the entry for the employer payroll taxes and the entry for employee benefits paid by the employer. You should make the entries in that order.

## Calculating Gross Pay

If you hire someone, the agreement you make with the employee may involve paying them by the hour, by the week, by the month, or by the year. Here are a couple of possibilities:

1. We pay John \$20.00 per hour for 8 hours per day, or 40 hours per week. The pay for an hourly employee is usually called wages. If John works for more than 40 hours during a week, he gets paid overtime. The overtime rate may be 1.5 to two times the regular rate. Your textbook focuses on a rate of 1.5 times the normal rate, often referred to as “time-and-a-half.”

So, if John works for 43 hours this week, what is his gross pay? Multiply 40 times \$20 = \$800 for his regular pay, plus 3 hours at "time-and-a-half" which would be 1.5 times \$20 or \$30. He gets 3 overtime hours = 3*\$30=\$90. His gross pay would be \$800 plus \$90 = \$890.

2. A second possibility is that the employee gets paid a salary. For example, Janet is a manager and her contract specifies that she receive \$48,000 per year. We would record Salaries Expense for Janet each month of \$4,000. In many cases, a salaried employee gets no overtime pay, though managers often work more than eight hours per day.

As mentioned above, we make three payroll entries. The first entry is to record the emplyees' wages or salaries. It may surprise you to know that payroll entries must follow certain laws--so if you become a payroll manager, it is critical that you follow the rules. A good first step is to acquire a copy of a document published by the Internal Revenue Service called "Publication 15 Circular E". This publication is available from www.irs.gov. I suggest you use Google with the request, “IRS Forms and Pubs.”

According to Pub 15, it is the employer's responsibility to deduct certain amounts from the employee's wages and deposit those amounts on a timely basis. The basic deductions from the employee's wages are:

1. Social Security contributions (to the employee's account, to be withdrawn after the employee retires);

2. Medicare contributions (for the employee's health care after retirement);

3. the employee's income tax obligations for wages or salaries earned this year.

4. Other deductions specified by the employee (savings account, investments, contributions).

## Employee Payroll Entry (Entry 1)

A business must act as an agent of the US government 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 Social Security Taxes Payable xxxxx Medicare Tax Payable xxxxx Federal 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 (Social Security Taxes Payable, Medicare Tax 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.

How do you know how much to deposit (on the employee's behalf) for Social Security, Medicare and Federal Income Tax? Good question. You will find the correct answers to these questions in Pub 15 Circular E. When a textbook is written, the amounts are "simulated", so that the textbook doesn't have to be revised to reflect the latest changes. Here are typical rates that a textbook would use:

Social Security Tax: Deduct 6% from each employee's paycheck for social security--but only on the first \$100,000 of wages or salaries the employee earns this year. A highly salaried employee might reach \$100,000 of wages this year, in which case, we stop taking out social security after we've taken out \$6,000 for the year. Note that we would resume taking out social security as of January 1 of the following year.

For Medicare Taxes, the rate is 1.5% of all wages or salaries earned. There is no limit on Medicare. Every dollar the employee earns is subject to the Medicare deduction.

For Income Taxes, use the tables in Pub 15, Circular E. The tax tables are set up so that if the employee works for 12 months, the total of the amount taken out by the employer should approximate the amount that the employee will be required to pay on tax day, April 15.

Also, some of the examples in the text refer to both Federal Income Tax Payable, and State Income Tax Payable. Most states in the U.S. have a state income tax. For example, if you are a resident of Oregon or California, you will pay both federal and state income taxes. A Washington resident, however, will pay federal income tax, but there is no state income tax. Washington raises tax revenues through other sources, such as sales tax and business/occupation taxes. The homework problems will clearly state whether state income taxes are to be accrued.

## Employer Payroll Tax Entry (Entry 2)

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

1.      Social Security Tax Payable (the employer matches the amount paid by the employee);

2.      Medicare Tax Payable (the employer matches the amount paid by the employee);

3.      SUTA Tax Payable (State Unemployment taxes at the rate of 5.4% of the first \$7,000 earned this year);

4.      FUTA Tax Payable (Federal Unemployment taxes at the rate of .8% of the first \$7,000 earned this year. Note that .8% is less than 1% and the decimal equivalent is .008.

## A Clarifying Example of Entry 1 and Entry 2

Let's go back to our employee, John, who earned \$890 the week of March 1-March 7. Let's assume John is our only employee. John must pay for his Social Security (6%) and Medicare taxes (1.5%), and let us say that the tax table in Pub 15 indicates that John must contribute \$160 dollars toward his income taxes. Here's the entry we make (Entry 1):

 Date Accounts Debit Credit March 7 Wages Expense 890.00 Social Security Tax Payable (.06 *890) 53.40 Medicare Tax Payable (.015*890) 13.35 Income Tax Payable (from withholding tax table) 160.00 Wages Payable 663.25

So that's the entry to record the employee's earnings, and the employee's contributions to his/her own social security, medicare and income taxes.

The second entry (Entry 2) records the employer's contributions on the employee's behalf. Here's what it would look like:

 Date Accounts Debit Credit March 7 Payroll Tax Expense 121.93 Social Security Tax Payable (.06 *890) 53.40 Medicare Tax Payable (.015*890) 13.35 State Unemployment Tax Payable (5.4% * 890) 48.06 Federal Unemployment Tax Payable (.8% * 890) 7.12

Taking the two entries into account (Entry 1 and Entry 2), \$106.80 is going to the employee's Social Security (\$53.40 + \$53.40) and \$26.70 (\$13.35 + \$13.35) is being contributed to Medicare. Note that the employee does not contribute to unemployment; unemployment taxes are a burden of the employer.

Conclusion: if you hire employees, do not forget to budget these additional costs of hiring.  It is not uncommon for an employer to discover that hiring an employee at a salary of \$20,000 may actually cost closer to \$30,000 when payroll taxes and benefits are included. In our case, the employee, John, earned \$890, but the total cost to the employer was 890.00 + 121.93 = \$1,011.93

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). As your book indicates, by contributing to SUTA, an employer can reduce the FUTA. Additionally, an employer's SUTA may vary by the industry in which the employer operates, and the employer's unemployment history.

## Additional Fringe Benefits (Entry 3)

Fringe benefits may consist of a health plan, a retirement plan, and vacation pay. The general rule would be record these as expenses of the employer, although employee contributions to those plans is quite common.

In times past, pension plans were set up as defined benefit plans, in which employee and employer contribute money toward the employee's retirement. At the time of retirement, the employee receives a pension of a known amount.

The modern approach to pension plans is the "defined contributions" approach, such as a 401K plan. Employee and employer both contribute to the employee's pension plan using the employee's pre-tax income. The retirement funds are held by an insurance company. The employee can decide how the retirement funds are invested--stock market, bond fund, money market fund, social choice fund, international stock market, etc. If the retirement funds earn interest or dividends, no tax is levied on the employee until withdrawal. Upon retirement, the employee can begin withdrawing the funds and must pay the income tax on his contributions at that time. This means that the employee can decide how much risk to take with the invested funds and defer income taxes on the fund's earnings. You should be aware of this type of retirement plan, because it is likely that you will participate in such a plan.

## Three Liquidity Ratios

The discussion of current liabilities brings to mind several ratios that are used to evaluate liquidity in a company. Here are three calculations you should be familiar with.

1. Current Ratio = Current Assets/Current Liabilities

2. Quick Ratio = Quick Assets/Current Liabilities

3. Working Capital=Current Assets - Current Liabilities.