# Current Liabilities

Text Reference: Chapter 10 of Horngren's Accounting 8th edition, pages 524-556.

## 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 lesson.

## Learning Objectives

This chapter covers the following topics:

1. Notes Payable

2. Sales Taxes Payable

3. Unearned Revenues

4. Current Maturities of Long Term Debt

5. Contingent Liabilities

6. 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.  The accounts listed above are examples of current liabilities.

## Notes Payable

The text describes the accounting procedure for Notes Payable: Example: 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. 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.

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:

After four months, the Interest Payable would amount to \$4,000, and the entry to record payment 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%? One approach is to use algebra. 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. These amounts could be checked against the cash register tape for reasonableness.

## Unearned Revenues

An Unearned Revenue occurs when someone pays us for services that we will provide in the future. Remember that the general rule is that we do not record revenues until they are earned. 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 the Seattle Seahawks, and payment of a lawyer's retainer. 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 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.

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

The first part of the section on Payroll covers general terms that you are probably aware of. Additionally, some internal control procedures are detailed to insure that employees have a legal claim to a paycheck. You should focus on two types of payroll entries that are made by an employer: the entry for the employees’ payroll, and the entry for the employer’s payroll taxes. A third type of entry is also possible if the company provides fringe benefits to its employees.

## 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.

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’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:

1. FICA Tax Payable (Social Security taxes);

2. FUTA Tax Payable (Federal Unemployment taxes);

3. SUTA Tax Payable (State Unemployment taxes).

Notice that the employer pays FICA for the benefit of the employee; in fact, the employer matches employees’ contributions to this social security fund.  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.

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. The journal entry for Payroll Tax Expense is shown on page 467. Here is a model entry you can use in your homework 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.

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.

## Discussion Questions for Current Liabilities

1. How would you define the term "current liability"?

2. Name 5 current liabilities. On which financial statement are they reported?

3. On January 1, John borrows \$1,000 on a 6%, 3 month note payable. a. When does John have to pay back the principal and interest? b. How much will John pay (principal and interest) at maturity? c. What entry will John make when he borrows the money? d. What entry will John make on the maturity date?

4. Describe how unearned revenue relates to each of the following situations: a. a magazine subscription b. season tickets for the Seattle Seahawks c. prepaid phone cards. How does revenue become earned in each case?

5. Philips manufactures TV sets that carry a one year warranty. Does Philips record this warranty liability when the TV is sold, or when the TV breaks down, or when the customer brings back the TV for repair/replacement (choose one).

6. Provide an example of a contingent liability. What is the rule for contingent liabilities?

7. Warden Company sells \$3,000 of goods in Washington state that are subject to an 8.8% sales tax. Assuming the sale is on account, how would the transaction be recorded?

8. Bobby earns \$15 per hour at his new job, and gets paid time-and-a-half for overtime. If Bobby works 43 hours this week, what is his gross pay?

9. Employer or employee? Who pays FICA (Social Security) taxes?

10. Employer or employee? Who pays unemployment taxes?

11. Using your book rates, what is the rate used for FICA _____; SUTA _____; FUTA _____?

12. There are three payroll entries described in your text; describe each of the three in words.

13. What information is in a payroll register? Should the payroll register have columns for recording SUTA and FUTA? Why or why not?

14. John obtained a \$300,000 mortgage on December 27, 2007 for purchase of an office building. The terms of the loan specify that John will make payments totaling \$18,000 in 2008. How would the mortgage be reported on the balance sheet at 12/31/07?

## Assignment, Current Liabilities

Current Liabilities Assignment

## Self Quiz

Current Liabilities Quiz

## Questions?

If you have questions regarding this lesson, please email me at the following address: