9781337913201.112 Warren Acct28e ch11

Chapter 11
Current Liabilities and Payroll
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Learning Objectives (1 of 2)
• LO1: Describe and illustrate current liabilities related to accounts payable,

the current portion of long-term debt, and notes payable.
• LO2: Determine employer liabilities for payroll, including liabilities arising
from employee earnings and deductions from earnings.
• LO3: Describe payroll accounting systems that use a payroll register,
employee earnings records, and a general journal.
• LO4: Journalize entries for employee fringe benefits, including vacation pay
and pensions.
Learning Objectives (2 of 2)
• LO5: Describe the accounting treatment for contingent liabilities and

journalize entries for product warranties.
• LO6: Describe and illustrate the use of the quick ratio in analyzing a
company’s ability to pay its current liabilities.
Current Liabilities
• When a company or a bank advances credit, it is making a loan.

• The company or bank is called a creditor (or lender).
• The individuals or companies receiving the loans are called debtors (or
borrowers).
• Debt is recorded as a liability by the debtor.
• Long-term liabilities are debts due beyond one year.
• Current liabilities are debts that will be paid out of current assets and are due within one
year.
Accounts Payable
• Accounts payable transactions involve a variety of purchases on account,

including the purchase of merchandise and supplies.
• For most companies, accounts payable is the largest current liability.
Current Portion of Long-Term Debt
• Long-term liabilities are often paid back in periodic payments, called

installments.
• Such installments that are due within the coming year are classified as a current liability.
• The installments due after the coming year are classified as a long-term liability.
Short-Term Notes Payable (1 of 8)
• Notes may be issued to purchase merchandise or other assets. Notes may

also be issued to creditors to satisfy an account payable created earlier.
• Assume that Nature’s Sunshine Company issued a 90-day, 12% note for
$1,000, dated August 1, 20Y7 to Murray Co. for a $1,000 overdue account.
The entry to record the issuance of the note is as follows:
• When the note matures, the entry to record the payment of $1,000 plus $30
interest ($1,000 × 12% × 90 ÷ 360) is as follows:
• The interest expense is reported in the Other Expense section of the income
statement for the year ended December 31, 20Y7.
• The interest expense account is closed at December 31.
• Each note transaction affects a debtor (borrower) and creditor (lender).
• A company may also borrow from a bank by issuing a note.

• Assume that on September 19, Iceburg Company borrowed cash from First
National Bank by issuing a $4,000, 90-day, 15% note to the bank. The entry
to record the issuance of the note and the cash proceeds is as follows:
• On the due date of the note (December 18), Iceburg Company owes First
National Bank $4,000 plus interest of $150 ($4,000 × 15% × 90 ÷ 360). The
entry to record the payment of the note is as follows:
• In some cases, a discounted note may be issued rather than an interest-

bearing note.
• A discounted note has the following characteristics:
• The interest rate on the note is called the discount rate.
• The amount of interest on the note, called the discount, is computed by multiplying the
discount rate times the face amount of the note.
• The debtor (borrower) receives the face amount of the note less the discount, called the
proceeds.
• The debtor must repay the face amount of the note on the due date.
• Assume that on August 10, Cary Company issues a $20,000, 90-day

discounted note to Western National Bank. The discount rate is 15%, and
the amount of the discount is $750 ($20,000 × 15% × 90 ÷ 360). Thus, the
proceeds received by Cary Company are $19,250. The entry by Cary
Company is as follows:
• The entry when Cary Company pays the discounted note on November 8 is
as follows:
Example Exercise: Proceeds from Notes Payable
• On July 1, Bella Salon Company borrowed cash from Best Bank by issuing a
60-day note with a face amount of $60,000.
a. Determine the proceeds of the note, assuming that the note carries an interest rate of
6%.
b. Determine the proceeds of the note, assuming that the note is discounted at 6%.
Payroll and Payroll Taxes
• In accounting, payroll refers to the amount paid to employees for services

they provided during the period.
• A company’s payroll is important for the following reasons:
• Payroll and related payroll taxes significantly affect the net income of most companies.
• Payroll is subject to federal and state regulations.
• Good employee morale requires payroll to be paid timely and accurately.
Liability for Employee Earnings (1 of 3)
• Usually refers to payment for managerial and administrative services

• Normally expressed in terms of a month or a year
Salary
• Employee’s salary may be increased by bonuses, commissions, profit
sharing, or other adjustments
• Usually refer to payments to employees for services that is stated on

an hourly or weekly basis
Wages • Employee’s wage may be increased by bonuses, commissions, profit
sharing, or other adjustments
• Companies engaged in interstate commerce must follow the Fair Labor

Standards Act. This act, sometimes called the Federal Wage and Hour Law,
requires employers to pay a minimum rate of 1½ times the regular rate for all
hours worked in excess of 40 hours per week.
• Assume that John T. McGrath is a salesperson employed by McDermott

Supply Co. McGrath’s regular rate is $34 per hour, and any hours worked in
excess of 40 hours per week are paid at 1½ times the regular rate. McGrath
worked 42 hours for the week ended December 27. His earnings for the
week are computed as follows:
Deductions from Employee Earnings
• The total earnings of an employee for a payroll period, including any

overtime pay, are called gross pay.
• From this amount is subtracted one or more deductions to arrive at the net
pay.
• The deductions normally include the following:
• Federal income taxes
• State income taxes
• Local income taxes
• Medical insurance
• Pension contributions
• Net pay is the amount the employee receives after deductions are subtracted from gross
pay.
Income Taxes (1 of 5)
• Employers normally withhold a portion of employee earnings for payment of

the employees’ federal income tax.
• Each employee authorizes the amount to be withheld by completing an
“Employee’s Withholding Allowance Certificate,” called a W-4.
Employee’s Withholding Allowance Certificate (W-4 Form)
• On the W-4, an employee indicates marital status and the number of

withholding allowances.
• A single employee may claim one withholding allowance.
• A married employee may claim an additional allowance for a spouse.
• An employee may also claim an allowance for each dependent other than a spouse.
• Each allowance reduces the federal income tax withheld from the
employee’s pay.
• The federal income tax withheld depends on each employee’s gross pay and W-4
allowance.
• Withholding tables issued by the Internal Revenue Service (IRS) are used to
determine amounts to withhold.
• Each year, the amount of standard withholding allowance is determined by
the IRS.
• For ease of computation and because this amount changes each year, we assume that
the standard withholding allowance to be deducted for a single person paid weekly is
$81.
• Assume that John T. McGrath made $1,462 for the week ended December
27. McGrath’s W-4 claims one withholding allowance of $81.
• Thus, the wages used in determining McGrath’s withholding bracket are $1,381 ($1,462
− $81).
• After the person’s withholding wage bracket has been computed, the federal
income tax to be withheld is determined as follows:
• Step 1. Locate the proper withholding wage bracket in the withholding tables issued by
the IRS.
• Step 2. Compute the withholding for the proper wage bracket using the directions in the
two-right columns of the withholding table.
Example Exercise: Federal Income Tax Withholding
(1 of 2)
• Karen Dunn’s weekly gross earnings for the present week were $2,250.
Dunn has two exemptions. Using the wage bracket withholding table below
with a $81 standard withholding allowance for each exemption, what is
Dunn’s federal income tax withholding?
Example Exercise: Federal Income Tax Withholding
(2 of 2)
FICA Tax (1 of 3)
• Employers are required by the Federal Insurance Contributions Act (FICA) to

withhold a portion of the earnings of each employee.
• The FICA tax withheld contributes to the following two federal programs:
• Social security, which provides payments for retirees, survivors, and disability insurance.
• Medicare, which provides health insurance for senior citizens.
FICA Tax (2 of 3)
• The amount withheld from each employee is based on the employee’s

earnings paid in the calendar year.
• The withholding tax rates and maximum earnings subject to tax are often
revised by Congress.
• To simplify, this chapter assumes the following rates and earnings subject to tax:
• Social security: 6% on all earnings
• Medicare: 1.5% on all earnings
FICA Tax (3 of 3)
• Assume that John T. McGrath’s earnings for the week ending December 27
are $1,462. Total FICA tax to be withheld is computed as follows:
Other Deductions
• Employees may choose to have additional amounts deducted from their

gross pay
• For example, an employee may authorize deductions for:
• Retirement savings
• Charitable contributions
• Life insurance
• Union contract may also require the deduction of union dues
Computing Employee Net Pay
• Gross earnings less payroll deductions equals net pay.

• Net pay is sometimes called take-home pay.
• Assume that John T. McGrath authorized deductions for retirement savings
and for a United Fund contribution. McGrath’s net pay for the week ended
December 27 is computed as follows:
Example Exercise: Employee Net Pay
• Karen Dunn’s weekly gross earnings for the week ending December 3 were
$2,250, and her federal income tax withholding was $371.58. Assuming that
the social security rate is 6% and Medicare is 1.5%, what is Dunn’s net pay?
Liability for Employer’s Payroll Taxes
• Employers are subject to the following payroll taxes for amounts paid their
employees:
Federal Insurance
• Employers must match the employee’s FICA tax
Contributions Act (FICA) contribution
Tax
Federal Unemployment • Provides for temporary payments to those who become

Compensation Tax (FUTA) unemployed
State Unemployment • Provides temporary payments to those who become

Compensation Tax (SUTA) unemployed
Responsibility for Tax Payments
Accounting Systems for Payroll and Payroll Taxes
(1 of 2)
• Payroll systems should be designed to:

• Pay employees accurately and timely.
• Meet regulatory requirements of federal, state, and local agencies.
• Provide useful data for management decision-making needs.
• Although payroll systems differ among companies, the major elements of
most payroll systems are:
• Payroll register
• Employee’s earnings record
• Payroll checks
Accounting Systems for Payroll and Payroll Taxes
(2 of 2)
• The payroll register is a multicolumn report used for summarizing the data
for each payroll period.
• Although payroll registers vary by company, a payroll register normally
includes the following columns:
• Employee name • Federal income tax withheld
• Total hours worked • Retirement savings withheld
• Regular earnings • Miscellaneous items withheld
• Overtime earnings • Total withholdings
• Total gross earnings • Net pay
• Social security tax withheld • Check number of payroll check issued
• Medicare tax withheld • Accounts debited for payroll expense
Payroll Register
Recording Employees’ Earnings
• The column totals of the payroll register provide the basis for recording the
journal entry for payroll. The entry based on the payroll register is as follows:
Example Exercise: Journalize Period Payroll
• The payroll register of Chen Engineering Services indicates $900 of social

security withheld and $225 of Medicare tax withheld on total salaries of
$15,000 for the period. Federal withholding for the period totaled $2,925.
• Provide the journal entry for the period’s payroll.
Recording and Paying Payroll Taxes (1 of 4)
• Payroll taxes are recorded as liabilities when the payroll is paid to

employees.
• In addition, employers compute and report payroll taxes on a calendar-year
basis, which may differ from the company’s fiscal year.
• On December 27, McDermott Supply has the following payroll data:
• Employers must match the employees’ social security and Medicare tax
contributions.
• In addition, the employer must pay state unemployment compensation tax
(SUTA) of 5.4% and federal unemployment compensation tax (FUTA) of
0.6%.
• When payroll is paid on December 27, these payroll taxes are computed as
follows:
• The entry to journalize the payroll tax expense for McDermott Supply is as
follows:
Example Exercise: Journalize Payroll Tax
• The payroll register of Chen Engineering Services indicates $900 of social

security withheld and $225 of Medicare tax withheld on total salaries of
$15,000 for the period. Earnings of $5,250 are subject to state and federal
unemployment compensation taxes at the federal rate of 0.6% and the state
rate of 5.4%.
• Provide the journal entry to record the payroll tax expense for the period.
Employee’s Earnings Record (1 of 2)
• Each employee’s earnings to date must be determined at the end of each

payroll period. This total is necessary for computing the employee’s social
security tax withholding and the employer’s payroll taxes.
• Thus, detailed payroll records must be kept for each employee. This record
is called an employee’s earnings record.
Employee’s Earnings Record (2 of 2)
Employee’s Wage and Tax Statement (W-2 Form)
Payroll Checks (1 of 2)
• Companies pay employees either by electronic funds transfer or by issuing

payroll checks.
• With electronic funds transfers, the employee’s net pay is electronically deposited into
their bank account each period. Later, the employees receive a payroll statement
summarizing how the net pay was computed.
• Each payroll check includes a detachable statement showing how the net pay was
computed, which is typically identical to the payroll statement accompanying electronic
funds transfers (EFTs).
Payroll Statement
Payroll Checks (2 of 2)
• Most companies use a special payroll bank account to disburse payroll.

• An advantage of using a separate payroll bank account is that reconciling the bank
statements is simplified.
• In addition, a payroll bank account establishes control over payroll checks and, thus,
prevents their theft or misuse.
Computerized Payroll System
• Classification of the inputs into a payroll system
Constants
• Data that remain unchanged from payroll to payroll
• Examples: Employee names, social security numbers, marital status, number of
income tax withholding allowances, rates of pay, tax rates, and withholding tables
Variables
• Data that change from payroll to payroll
• Examples: Number of hours or days worked for each employee, accrued days of sick
leave, vacation credits, total earnings to date, and total taxes withheld
Internal Controls for Payroll Systems
• Some examples of payroll controls include the following:

• If a check-signing machine is used, blank payroll checks and access to the machine
should be restricted to prevent their theft or misuse.
• The hiring and firing of employees should be properly authorized and approved in
writing.
• All changes in pay rates should be properly authorized and approved in writing.
• Employees should be observed when arriving for work to verify that employees are
“checking in” for work only once and only for themselves. Employees may “check in” for
work by using a time card or by swiping their employee ID card.
• Payroll checks should be distributed by someone other than employee supervisors.
• A special payroll bank account should be used.
Employees’ Fringe Benefits
• Many companies provide their employees benefits in addition to salary and

wages earned. Such fringe benefits may include:
• Vacation pay
• Medical benefits
• Retirement benefits
• The cost of employee fringe benefits is recorded as an expense by the
employer.
Vacation Pay (1 of 2)
• The liability to pay for employee vacations could be accrued as a liability at

the end of each pay period. However, many companies wait and record an
adjusting entry for accrued vacation at the end of the year.
• Assume that employees earn one day of vacation for each month worked.
The estimated vacation pay for the year ending December 31 is $325,000.
The adjusting entry for the accrued vacation is as follows:
Vacation Pay (2 of 2)
If employees are required to take all their vacation time within one year, the vacation
pay payable is reported as a current liability on the balance sheet.
If employees are allowed to accumulate their vacation pay, the estimated vacation
pay payable that will not be taken within a year is reported as a long-term liability.
When employees take vacation, the liability for vacation pay is decreased by
debiting Vacation Pay Payable. Salaries or Wages Payable and the other related
payroll accounts for taxes and withholdings are credited.
Pensions
• A pension is a cash payment to retired employees.

• Pension benefits are accrued by employees as they work, based on the
employer’s pension plan.
• Two basic types of pension plans are:
• Defined contribution plan
• Defined benefit plan
Defined Contribution Plans (1 of 3)
• In a defined contribution plan, the company invests contributions on behalf

of the employee during the employee’s working years.
• Normally, the employee and employer contribute to the plan.
• The employee’s pension depends on the total contributions and the investment returns
earned on those contributions.
401K Plan
• One of the more popular defined contribution plans

• Employees contribute a portion of their gross pay before taxes to
investments
• Offers employees two advantages:
• Employee contribution is deducted before taxes
• Contributions and related earnings are not taxed until withdrawn at
retirement
• In most cases, the employer matches some portion of the employee’s

contribution.
• The employer’s cost is debited to Pension Expense.
• Assume that Heaven Scent Perfumes Company contributes 10% of
employee monthly salaries to an employee 401K plan. Assuming $500,000
of monthly salaries, the journal entry to record the monthly contribution is as
follows:
Defined Benefit Plans (1 of 3)
• In a defined benefit plan, the company pays the employee a fixed annual
pension based on a formula. The formula is normally based on such factors
as the employee’s years of service, age, and past salary.
• In a defined benefit plan, the employer is obligated to pay for (fund) the
employee’s future pension benefits.
• The pension cost of a defined benefit plan is debited to Pension Expense.
Cash is credited for the amount contributed (funded) by the employer, and
any unfunded amount is credited to Unfunded Pension Liability.
• Assume that the defined benefit plan of Hinkle Co. requires an annual
pension cost of $80,000. This annual contribution is based on estimates of
Hinkle’s future pension liabilities. On December 31, Hinkle Co. pays $60,000
to the pension fund. The entry to record the payment and unfunded liability is
as follows:
• If the unfunded pension liability is to be paid within one year, it is reported as

a current liability on the balance sheet.
• Any portion of the unfunded pension liability that will be paid beyond one
year is a long-term liability.
Example Exercise: Vacation Pay and Pension Benefits
• Manfield Services Company provides its employees with vacation benefits

and a defined contribution pension plan. Employees earned vacation pay of
$44,000 for the period. The pension plan requires a contribution to the plan
administrator equal to 8% of employee salaries. Salaries were $450,000
during the period.
• Provide the journal entry for the (a) vacation pay and (b) pension benefit.
Postretirement Benefits Other than Pensions (1 of 2)
• Employees may earn rights to other postretirement benefits from their

employer. Such benefits may include the following:
• Dental care
• Eye care
• Medical care
• Life insurance
• Tuition assistance
• Tax services
• Legal services
Postretirement Benefits Other than Pensions (2 of 2)
• The estimate of the annual benefits expense is recorded by debiting

Postretirement Benefits Expense. If the benefits are fully funded, Cash is
credited for the same amount. If the benefits are not fully funded, a
postretirement benefits plan liability account is also credited.
• The financial statements should disclose the nature of the postretirement
benefit liabilities. These disclosures are usually included as notes to the
financial statements.
Current Liabilities on the Balance Sheet
Contingent Liabilities
• Some liabilities may arise from past transactions only if certain events occur
in the future. These potential obligations are called contingent liabilities.
• The accounting for contingent liabilities depends on the following two factors:
• Likelihood of occurring
• The likelihood that the event creating the liability occurring is classified as probable,
reasonably possible, or remote.
• Measurement
• The ability to estimate the potential liability is classified as estimable or not
estimable.
Probable and Estimable (1 of 2)
• If a contingent liability is probable and the amount of the liability can be

reasonably estimated, it is recorded and disclosed.
• The liability is recorded by debiting an expense and crediting a liability.
• Assume that during June, a company sold a product for $60,000 that
includes a 36-month warranty for repairs. The average cost of repairs over
the warranty period is 5% of the sales price. The entry to record the
estimated product warranty expense for June is as follows:
Probable and Estimable (2 of 2)
• If the product is repaired under warranty, the repair costs are recorded by
debiting Product Warranty Payable and crediting Cash, Supplies, Wages
Payable, or other accounts.
• Assume that a $200 part is replaced under warranty on August 16. The entry
to record the replacement of the defective part is as follows:
Accounting Treatment of Contingent Liabilities
Example Exercise: Estimated Warranty Liability
• Cook-Rite Co. sold $140,000 of kitchen appliances during August under a

six-month warranty. The cost to repair defects under the warranty is
estimated at 6% of the sales price. On September 12, a customer required a
$200 part replacement plus $90 of labor under the warranty.
• Provide the journal entry for (a) the estimated warranty expense on August
31 for August sales and (b) the September 12 warranty work.
Financial Analysis and Interpretation: Quick Ratio
(1 of 6)
• Current position analysis helps creditors evaluate a company’s ability to

pay its current liabilities. This analysis is based on:
• Working capital
• Current ratio
• Quick ratio
(2 of 6)
• Working capital is computed as follows:
• The current ratio is computed as follows:
(3 of 6)
• While these two measures can be used to a company’s ability to pay its
current liabilities, they do not provide insight into the company’s ability to pay
these liabilities within a short period of time.
• This is because some current assets cannot be converted into cash as quickly as other
current assets.
(4 of 6)
• The quick ratio overcomes this limitation by measuring the “instant” debt-
paying ability of a company.
• It is computed as follows:
• Quick assets are cash and other current assets that can be easily be
converted to cash.
• A quick ratio below 1.0 indicates that the company does not have
enough quick assets to cover its current liabilities.
(5 of 6)
• Consider the following data for TechSolutions, Inc., at the end of 20Y7:
(6 of 6)
• The quick ratio for TechSolutions, Inc., is computed as follows:
Example Exercise: Quick Ratio (1 of 2)
• Sayer Company reported the following current assets and current liabilities
for the years ended December 31, 20Y9 and 20Y8:
a. Compute the quick ratio for 20Y9 and 20Y8.

b. Interpret the company’s quick ratio across the two time periods.
Example Exercise: Quick Ratio (2 of 2)

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Chapter 11

Current Liabilities and Payroll

• LO1: Describe and illustrate current liabilities related to accounts payable,

• LO5: Describe the accounting treatment for contingent liabilities and

• When a company or a bank advances credit, it is making a loan.

• Accounts payable transactions involve a variety of purchases on account,

• Long-term liabilities are often paid back in periodic payments, called

• Notes may be issued to purchase merchandise or other assets. Notes may

• Each note transaction affects a debtor (borrower) and creditor (lender).

• A company may also borrow from a bank by issuing a note.

• In some cases, a discounted note may be issued rather than an interest-

• Assume that on August 10, Cary Company issues a $20,000, 90-day

• In accounting, payroll refers to the amount paid to employees for services

• Usually refers to payment for managerial and administrative services

• Usually refer to payments to employees for services that is stated on

• Companies engaged in interstate commerce must follow the Fair Labor

• Assume that John T. McGrath is a salesperson employed by McDermott

• The total earnings of an employee for a payroll period, including any

• Employers normally withhold a portion of employee earnings for payment of

• On the W-4, an employee indicates marital status and the number of

• Employers are required by the Federal Insurance Contributions Act (FICA) to

• The amount withheld from each employee is based on the employee’s

• Employees may choose to have additional amounts deducted from their

• Gross earnings less payroll deductions equals net pay.

Federal Unemployment • Provides for temporary payments to those who become

State Unemployment • Provides temporary payments to those who become

• Payroll systems should be designed to:

• The payroll register of Chen Engineering Services indicates $900 of social

• Payroll taxes are recorded as liabilities when the payroll is paid to

• On December 27, McDermott Supply has the following payroll data:

• The payroll register of Chen Engineering Services indicates $900 of social

• Each employee’s earnings to date must be determined at the end of each

• Companies pay employees either by electronic funds transfer or by issuing

• Most companies use a special payroll bank account to disburse payroll.

• Classification of the inputs into a payroll system

• Some examples of payroll controls include the following:

• Many companies provide their employees benefits in addition to salary and

• The liability to pay for employee vacations could be accrued as a liability at

• A pension is a cash payment to retired employees.

• In a defined contribution plan, the company invests contributions on behalf

• One of the more popular defined contribution plans

• In most cases, the employer matches some portion of the employee’s

• If the unfunded pension liability is to be paid within one year, it is reported as

• Manfield Services Company provides its employees with vacation benefits

• Employees may earn rights to other postretirement benefits from their

• The estimate of the annual benefits expense is recorded by debiting

• If a contingent liability is probable and the amount of the liability can be

• Cook-Rite Co. sold $140,000 of kitchen appliances during August under a

• Current position analysis helps creditors evaluate a company’s ability to

• Working capital is computed as follows:

• The current ratio is computed as follows:

• The quick ratio for TechSolutions, Inc., is computed as follows:

a. Compute the quick ratio for 20Y9 and 20Y8.

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