Chapter 8: Current liabilities and payroll

Liabilities are what a company owes. This chapter deals with current liabilities, debts due within a year: those whose amount is known (accounts payable, sales tax, unearned revenue, short-term notes, the current part of long-term debt), payroll, liabilities that must be estimated (bonuses, vacation pay, warranties) and contingent liabilities that may or may not arise. It ends with the times-interest-earned ratio.

What a liability is

A liability has three characteristics: it results from a past transaction or event, it creates a present obligation to pay cash or deliver goods or services in the future, and the obligation is unavoidable. Current liabilities must be paid within one year or the operating cycle; long-term liabilities later (notes payable, mortgages, bonds; chapter 9).

Current liabilities of known amount

Accounts payable arise from buying goods or services on credit.

Sales tax payable. In the US the seller adds sales tax to the price and passes it on to the state (comparable to Dutch VAT). It is not an expense of the business but a liability. December taxable sales of $10,000 with 6% sales tax: Dr Cash 10,600, Cr Sales revenue 10,000, Cr Sales tax payable 600. When the tax is paid: Dr Sales tax payable 600, Cr Cash 600.

Unearned revenue (deferred revenue): cash received before the work is done. $900 received in advance for a month's work; when one third is done, Dr Unearned revenue 300, Cr Service revenue 300.

Short-term notes payable: a written promise to pay, usually with interest, within a year. Merchandise of $8,000 bought on 1 May with a 10%, 90-day note: at maturity the company pays principal plus interest of 8,000 × 0.10 × 90/365 = $197 (Dr Notes payable 8,000, Dr Interest expense 197, Cr Cash 8,197). A $10,000 bank loan at 6% for five months taken on 1 November requires an accrual of two months' interest at 31 December: 10,000 × 0.06 × 2/12 = $100 (Dr Interest expense, Cr Interest payable). The other $150 belongs to the next year.

Current portion of long-term notes payable. When long-term debt is repaid in instalments, the part due within the next year is reported as a current liability; the rest stays long-term. No journal entry is needed to reclassify it.

Payroll

Payroll (employee compensation) is a major expense, especially for service firms. Pay can take the form of salary, wages (hourly), commission, bonus and benefits. Two amounts matter:

• Gross pay: everything the employee earned in the period (salary, wages, commissions, bonuses).
• Net pay (take-home pay): gross pay minus withholdings.

Example: an employee earns $15 an hour for a 40-hour week and time-and-a-half ($22.50) for overtime. For 42 hours gross pay is 40 × 15 + 2 × 22.50 = $645.

Withholding deductions are required (income tax, social security tax) or optional (insurance premiums, retirement contributions, charitable gifts). The employer withholds them and pays them on to the government or other parties, so until then they are liabilities. The employer also pays its own payroll taxes on top of gross pay (in the US: the employer's share of social security and unemployment taxes), which are an extra expense.

In this example from the solutions social security is 6.2% + 1.45% of $4,900 ($304 + $71). The employer's matching payroll tax is recorded separately: Dr Payroll tax expense 375, Cr the two tax payable accounts. Gross pay is the expense; withholdings are liabilities until paid.

Companies keep a payroll register that lists, per employee and pay period, the hours, gross pay, every deduction and net pay. Its column totals feed the payroll journal entry. On payday the company pays the net amount to its employees (Dr Salaries payable, Cr Cash); later it pays the withheld amounts and its own payroll taxes to the government and other parties (Dr each payable, Cr Cash).

The tax names (income tax, social security, unemployment tax) are American; in the Netherlands the employer withholds loonheffing and pays employer contributions, but the accounting logic is identical.

Current liabilities that must be estimated

Sometimes a liability clearly exists but its exact amount is unknown. It must still be estimated and reported. Examples: bonus plans, vacation pay, health and pension benefits, warranties.

Bonus. Smart Touch Learning pays a 5% bonus on net income after deducting the bonus itself. Net income before the bonus is $315,000. If B is the bonus, B = 0.05 × (315,000 − B), so

Entry: Dr Employee bonus expense 15,000, Cr Employee bonus payable 15,000.

Warranties. The matching principle requires warranty expense to be recorded in the period of the sale, not when repairs happen. Sales of $50,000 with estimated warranty costs of 3%: Dr Warranty expense 1,500, Cr Estimated warranty payable 1,500. When customers later claim $800 of replacements: Dr Estimated warranty payable 800, Cr Merchandise inventory 800. The claim does not create a new expense.

Contingent liabilities

A contingent liability is a potential liability that depends on a future event, for example the outcome of a lawsuit. The treatment depends on how likely the event is:

Example: a customer sues a company for $100,000 after an accident in its shop. If the company's lawyers think losing is remote, nothing is reported. If losing is reasonably possible, a note describes the lawsuit. If losing is probable and the lawyers expect a settlement of about $60,000, the company records Dr Lawsuit loss (expense) 60,000, Cr Estimated lawsuit liability 60,000. The rule follows from faithful representation and prudence: users must not be surprised by a likely obligation, but the balance sheet is not loaded with every remote possibility.

Times-interest-earned ratio

The numerator is operating income before interest and taxes (EBIT). The ratio, also called the interest-coverage ratio, shows how many times the company can pay its interest from its earnings; higher is safer. Kohl's 2018: (801 + 241 + 256) / 256 = 5.07; 2017: (859 + 258 + 299) / 299 = 4.74, so coverage improved.