Debt is an obligation to pay on a future date that is recorded as a liability. Long-term liabilities are obligations due for a period of time greater than one year. Obligations that will be paid within a short time, generally less than one year, are current liabilities. there are three types of current liabilities: current portion of long term debt, Accounts Payable and Notes Payable.
Current Portion of Long Term Debt
Some liabilities will last for multiple years. A 30 year mortgage or 5 year car loan are examples of long term debt. These are often paid back in periodic payments, or installments. The installments that are due within the coming year are classified as a current liability. The total amount of installments due after the coming year are classified as long-term liabilities. As an example, Driden Enterprises has the following schedule debt payments for long-term debts:
|Fiscal year ending||Amount|
|Total of Payments||$117,000|
In 2008, $50,000 of the debt would be classified as current liabilities. The remaining $67,000 are classified as long-term liabilities.
We've discussed a little about Accounts Payable in previous articles. Accounts payable come from purchasing goods or services on credit. For most businesses, this is usually the largest portion of their current liability.
We've discussed a little about Notes Payable in previous articles. These are written notes to pay a debt, such as a 90 day 12% note for $1,500. The entry to record the issuance of the note is to debit Accounts Payable (if being used to satisfy a present AP entry) or cash, and credit Notes Payable for the amount issued. When the note matures, Notes Payable is credited for the amount of the note. The interest accrued on the note is credited as an Interest Expense, and the total of both is debited to cash. The interest expense is reported in the Other Expense section of the income statement, and is closed at the end of each cycle.
Payroll and Payroll Taxes
Payroll refers to the amount paid to employees for the services they provide during a period. Salaries and wages paid to employees are an employer's labor expenses. Salary refers to payment for managerial, administrative, or similar services. The rate of salary is normally expressed in terms of a month or a year. Wages refers to payment for skilled and unskilled manual labor. The rate of wages is normally stated on an hourly or weekly basis.
The basic salary or wage of an employee may be increased by commissions, profit sharing, cost-of-living adjustments, or bonuses. Businesses engaged in interstate commerce must follow the requirements of the Fair Labor Standards Act, commonly called the Federal Wage and Hour Law. They are required to pay a minimum rate of 1.5 times the regular rate for all hours worked in excess of 40 hours per week. Exemptions are provided for certain supervisory, administrative and executive positions. Premium rates for working nights, holidays, weekends, or other less desirable times are fairly common, and in some cases, may be as much as twice the base rate.
Deductions from Employee Earnings
Total earnings of an employee for a payroll period are called gross pay. From this, one or more deductions are subtracted to arrive at net pay. Net pay is the amount the employer must pay the employee. The deductions for federal taxes are usually the largest deduction. Other deductions may be made for state or local taxes, medical insurance, contributions to retirement accounts, and items authorized by individual employees.
Income Taxes - Except for certain types of employment, all employers must withhold a portion of employee earnings for payment of the employee's federal income tax. As a basis for determining how much is to be withheld, each employee must complete a W-4, or Employee's Withholding Allowance Certificate. This indicates an employee's marital status, number of withholding allowances, and if any additional withholdings are authorized. The amount that must be withheld differs depending up on each employee's gross pay and completed W-4.
FICA Tax - Employers are required by the Federal Insurance Contributions Act (FICA) to withhold a portion of the earnings of each of the employees. The amount of FICA tax withheld is the employee's contribution to two federal programs. The first programs is social security. The second program is for Medicare. The amount of tax that employers are required to withhold is based on the amount of earnings paid in the calendar year.
Other Deductions -Neither the employer nor the employee have a choice in deducting the taxes from the gross earnings. Employees may choose to have additional amounts withheld for other purposes. For example, the employee may have a retirement savings account, such as a 401k. Also, the employee may have contributions to a charitable organization such as the United Way, or premiums for employee insurance.
Employer's Payroll Taxes Liabilities
Up to this point, we've discussed the deductions from the employee's paycheck for payroll taxes. Most employers are subject to federal and state payroll taxes based on the amount paid their employees. These taxes are an operating expense of the business.
FICA Tax - Employers are required to contribute to the social security and Medicare programs for each employee. The employer must match the employee's contribution to each program. As an example, if a business pays it's employees, and the total of deductions for FICA Tax from their gross pay is $1,000, the company must send this $1,000 on behalf of the employee, along with another $1,000 on behalf of the business to match the employee's contributions, to the government to fund the FICA programs (social security and Medicare).
Federal Unemployment Compensation Tax - The FUTA provides for temporary payments to those that become unemployed as a result of layoffs due to economic causes beyond their control. A tax is levied on employers only, rather than on both employees and employers (as with FICA). The funds collected by the federal government are not paid directly to the unemployed, but are allocated among the states for use in state unemployment programs.
State Unemployment Compensation Tax - SUTA also provides for payments to unemployed workers. The few states require employee contributions, but for the most part, this is also a tax levied only on the employers.
Accounting Systems for Payroll
Although payroll systems differ among businesses, the major elements common to most systems are the payroll register, employee's earnings record and payroll checks.
Payroll Register - The payroll register is a multicolumn report that summarizes the data for each payroll period. The number of hours worked, earnings, and deduction data are placed in the proper columns. The sum of the deductions for each employee is then subtracted from the total earnings to arrive at the net pay. Check numbers are recorded on the payroll register as evidence of payment. The employer's payroll taxes become liabilities when the employees are paid. In addition, employers are required to computer and report payroll taxes on a calendar year basis.
Employee's Earnings Record - The amount of each employee's earnings to date must be available at the end of each payroll period. The cumulative amount is required in order to compute each employee's social security and Medicare tax withholding. Where the payroll register shows the information for all of the employees for one payroll period, the employee's earnings record is for one employee for all payroll periods.
Payroll Checks - Payroll checks are not always actual checks. Many businesses pay by direct deposit. In a case such as this, the employee would receive a pay statement summarizing the details of how pay was computed.
in addition to salary and wages earned, many companies provide fringe benefits to their employees. There are many types of fringe benefits, such as vacations, medical, and post retirement benefits, such as pension plans. When the employer pays part or all of the cost of the fringe benefits, these costs must be recognized as expenses. The estimated cos of these benefits should be recorded as an expense during the period in which the employee earns the benefit.
Most employers grant vacation rights, called compensated absences. Such rights are a liability to the company. The liability pay should be accrued as a liability as the vacation rights are earned. The recording is as a debit to Vacation Pay Expense and a credit to Vacation Pay Payable.
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 time, the estimated pay liability that is applicable to time that will not be taken within one year is a long-term liability.
When vacation time is taken, vacation pay payable is reduced. The entry debits Vacation Pay Payable and credits Salaries Payable, as well as the other related accounts for taxes and withholding.
A pension is a cash payment to retired employees. Rights to pension payments are earned by employees during their working years, based on the pension plan established by the employer. The two types of pension plans are defined contribution plans and defined benefit plans.
Defined Contribution Plan - In a defined contribution plan, a fixed amount of money is invested on the employee's behalf during the employee's working years. It is common for both the employee and employer to make contributions to the plan. One of the most common is the 401k plan. With this plan, the employee bears the investment risk.
Defined Benefit Plan - Employers may choose to promise employees a fixed annual pension benefit as retirement, based on years of service and compensation levels. Pension benefits based on a formula are termed a defined benefit plan. Unlike a defined contribution plan, the employer bears the investment risk in funding a future retirement income benefit.
Some past transactions may result in liabilities if certain events occur in the future. These potential obligations are called contingent liabilities. If the contingent liability is probable, and the amount of the liability can be reasonably estimated, then it should be recorded in the accounts. A vehicle warranty costs are an example of a recordable contingent liability. The warranty costs are probable, and can be estimated, based on past warranties.
If the liability is probable, but cannot be reasonably estimated, or is only possible rather than probable, then the liability should be disclosed in the notes to the financial statement. Common examples of disclosed contingent liabilities are litigation, guarantees, and environmental matters.