Acct 230 1st Edition Lecture 21 Outline of Last Lecture I Long Term Assets a Asset Disposition Outline of Current Lecture II Current Liabilities a Current Liabilities Current Lecture III Current Liabilities a Liability A present responsibility to sacrifice assets in the future due to a transaction or other event that happened in the past b Current liabilities are usually but not always due within one year Notes payable accounts payable and payroll liabilities are the three main categories i Note If a company has an operating cycle longer than one year its current liabilities are defined by the operating cycle rather than by the length of a year c Current liabilities are also sometimes called short term liabilities d Distinguish between current and long term liabilities i Liabilities have three essential characteristics Liabilities are 1 probable future sacrifices of economic benefits 2 arising from present obligations to other entities 3 resulting from past transactions or events ii The definition of liabilities touches on the present the future and the past iii Recall that assets represent probable future benefits In contrast liabilities represent probable future sacrifices of benefits iv In a classified balance sheet we categorize liabilities as either current or long term In most cases current liabilities are payable within one year and long term liabilities are payable more than one year from now These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute v Reporting Current Liabilities 1 Distinguishing between current and long term liabilities helps investors and creditors assess risk 2 Companies often prefer to report a liability as long term because it may cause the firm to appear less risky 3 Many companies list notes payable first followed by accounts payable and then other current liabilities from largest to smallest e Account for Notes Payable and Interest Expense i Notes Payable 1 A company borrowing cash borrower from a bank is required to sign a note promising to repay the amount borrowed plus interest 2 The borrower reports its liability as notes payable 3 Notes payable is a liability that creates interest expense ii Small firms rely heavily on short term financing iii Large companies also use short term debt as a significant part of their capital structure iv Measuring Interest 1 Interest is stated in terms of an annual percentage rate to be applied to the face value of the loan 2 Interest rate is stated as an annual rate 3 When calculating interest for a period less than one year adjust for the fraction of the annual period the loan spans 4 Interest Face value x Annual interest rate x Fraction of the Year v Interest Accrued and Repayment of Note 1 The purpose of the adjusting entry is to report four months interest September October November and December in 2012 Southwest will report the remaining 1 000 of interest for January and February in 2013 Since the firm won t actually pay the 2012 interest until March 1 2013 its financial statements for the year ended December 31 2012 will show interest payable of 2 000 along with notes payable of 100 000 as a current liability on the balance sheet and the other expenses section of the income statement will report interest expense of 2 000 2 When the note comes due on March 1 2013 Southwest Airlines will pay the face value of the loan 100 000 plus the entire 3 000 interest incurred 100 000 6 6 12 The 3 000 represents six months of interest the four months of f interest 2 000 in 2012 previously recorded as interest payable and two months of interest 1 000 in 2013 Southwest makes the following journal entry on March 1 2013 3 The journal entry on March 1 does the following a Removes the note payable 100 000 b Records interest expense for January and February 2013 1 000 c Removes the interest payable recorded in the December 31 2012 entry 2 000 d Reduces cash 103 000 4 Notice that we record interest expense incurred for four months in 2012 and two months in 2013 rather than recording all six months interest expense in 2013 when we pay it This is consistent with the matching principle vi Line of Credit 1 An informal agreement that permits a company to borrow up to a prearranged limit without having to follow formal loan procedures and prepare paperwork a Similar to notes payable except the company is able to borrow without having to go through a formal loan approval process each time it borrows money b Many short term loans are arranged under an existing line of credit with a bank or for larger corporations in the form of commercial paper a loan from one company to another Account for Employee and Employer Payroll Liabilities i Prior to depositing a monthly payroll check an employer withholds 1 Federal and state income taxes 2 Social Security and Medicare 3 Health dental disability and life insurance premiums and 4 Employee investments to retirement or savings plans ii As an employer the costs of hiring an employee are higher than the salary iii Significant costs include iv Federal and state unemployment taxes 1 The employer portion of Social Security and Medicare 2 Employer contributions for health dental disability and life insurance 3 Employer contributions to retirement or savings plans v Summary of Payroll Costs 1 vi Employee Costs 1 Employers are required by law to withhold federal and state income taxes from employees paychecks and remit these taxes to the government 2 FICA taxes Collectively Social Security and Medicare taxes 3 FICA Act requires employers to withhold a 6 2 Social Security tax up to a maximum base amount b 1 45 Medicare tax with no maximum c Total FICA tax is 7 65 6 2 1 45 on income up to a base amount 106 800 in 2010 and 1 45 on all income above the base amount 4 Employees may opt to have additional amounts withheld from their paychecks vii Employer Costs 1 Employer pays an additional matching FICA tax on behalf of the employee 2 Employer s limits on FICA tax are the same as employee s 3 Employer must also pay federal and state unemployment taxes on behalf of the employees 4 FUTA requires a tax of 6 2 on the first 7 000 earned by each employee This amount is reduced by a 5 4 maximum credit for contributions to state unemployment programs so the net federal rate often is 0 8 5 SUTA in many states the maximum state unemployment tax rate is 5 4 but many companies pay a lower rate based on past employment