Current Liabilities and Payroll Study Guide

Overview of Current Liabilities and Payroll

Learning Objectives

• Accounting for certain current liabilities.
• Accounting for uncertain liabilities.
• Determining payroll costs and recording payroll transactions.
• Preparing the current liabilities section of the balance sheet.
• Calculating mandatory payroll deductions (based on Appendix 10A).

Nature and Classification of Liabilities

Definition of Current Liabilities

• Current Liabilities: Present obligations that are expected to be settled within one year of the balance sheet date or within the company's normal operating cycle.

Certain vs. Uncertain Liabilities

Certain Liabilities

These liabilities possess three definitive characteristics:

1. Known Amount: The exact dollar value is established.
2. Known Payee: The entity or individual to whom the money is owed is identified.
3. Known Due Date: The specific timing for settlement is fixed.

Uncertain Liabilities

These are categorized into two types based on their characteristics and the likelihood of the obligation.

1. Provisions

• Definition: A liability exists, but the specific amount and timing of the settlement are uncertain.
• Recognition Criteria: A provision must be recorded as a liability when:
  • Settlement is likely.
  • The amount can be reasonably estimated.
• Examples: Product warranties, customer loyalty programs, and gift cards.

2. Contingencies

• Definition: A possible obligation resulting from past events (e.g., a lawsuit).
• Characteristics: Significant uncertainty regarding the timing, amount, and sometimes even the existence of the liability.
• Accounting Treatment:
  • Likely but cannot be reasonably estimated: No liability is recorded on the balance sheet; however, it must be disclosed in the notes to the financial statements.
  • Unlikely: Generally not disclosed. However, if the event is substantial, it should still be disclosed in the notes. If the event is neither likely nor substantial, no disclosure is required.

Practical Application: Identifying and Classifying Liabilities

Classification Exercise (BE10.17)

• Product warranty: Current Liability.
• Cash received in advance for airline tickets: Current Liability (Unearned Revenue).
• HST (Harmonized Sales Tax) collected on sales: Current Liability.
• Bank indebtedness: Current Liability.
• Interest owing on an overdue account payable: Current Liability.
• Interest due on an overdue account receivable: Current Asset.
• Lawsuit pending (outcome unsure): Contingent Liability (Disclosed in Notes to Financial Statements).
• Amounts withheld from employees’ weekly pay: Current Liability.
• Prepaid property tax: Current Asset.
• Mortgage payable ($75,000$ total, $5,000$ due next year):
  • Current Liability: Current portion of Mortgage Payable ($5,000$).
  • Long-term (Non-current) Liability: Remaining balance ($70,000$).

Liability Type Case Studies (E10.14)

1. Car Model Recall (Brake Problem): Estimated liability. The company knows it must pay, and while the exact cost is unknown, it can be estimated based on the number of cars.
2. Money-back Guarantee (Retail Store): Estimated liability. This is a standard policy where costs are estimated based on historical return rates.
3. Three-year Warranty: Estimated liability. Costs are recognized at the time of sale based on expected future repairs.
4. Sales Promotion (Bottle Cap Prizes): Certain liability. Once the condition is met, the obligation is fixed.
5. Chemical Contamination Lawsuit: Contingent Liability. Because the outcome is being vigorously defended and the amount is uncertain, it is disclosed in notes rather than recorded.

Accounting for Notes Payable

Notes payable represent formal written promises to pay a specific sum of money at a definite future date, typically with interest.

Transaction Example (E10.4: Novack Company)

• June 1, 2028: Purchase equipment on account for $50,000$.
  • Equipment: Dr $50,000$
  • Accounts Payable: Cr $50,000$
• July 1, 2028: Convert account payable into a three-month, $7\%$ note payable.
  • Accounts Payable: Dr $50,000$
  • Notes Payable: Cr $50,000$
• August 1, 2028: Record first monthly interest payment.
  • Calculation: $50,000 \times 0.07 \times \frac{1}{12} = 291.67$ (rounded to $292$ per transcript).
  • Interest Expense: Dr $292$
  • Cash: Cr $292$
• August 31, 2028: Year-end adjusting entry for accrued interest.
  • Interest Expense: Dr $292$
  • Interest Payable: Cr $292$
• September 1, 2028: Payment of the accrued interest.
  • Interest Payable: Dr $292$
  • Cash: Cr $292$
• October 1, 2028: Payment of note maturity (Principal + final month interest).
  • Notes Payable: Dr $50,000$
  • Interest Expense: Dr $292$
  • Cash: Cr $50,292$

Accounting for Warranties

Philosophy

When goods are sold with a warranty, the company knows a liability exists even though the specific units that will fail, the timing of the failure, and the ultimate payee remain unknown at the time of sale. The matching principle requires the expense to be recognized in the same period as the sale.

Case Study 1: Silver Cloud (E10.12)

• Unit Price: $2,000$
• Warranty Estimate: $5\%$ of sales.

Warranty Expense Calculations

• 2026: $500 \text{ units} \times 2,000 \times 0.05 = 50,000$
• 2027: $600 \text{ units} \times 2,000 \times 0.05 = 60,000$
• 2028: $525 \text{ units} \times 2,000 \times 0.05 = 52,500$

Warranty Liability Tracking (T-Account)

• End of 2026: Accrued $50,000$, Actual Costs $30,000$. Balance: $20,000$.
• End of 2027: Beginning balance $20,000$ + Accrued $60,000$ - Actual Costs $46,000$. Balance: $34,000$.
• End of 2028: Beginning balance $34,000$ + Accrued $52,500$ - Actual Costs $53,500$. Balance: $33,000$.

Case Study 2: Gametime Inc. (E10.11)

• Parameters: $60$-day warranty. Estimate: $3\%$ of units become defective. Average repair/replacement cost: $50$ per unit.
• Sales History:
  • November: $30,000$ units sold.
  • December: $32,000$ units sold.
  • Total Units for 2028: $62,000$ units.

Accrual Entry (December 31, 2028)

• Calculation: $62,000 \text{ units} \times 0.03 = 1,860 \text{ defective units}$.
• Total Estimated Cost: $1,860 \times 50 = 93,000$.
• Journal Entry:
  • Warranty Expense: Dr $93,000$
  • Warranty Liability: Cr $93,000$

Recording Actual Costs

• Total actual cost of replacing units returned in Nov/Dec: $43,200$.
• Journal Entry:
  • Warranty Liability: Dr $43,200$
  • Merchandise Inventory: Cr $43,200$

Financial Statement Impact (2028)

• Income Statement: Operating Expense (Warranty Expense) of $93,000$.
• Balance Sheet: Current Liability (Warranty Liability) of $49,800$ ($93,000 - 43,200$).

Payroll Accounting

Payroll costs are split into two categories: costs paid by the employee (withheld by the employer) and costs paid directly by the employer.

1. Employee Costs

• Gross Pay: The total amount earned by the employee before any deductions.
• Net Pay: Gross Pay - Total Deductions.
• Mandatory Deductions: Required by law. Includes Personal Income Tax, Canada Pension Plan (CPP), and Employment Insurance (EI). These are determined using payroll deduction tables.
• Voluntary Deductions: Includes charitable contributions, retirement savings, and insurance premiums. These require written authorization from the employee and are not an expense to the employer.

2. Employer Costs

• Required Government Contributions:
  • CPP: Employer must match the employee's contribution ($1:1$).
  • EI: Employer must contribute $1.4\times$ the employee's contribution.
  • Other: Workplace health, safety, and compensation premiums.
• Employee Benefits:
  • Paid Absences: Sick days, vacation pay, and statutory holidays.
  • Post-employment benefits: Benefits provided to retired employees.

Payroll Calculation Exercise (BE10.14: Becky Sherrick)

• Regular Rate: $20.00/\text{hr}$. Overtime: Rate and a half ($30.00/\text{hr}$) for hours over $40$.
• Hours Worked: $46$ hours ($40$ regular, $6$ overtime).
• Deductions: CPP $54.31$, EI $16.27$, Income Tax $132.45$.

(a) Gross and Net Pay

• Gross Pay:
  • Regular: $40 \times 20 = 800$
  • Overtime: $6 \times 30 = 180$
  • Total Gross: $980$
• Total Deductions: $54.31 + 16.27 + 132.45 = 203.03$
• Net Pay: $980 - 203.03 = 776.97$

(b) Employer Costs

• Employer CPP: Match employee amount = $54.31$
• Employer EI: $16.27 \times 1.4 = 22.78$
• Total Employer Payroll Taxes: $54.31 + 22.78 = 77.09$

Comprehensive Payroll Transaction (E10.16: Hidden Dragon Restaurant)

• Gross Payroll (April): $46,600$
• Employee Deductions: CPP $2,773$, EI $774$, Income Tax $9,553$.
• Employer Metrics: Workers' comp $1\%$, Vacation pay $4\%$.

(a) Payroll Payment Entry (April 30)

• Salary Expense: Dr $46,600$
• CPP Payable: Cr $2,773$
• EI Payable: Cr $774$
• Income Tax Payable: Cr $9,553$
• Cash (Net Pay): Cr $33,500$

(b) Accruing Employer Costs (April 30)

• Calculations:
  • Employer CPP: $2,773$
  • Employer EI: $774 \times 1.4 = 1,084$
  • Workers' Comp: $46,600 \times 0.01 = 466$
  • Vacation Pay: $46,600 \times 0.04 = 1,864$
  • Total Employee Benefit Expense: $2,773 + 1,084 + 466 + 1,864 = 6,187$
• Journal Entry:
  • Employee Benefit Expense: Dr $6,187$
  • CPP Payable: Cr $2,773$
  • EI Payable: Cr $1,084$
  • Workers’ Compensation Payable: Cr $466$
  • Vacation Pay Payable: Cr $1,864$

(c) Remittance to Receiver General (May 15)

• Journal Entry:
  • CPP Payable ($2,773 \text{ employee} + 2,773 \text{ employer}$): Dr $5,546$
  • EI Payable ($774 \text{ employee} + 1,084 \text{ employer}$): Dr $1,858$
  • Income Tax Payable: Dr $9,553$
  • Cash: Cr $16,957$

Balance Sheet Presentation

Example: Medlen Models (Partial Balance Sheet)

Medlen had the following data at Dec 31, 2028:

• Notes Payable: $100,000$ (with $60,000$ due after 2029, meaning $40,000$ is current).
• Mortgage Payable: $250,000$ (with $90,000$ due in 2029).
• Lawsuit: Probable damages of $25,000$ in 2029 (Litigation Liability).
• Unearned Revenue: $70,000$.
• Salaries Payable: $32,000$.
• Accounts Payable: $63,000$.

Medlen Models Partial Balance Sheet

Current Liabilities

• Accounts payable: $63,000$
• Salaries payable: $32,000$
• Unearned revenue: $70,000$
• Notes Payable—current portion: $40,000$
• Litigation liability: $25,000$
• Mortgage payable—current portion: $90,000$
• Total current liabilities: $320,000$

Internal Control for Payroll

• Objectives of internal control for payroll include ensuring that payments are made only to legitimate employees for work actually performed, and that all payroll transactions are recorded accurately to comply with government regulations.
• Implementation typically involves segregation of duties (e.g., the person maintaining personnel files should not be the person distributing checks).