Completing theOperating CycleCompleting theOperating Cycle

C H A P T E R 8

Learning Objective 1

Account for the various components of employee compensation expense.

Describe the Employee Compensation Time Line

Time

Payroll Compen-sated

AbsencesStock

Options and

Bonuses

Post-employ-

ment Benefits

Pensions and Post-retirement Benefits

Other than

Pensions

Salaries and wages earned by employees in the current period. What are the correct journal entries?

Accounting for salaries of $2,700: When employees work:

Payroll

Salaries Expense. . . . . . . . . . . . . . . . . . . . .2,700Salaries Payable . . . . . . . . . . . . . . . . . . 2,700

Salaries Payable. . . . . . . . . . . . . . . . . . . . . . 2,700Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,700

When wages are paid:

However, accounting for salaries and related payroll taxes is never this simple.

Recording the payment of this payable is similar to journal entry to record payment of every payable. The payable is debited and cash is credited.

WithholdingsWhich taxes must employers withhold from employees’ salaries and wages?

Federal and state income taxes.

Social Security (FICA) taxes.

Voluntary or contractual withholdings (union dues, medical insurance premiums, and charitable donations).

They are not additional expenses to the employer since the employee pays the taxes. The business acts as agent to assist in the collection of funds for the government or organization.

Salaries Expense Entry

Salaries Expense. . . . . . . . . . . . . . . . . . . . . . 2,700FICA Taxes Payable, Employee. . . . . . . 180Federal Withholding Taxes Payable . . . 486State Withholding Taxes Payable . . . . . 243Union Dues Payable . . . . . . . . . . . . . . . . 68Salaries Payable . . . . . . . . . . . . . . . . . . . 1723

To record Sally Wage’s salary.

Sally Wage works for you and earns $32,400 annually. Make the appropriate journal entry for Sally’s January salary.

Payroll Tax Expense Entry

Payroll Tax Expense. . . . . . . . . . . . . . . . . . . 278FICA Taxes Payable, Employer . . . . . . .

180Federal Unemployment Taxes Payable.

30State Unemployment Taxes Payable. . .

68

To record liabilities associated with Sally Wage’s salary.

Now that the appropriate journal entry is made for Sally’s wages, make the entry to record your company’s portion.

Compensated Absences Matching principle

The expense associated with the compensated absence must be accounted for in the period in which it is earned by the employee.

Therefore, the expense is estimated.

Salaries Expense . . . . . . . . . . . . . . . . . . . . 125Sick Days Payable . . . . . . . . . . . . . . . . 125

To recognize accrued sick pay.Journal entry when the sick day is actually taken:

Sick Days Payable . . . . . . . . . . . . . . . . . . . 125Various Taxes Payables. . . . . . . . . . . .

35Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . .

90

To record payment of sick day net of FICA, federal, and state taxes.

Describe Bonuses and Stock Options

Employees, generally top management, may have the option to purchase stock in the future at a price specified today.

Generally, the stock is presently selling at an amount below the option price.

The objective is to provide management with an incentive to effectively run the company in such a way that the stock price increases.

Bonuses and Stock Options

Salaries Expense . . . . . . . . . . . . . . . . . . . . 150,000Various Taxes Payables. . . . . . . . . . . . 60,000Bonus Payable . . . . . . . . . . . . . . . . . . . 90,000

To record bonus earned by Mr. Will Fences.

Your firm met its target goals this year. Your President, Mr. Will Fences, is therefore entitled to a bonus. His annual salary is $1 million and his bonus is 15 percent, payable at the end of the year. Make the appropriate December 31 journal entry for the bonus.

Post-employment Benefits Those benefits incurred after an employee has

ceased to work for an employer but before that employee retires.

Examples: severance packages, retraining costs, education costs.

Journal entry when estimated salaries are $2,000:

Salaries Expense . . . . . . . . . . . . . . . . . . . . 2,000Benefits Payable. . . . . . . . . . . . . . . . . . 2,000

To record post-employment benefits for laid-off employees.

When paid, a journal entry is made to reduce the payable and to record the cash outflow.

Define Pensions Compensation received by an employee after retirement. Defined contribution plan.

Employer sets aside money to be paid followingretirement.

Employee gets what was contributed plus theearnings.

Defined benefit plan. Benefits based on number of years worked. Employee gets whatever benefit is defined in

the plan. Company attempts to determine costs to be paid in the

future and records an estimate in the current period.

Learning Objective 2

Compute income taxexpense includingappropriate considerationof deferred taxitems.

Taxes on OperationsWhat other taxes are companies responsible to pay?

Sales Taxes

Property Taxes

Income Taxes

Michael’s Mowers sold a lawnmower for $340. What is the journal entry assuming the state charges a 5 percent sales tax?

Example: Sales Taxes

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357Sales Revenue. . . . . . . . . . . . . . . . . . 340Sales Tax Payable. . . . . . . . . . . . . . . 17

From sale of lawnmower, including 5% sales tax.

Example: Property Taxes

12/31/03 Property Tax Expense . . . . . . 6,200 Property Tax Payable. . . . . 6,200

To record property tax expense and liability to Greenlawn City.

The City of Greenlawn assesses property taxes on land and buildings. Michael’s Mowers pays its property taxes on a calendar-year basis and owes Greenlawn $6,200 for 2004. Make Michael’s appropriate journal entry.

Example: Income Taxes

Michael’s Mowers pretax income is $385,000. Its income tax rate for 2003 for both federal and state is 30 percent. Prepare an adjusting entry at year-end showing the company’s tax expense.

12/31/03 Income Tax Expense . . . . . . . .115,500 Income Tax Payable. . . . . . . 115,500

To record income tax expense and tax liability on $385,000 pretax income for 2001 using a 30 percent effective tax rate.

Learning Objective 3

Distinguish between contingent items that should be recognized in the financial statements and those that should be merely disclosed in the financial statement notes.

Contingencies Contingency: An event that

may or may not occur. Accounting standard setters

say proper disclosure depends upon the assessed outcome.

Terms used to describe contingencies: probable, reasonably possible, and remote.

A firm must obtain objective assessments and then account for those events based on that assessment.

Contingent Liabilities

Term Definition Accounting

Reasonably The chance of the future Provide detailed possible event occurring is more disclosure of the

than remote but less than possible liability inlikely. the notes.

Probable The future event is likely Estimate the amount to occur. of the

contingency and make the appropriate

journal entry; provide detailed disclosure in the notes.

Remote The chance of the future No disclosure event occurring is slight.required.

Learning Objective 4

Understand when an expenditure should be recorded as an asset and when it should be recorded as an expense.

Describe the Expense/Asset Continuum

Expense Asset

Land and

BuildingResearch and DevelopmentRepairs

Office Supplies

Used

Michael’s builds a new $1 million store. Should it simply show this as an expense or capitalize it as an asset?

Expense or Capitalize?Why the Debate?

If Michael’s chooses not to capitalize, the company’s financial statements will be misstated.

The income statement in Year 1 will have too much expense. The income statements for Years 2 through 20 will contain too

little expense. Potential investors may invest elsewhere because of the low

net income figure resulting from the large expense. The balance sheet will not show an item that is expected to

benefit future periods. Bad resource allocation decisions could result.

Learning Objective 5Prepare an income statement summarizing operating activities as well as other revenues and expenses, extraordinary items, and earnings per share.

Income StatementPut these major components of an Income Statement in correct order:

Net sales revenue Net income Sales revenue Cost of goods sold Operating expenses Operating income

261345

Revenues– Cost of goods sold= Gross margin

– Selling expenses– General and administrative expenses= Operating income

+/– Other revenues and expenses= Income before taxes

– Income tax= Income after taxes

+/– Extraordinary items= Net income

Income Statement Format

Define Other Revenue and Expenses

Those items incurred or earned from activities that are outside of, or peripheral to, the normal operations of a firm.

For example, Michael’s Mowers sponsored a local little league team. Its expense for uniforms may be shown under “Other Revenues and Expenses.”

Define Extraordinary Items Reserved for reporting special non-operating gains

and losses. Restrictive and includes only those items that are:

unusual in natureinfrequent in occurrencematerial in amount

Separate so financial statement users can know they are one-time or nonrecurring events.

Examples: losses from floods, fires, earthquakes.

Define Earnings per Share EPS is required on the income statement. If extraordinary items are included, EPS

figures are reported on income before extraordinary items, on extraordinary items, and on net income.

Allows potential investors to compare profitability across firms of different sizes.

How do you do the calculation?

Net income

Average number of shares outstanding