Skip to Content
OpenStax Logo
Principles of Accounting, Volume 1: Financial Accounting

12.2 Analyze, Journalize, and Report Current Liabilities

Principles of Accounting, Volume 1: Financial Accounting12.2 Analyze, Journalize, and Report Current Liabilities
Buy book
  1. Preface
  2. 1 Role of Accounting in Society
    1. Why It Matters
    2. 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
    3. 1.2 Identify Users of Accounting Information and How They Apply Information
    4. 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
    5. 1.4 Explain Why Accounting Is Important to Business Stakeholders
    6. 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
  3. 2 Introduction to Financial Statements
    1. Why It Matters
    2. 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
    3. 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
    4. 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Analyzing and Recording Transactions
    1. Why It Matters
    2. 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
    3. 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
    4. 3.3 Define and Describe the Initial Steps in the Accounting Cycle
    5. 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
    6. 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
    7. 3.6 Prepare a Trial Balance
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  5. 4 The Adjustment Process
    1. Why It Matters
    2. 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
    3. 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
    4. 4.3 Record and Post the Common Types of Adjusting Entries
    5. 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
    6. 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  6. 5 Completing the Accounting Cycle
    1. Why It Matters
    2. 5.1 Describe and Prepare Closing Entries for a Business
    3. 5.2 Prepare a Post-Closing Trial Balance
    4. 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
    5. 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  7. 6 Merchandising Transactions
    1. Why It Matters
    2. 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
    3. 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
    4. 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
    5. 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
    6. 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
    7. 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
    8. 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  8. 7 Accounting Information Systems
    1. Why It Matters
    2. 7.1 Define and Describe the Components of an Accounting Information System
    3. 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
    4. 7.3 Analyze and Journalize Transactions Using Special Journals
    5. 7.4 Prepare a Subsidiary Ledger
    6. 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Fraud, Internal Controls, and Cash
    1. Why It Matters
    2. 8.1 Analyze Fraud in the Accounting Workplace
    3. 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
    4. 8.3 Describe Internal Controls within an Organization
    5. 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
    6. 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
    7. 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
    8. 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  10. 9 Accounting for Receivables
    1. Why It Matters
    2. 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
    3. 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
    4. 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
    5. 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
    6. 9.5 Apply Revenue Recognition Principles to Long-Term Projects
    7. 9.6 Explain How Notes Receivable and Accounts Receivable Differ
    8. 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  11. 10 Inventory
    1. Why It Matters
    2. 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
    3. 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
    4. 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
    5. 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
    6. 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  12. 11 Long-Term Assets
    1. Why It Matters
    2. 11.1 Distinguish between Tangible and Intangible Assets
    3. 11.2 Analyze and Classify Capitalized Costs versus Expenses
    4. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
    5. 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
    6. 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Current Liabilities
    1. Why It Matters
    2. 12.1 Identify and Describe Current Liabilities
    3. 12.2 Analyze, Journalize, and Report Current Liabilities
    4. 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
    5. 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
    6. 12.5 Record Transactions Incurred in Preparing Payroll
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  14. 13 Long-Term Liabilities
    1. Why It Matters
    2. 13.1 Explain the Pricing of Long-Term Liabilities
    3. 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
    4. 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
    5. 13.4 Appendix: Special Topics Related to Long-Term Liabilities
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  15. 14 Corporation Accounting
    1. Why It Matters
    2. 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
    3. 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
    4. 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
    5. 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
    6. 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  16. 15 Partnership Accounting
    1. Why It Matters
    2. 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
    3. 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
    4. 15.3 Compute and Allocate Partners’ Share of Income and Loss
    5. 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
    6. 15.5 Discuss and Record Entries for the Dissolution of a Partnership
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  17. 16 Statement of Cash Flows
    1. Why It Matters
    2. 16.1 Explain the Purpose of the Statement of Cash Flows
    3. 16.2 Differentiate between Operating, Investing, and Financing Activities
    4. 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
    5. 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
    6. 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
    7. 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  18. Financial Statement Analysis
  19. Time Value of Money
  20. Suggested Resources
  21. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
  22. Index

To illustrate current liability entries, we use transaction information from Sierra Sports (see Figure 12.6). Sierra Sports owns and operates a sporting goods store in the Southwest specializing in sports apparel and equipment. The company engages in regular business activities with suppliers, creditors, customers, and employees.

Image shows the Sierra Sports logo. The logo has three mountain tops, colored in white, blue, green, and orange shades.
Figure 12.6 Sierra Sports Logo. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Accounts Payable

On August 1, Sierra Sports purchases $12,000 of soccer equipment from a manufacturer (supplier) on credit. Assume for the following examples that Sierra Sports uses the perpetual inventory method, which uses the Inventory account when the company buys, sells, or adjusts the inventory balance, such as in the following example where they qualified for a discount. In the current transaction, credit terms are 2/10, n/30, the invoice date is August 1, and shipping charges are FOB shipping point (which is included in the purchase cost).

Recall from Merchandising Transactions, that credit terms of 2/10, n/30 signal the payment terms and discount, and FOB shipping point establishes the point of merchandise ownership, the responsibility during transit, and which entity pays shipping charges. Therefore, 2/10, n/30 means Sierra Sports has ten days to pay its balance due to receive a 2% discount, otherwise Sierra Sports has net thirty days, in this case August 31, to pay in full but not receive a discount. FOB shipping point signals that since Sierra Sports takes ownership of the merchandise when it leaves the manufacturer, it takes responsibility for the merchandise in transit and will pay the shipping charges.

Sierra Sports would make the following journal entry on August 1.

A journal entry is made on August 1 and shows a Debit to Inventory for $12,000, and a credit to Accounts payable for $12,000, with the note “To recognize the purchase of equipment on credit, terms 2 / 10, n / 30, invoice date August 1.”

The merchandise is purchased from the supplier on credit. In this case, Accounts Payable would increase (a credit) for the full amount due. Inventory, the asset account, would increase (a debit) for the purchase price of the merchandise.

If Sierra Sports pays the full amount owed on August 10, it qualifies for the discount, and the following entry would occur.

A journal entry is made on August 10 and shows a Debit to Accounts payable for $12,000, a credit to Inventory for $240, and a credit to Cash for $11,760 with the note “To recognize payment of the amount due, less discount.”

Assume that the payment to the manufacturer occurs within the discount period of ten days (2/10, n/30) and is recognized in the entry. Accounts Payable decreases (debit) for the original amount due, Inventory decreases (credit) for the discount amount of $240 ($12,000 × 2%), and Cash decreases (credit) for the remaining balance due after discount.

Note that Inventory is decreased in this entry because the value of the merchandise (soccer equipment) is reduced. When applying the perpetual inventory method, this reduction is required by generally accepted accounting principles (GAAP) (under the cost principle) to reflect the actual cost of the merchandise.

A second possibility is that Sierra will return part of the purchase before the ten-day discount window has expired. Assume in this example that $1,000 of the $12,000 purchase was returned to the seller on August 8 and the remaining account payable due was paid by Sierra to the seller on August 10, which means that Sierra qualified for the remaining eligible discount. The following two journal entries represent the return of inventory and the subsequent payment for the remaining account payable owed. The initial journal entry from August 1 will still apply, because we assume that Sierra intended to keep the full $12,000 of inventory when the purchase was made.

When the $1,000 in inventory was returned on August 8, the accounts payable account and the inventory accounts should be reduced by $1,000 as demonstrated in this journal entry.

A journal entry is made on August 8 and shows a Debit to Accounts payable for $1,000, and a credit to Inventory for $1,000, with the note “To recognize return of inventory purchased.”

After this transaction, Sierra still owed $11,000 and still had $11,000 in inventory from the purchase, assuming that Sierra had not sold any of it yet.

When Sierra paid the remaining balance on August 10, the company qualified for the discount. However, since Sierra only owed a remaining balance of $11,000 and not the original $12,000, the discount received was 2% of $11,000, or $220, as demonstrated in this journal entry. Since Sierra owed $11,000 and received a discount of $220, the supplier was paid $10,780. This second journal entry is the same as the one that would have recognized an original purchase of $11,000 that qualified for a discount.

A journal entry is made on August 8 and shows a Debit to Accounts payable for $11,000, a credit to Inventory for $220, and a credit to Cash for $10,780 with the note “To recognize payment of remaining accounts payable balance after qualifying for the discount.”

Remember that since we are assuming that Sierra was using the perpetual inventory method, purchases, payments, and adjustments in goods available for sale are reflected in the company’s Inventory account. In our example, one of the potential adjustments is that discounts received are recorded as reductions to the Inventory account.

To demonstrate this concept, after buying $12,000 in inventory, returning $1,000 in inventory, and then paying for the remaining balance and qualifying for the discount, Sierra’s Inventory balance increased by $10,780, as shown.

The image shows the Inventory account of the Sierra Sports company. Initial inventory purchase (August 1) $12,000, minus Return of inventory (August 8) $1,000, equals the subtotal (August 9) of $11,000, minus Discount allowed August 10 (reduction in inventory) of $220, equals Final inventory after account payable of $10,780.

If Sierra had bought $11,000 of inventory on August 1 and paid cash and taken the discount, after taking the $220 discount, the increase of Inventory on their balance sheet would have been $10,780, as it finally ended up being in our more complicated set of transactions on three different days. The important factor is that the company qualified for a 2% discount on inventory that had a retail price before discounts of $11,000.

In a final possible scenario, assume that Sierra Sports remitted payment outside of the discount window on August 28, but inside of thirty days. In this case, they did not qualify for the discount, and assuming that they made no returns they paid the full, undiscounted balance of $12,000.

A journal entry is made on August 28 and shows a Debit to Accounts payable for $12,000, and a credit to Cash for $12,000, with the note “To recognize payment of the amount due, no discount applied.”

If this occurred, both Accounts Payable and Cash decreased by $12,000. Inventory is not affected in this instance because the full cost of the merchandise was paid; so, the increase in value for the inventory was $12,000, and not the $11,760 value determined in our beginning transactions where they qualified for the discount.

Your Turn

Accounting for Advance Payments

You are the owner of a catering company and require advance payments from clients before providing catering services. You receive an order from the Coopers, who would like you to cater their wedding on June 10. The Coopers pay you $5,500 cash on March 25. Record your journal entries for the initial payment from the Coopers, and when the catering service has been provided on June 10.

Solution

The first journal entry is made on March 25 and shows a Debit to Cash for $5,500, a credit to Unearned catering revenue for $5,500 with the note “To recognize advanced payment from client.” The second journal entry is made on June 10, and shows a Debit to Unearned Catering revenue for $5,500 and a credit to Catering revenue for $5,500 with the note “To recognize catering revenue earned.”

Unearned Revenue

Sierra Sports has contracted with a local youth football league to provide all uniforms for participating teams. The league pays for the uniforms in advance, and Sierra Sports provides the customized uniforms shortly after purchase. The following situation shows the journal entry for the initial purchase with cash. Assume the league pays Sierra Sports for twenty uniforms (cost per uniform is $30, for a total of $600) on April 3.

A journal entry is made on April 3 and shows a Debit to Cash for $600, and a credit to unearned uniform revenue for $600, with the note “To recognize advanced payment for 20 uniforms at $30 each.”

Sierra Sports would see an increase to Cash (debit) for the payment made from the football league. The revenue from the sale of the uniforms is $600 (20 uniforms × $30 per uniform). Unearned Uniform Revenue accounts reflect the prepayment from the league, which cannot be recognized as earned revenue until the uniforms are provided. Unearned Uniform Revenue is a current liability account that increases (credit) with the increase in outstanding product debt.

Sierra provides the uniforms on May 6 and records the following entry.

A journal entry is made on May 6 and shows a Debit to Unearned uniform revenue for $600, and a credit to Uniform revenue for $600, with the note “To recognize uniform revenue as earned.” A second journal entry on May 6 shows a Debit to Cost of goods sold for $280, and a credit to Inventory for $280, with the note “To recognize cost of goods sold of uniform sales.”

Now that Sierra has provided all of the uniforms, the unearned revenue can be recognized as earned. This satisfies the revenue recognition principle. Therefore, Unearned Uniform Revenue would decrease (debit), and Uniform Revenue would increase (credit) for the total amount.

Let’s say that Sierra only provides half the uniforms on May 6 and supplies the rest of the order on June 2. The company may not recognize revenue until a product (or a portion of a product) has been provided. This means only half the revenue can be recognized on May 6 ($300) because only half of the uniforms were provided. The rest of the revenue recognition will have to wait until June 2. Since only half of the uniforms were delivered on May 6, only half of the costs of goods sold would be recognized on May 6. The other half of the costs of goods sold would be recognized on June 2 when the other half of the uniforms were delivered. The following entries show the separate entries for partial revenue recognition.

A journal entry is made on May 6 and shows a Debit to Unearned uniform revenue for $300, and a credit to Uniform revenue for $300, with the note “To recognize partial uniform revenue as earned.” A second journal entry on May 6 shows a Debit to Cost of goods sold for $140, and a credit to Inventory for $140, with the note “To recognize cost of goods sold of uniform sales.” A second journal entry is made on June 2 and shows a Debit to Unearned uniform revenue for $300, and a credit to Uniform revenue for $300, with the note “To recognize partial uniform revenue as earned.” A second journal entry on May 6 shows a Debit to Cost of goods sold for $140, and a credit to Inventory for $140, with the note “To recognize cost of goods sold of uniform sales.”

In another scenario using the same cost information, assume that on April 3, the league contracted for the production of the uniforms on credit with terms 5/10, n/30. They signed a contract for the production of the uniforms, so an account receivable was created for Sierra, as shown.

A journal entry is made on April 3 and shows a Debit to Accounts receivable for $600, and a credit to Unearned Revenue: Uniforms for $600, with the note “To recognize advanced payment on credit for 20 uniforms (5 / 10, n / 30).”

Sierra and the league have worked out credit terms and a discount agreement. As such, the league can delay cash payment for ten days and receive a discount, or for thirty days with no discount assessed. Instead of cash increasing for Sierra, Accounts Receivable increases (debit) for the amount the football league owes.

The league pays for the uniforms on April 15, and Sierra provides all uniforms on May 6. The following entry shows the payment on credit.

A journal entry is made on April 15 and shows a Debit to Cast for $600, and a credit to Accounts Receivable for $600, with the note “To recognize payment of the amount due; no discount applied.”

The football league made payment outside of the discount period, since April 15 is more than ten days from the invoice date. Thus, they do not receive the 5% discount. Cash increases (debit) for the $600 paid by the football league, and Accounts Receivable decreases (credit).

In the next example, let’s assume that the league made payment within the discount window, on April 13. The following entry occurs.

A journal entry is made on April 13 and shows a Debit to Cash for $570, a debit to Sales discount for $30, and a credit to Accounts receivable for $600, with the note “To recognize league payment with 5 percent discount.”

In this case, Accounts Receivable decreases (credit) for the original amount owed, Sales Discount increases (debit) for the discount amount of $30 ($600 × 5%), and Cash increases (debit) for the $570 paid by the football league less discount.

When the company provides the uniforms on May 6, Unearned Uniform Revenue decreases (debit) and Uniform Revenue increases (credit) for $600.

A journal entry is made on May 6 and shows a Debit to Unearned Revenue: Uniforms for $600, and a credit to Revenue: Uniforms for $600, with the note “To recognize uniform revenue as earned.”

Ethical Considerations

Stock Options and Unearned Revenue Manipulation

The anticipated income of public companies is projected by stock market analysts through whisper-earnings, or forecasted earnings. It can be advantageous for a company to have its stock beat the stock market’s expectation of earnings. Likewise, falling below the market’s expectation can be a disadvantage. If a company’s whisper-earnings are not going to be met, there could be pressure on the chief financial officer to misrepresent earnings through manipulation of unearned revenue accounts to better match the stock market’s expectation.

Because many executives, other top management, and even employees have stock options, this can also provide incentive to manipulate earnings. A stock option sets a minimum price for the stock on a certain date. This is the date the option vests, at what is commonly called the strike price. Options are worthless if the stock price on the vesting date is lower than the price at which they were granted. This could result in a loss of income, potentially incentivizing earnings manipulation to meet the stock market’s expectations and exceed the vested stock price in the option.

Researchers have found that when executive options are about to vest, companies are more likely to present financial statements meeting or just slightly beating the earnings forecasts of analysts. The proximity of the actual earnings to earnings forecasts suggests they were manipulated because of the vesting.2 As Douglas R. Carmichael points out, “public companies that fail to report quarterly earnings which meet or exceed analysts’ expectations often experience a drop in their stock prices. This can lead to practices that sometimes include fraudulent overstatement of quarterly revenue.”3 If earnings meet or exceed expectations, a stock price can hit or surpass the vested stock price in the option. For company members with stock options, this could result in higher income. Thus, financial statements that align closely with analysts’ estimates, rather than showing large projections above or below whisper-earnings, could indicate that accounting information has possibly been adjusted to meet the expected numbers. Such manipulations can be made in unearned revenue accounts.

In November 1998, the Securities and Exchange Commission (SEC) issued Practice Alert 98-3, Revenue Recognition Issues, SEC Practice Section Professional Issues Task Force, recognizing and discussing the manipulation of earnings used to exceed stock market and analysts’ expectations. Accountants should watch for revenue recognition related issues in preparing the financial statements of their company or client, especially when employees’ or management’s stock options are about to vest.

Current Portion of a Noncurrent Note Payable

Sierra Sports takes out a bank loan on January 1, 2017 to cover expansion costs for a new store. The note amount is $360,000. The note has terms of repayment that include equal principal payments annually over the next twenty years. The annual interest rate on the loan is 9%. Interest accumulates each month based on the standard interest rate formula discussed previously, and on the current outstanding principal balance of the loan. Sierra records interest accumulation every three months, at the end of each third month. The initial loan (note) entry follows.

A journal entry is made on January 1 and shows a Debit to Cash for $360,000, and a credit to Notes payable for $360,000, with the note “To recognize long-term loan, interest rate 9 percent.”

Notes Payable increases (credit) for the full loan principal amount. Cash increases (debit) as well. On March 31, the end of the first three months, Sierra records their first interest accumulation.

A journal entry is made on March 31 and shows a Debit to Interest expense for $8,100, and a credit to Interest payable for $8,100, with the note “To recognize interest accumulated after three months.”

Interest Expense increases (debit) as does Interest Payable (credit) for the amount of interest accumulated but unpaid at the end of the three-month period. The amount $8,100 is found by using the interest formula, where the outstanding principal balance is $360,000, interest rate of 9%, and the part of the year being three out of twelve months: $360,000 × 9% × (3/12).

The same entry for interest will occur every three months until year-end. When accumulated interest is paid on January 1 of the following year, Sierra would record this entry.

A journal entry is made on January 1 and shows a Debit to Interest payable for $32,400, and a credit to Cash for $32,400, with the note “To recognize interest payment for 2017.”

Both Interest Payable and Cash decrease for the total interest amount accumulated during 2017. This is calculated by taking each three-month interest accumulation of $8,100 and multiplying by the four recorded interest entries for the periods. You could also compute this by taking the original principal balance and multiplying by 9%.

On December 31, 2017, the first principal payment is due. The following entry occurs to show payment of this principal amount due in the current period.

A journal entry is made on December 31 and shows a Debit to Notes payable for $18,000, and a credit to Cash for $18,000, with the note “To recognize current principal payment for 2017.”

Notes Payable decreases (debit), as does Cash (credit), for the amount of the noncurrent note payable due in the current period. This amount is calculated by dividing the original principal amount ($360,000) by twenty years to get an annual current principal payment of $18,000 ($360,000/20).

While the accounts used to record a reduction in Notes Payable are the same as the accounts used for a noncurrent note, the reporting on the balance sheet is classified in a different area. The current portion of the noncurrent note payable ($18,000) is reported under Current Liabilities, and the remaining noncurrent balance of $342,000 ($360,000 – $18,000) is classified and displayed under noncurrent liabilities, as shown in Figure 12.7.

The figure shows the Balance Sheet at December 31, 2017 of Sierra Sports. Assets are categorized by Current assets and Property, Plant, and Equipment. Under current assets: Cash $21,580, Accounts receivable $2,000, Total current assets $23,580. Under Property, Plant, and Equipment: Buildings $300,000, Sporting Equipment $60,000, Total Property, Plant, and Equipment $360,000. Total assets $383,580. Liabilities and stockholders’ equity are categorized by Current liabilities, Long-term liabilities, and Stockholders’ Equity. Under Current liabilities: Note Payable: Current $18,000, Accounts payable $9,000, Unearned revenue $4,000, Total current liabilities $31,000. Under Long-term liabilities: Notes payable $342,000. Under Stockholders’ equity: Common stock $5,000, Retained earnings $5,580, Total Stockholders’ equity $10,580. Total Liabilities and Stockholders’ equity $383,580.
Figure 12.7 Sierra Sports Balance Sheet. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Taxes Payable

Let’s consider our previous example where Sierra Sports purchased $12,000 of soccer equipment in August. Sierra now sells the soccer equipment to a local soccer league for $18,000 cash on August 20. The sales tax rate is 6%. The following revenue entry would occur.

A journal entry is made on August 20 and shows a Debit to Cash for $19,080, a credit to Sales tax payable for $1,080, and a credit to Sales for $18,000 with the note “To recognize soccer equipment sale, tax rate 6 percent.”

Cash increases (debit) for the sales amount plus sales tax. Sales Tax Payable increases (credit) for the 6% tax rate ($18,000 × 6%). Sierra’s tax liability is owed to the State Tax Board. Sales increases (credit) for the original amount of the sale, not including sales tax. If Sierra’s customer pays on credit, Accounts Receivable would increase (debit) for $19,080 rather than Cash.

When Sierra remits payment to the State Tax Board on October 1, the following entry occurs.

A journal entry is made on October 1 and shows a Debit to Sales tax payable for $1,080, and a credit to Cash for $1,080 with the note “To recognize State Tax Board payment.”

Sales Tax Payable and Cash decrease for the payment amount of $1,080. Sales tax is not an expense to the business because the company is holding it on account for another entity.

Sierra Sports payroll tax journal entries will appear in Record Transactions Incurred in Preparing Payroll.

Your Turn

Accounting for Purchase Discounts

You own a shipping and packaging facility and provide shipping services to customers. You have worked out a contract with a local supplier to provide your business with packing materials on an ongoing basis. Terms of your agreement allow for delayed payment of up to thirty days from the invoice date, with an incentive to pay within ten days to receive a 5% discount on the packing materials. On April 3, you purchase 1,000 boxes (Box Inventory) from this supplier at a cost per box of $1.25. You pay the amount due to the supplier on April 11. Record the journal entries to recognize the initial purchase on April 3, and payment of the amount due on April 11.

Solution

The first journal entry is made on April 3 and shows a Debit to Box inventory for $1,250, and a credit to Accounts payable for $1,250 with the note “To recognize purchases of boxes, 5 / 10, n / 30.” The second journal entry is made on April 11, and shows a Debit to Accounts payable for $1,250, a credit to Box inventory for $62.50 and a credit to Cash for $1,187.50 with the note “To recognize payment, less discount.”

Footnotes

  • 2 Jena McGregor. “How Stock Options Lead CEOs to Put Their Own Interests First.” Washington Post. February 11, 2014. https://www.washingtonpost.com/news/on-leadership/wp/2014/02/11/how-stock-options-lead-ceos-to-put-their-own-interests-first/?utm_term=.24d99a4fb1a5
  • 3 Douglas R. Carmichael. “Hocus-Pocus Accounting.” Journal of Accountancy. October 1, 1999. https://www.journalofaccountancy.com/issues/1999/oct/carmichl.html
Citation/Attribution

Want to cite, share, or modify this book? This book is Creative Commons Attribution-NonCommercial-ShareAlike License 4.0 and you must attribute OpenStax.

Attribution information
  • If you are redistributing all or part of this book in a print format, then you must include on every physical page the following attribution:
    Access for free at https://openstax.org/books/principles-financial-accounting/pages/1-why-it-matters
  • If you are redistributing all or part of this book in a digital format, then you must include on every digital page view the following attribution:
    Access for free at https://openstax.org/books/principles-financial-accounting/pages/1-why-it-matters
Citation information

© Apr 11, 2019 OpenStax. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License 4.0 license. The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the Creative Commons license and may not be reproduced without the prior and express written consent of Rice University.