The treatment of accounts payable is somewhat more complicated than the treatment of its counterpart on the balance sheet, accounts receivable [discussed on the previous post you may want to read it too: read]. This is because the underlying transaction is more complex, and also due to the wide range of accruals that may potentially be required for the accountant to fairly represent the state of current liabilities on the balance sheet. This post describes accounting treatment for a wide range of current liabilities [i.e,.: accounts payable transaction, period-end cutoff, advance payments from customers, various accrued expenses, unclaimed wages, interest payable, termination benefits, estimated product returns, contingent liabilities, long-term payables] and how they should be accounted for. Enjoy!
Definition Of Current Liabilities
A trade account payable is one for which there is a clear commitment to pay, and that generally involves an obligation related to goods or services. Typically, it also involves a payment that is due within one year, and is considered to include anything for which an invoice is received.
An accrued liability is one for which there is also a clear commitment to pay, but for which an invoice has not yet been received. Typical accrued liabilities are wages payable, payroll taxes payable, and interest payable.
A contingent liability is one that will occur if a future event comes to pass, and that is based on a current situation.
The Accounts Payable Transaction Flow
The typical transaction flow for the accounts payable process is for the purchasing department to release a purchase order to a supplier, after which the supplier ships to the company whatever was ordered. The shipping manifest delivered with the product contains the purchase order number that authorizes the transaction. The receiving staff compares the delivery to the referenced purchase order, and accepts the delivery if it matches the purchase order. The receiving staff then sends a copy of the receiving documentation to the accounts payable department. Meanwhile, the supplier issues an invoice to the company’s accounting department.
Once the accounting staff receive the invoice, they match it to the initiating purchase order as well as the receiving documentation, thereby establishing proof that the invoice was both authorized and received. If everything cross-checks properly, then the invoice is entered into the accounting system for payment, with a debit going to either an expense account or an asset account, and a credit going to the accounts payable account. Once the invoice is due for payment, a check is printed, and a credit is made to the cash account and a debit to the accounts payable account.
A variation on this transaction is for the accounting staff to initially record an account payable at an amount net of its early payment discount. However, this requires one to apportion the amount of the discount over all line items being billed on the supplier invoice. Also, since taking or avoiding the early payment discount can also be viewed as an unrelated financing decision, this would lead one to record each invoice at its gross amount and then to record the discount separately if the decision is made to take it.
The accounts payable transaction flow is one requiring a number of types of paperwork to be assembled from three different departments, which tends to lead to a great deal of confusion and missing paperwork. Frequently, the delay is so excessive that the accounting staff cannot process the paperwork in time to meet the deadlines by which early payment discounts can be taken. Accordingly, there are several alternatives to the basic process flow that can alleviate its poor level of efficiency:
Pay without approval. Invoices may be entered into the system immediately upon receipt and paid, irrespective of where they may stand in the approval process. This approach ensures that all early payment discounts are taken, but tends to result in some payments for unauthorized shipments.
Pay from the purchase order. A much simpler approach than the traditional one just described is to require that all deliveries be authorized by a purchase order, and that the receiving staff have access to this information on-line at the receiving dock, so that it can check off receipts as soon as they appear. The computer system then automatically schedules payment to the supplier, based on the price per unit listed in the purchase order and the quantity recorded at the receiving dock. This approach requires considerable interaction with suppliers to ensure that the resulting payments are acceptable.
Pay from completed production. The most streamlined approach to the payment of accounts payable is that used by just-in-time manufacturing systems, under which suppliers are pre-certified as to the quality of their products, which therefore require no inspection by a company’s receiving staff at all. Instead, they deliver directly to the production workstations where they are immediately needed, avoiding all receiving paperwork. Once the company completes its production process, it determines the number of finished goods completed, and the number of units of parts from each supplier that were included in those completed finished goods. It then pays the suppliers based on this standard number of parts.
This system requires a high degree of accuracy in production tracking, as well as a separate scrap tracking system that accumulates all parts thrown out or destroyed during the production process (because suppliers must also be reimbursed for these parts).
Many invoices are also received that have nothing to do with the production process, such as utility, subscription, and rent billings. These should first be entered in the accounts payable system for processing, and then routed to the applicable managers for approval. In many cases, the accounts payable staff is authorized to approve these invoices up to the amount of the periodic budget, with further inspection required if the budget is exceeded.
Accounting For The Period-End Cutoff
If an accountant were to issue financial statements immediately after the end of a reporting period, it is quite likely that the resulting financial statements would underreport the amount of accounts payable. The reason is that the company may have received inventory items prior to period-end and recorded them as an increase in the level of inventory (thereby reducing the cost of goods sold), without having recorded the corresponding supplier invoice, which may have been delayed by the postal service until a few days following the end of the period.
Proper attention to the period-end cutoff issue can resolve this problem. The key activity for the accountant is to compare the receiving department’s receiving log for the few days near period-end to the supplier invoices logged into that period, to see if there are any receipts for which there are no supplier invoices. If not, the accountant can accrue the missing invoice at the per-unit rate shown on the originating purchase order, or else used the cost noted on an earlier invoice for the same item.
Similarly, there will be a number of other types of invoices that will arrive several days after the end of the period, such as maintenance billings and telephone bills. The accountant can anticipate their arrival by accruing for them based on a checklist of invoices that are typically late in arriving, and for which an estimate can be made that is based on invoices from previous reporting periods.
Proper attention to the cutoff issue is extremely important, since ignoring it can lead to wide gyrations in reported income from period to period, as invoices are continually recorded in the wrong period.
Accounting For Advance Payments From Customers
If a customer makes a payment for which the company has not made a corresponding delivery of goods or services, then the accountant must record the cash receipt as a customer advance, which is a liability. This situation commonly arises when a customer order is so large or specialized that the company is justified in demanding cash in advance of the order. Another common situation is when customers are required to make a deposit, such as when a property rental company requires one month’s rent as a damage deposit. This may be recorded as a current liability if the corresponding delivery of goods or services is expected to be within the next year. However, if the offset is expected to be further in the future, then it should be recorded as a long-term liability.
Accounting For Accrued Expenses
One of the primary tasks of the accountant during the period-end closing process is the calculation of expense accruals, of which there are potentially a great number. Here are the most common ones:
Accrued bonuses. Rather than waiting until bonuses are fully earned and payable to recognize them, the accountant should accrue some proportion of bonuses in each reporting period if there is a reasonable expectation that they will be earned and that the eventual amount of the bonuses can be approximately determined.
Accrued commissions. The amount of commissions due to the sales staff may not be precisely ascertainable at the end of the reporting period, since they may be subject to later changes based on the precise terms of the commission agreement with the sales staff, such as subsequent reductions if customers do not pay for their delivered goods or services. In this case, commissions should be accrued based on the maximum possible commission payment, minus a reduction for later eventualities; the reduction can reasonably be based on historical experience with actual commission rates paid.
Accrued property taxes. The accounting staff is usually notified well in advance by the local government authorities of the exact amount of property tax that will be payable on a later date. However, there is no reason to record the entire amount of this tax at the point of notification; since property taxes do not vary much from year to year, the accountant can easily record a monthly property tax accrual, and adjust it slightly when the exact amount payable becomes known.
Accrued royalties. Aroyalty expense accrual should be treated in the same manner as a commission—if there is any uncertainty in regard to the amount due, record the maximum amount, less a reduction for future eventualities that is based on historical results.
Accrued sick time. The amount of sick time allowed to employees is usually so small that there is no discernible impact on the financial statements if they are accrued or not. This is particularly true if unused sick time cannot be carried forward into future years as an ongoing residual employee benefit that may be paid out at some future date. If these restrictions are not the case, then the accounting treatment of sick time is the same as for vacation time, which is noted in the next bullet point.
Accrued vacations. The accountant should accrue for vacation hours earned, but only if they are already earned as of the end of the reporting period. For example, if a company awards vacation hours to its employees at a constant hourly rate that adds up to two weeks per year, then it should accrue the difference between the amount accrued to date and the amount taken in actual vacation hours. However, if there is a “use it or lose it” limitation that restricts the number of vacation hours that can be carried forward into future periods, then the accrual is limited to the maximum of this carry forward amount.
Accrued wages. Even if a company times its payroll period-end dates to correspond with the end of each reporting period, this will only ensure that no accrual is needed for those employees who receive salaries (because they are usually paid through the payroll period ending date). The same is not usually true for those who receive an hourly wage. In their case, the pay period may end as much as a week prior to the actual payment date. Consequently, the accountant must accrue the wage expense for the period between the pay period end date and the end of the reporting period. This can be estimated on a person-by-person basis, but an easier approach is to accrue based on a historical hourly rate that includes average overtime percentages. One must also include the company’s share of all payroll taxes in this accrual.
Accrued warranty claims. The accountant should accrue an expense for warranty claims, based on the company’s past history with claims for similar types of products or product lines. It may also use industry information if in-house data is not available.
Accounting For Unclaimed Wages
There are a small number of cases in which employees do not cash their payroll checks. This most commonly arises when an employee has left the company and moved away, so that the company cannot track down the person’s whereabouts. In this case, the funds can be deposited to an unclaimed wages account in the current liabilities section of the balance sheet. Under some state laws, these funds must be forwarded to the state government after they have gone unclaimed for a certain period of time. If so, the accountant should be very careful in regard to the record keeping for these transactions. If there is no such state law, the company should reverse the original payroll transaction, crediting the salaries and wages account for the amount of the unclaimed check.
Accounting For Interest Payable
If a company has an obligation to pay back a loan, it should accrue the interest payable under the terms of that note for the current reporting period, and store this information in the current liabilities section of the balance sheet. The required calculation is to multiply the average loan balance outstanding per day by the interest rate stated on the loan document.
However, if the stated interest rate is substantially lower than the market rate at the time the loan document was initiated, then the interest rate should be an imputed one, based on the market rate at the time of loan initiation. In this later case, the loan should have been recorded on the company’s books at its net present value, using the market interest rate as the discount rate. The resulting interest expense will be debited to the interest expense account and credited to the accrued interest liability account.
Accounting For Termination Benefits
If company management has formally approved of a termination plan that is designed to reduce headcount, the expenses associated with the plan should be recognized at once, under certain circumstances that will allow the accountant to reasonably estimate the associated costs. The first requirement after plan approval is that the plan clearly outline the benefits to be granted. This information usually specifies a fixed dollar payout based on the amount of time that an employee has been with the company. Though there is typically a lack of knowledge regarding precisely which employees will be terminated at the time the plan is approved, the accountant can use the fixed benefit payment amounts and general estimates of which groups of employees are likely to be terminated to arrive at a reasonably accurate accrual of benefit expenses.
The second requirement is that the plan must specify the general categories and numbers of employees to be let go, since the accountant needs this information to extend the per-person benefit costs specified in the first requirement. The remaining requirements are that employees be informed about the plan, and that further significant changes to the plan be unlikely; these requirements lock in the range of possible costs that are likely to occur as a result of the plan, rendering the benefit cost accrual more accurate.
Accounting For Estimated Product Returns
Manufacturing companies will occasionally experience product returns from their customers. This may involve an amount too small to register on the financial statements, or such large ones that they have a major impact on the reported level of profitability.
Recent examples of the latter case include tires, automobiles, and even infant car seats. If there is some reasonable expectation of product returns, then a reserve must be estimated and recorded within the current liabilities section of the balance sheet. This estimate may be based on a company’s past history with similar products, or industry experience in general.
If there are no reasonable grounds for calculating an estimate, but there is an expectation of product returns, then the company cannot recognize revenue from the underlying product sales until either there are better grounds for making an estimate or the time period during which returns are allowed from customers has expired. This situation may arise if few products have been sold, if each product is customized to some degree, if there is no returns experience with the product (usually because it is a new product line), if there is a long period during which returns are allowed, or if rapid obsolescence is a possibility. Given that few companies wish to delay the recognition of revenue for a potentially long period, the accountant will be under some pressure to calculate a reasonably justifiable product return percentage.
Accounting For Contingent Liabilities
A contingent liability is one that will occur if a future event comes to pass, and that is based on a current situation. For example, a company may be engaged in a lawsuit; if it loses the suit, it will be liable for damages. Other situations that may give rise to a contingent liability are a standby letter of credit (if the primary creditor cannot pay a liability, then the company’s standby letter of credit will be accessed by the creditor), a guarantee of indebtedness, an expropriation threat, a risk of damage to company property, or any potential obligations associated with product warranties or defects.
If any of these potential events exists, then the accountant is under no obligation to accrue for any potential loss until the associated events come to pass, but should disclose them in a footnote. However, if the conditional events are probable, then the accountant must accrue a loss against current income. The amount of the contingent liability must be reasonably determinable, or at least be stated within a high-low range of likely outcomes. If the liability can only be stated within a probable range, then the accountant should accrue for the most likely outcome. If there is no most likely outcome, then the minimum amount in the range should be accrued.
An interesting variation pertaining to litigation is that many companies are unwilling to accrue for a contingent liability even after there has been a finding against them in a lower court. Instead, they prefer to disclose this information without an associated accrual, until such time as the ruling is confirmed by a court of appeals.
Accounting For Long-Term Payables [Nearing Payment Dates]
If a company has a long-term payable that is approaching its termination date, then any amount due under its payment provisions within the next year must be recorded as a current liability. If only a portion of total payments due under the liability is expected to fall within that time frame, then only that portion of the liability should be reported as a current liability. A common situation in which this issue arises is for a copier leasing arrangement, where the most recent payments due under the agreement are split away from the other copier lease payments that are not due until after one year. This situation commonly arises for many types of long-term equipment and property rentals.
There are a number of situations applying to current liabilities that require differing accounting treatment—unclaimed payroll checks, warranties, contingent liabilities, and the like. In addition, there are a number of ways to handle the accounts payable process flow that will result in varying degrees of efficiency and accuracy.