Current Liabilities and Contingencies

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Chapter 13 Current Liabilities and Contingencies


1. Distinguish between a current liability and a long-term debt.
Assume that your friend Will Morris, who is a music major, asks you to define and discuss the nature of a liability. Assist him by preparing a definition of a liability and by explaining to him what you believe are the elements or factors inherent in the concept of a liability.
Why is the liabilities section of the balance sheet of primary significance to bankers?
How are current liabilities related by definition to current assets? How are current liabilities related to a company’s operating cycle?
Leon Wight, a newly hired loan analyst, is examining the current liabilities of a corporate loan applicant. He observes that unearned revenues have declined in the current year compared to the prior year. Is this a positive indicator about the client’s liquidity? Explain.
How is present value related to the concept of a liability?
What is the nature of a “discount” on notes payable?
How should a debt callable by the creditor be reported in the debtor’s financial statements?
Under what conditions should a short-term obligation be excluded from current liabilities?
What evidence is necessary to demonstrate the ability to consummate the refinancing of short-term debt?
Discuss the accounting treatment or disclosure that should be accorded a declared but unpaid cash dividend; an accumulated but undeclared dividend on cumulative preferred stock; a stock dividend distributable.
How does unearned revenue arise? Why can it be classified properly as a current liability? Give several examples of business activities that result in unearned revenues.
What are compensated absences?
Under what conditions must an employer accrue a liability for the cost of compensated absences?
Under what conditions is an employer required to accrue a liability for sick pay? Under what conditions is an employer permitted but not required to accrue a liability for sick pay?
Faith Battle operates a health food store, and she has been the only employee. Her business is growing, and she is considering hiring some additional staff to help her in the store. Explain to her the various payroll deductions that she will have to account for, including their potential impact on her financial statements, if she hires additional staff.
Define (a) a contingency and (b) a contingent liability.
Under what conditions should a contingent liability be recorded?
Distinguish between a current liability and a contingent liability. Give two examples of each type.
How are the terms “probable,” “reasonably possible,” and “remote” related to contingent liabilities?
Contrast the cash-basis method and the accrual method of accounting for warranty costs.
Grant Company has had a record-breaking year in terms of growth in sales and profitability. However, market research indicates that it will experience operating losses in two of its major businesses next year. The controller has proposed that the company record a provision for these future losses this year, since it can afford to take the charge and still show good results. Advise the controller on the appropriateness of this charge.
How does the expense warranty approach differ from the sales warranty approach?
Southeast Airlines Inc. awards members of its Flightline program a second ticket at half price, valid for 2 years anywhere on its flight system, when a full-price ticket is purchased. How would you account for the full-fare and half-fare tickets?
Pacific Airlines Co. awards members of its Frequent Fliers Club one free round-trip ticket, anywhere on its flight system, for every 50,000 miles flown on its planes. How would you account for the free ticket award?
When must a company recognize an asset retirement obligation?
Should a liability be recorded for risk of loss due to lack of insurance coverage? Discuss.
What factors must be considered in determining whether or not to record a liability for pending litigation? For threatened litigation?
Within the current liabilities section, how do you believe the accounts should be listed? Defend your position.
How does the acid-test ratio differ from the current ratio? How are they similar?
When should liabilities for each of the following items be recorded on the books of an ordinary business corporation? (a) Acquisition of goods by purchase on credit. (b) Officers’ salaries. (c) Special bonus to employees. (d) Dividends. (e) Purchase commitments.

BE13-1 Roley Corporation uses a periodic inventory system and the gross method of accounting for purchase discounts. On July 1, Roley purchased $60,000 of inventory, terms 2/10, n/30, FOB shipping point. Roley paid freight costs of $1,200. On July 3, Roley returned damaged goods and received credit of $6,000. On July 10, Roley paid for the goods. Prepare all necessary journal entries for Roley.
Upland Company borrowed $40,000 on November 1, 2012, by signing a $40,000, 9%, 3-month note. Prepare Upland’s November 1, 2012, entry; the December 31, 2012, annual adjusting entry; and the February 1, 2013, entry.
Takemoto Corporation borrowed $60,000 on November 1, 2012, by signing a $61,350, 3-month, zero-interest-bearing note. Prepare Takemoto’s November 1, 2012, entry; the December 31, 2012, annual adjusting entry; and the February 1, 2013, entry.
At December 31, 2012, Burr Corporation owes $500,000 on a note payable due February 15, 2013. (a) If Burr refinances the obligation by issuing a long-term note on February 14 and using the proceeds to pay off the note due February 15, how much of the $500,000 should be reported as a current liability at December 31, 2012? (b) If Burr pays off the note on February 15, 2013, and then borrows $1,000,000 on a long-term basis on March 1, how much of the $500,000 should be reported as a current liability at December 31, 2012, the end of the fiscal year?
Sport Pro Magazine sold 12,000 annual subscriptions on August 1, 2012, for $18 each. Prepare Sport Pro’s August 1, 2012, journal entry and the December 31, 2012, annual adjusting entry. 1 1 1 1 2 1
Dillons Corporation made credit sales of $30,000 which are subject to 6% sales tax. The corporation also made cash sales which totaled $20,670 including the 6% sales tax. (a) Prepare the entry to record Dillons’ credit sales. (b) Prepare the entry to record Dillons’ cash sales.
Lexington Corporation’s weekly payroll of $24,000 included FICA taxes withheld of $1,836, federal taxes withheld of $2,990, state taxes withheld of $920, and insurance premiums withheld of $250. Prepare the journal entry to record Lexington’s payroll.
Kasten Inc. provides paid vacations to its employees. At December 31, 2012, 30 employees have each earned 2 weeks of vacation time. The employees’ average salary is $500 per week. Prepare Kasten’s December 31, 2012, adjusting entry.
Mayaguez Corporation provides its officers with bonuses based on net income. For 2012, the bonuses total $350,000 and are paid on February 15, 2013. Prepare Mayaguez’s December 31, 2012, adjusting entry and the February 15, 2013, entry.
Scorcese Inc. is involved in a lawsuit at December 31, 2012. (a) Prepare the December 31 entry assuming it is probable that Scorcese will be liable for $900,000 as a result of this suit. (b) Prepare the December 31 entry, if any, assuming it is not probable that Scorcese will be liable for any payment as a result of this suit.
Buchanan Company recently was sued by a competitor for patent infringement. Attorneys have determined that it is probable that Buchanan will lose the case and that a reasonable estimate of damages to be paid by Buchanan is $300,000. In light of this case, Buchanan is considering establishing a $100,000 selfinsurance allowance. What entry(ies), if any, should Buchanan record to recognize this loss contingency?
Calaf’s Drillers erects and places into service an off-shore oil platform on January 1, 2013, at a cost of $10,000,000. Calaf is legally required to dismantle and remove the platform at the end of its useful life in 10 years. Calaf estimates it will cost $1,000,000 to dismantle and remove the platform at the end of its useful life in 10 years. (The fair value at January 1, 2013, of the dismantle and removal costs is $450,000.) Prepare the entry to record the asset retirement obligation.
Streep Factory provides a 2-year warranty with one of its products which was first sold in 2012. In that year, Streep spent $70,000 servicing warranty claims. At year-end, Streep estimates that an additional $400,000 will be spent in the future to service warranty claims related to 2012 sales. Prepare Streep’s journal entry to record the $70,000 expenditure, and the December 31 adjusting entry.
Leppard Corporation sells DVD players. The corporation also offers its customers a 2-year warranty contract. During 2012, Leppard sold 20,000 warranty contracts at $99 each. The corporation spent $180,000 servicing warranties during 2012, and it estimates that an additional $900,000 will be spent in the future to service the warranties. Prepare Leppard’s journal entries for (a) the sale of contracts, (b) the cost of servicing the warranties, and (c) the recognition of warranty revenue.
Wynn Company offers a set of building blocks to customers who send in 3 UPC codes from Wynn cereal, along with 50. The block sets cost Wynn $1.10 each to purchase and 60 each to mail to customers. During 2012, Wynn sold 1,200,000 boxes of cereal. The company expects 30% of the UPC codes to be sent in. During 2012, 120,000 UPC codes were redeemed. Prepare Wynn’s December 31, 2012, adjusting entry. 1 3 3 3 4 5 4 5 4 5 4 5 4 5 4 5 EXERCI S E S
E13-1 (Balance Sheet Classification of Various Liabilities)
How would each of the following items be reported on the balance sheet? (a) Accrued vacation pay. (j) Premium offers outstanding. (b) Estimated taxes payable. (k) Discount on notes payable. (c) Service warranties on appliance sales. (l) Employee payroll deductions unremitted. (d) Bank overdraft. (m) Current maturities of long-term debts to (e) Personal injury claim pending. be paid from current assets. (f) Unpaid bonus to offi cers. (n) Cash dividends declared but unpaid. (g) Deposit received from customer to guarantee (o) Dividends in arrears on preferred stock. performance of a contract. (p) Loans from offi cers. (h) Sales taxes payable. (i) Gift certifi cates sold to customers but not yet redeemed.
E13-2 (Accounts and Notes Payable)
The following are selected 2012 transactions of Darby Corporation. Sept. 1 Purchased inventory from Orion Company on account for $50,000. Darby records purchases gross and uses a periodic inventory system. Oct. 1 Issued a $50,000, 12-month, 8% note to Orion in payment of account. Oct. 1 Borrowed $75,000 from the Shore Bank by signing a 12-month, zero-interest-bearing $81,000 note.
(a) Prepare journal entries for the selected transactions above. (b) Prepare adjusting entries at December 31. (c) Compute the total net liability to be reported on the December 31 balance sheet for: (1) The interest-bearing note. (2) The zero-interest-bearing note.
E13-3 (Refinancing of Short-Term Debt)
On December 31, 2012, Alexander Company had $1,200,000 of short-term debt in the form of notes payable due February 2, 2013. On January 21, 2013, the company issued 25,000 shares of its common stock for $36 per share, receiving $900,000 proceeds after brokerage fees and other costs of issuance. On February 2, 2013, the proceeds from the stock sale, supplemented by an additional $300,000 cash, are used to liquidate the $1,200,000 debt. The December 31, 2012, balance sheet is issued on February 23, 2013.
Show how the $1,200,000 of short-term debt should be presented on the December 31, 2012, balance sheet, including note disclosure.
E13-4 (Refinancing of Short-Term Debt)
On December 31, 2012, Santana Company has $7,000,000 of short-term debt in the form of notes payable to Golden State Bank due in 2013. On January 28, 2013, Santana enters into a refinancing agreement with Golden that will permit it to borrow up to 60% of the gross amount of its accounts receivable. Receivables are expected to range between a low of $5,000,000 in May to a high of $8,000,000 in October during the year 2013. The interest cost of the maturing short-term debt is 15%, and the new agreement calls for a fluctuating interest rate at 1% above the prime rate on notes due in 2017. Santana’s December 31, 2012, balance sheet is issued on February 15, 2013.
Prepare a partial balance sheet for Santana at December 31, 2012, showing how its $7,000,000 of short-term debt should be presented, including footnote disclosure.
E13-5 (Compensated Absences)
Matthewson Company began operations on January 2, 2012. It employs 9 individuals who work 8-hour days and are paid hourly. Each employee earns 10 paid vacation days and 6 paid sick days annually. Vacation days may be taken after January 15 of the year following the year in which they are earned. Sick days may be taken as soon as they are earned; unused sick days accumulate. Additional information is as follows. Actual Hourly Vacation Days Used Sick Days Used Wage Rate by Each Employee by Each Employee 2012 2013 2012 2013 2012 2013 $12 $13 0 9 4 5 Matthewson Company has chosen to accrue the cost of compensated absences at rates of pay in effect during the period when earned and to accrue sick pay when earned.
(a) Prepare journal entries to record transactions related to compensated absences during 2012 and 2013. (b) Compute the amounts of any liability for compensated absences that should be reported on the balance sheet at December 31, 2012 and 2013.
E13-6 (Compensated Absences)
Assume the facts in
E13-5, except that Matthewson Company has chosen not to accrue paid sick leave until used, and has chosen to accrue vacation time at expected future rates of pay without discounting. The company used the following projected rates to accrue vacation time.
Year in Which Vacation Projected Future Pay Rates Time Was Earned Used to Accrue Vacation Pay 2012 $12.90 2013 13.70 1 2 2 3 3
(a) Prepare journal entries to record transactions related to compensated absences during 2012 and 2013. (b) Compute the amounts of any liability for compensated absences that should be reported on the balance sheet at December 31, 2012 and 2013.
E13-7 (Adjusting Entry for Sales Tax)
During the month of June, Danielle’s Boutique had cash sales of $265,000 and credit sales of $153,700, both of which include the 6% sales tax that must be remitted to the state by July 15.
Prepare the adjusting entry that should be recorded to fairly present the June 30 financial statements.
E13-8 (Payroll Tax Entries)
The payroll of Delaney Company for September 2012 is as follows. Total payroll was $480,000, of which $140,000 is exempt from Social Security tax because it represented amounts paid in excess of $106,800 to certain employees. The amount paid to employees in excess of $7,000 was $410,000. Income taxes in the amount of $80,000 were withheld, as was $9,000 in union dues. The state unemployment tax is 3.5%, but Delaney Company is allowed a credit of 2.3% by the state for its unemployment experience. Also, assume that the current FICA tax is 7.65% on an employee’s wages to $106,800 and 1.45% in excess of $106,800. No employee for Delaney makes more than $125,000. The federal unemployment tax rate is 0.8% after state credit.
Prepare the necessary journal entries if the wages and salaries paid and the employer payroll taxes are recorded separately.
E13-9 (Payroll Tax Entries)
Allison Hardware Company’s payroll for November 2012 is summarized below. Amount Subject to Payroll Taxes Unemployment Tax Payroll Wages Due FICA Federal State Factory $140,000 $140,000 $40,000 $40,000 Sales 32,000 32,000 4,000 4,000 Administrative 36,000 36,000 — — Total $208,000 $208,000 $44,000 $44,000 At this point in the year, some employees have already received wages in excess of those to which payroll taxes apply. Assume that the state unemployment tax is 2.5%. The FICA rate is 7.65% on an employee’s wages to $106,800 and 1.45% in excess of $106,800. Of the $208,000 wages subject to FICA tax, $20,000 of the sales wages is in excess of $106,800. Federal unemployment tax rate is 0.8% after credits. Income tax withheld amounts to $16,000 for factory, $7,000 for sales, and $6,000 for administrative.
(a) Prepare a schedule showing the employer’s total cost of wages for November by function. (b) Prepare the journal entries to record the factory, sales, and administrative payrolls including the employer’s payroll taxes.
E13-10 (Warranties)
Winslow Company sold 150 color laser copiers in 2012 for $4,000 apiece, together with a one-year warranty. Maintenance on each copier during the warranty period averages $300.
(a) Prepare entries to record the sale of the copiers and the related warranty costs, assuming that the accrual method is used. Actual warranty costs incurred in 2012 were $17,000. (b) On the basis of the data above, prepare the appropriate entries, assuming that the cash-basis method is used.
E13-11 (Warranties)
Selzer Equipment Company sold 500 Rollomatics during 2012 at $6,000 each. During 2012, Selzer spent $30,000 servicing the 2-year warranties that accompany the Rollomatic. All applicable transactions are on a cash basis.
(a) Prepare 2012 entries for Selzer using the expense warranty approach. Assume that Selzer estimates the total cost of servicing the warranties will be $120,000 for 2 years. (b) Prepare 2012 entries for Selzer assuming that the warranties are not an integral part of the sale. Assume that of the sales total, $160,000 relates to sales of warranty contracts. Selzer estimates the total cost of servicing the warranties will be $120,000 for 2 years. Estimate revenues earned on the basis of costs incurred and estimated costs. 1 3
E13-12 (Premium Entries)
Moleski Company includes 1 coupon in each box of soap powder that it packs, and 10 coupons are redeemable for a premium (a kitchen utensil). In 2012, Moleski Company purchased 8,800 premiums at 90 cents each and sold 120,000 boxes of soap powder at $3.30 per box; 44,000 coupons were presented for redemption in 2012. It is estimated that 60% of the coupons will eventually be presented for redemption.
Prepare all the entries that would be made relative to sales of soap powder and to the premium plan in 2012.
E13-13 (Contingencies)
Presented below are three independent situations. Answer the question at the end of each situation. 1. During 2012, Maverick Inc. became involved in a tax dispute with the IRS. Maverick’s attorneys have indicated that they believe it is probable that Maverick will lose this dispute. They also believe that Maverick will have to pay the IRS between $800,000 and $1,400,000. After the 2012 financial statements were issued, the case was settled with the IRS for $1,200,000. What amount, if any, should be reported as a liability for this contingency as of December 31, 2012? 2. On October 1, 2012, Holmgren Chemical was identified as a potentially responsible party by the Environmental Protection Agency. Holmgren’s management along with its counsel have concluded that it is probable that Holmgren will be responsible for damages, and a reasonable estimate of these damages is $6,000,000. Holmgren’s insurance policy of $9,000,000 has a deductible clause of $500,000. How should Holmgren Chemical report this information in its financial statements at December 31, 2012? 3. Shinobi Inc. had a manufacturing plant in Darfur, which was destroyed in the civil war. It is not certain who will compensate Shinobi for this destruction, but Shinobi has been assured by governmental officials that it will receive a definite amount for this plant. The amount of the compensation will be less than the fair value of the plant but more than its book value. How should the contingency be reported in the financial statements of Shinobi Inc.?
E13-14 (Asset Retirement Obligation)
Bassinger Company purchases an oil tanker depot on January 1, 2012, at a cost of $600,000. Bassinger expects to operate the depot for 10 years, at which time it is legally required to dismantle the depot and remove the underground storage tanks. It is estimated that it will cost $70,000 to dismantle the depot and remove the tanks at the end of the depot’s useful life.
(a) Prepare the journal entries to record the depot (considered a plant asset) and the asset retirement obligation for the depot on January 1, 2012. Based on an effective-interest rate of 6%, the fair value of the asset retirement obligation on January 1, 2012, is $39,087. (b) Prepare any journal entries required for the depot and the asset retirement obligation at December 31, 2012. Bassinger uses straight-line depreciation; the estimated residual value for the depot is zero. (c) On December 31, 2021, Bassinger pays a demolition firm to dismantle the depot and remove the tanks at a price of $80,000. Prepare the journal entry for the settlement of the asset retirement obligation.
E13-15 (Premiums)
Presented below are three independent situations. 1. Marquart Stamp Company records stamp service revenue and provides for the cost of redemptions in the year stamps are sold to licensees. Marquart’s past experience indicates that only 80% of the stamps sold to licensees will be redeemed. Marquart’s liability for stamp redemptions was $13,000,000 at December 31, 2011. Additional information for 2012 is as follows. Stamp service revenue from stamps sold to licensees $9,500,000 Cost of redemptions (stamps sold prior to 1/1/12) 6,000,000 If all the stamps sold in 2012 were presented for redemption in 2013, the redemption cost would be $5,200,000. What amount should Marquart report as a liability for stamp redemptions at December 31, 2012? 2. In packages of its products, Wiseman Inc. includes coupons that may be presented at retail stores to obtain discounts on other Wiseman products. Retailers are reimbursed for the face amount of coupons redeemed plus 10% of that amount for handling costs. Wiseman honors requests for coupon redemption by retailers up to 3 months after the consumer expiration date. Wiseman estimates that 60% of all coupons issued will ultimately be redeemed. Information relating to coupons issued by Wiseman during 2012 is as follows. Consumer expiration date 12/31/12 Total face amount of coupons issued $850,000 Total payments to retailers as of 12/31/12 330,000 5 4 5 5 5 What amount should Wiseman report as a liability for unredeemed coupons at December 31, 2012? 3. Newell Company sold 600,000 boxes of pie mix under a new sales promotional program. Each box contains one coupon, which when submitted with $4.00, entitles the customer to a baking pan. Newell pays $6.00 per pan and $0.50 for handling and shipping. Newell estimates that 70% of the coupons will be redeemed, even though only 250,000 coupons had been processed during 2012. What amount should Newell report as a liability for unredeemed coupons at December 31, 2012? (AICPA adapted)
E13-16 (Financial Statement Impact of Liability Transactions)
Presented below is a list of possible transactions. 1. Purchased inventory for $80,000 on account (assume perpetual system is used). 2. Issued an $80,000 note payable in payment on account (see item 1 above). 3. Recorded accrued interest on the note from item 2 above. 4. Borrowed $100,000 from the bank by signing a 6-month, $112,000, zero-interest-bearing note. 5. Recognized 4 months’ interest expense on the note from item 4 above. 6. Recorded cash sales of $75,260, which includes 6% sales tax. 7. Recorded wage expense of $35,000. The cash paid was $25,000; the difference was due to various amounts withheld. 8. Recorded employer’s payroll taxes. 9. Accrued accumulated vacation pay. 10. Recorded an asset retirement obligation. 11. Recorded bonuses due to employees. 12. Recorded sales of product and related warranties (assume sales warranty approach). 13. Accrued warranty expense (assume expense warranty approach). 14. Paid warranty costs that were accrued in item 13 above. 15. Recorded a contingent loss on a lawsuit that the company will probably lose. 16. Paid warranty costs under contracts from item 12. 17. Recognized warranty revenue (see item 12). 18. Recorded estimated liability for premium claims outstanding.
Set up a table using the format shown below and analyze the effect of the 18 transactions on the financial statement categories indicated. # Assets Liabilities Owners’ Equity Net Income 1 Use the following code: I: Increase D: Decrease NE: No net effect
E13-17 (Ratio Computations and Discussion)
Costner Company has been operating for several years, and on December 31, 2012, presented the following balance sheet. The net income for 2012 was $25,000. Assume that total assets are the same in 2011 and 2012.
Compute each of the following ratios. For each of the four, indicate the manner in which it is computed and its significance as a tool in the analysis of the financial soundness of the company. (a) Current ratio. (c) Debt to total assets. (b) Acid-test ratio. (d) Rate of return on assets. COSTNER COMPANY BALANCE SHEET DECEMBER 31, 2012 Cash $ 40,000 Accounts payable $ 70,000 Receivables 75,000 Mortgage payable 140,000 Inventory 95,000 Common stock ($1 par) 160,000 Plant assets (net) 220,000 Retained earnings 60,000 $430,000 $430,000
E13-18 (Ratio Computations and Analysis)
Vogue Company’s condensed financial statements provide the following information. VOGUE COMPANY BALANCE SHEET Dec. 31, 2012 Dec. 31, 2011 Cash $ 52,000 $ 60,000 Accounts receivable (net) 158,000 80,000 Short-term investments 80,000 40,000 Inventory 440,000 360,000 Prepaid expenses 3,000 7,000 Total current assets 733,000 547,000 Property, plant, and equipment (net) 897,000 853,000 Total assets $1,630,000 $1,400,000 Current liabilities 240,000 160,000 Bonds payable 400,000 400,000 Common stockholders’ equity 990,000 840,000 Total liabilities and stockholders’ equity $1,630,000 $1,400,000 INCOME STATEMENT FOR THE YEAR ENDED 2012 Sales $1,640,000 Cost of goods sold (800,000) Gross profi t 840,000 Selling and administrative expenses (480,000) Interest expense (40,000) Net income $ 320,000
(a) Determine the following for 2012. (1) Current ratio at December 31. (2) Acid-test ratio at December 31. (3) Accounts receivable turnover. (4) Inventory turnover. (5) Rate of return on assets. (6) Profit margin on sales. (b) Prepare a brief evaluation of the financial condition of Vogue Company and of the adequacy of its profits.
E13-19 (Ratio Computations and Effect of Transactions)
Presented below is information related to Leland Inc. LELAND INC. BALANCE SHEET DECEMBER 31, 2012 Cash $ 45,000 Notes payable (short-term) $ 50,000 Receivables $110,000 Accounts payable 32,000 Less: Allowance 15,000 95,000 Accrued liabilities 5,000 Inventory 170,000 Common stock (par $5) 260,000 Prepaid insurance 8,000 Retained earnings 141,000 Land 20,000 Equipment (net) 150,000 $488,000 $488,000 6 6 LELAND INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2012 Sales $1,400,000 Cost of goods sold Inventory, Jan. 1, 2012 $200,000 Purchases 790,000 Cost of goods available for sale 990,000 Inventory, Dec. 31, 2012 (170,000) Cost of goods sold 820,000 Gross profi t on sales 580,000 Operating expenses 370,000 Net income $ 210,000
(a) Compute the following ratios or relationships of Leland Inc. Assume that the ending account balances are representative unless the information provided indicates differently. (1) Current ratio. (2) Inventory turnover. (3) Receivables turnover. (4) Earnings per share. (5) Profit margin on sales. (6) Rate of return on assets on December 31, 2012. (b) Indicate for each of the following transactions whether the transaction would improve, weaken, or have no effect on the current ratio of Leland Inc. at December 31, 2012. (1) Write off an uncollectible account receivable, $2,200. (2) Repurchase common stock for cash. (3) Pay $40,000 on notes payable (short-term). (4) Collect $23,000 on accounts receivable. (5) Buy equipment on account. (6) Give an existing creditor a short-term note in settlement of account.  PROBLEMS
P13-1 (Current Liability Entries and Adjustments)
Described below are certain transactions of Edwardson Corporation. The company uses the periodic inventory system. 1. On February 2, the corporation purchased goods from Martin Company for $70,000 subject to cash discount terms of 2/10, n/30. Purchases and accounts payable are recorded by the corporation at net amounts after cash discounts. The invoice was paid on February 26. 2. On April 1, the corporation bought a truck for $50,000 from General Motors Company, paying $4,000 in cash and signing a one-year, 12% note for the balance of the purchase price. 3. On May 1, the corporation borrowed $83,000 from Chicago National Bank by signing a $92,000 zerointerest- bearing note due one year from May 1. 4. On August 1, the board of directors declared a $300,000 cash dividend that was payable on September 10 to stockholders of record on August 31.
(a) Make all the journal entries necessary to record the transactions above using appropriate dates. (b) Edwardson Corporation’s year-end is December 31. Assuming that no adjusting entries relative to the transactions above have been recorded, prepare any adjusting journal entries concerning interest that are necessary to present fair financial statements at December 31. Assume straight-line amortization of discounts. 1
P13-2 (Liability Entries and Adjustments)
Listed below are selected transactions of Schultz Department Store for the current year ending December 31. 1. On December 5, the store received $500 from the Jackson Players as a deposit to be returned after certain furniture to be used in stage production was returned on January 15. 2. During December, cash sales totaled $798,000, which includes the 5% sales tax that must be remitted to the state by the fifteenth day of the following month. 3. On December 10, the store purchased for cash three delivery trucks for $120,000. The trucks were purchased in a state that applies a 5% sales tax. 4. The store determined it will cost $100,000 to restore the area (considered a land improvement) surrounding one of its store parking lots, when the store is closed in 2 years. Schultz estimates the fair value of the obligation at December 31 is $84,000.
Prepare all the journal entries necessary to record the transactions noted above as they occurred and any adjusting journal entries relative to the transactions that would be required to present fair financial statements at December 31. Date each entry. For simplicity, assume that adjusting entries are recorded only once a year on December 31.
P13-3 (Payroll Tax Entries)
Cedarville Company pays its office employee payroll weekly. Below is a partial list of employees and their payroll data for August. Because August is their vacation period, vacation pay is also listed. Earnings to Weekly Vacation Pay to Be Employee July 31 Pay Received in August Mark Hamill $4,200 $200 — Karen Robbins 3,500 150 $300 Brent Kirk 2,700 110 220 Alec Guinness 7,400 250 — Ken Sprouse 8,000 330 660 Assume that the federal income tax withheld is 10% of wages. Union dues withheld are 2% of wages. Vacations are taken the second and third weeks of August by Robbins, Kirk, and Sprouse. The state unemployment tax rate is 2.5% and the federal is 0.8%, both on a $7,000 maximum. The FICA rate is 7.65% on employee and employer on a maximum of $106,800 per employee. In addition, a 1.45% rate is charged both employer and employee for an employee’s wages in excess of $106,800.
Make the journal entries necessary for each of the four August payrolls. The entries for the payroll and for the company’s liability are made separately. Also make the entry to record the monthly payment of accrued payroll liabilities.
P13-4 (Payroll Tax Entries)
Below is a payroll sheet for Otis Import Company for the month of September 2012. The company is allowed a 1% unemployment compensation rate by the state; the federal unemployment tax rate is 0.8% and the maximum for both is $7,000. Assume a 10% federal income tax rate for all employees and a 7.65% FICA tax on employee and employer on a maximum of $106,800. In addition, 1.45% is charged both employer and employee for an employee’s wages in excess of $106,800 per employee. Income Earnings September Tax State Federal Name to Aug. 31 Earnings Withholding FICA U.C. U.C. B.D. Williams $ 6,800 $ 800 D. Raye 6,500 700 K. Baker 7,600 1,100 F. Lopez 13,600 1,900 A. Daniels 107,000 13,000 B. Kingston 112,000 16,000
(a) Complete the payroll sheet and make the necessary entry to record the payment of the payroll. (b) Make the entry to record the payroll tax expenses of Otis Import Company. (c) Make the entry to record the payment of the payroll liabilities created. Assume that the company pays all payroll liabilities at the end of each month. 1 5 3 3
P13-5 (Warranties, Accrual, and Cash Basis)
Brooks Corporation sells computers under a 2-year warranty contract that requires the corporation to replace defective parts and to provide the necessary repair labor. During 2012, the corporation sells for cash 400 computers at a unit price of $2,500. On the basis of past experience, the 2-year warranty costs are estimated to be $155 for parts and $185 for labor per unit. (For simplicity, assume that all sales occurred on December 31, 2012.) The warranty is not sold separately from the computer.
(a) Record any necessary journal entries in 2012, applying the cash-basis method. (b) Record any necessary journal entries in 2012, applying the expense warranty accrual method. (c) What liability relative to these transactions would appear on the December 31, 2012, balance sheet and how would it be classified if the cash-basis method is applied? (d) What liability relative to these transactions would appear on the December 31, 2012, balance sheet and how would it be classified if the expense warranty accrual method is applied? In 2013, the actual warranty costs to Brooks Corporation were $21,400 for parts and $39,900 for labor. (e) Record any necessary journal entries in 2013, applying the cash-basis method. (f) Record any necessary journal entries in 2013, applying the expense warranty accrual method.
P13-6 (Extended Warranties)
Dos Passos Company sells televisions at an average price of $900 and also offers to each customer a separate 3-year warranty contract for $90 that requires the company to perform periodic services and to replace defective parts. During 2012, the company sold 300 televisions and 270 warranty contracts for cash. It estimates the 3-year warranty costs as $20 for parts and $40 for labor and accounts for warranties separately. Assume sales occurred on December 31, 2012, and straight-line recognition of warranty revenues occurs.
(a) Record any necessary journal entries in 2012. (b) What liability relative to these transactions would appear on the December 31, 2012, balance sheet and how would it be classified? In 2013, Dos Passos Company incurred actual costs relative to 2012 television warranty sales of $2,000 for parts and $4,000 for labor. (c) Record any necessary journal entries in 2013 relative to 2012 television warranties. (d) What amounts relative to the 2012 television warranties would appear on the December 31, 2013, balance sheet and how would they be classified?
P13-7 (Warranties, Accrual, and Cash Basis)
Alvarado Company sells a machine for $7,400 under a 12-month warranty agreement that requires the company to replace all defective parts and to provide the repair labor at no cost to the customers. With sales being made evenly throughout the year, the company sells 600 machines in 2012 (warranty expense is incurred half in 2012 and half in 2013). As a result of product testing, the company estimates that the warranty cost is $390 per machine ($170 parts and $220 labor).
Assuming that actual warranty costs are incurred exactly as estimated, what journal entries would be made relative to the following facts? (a) Under application of the expense warranty accrual method for: (1) Sale of machinery in 2012. (2) Warranty costs incurred in 2012. (3) Warranty expense charged against 2012 revenues. (4) Warranty costs incurred in 2013. (b) Under application of the cash-basis method for: (1) Sale of machinery in 2012. (2) Warranty costs incurred in 2012. (3) Warranty expense charged against 2012 revenues. (4) Warranty costs incurred in 2013. (c) What amount, if any, is disclosed in the balance sheet as a liability for future warranty costs as of December 31, 2012, under each method? (d) Which method best reflects the income in 2012 and 2013 of Alvarado Company? Why?
P13-8 (Premium Entries)
To stimulate the sales of its Alladin breakfast cereal, Loptien Company places 1 coupon in each box. Five coupons are redeemable for a premium consisting of a children’s hand puppet. In 2013, the company purchases 40,000 puppets at $1.50 each and sells 480,000 boxes of Alladin at $3.75 a box. From its experience with other similar premium offers, the company estimates that 40% of the coupons issued will be mailed back for redemption. During 2013, 115,000 coupons are presented for redemption.
Prepare the journal entries that should be recorded in 2013 relative to the premium plan.
P13-9 (Premium Entries and Financial Statement Presentation)
Sycamore Candy Company offers a CD single as a premium for every five candy bar wrappers presented by customers together with $2.50. The candy bars are sold by the company to distributors for 30 cents each. The purchase price of each CD to the company is $2.25; in addition, it costs 50 cents to mail each CD. The results of the premium plan for the years 2012 and 2013 are as follows. (All purchases and sales are for cash.) 2012 2013 CDs purchased 250,000 330,000 Candy bars sold 2,895,400 2,743,600 Wrappers redeemed 1,200,000 1,500,000 2012 wrappers expected to be redeemed in 2013 290,000 2013 wrappers expected to be redeemed in 2014 350,000
(a) Prepare the journal entries that should be made in 2012 and 2013 to record the transactions related to the premium plan of the Sycamore Candy Company. (b) Indicate the account names, amounts, and classifications of the items related to the premium plan that would appear on the balance sheet and the income statement at the end of 2012 and 2013.
P13-10 (Loss Contingencies: Entries and Essay)
On November 24, 2012, 26 passengers on Windsor Airlines Flight No. 901 were injured upon landing when the plane skidded off the runway. Personal injury suits for damages totaling $9,000,000 were filed on January 11, 2013, against the airline by 18 injured passengers. The airline carries no insurance. Legal counsel has studied each suit and advised Windsor that it can reasonably expect to pay 60% of the damages claimed. The financial statements for the year ended December 31, 2012, were issued February 27, 2013.
(a) Prepare any disclosures and journal entries required by the airline in preparation of the December 31, 2012, financial statements. (b) Ignoring the Nov. 24, 2012, accident, what liability due to the risk of loss from lack of insurance coverage should Windsor Airlines record or disclose? During the past decade, the company has experienced at least one accident per year and incurred average damages of $3,200,000. Discuss fully.
P13-11 (Loss Contingencies: Entries and Essays)
Polska Corporation, in preparation of its December 31, 2012, financial statements, is attempting to determine the proper accounting treatment for each of the following situations. 1. As a result of uninsured accidents during the year, personal injury suits for $350,000 and $60,000 have been filed against the company. It is the judgment of Polska’s legal counsel that an unfavorable outcome is unlikely in the $60,000 case but that an unfavorable verdict approximating $250,000 will probably result in the $350,000 case. 2. Polska Corporation owns a subsidiary in a foreign country that has a book value of $5,725,000 and an estimated fair value of $9,500,000. The foreign government has communicated to Polska its intention to expropriate the assets and business of all foreign investors. On the basis of settlements other firms have received from this same country, Polska expects to receive 40% of the fair value of its properties as final settlement. 3. Polska’s chemical product division consisting of five plants is uninsurable because of the special risk of injury to employees and losses due to fire and explosion. The year 2012 is considered one of the safest (luckiest) in the division’s history because no loss due to injury or casualty was suffered. Having suffered an average of three casualties a year during the rest of the past decade (ranging from $60,000 to $700,000), management is certain that next year the company will probably not be so fortunate.
(a) Prepare the journal entries that should be recorded as of December 31, 2012, to recognize each of the situations above. (b) Indicate what should be reported relative to each situation in the financial statements and accompanying notes. Explain why.
P13-12 (Warranties and Premiums)
Garison Music Emporium carries a wide variety of musical instruments, sound reproduction equipment, recorded music, and sheet music. Garison uses two sales promotion techniques—warranties and premiums—to attract customers. 5 6 4 5 4 5 5 Musical instruments and sound equipment are sold with a one-year warranty for replacement of parts and labor. The estimated warranty cost, based on past experience, is 2% of sales. The premium is offered on the recorded and sheet music. Customers receive a coupon for each dollar spent on recorded music or sheet music. Customers may exchange 200 coupons and $20 for a CD player. Garison pays $32 for each CD player and estimates that 60% of the coupons given to customers will be redeemed. Garison’s total sales for 2012 were $7,200,000—$5,700,000 from musical instruments and sound reproduction equipment and $1,500,000 from recorded music and sheet music. Replacement parts and labor for warranty work totaled $164,000 during 2012. A total of 6,500 CD players used in the premium program were purchased during the year and there were 1,200,000 coupons redeemed in 2012. The accrual method is used by Garison to account for the warranty and premium costs for financial reporting purposes. The balances in the accounts related to warranties and premiums on January 1, 2012, were as shown below. Inventory of Premiums $ 37,600 Premium Liability 44,800 Warranty Liability 136,000
Garison Music Emporium is preparing its financial statements for the year ended December 31, 2012. Determine the amounts that will be shown on the 2012 financial statements for the following. (1) Warranty Expense. (4) Inventory of Premiums. (2) Warranty Liability. (5) Premium Liability. (3) Premium Expense. (CMA adapted)
P13-13 (Liability Errors)
You are the independent auditor engaged to audit Millay Corporation’s December 31, 2012, financial statements. Millay manufactures household appliances. During the course of your audit, you discovered the following contingent liabilities. 1. Millay began production of a new dishwasher in June 2012 and, by December 31, 2012, sold 120,000 to various retailers for $500 each. Each dishwasher is under a one-year warranty. The company estimates that its warranty expense per dishwasher will amount to $25. At year-end, the company had already paid out $1,000,000 in warranty expenses. Millay’s income statement shows warranty expenses of $1,000,000 for 2012. Millay accounts for warranty costs on the accrual basis. 2. In response to your attorney’s letter, Morgan Sondgeroth, Esq., has informed you that Millay has been cited for dumping toxic waste into the Kishwaukee River. Clean-up costs and fines amount to $2,750,000. Although the case is still being contested, Sondgeroth is certain that Millay will most probably have to pay the fine and clean-up costs. No disclosure of this situation was found in the financial statements. 3. Millay is the defendant in a patent infringement lawsuit by Megan Drabek over Millay’s use of a hydraulic compressor in several of its products. Sondgeroth claims that, if the suit goes against Millay, the loss may be as much as $5,000,000; however, Sondgeroth believes the loss of this suit to be only reasonably possible. Again, no mention of this suit is made in the financial statements. As presented, these contingencies are not reported in accordance with GAAP, which may create problems in issuing a favorable audit report. You feel the need to note these problems in the work papers.
Heading each page with the name of the company, balance sheet date, and a brief description of the problem, write a brief narrative for each of the above issues in the form of a memorandum to be incorporated in the audit work papers. Explain what led to the discovery of each problem, what the problem really is, and what you advised your client to do (along with any appropriate journal entries) in order to bring these contingencies in accordance with GAAP.
P13-14 (Warranty and Coupon Computation)
Schmitt Company must make computations and adjusting entries for the following independent situations at December 31, 2013. 1. Its line of amplifiers carries a 3-year warranty against defects. On the basis of past experience the estimated warranty costs related to dollar sales are: first year after sale—2% of sales; second year after sale—3% of sales; and third year after sale—5% of sales. Sales and actual warranty expenditures for the first 3 years of business were: Warranty Sales Expenditures 2011 $ 800,000 $ 6,500 2012 1,100,000 17,200 2013 1,200,000 62,000
Compute the amount that Schmitt Company should report as a liability in its December 31, 2013, balance sheet. Assume that all sales are made evenly throughout each year with warranty expenses also evenly spaced relative to the rates above. 2. With some of its products, Schmitt Company includes coupons that are redeemable in merchandise. The coupons have no expiration date and, in the company’s experience, 40% of them are redeemed. The liability for unredeemed coupons at December 31, 2012, was $9,000. During 2013, coupons worth $30,000 were issued, and merchandise worth $8,000 was distributed in exchange for coupons redeemed.
Compute the amount of the liability that should appear on the December 31, 2013, balance sheet. (AICPA adapted) CONCEPTS FOR ANALYS I S
CA13-1 (Nature of Liabilities)
Presented below is the current liabilities section of Micro Corporation. ($000) 2013 2012 Current Liabilities Notes payable $ 68,713 $ 7,700 Accounts payable 179,496 101,379 Compensation to employees 60,312 31,649 Accrued liabilities 158,198 77,621 Income taxes payable 10,486 26,491 Current maturities of long-term debt 16,592 6,649 Total current liabilities $493,797 $251,489
Answer the following questions. (a) What are the essential characteristics that make an item a liability? (b) How does one distinguish between a current liability and a long-term liability? (c) What are accrued liabilities? Give three examples of accrued liabilities that Micro might have. (d) What is the theoretically correct way to value liabilities? How are current liabilities usually valued? (e) Why are notes payable reported first in the current liabilities section? (f) What might be the items that comprise Micro’s liability for “Compensation to employees”?
CA13-2 (Current versus Noncurrent Classification)
Rodriguez Corporation includes the following items in its liabilities at December 31, 2012. 1. Notes payable, $25,000,000, due June 30, 2013. 2. Deposits from customers on equipment ordered by them from Rodriguez, $6,250,000. 3. Salaries payable, $3,750,000, due January 14, 2013.
Indicate in what circumstances, if any, each of the three liabilities above would be excluded from current liabilities.
CA13-3 (Refinancing of Short-Term Debt)
Dumars Corporation reports in the current liability section of its balance sheet at December 31, 2012 (its year-end), short-term obligations of $15,000,000, which includes the current portion of 12% long-term debt in the amount of $10,000,000 (matures in March 2013). Management has stated its intention to refinance the 12% debt whereby no portion of it will mature during 2013. The date of issuance of the financial statements is March 25, 2013.
(a) Is management’s intent enough to support long-term classification of the obligation in this situation? (b) Assume that Dumars Corporation issues $13,000,000 of 10-year debentures to the public in January 2013 and that management intends to use the proceeds to liquidate the $10,000,000 debt maturing in March 2013. Furthermore, assume that the debt maturing in March 2013 is paid from these proceeds prior to the issuance of the financial statements. Will this have any impact on the balance sheet classification at December 31, 2012? Explain your answer. (c) Assume that Dumars Corporation issues common stock to the public in January and that management intends to entirely liquidate the $10,000,000 debt maturing in March 2013 with the proceeds of this equity securities issue. In light of these events, should the $10,000,000 debt maturing in March 2013 be included in current liabilities at December 31, 2012? (d) Assume that Dumars Corporation, on February 15, 2013, entered into a financing agreement with a commercial bank that permits Dumars Corporation to borrow at any time through 2014 up to $15,000,000 at the bank’s prime rate of interest. Borrowings under the financing agreement mature three years after the date of the loan. The agreement is not cancelable except for violation of a provision with which compliance is objectively determinable. No violation of any provision exists at the date of issuance of the financial statements. Assume further that the current portion of long-term debt does not mature until August 2013. In addition, management intends to refinance the $10,000,000 obligation under the terms of the financial agreement with the bank, which is expected to be financially capable of honoring the agreement. (1) Given these facts, should the $10,000,000 be classified as current on the balance sheet at December 31, 2012? (2) Is disclosure of the refinancing method required?
CA13-4 (Refinancing of Short-Term Debt)
Andretti Inc. issued $10,000,000 of short-term commercial paper during the year 2012 to finance construction of a plant. At December 31, 2012, the corporation’s yearend, Andretti intends to refinance the commercial paper by issuing long-term debt. However, because the corporation temporarily has excess cash, in January 2013 it liquidates $3,000,000 of the commercial paper as the paper matures. In February 2013, Andretti completes an $18,000,000 long-term debt offering. Later during the month of February, it issues its December 31, 2012, financial statements. The proceeds of the long-term debt offering are to be used to replenish $3,000,000 in working capital, to pay $7,000,000 of commercial paper as it matures in March 2013, and to pay $8,000,000 of construction costs expected to be incurred later that year to complete the plant.
(a) How should the $10,000,000 of commercial paper be classified on the December 31, 2012, January 31, 2013, and February 28, 2013, balance sheets? Give support for your answer and also consider the cash element. (b) What would your answer be if, instead of a refinancing at the date of issuance of the financial statements, a financing agreement existed at that date?
CA13-5 (Loss Contingencies)
On February 1, 2013, one of the huge storage tanks of Viking Manufacturing Company exploded. Windows in houses and other buildings within a one-mile radius of the explosion were severely damaged, and a number of people were injured. As of February 15, 2013 (when the December 31, 2012, financial statements were completed and sent to the publisher for printing and public distribution), no suits had been filed or claims asserted against the company as a consequence of the explosion. The company fully anticipates that suits will be filed and claims asserted for injuries and damages. Because the casualty was uninsured and the company considered at fault, Viking Manufacturing will have to cover the damages from its own resources.
Discuss fully the accounting treatment and disclosures that should be accorded the casualty and related contingent losses in the financial statements dated December 31, 2012.
CA13-6 (Loss Contingency)
Presented below is a note disclosure for Matsui Corporation. Litigation and Environmental: The Company has been notified, or is a named or a potentially responsible party in a number of governmental (federal, state and local) and private actions associated with environmental matters, such as those relating to hazardous wastes, including certain sites which are on the United States EPA National Priorities List (“Superfund”). These actions seek clean-up costs, penalties and/or damages for personal injury or to property or natural resources. In 2012, the Company recorded a pre-tax charge of $56,229,000, included in the “Other expense (income)— net” caption of the Company’s consolidated income statements, as an additional provision for environmental matters. These expenditures are expected to take place over the next several years and are indicative of the Company’s commitment to improve and maintain the environment in which it operates. At December 31, 2012, environmental accruals amounted to $69,931,000, of which $61,535,000 are considered noncurrent and are included in the “Deferred credits and other liabilities” caption of the Company’s consolidated balance sheets. While it is impossible at this time to determine with certainty the ultimate outcome of environmental matters, it is management’s opinion, based in part on the advice of independent counsel (after taking into account accruals and insurance coverage applicable to such actions) that when the costs are finally determined they will not have a material adverse effect on the financial position of the Company.
Answer the following questions. (a) What conditions must exist before a loss contingency can be recorded in the accounts? (b) Suppose that Matsui Corporation could not reasonably estimate the amount of the loss, although it could establish with a high degree of probability the minimum and maximum loss possible. How should this information be reported in the financial statements? (c) If the amount of the loss is uncertain, how would the loss contingency be reported in the financial statements?
CA13-7 (Warranties and Loss Contingencies)
The following two independent situations involve loss contingencies. Part 1 Benson Company sells two products, Grey and Yellow. Each carries a one-year warranty. 1. Product Grey—Product warranty costs, based on past experience, will normally be 1% of sales. 2. Product Yellow—Product warranty costs cannot be reasonably estimated because this is a new product line. However, the chief engineer believes that product warranty costs are likely to be incurred.
How should Benson report the estimated product warranty costs for each of the two types of merchandise above? Discuss the rationale for your answer. Do not discuss disclosures that should be made in Benson’s financial statements or notes. Part 2 Constantine Company is being sued for $4,000,000 for an injury caused to a child as a result of alleged negligence while the child was visiting the Constantine Company plant in March 2012. The suit was filed in July 2012. Constantine’s lawyer states that it is probable that Constantine will lose the suit and be found liable for a judgment costing anywhere from $400,000 to $2,000,000. However, the lawyer states that the most probable judgment is $1,000,000.
How should Constantine report the suit in its 2012 financial statements? Discuss the rationale for your answer. Include in your answer disclosures, if any, that should be made in Constantine’s financial statements or notes. (AICPA adapted)
CA13-8 (Warranties)
The Dotson Company, owner of Bleacher Mall, charges Rich Clothing Store a rental fee of $600 per month plus 5% of yearly profits over $500,000. Matt Rich, the owner of the store, directs his accountant, Ron Hamilton, to increase the estimate of bad debt expense and warranty costs in order to keep profits at $475,000.
Answer the following questions. (a) Should Hamilton follow his boss’s directive? (b) Who is harmed if the estimates are increased? (c) Is Matt Rich’s directive ethical? USING YOUR JUDGMENT

Financial Reporting Problem

The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B or can be accessed at the book’s companion website,
Refer to these financial statements and the accompanying notes to answer the following questions. (a) What was P&G’s 2009 short-term debt and related weighted-average interest rate on this debt? (b) What was P&G’s 2009 working capital, acid-test ratio, and current ratio? Comment on P&G’s liquidity. (c) What types of commitments and contingencies has P&G’s reported in its financial statements? What is management’s reaction to these contingencies?
Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) How much working capital do each of these companies have at the end of 2009? (b) Compute both company’s (a) current cash debt coverage ratio, (b) cash debt coverage ratio, (c) current ratio, (d) acid-test ratio, (e) receivable turnover ratio and (f) inventory turnover ratio for 2009. Comment on each company’s overall liquidity. (c) In PepsiCo’s financial statements, it reports in the long-term debt section “short-term borrowings, reclassified.” How can short-term borrowings be classified as long-term debt? (d) What types of loss or gain contingencies do these two companies have at the end of 2009? Financial Statement Analysis Cases
Case 1 Northland Cranberries
Despite being a publicly traded company only since 1987, Northland Cranberries of Wisconsin Rapids, Wisconsin, is one of the world’s largest cranberry growers. During its short life as a publicly traded corporation, it has engaged in an aggressive growth strategy. As a consequence, the company has taken on significant amounts of both short-term and long-term debt. The following information is taken from recent annual reports of the company. Using Your Judgment 769
(a) Evaluate the company’s liquidity by calculating and analyzing working capital and the current ratio. (b) The discussion of the company’s liquidity, shown on page 770, was provided by the company in the Management Discussion and Analysis section of the company’s annual report. Comment on whether you agree with management’s statements, and what might be done to remedy the situation. Northland Cranberries Current Prior Year Year Current assets $ 6,745,759 $ 5,598,054 Total assets 107,744,751 83,074,339 Current liabilities 10,168,685 4,484,687 Total liabilities 73,118,204 49,948,787 Shareholders’ equity 34,626,547 33,125,552 Net sales 21,783,966 18,051,355 Cost of goods sold 13,057,275 8,751,220 Interest expense 3,654,006 2,393,792 Income tax expense 1,051,000 1,917,000 Net income 1,581,707 2,942,954
Answer the following questions. (a) What is the difference between the cash basis and the accrual basis of accounting for warranty costs? (b) Under what circumstance, if any, would it be appropriate for Mohican Company to recognize deferred revenue on warranty contracts? (c) If Mohican Company recognized deferred revenue on warranty contracts, how would it recognize this revenue in subsequent periods?
Case 3 BOP Clothing Co.
As discussed in the chapter, an important consideration in evaluating current liabilities is a company’s operating cycle. The operating cycle is the average time required to go from cash to cash in generating revenue. To determine the length of the operating cycle, analysts use two measures: the average days to sell inventory (inventory days) and the average days to collect receivables (receivable days). The inventory-days computation measures the average number of days it takes to move an item from raw materials or purchase to final sale (from the day it comes in the company’s door to the point it is converted to cash or an account receivable). The receivabledays computation measures the average number of days it takes to collect an account. Most businesses must then determine how to finance the period of time when the liquid assets are tied up in inventory and accounts receivable. To determine how much to finance, companies first determine accounts payable days—how long it takes to pay creditors. Accounts payable days measures the number of days it takes to pay a supplier invoice. Consider the following operating cycle worksheet for BOP Clothing Co. (dollars in thousands) Current Year Prior Year Current liabilities Current portion of long-term debt $ 15,000 $ 10,000 Short-term debt 2,668 405 Accounts payable 29,495 42,427 Accrued warranty 16,843 16,741 Accrued marketing programs 17,512 16,585 Other accrued liabilities 35,653 33,290 Accrued and deferred income taxes 16,206 17,348 Total current liabilities $133,377 $136,796 Notes to Consolidated Financial Statements Note 1 (in part): Summary of Signifi cant Accounting Policies and Related Data Accrued Warranty The company provides an accrual for future warranty costs based upon the relationship of prior years’ sales to actual warranty costs. The lower comparative current ratio in the current year was due to $3 million of short-term borrowing then outstanding which was incurred to fund the Yellow River Marsh acquisitions last year. As a result of the extreme seasonality of its business, the company does not believe that its current ratio or its underlying stated working capital at the current, fiscal year-end is a meaningful indication of the Company’s liquidity. As of March 31 of each fiscal year, the Company has historically carried no significant amounts of inventories and by such date all of the Company’s accounts receivable from its crop sold for processing under the supply agreements have been paid in cash, with the resulting cash received from such payments used to reduce indebtedness. The Company utilizes its revolving bank credit facility, together with cash generated from operations, to fund its working capital requirements throughout its growing season.
Case 2 Mohican Company
Presented below is the current liabilities section and related note of Mohican Company. These data indicate that BOP has reduced its overall operating cycle (to 261.5 days) as well as the number of days to be financed with sources of funds other than accounts payable (from 78 to 63 days). Most businesses cannot finance the operating cycle with accounts payable financing alone, so working capital financing, usually short-term interest-bearing loans, is needed to cover the shortfall. In this
Case, BOP would need to borrow less money to finance its operating cycle in 2012 than in 2011.

(a) Use the BOP analysis to briefly discuss how the operating cycle data relate to the amount of working capital and the current and acid-test ratios. (b) Select two other real companies that are in the same industry and complete the operating cycle worksheet on the previous page, along with the working capital and ratio analysis. Briefly summarize and interpret the results. To simplify the analysis, you may use ending balances to compute turnover ratios. [Adapted from Operating Cycle Worksheet at]
Accounting, Analysis, and Principles (Note: For any part of this problem requiring an interest or discount rate, use 10 percent.) YellowCard Company manufactures accessories for iPods. It had the following selected transactions during 2012. 1. YellowCard provides a 2-year warranty on its docking stations, which it began selling in 2012. During 2012, YellowCard spent $6,000 servicing warranty claims. At year-end, Yellow- Card estimates that an additional $45,000 will be spent in the future to service warranties related to 2012 sales. 2. YellowCard has a $200,000 loan outstanding from First Trust Corp. The loan is set to mature on February 28, 2013. For several years, First Trust has agreed to extend the loan, as long as YellowCard makes all its quarterly interest payments (interest is due on the last days of each February, May, August, and November) and maintains an acid-test ratio (also called “quick ratio”) of at least 1.25. First Trust has provided YellowCard a “commitment letter” indicating that First Trust will extend the loan another 12 months, providing YellowCard makes the interest payment due on March 31. Using Your Judgment 771 2011 2012 Cash $ 45,000 $ 30,000 Accounts receivable 250,000 325,000 Inventory 830,000 800,000 Accounts payable 720,000 775,000 Purchases 1,100,000 1,425,000 Cost of goods sold 1,145,000 1,455,000 Sales 1,750,000 1,950,000 Operating Cycle Inventory days1 264.6 200.7 Receivable days2 52.1 60.8 Operating cycle 316.7 261.5 Less: Accounts payable days3 238.9 198.5 Days to be fi nanced 77.8 63.0 Working capital $ 405,000 $ 380,000 Current ratio 1.56 1.49 Acid-test ratio 0.41 0.46 1Inventory days 5 (Inventory 3 365) 4 Cost of goods sold 2Receivable days 5 (Accounts receivable 3 365) 4 Sales 3Accounts payable days 5 (Accounts payable 3 365) 4 Purchases Purchases 5 Cost of goods sold 1 Ending inventory 2 Beginning inventory. The ratios above assume that other current assets and liabilities are negligible. 3. During 2011, YellowCard constructed a small manufacturing facility specifically to manufacture one particular accessory. YellowCard paid the construction contractor $5,000,000 cash (which was the total contract price) and placed the facility into service on January 1, 2012. Because of technological change, YellowCard anticipates that the manufacturing facility will be useful for no more than 10 years. The local government where the facility is located required that, at the end of the 10-year period, YellowCard remediate the facility so that it can be used as a community center. YellowCard estimates the cost of remediation to be $500,000.
Accounting Prepare all 2012 journal entries relating to (a) YellowCard’s warranties, (b) YellowCard’s loan from First Trust Corp., and (c) the new manufacturing facility YellowCard opened on January 1, 2012.
Analysis Describe how the transactions above affect ratios that might be used to assess YellowCard’s liquidity. How important is the commitment letter that YellowCard has from First Trust Corp. to these ratios? Principles YellowCard is contemplating offering an extended warranty. If customers pay an additional $50 at the time of product purchase, YellowCard would extend the warranty an additional two years. Would the extended warranty meet the definition of a liability under current generally accepted accounting principles? Briefly explain?
BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation
Pleasant Co. manufactures specialty bike accessories. The company is known for product quality, and it has offered one of the best warranties in the industry on its higher-priced products—a lifetime guarantee, performing all the warranty work in its own shops. The warranty on these products is included in the sales price. Due to the recent introduction and growth in sales of some products targeted to the lowprice market, Pleasant is considering partnering with another company to do the warranty work on this line of products, if customers purchase a service contract at the time of original product purchase. Pleasant has called you to advise the company on the accounting for this new warranty arrangement.
If your school has a subscription to the FASB Codification, go to to log in and prepare responses to the following. Provide Codification references for your responses. (a) Identify the accounting literature that addresses the accounting for the type of separately priced warranty that Pleasant is considering. (b) When are warranty contracts considered separately priced? (c) What are incremental direct acquisition costs and how should they be treated? Professional Simulation In this simulation, you are asked to address questions related to the accounting for current liabilities. Prepare responses to all parts.  

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