True/False Questions

 

1. Some liabilities are not contractual obligations and may not be payable in cash.

 

Answer: True    Learning Objective: 1       Level of Learning:

 

2. Long-term debt that is callable by the creditor in the upcoming year should be classified as a current liability only if the debt is expected to be called.

 

Answer: False    Learning Objective: 1       Level of Learning: 1

 

3. A customer advance produces a liability that is satisfied when the product or service is provided.

 

Answer: True    Learning Objective: 3       Level of Learning: 1

 

4. Amounts withheld from employees in connection with payroll often represent liabilities to third parties.

 

Answer: True    Learning Objective: 1       Level of Learning: 1

 

5. A company should accrue a liability for a loss contingency if it is at least reasonably possible that assets have been impaired, and the amount of potential loss can be reasonably estimated.

 

Answer: False    Learning Objective: 6       Level of Learning:1

 

6. A disclosure note is required for all material loss contingencies for which the probability of loss is reasonably possible.

 

Answer: True    Learning Objective: 6       Level of Learning: 1

 

7. The concept of substance over form influences the classification of obligations expected to be refinanced.

 

Answer: True    Learning Objective: 4       Level of Learning: 1

 

8. For a loss contingency to be accrued, the claim must have been made before the accounting period ended.

 

Answer: False    Learning Objective: 5       Level of Learning: 2

 

9. Warranty expense is recorded along with the related liability in the reporting period in which the product under warranty is sold.

 

Answer: True    Learning Objective: 5       Level of Learning: 1

 

10. The cost of promotional offers should be recorded as expenses in the accounting period when the offers are redeemed by customers.

 

Answer: False    Learning Objective: 6       Level of Learning: 2

 

 

 

Matching Pair Questions

 

Use the following to answer questions 11-15:

 

11-15.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Accrued liabilities
2. Advances from customers
3. Callable
4. Discount on notes payable
5. Interest payable
6. Probable
7. Sales tax payable
8. Secured loan
9. Short-term note
10. Warranty liability

Phrases:

11. ____ A liability when received.
12. ____ Confirming event is likely to occur.
13. ____ A loss contingency accrued in the period of related sales.
14. ____ Most common temporary financing arrangement.
15. ____ Requires collateral.

 

Answer: 11-B; 12-F; 13-J; 14-I; 15-H

 

Use the following to answer questions 16-20:

 

16-20.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Accrued liabilities
2. Advances from customers
3. Callable
4. Discount on notes payable
5. Interest payable
6. Probable
7. Sales tax payable
8. Secured loan
9. Short-term note
10. Warranty liability

Phrases:

16. ____ Due on demand.
17. ____ A contra liability account.
18. ____ A third party liability.
19. ____ Accrues with passage of time.
20. ____ Expenses incurred but not yet paid.

 

Answer: 16-C; 17-D; 18-G; 19-E; 20-A

 

 

Use the following to answer questions 21-25:

 

21-25.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Accounting liabilities
2. Customer deposits
3. Effective interest
4. Factoring
5. Gain contingency
6. Interest paid on debt
7. Noncommitted line of credit
8. Reasonably possible
9. Subsequent event
10. Unasserted claims

Phrases:

21. ____ Liability until refunded.
22. ____ More than remote but less than likely.
23. ____ Face amount x rate x time.
24. ____ Not recorded until realized.
25. ____ Informal borrowing agreement.

 

Answer: 21-B; 22-H; 23-F; 24-E; 25-G

 

Use the following to answer questions 26-30:

 

26-30.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Accounting liabilities
2. Customer deposits
3. Effective interest
4. Factoring
5. Gain contingency
6. Interest paid on debt
7. Noncommitted line of credit
8. Reasonably possible
9. Subsequent event
10. Unasserted claims

Phrases:

26. ____ Exceeds the stated rate on discounted notes.
27. ____ May include items that are not legal liabilities.
28. ____ Sale of receivables.
29. ____ Evaluated for recognition only if an unfavorable outcome is probable.
30. ____ Occurs in the current year before prior year financial statements are issued.

 

Answer: 26-C; 27-A; 28-D; 29-J; 30-I

 

 

 

Use the following to answer questions 31-35:

 

31-35.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Accounts payable
2. Commercial paper
3. Committed line of credit
4. Current liabilities
5. Disclosure notes
6. Long-term liability
7. Loss contingency
8. Noninterest-bearing note
9. Pledging
10. Usual valuation of long-term liabilities

Phrases:

31. ____ Uses accounts receivable as collateral.
32. ____ Often requires compensating balance.
33. ____ Only formal credit instrument is the invoice.
34. ____ Effective interest higher than stated interest.
35. ____ Recorded if probable and amount is known or reasonably estimable.

 

Answer: 31-I; 32-C; 33-A; 34-H; 35-G

 

Use the following to answer questions 36-40:

 

36-40.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Accounts payable
2. Commercial paper
3. Committed line of credit
4. Current liabilities
5. Disclosure notes
6. Long-term liability
7. Loss contingency
8. Noninterest-bearing notes
9. Pledging
10. Usual valuation of long-term liabilities

Phrases:

36. ____ Present value of interest plus present value of principal.
37. ____ Required for contingencies.
38. ____ Payable with current assets.
39. ____ Short-term debt to be refinanced with long-term bonds payable.
40. ____ Avoids registration with SEC.

 

Answer: 36-J; 37-E; 38-D; 39-F; 40-B

 

 

Use the following to answer questions 41-44:

 

41-44.  Indicate (by letter) the way each of the items listed below should be reported on a balance sheet at December 31, 2006.

 

Reporting Method

1. Asset
2. Liability
3. Disclosure note only
4. Not reported

 

41. ____ An estimable gain that is contingent on a future event that appears exceedingly likely.
42. ____ An assessment of back taxes that probably will be asserted by the IRS, in which case a determinable additional payment is probable.
43. ____ Unassessed back taxes with a reasonable possibility of being asserted, in which case a determinable additional payment is probable.
44. ____ A extremely likely loss due an event that occurred previously and whose amount is unknown but estimable.

 

Answer: 41-D; 42-L; 43-N; 44-L

 

 

Multiple Choice Questions

 

45. The most common type of liability is:
46. A) One that comes into existence due to a loss contingency.
47. B) One that must be estimated.
48. C) One that comes into existence due to a gain contingency.
49. D) One to be paid in cash and for which the amount and timing are known.

 

Answer: D    Learning Objective: 1       Level of Learning: 1

 

46. Which of the following is not a characteristic of a liability?
47. A) It represents a probable, future sacrifice of economic benefits.
48. B) It must be payable in cash.
49. C) It arises from present obligations to other entities.
50. D) It results from past transactions or events.

 

Answer: B    Learning Objective: 1      Level of Learning: 1

 

47. Which of the following is not a liability?
48. A) An unused line of credit.
49. B) Estimated income taxes.
50. C) Sales tax collected from customers.
51. D) Advances from customers.

 

Answer: A    Learning Objective: 1       Level of Learning: 2

 

 

 

48. Current liabilities are normally recorded at the amount expected to be paid rather than at their present value. This practice can be supported by GAAP according to the concept of:
49. A)
50. B)
51. C) Materiality.
52. D)

 

Answer: C    Learning Objective: 1       Level of Learning: 2

 

49. Which of the following is the best definition of a current liability?
50. A) An obligation payable within one year.
51. B) An obligation payable within one year of the balance sheet date.
52. C) An obligation payable within one year or within the normal operating cycle, whichever is longer.
53. D) An obligation expected to be satisfied with current assets or by the creation of other current liabilities.

 

Answer: D    Learning Objective: 1       Level of Learning: 1

 

50. Current liabilities are normally recorded at their:
51. A) Present value.
52. B)
53. C) Maturity amount.
54. D) Expected value.

 

Answer: C    Learning Objective: 1       Level of Learning: 1

 

51. Which of the following is not a current liability?
52. A) Accounts payable.
53. B) A note payable due in 2 years.
54. C) Accrued interest payable.
55. D) Sales tax payable.

 

Answer: B    Learning Objective: 4       Level of Learning: 2

 

52. The key accounting considerations relating to accounts payable are:
53. A) Determining their existence and ensuring that they are recorded in the appropriate accounting period.
54. B) Determining their present value and ensuring that they are recorded in the appropriate accounting period.
55. C) Determining their existence and determining the correct amount.
56. D) Determining the present value of the principal and the amount of the interest.

 

Answer: A    Learning Objective: 1       Level of Learning: 2

 

53. Discount on a noninterest-bearing note payable is classified on the balance sheet as:
54. A) An asset.
55. B) A component of shareholders’ equity.
56. C) A contingent liability.
57. D) A contra liability.

 

Answer: D    Learning Objective: 2       Level of Learning: 1

 

 

54. The rate of interest that is actually incurred on a note payable is called the:
55. A) Face rate.
56. B) Contract rate.
57. C) Effective rate.
58. D) Stated rate.

 

Answer: C    Learning Objective: 2       Level of Learning: 1

 

55. The rate of interest printed on the face of a note payable is called the:
56. A) Yield rate.
57. B) Effective rate.
58. C) Market rate.
59. D) Stated rate.

 

Answer: D    Learning Objective: 2       Level of Learning: 1

 

56. Classifying liabilities as either current or long-term helps creditors assess:
57. A) The extent of a firm’s liabilities.
58. B) The relative risk of a firm’s liabilities.
59. C) The degree of a firm’s liabilities.
60. D) The amount of a firm’s liabilities.

 

Answer: B    Learning Objective: 1       Level of Learning: 2

 

57. Large, highly rated firms sometimes sell commercial paper:
58. A) To borrow funds at a lower rate than through a bank.
59. B) To borrow funds that are not available at banks.
60. C) Because they can’t borrow anywhere else.
61. D) Because the interest rate is locked in by the federal reserve board.

 

Answer: A    Learning Objective: 4       Level of Learning: 2

 

58. When cash is received from customers in the form of a refundable deposit, the cash account is increased and there is a corresponding increase in:
59. A) A current liability.
60. B) A non-current asset.
61. C) Shareholders’ equity.
62. D) Paid-in capital.

 

Answer: A    Learning Objective: 1       Level of Learning: 2

 

59. When a deposit on returnable containers is forfeited, the firm holding the deposit will experience:
60. A) A decrease in cost of goods sold.
61. B) An increase in current liabilities.
62. C) An increase in accounts receivable.
63. D) An increase in revenue.

 

Answer: D    Learning Objective: 1       Level of Learning: 2

 

 

 

60. At times, businesses require advance payments from customers that will be applied to the purchase price when goods are delivered or services provided. These customer advances represent:
61. A) Liabilities until the product or service is provided.
62. B) A component of shareholders’ equity.
63. C) Long-term assets until the product or service is provided.
64. D) Revenue upon receipt of the advance payment.

 

Answer: A    Learning Objective: 3       Level of Learning: 1

 

61. When a product or service is delivered for which a customer advance has been previously received, the appropriate journal entry includes:
62. A) A debit to a revenue and a credit to a liability account.
63. B) A debit to a revenue and a credit to an asset account.
64. C) A debit to an asset and a credit to a revenue account.
65. D) A debit to a liability and a credit to a revenue account.

 

Answer: D    Learning Objective: 3       Level of Learning: 3

 

62. All of the following but one represent collections for third parties. Which one of the following is not a collection for a third party?
63. A) Sales tax payable.
64. B) Customer deposits.
65. C) Employee insurance deductions.
66. D) Social security taxes deductions.

 

Answer: B    Learning Objective: 1       Level of Learning: 2

 

63. Other things being equal, most managers would prefer to report liabilities as noncurrent rather than current. The logic behind this preference is that the long-term classification permits the company to report:
64. A) Higher working capital and a higher inventory turnover.
65. B) Lower working capital and a higher current ratio.
66. C) Higher working capital and a higher current ratio.
67. D) Higher working capital and a lower debt to equity ratio.

 

Answer: C    Learning Objective: 4       Level of Learning: 2

 

64. Footnote disclosure is required for material potential losses when the loss is at least reasonably possible:
65. A) Only if the amount is known.
66. B) Only if the amount is known or reasonably estimable.
67. C) Unless the amount is not reasonably estimable.
68. D) Even if the amount is not reasonably estimable.

 

Answer: D    Learning Objective: 5       Level of Learning: 1

 

 

 

65. Which of the following situations would not require that long-term liabilities be reported as current liabilities on a classified balance sheet?
66. A) The long-term debt is callable by the creditor.
67. B) The creditor has the right to demand payment due to a contractual violation.
68. C) The long-term debt matures within the upcoming year.
69. D) All of the above require the current classification.

 

Answer: D    Learning Objective: 4       Level of Learning: 2

 

66. Short-term obligations can be reported as long-term liabilities if:
67. A) The firm has a long-term line of credit.
68. B) The firm has tentative plans to issue long-term bonds.
69. C) The firm intends to and has the ability to refinance as long-term.
70. D) The firm has the ability to refinance on a long-term basis.

 

Answer: C    Learning Objective: 4       Level of Learning: 1

 

67. Of the following, which typically would not be classified as a current liability?
68. A) Estimated liability from cash rebate program.
69. B) A long-term note payable maturing within the coming year.
70. C) Rent revenue received in advance.
71. D) A six-month bank loan to be paid with the proceeds from the sale of common stock.

 

Answer: D    Learning Objective: 4       Level of Learning: 1

 

68. Gain contingencies usually are recognized in a company’s income statement when:
69. A) Realized.
70. B) The amount can be reasonably estimated.
71. C) The gain is reasonably possible and the amount can be reasonable estimated.
72. D) The gain is probable and the amount can be reasonably estimated.

 

Answer: A    Learning Objective: 5       Level of Learning: 1

 

69. A loss contingency should be accrued on a company’s financial statements only if the likelihood that a liability has been incurred is:
70. A) At least remotely possible and the amount of the loss is known.
71. B) At least reasonably possible and the amount of the loss is known.
72. C) At least reasonably possible and the amount of the loss can be reasonably estimated.
73. D) Probable and the amount of the loss can be reasonably estimated.

 

Answer: D    Learning Objective: 5       Level of Learning: 1

 

70. When a gain contingency is probable and the amount of gain can be reasonably estimated, the gain should be:
71. A) Reported in the income statement and disclosed.
72. B) Offset against shareholders’ equity.
73. C) Disclosed, but not recognized in the income statement.
74. D) Neither recognized in the income statement nor disclosed.

 

Answer: C    Learning Objective: 6       Level of Learning: 2

 

 

 

71. A contingent loss should be reported in a footnote to the financial statements rather than being accrued if:
72. A) The likelihood of a loss is remote.
73. B) The incurrence of a loss is reasonably possible.
74. C) The incurrence of a loss is probable.
75. D) The likelihood of a loss is eighty percent.

 

Answer: B    Learning Objective: 5       Level of Learning: 2

 

72. Paul Company issues a product recall due to a defect discovered after the end of its fiscal year. Financial statements have not been issued yet. The action required on the books of Paul Company for this contingency for the year just ended is:
73. A) To disclose it in a footnote.
74. B) To accrue the liability.
75. C) To accrue the liability and explain it in a footnote.
76. D) To do nothing relative to the contingency.

 

Answer: A    Learning Objective: 6       Level of Learning: 3

 

73. Which of the following is a contingency that would most likely require accrual?
74. A) Potential losses from extended warranties.
75. B) Customer premium offers.
76. C) Potential liability on a product where none have yet been sold.
77. D) Sales tax payable.

 

Answer: B    Learning Objective: 6       Level of Learning: 2

 

74. Volt Electronics sells equipment that includes a three-year warranty. Volt repairs under the warranty are performed by an independent service company under a contract with Volt. Based on prior experience, warranty costs are estimated to be $25 per item sold. Volt should recognize these warranty costs:
75. A) When the equipment is sold.
76. B) When the repairs are performed.
77. C) When payments are made to the service firm.
78. D) Evenly over the life of the warranty.

 

Answer: A    Learning Objective: 6       Level of Learning: 3

 

75. Which of the following is a contingency that should be accrued?
76. A) The company is being sued and a loss is reasonably possible and reasonably estimable.
77. B) The company deducts life insurance premiums from employees’ paychecks.
78. C) The company offers a two-year warranty and the expenses can be reasonably estimated.
79. D) It is probable that the company will receive $100,000 in settlement of a lawsuit.

 

Answer: C    Learning Objective: 5       Level of Learning: 2

 

 

 

76. The cost of customer premium offers should be charged to expense:
77. A) When the related product is sold.
78. B) When the premium offer expires.
79. C) Over the life cycle of the product to which the premium relates.
80. D) When the premiums are claimed.

 

Answer: A    Learning Objective: 6       Level of Learning: 2

 

77. The accounting concept that requires recognition of a liability for customer premium offers is
78. A)
79. B)
80. C) Historical cost.
81. D) The matching principle.

 

Answer: D    Learning Objective: 6       Level of Learning: 2

 

78. Which of the following may create employer liabilities in connection with their payrolls?
79. A) Employees’ withholding taxes
80. B) Employee voluntary deductions
81. C) Employee fringe benefits
82. D) All of the above are correct.

 

Answer: D    Learning Objective: 6       Level of Learning: 1

 

79. Accounting for costs of incentive programs for frequent customer purchases involves:
80. A) Recording an expense and a liability each period.
81. B) Recording a liability and a reduction of revenue each period.
82. C) Recording an expense and an asset reduction each period.
83. D) Recording an expense and revenue each period.

 

Answer: A    Learning Objective: 6       Level of Learning: 2

 

80. Accounting for costs of incentive programs for frequent customer purchases:
81. A) Requires probability estimation.
82. B) Uses the matching principle.
83. C) Is a loss contingency situation.
84. D) All of the above are correct.

 

Answer: D    Learning Objective: 6       Level of Learning: 1

 

81. Providing a monetary rebate program for purchasing a product:
82. A) Is accounted for similarly to product warranties.
83. B) Creates an expense for the seller in the period of sale.
84. C) Creates a contingent liability for the seller at the time of sale.
85. D) All of the above are correct.

 

Answer: D    Learning Objective: 6       Level of Learning: 1

 

 

 

82. The main difference between accounting for rebate and cash discount coupons is:
83. A) The latter is not treated as an expense.
84. B) Only the former creates a contingent liability when issued.
85. C) The expense for the latter is deferred until redemption of the coupon.
86. D) There are no significant differences in accounting between the two.

 

Answer: C    Learning Objective: 6       Level of Learning: 1

 

83. Which of the following have essentially the same accounting treatment?
84. A) Coupons for cash rebates and coupons for other premiums
85. B) Cents off coupons and coupons for other premiums
86. C) Cents off coupons and coupons for cash rebates
87. D) All of the above are correct.

 

Answer: A    Learning Objective: 6.       Level of Learning: 1

 

Use the following to answer questions 84-85:

 

In 2006, Holyoak Inc. offers a $20 cash rebate coupon to customers who purchased one of its new line of products.  Holyoak sold 10,000 of these products during the year.  By year end of 2006, 7,600 of the rebates had been claimed, and 7,100 had been paid.  Holyoak’s historical experience with such rebates indicates that 85% of customers claim the rebates.

 

84. What is the expense that Holyoak should report for its promotional rebates in its 2006 income statement?
85. A) $142,000
86. B) $152,000
87. C) $170,000
88. D) $200,000

 

Answer: C    Learning Objective: 6       Level of Learning: 3

Rationale: This is the expected amount to be claimed from 2006 sales; i.e., $20 x 10,000 x .85.

 

85. What is the rebate promotion liability that Holyoak should report in its 12/31/06 balance sheet?
86. A) $20,000
87. B) $28,000
88. C) $18,000
89. D) None of the above is correct.

 

Answer: B    Learning Objective: 6       Level of Learning: 3

Rationale: This is (8,500 expected 7,100 paid) x $20 = $28,000.

 

 

Use the following to answer questions 86-88:

 

Always Late Airline (ALA) operates a frequent flyer program in which mileage credits are earned by its customers for traveling on the airline.   Awards are issued to members at the 25,000 miles level, and all awards expire five years from the date earned. The airline’s historical experience indicates that 80% of all travel awards will actually be redeemed.

 

ALA accounts for its frequent flyer obligation on the accrual basis, using the incremental cost method. ALA’s liability for free travel at the beginning of 2005 was $28 million. The incremental cost of free travel awards redeemed in 2005 was $19 million. The estimated cost of free travel earned for miles traveled in 2005 are $50 million.

 

86. What is the expense that ALA should report for its frequent flyer program in its 2005 income statement?
87. A) $40 million
88. B) $41 million
89. C) $50 million
90. D) $69 million

 

Answer: A    Learning Objective: 6       Level of Learning: 3

Rationale: This is 80% of the $50 million cost of free travel awards earned.

 

87. Assume the same facts as in question 86, except that $2 million in earned travel awards on ALA expired during 2005.  What is the expense that ALA should report for its frequent flyer program in its 2005 income statement?
88. A) $38 million
89. B) $40 million
90. C) $42 million
91. D) None of the above is correct.

 

Answer: B    Learning Objective: 6       Level of Learning: 3

Rationale: The answer is the same as for question 86 because the cost for that year’s customer benefits is the same.

 

88. Assume the same facts as in question 86.  What is the frequent flyer program liability that ALA should report in its 12/31/05 balance sheet?
89. A) $31 million
90. B) $40 million
91. C) $45 million
92. D) None of the above is correct.

 

Answer: D    Learning Objective: 6       Level of Learning: 3

Rationale: This is the beginning liability of $28 million awards redeemed of $19 million + new awards accrued of $40 million= $49 million.

 

 

89. On October 31, 2006, Simeon Builders borrowed $16 million cash and issued a 7-month, noninterest-bearing note. The loan was made by Star Finance Co. whose stated discount rate is 8%. Sky’s effective interest rate on this loan is:
90. A) More than the stated discount rate of 8%.
91. B) Less than the stated discount rate of 8%.
92. C) Equal to the stated discount rate of 8%.
93. D) Unrelated to the stated discount rate of 8%.

 

Answer: A    Learning Objective: 2       Level of Learning: 3

 

90. In the current year, Hanna Company reported warranty expense of $190,000 and the warranty liability account increased by $20,000. What were warranty expenditures during the year?
91. A) $190,000.
92. B) $170,000.
93. C) $210,000
94. D) $0

 

Answer: B    Learning Objective: 6       Level of Learning: 3

Rationale:

Expense	$190,000
Increase in liability	(20,000)
Expenditures	$170,000

 

91. Panther Co. had a warranty liability of $350,000 at the beginning of 2006, and $310,000 at end of 2006. Warranty expense is based on 4% of sales, which were $50 million for the year. What were the warranty expenditures for 2006?
92. A) $0.
93. B) $1,960,000.
94. C) $2,000,000.
95. D) $2,040,000.

 

Answer: D    Learning Objective: 6       Level of Learning: 3

Rationale:

Warranty Liability
	$ 350,000
?	2,000,000	($50,000,000 x 4%)
	310,000

 

$350,000 + $2,000,000 $310,000 = $2,040,000

 

 

92. Carpenter Inc. had a balance of $80,000 in its warranty liability account as of December 31, 2005. In 2006, Carpenter’s warranty expenditures were $445,000. Its warranty expense is calculated as 1% of sales. Sales in 2006 were $40 million. What was the balance in the warranty liability account as of December 31, 2006?
93. A) $  35,000.
94. B) $425,000.
95. C) $125,000.
96. D) $480,000.

 

Answer: A    Learning Objective: 6       Level of Learning: 3

Rationale:

Warranty Liability (in thousands)
	80
445	400	(40,000 x 1%)
	35

 

93. What is the effective interest rate on a 3-month, noninterest-bearing note with a stated rate of 12% and a maturity value of $200,000?
94. A) 36%.
95. B) 00 %.
96. C) 46%.
97. D) 00%.

 

Answer: A    Learning Objective: 2       Level of Learning: 3

Rationale:

$200,000 x 12% x 3/12 = $6,000

$6,000/($200,000 $6,000) = 3.09%

3.09% x 12/3 = 12.36%

 

94. Oklahoma Oil Corp. paid interest of $785,000 during 2006, and the interest payable account decreased by $125,000. What was interest expense for the year?
95. A) $890,000.
96. B) $660,000.
97. C) $555,000.
98. D) $785,000.

 

Answer: B    Learning Objective: 2       Level of Learning: 3

Rationale:

Interest paid	$   785,000
Decrease in payable	(125,000)
Total interest expense	$660,000

 

 

 

95. On June 1, 2006, Dirty Harry Co. borrowed cash by issuing a 6-month noninterest-bearing note with a maturity value of $500,000 and a discount rate of 6%. What is the carrying value of the note as of September 30, 2006?
96. A) $525,000.
97. B) $300,000.
98. C) $495,000.
99. D) $475,000.

 

Answer: C    Learning Objective: 2       Level of Learning: 3

Rationale:

Face amount	$500,000
Discount ($500,000 x 6% x 6/12)	(15.000	)
Carrying value, 6/1/06	485,000
Discount amortization (4/6)	10,000
Carrying value, 9/30/06	$495,000

 

Use the following to answer questions 96-98:

 

General Product Inc. shipped 100 million coupons in products it sold in 2006. The coupons are redeemable for thirty cents each. General anticipates that 70% of the coupons will be redeemed. The coupons expire on December 31, 2007. There were 45 million coupons redeemed in 2006, and 30 million redeemed in 2007.

 

96. What was General’s coupon liability as of December 31, 2006?
97. A) $7.5 million.
98. B) $13.5 million.
99. C) $16.5 million.
100. D) $21.0 million.

 

Answer: A    Learning Objective: 6       Level of Learning: 3

Rationale:

100 million x $.30 x 70% = $21 million

$21 million (45 x $.30) = $7.5 million

 

97. What was General’s coupon promotion expense in 2006?
98. A) $30.0 million.
99. B) $21.0 million.
100. C) $13.5 million.
101. D) $7.5 million.

 

Answer: B    Learning Objective: 6       Level of Learning: 3

Rationale:

100 million x $.30 x 70% = $21 million

 

 

98. What was General’s coupon promotional expense in 2007?
99. A) Zero, since all the expense should be reflected in 2006.
100. B) $1.5 million.
101. C) $7.5 million.
102. D) $9.0 million.

 

Answer: B    Learning Objective: 6       Level of Learning: 3

Rationale:

(in millions)

Sales in 2006:
Promotional expense	21.0
Estimated premium liability		21.0
Redemptions in 2006:
Estimated premium liability	13.5
Cash		13.5
Redemptions in 2007:
Estimated premium liability	7.5
Promotional expense	1.5
Cash		9.0

 

99. Slotnick Chemical received customer deposits on returnable containers in the amount of $300,000 during 2006. Fifteen percent of the containers were not returned. The deposits are based on the container cost marked up 20%. How much profit did Slotnick realize on the forfeited deposits?
100. A) $0.
101. B) $7,500.
102. C) $9,000.
103. D) $45,000.

 

Answer: B    Learning Objective: 3       Level of Learning: 3

Rationale:

Total deposits forfeited ($300,000 x 15%)	$45,000
Less costs ($45,000/120%)	37,500
Profit	$  7,500

 

100. On September 1, 2006, Hiker Shoes issued a $100,000, 8-month, noninterest-bearing note. The loan was made by Second Commercial Bank whose stated discount rate is 9%. Hiker’s effective interest rate on this loan is:
101. A) 00%.
102. B) 49%.
103. C) 50%.
104. D) 57%.

 

Answer: D    Learning Objective: 2       Level of Learning: 3

Rationale:

$100,000 x 9% x 8/12 = $6,000

[$6,000/$100,000 $6,000)] x 12/8 = 9.57%

 

 

101. Universal Travel Inc. borrowed $500,000 on November 1, 2006, and signed a 12-month note bearing interest at 6%. Interest is payable in full at maturity on October 31, 2007. In connection with this note, Universal Travel Inc. should report interest payable at December 31, 2006, in the amount of:
102. A) $ 8,000.
103. B) $30,000.
104. C) $ 5,000.
105. D) $25,000.

 

Answer: C    Learning Objective: 2       Level of Learning: 3

Rationale:

$500,000 x 6% x 2/12 = $5,000

 

102. Jane’s Donut Co. borrowed $200,000 on January 1, 2006, and signed a two-year note bearing interest at 12%. Interest is payable in full at maturity on January 1, 2008. In connection with this note, Jane’s should report interest expense at December 31, 2006, in the amount of:
103. A) $0.
104. B) $24,000.
105. C) $48,000.
106. D) $50,880.

 

Answer: B    Learning Objective: 2       Level of Learning: 3

Rationale:

$200,000 x 12% x 12/12 = $24,000

 

103. Clark’s Chemical Company received customer deposits on returnable containers in the amount of $100,000 during 2006. Twelve percent of the containers were not returned. The deposits are based on the container cost marked up 20%. What is cost of goods sold relative to this forfeiture?
104. A) $0.
105. B) $2,000.
106. C) $10,000.
107. D) $14,400.

 

Answer: C    Learning Objective: 3       Level of Learning: 3

Rationale:

($100,000 x 12%) 120% = $10,000

 

 

104. Branch Company, a building materials supplier, has $18,000,000 of notes payable due April 12, 2007. At December 31, 2006, Branch signed an agreement with First Bank to borrow up to $18,000,000 to refinance the notes on a long-term basis. The agreement specified that borrowings would not exceed 75% of the value of the collateral that Branch provided. At the date of issue of the December 31, 2006, financial statements, the value of Branch’s collateral was $20,000,000. On its December 31, 2006, balance sheet, Branch should classify the notes as follows:
105. A) $15,000,000 long-term and $3,000,000 current liabilities.
106. B) $4,500,000 short-term and $13,500,000 current liabilities.
107. C) $18,000,000 of current liabilities.
108. D) $18,000,000 of long-term liabilities.

 

Answer: A    Learning Objective: 1       Level of Learning: 3

Rationale:

Notes payable	$18,000,000
Refinancing ability ($20,000,000 x 75%)	15,000,000	L-T
Current liability from notes payable	$  3,000,000	S-T

 

105. At the beginning of 2006, Angel Corporation began offering a 2-year warranty on its products. The warranty program was expected to cost Angel 4% of net sales. Net sales made under warranty in 2006 were $180 million. Fifteen percent of the units sold were returned in 2006 and repaired or replaced at a cost of $5.3 million. The amount of warranty expense on Angel’s 2006 income statement is:
106. A) $  3 million.
107. B) $  2 million.
108. C) $10.6 million.
109. D) $27.0 million.

 

Answer: B    Learning Objective: 6       Level of Learning: 3

Rationale:

$180 million x 4% = $7.2 million

Repairs during the year cost less than the estimated liability, so no additional expense is reported.

 

106. During 2006, Deluxe Leather Goods sold 800,000 reversible belts under a new sales promotional program. Each belt carried one coupon, which entitles the customer to a $5.00 cash rebate. Deluxe estimates that 70% of the coupons will be redeemed, even though only 350,000 coupons had been processed during 2006. At December 31, 2006, Deluxe should report a liability for unredeemed coupons of:
107. A) $   560,000.
108. B) $1,050,000.
109. C) $1,225,000.
110. D) $1,750,000.

 

Answer: B    Learning Objective: 6       Level of Learning: 3

Rationale:

[($800,000 x 70%) 350,000] x $5 = $1,050,000

 

 

107. Captain Cook Cereal includes one coupon in each package of Granola that it sells and offers a puzzle in exchange for $2.00 and 3 coupons. The puzzles cost Captain Cook $3.50 each. Experience indicates that 20% of the coupons eventually will be redeemed. During the last month of 2006, the first month of the offer, Captain Cook sold 6 million boxes of Granola and 900,000 of the coupons were redeemed. What amount should Captain Cook report as a liability for coupons on its December 31, 2006, balance sheet?
108. A) $
109. B) $150,000.
110. C) $300,000.
111. D) $450,000.

 

Answer: B    Learning Objective: 6       Level of Learning: 3

Rationale:

[(6,000,000 x 20%) 900,000]/3 = 100,000 puzzles

100,000 x ($3.50 $2.00) = $150,000

 

108. Funzy Cereal includes one coupon in each package of Wheatos that it sells and offers a toy car in exchange for $1.00 and 3 coupons. The cars cost Funzy $1.50 each. Experience indicates that 40% of the coupons eventually will be redeemed. During the last month of 2006, the first month of the offer, Funzy sold 12 million boxes of Wheatos and 2.4 million of the coupons were redeemed. What amount should Funzy report as a promotional expense for coupons on its December 31, 2006, income statement?
109. A) $
110. B) $   400,000.
111. C) $   800,000.
112. D) $1,200,000.

 

Answer: C    Learning Objective: 6       Level of Learning: 3

Rationale:

[(12,000,000 x 40%)/3] x ($1.50 $1.00) = $800,000

 

109. In May of 2006, Raymond Financial Services became involved in a tax dispute with the IRS. At December 31, 2006, the tax attorney for Raymond indicated that an unfavorable outcome to the dispute was probable. The additional taxes were estimated to be $770,000 but could be as high as $1,170,000. After the year-end, but before the 2006 financial statements were issued, Raymond accepted an IRS settlement offer of $900,000. Raymond should have reported an accrued liability on its December 31, 2006, balance sheet of:
110. A) $   770,000.
111. B) $   900,000.
112. C) $   970,000.
113. D) $1,170,000.

 

Answer: B    Learning Objective: 3       Level of Learning: 3

 

 

 

 

Problems

 

110. Ontario Resources, a natural energy supplier, borrowed $80 million cash on November 1, 2006, to fund a geological survey. The loan was made by Quebec Banque under a short-term credit line. Ontario Resources issued a 9-month, 12% promissory note with interest payable at maturity. Ontario Resources’ fiscal period is the calendar year.

 

Required:

• Prepare the journal entry for the issuance of the note by Ontario Resources.
• Prepare the appropriate adjusting entry for the note by Ontario Resources on December 31, 2006. Show calculations.
• Prepare the journal entry for the payment of the note at maturity. Show calculations.

 

Answer:

(1.)	11/1/2006 issuance of the note by Ontario Resources:
	Cash	80,000,000
	Notes payable		80,000,000
(2.)	12/31/2006 adjusting entry for the note by Ontario Resources:
	Interest expense	1,600,000
	Interest payable		1,600,000
	($80,000,000 x 12% x 2/12)
(3.)	8/1/2007 payment of the note at maturity:
	Interest expense*	5,600,000
	Interest payable (from adjusting entry)	1,600,000
	Notes payable (face amount)	80,000,000
	Cash (total)		87,200,000
	*($80,000,000 x 12% x 7/12)

 

Learning Objective: 2       Level of Learning: 3

 

111. A $90,000, 6-month, noninterest-bearing note is discounted at the bank at a 10% discount rate.

 

Required:

• Prepare the appropriate journal entry to record the issuance of the note.
• Determine the effective interest rate.

 

Answer:

(1.)	Issuance of the note:
	Cash	85,500
	Discount on notes payable*	4,500
	Note payable		90,000
	*($90,000 x 10% x 6/12)
(2.)	Effective interest rate:
	The effective interest rate is: ($4,500/$85,500) x 12/6 = 10.53%

 

Learning Objective: 2       Level of Learning: 3

 

 

112. On November 1, 2006, a $216,000, 9-month, noninterest-bearing note is discounted at the bank at a 10% discount rate.

 

Required:

• Prepare the appropriate journal entry to record the issuance of the note.
• Determine the effective interest rate.
• Prepare the appropriate journal entry on December 31, 2006, to record interest on the note for the 2006 financial statements.
• Prepare the appropriate journal entry(s) on July 31, 2007, to record interest and the payment of the note.

 

Answer:

(1.)	Issuance of the note (November 1, 2006):
	Cash	199,800
	Discount on notes payable*	16,200
	Note payable		216,000
	*($216,000 x 10% x 9/12)
(2.)	Effective interest rate:
	The effective interest rate is: ($16,200/$199,800) x 12/9 = 10.81%
(3.)	Adjusting entry (December 31, 2006):
	Interest expense	3,600
	Discount on notes payable		3,600
	($216,000 x 10% x 2/12)
(4.)	Maturity (July 31, 2007)
	Interest expense	12,600
	Discount on notes payable		12,600
	($216,000 x 10% x 7/12)
	Notes payable (face amount)	216,000
	Cash		216,000

 

Learning Objective: 2       Level of Learning: 3

 

113. On June 30, 2006, Chu Industries issued 9-month notes in the amount of $700,000. Assume that interest is payable at maturity in the following three independent cases:

 

	Interest rate	Fiscal Year End
(1.)	9%	December 31
(2.)	6%	August 31
(3.)	12%	October 31

 

Required:

            Determine the amount of interest expense that should be accrued in a year-end adjusting entry under each assumption:

 

 

Answer:

(1.)	Interest rate	Fiscal Year-End
	9%	December 31
	$700,000 x 9% x 6/12 = $31,500
(2.)	Interest rate	Fiscal Year-End
	8%	August 31
	$700,000 x 6% x 2/12 = $7,000
(3.)	Interest rate	Fiscal Year-End
	12%	October 31
	$700,000 x 12% x 4/12 = $28,000

 

Learning Objective: 3       Level of Learning: 3

 

114. On November 1, 2006, Ziegler Products issued a $200,000, 9-month, noninterest-bearing note to the bank. Interest was discounted at a 12% discount rate.

 

Required:

• Prepare the appropriate journal entry by Ziegler to record the issuance of the note.
• Determine the effective interest rate.
• Suppose the note had been structured as a 12% note with interest and principal payable at maturity. Prepare the appropriate journal entry to record the issuance of the note by Ziegler.
• Prepare the appropriate journal entry on December 31, 2006, to accrue interest expense on the note described in (3.) for the 2006 financial statements.

 

Answer:

(1.)	Issuance of the note (November 1, 2006)
	Cash	182,000
	Discount on notes payable	18,000
	($200,000 x 12% x 9/12)
	Note payable		200,000
(2.)	Effective interest rate
	($18,000 ÷ $182,000) x 12/9 = 13.2%
(3.)	Issuance of the note (November 1, 2006)
	Cash	200,000
	Note payable		200,000
(4.)	Adjusting entry (December 31, 2006)
	Interest expense ($200,000 x 12% x 2/12)	4,000
	Interest payable		4,000

 

Learning Objective: 2       Level of Learning: 3

 

 

115. The following selected transactions relate to liabilities of Chicago Glass Corporation (Chicago) for 2006. Chicago’s fiscal year ends on December 31.

• On January 15, Chicago received $7,000 from Henry Construction toward the purchase of $66,000 of plate glass to be delivered on February 6.
• On February 3, Chicago received $6,700 of refundable deposits relating to containers used to transport glass components.
• On February 6, Chicago delivered the plate glass to Henry Construction and received the balance of the purchase price.
• First quarter credit sales totaled $700,000. The state sales tax rate is 4% and the local sales tax rate is 2%.

 

Required:

            Prepare journal entries for the above transactions.

 

Answer:

(1.)	1/15/06
	Cash	7,000
	Liability for customer advance		7,000
(2.)	2/3/06
	Cash	6,700
	Liability for refundable deposits		6,700
(3.)	2/6/06
	Cash	59,000
	Liability for customer advance	7,000
	Sales revenue		66,000
(4.)	3/31/06
	Accounts receivable	742,000
	Sales revenue		700,000
	Sales taxes payable		42,000
	[(4% + 2%) x $700,000]

 

Learning Objective: 3       Level of Learning: 3

 

116. Mozart Music Co. began operations in December of 2006. The company sold gift certificates during December in various amounts totaling $1,600. The gift certificates are redeemable for merchandise within 3 years of the purchase date. However, experience within the industry predicts that 90% of gift certificates will be redeemed within one year. Certificates totaling $500 were presented for redemption during 2006 as part of merchandise purchases having a total retail price of $750.

 

Required:

• Determine the liability for gift certificates to be reported on the December 31, 2006, balance sheet.
• What is the appropriate classification (current or noncurrent) of the liabilities at December 31, 2006? Show calculations.

 

 

Answer:

Requirement 1:
Gift certificates sold	$1,600
Gift certificates redeemed	(500	)
Liability to be reported at December 31	$1,100
Requirement 2:
The liability for gift certificates is part current and part noncurrent:
Gift certificates sold	$1,600
	x  90%
Estimated current liability	1,440
Gift certificates redeemed	(500	)
Current liability at December 31	940
Noncurrent liability at December 31 ($1,600 x 10%)	160
Total	$1,100

 

Learning Objective: 4       Level of Learning: 3

 

117. The following selected transactions relate to contingencies of Eastern Products Inc. which began operations in July, 2006. Eastern’s fiscal year ends on December 31. Financial statements are published in April 2004.

 

• No customer accounts have been shown to be uncollectible as yet, but Eastern estimates that 3% of credit sales will eventually prove uncollectible. Sales were $300 million (all credit) for 2006.
• Eastern offers a one-year warranty against manufacturer’s defects for all its products. Industry experience indicates that warranty costs will approximate 2% of sales. Actual warranty expenditures were $3.5 million in 2006 and were recorded as warranty expense when incurred.
• In December, 2006, Eastern became aware of an engineering flaw in a product that poses a potential risk of injury. As a result, a product recall appears inevitable. This move would likely cost the company $1.5 million.
• In November, 2006, the State of Vermont filed suit against Eastern, asking civil penalties and injunctive relief for violations of clean water laws. Eastern reached a settlement with state authorities to pay $4.2 million in penalties on February 3, 2007.
• Eastern is the plaintiff in a $40 million lawsuit filed against a customer for costs and lost profits from contracts rejected in 2006. The lawsuit is in final appeal and attorneys advise that it is virtually certain that Eastern will be awarded $30 million.

 

Required:

            Prepare the appropriate journal entries that should be recorded as a result of each of these contingencies. If no journal entry is indicated, state why.

 

 

Answer:

(1.)	Bad debt expense	9,000,000
	Allowance for uncollectible accounts		9,000,000
	(3% x $300,000,000)
(2.)	Warranty expense	2,500,000
	Estimated warranty liability		2,500,000
	[(2% x $300,000,000) — $3,500,000]
(3.)	Loss from product recall	1,500,000
	Estimated liability — product recall		1,500,000
	Note: A disclosure note is also appropriate.
(4.)	Loss from litigation	4,200,000
	Litigation liability		4,200,000

 

Note: This is a loss contingency. Eastern can use the information occurring after the end of the year and before the financial statements are issued to determine appropriate disclosure. A disclosure note is also appropriate.

 

• No entry. This is a gain contingency. Gain contingencies are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. A disclosure note is appropriate.

 

Learning Objective: 5       Level of Learning: 3

 

118. The following selected transactions relate to contingencies of Bowe-Whitney Inc. which began operations in 1998. Bowe-Whitney’s fiscal year ends on December 31, 2006, and financial statements are published in March 2007.

 

• Bowe-Whitney is involved in a lawsuit resulting from a dispute with a customer over a 2006 transaction. At December 31, attorneys advised that it was probable that Bowe-Whitney would lose $3 million in an unfavorable outcome. On February 12, 2007, judgment was rendered against Bowe-Whitney in the amount of $14 million plus interest, a total of $15.2 million. Bowe-Whitney does not plan to appeal the judgment.
• Since August of 2006, Bowe-Whitney has been involved in labor disputes at two of its facilities. Negotiations between the company and the unions have not produced a settlement and, since January 2004, strikes have been ongoing at these facilities. It is virtually certain that material costs will be incurred but the amount of resultant costs cannot be adequately predicted.
• Bowe-Whitney is the defendant in a lawsuit filed in January 2007 in which Access Company seeks $10 million as an adjustment to the purchase price related to the sale of Bowe-Whitney’s hardwood division in 2006. The lawsuit alleges that Bowe-Whitney misrepresented the division’s assets and liabilities. Legal counsel advises that it is reasonably possible that Bowe-Whitney could lose $5 million, but that it’s extremely unlikely it could lose the $10 million asked for.
• At March 1, 2007, the IRS is in the process of auditing Bowe-Whitney’s tax returns for 2002-2004, but has not proposed a deficiency assessment. Management feels an assessment is reasonably possible, and if an assessment is made, a settlement of up to $33 million is probable.

 

Required:

            Prepare journal entries that should be recorded as a result of each of the above contingencies.

 

 

Answer:

(1.)	Loss from litigation	15,200,000
	Litigation liability		15,200,000

 

Note: This is a loss contingency. Bowe-Whitney can use the information occurring after the end of the year and before the financial statements are issued to determine the appropriate amount. A disclosure note is also appropriate.

 

• No entry. This is a loss contingency but cannot be accrued unless it is both probable and reasonably estimable. Costs cannot be adequately predicted. A disclosure note is appropriate.

 

• No entry. This is a loss contingency but cannot be accrued unless it is both probable and reasonably estimable. It is only reasonably possible, not probable, that a loss will result. A disclosure note is appropriate.

 

• No entry. This is an unasserted assessment. It must first be probable that an assessment will be made, and then cannot be accrued unless it is both probable and reasonably estimable that the assessment will result in a loss. It is only reasonably possible, not probable, that an assessment will be made. A disclosure note is not indicated.

 

Learning Objective: 5       Level of Learning: 3

 

119. At the beginning of 2006, Scarlet Industries began offering a 3-year warranty on its products. The warranty program was expected to cost Scarlet 2% of net sales, approximately equally over the three-year warranty period. Net sales made under warranty in 2006 were $270 million. Thirteen percent of the units sold were returned in 2006 and repaired or replaced at a cost of $2 million. This amount was debited to warranty expense as incurred.

 

Required:

            Prepare the appropriate adjusting entry to adjust warranty expense on December 31, 2006. Show calculations.

 

Answer:

($ in millions)
Warranty expense	3.4
Estimated warranty liability		3.4
Calculation: ($270 x 2%) — $2.0 = $3.4

 

Learning Objective: 6       Level of Learning: 3

 

 

120. Concept 1 Office Products sells office electronics that carry a 60-day manufacturer’s warranty. At the time of purchase, customers are offered the opportunity to also buy a 1-year or 2-year extended warranty for an additional charge.

 

Required:

1. Does this situation represent a loss contingency?
2. Provide pro forma journal entries for the extended warranty sales and revenue recognition.

 

Answer:

• This is not a loss contingency. An extended warranty is priced and sold separately from the warranted product and therefore, essentially constitutes a separate sales transaction. Since the earning process for an extended warranty continues during the contract period, revenue should be recognized over the same period. Revenue from separately priced extended warranty contracts are deferred as a liability at the time of sale, and recognized over the contract period on a straight-line basis.

 

• Sale of extended warranty:

 

Cash	XX
Unearned revenue		XX

 

Adjusting journey entry in each period of the warranty to recognize revenue:

 

Unearned revenue	XX
Extended warranty revenue		XX

 

Learning Objective: 5       Level of Learning: 3

 

121. Yummy Rice Cereal offers a all-star bowl in exchange for 3 return box tops. Yummy Rice estimates that 30% will be redeemed. The bowls cost Yummy Rice $1 each. In 2006, 5,000,000 boxes of cereal were sold. By year-end 900,000 box tops had been redeemed.

 

Required:

            Calculate the liability that Yummy Rice should report at December 31, 2006.

 

Answer:

5,000,000 X 30% =	1,500,000		Box tops expected to be redeemed
	¸______3
	500,000		Total bowls expected
900,000/3 =	300,000		Bowls issued
	200,000		Bowls yet to be issued
	x      $1
	$  200,000		Liability

 

Learning Objective: 6       Level of Learning: 3

 

 

122. Diversified Industries sells perishable electronic products. Some must be shipped in reusable containers. Customers pay a deposit for each container. The deposit is equal to the container’s cost. Customers receive a refund when the container is returned. During 2006, deposits collected on containers shipped were $700,000. Deposits are forfeited if containers are not returned in 18 months. Containers held by customers on January 1, 2006, were $330,000. During 2006, $410,000 was refunded and deposits of $25,000 were forfeited.

 

Required:

• Prepare the appropriate journal entries for the deposits received and returned during 2006.
• Determine the liability for refundable deposits to be reported on the December 31, 2006, balance sheet.

 

Answer:

(1.)	Deposits Collected:
	Cash	700,000
	Liability-refundable deposits		700,000
	Containers Returned:
	Liability-refundable deposits	410,000
	Cash		410,000
	Deposits Forfeited:
	Liability-refundable deposits	25,000
	Revenue-sale of containers		25,000
	Cost of goods sold	25,000
	Inventory of containers		25,000
(2.)	Determine the liability on December 31, 2006
	Balance, Jan. 1	$330,000
	Deposits received	700,000
	Deposits returned	(410,000	)
	Deposits forfeited	(25,000	)
	Balance, Dec. 31	$595,000

 

Learning Objective: 3       Level of Learning: 3

 

123. In 2006, Cap City Inc. introduced a new line of televisions that carry a two-year warranty against manufacturer’s defects. Based on past experience with similar products, warranty costs are expected to be approximately 1% of sales during the first year of the warranty and approximately an additional 3% of sales during the second year of the warranty.  Sales were $6,000,000 for the first year of the product’s life and actual warranty expenditures were $29,000.  Assume that all sales are on credit.

 

Required:

• Prepare journal entries to summarize the sales and any aspects of the warranty for 2006.
• What amount should Cap City report as a liability at December 31, 2006?

 

 

Answer:

Requirement 1:
Sales
Accounts receivable		6,000,000
Sales			6,000,000
Accrued liability and expense:
Warranty expense (4% x $6,000,000)		240,000
Estimated warranty liability			240,000
Actual expenditures:
Estimated warranty liability		29,000
Cash, parts, supplies, etc.			29,000
Requirement 2:
Estimated liability	$240,000
Actual Expenditures	(29,000	)
Balance Dec 31	$211,000

 

Learning Objective: 1       Level of Learning: 3

 

124. Sunnyvale Computer Company sells a line of computers that carry a 6-month warranty. Customers are offered the opportunity to buy a 2-year extended warranty for an additional charge. During 2006, Sunnyvale received $320,000 from customers for these extended warranties. All sales are on credit, and funds are received evenly throughout the year and go into effect immediately after purchase.

 

Required:

            Prepare a summary journal entry to record sales of the extended warranties. Also prepare any other entries associated with the warranties that should be recorded during 2006.

 

Answer:

During 2006:
Accounts receivable	320,000
Unearned revenue-extended warranties		320,000
December 31, 2006 adjusting entry:
Unearned revenue-extended warranties	80,000
Extended warranties revenue		80,000
($320,000/2 yrs.) x 1/2 year

 

Learning Objective: 6       Level of Learning: 3

 

 

125. Stern Corporation borrowed $10 million cash on September 1, 2006, to provide additional working capital for the year’s production. Stern issued a 6-month, 10% promissory note to Second State Bank. Interest on the note is payable at maturity. Each firm uses the calendar year as the fiscal year.

 

Required:

• Prepare all journal entries from issuance to maturity for Stern Corporation.
• Prepare all journal entries from issuance to maturity for Second State Bank.

 

Answer:

Requirement 1:

Stern Corporation
Issuance of note:
Cash	10,000,000
Notes payable		10,000,000
December 31, 2006 adjustment:
Interest expense*	333,333
Interest payable		333,333
March 1, 2007 maturity:
Interest expense**	166,667
Interest payable	333,333
Notes payable	10,000,000
Cash		10,500,000
*($10,000,000 x 10% x 4/12)
**($10,000,000 x 10% x 2/12)
Requirement 2:
Second State Bank
Issuance of note:
Notes receivable	10,000,000
Cash		10,000,000
December 31, 2006 adjustment:
Interest receivable*	333,333
Interest revenue		333,333
March 1, 2007 maturity:
Cash	10,500,000
Interest revenue**		166,667
Interest receivable		333,333
Notes receivable		10,000,000
*($10,000,000 x 10% x 4/12)
**($10,000,000 x 10% x 2/12)

 

Learning Objective: 2       Level of Learning: 3

 

 

126. Grossman Products began operations in 2006. The following selected transactions occurred from September 2006 through March 2007. Grossman’s fiscal year ends on December 31.

 

2006:

• On September 5, Grossman opened a checking account and negotiated a short-term line of credit of up to $10,000,000 at 10% interest. The company is not required to pay any commitment fees.
• On October 1, Grossman borrowed $8,000,000 cash and issued a 5-month promissory note with 10% interest payable at maturity.
• Grossman received $3,000 of refundable deposits in December for reusable containers.
• For the September through December period, sales totaled $5,000,000. The state sales tax rate is 4% and 75% of sales are subject to sales tax.
• Grossman recorded accrued interest.

 

2007:

• Grossman paid the promissory note on the March 1 due date.
• Half of the storage containers are returned in March, with the other half expected to be returned over the next 6 months.

 

Required:

1. Prepare the appropriate journal entries for the 2006 transactions.
2. Prepare the liability section of the balance sheet at December 31, 2006, based on the data supplied.
3. Prepare the appropriate journal entries for the 2007 transactions.

 

Answer:

Requirement 1:

2006:

• No entry is made for a line of credit until a loan is made. It would be disclosed in a footnote.

 

(b.)	Cash	8,000,000
	Notes payable		8,000,000
(c.)	Cash	3,000
	Liability-refundable deposits		3,000
(d.)	Accounts receivable	5,150,000
	Sales		5,000,000
	Sales tax payable		150,000	($5M x 75%) x 4%
(e.)	Interest expense	200,000
	Interest payable		200,000
	($8,000,000 x 10% x 3/12)

 

 

 

Requirement 2:

 

	Current Liabilities:
	Notes payable	$8,000,000
	Sales tax payable	150,000
	Liability-refundable deposits	3,000
	Interest payable	200,000
	Total current liabilities	$8,353,000

 

Requirement 3:

 

2007:
(a.)	Interest expense*	133,333
	Interest payable	200,000
	Notes payable	8,000,000
	Cash		8,333,333
	*($8,000,000 x 10% x 2/12)
(b.)	Liability-refundable deposits	1,500
	Cash		1,500

 

Learning Objective: 2       Level of Learning: 3

 

 

127. Hardin Widget Manufacturing began operations in January 2006. Hardin sells widgets that carry a two-year manufacturer’s warranty against defects in workmanship. Hardin’s management project that 2% of the widgets will require repair during the first year of the warranty while approximately 6% will require repair during the second year of the warranty. The widgets sell for $400 each. The average cost to repair a widget is $50. The company sells 60% of the widgets to retail customers who must pay a 6% sales tax. Sales and warranty information for 2006 and 2007 are as follows:

2006: Sold 200 widgets on account; incurred warranty expenditures of $300.

2007: Sold 300 widgets on account; actual warranty expenditures were $500.

 

Required:

• Prepare journal entries that summarize the sales and any aspects of the warranty for 2006.
• Prepare journal entries that summarize the sales and any aspects of the warranty for 2007.

 

Answer:

Requirement 1:
2006:
Accounts receivable	82,880
Sales (200 x $400)		80,000
Sales tax payable		2,880
($80,000 x 60% x 6%)
Warranty expense	800
Estimated warranty liability		800
(200 x 8% x $50)
Estimated warranty liability	300
Cash, supplies, parts, etc.		300
Requirement 2:
2007:
Accounts receivable	124,320
Sales (300 x $400)		120,000
Sales tax payable		4,320
(120,000 x 60% x 6%)
Warranty expense	1,200
Estimated warranty liability		1,200
(300 x 8% x $50)
Estimated warranty liability	500
Cash, supplies, parts, etc.		500

 

Learning Objective: 6       Level of Learning: 3

 

 

128. Albertson Corporation began a special promotion in July 2006 in an attempt to increase sales. A coupon was placed in each box of product. Customers could send in 5 coupons for a free prize. Each prize cost Albertson Corporation $3.00. Albertson’s management estimated that 80% of the coupons would be redeemed. For the six months ended December 31, 2006, the following information is available:

 

Products sold	2,000,000 boxes
Prizes purchased	240,000
Coupons redeemed	560,000

 

Required:

            What is the estimated liability for the premium offer at December 31, 2006?

 

Answer:

Number of coupons issued	2,000,000
Expected participation rate	80%
Expected coupon redemptions	1,600,000
Divided by # of coupons per prize	5
Estimated prizes to be awarded	320,000
Number awarded to date (560,000/5)	112,000
Expected future awards	208,000
Cost per prize	$3
Estimated liability, Dec. 31, 2006	$ 624,000

 

Learning Objective: 1       Level of Learning: 3

 

129. Cracker Corporation began a special promotion in July 2006 in an attempt to increase sales. A coupon was placed in each box of product. Customers could send in 5 coupons for a free prize. Each prize cost Cracker Corporation $2.00. Cracker’s management estimated that 70% of the coupons would be redeemed. For the six months ended December 31, 2006, the following information is available:

 

Products sold	2,000,000 boxes
Prizes purchased	240,000
Coupons redeemed	560,000

 

Required:

            Record all necessary journal entries for the premium offer for 2006.

 

Answer:

Promotional expense	560,000
Estimated premium liability		560,000
[$2 x (2,000,000 x 70%)/5]
Prize inventory	480,000
Cash (or Accounts payable)		480,000
Estimated premium liability	224,000
Prize inventory		224,000
(560,000 /5) x $2

 

Learning Objective: 6       Level of Learning: 3

 

 

Use the following to answer questions 130-132:

 

In its 2001 annual report to shareholders, the Goodyear Tire and Rubber Company included the following footnote excerpts on CONTINGENCIES in its annual report to shareholders:

 

At December 31, 2001, Goodyear had recorded liabilities aggregating $66.5 million for anticipated costs related to various environmental matters, primarily the remediation of numerous waste disposal sites and certain properties sold by Goodyear. These costs include legal and consulting fees, site studies, the design and implementation of remediation plans, post-remediation monitoring and related activities and will be paid over several years. The amount of Goodyear’s ultimate liability in respect of these matters may be affected by several uncertainties, primarily the ultimate cost of required remediation and the extent to which other responsible parties contribute.

 

At December 31, 2001, Goodyear had recorded liabilities aggregating $218.7 million for potential product liability and other tort claims, including related legal fees expected to be incurred, presently asserted against Goodyear. The amount recorded was determined on the basis of an assessment of potential liability using an analysis of available information with respect to pending claims, historical experience and, where available, current trends.

 

Goodyear is a defendant in numerous lawsuits involving at December 31, 2001, approximately 63,000 claimants alleging various asbestos related personal injuries purported to result from exposure to asbestos in certain rubber coated products manufactured by Goodyear in the past or in certain Goodyear facilities. Typically, these lawsuits have been brought against multiple defendants in state and Federal courts. In the past, Goodyear has disposed of approximately 22,000 cases by defending and obtaining the dismissal thereof or by entering into a settlement. Goodyear has policies and coverage-in-place agreements with certain of its insurance carriers that cover a substantial portion of estimated indemnity payments and legal fees in respect of the pending claims. At December 31, 2001, Goodyear has recorded an asset in the amount it expects to collect under the policies and coverage-in-place agreements with certain carriers related to its estimated asbestos liability. Goodyear has also commenced discussions with certain of its excess coverage insurance carriers to establish arrangements in respect of their policies.

 

Subject to the uncertainties referred to above, Goodyear has concluded that in respect of any of the above described liabilities, it is not reasonably possible that it would incur a loss exceeding the amount recognized at December 31, 2001, with respect thereto which would be material relative to the consolidated financial position, results of operations, or liquidity of Goodyear.

 

130. Required:

            Show the summary journal entry that Goodyear recorded for the environmental cleanup and product liabilitiy/tort claim matters, described in the footnote disclosure.

 

Answer:

Environmental costs	66.5 million
Product tort and legal costs	218.7 million
Liability for environmental cleanup		66.5 million
Liability for product damage and  tort claims		218.7 million

 

Learning Objective: 5       Level of Learning: 3

 

 

131. Required:

            Briefly explain the authoritative basis on which the costs/obligations for environmental cleanup and product liabilitiy/tort claim matters were accrued in the financial statements.

 

Answer: SFAS #5 requires that contingent losses (and the corresponding obligations) be recorded (accrued) when the loss is both probable and the amount is known or reasonably estimable.  Goodyear based its analysis on pending claims, historical experience and current trends, such as recent case verdicts with similar manufacturers, such as Firestone.

 

Learning Objective: 5       Level of Learning: 2

 

132. Required:

            What is the point of the last paragraph of the Goodyear disclosure?  Explain in terms of authoritative GAAP.

 

Answer: SFAS #5 indicates that outcomes of contingent losses that are remote (i.e., less than reasonably possible) need not be accrued or disclosed in the financial statements and footnotes.  This is a catch-all statement by the company that any other possible losses not disclosed are excluded because of the remote probability assessed.

 

Learning Objective: 5       Level of Learning: 2

 

133. In its 2004 annual report to shareholders, Pemco Aviation Group Inc. included the following disclosure:

 

On October 6, 2003, the company’s subsidiary, Pemco Aeroplex, filed suit against Certex of Alabama, an unincorporated division of Bridon American Corporation, for breach of contract and fraud with regard to the supply of deficient wire rope that is installed as aircraft flight control cables on KC-135 aircraft. The case, filed in the circuit court of Jefferson County, Alabama, was brought to trial and on September 20, 2004, a jury returned with a verdict in favor of the company in the amount of $7.5 million. The Court, upon a post-judgment motion filed by Certex, reduced the judgment to $2.5 million. Certex has appealed that Order to the Supreme Court of Alabama. The company believes the appeal is without merit and will continue to pursue final judgment on the Order. The company, pending appeal, has not recorded the $2.5 million favorable judgment.

 

Required:

            What journal entries, if any, has Pemco recorded regarding this contingency.  Explain their rationale.

 

Answer:

Pemco has not recorded a journal entry for the contingency.  Although a jury returned a verdict in favor of Pemco’s subsidiary, the case is still on appeal.  Thus, this is a gain contingency for Pemco and should not be recorded until the case appeal has been ruled upon.

 

Learning Objective: 6       Level of Learning: 2

 

 

134. In its 2004 annual report to shareholders, Pittsburgh Times Inc. included the following disclosure:

 

REVENUE RECOGNITION

 

• Advertising revenue is recognized when advertisements are published, broadcast or when placed on the Company’s Web sites, net of provisions for estimated rebates, credit and rate adjustments and discounts.

 

• Circulation revenue includes single copy and home-delivery subscription revenue. Single copy revenue is recognized based on date of publication, net of provisions for related returns. Proceeds from home-delivery subscriptions and related costs, principally agency commissions, are deferred at the time of sale and are recognized in earnings on a pro rata basis over the terms of the subscriptions.

 

• Other revenue is recognized when the related service or product has been delivered.

 

Also, the following information on its current liabilities was included in its comparative balance sheets:

 

	12/30/2004	12/30/2003
CURRENT LIABILITIES
Commercial paper outstanding	$158,300,000	$291,251,000
Accounts payable	$170,950,000	$174,552,000
Accrued payroll and other related liabilities	$81,299,000	$126,983,000
Accrued expenses	$160,867,000	$190,748,000
Accrued income taxes	$225,220,000	$    9,852,000
Unexpired subscriptions	$61,706,000	$  81,385,000
Current portion of long-term debt and capital lease obligations	$    2,534,000	$    2,599,000
Total current liabilities	$860,876,000	$877,370,000

 

Required:

            Assuming that Pittsburgh Times Inc. collected $440,000,000 in cash for home delivery subscriptions during fiscal year 2004, what amount of revenue did it recognize during 2004 from this source?  Show the relevant T-account information to support your answer.

 

Answer:

$459,679,000

 

Unexpired Subscriptions
	81,385,000	Beg. balance
Revenue earned    ?	440,000,000	(also debit to cash)
	61,706,000	End. balance

 

Learning Objective: 3       Level of Learning: 3

 

 

135. In its 2001 annual report to shareholders, American Airlines Inc. presented the following balance sheet information about its liabilities:

 

	12/31/2001	12/31/2000
CURRENT LIABILITIES
Accounts payable	$1,717,000,000	$1,178,000,000
Accrued salaries and wages	$681,000,000	$924,000,000
Accrued liabilities	$1,336,000,000	$1,143,000,000
Air traffic liability	$2,763,000,000	$2,696,000,000
Payable to affiliates, net	$66,000,000	$511,000,000
Current maturities of long-term debt	$421,000,000	$108,000,000
Current obligations under capital leases	$189,000,000	$201,000,000
Total current liabilities	$7,173,000,000	$6,761,000,000
LONG-TERM DEBT, LESS CURRENT MATURITIES	$6,530,000,000	$2,601,000,000

 

In addition, American presented the following among its footnote disclosures:

 

Maturities of long-term debt (including sinking fund requirements) for  the next five years are: 2002 — $421 million; 2003 — $212 million; 2004 — $273 million; 2005 — $1.0 billion; 2006 — $777 million.

 

Required:

           

            Consider the appropriate classification of these long-term debt obligations.  All other things being equal, what are the implications of the information above for American’s liquidity and solvency risk in 2003 and following?

 

Answer: Because some of the debt is being reclassified from long-term to current as installment payments come due, the long-term debt will decline.  The current portion will decline when large installments come due (all other things equal) on the year-end 2002 and 2003 balance sheets, but sharply increase on the year-end 2004 and 2005 balance sheets.  The liquidity of the company will vary inversely to these changes.  Also, assuming no new issuance of long-term debt, the balance will be cut nearly in half by the end of 2006, thereby improving the company’s solvency (all other things equal).

 

Learning Objective: 4       Level of Learning: 3

 

 

Essay

 

Instructions:

 

The following answers point out the key phrases that should appear in students’ answers.  They are not intended to be examples of complete student responses. It might be helpful to provide detailed instructions to students on how brief or in-depth you want their answers to be.

 

136. Identify the major components included in the official definition of a liability as set forth by the FASB.

 

Answer:

The FASB’s definition of a liability includes the following:

• A liability is the result of past transactions or events.
• A liability involves a probable future transfer of assets or services.
• A liability represents an obligation to a particular entity.

All three criteria should be met before a liability is recorded.

 

Learning Objective: 1       Level of Learning: 1

 

137. Define and distinguish between current and noncurrent liabilities.

 

Answer: Current liabilities represent claims arising from past transactions or events that are expected to be satisfied with current assets. These current obligations generally must be satisfied within the company’s normal operating cycle or one year, whichever is longer. Noncurrent liabilities will not require payment within one year of the balance sheet date nor will they require the use of current assets for payment.

 

Learning Objective: 4       Level of Learning: 1

 

138. Define the following:

• Liabilities that are definite in amount.
• Liabilities that must be estimated.
• Liabilities that are contingent.

 

Answer:

• Liabilities that are definite in amount — Both the existence and the amount of the liability are determinable due to a contract, trade agreement, or business practice.
• Liabilities that must be estimated — The existence is determinable but the amount is in question. The amount is estimated and the liability is recorded in the current period.
• Liabilities that are contingent -No definite liability exists, but there is the potential for obligation based on the outcome of a future event (the contingency). Sometimes the amount is known, but the existence of an obligation is still questionable.

 

Learning Objective: 1       Level of Learning: 1

 

 

139. What factors are important in determining whether a pending lawsuit should be accrued as a liability and reflected in the financial statements?

 

Answer:

Factors that are important for consideration include:

• When did the cause of action occur? No liability should be recognized until after the cause of action occurs.
• Has the case come to trial?
• Is there an appeal pending?
• What is the probability of loss according to legal counsel?
• Has this type of lawsuit occurred before? What was the outcome?

If a loss from a lawsuit is probable and the amount can be reasonably estimated, then a journal entry should be made to recognize the loss. If it is reasonably possible, then only footnote disclosure is required. If the chance of loss is remote, then nothing is required to be disclosed.

 

Learning Objective: 5       Level of Learning: 1

 

140. Bank loans are often arranged in advance as lines of credit. What is a line of credit? How do a committed and a noncommitted line of credit differ?

 

Answer:

Lines of credit permit a company to borrow cash from a bank up to a prearranged amount at a predetermined rate of interest. The interest is frequently floating and tied to some prime rate. Lines of credit usually must be available to support the issuance of commercial paper.

 

A committed line of credit is formal and usually requires a commitment fee expressed as a percentage of the unused balance. Sometimes a compensating balance is required.

 

A noncommitted line of credit allows the company to borrow without having to follow a formal loan process at the time the loan is needed. Sometimes a compensating balance is required.

 

Learning Objective: 2       Level of Learning: 2

 

141. How are customer advances and refundable deposits similar and yet different?

 

Answer: When a company collects cash from a customer as a refundable deposit or as an advance payment for products or services, a liability is created obligating the firm to return the deposit or to supply the goods or services. When the amount is to be returned in cash, it is a refundable deposit. When the amount of the deposit is to be applied to the purchase of goods or services, it is a customer advance.

 

Learning Objective: 3       Level of Learning: 2

 

 

142. Define a loss contingency and give two examples that almost always are accrued.

 

Answer:

A loss contingency is an existing situation, or a set of circumstances, involving potential loss that will be resolved when some future event occurs or doesn’t occur.

Two loss contingencies that are almost always accrued include:

• Manufacturers’ warranties — these inevitably involve expenditures and can reasonably be estimated using prior experience.
• Cash rebates and premium offers — these inevitably involve expenditures and reasonably accurate estimates can be made based on prior experience.

 

Learning Objective: 5       Level of Learning: 2

 

143. Texon Oil is being sued for price fixing and environmental damage. The litigation started this year and is expected to last five years. There is no doubt that Texon is guilty but the settlement cost range will be between $3 billion and $22 billion. Briefly explain how Texon would address this in its current year financial statements.

 

Answer: One has to decide if $3 billion to $22 billion is a reasonably estimable amount. If it is not, disclosure is all that is required. Side issues might include the effect on going concern status and the impact on the auditor’s report.  Students might suggest accrual of that portion of the cost that becomes reasonably estimable. With a given 5-year litigation period with billions at stake, these costs would be sizable.

 

Learning Objective: 5       Level of Learning: 3

 

144. Identify and define the three terms used in FASB statement No. 5 to identify the range of possibilities of accounting action to be taken on contingent liabilities. Describe the accounting action to be taken for each term.

 

Answer:

• Probable — The future event is likely to occur. Record the event if the amount is known or reasonably estimable. If it is not estimable, report it in a footnote.
• Reasonably possible — The chance of the future event occurring is more than remote but less than likely. Report it in a footnote.
• Remote — Only a slight chance of the future event occurring. No reporting or recording is generally necessary.

 

Learning Objective: 5       Level of Learning: 1

 

145. Swift Drug Company is being sued this year for a wrongful death due to violation of FDA rules. There is no doubt that Swift is guilty and the settlement is reasonably estimable at $10 billion payable evenly over 10 years starting next year. Briefly explain how Swift would address this in its current year financial statements.

 

Answer: In the Swift case, the loss contingency accrual is clearly the full $10 billion. Given the payment terms, the students should note the proper current/noncurrent classification.

 

Learning Objective: 6       Level of Learning: 2

 

 

146. Safeway Inc. is one of the largest food and drug retailers in North America.  In its 2005 annual report to shareholders, it made the following disclosure:

 

In 1987, Safeway assigned a number of leases to Furr’s Inc. (Furr’s) and Homeland Stores, Inc. (Homeland ) as part of the sale of the Company s former El Paso, Texas and Oklahoma City, Oklahoma divisions. Safeway is contingently liable if Furr’s and Homeland are unable to continue making rental payments on these leases. In 2001, Safeway recorded a pretax charge to earnings of $42.7 million to recognize the estimated lease liabilities associated with the Furr’s and Homeland bankruptcies and for a single lease from Safeway s former Florida division. In 2002, Furr’s began the liquidation process and Homeland emerged from bankruptcy and, based on the resolution of various leases, Safeway reversed $12.1 million of this accrual.

 

Explain the accounting principle(s) that required Safeway to record the $42.7 million charge in 2001 and the $12.1 million reversal in 2002.

 

Answer:

SFAS 5 requires that a loss and corresponding liability be recorded when an unresolved matter leading to a loss is probable and reasonably estimable.  In this case, the bankruptcy filings by Furr’s and by Homeland in 2001 raised the probability of Safeway having to make good on these leases to a point where accrual was necessary. As a result of events in 2002, Safeway made a change in estimate, reducing the contingent loss, and recording a reversal, of $12.1 million.

 

Learning Objective: 5       Level of Learning: 3