chapter 9: current liabilities, contingencies, and...

CHAPTER 9

Current Liabilities, Contingencies, and the Time Value of Money

OVERVIEW OF EXERCISES, PROBLEMS, AND CASESEstimated

Time inLearning Outcomes Exercises Minutes Level

1. Identify the components of the current liability category of 1 10 Easythe balance sheet. 2 10 Easy

3 10 Easy

2. Examine how accruals affect the current liability category. 4 20 Mod5 15 Mod6 10 Mod7 15 Mod8 15 Mod

3. Show that you understand how changes in current liabilities 9 5 Easyaffect the statement of cash flows. 10 5 Mod

11 5 Mod

4. Determine when contingent liabilities should be presented on the 12 15 Modbalance sheet or disclosed in notes and how to calculate their amounts.

5. Explain the difference between simple and compound interest. 13 20 Mod

6. Calculate amounts using the future value and present value concepts. 14 5 Easy15 5 Mod16 10 Mod17 10 Mod24* 10 Diff25* 10 Diff

7. Apply the compound interest concepts to some common 18 5 Modaccounting situations. 19 10 Mod

20 10 Diff 24* 10 Diff25* 10 Diff

8. Show that you understand the deductions 21 15 Modand expenses for payroll accounting (Appendix A). 22 20 Mod

9. Determine when compensated absences must be 23 10 Diffaccrued as a liability (Appendix A).

*Exercise, problem, or case covers two or more learning outcomesLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

9-1

9-2 FINANCIAL ACCOUNTING SOLUTIONS MANUAL

Problems Estimatedand Time in

Learning Outcomes Alternates Minutes Level

1. Identify the components of the current liability category of 12* 10 Modthe balance sheet.

2. Examine how accruals affect the current liability category. 1 40 Mod11* 30 Mod

3. Show that you understand how changes in current 2 30 Modliabilities affect the statement of cash flows. 3 20 Diff

4. Determine when contingent liabilities should be presented on the 4 20 Modbalance sheet or disclosed in notes and how to calculate 5 10 Modtheir amounts. 12* 10 Mod

5. Explain the difference between simple and compound interest. 6 40 Diff11* 30 Mod

6. Calculate amounts using the future value and present value concepts. 7 25 Easy8 30 Mod

13* 10 Diff14* 10 Diff

7. Apply the compound interest concepts to some common 13* 10 Diffaccounting situations. 14* 10 Diff

8. Show that you understand the deductions 9 30 Modand expenses for payroll accounting (Appendix A).

9. Determine when compensated absences must be 10 10 Modaccrued as a liability (Appendix A).


CHAPTER 9 • CURRENT LIABILITIES, CONTINGENCIES, AND THE TIME VALUE OF MONEY 9-3

EstimatedTime in

Learning Outcomes Cases Minutes Level

1. Identify the components of the current liability category of 1* 30 Modthe balance sheet. 5* 25 Mod

2. Examine how accruals affect the current liability category. 1* 30 Mod5* 25 Mod

3. Show that you understand how changes in current liabilities 2* 20 Modaffect the statement of cash flows. 3* 25 Mod

4. Determine when contingent liabilities should be presented on the 2*balance sheet or disclosed in notes and how to calculate 3* 25 Modtheir amounts. 4 20 Mod

7 30 Mod8 20 Mod

5. Explain the difference between simple and compound interest.

6. Calculate amounts using the future value and present value concepts.

7. Apply the compound interest concepts to some common 6 25 Modaccounting situations.

8. Show that you understand the deductions and expenses for payroll accounting (Appendix A).

9. Determine when compensated absences must beaccrued as a liability (Appendix A).



QUESTIONS

1. A current liability is an obligation that will be satisfied within the next operating cycle, or within one year if the cycle is shorter than one year. Current liabilities are impor-tant to determine a firm’s liquidity, i.e., its ability to pay for those items due within a short time period.

2. Generally, it is to the company’s benefit to take advantage of discounts available be-cause of the rate of the discount. For example, if a 2% discount is available for pay-ment within 10 days, a firm can borrow money and pay interest on the loan in order to take advantage of the discount. Also, prompt payment of accounts is essential in order to ensure good relationships with suppliers and other creditors.

3. No, the real rate of interest is not 10%. The real interest rate could be calculated as $100/$900, or approximately 11.11%. The rate should be calculated on the basis of the amount that the firm actually obtained, rather than the face amount of the note.

4. The account Discount on Notes Payable is a balance sheet account.

5. Income tax is an item that should be accrued as a liability as of year-end. If the firm’s year-end is December 31, then the amount should appear as a current liability on the balance sheet dated December 31.

6. A contingent liability involves an existing condition where the outcome of that condi-tion is not known with certainty and is dependent on some event that will occur in the future. Contingent liabilities are accounted for differently than contingent assets be-cause of the conservatism principle. It should be noted that the accounting, while conservative, leads to an inconsistency in the accounting for assets and liabilities.

7. A contingent liability should be recorded only if its likelihood of occurrence is proba-ble and the amount can be reasonably estimated. The firm must make a good-faith effort to estimate the amount when it is not known. If the dollar amount cannot be es-timated, the contingent liability should be disclosed in the notes to the financial state-ments.

8. The lawsuit should be described in as much detail as possible in the notes to the fi-nancial statements. The nature of the lawsuit and the expected resolution should be described. If the dollar amount can be estimated, it should be disclosed. If it cannot be estimated, it may be possible to determine and disclose a range of values that represents the potential loss to the firm.

9. Simple interest is calculated on the balance of the principal only. Compound interest is calculated on the principal plus previous amounts of interest accumulated. The amount of interest accumulated by simple interest is always less than the amount if interest is compounded at the same interest rate.


10. If interest is compounded quarterly, it should be calculated at one-fourth of the an-nual rate but for four times as many compounding periods. The amount accumulated for quarterly compounding will always exceed the amount accumulated for annual compounding because of the “interest on interest” feature of compound interest.

11. A future value represents the amount that will be accumulated at a future time if a known amount is invested for a given time at a given interest rate. The present value represents the value today of an amount to be received or paid at a future time. You can determine whether or not to calculate a present value or future value based on the timing of the known and unknown quantities. If the known amount is in the pres-ent time, you are attempting to calculate the future amount. If the known amount is in the future, you are attempting to calculate the present value of an equivalent amount.

12. The word annuity means a series of payments of the same amount. The present value of an annuity could be calculated as a series of single amounts, but not with a single calculation. You would first calculate the present value of a single payment one year in the future; then the present value of a single payment two years in the future, etc. The present value of the single sums would be totaled to determine the present value of an annuity. To avoid the calculations, tables have been developed to calculate the present value of an annuity based on one calculation.

13. The interest rate of the loan could be calculated by dividing the total dollar amount of the loan by the dollar amount of the monthly payments. The result is a number that represents an interest factor or table value in the table for the present value of an annuity. Find the table value that corresponds to the number of years of the loan, and then read across that row to find the interest rate.

14. Loan payable and bond payable accounts are recorded at present value amounts. Other accounts based on present value concepts are pensions, leases, and some long-term receivables.

15. The amount of income tax withheld should be treated as a current liability of the em-ployer’s financial statements until the time the amount is remitted to the U.S. Trea-sury.

16. Unemployment tax should be recorded as a debit to an expense account and a credit to a liability account. The expense account appears on the employer’s income statement as an expense in the year incurred. The liability should appear on the bal-ance sheet as a current liability until the tax is remitted.

17. Compensated absences are absences from employment such as vacation, illness, and holidays, for which it is expected that employees will be paid.

18. The statement given is not a correct statement. Vacation pay should be recorded as an expense when the employee earns the vacation days and not in the period when the employee actually takes the vacation.


EXERCISES

LO 1 EXERCISE 9-1 CURRENT LIABILITIES

The treatment of the items should be as follows:Taxes Payable—Current liabilityAccounts Receivable—Current assetNotes Payable, 9%, due in 90 days—Current liabilityInvestment in Bonds—Long-term assetCapital Stock—Stockholders’ equityAccounts Payable—Current liabilityEstimated Warranty Payable in 2008—Current liabilityRetained Earnings—Stockholders’ equityTrademark—Intangible assetMortgage Payable—$10,000 due in 2008 should be current liability.

The remaining portion should be long-term liability.

LO 1 EXERCISE 9-2 CURRENT LIABILITIES

1. and 2.Classification Account Title

a. Current liability Accounts Payableb. Current liability Notes Payablec. Long-term liability Notes Payabled. Current liability Wages Payablee. Current liability Interest Payablef. Current liability Current Portion of Long-Term Debt

andLong-term liability Long-Term Debt

g. Current liability Taxes Payable

3. Investors are interested in this information because it enables them to better predict the timing of future cash flows. Items that are classified as current liabilities require the use of current assets to satisfy them, whereas long-term liabilities do not.


LO 1 EXERCISE 9-3 CURRENT LIABILITIES SECTION

JACKIE COMPANYBALANCE SHEET

DECEMBER 31, 2007Current liabilities:

Accounts payable $ 24,400Notes payable, 10%, due June 2, 2008 $1,000Less: Discount on notes payable 150 850Current maturities of long-term debt 6,900

Other accrued liabilities:Interest payable $3,010Wages payable 6,000Unearned revenue 4,320 13,330

Income taxes payable 61,250 Total current liabilities $106,730

LO 2 EXERCISE 9-4 TRANSACTION ANALYSIS

1. a. The effect on the accounting equation of purchasing inventory on account is as follows:

BALANCE SHEET INCOME STATEMENT

Assets = Liabilities + Stockholders’ Equity + Revenues – Expenses

Accounts Payable 8,000 Purchases (8,000)

b. The effect on the accounting equation of purchasing land is as follows:

BALANCE SHEET INCOME STATEMENTAssets = Liabilities + Stockholders’ Equity + Revenues – Expenses

Land 44,500 Notes Payable 35,600Cash (8,900)*

*$44,500 × 20% = $8,900

c. The effect on the accounting equation of the purchase return is as follows:


Accounts Payable (450) Purchase Returns and Allowances 450


EXERCISE 9-4 (Continued)

d. The effect on the accounting equation of the payment on account is as follows:



Cash (7,550) Accounts Payable (7,550)

e. The effect on the accounting equation of the loan less interest in advance is as follows:



Cash 13,800 Notes Payable 15,000Discount on

Notes Payable (1,200)

f. The effect on the accounting equation of the sale of gift certificates is as follows:



Cash 5,000* Unearned Revenue 5,000

*200 × $25 = $5,000

g. The effect on the accounting equation of the sales and related sales tax is as fol-lows:



Cash 114,480* Sales Tax Sales 120,000Accounts Payable 7,200 Receivable 12,720

*$127,200 × 90% = $114,480


EXERCISE 9-4 (Concluded)

2. b. The effect on the accounting equation of the accrual of interest on the note is as follows:



Interest Payable 1,898.67* Interest Expense (1,898.67)

*$35,600 × 8% × 8/12 = $1,898.67

e. The effect on the accounting equation of the recognition of interest on the note is as follows:



Discount on Interest Expense (700)Notes Payable 700*

*$1,200 × 7/12 = $700

f. The effect on the accounting equation of the redemption of the gift certificates is as follows:



Unearned Sales 1,750Revenue (1,750)*

*$5,000 × 35% = $1,750

3. Sales tax payable $ 7,200.00Notes payable, due November 1 35,600.00Notes payable, due June 1 $15,000.00Less: Discount on notes payable* 500 .00 14,500.00Unearned sales revenue** 3,250.00Interest payable 1,898 .67 Total current liabilities $62,448 .67

*$1,200 – $700 = $500**$5,000 – $1,750 = $3,250


LO 2 EXERCISE 9-5 CURRENT LIABILITIES AND RATIOS

1. KRUSE COMPANYBALANCE SHEET

DECEMBER 31, 2007Current liabilities:

Accounts payable $ 55,000Notes payable, 12%, due in 60 days 20,000Taxes payable 15,000Salaries payable 10,000

Total current liabilities $100,000

2. Working capital = Current assets – Current liabilities= $300,000* – $100,000= $200,000

*Current assets = Cash $ 15,000Accounts receivable 180,000Less: Allowance for doubtful accounts (20,000)Marketable securities 40,000Inventory 85,000

$300,000

3. Current ratio = Current assets/Current liabilities= $300,000/$100,000= 3:1

Kruse has sufficient current assets to meet its short-term obligations (pay its current liabilities).


LO 2 EXERCISE 9-6 DISCOUNTS

1. a. Purchase price × Discount rate = Discount

$450 × 2% = $9.00

Annualized interest rate = 2% × (360/30) = 0.24, or 24%

b. Discount = $1,500 × 1% = $15

Annualized interest rate = 1% × (360/20) = 0.18, or 18%

2. a. Discount/Purchase price = Discount rate

($200 – $196)/$200 = 0.02, or 2%

b. ($2,800 – $2,674)/$2,800 = 0.045, or 4.5%

LO 2 EXERCISE 9-7 NOTES PAYABLE AND INTEREST

1. The effect on the accounting equation of issuing the note is as follows:


Cash 25,000 Notes Payable 25,000

2. The effect on the accounting equation of the year-end adjustment for interest ex-pense is as follows:



Interest Payable 1,000* Interest Expense (1,000)

*$25,000 × 8% × 6/12 = $1,000

3. The effect on the accounting equation of the payment of the principal and interest is as follows:



Cash (26,667) Notes Payable (25,000) Interest Interest Payable (1,000) Expense (667)*

*$25,000 × 8% × 4/12 = $667


LO 2 EXERCISE 9-8 NON-INTEREST-BEARING NOTES PAYABLE

1. The effect on the accounting equation of the issuance of the note is as follows:




Notes Payable (1,620)*

*$18,000 × 9% = $1,620

2. The effect on the accounting equation of the accrual of interest is as follows:



Discount on Interest Expense (405)Notes Payable 405*

*$1,620 × 3/12 = $405

3. The effect on the accounting equation of the payment of the note is as follows:



Cash (18,000) Notes Payable (18,000) Interest Expense (1,215)Discount on

Notes Payable 1,215*

*$1,620 – $405 = $1,215

4. Effective interest rate = $1,620/$16,380 = 9.89%


LO 3 EXERCISE 9-9 IMPACT OF TRANSACTIONS INVOLVING CURRENT LIABILITIES ON STATEMENT OF CASH FLOWS

Accounts payable: OCurrent maturities of long-term debt: FNotes payable: FOther accrued liabilities: OSalaries and wages payable: OTaxes payable: O

LO 3 EXERCISE 9-10 IMPACT OF TRANSACTIONS INVOLVING CONTINGENT LIABILITIES ON STATEMENT OF CASH FLOWS

Estimated liability for warranties: OEstimated liability for product premiums: OEstimated liability for probable loss relating to litigation: O

LO 3 EXERCISE 9-11 IMPACT OF TRANSACTIONS INVOLVING PAYROLL LIABILITIES ON STATEMENT OF CASH FLOWS

Accrued vacation days (compensated absences): OHealth insurance premiums payable: OFICA payable: OUnion dues payable: OSalary payable: OUnemployment taxes payable: O


LO 4 EXERCISE 9-12 WARRANTIES

The effect on the accounting equation of the sales made with warranties is as follows:



Cash/Accounts Sales 32,500,000Receivable 32,500,000*

*$325 × 100,000 = $32,500,000

The effect on the accounting equation of the current year's estimated warranty expense is as follows:



Estimated Warranty Liability for Expense (168,000)

Warranties 168,000*

*(100,000 units × 12%) × $14 = $168,000

The effect on the accounting equation of the actual expenditures for warranty work is as follows:


Cash/ Estimated Inventory (150,000) Liability for

Warranties (150,000)

Beginning balance $ 120,000Warranty estimate 168,000Actual expense (150,000 )Ending balance $ 138,000


LO 5 EXERCISE 9-13 SIMPLE VERSUS COMPOUND INTEREST

Part 1.

1. $20,000 × 4% × 6 years = $4,800

2. $20,000 × 6% × 4 years = $4,800

3. $20,000 × 8% × 3 years = $4,800

Part 2.

1. n = 6, i = 4%Future value = $20,000 × 1.265 = $25,300Interest = Future value – Beginning amount

= $25,300 – $20,000= $5,300


= $25,240 – $20,000= $5,240


= $25,200 – $20,000= $5,200

Part 3.


= $25,360 – $20,000= $5,360

2. n = 8, i = 3%Future value = $20,000 × 1.267 = $25,340Interest = $25,340 – $20,000 = $5,340

3. n = 6, i = 4%Future value = $20,000 × 1.265 = $25,300Interest = $25,300 – $20,000 = $5,300

You would want to choose an investment that yields the highest future value. All other factors being equal, higher interest rates, more frequent compounding, and a longer term will increase the future value of your investment.


LO 6 EXERCISE 9-14 PRESENT VALUE, FUTURE VALUE

n = 10, i = 5%Present value = Amount × Table factor

= $150,000 × 0.614= $92,100

orFuture value = Amount × Table factor$150,000 = ? × 1.629Amount = $150,000/1.629

= $92,081

Slight difference due to rounding.

LO 6 EXERCISE 9-15 EFFECT OF COMPOUNDING PERIOD

1. $1,000 × 1.166 = $1,166 n = 2, i = 8%

2. $1,000 × 1.170 = $1,170 n = 4, i = 4%

3. $1,000 × 1.172 = $1,172 n = 8, i = 2%


1. a. $7,000 × 1.469 = $10,283 n = 5, i = 8%b. $7,000 × 1.480 = $10,360 n = 10, i = 4%c. $7,000 × 1.486 = $10,402 n = 20, i = 2%

2. a. $15,000 × 0.681 = $10,215 n = 5, i = 8%b. $15,000 × 0.676 = $10,140 n = 10, i = 4%c. $15,000 × 0.673 = $10,095 n = 20, i = 2%


1. a. $16,000 × 1.469 = $23,504 n = 5, i = 8%b. $16,000 × 1.480 = $23,680 n = 10, i = 4%c. $16,000 × 1.486 = $23,776 n = 20, i = 2%

2. a. $20,000 × 0.681 = $13,620 n = 5, i = 8%b. $20,000 × 0.676 = $13,520 n = 10, i = 4%c. $20,000 × 0.673 = $13,460 n = 20, i = 2%


LO 7 EXERCISE 9-18 ANNUITY

$2,000 × 20.024 = $40,048 n = 15, i = 4%

LO 7 EXERCISE 9-19 CALCULATION OF YEARS

$41,000/$1,600 = 25.625 table figure at 4% interest = about 18 years.

LO 7 EXERCISE 9-20 VALUE OF PAYMENTS

1. Present value = Payment × Table factor= $1,480 × 1.690 = $2,501.20

(present value of an annuity of $1 for n = 2, i = 12%)

2. n = 8, i = 3%Present value = Payment × Table factor$2,501.20 = payment × 7.020Payment = $2,501.20/7.020 = $356.30

With annual payments:2 payments at $1,480 = $2,960.00Less: Present value 2,501 .20 Interest expense $ 458 .80

With quarterly payments:8 payments at $356.30 = $2,850.40Less: Present value 2,501 .20 Interest expense $ 349 .20 Interest with annual payments $458.80

Less: Interest with quarterly payments 349 .20 Interest saved $109 .60

Payments would be smaller and total interest would be less if she made monthly payments.


LO 8 EXERCISE 9-21 PAYROLL TRANSACTIONS (Appendix A)

1. Gross pay $ 385,000Withholdings:

Federal income tax ($385,000 × 28%) (107,800)State income tax ($385,000 × 5%) (19,250)FICA tax ($385,000 × 7.65%) (29,453)

Deductions:Health insurance (7,000)Union dues (980 )

Net pay $ 220,517

The effect on the accounting equation of the payroll is as follows:



Salary and Salary and Wages Wages Payable 220,517 Expense (385,000) Federal Income Tax Payable 107,800 State Income Tax Payable 19,250 FICA Tax Payable 29,453 Health Insurance Payable 7,000 Union Dues Payable 980

2. The employer’s portion of payroll taxes would be calculated as follows:

FICA tax payable $29,453Federal unemployment tax 3,080 ($385,000 × 0.8%)State unemployment tax 12,320 ($385,000 × 3.2%)

Total $44,853

3. A company’s fringe benefits would be reported as additional payroll expenses. Amounts to be contributed to health insurance coverage would be reported as a lia -bility until remitted to the insurance company.


LO 8 EXERCISE 9-22 PAYROLL, EMPLOYER’S PORTION (Appendix A)

1. Dell FICA: $11,710 × 7.65% = $ 896Unemp: $ 0

Fin FICA: $ 2,660 × 7.65% = $ 203Unemp: $ 2,660 × 0.8% = $ 21

$ 2,660 × 2.6% = $ 69

Hook FICA: $15,660 × 7.65% = $1,198Unemp: $ 0

Patty FICA: $26,200 × 7.65% = $2,004Unemp: $ 0

Tuss FICA: $19,350 × 7.65% = $1,480Unemp: $ 0

Woo FICA: $ 3,900 × 7.65% = $ 298Unemp: $ 700 × 0.8% = $ 6

$ 700 × 2.6% = $ 18

2. The effect on the accounting equation of the employer's portion of payroll taxes is as follows:



FICA Tax Payable 6,079 Payroll TaxFederal Unemployment Expense (6,193)

Tax Payable 27State Unemployment Tax Payable 87


LO 9 EXERCISE 9-23 COMPENSATED ABSENCES (Appendix A)

1. a. Wonder Inc. should record only a transaction for vacation days at the time payroll is recognized.

b. Sick days are not recognized as an expense until employees are actually absent.


Accrued Vacation Vacation Days Days 3,600* Expense (3,600)

*$72,000 ÷ 24 = $3,000 per employee ÷ 20 = $150 per day × 24 = $3,600

2. From an internal control perspective, key employees should be required to take an-nual vacations rather than accumulating vacation time. As noted above, sick pay is not accrued; it is expensed as incurred. As a result, under certain circumstances, sick pay that has been accumulating and then is taken in a single year may ad-versely affect the company’s financial statements for that year.

MULTI-CONCEPT EXERCISES

LO 6,7 EXERCISE 9-24 COMPARE ALTERNATIVES

Present value of 1: $100,000 × 1.000 = $100,000Present value of 2: $108,000 × 0.926 = $100,008

n = 1, i = 8%Present value of 3: $ 20,000 × 5.747 = $114,940

n = 8, i = 8%Present value of 4: $ 10,000 × 11.258 = $112,580

n = 30, i = 8%Jane should choose Option 3.

LO 6,7 EXERCISE 9-25 TWO SITUATIONS

1. $53,300/$13,000 = 4.100 table factor for present value of an annuity for 5 years, i = 7%.

2. $13,300 × 15.026 (future value of an annuity for n = 12, i = 4%) = $199,846.

No, Sampson will not have accumulated quite enough money.


PROBLEMS

LO 2 PROBLEM 9-1 NOTES AND INTEREST

a. The effect on the accounting equation of issuing a loan at 10% interest on Janu-ary 1 is as follows:




b. On January 10, only a memorandum entry is made.

c. The effect on the accounting equation of issuing a non-interest-bearing note on February 1 is as follows:


Equipment 18,800 Notes Payable 20,000Discount on


*$20,000 × 12% × 1/2 = $1,200

d. The effect on the accounting equation of borrowing on March 1 with a line of credit is as follows:


Cash 150,000 Loan Payable 150,000

e. The effect on the accounting equation of the partial payment of the line of credit on June 1 is as follows:



Cash (102,250) Loan Payable (100,000) Interest Expense (2,250)*

*$100,000 × 9% × 3/12 = $2,250


PROBLEM 9-1 (Continued)

f. The effect on the accounting equation of accruing interest on the interest-bear-ing note on June 30 is as follows:



*Interest-bearing$25,000 × 10%

× 6/12 $1,250$50,000 × 9%

× 4/12 1,500 Subtotal $ 2,750

The effect on the accounting equation of accruing interest on the non-interest-bear-ing note on June 30 is as follows:


Discount on Interest Expense (1,000)Notes Payable 1,000*

Non-interest-bearing$1,200 × 5/6 = $1,000

g. The effect on the accounting equation of the August 1 payment of the six-month non-interest-bearing note is as follows:



Cash (20,000) Notes Payable (20,000) Interest Discount on Expense (200) Notes Payable 200*

*$1,200 – $1,000 = $200


PROBLEM 9-1 (Concluded)

h. The effect on the accounting equation of the amount borrowed on September 1 on the line of credit is as follows:




i. The effect on the accounting equation of the payment of the November 1 is-suance of a three-month note in payment of account is as follows:



Accounts Payable (12,000)

Notes Payable 12,000

j. The effect on the accounting equation of payment of the 10% note and interest on December 31 is as follows:



Cash (27,500) Notes Payable (25,000) Interest Interest Payable (1,250) Expense (1,250)*

*$25,000 × 10% × 6/12 = $1,250

2. Line of credit:$50,000 × 9% × 10/12 = $3,750$200,000 × 9% × 4/12 = 6,000

8% Note:$12,000 × 8% × 2/12 = 160

$9,910


LO 3 PROBLEM 9-2 EFFECTS OF SARA LEE’S CURRENT LIABILITIES ON ITS STATE-MENT OF CASH FLOWS

1. Adjustments to reconcile net income to net cash provided by operating activities:

Net income $xxxAdjustments to reconcile net income to net

cash provided by operating activities:Decrease in accounts payable (21)*Changes in accrued liabilities:

Decrease in payroll and employee benefits $ (33)Increase in advertising and promotions 100Increase in taxes other than payroll and income 11Increase in income taxes 246Decrease in other (53 ) 271*

*The amount reported on Sara Lee’s statement of cash flows differs from that calcu-lated here; the reason for the difference is not readily apparent from its annual report.

The changes in notes payable and in current portion of long-term debt during the year are not included as adjustments above because they are not directly related to Sara Lee’s operating activities. Transactions related to notes payable and long-term payable and long-term debt are financing activities.

2. Sara Lee must have access to cash or other assets that can be converted to cash, in amounts sufficient to pay its current liabilities. Sara Lee’s current ratio would be use-ful in assessing its liquidity. However, Sara Lee would be expected to have a large amount of inventory on hand. Therefore, its quick ratio would be a more conserva-tive measure of its ability to pay its bills on time.

LO 3 PROBLEM 9-3 EFFECTS OF TOMMY HILFIGER’S CHANGES IN CURRENT ASSETS AND LIABILITIES ON STATEMENT OF CASH FLOWS

1. Operating Activities Section of Cash Flow Statement:Net income $xxx,xxxAdjustments to reconcile net income to net

cash provided by operating activities:*Increase in accounts receivable (3,205)Decrease in inventories 23,352Increase in other current assets (8,159)Decrease in accounts payable (15,035)Increase in accrued expenses and other liabilities 21,267

*The amount reported on Hilfiger’s statement of cash flows differs from that calcu-lated here; the reason for the difference is not readily apparent from its annual report.



2. The change in short-term borrowings during the year is not included as an adjust-ment above because it is not directly related to Hilfiger’s operating activities. Trans-actions related to short-term borrowings are financing activities.

LO 4 PROBLEM 9-4 WARRANTIES

1. XX defective units × $150 per unit = $12,600XX defective units = $12,600/$150 per unitDefective units = 84

2. 600 units sold × XX% = 84 defective unitsXX% = 84 defective units/600 units sold = 14% of sales

3. If the actual amount of warranty costs incurred during 2008 is significantly higher than the estimated liability recorded for warranty costs at the end of 2007, Clearview should review its method for determining the accrual for warranty costs. Clearview should ensure that its estimates of the number of defective television sets sold and the average costs for replacement parts and labor are reasonable. Most likely, one or more of those estimates were too low.

LO 4 PROBLEM 9-5 WARRANTIES

1. The effect on the accounting equation of the current year’s estimated warranty cost is as follows:



Estimated Warranty Liability for Expense (5,400)

Warranties 5,400

$1,500 × 120 × 3% = $5,400

2. The effect on the accounting equation of the actual warranty repairs is as follows:


Inventory (4,950) Estimated Liability for Warranties (4,950)


LO 5 PROBLEM 9-6 COMPARISON OF SIMPLE AND COMPOUND INTEREST

1. The effect on the accounting equation of the interest accrual for 2007 is as follows:


200712/31 Interest Payable 1,000* Interest Expense (1,000)

*$25,000 × 8% × 1/2 = $1,000

The effect on the accounting equation of the interest accrual for 2008 is as follows:



*$25,000 × 8% × 1 = $2,000

The effect on the accounting equation of the payment of the note and interest is as follows:



20096/30 Cash (29,000) Notes Payable (25,000) Interest Expense (1,000)**

Interest Payable (3,000)*

*$1,000 + $2,000 = $3,000

**$25,000 × 8% × 1/2 = $1,000

2. The effect on the accounting equation of the interest accrual for 2007 is as follows:


200712/31 Interest Payable 1,000 Interest Expense (1,000)

*$25,000 × 8% × 1/2 = $1,000



The effect on the accounting equation of the interest accrual for 2008 is as follows:


200812/31 Interest Payable 2,122 Interest Expense (2,122)

First 6 months: ($25,000 + $1,000) × 8% × 1/2 year = $1,040Second 6 months: ($26,000 + $1,040) × 8% × 1/2 year = 1,082 Total $ 2,122

The effect on the accounting equation of the payment of the note and interest is as follows:



20096/30 Cash (29,247) Notes Payable (25,000) Interest Expense (1,125)**

Interest Payable (3,122)*

*$1,000 + $2,122 = $3,122

**($27,040 + $1,082) × 8% × 1/2 year = $1,125

3. Interest recognized in (b) ($1,000 + $2,000 + $1,000) $4,000Interest recognized in (a) ($1,000 + $2,122 + $1,125) 4,247 Additional interest with compounding at 8% $ 247

LO 6 PROBLEM 9-7 INVESTMENT WITH VARYING INTEREST RATE

Principal at Interest AccumulatedYear Beginning of Year Factor at End of Period2007 $1,000 1.04 $1,0402008 1,040 1.05 1,0922009 1,092 1.06 1,1582010 1,158 1.07 1,2392011 1,239 1.08 1,338


LO 6 PROBLEM 9-8 COMPARISON OF ALTERNATIVES

a. $180,000 × 1.0 = $180,000

b. $196,200 × 0.926 (present value of $1 for n = 1, i = 8%) = $181,681

c. $220,500 × 0.857 (present value of $1 for n = 2, i = 8%) = $188,969

d. $55,000 × 3.312 (present value of annuity of $1 for n = 4, i = 8%) = $182,160

Option (a) is the least cost alternative.

LO 8 PROBLEM 9-9 PAYROLL ENTRIES (Appendix A)

1. The effect on the accounting equation of accruing the amount payable to employ-ees is as follows:



Salary Payable 142,550 Salary Expense (210,000)Income Tax

Payable 42,500FICA Tax

Payable 16,000Heart Fund

Payable 5,800Union Dues

Payable 3,150

2. The effect on the accounting equation when the employees are paid is as follows:


Cash (142,550) Salary Payable (142,550)

3. The effect on the accounting equation of recording the employer's payroll costs is as follows:



FICA Tax Payroll Tax Payable 16,000 Expense (22,300)

Unemployment Tax Payable 6,300*

*$210,000 × 3% = $6,300



4. The effect on the accounting equation of remitting the withholdings is as follows:


Cash (89,750) Income Tax Payable (42,500)

FICA Tax Payable (32,000)

Heart Fund Payable (5,800)

Union Dues Payable (3,150)

Unemployment Tax Payable (6,300)

LO 9 PROBLEM 9-10 COMPENSATED ABSENCES (Appendix A)

To: Bookkeeper

Each time payroll is recorded, you must recognize vacation and sick day expense and a corresponding liability. This is necessary because employees have performed the ser-vice and payment is certain, since they are vested (receive payment when they retire or quit). The amount to be recognized for vacation pay expense will be equal to the weekly payroll divided by 20, since we have five work days in each work week and employees accrue one vacation day for every four weeks they work. To calculate the amount to be recognized for sick pay expense, first calculate the weekly payroll less the pay earned by employees who were absent one or more days during the week. This amount is then divided by 30, since we have five work days in each week and employees accrue one sick day for every six weeks they work.

MULTI-CONCEPT PROBLEMS

LO 2,5 PROBLEM 9-11 INTEREST IN ADVANCE VERSUS INTEREST PAID WHEN LOAN IS DUE

1. a. $103,200

b. $103,200/(100% – 14%) = $120,000

2. a. $103,200 × 14% = $14,448; $14,448/$103,200 = 14%

b. ($120,000 – $103,200)/$103,200 = 16.28%


PROBLEM 9-11 (Continued)

3. a. The effect on the accounting equation of the issuance of the note on July 1, 2007, is as follows:




The effect on the accounting equation of accruing the interest for 2007 on Decem-ber 31 is as follows:




*$103,200 × 14% × 6/12 = $7,224

The effect on the accounting equation of payment of the principal and interest on July 1, 2008, is as follows:



Cash (117,648) Notes Payable (103,200) Interest Expense (7,224)Interest

Payable (7,224)

b. The effect on the accounting equation of issuing the note on July 1, 2007, is as follows:





The effect on the accounting equation of accruing the interest for 2007 on Decem-ber 31 is as follows:



Discount on Interest Expense (8,400)Notes Payable 8,400*

*$16,800 × 1/2 = $8,400



The effect on the accounting equation of the payment of the note on July 1, 2008, is as follows:



Cash (120,000) Notes Payable (120,000) Interest Expense (8,400)Discount on

Notes Payable 8,400

4. a. Note payable $103,200

b. Note payable $120,000Less: Discount on note payable 16,800

$103,200

LO 1,4 PROBLEM 9-12 CONTINGENT LIABILITIES

1. Items a, d, e: The liability is probable and an estimate is available.

2. Item c: The liability is reasonably possible, but an estimate is not available.

Item b is not recorded or disclosed, because it is a contingent asset.

LO 6,7 PROBLEM 9-13 TIME VALUE OF MONEY CONCEPTS

1. $9,750 × 5.895 (future value of $1 for n = 17, i = 11%) = $57,476

2. $42,487/$21,600 = 1.967; future value of $1 for n = 10, i = 7%

3. $15,000/1.714 (future value of $1 for n = 7, i = 8%) = $8,751

OR: $15,000 × 0.583 (present value of $1 for n = 7, i = 8%) = $8,745. Slight differ-ence due to rounding.

4. $15,026/$5,800 = 2.591; future value of $1 for i = 10%, n = 10 years


LO 6,7 PROBLEM 9-14 COMPARISON OF ALTERNATIVES

a. $15,000 × 1.360 (future value of $1 for n = 4, i = 8%) = $20,400

b. $2,250 × 9.214 (future value of annuity of $1 for n = 8, i = 4%) = $20,731.50

c. $4,350 × 4.506 (future value of annuity of $1 for n = 4, i = 8%) = $19,601.10

Alternative (b) is preferable.

ALTERNATE PROBLEMS

LO 2 PROBLEM 9-1A NOTES AND INTEREST

1. a. The effect on the accounting equation of issuing the note on January 1 is as fol-lows:




b. January 10. Only a memorandum note would be made.

c. The effect on the accounting equation of the issuance of a non-interest-bearing note is as follows:



2/1 Equip- 26,320 Notes Payable 28,000 ment Discount on


*$28,000 × 12% × 1/2 = $1,680

d. The effect on the accounting equation of the line of credit borrowing is as fol-lows:



3/1 Cash 210,000 Loan Payable 210,000


PROBLEM 9-1A (Continued)

e. The effect on the accounting equation of the partial payment of the line of credit is as follows:



6/1 Cash (143,150) Loan Payable (140,000) Interest Expense (3,150)*

*$140,000 × 9% × 3/12 = $3,150

f. The effect on the accounting equation of accruing interest on the interest-bear-ing note is as follows:




*$35,000 × 0.10 × 6/12 $1,750$70,000 × 0.09 × 4/12 2,100

$3,850

The effect on the accounting equation of accruing interest on the non-interest-bear-ing note is as follows:



6/30 Discount on Interest Expense (1,400) Notes Payable 1,400*

*$1,680 × 5/6 = $1,400

g. The effect on the accounting equation of repayment of the non-interest-bearing note on August 1 is as follows:



Cash (28,000) Notes Payable (28,000) Interest Expense (280) Discount on Notes Payable 280


PROBLEM 9-1A (Concluded)

h. The effect on the accounting equation of borrowing on the line of credit on Sep-tember 1 is as follows:




i. The effect on the accounting equation of issuance of the 8% note in payment of account on November 1 is as follows:



Notes Payable 16,800Accounts

Payable (16,800)

j. The effect on the accounting equation of the repayment of the note plus interest on December 31 is as follows:



Cash (38,500) Notes Payable (35,000) Interest Interest Payable (1,750) Expense (1,750)*

*$35,000 × 10% × 6/12 = $1,750

2. Line of credit:($210,000 – $140,000) × 9% × 10/12 = $ 5,250$280,000 × 9% × 4/12 = 8,400

8% Note:$16,800 × 8% × 2/12 = 224

$13,874


LO 3 PROBLEM 9-2A EFFECTS OF BOEING’S CURRENT LIABILITIES ON ITS STATE-MENT OF CASH FLOWS

1. Adjustments to reconcile net income to net cash provided by operating activities:Net income $ xxxAdjustments to reconcile net income to net cash

provided by operating activities:Increase in accounts payable and other liabilities 1,355Increase in advances in excess of related costs 659Increase in income taxes payable 245*

*The amount reported on Boeing’s statement of cash flows differs from that calcu-lated here because of the impact of deferred taxes.

The changes in short-term debt and current portion of long-term debt during the year are not included as adjustments above because they do not directly relate to Boeing’s operating activities. Transactions relating to long-term debt are financing activities.

2. Boeing must have access to cash, or other assets that can be converted to cash, in amounts sufficient to pay its current liabilities. Boeing’s current ratio would be useful in assessing its liquidity. However, Boeing would be expected to have a large amount of inventory on hand. Therefore, its quick ratio would be a more conserva-tive measure of its ability to pay its bills on time.

LO 3 PROBLEM 9-3A EFFECTS OF NIKE’S CHANGES IN CURRENT ASSETS AND LIA-BILITIES ON ITS STATEMENT OF CASH FLOWS

1. Adjustments to reconcile net income to net cash provided by operating activities:Net income $xxx,xxxAdjustments to reconcile net income to net

cash provided by operating activities:*Increase in accounts receivable (36.3)Increase in inventories (118.7)Increase in prepaid expenses and other current assets (31.9)Increase in accounts payable 191.1Decrease in income taxes payable (12.4)Decrease in accrued liabilities (61.8)

*The amount reported on Nike’s statement of cash flows differs from that calculated here; the reason for the difference is not readily apparent from its annual report.

2. The changes in the current portion of long-term debt and notes payable during the year are not included as adjustments above because they are not directly related to Nike’s operating activities. Transactions involving long-term debt and notes payable are financing activities.


LO 4 PROBLEM 9-4A WARRANTIES

1. XX defective units × $300 per unit = $25,200XX defective units = $25,200/$300 per unitDefective units = 84

2. XX% = 84 defective units/600 units sold = 14% of sales

LO 4 PROBLEM 9-5A WARRANTIES

1. The effect on the accounting equation of estimating the warranty expense is as fol-lows:



Estimated Warranty Liability for Expense (15,360)Warranties 15,360*

*$3,200 × 120 × 4% = $15,360

2. The effect on the accounting equation of the actual warranty costs is as follows:



Inventory (10,200) Estimated Liability for Warranties (10,200)

3. Beginning balance $ 1,100Add: Warranty estimate 15,360Less: Actual expense (10,200 )Ending balance $ 6,260

LO 5 PROBLEM 9-6A COMPARISON OF SIMPLE AND COMPOUND INTEREST

1. Dec. 31, 2007 $25,000 × 6% × 6/12 = $ 750Dec. 31, 2008 $25,000 × 6% × 12/12 = 1,500June 30, 2009 $25,000 × 6% × 6/12 = 750 Total accrued $3,000



2. Dec. 31, 2007: $25,000 × 6% × 1/2 = $ 750Dec. 31, 2008:

First 6 months: ($25,000 + $750) × 6% × 1/2 year = $773Second 6 months: ($25,750 + $773) × 6% × 1/2 year = 796

Total for 2008 1,569

June 30, 2009: ($26,523 + $796) × 6% × 6/12 = 820 Total accrued $3,139

3. Interest recognized in (2) ($750 + $1,569 + $820) $3,139Interest recognized in (1) ($750 + $1,500 + $750) 3,000 Additional interest with compounding at 6% $ 139

LO 6 PROBLEM 9-7A INVESTMENT WITH VARYING INTEREST RATE

Principal at Interest AccumulatedYear Beginning of Year Factor at End of Period2007 $2,000 1.04 $2,0802008 2,080 1.05 2,1842009 2,184 1.06 2,3152010 2,315 1.07 2,4772011 2,477 1.08 2,675

LO 6 PROBLEM 9-8A COMPARISON OF ALTERNATIVES

a. $270,000 × 1.0 = $270,000 n = 0, i = 8%

b. $294,300 × 0.926 (present value of $1 for n = 1, i = 8%) = $272,522

c. $334,750 × 0.857 (present value of $1 for n = 2, i = 8%) = $286,881

d. $82,500 × 3.312 (present value of annuity of $1 for n = 4, i = 8%) = $273,240

Option (a) is the least cost alternative.


LO 8 PROBLEM 9-9A PAYROLL TRANSACTIONS (Appendix A)

1. The effect on the accounting equation of accruing the amount payable to the em-ployees is as follows:



Salary Payable 228,080 Salary Expense (336,000)Income Tax

Payable 68,000FICA Tax

Payable 25,600Heart Fund

Payable 9,280Union Dues

Payable 5,040

2. The effect on the accounting equation when the employees are paid is as follows:


Cash (228,080) Salary Payable (228,080)

3. The effect on the accounting equation of recording the employer's payroll costs is as follows:



FICA Tax Payroll Tax Payable 25,600 Expense (35,680)

Unemployment Tax Payable 10,080*

*$336,000 × 3% = $10,080

4. The effect on the accounting equation when the withholdings are remitted is as fol -lows:



Cash (143,600) Income Tax Payable (68,000)

FICA Tax Payable (51,200)Heart Fund

Payable (9,280)Union Dues

Payable (5,040)Unemployment Tax Payable (10,080)


LO 9 PROBLEM 9-10A COMPENSATED ABSENCES (Appendix A)

If sick days are allowed to accrue to employees and are paid to employees when they retire, the sick days should be considered an expense when they are earned and not when they are paid. The accountant should recommend a change in policy to corporate headquarters. Divisional budgets should reflect the cost of sick days as they are earned. This would prevent the problem that occurs when several employees all retire at the same time. Of course, the policy should include measures to ensure that divisions do not overestimate or underestimate the cost of accrued sick days.

ALTERNATE MULTI-CONCEPT PROBLEMS

LO 2,5 PROBLEM 9-11A INTEREST IN ADVANCE VERSUS INTEREST PAID WHEN LOAN IS DUE

1. a. $206,400

b. $206,400/(100% – 14%) = $240,000

2. a. $206,400 × 14% = $28,896; $28,896/$206,400 = 14%

b. ($240,000 – $206,400)/$206,400 = 16.28%

3. a. The effect on the accounting equation of issuing the interest-bearing note on July 1, 2007, is as follows:




The effect on the accounting equation of the accrual of interest on December 31, 2007, is as follows:




*$206,400 × 14% × 6/12 = $14,448



The effect on the accounting equation of payment of the note plus interest on July 1, 2008, is as follows:



Cash (235,296) Notes Payable (206,400) Interest Interest Expense (14,448)

Payable (14,448)

b. The effect on the accounting equation of issuing the non-interest-bearing note on July 1, 2007, is as follows:





The effect on the accounting equation of accruing interest on the note on December 31, 2007, is as follows:



Discount on Interest Notes Payable 16,800* Expense (16,800)

*$33,600 × 1/2 = $16,800

The effect on the accounting equation of the payment of the note on July 1, 2008, is as follows:



Cash (240,000) Notes Payable (240,000) Interest Discount on Expense (16,800)

Notes Payable 16,800

4. a. Note payable $206,400

b. Note payable $240,000

Less: Discount on note payable 33,600

$206,400


LO 1,4 PROBLEM 9-12A CONTINGENT LIABILITIES

1. Items a, d, e: The liability is probable in occurrence, and an estimate is available.

2. Item b: The liability is possible, but an estimate is not available.

Item c is not recorded or disclosed, because it is a contingent asset.

LO 6,7 PROBLEM 9-13A TIME VALUE OF MONEY CONCEPTS

1. $19,500 × 5.895 (future value of $1 for n = 17, i = 11%) = $114,953

2. $84,974/$43,200 = 1.967; future value of $1 for n = 10, i = 7%

3. $30,000/1.714 = (future value of $1 for n = 7, i = 8%) = $17,503

OR: $30,000 × 0.583 (present value of $1 for n = 7, i = 8%) = $17,490. Slight differ-ence due to rounding.

4. $30,052/$11,600 = 2.591; future value of $1 for i = 10%, n = 10 years

LO 6,7 PROBLEM 9-14A COMPARISON OF ALTERNATIVES

a. $16,000 × 1.360 (future value of $1 for n = 4, i = 8%) = $21,760

b. $2,400 × 9.214 (future value of annuity of $1 for n = 8, i = 4%) = $22,114

c. $4,640 × 4.506 (future value of annuity of $1 for n = 4, i = 8%) = $20,908

Option (b) is preferable.

DECISION CASES

READING AND INTERPRETING FINANCIAL STATEMENTS

LO 1,2 DECISION CASE 9-1 FINISH LINE’S CURRENT LIABILITIES

1. For 2005: Current assets $381,527/Current liabilities $142,415 = 2.67

For 2004: Current assets $371,800/Current liabilities $137,016 = 2.71

The current ratio for both years indicates that the company has maintained a strong liquidity position. The company has sufficient current assets on hand to meet its obli -gations when they come due.


DECISION CASE 9-1 (Concluded)

2. Accrued property and sales tax would represent taxes that have been incurred by the company but have not yet been paid. They are treated as an expense in the pe-riod incurred under accrual accounting methods even though they will not be paid until the following period.

3. A note to the statement indicates the company is party to several lawsuits. The law-suits have been disclosed in the notes but have not been recorded as a liability on the balance sheet because the company does not feel that it is probable that a mate-rial amount of loss will occur.

LO 3,4 DECISION CASE 9-2 COMPARING TWO COMPANIES IN THE SAME INDUSTRY: FOOT LOCKER AND FINISH LINE

1. For 2005, Finish Line generated slightly more than $74 million from operating activi-ties, and Foot Locker generated $354 million. Both are positive indications about the companies. It should be noted that Foot Locker is a larger company and therefore must generate more from operating activities. For both companies, the primary source of operating activities was the net income generated.

2. A negative amount for inventories in the operating category indicates the company had to spend cash to increase its inventory levels. This could be a positive sign that the company expects sales to increase. However, it should be monitored carefully to make sure the company is not holding obsolete or unsalable inventory.

3. A positive amount for accounts payable indicates that accounts payable has in-creased during the period. This is consistent with the increase in inventory levels and indicates the company has purchased inventory on account and will have to pay for it in the following period.

4. The most important reason was the $171 million recognized as depreciation and amortization. Depreciation reduces a company’s net income but does not require cash. Therefore, it appears as a positive amount on the statement of cash flows.

LO 3,4 DECISION CASE 9-3 MICROSOFT CORPORATION’S CONTINGENT LIABILITIES

1. How the settlement of the lawsuit should be treated is a matter of judgment. It ap-pears that the payment of $497 million is probable and the amount has been deter -mined. If that is the case, then the settlement should be recorded as an expense on the income statement and as a current liability on the balance sheet. It appears that Microsoft took such action and recorded the amount on its financial statements.



2. Since the accrual is reported on the income statement, it affects the net income re-ported. However, the amount does not represent a cash payment during 2004. Therefore, the increase in the current liability representing the settlement should be added back in the Operating Activities section of the cash flows statement. The set-tlement will actually affect cash flows in the period that it is paid.

3. How the legal dispute should be reported is also a matter of judgment. In this case, it does not appear that a loss was both probable and could be reasonably estimated at the balance sheet date. Therefore, the company is not required to record a contin-gent liability on the balance sheet but is required to disclose the existence of the le-gal dispute in the notes. Accrual of the liability should occur when the company be-lieves that the loss is probable and the amount of the loss can be reasonably esti -mated.

LO 4 DECISION CASE 9-4 FORD MOTOR COMPANY’S CONTINGENT LIABILITY

1. The company has stated quite strongly in the notes that in its belief the amount of possible loss from the lawsuits in the future could not be estimated. (Note that the company does not make statements about whether a loss is “probable.”) Because the accounting rule requires a loss to be both probable and subject to reasonable estimation, the company has not recorded a liability for the lawsuits as of the bal-ance sheet date.

2. The lawsuits regarding Firestone tires are still ongoing as of the date of publication of the text. Therefore, it cannot be determined when Ford did in fact record the liabil-ity related to the lawsuits and personal injury claims. However, events occurring after 2000 may cause students to question whether or not the note in the 2000 annual re -port was sufficient reporting of the company’s exposure to loss.

MAKING FINANCIAL DECISIONS

LO 1,2 DECISION CASE 9-5 CURRENT RATIO LOAN PROVISION

1. The company is experiencing difficulties that are similar to many small, start-up com-panies. The company must either take action to get a 2:1 ratio of current assets to current liabilities or must approach its bank and ask for a modification of that provi -sion. If the firm wishes to achieve a 2:1 ratio, it must increase current assets, decrease current liabilities, or both. Actions that should be considered include the following:

a. Request from the bank a long-term line of credit to be used to pay the current lia -bilities.


b. Work with creditors to stretch out the payment of liabilities in order to conserve current assets.


c. Speed the sale of inventory and the collection of cash from customers.

d. Delay the purchase of additional inventory.

Normally, a combination of all the above actions is necessary and should be recom-mended. However, the above actions are rather short term in nature. The firm must achieve a solid financial base to alleviate similar liquidity problems.

2. Some actions to improve liquidity are referred to as window-dressing. The term refers to actions that artificially make the financial statements appear more favorable for a short time. An example of window-dressing in this case would be to use current assets to pay current liabilities which in many cases will increase the current ratio. Window-dressing actions are seldom beneficial in the long run. In fact, such actions do not recognize the other financial needs of the firm and may be detrimental in the long run.

LO 7 DECISION CASE 9-6 ALTERNATIVE PAYMENT OPTIONS

The only way to compare the dollars is to determine the present value of each of these options discounted at 8%.

a. $2,000 + [($18,000 × 1.08) × 0.926] = $20,001 (rounded)

b. $2,000 + [$18,000 × (1 + 0.02)4 × 0.926] = $20,042 (rounded)

c. $21,600 × 0.926 = $20,002 (rounded)

The present value of a $20,000 cash sale is $20,000. When these options are com-pared, the option with the highest present value of cash flows, discounted at 8%, is op-tion (b). Kathy should also consider the financial position of the buyer, because these amounts are not materially different. Since the buyer is starting a new business, she may be better off taking the cash up front if it is possible for the buyer to get cash from another source.


ETHICAL DECISION MAKING

LO 4 DECISION CASE 9-7 WARRANTY COST ESTIMATE

The purpose of the case is to allow students to understand that judgment is necessary in the accrual of an estimated liability such as warranty costs. Because the decision re-quires the exercise of judgment, it should be emphasized that there is no right answer, and in this case few good alternatives seem to exist. Discussion of the case should begin with the evidence available, which convinced John that 5% is inadequate as an accrual for warranties. Can he rely on the evidence? Would others reach the same con-clusion with the same evidence? If students conclude that John should stick with his de-cision, then the available courses of action should be examined.

Students should be encouraged to develop the pros and cons of (a) remaining silent and accepting the 5% figure, (b) approaching the owner and informing him that the ex-pense is understated, (c) approaching the bank officer and relating his concern. While options (b) and (c) may appear to be “morally correct,” students should see the negative consequences that could result if John did not follow the chain of command. Can an employee always make decisions that are consistent with personal and team objec-tives?

Finally, students should be encouraged to develop innovative compromise solutions. How could the company prevent similar situations? Could a third party serve as an arbi-trator? What should be the role of the internal and external auditors in this matter?

LO 4 DECISION CASE 9-8 RETAINER FEES AS SALES

The retainer fee should be recorded as sales when the sales are made and charged off against the retainer. Even if the retainer were nonrefundable, the amount would be rec-ognized as sales at the time the goods are delivered, on the basis of the going concern concept. The controller may be eager to show the amount as sales because the amount may improve net income, since sales would be recorded with no corresponding ex-penses. Ratios that involve net income would be improved. Working capital would be in-creased because a lower liability amount would be reported. Correspondingly, the work-ing capital ratios would improve.


REAL WORLD PRACTICE 9.1

Accounts listed as current liabilities include the following:

Notes payableCurrent maturities of long-term debtTrade accounts payableIncome taxes payableLiabilities associated with assets held for saleAccrued expenses and other current liabilities

Trade Accounts Payable increased by $21.4 million ($123.7 – $102.3) from 2003 to 2004.

REAL WORLD PRACTICE 9.2

The accrued expenses include amounts owed, but unpaid, at the end of the period for items such as salaries, utilities, and taxes. The items are not included in the Accounts Payable account because the Accounts Payable account reflects the amount owed to the companies from which Foot Locker buys parts and supplies used to produce its products.

chapter 9: current liabilities, contingencies, and...

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