Chapter 1 (Unit 2 Pt 1) Current Liabilities and Contingencies

Question 1

Company A is involved in a lawsuit. It is probable that the company will be liable for $900,000 as a result of this suit. How would this be recorded?

Answer 1

Dr. Lawsuit Loss $900,000
Cr. Lawsuit Liability $900,000

Question 2

Company A is involved in a lawsuit. It is not probable that the company will be liable for $900,000 as a result of this suit. How would this be recorded?

Answer 2

Because the loss contingency is not probable, nothing is recorded in the books.

Question 3

Only potential loss contingencies that are reasonably possible should be estimated and accrued in the books. What (3) loss contingencies are always considered probable?

Answer 3

Collectability of receivables

Obligations related to warranties and product defects

Premiums offered to customers

Question 4

What are the two types of warranties companies often provide to customers?

Answer 4

Assurance-type warranty

Service-type warranty

Question 5

What is an Assurance-type warranty and how is it handled in the books?

Answer 5

A warranty that the product meets agreed-upon specifications in the contract at the time the product is sold.

Should be expensed in the period the goods are provided or services performed and we record a warranty liability.

Question 6

What is a Service-type warranty and how is it handled in the books?

Answer 6

A warranty that provides an additional service beyond the assurance-type warranty.

This is recorded as a separate performance obligation and recorded in an Unearned Warranty Revenue account. Then recognize revenue on a straight-line basis over the period the service-type warranty is in effect.

Question 7

Assurance-Type Warranty
Denson Company begins production of a new machine in July 2020 and sells 100 of these machines for $5,000 cash by year-end for a total sales revenue of $500,000 (100 x $5,000). Each machine is under warranty for one year. Denson estimates, based on past experience with similar machines, that the warranty cost will average $200 per unit for a total expected warranty expense of $20,000 (100 x $200). Further, as a result of parts replacements and services performed in compliance with machinery warranties, it incurs $4,000 in warranty costs in 2020 and $16,000 in 2021.

a) What is the journal entry to record the sale of machines and related warranty costs (July-Dec 2020)?

b) What is the journal entry to record payment for warranty costs incurred (July-Dec 2020)?

c) What is the adjusting journal entry to record estimated warranty expense and warranty liability for expected claims in 2021?

d) What is the entry to record the payment for warranty costs in 2021 from 2020 sales?

Answer 7

a) Cash 500,000
Sales Revenue 500,000
[5,000*100]

b) Warranty Expense 4,000
Cash/Inventory/AP, etc. 4,000

c) Warranty Expense 16,000
Warranty Liability 16,000
[20,000 - 4,000]

d) Warranty Liability 16,000
Cash/Inventory/AP, etc. 16,000

Question 8

Service-Type Warranty
You purchase an automobile from Hamlin Auto for $30,000 on January 2, 2020. Hamlin estimates the assurance-type warranty costs on the automobile to be $700 (Hamlin will pay for repairs for the first 36,000 miles or three years, whichever comes first). You also purchase for $900 a service-type warranty for an additional three years or 36,000 miles. Hamlin incurs warranty costs related to the assurance-type warranty of $500 in 2020 and $200 in 2021. Hamlin records revenue on warranties using straight line.

a) What is the journal entry to record the sale of the car and warranties on 1/2/2020?

b) What is the journal entry to record warranty costs incurred (2020)?

c) What is the adjusting journal entry to record estimated warranty expense and warranty liability for expected assurance warranty claims in 2021?

d) What is the entry to record revenue recognized in 2023, 2024, and 2025 from 2020 sales?

Answer 8

a) Cash 30,900
Sales Revenue 30,000
Unearned Warranty Revenue 900
[Assurance-Type warranties are folded into the price of the car. The Service-Type are not.]

b) Warranty Expense 500
Cash/Inventory/Payroll, etc. 500

c) Warranty Expense 200
Warranty Liability 200
[700 - 500]

d) Unearned Warranty Revenue 300
Warranty Revenue 300

Question 9

How should a company handle Premiums & Coupons?

Answer 9

Companies should charge the costs of premiums and coupons to expense in the period of the sale that benefits from the plan.

Company estimates the number of outstanding premium offers that customers will present for redemption.

Company charges the cost of premium offers to Premium Expense and credits Premium Liability

Question 10

What is an ARO?

Answer 10

Asset Retirement Obligation - an environmental liability

A company must recognize an ARO when it has an existing legal obligation associated with the retirement of a long-lived asset and when it can reasonably estimate the amount of the liability.

ARO’s should be recorded as fair value.

Question 11

On January 1, 2020, Wildcat Oil Company erected an oil platform in the Gulf of Mexico. Wildcat is legally required to dismantle and remove the platform at the end of its useful life, estimated to be five years. Wildcat estimates that dismantling and removal will cost $1,000,000. Based on a 10 percent discount rate, the fair value of the asset retirement obligation is estimated to be $620,920 ($1,000,000 x .62092). Wildcat uses straight-line depreciation and has a calendar-year fiscal end. On 1/10/25, Wildcat contracts with another entity to dismantle the platform for $995,000.

a) What is the entry to record this ARO?

b) What is the entry to record depreciation every year?

c) What is the entry to record 2020 interest expense?

d) 5 years later, what is the entry to record settlement of the ARO?

Answer 11

a) Drilling Platform 620,920
Asset Retirement Obligation 620,920
[Adding the present value of the ARO to the asset itself]

b) Depreciation Expense 124,184
Accumulated Depreciation 124,184
[620,920 / 5]

c) Interest Expense 62,092
Asset Retirement Obligation 62,092
[620,920 x 10%; as that debt increases in value, the interest cost will go up every year because the value of the debt will be higher]

d) Asset Retirement Obligation 1,000,000
Cash 995,000
Gain on Settlement of ARO 5,000

Question 12

How is the Acid-test ratio (aka quick ratio) calculated? What does it measure?

Answer 12

Cash + Short-term investments + Net AR
___________________________________________
Current Liabilities

The current ratio determines how many times the current assets can cover the current liabilities. But because not all of our current assets can be quickly liquidated to pay a current liability, this ratio relates total current liabilities to cash marketable securities and receivables. These are assets that can be truly flipped over with sufficient expedience to pay a current liability in a pinch.

Question 13

What is the definition of a Current Liability?

Answer 13

A current liability is one that will be extinguished:

with current assets, or

through the incurrence of other current liabilities

Within one year of the balance sheet date or operating cycle, whichever is longer

Question 14

Lyle, Inc. is preparing its financial statement for the year ended December 31, year 2. Accounts payable amounted to $360,000 before any year-end adjustment related to the following:

At December 31, year 2, Lyle has a $50,000 debit balance in its accounts payable to Ross, a supplier, resulting from a $50,000 advance payment for goods to be manufactured to Lyle’s specifications.

Checks in the amount of $100,000 were written to vendors and recorded on December 29, year 2. The checks were mailed on January 5, year 3.

What amount should Lyle report as accounts payable in its December 31, year 2 balance sheet?

Answer 14

Unadjusted accounts payable = $360,000

Reclassification of advance = $50,000

Error correction = $100,000

360,000 + 50,000 + 100,000 = 510,000

Adjusted accounts payable = $510,000

Question 15

Kemp Co. received a $500 advertising bill on January 7, year 3, for $375 of advertisements run in December year 2, and $125 of advertisements run in January year 3.

Kemp also has a store lease, effective December 16, year 1 for fixed rent of $1,200 per month, payable one month from the effective date and monthly thereafter. In addition, rent equal to 5% of net sales over $300,000 per calendar year is payable on January 31 of the following year. Net sales for year 2 were $550,000.

What amount of accrued liabilities should be reported by Kemp on its December 31, year 2 balance sheet?

Answer 15

$375.00 for advertisements that ran in year 2
+ $600.00 (1,2000.05) fixed rent
+ 12,500 [(550,000 - 300,000)0.05] variable rent = $13,475 total accrued liabilities

Question 16

How are current and noncurrent liabilities reported on the balance sheet?

Answer 16

Current Liabilities - nominal rate
Noncurrent Liabilities - the present value of all future payments (can also be valued at fair value if the company chooses the fair value option)

Question 17

When would a short-term liability not be classified as current? (2)

Answer 17

A note payable that will be settled with the stock of the debtor. (Current liabilities are extinguished with current assets or current liabilities, not equity)

The entity has shown the ability and intent to refinance as long-term debt.

Question 18

When would a long-term liability be classified as current (2)?

Answer 18

A note payable due many years from now but payable on demand by the creditor.

The entity violated a debt covenant. (When this happens, the note may become due)

Question 19

Tate Company purchased equipment on November 1, year 1 and gave a 3-month, 9% note with a face value of $80,000. What is the December 31, year 1 adjusting entry?

Answer 19

Db: Interest Expense $1,200
Cr: Interest Payable $1,200
[$80,000 x 0.09 x 2/12]

Question 20

A firm is a defendant in a lawsuit and there is a 90% chance that the firm will lose the lawsuit.

Estimates of loss range from $5,000,000 to $20,000,000 and possibly as much as $30,000,000.

None of the estimates are more likely than the others.

a) What amount of liability is accrued?

b) Assume the final cost of the lawsuit is $5.2 million. What would be the appropriate journal entry?

c) Assume the final cost of the lawsuit is $4.8 million. What would be the appropriate journal entry?

Answer 20

a) The lowest amount in the range, $5,000,000, is accrued.

Dr: Estimated Lawsuit Loss $5,000,000
Cr: Estimated Lawsuit Liability $5,000,000

The difference between final amount and $5 million is treated as a change in estimate.

b) Dr: Estimated lawsuit liability $5,000,000
Dr: Lawsuit Loss $0.2 million
Cr: Cash $5.2 million

c) Dr: Estimated lawsuit liability $5 million
Cr: Cash $4.8 million
Cr: Gain $0.2 million

Question 21

If a range of values for a contingent liability is given, what value should be chosen to recognize?

Answer 21

• If one value is more likely than the others, that amount is accrued.
• If there is a range of values with no one value more likely than the others, accrue the lowest amount in the range.

Question 22

What are the two Solvency ratios for analysis of long-term debt and how are they calculated?

Answer 22

Debt to assets ratio = Total Liabilities / Total Assets
**The higher the percentage of liabilities to total assets, the greater the risk that the company may be unable to meet its maturing obligations.

Times interest earned = Income before income taxes and interest expense / Interest Expense
**Indicates the company’s ability to meet interest payments as they come due.

Question 23

Regular Warranty

Assume an entity offers a regular warranty on products for 3 years after purchase. Warranty costs to the entity average 6% of selling price in the year of sale. Current year sales are $4 million and $230,000 was spent for warranty claims.

a) Record the sales
b) Accrue the estimated warranty costs
c) Record actual warranty costs

Answer 23

a) DR: Accounts Receivable 4,000,000
CR: Sales 4,000,000

b) DR: Warranty expense 240,000
CR: Warranty liability 240,000

c) DR: Warranty liability 230,000
CR: Cash/Inventory/AP, etc. 230,000