Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies 10-33
15. On December 31, 2017, Barton Incorporated had total liabilities of $60,000 and total
shareholders’ equity of $90,000, resulting in a debt/equity ratio of 0.67 before income tax
expense is recognized. On December 31, 2017, Barton paid its 2017 income taxes of
$6,000 while its income tax expense on its 2017 income statement was $8,000. This
difference exists because Barton uses straight-line depreciation on its books and double-
declining-balance depreciation on its tax returns. What is Barton’s debt/equity ratio after
the tax expense and deferred tax liability are recognized?
16. On December 31, 2017, Carlson Incorporated had total liabilities of $60,000 and total
shareholders’ equity of $100,000, resulting in a debt/equity ratio of 0.60 before warranty
expense is recognized. On December 31, 2017, Carlson estimated warranty expense to
be 5% of sales of $100,000. What is Carlson’s debt/equity ratio after the warranty
expense and related liability is recognized?
10–34 Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies
17. On March 2, 2017, Knight Company’s CFO, Bob Martin, will receive a bonus equal to
6% of income before income taxes as reported for the year ended December 31, 2016.
The current 2016 income statement shows income before income taxes as $600,000.
Required:
(1) What journal entry should be made on December 31, 2016?
(2) What journal entry should be made on March 2, 2017?
(3) If Bob decides to postpone $50,000 of 2016 research and development expenditures
until 2017, what impact would this have on his bonus? Explain and show your
calculations.
18. On December 31, 2017, Stanley Co. had current assets of $20,000 (all cash) and
current liabilities of $9,000 in accounts payable, resulting in a current ratio of 2.22. On
December 31, 2017, Stanley purchases $6,000 of inventory on account. Calculate
Stanley’s current ratio after the inventory has been purchased.
Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies 10-35
19. Vista Corporation, producer of computer software packages, began operations on
January 1. It acquired financing from the issuance of common stock for $60,000,000 and
long-term debt for $80,000,000. At the beginning of business operations, Vista produced
the following projected income statement and balance sheet for the first year. All
amounts are in thousands.
Vista Corporation
Projected Income Statement
First Year of Operations
Sales
Expenses:
Warranty
$10,000
Depreciation
40,000
Research
20,000
Operating income before bonus
Bonus
Operating income
Interest expense
Income before taxes
Income taxes (40%)
Net income
Vista Corporation
Projected Balance Sheet
December 31 of First Year
Assets:
Cash
$ 30,000
Accounts receivable
24,000
Net computers
158,000
Total assets
$212,000
Liabilities & Shareholders’ Equity:
Accounts payable
$ 50,000
Warranty payable
10,000
Long-term debt
80,000
Common stock
60,000
Retained earnings
12,000
Total liabilities and shareholders‘ equity
$212,000
The new president is rather disappointed with these projected results having just quit a
job of which his compensation package was $4,000,000. After examining the forecasts
of a bonus of only $3,000,000, the president decides to use his knowledge of financial
statements to modify his bonus. He meets with the company’s CFO the next day to see
what could be done. He suggested the following possibilities that would boost the first
year’s income:
1. Slash research and development expenditures, which are paid in cash, from $20
million to $10 million.
2. Double the estimated life of the computers, which will decrease depreciation
expense from $40 million to $20 million. Because identical accounting
procedures are used for taxes, no deferred taxes will be generated. Taxes
require immediate payment.
3. Reduce estimated warranty expense from 10% of sales to 7% of sales.
4. Any resultant change in the bonus of 10% of operating income before the bonus
will be paid to the president in cash.
A. Adjacent to the income statement for Year 1, create a new statement using the
alternative accounting procedures and operating decisions.
B. Compare the president’s compensation if the changes in part A are enacted with his
current compensation. What are the ramifications of these changes on the future?
10–36 Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies
20. On December 31, 2017, Cocoa Incorporated had total liabilities of $80,000 and total
shareholders’ equity of $100,000, resulting in a debt/equity ratio of 0.80 before executive
bonus expense is recognized. During 2017, Cocoa’s CEO earned a 5% bonus on net
income before bonus of $100,000. If Cocoa pays the bonus due its CEO on December
31, 2017, what is Cocoa’s debt/equity ratio after the bonus expense and what related
liability is recognized?
Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies 10-37
21. Howell Incorporated current income statement and December 31 balance sheet follow:
Income Statement
Revenue
$180,000
Expenses and losses
130,000
Net income
$ 50,000
Balance Sheet
Current assets
$ 10,000
Long-lived assets
200,000
Total assets
$210,000
Current liabilities
$ 5,000
Long-term liabilities
95,000
Shareholders‘ equity
110,000
Total liabilities and shareholders‘ equity
$210,000
During an audit of Howell’s current financial statements, its auditor discovered that
Howell is a defendant in a $20,000 lawsuit for infringement of patent rights. Howell’s
management, under the advice of its legal counsel, decided that it was only reasonably
possible that they would lose the suit and have to pay $20,000. However, its auditor
disagreed with the treatment of the contingent loss and effectively argued that it is
probable that the lawsuit will require Howell to pay $20,000 in the forthcoming year. The
management of Howell decided to “take a bath” and treat the $20,000 lawsuit consistent
with GAAP on probable conditional liabilities.
A. Reconstruct Howell current income statement and 12/31 balance sheet under the
auditor’s judgment concerning the $20,000 lawsuit
B. Calculate and compare current, debt/equity, and debt/asset ratios resulting from
Howell’s initial and reconstructed financial statements. Comment on Howell’s
solvency.
Solution:
Income Statement
Revenue
Expenses and losses
Net income
Balance Sheet
Current assets
Total assets
Current liabilities
Shareholders’ equity
Total liabilities and shareholders‘ equity
Current ratio (Rev – $10/$25)
Debt/Equity ratio (Rev – $120/$90)
Debt/Asset ratioc(Rev – $129/$210)
10–38 Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies
SHORT ESSAY QUESTIONS
1. State laws generally require insurance companies to maintain certain debt and solvency
ratios. Insurance companies that fail to maintain the minimum levels are subject to
severe penalties, most often affecting the company’s continuation as a going concern.
How may regulatory requirements such as these impact management decisions?
2. A major airline issues frequent flyer credits that allow the passenger to receive credit
toward future flights. For every ticket sold the customer receives a credit which, when 40
are collected, can be exchanged for a free ticket. During the year, the airline company
recorded revenues of $60 million, which represented 100,000 tickets. The airline did not
recognize the flyer credits on its income statement or its balance sheet. In the context of
contingent liabilities, comment on the airline’s accounting procedures.
Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies 10-39
3. What concerns might exist when a company‘s debt ratio increases?
4. What concerns might management have with additional debt on its balance sheet?
5. What three characteristics should all liabilities that appear on the balance sheet have in
common?
10–40 Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies
6. During the 1990’s, Golden Inc. entered into long-term contracts with corporate
customers to supply one million ounces of ore for $100 an ounce over the next 5 years.
During the following years, the price of ore increased to $175 an ounce, which Golden
Inc., because it did not hedge the price, would have to pay in order to meet its sales
contracts. Although Golden Inc.’s auditor argued that a $75 million loss and liability
should be recognized, Golden Inc. stated that the amount of the loss cannot be
reasonably estimated prior to the results of renegotiations it was conducting with its
corporate customers. Golden Inc. expected to renegotiate an increase in the initial
contract price of $100 or reduce the amount of ounces to be delivered under the long–
term sales contract. Defend a position of how the long-term contract should be treated
from an accounting perspective.
7. Identify the primary problem related to current liabilities.
8. How do ‘determinable’ current liabilities differ from ‘contingent’ liabilities?
Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies 10-41
9. Sunshine Company obtained a line of credit with its bank of $4 million. How should
Sunshine Company disclose the line of credit on its financial statements?
10. Identify two different third-party collections and explain why they should be reported as
liabilities.
11. Explain why short-term notes often have a face amount that differs from the cash
received upon signing a note payable. Describe what this difference represents.
10–42 Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies
12. How is unamortized interest on short-term notes payable reported on a balance sheet?
13. Harrison Inc. issues community concert season tickets to a number of corporations for
$1,000 each. Revenue is accrued equally throughout the season that the pass is valid.
How should Harrison Inc. report any amounts that have not yet been recognized as
revenue?
14. Why are gain contingencies typically omitted from financial statement disclosure?
Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies 10-43
15. What impact have environmental cleanup costs had on corporate disclosures?
Solution: