9.4-17) Decide whether each of the following lease agreements should be recorded as a capital lease or an
operating lease:
a. The present value of the lease payments is 75% of the fair value of the leased asset at the start of the
lease. The lease term is for 6 years; the estimated useful life of the leased asset is 10 years. There is a
bargain purchase agreement for the lessee to purchase the leased asset at well below fair value at the end
of the lease term.
b. The present value of the lease payments is 90% of the fair value of the leased asset the start of the lease.
The lease term is for 2 years; the estimated useful life of the leased asset is 10 years. The leased asset
reverts back to the lessor at the end of the lease.
c. The lease transfers ownership of the leased asset to the lessee at the end of the lease. The present value
of the lease payments is 75% of the fair value of the leased asset the start of the lease. The lease term is for
3 years; the estimated useful life of the leased asset is 10 years.
d. The lease agreement doesn’t contain a bargain purchase agreement. The leased asset reverts back to the
lessor at the end of the lease agreement. The present value of the lease payments is 85% of the fair value
of the leased asset the start of the lease. The lease term is for 10 years; the estimated useful life of the
leased asset is 15 years.
Learning Objective 9.5 Questions
9.5-1) Accounting for postretirement benefits requires
A) the use of present value to compute a dollar amount.
B) a “pay as you go” system with no liability on the balance sheet until employees retire.
C) a liability to be recorded as the benefit is earned.
D) All of the above
E) A and C
9.5-2) Postretirement benefits
A) require estimated life expectancy, future ages at retirement, and future payments to retirees.
B) are mandated by the U.S. government for all employees and companies.
C) are optional but payments must be made to an independent trustee.
D) are a contra–liability account.
E) are accumulated as an asset.
9.5-3) Defined benefit pension plans
A) require estimated life expectancy, future ages at retirement, and future payments to retirees.
B) are mandated by the U.S. government for all employees and companies.
C) are optional but payments must be made to an independent trustee.
D) are a contra account.
E) must be recognized as a liability under accrual accounting.
9.5-4) Companies must include a net long–term liability on its balance sheet for pensions if
A) the pension expense is more than the pension liability.
B) the fair value of the pension obligation is more than the cash invested yearly.
C) the fair value of the pension obligation is less than the cash invested yearly.
D) the fair value of the pension fund assets are less than the pension obligations.
E) the fair value of the pension fund assets are greater than the pension obligations.
9.5-5) The unfunded portion of the obligation to provide postretirement benefits are reported as liabilities
on the balance sheet.
9.5-6) Due to accrual accounting’s system of matching expenses with their associated revenues, pensions
and postretirement benefits are liabilities when earned by employees.
9.5-7) Health insurance, life insurance, and other employee benefits paid to employees (excluding
pensions) upon retirement are referred to as postretirement benefits.
9.5-8) The U.S. tax law provides incentives for companies to make payments into a pension fund that is
separate from the company’s assets and controlled by a trustee.
9.5-9) The U.S. tax law provides incentives for companies to make payments into a postretirement benefit
fund that is separate from the company’s assets and controlled by a trustee.
9.5-10) Unfunded pension and postretirement benefits that are earned by employees must be recognized
as a liability under accrual accounting.
9.5-11) Garden Enterprises offers pensions and postretirement benefits to its employees. For the fiscal
year ended March 31, 2X09, Garden Enterprises‘ employees accumulated $16 million in additional
retirement pay, but Garden Enterprises did not contribute additional cash into the fund. In addition,
Garden Enterprises paid retirees a total of $2 million in health benefits with an actuarial gain of $1.2
million.
Prepare the journal entries to
1. account for the pension fund.
2. account for the health insurance payment and gain.
Learning Objective 9.6 Questions
9.6-1) A deferred income tax liability
A) arises because of differences between U.S. income tax rules and foreign income tax rules.
B) can arise because of “permanent” and “transitory” differences.
C) arise because managers wish to maximize taxable income and minimize income for financial reporting.
D) can arise when a firm uses special accelerated depreciation for tax purposes while using straight–line
depreciation for financial reporting.
E) occurs when the company has a NOL (net operating loss).
9.6-2) If timing differences arise, generally accepted accounting principles require
A) that the amount actually paid to the government each year be reported as tax expense.
B) that tax expense be reported as the tax that would have been paid if the pretax income used for
shareholder reporting had also been reported to the tax authorities.
C) that a company ignore the differences.
D) that the company pay a flat rate of 40%.
E) that the company change its financial accounting procedures to agree with those required by tax law.
9.6-3) Which of the following statements regarding temporary differences is false?
A) Temporary differences can result in deferred liabilities and deferred assets.
B) Deferred tax liabilities are found on the balance sheets of nearly every company.
C) For most companies, the primary source of deferred taxes is timing differences related to depreciation.
D) Many countries require the use of deferred taxes when financial reporting of expenses differs from the
timing of reporting corresponding tax deductions.
E) Temporary differences result in the cancellation of taxes.
9.6-4) A contingent liability
A) is a potential liability that depends on a future event arising out of a past transaction.
B) can always be calculated with great precision (i.e., always has a definite amount).
C) include liabilities for warranty repairs.
D) must be disclosed in the body of the financial statements, including the expected dollar amount.
E) is not of interest to readers of financial statements.
9.6-5) An example of a contingent liability is
A) a bond that can be converted into common stock.
B) any interest–bearing liability.
C) a bond that was not sold at par.
D) the unrealized loss from the reduction in the market price of a long–term liability.
E) a lawsuit being filed against a company.
Table 9–6
Clarkson Company manufactures and sells plastic bottles. Because of good styling and marketing, sales
have grown briskly. Clarkson has no pre–existing deferred tax liability. During 20X9, the following
transactions occurred:
1. On January 1, 20,000 new shares of common stock were sold at $100 per share.
2. Half of the proceeds from the stock sale were immediately invested in tax–free bonds yielding 8% per
annum. The bonds were held throughout the year, resulting in interest revenue of $1,000,000 × .08 =
$80,000.
3. Sales for the year were $9,000,000, with expenses of $4,300,000 reported under GAAP (not including
income tax expense).
4. Tax depreciation exceeded depreciation included in item 3 above by $500,000.
5. For financial reporting purposes, warranty costs are calculated at 2% of sales, and the resulting
$180,000 is included in the $4,300,000 of expenses. Actual expenditures under warranty were $95,000. The
difference is $85,000.
9.6-6) Referring to Table 9–6, calculate earnings before tax for shareholder reporting.
A) $4,780,000
B) $4,700,000
C) $4,500,000
D) $6,780,000
E) $6,200,000
9.6-7) Referring to Table 9–6, what would Clarkson report as income tax payable to the tax authorities
assuming a 40% tax rate?
A) $1,880,000
B) $1,680,000
C) $1,714,000
D) $2,680,000
E) $2,480,000
9.6-8) Referring to Table 9–6, what would Clarkson report as income tax expense for shareholder
reporting using a 40% tax rate?
A) $1,912,000
B) $1,880,000
C) $1,800,000
D) $1,897,000
E) $1,865,000
9.6-9) Referring to Table 9–6, what journal entry would Clarkson make?
A) Deferred Tax Asset 34,000
Income Tax Expense 1,880,000
Income Tax Payable 1,714,000
Deferred Tax Liability 200,000
B) Income Tax Expense 1,912,000
Income Tax Payable 1,880,000
Deferred Tax Liability 32,000
C) Income Tax Expense 1,800,000
Income Tax Payable 1,714,000
Deferred Tax Liability 86,000
D) Income Tax Payable 1,714,000
Deferred Tax Liability 151,000
Income Tax Expense 1,865,000
E) Income Tax Payable 1,880,000
Deferred Tax Liability 32,000
Income Tax Expense 1,912,000
9.6-10) Referring to Table 9–6, the total amount of the permanent difference is
A) $–0–.
B) $80,000.
C) $500,000.
D) $85,000.
E) $580,000.
9.6-11) The percentage of taxable income paid to the government by corporations is known as the tax rate.
9.6-12) A contingent liability is a liability having an estimated amount.
9.6-13) Restructuring includes the closing of one or more plants, firing of a significant number of
employees, and the termination or relocation of various activities.
9.6-14) Permanent differences between income under the tax law and income under GAAP arise because
some items are recognized at different times for tax purposes than for financial reporting purposes.
9.6-15) Temporary differences between income tax under the tax law and income tax under GAAP always
result in a liability called Deferred Tax Liability.
9.6-16) Permanent differences between income tax per GAAP and income tax per the tax law lead to
deferred tax liabilities.
9.6-17) Gringle, Inc.’s 20X9 income statement included the following:
Profit on ordinary activities before taxation $299,000
Tax on profit on ordinary activities 89,625
Profit on ordinary activities after taxation $209,375
As a result of 20X9 operations, the deferred tax liability account increased by $12,000.
a. Compute taxes paid to the government in 20X9.
b. Prepare the journal entry to record taxes on ordinary income for 20X9.
9.6-18) Determine whether each of the following scenarios constitutes a contingent liability.
1) Serial Company is involved in a lawsuit with Bednam Industries for faulty parts. Serial Company is
not sure whether they need to journalize a transaction for the amount. Serial Company’s attorney has
stated that it is probable that Serial Company will lose the lawsuit and be expected to pay $2 million in
damages.
2) Bags For U estimates warranties on its bags to be $5,000 per year even though Bags R Us has never had
a warranty claim in its 25 years in operation.
3) Highlights Salon is involved in a lawsuit with Key Color. Highlights’ attorney has stated that it is
probable that Highlights will win $150,000.
4) Moosey Industries is involved in a lawsuit. Moosey Industries is expected to lose the lawsuit and pay
$1.2 million.
9.6-19) Define a contingent liability and give an example. How are they reported on the balance sheet?
9.6-20) Define a “restructuring,” give two examples, and explain the liabilities that may result from such
an activity.
Learning Objective 9.7 Questions
9.7-1) Debt ratios
A) are used to measure the extent to which a company has issued stock to finance its activities.
B) indicate that the more the equity and the less the borrowing, the riskier it is to lend stockholders’
money to a firm.
C) include the debt–to–equity ratio.
D) are not very useful and, thus, are not often calculated.
E) do not vary between firms in the same industry.
9.7-2) The interest–coverage ratio is calculated by dividing pretax income plus interest expense by
A) total shareholders’ equity.
B) total shareholders’ equity and long–term debt.
C) total assets.
D) interest expense.
E) total current assets.
Table 9–7
Given below are the balance sheet at December 31, 20X9 and income statement for the year ended,
December 31, 20X9 for Hortense Company:
Hortense Company
Balance Sheet
December 31, 20X9
Current Assets: Current Liabilities:
Cash $ 6,000 Accounts Payable $ 3,000
Accounts Receivable 4,000 Wages Payable 2,000
Inventory 14,000 Total Current Liabilities $ 5,000
Total Current Assets 24,000 Long–term Bond Payable 24,000
Total Liabilities $29,000
Long–term Assets: Stockholders’ Equity:
Fixed Assets $60,000 Common Stock $ 12,000
Accumulated Depr. (17,000) Retained Earnings 26,000
Net Fixed Assets 43,000 Total Stockholders’ Equity 38,000
Total Assets $67,000 Total Liabilities & Equity $67,000
Hortense Company
Income Statement
For The Year Ended December 31, 20X9
Sales $240,000
Cost of Goods Sold 103,000
Gross Profit $137,000
Operating Expenses 82,000
Operating Income $ 55,000
Interest Expense 2,000
Income before Taxes $ 53,000
Income Tax Expense 27,000
Net Income $ 26,000
9.7-3) Referring to Table 9–7, the debt–to–equity ratio for Hortense Company at December 31, 20X9, is
A) 43.28%.
B) 63.16%.
C) 76.32%.
D) 92.31%.
E) 111.54%.
9.7-4) Referring to Table 9–7, the long–term–debt–to–total–capital ratio for Hortense Company at December
31, 20X9, is
A) 35.82%.
B) 38.71%.
C) 63.16%.
D) 92.31%.
E) 200.00%.
9.7-5) Referring to Table 9–7, the debt–to–total–assets ratio for Hortense Company at December 31, 20X9, is
A) 7.46%.
B) 35.82%.
C) 43.28%.
D) 100.00%.
E) 231.03%.
9.7-6) Referring to Table 9–7, the interest–coverage ratio for Hortense Company at December 31, 20X9, is
A) 8.33.
B) 0.25.
C) 14.00.
D) 27.50.
E) 28.50.
9.7-7) The ________ is calculated by dividing total liabilities by total shareholders’ equity.
A) debt–to–equity ratio
B) long–term–debt–to–total capital ratio
C) debt–to–total–assets ratio
D) interest–coverage ratio
E) current ratio
9.7-8) The ________ is calculated by dividing interest expense into the sum of pretax income and interest
expense.
A) debt–to–equity ratio
B) long–term–debt–to–total capital ratio
C) debt–to–total–assets ratio
D) interest–coverage ratio
E) current ratio
9.7-9) Debt–to–equity ratios can vary greatly from industry to industry.
9.7-10) The interest coverage ratio measures the firm’s ability to meet its interest obligation.
9.7-11) Total receivables (accounts receivable and/or other receivables) is/are (one of the) common
denominators of debt ratios.
9.7-12) Given below are the balance sheet at December 31, 20X9 and income statement of Waite Company
for the year ended, December 31, 20X9. Determine the following:
(a) The debt–to–equity ratio
(b) Long term debt–to–total–capital ratio
(c) Debt–to–total–assets ratio
(d) The interest–coverage ratio.
Waite Company
Balance Sheet
December 31, 20X9
Current Assets: Current Liabilities:
Cash $ 3,300 Accounts Payable $ 4,900
Accounts Receivable 5,900 Interest Payable 1,500
Inventory 11,100 Wages Payable 2,100
Total $20,300 Total Current Liabilities $8,500
Fixed Assets $59,300 Long–term Bond Payable 35,000
Less: Accum. Depr. (13,800) Total Liabilities $43,500
Fixed Assets, net 45,500 Stockholders’ Equity:
Common Stock $12,000
Retained Earnings 10,300 22,300
Total Liabilities
Total Assets $65,800 & Stockholders’ Equity $65,800
Waite Company
Income Statement
For The Year Ended December 31, 20X9
Sales $94,000
Cost of Goods Sold 51,000
Gross Profit $43,000
Operating expenses 35,000
Operating income $ 8,000
Interest expense 3,000
Income before taxes $ 5,000
Income tax expense 2,300
Net Income $ 2,700
9.7-13) From the list of ratios below, determine whether a company would pay a higher interest rate and
thus be a riskier company if the ratio had a higher or lower proportion.
1. Debt–to–equity ratio ________
2. Long–term–debt–to–total–capital–ratio ________
3. Debt–to–total–assets–ratio ________
4. Interest–coverage ratio ________
Learning Objective 9.8 Questions
9.8-1) The amount earned by an investor expressed as a percentage of the amount invested is called
A) discount rate.
B) rate of return.
C) present value.
D) future value.
E) expected past rate.
9.8-2) An amount that is calculated by multiplying an interest rate by a principal amount that is increased
each interest period by the previously accumulated interest is known as
A) interest.
B) simple interest.
C) compound interest.
D) nominal interest rate.
E) stated interest.
9.8-3) What is the present value of $2,000 with 16% interest, to be received in 18 years?
A) $161.61
B) $150.30
C) $155.83
D) $148.48
E) $138.20
9.8-4) A series of equal cash flows to take place at the end of successive periods of equal length is called
A) rate of return.
B) an ordinary annuity.
C) a serial note.
D) a deferred annuity.
E) a perpetuity or consul.
9.8-5) Marie buys a note from a municipality that promises to pay $1,500 at the end of each of 3 years.
How much should Marie pay for the note if she desires a rate of return of 8%, compounded annually?
A) $4,000
B) $3,866
C) $3,905
D) $3,950
E) $3,750
9.8-6) If Theresa deposits $9,000 in an account that pays 10% yearly interest, compounded annually, how
much will he have in the account at the end of 3 years?
A) $8,990
B) $9,750
C) $10,909
D) $11,979
E) $12,500
9.8-7) The amount accumulated, including principal and interest is the ________.
A) future value
B) annuity value
C) present value
D) rate of return
E) accumulated full value
9.8-8) The value today of a future cash inflow or outflow is the ________.
A) present value
B) annuity value
C) future value
D) rate of return
E) estimated return
9.8-9) Simple interest is calculated by multiplying an interest rate by an unchanging principal amount.
9.8-10) Simple interest is more frequently used than compounded interest in U.S. financial practice.
9.8-11) Compound interest is calculated by multiplying an interest rate by a principal amount. The
principal amount increases each time interest is earned. The accumulated interest is added to the
principal to become the new principal for the next period.
9.8-12) Accountants generally use future values rather than present values to record long–term liabilities.
9.8-13) Discount rates are the interest rates used in determining present values.
9.8-14) An ordinary annuity is a series of different cash flows to take place at the end of successive
periods.
9.8-15) Solve each of the following independent cases using the present value tables.
The following are actual contracts signed by athletes:
a. $25,000,000 contract, payable at $2,500,000 per year for 10 years.
b. $25,000,000 contract, payable at $1,000,000 per year for 25 years.
c. $25,000,000 contract, payable at $1,562,500 per year for 16 years.
Determine the present value of each contract and indicate which contract you would prefer to have.
Assume a 12% interest rate.