Alternate Let’s Review
Problem #1
Assume Blue Sky Airlines borrows $1,000,000 from Midtown Bank on November 1, 2015 signing an 8%,
six-month note payable.
Required:
1. Record the issuance of the note.
2. Record the appropriate adjusting entry for the note on December 31, 2015.
3. Record the payment of the note at maturity.
1. November 1, 2015 Debit Credit
Cash 1,000,000
Notes Payable 1,000,000
(Issuance of notes payable)
2. December 31, 2015
Interest Expense ($1,000,000 x 8% x 2/12) 13,333
Interest Payable 13,333
(Interest expense incurred, but not paid)
3. May 1, 2016
Notes Payable 1,000,000
Interest Expense ($1,000,000 x 8% x 4/12) 26,667
Interest Payable ($1,000,000 x 8% x 2/12) 13,333
Cash 1,040,000
(Payment of notes payable and interest)
Problem #2
The Nebraska Cornhuskers football stadium has a seating capacity of about 81,000. The Cornhuskers hold
6 regular season games at home. Nebraska season football tickets have sold out each year for almost 50
years. Let’s assume the Cornhuskers collect $24 million in season ticket sales prior to the beginning of the
season.
The journal entry to record season ticket sales is:
($ in millions)
Cash …………………………………………………………..24
Unearned Revenue ………………….………………………. 24
(Sale o f season tickets prior to the beginning of the season)
After each of the six home games, the Nebraska Cornhuskers record one-sixth of the $24 million in
revenue as follows:
($ in millions)
Unearned Revenue ……………………………………………4
Revenue………………………………………………………… 4
(Revenue earned each home game played)
Problem #3
Selected financial data regarding current assets and current liabilities for two competing airlines are as
follows.
($ in millions) Company A Company B
Current Assets
Cash And Cash Equivalents $911 $5,044
Short Term Investments 4,246 71
Net Receivables 768 1,460
Inventory 557 327
Other Current Assets 309 846
Total Current Assets $6,791 $7,748
Current Liabilities
Accounts Payable $3,103 $3,437
Short/Current Long Term Debt 1,194 1,672
Other Current Liabilities 3,431 4,688
Total Current Liabilities $7,728 $9,797
Required:
1. Calculate the current ratio for both airlines. Which has the better current ratio?
2. Calculate the acid-test (quick) ratio for both airlines. Which has the better acid-test ratio?
Solution:
1.
($ in millions)
Total
Current
Assets
÷
Total
Current
Liabilities
=Current
Ratio
Company A $6,791 ÷$7,728 = 0.88
Company B $7,748 ÷$9,797 = 0.79
Company A has a slightly better current ratio, but current liabilities exceed current assets (current ratio is
less than 1) for both airlines.
2.
($ in millions)
Quick
Assets
÷
Total
Current
Liabilities
=Acid-Test
Ratio
Company A $5,925 ÷$7,728 = 0.77
Company B $6,575 ÷$9,797 = 0.67
By eliminating less-liquid current assets such as inventory, the acid-test ratio often provides a better
indicator of liquidity. Once again, Company A has a slightly better acid-test ratio of 0.77 compared to
0.67 for Company B.
Key Points by Learning Objective
LO8-1 Distinguish between current and long-term liabilities.
In most cases, current liabilities are payable within one year and long-term liabilities are payable more
than one year from now.
LO8-2 Account for notes payable and interest expense.
We record interest expense in the period we incur it, rather than in the period we pay it.
Many short-term loans are arranged under an existing line of credit with a bank, or for larger corporations
in the form of commercial paper, a loan from one company to another.
LO8-3 Account for employee and employer payroll liabilities.
Employee salaries are reduced by withholdings for federal and state income taxes, FICA taxes, and the
employee portion of insurance and retirement contributions. The employer, too, incurs additional payroll
expenses for unemployment taxes, the employer portion of FICA taxes, and employer insurance and
retirement contributions.
LO8-4 Explain the accounting for other current liabilities.
When a company receives cash in advance, it debits cash and credits unearned revenue, a current liability
account. When it earns the revenue, the company debits unearned revenue and credits revenue.
Sales taxes collected from customers by the seller are not an expense. Instead, they represent current
liabilities payable to the government.
We report the currently maturing portion of a long-term debt as a current liability on the balance sheet.
Net income and taxable income often differ because of differences between financial accounting and tax
accounting rules. These differences can result in deferred tax liabilities, in which income is reported now
but the tax on the income will not be paid until future years.
LO8-5 Apply the appropriate accounting treatment for contingencies.
A contingent liability is recorded only if a loss is probable and the amount can be reasonably estimated.
Unlike contingent liabilities, contingent gains are not recorded until the gain is certain and no longer a
contingency.
Analysis
LO8-6 Assess liquidity using current liability ratios.
Working capital is the difference between current assets and current liabilities. The current ratio is equal
to current assets divided by current liabilities. The acid-test ratio is equal to quick assets (cash, short-term
investments, and accounts receivable) divided by current liabilities. Each measures a company’s liquidity,
its ability to pay currently maturing debts.
Common Mistakes
Common Mistake
When calculating the number of months of interest, students sometimes mistakenly
subtract December (month 12) from September (month 9) and get three months.
However, the time from September 1 to December 31 includes both September and
December, so there are four months. If you are ever in doubt, count out the months
on your fingers. Your fingers never lie.
Common Mistake
Many people think FICA taxes are paid only by the employee. The employer is
required to match the amount withheld for each employee, effectively doubling the
amount paid into Social Security.
Common Mistake
Some students think the balance in the Warranty Liability account is equal to
warranty expense, $45,000 in this example. Remember, the liability is increased by
warranty expense, but then is reduced over time by actual warranty expenditures.
Common Mistake
As a general rule, a higher current ratio is better. However, a high current ratio is not
always a positive signal. Companies having difficulty collecting receivables or
holding excessive inventory will also have a higher current ratio. Managers must
balance the incentive for strong liquidity (yielding a high current ratio) with the need
to minimize levels of receivables and inventory (yielding a lower current ratio).
Decision Points
Question Accounting Information Analysis & Decision
How can you tell
the amount and
interest rate of a
company’s line of
credit?
Notes to the financial
statements
Companies are required to
disclose the terms of available
lines of credit such as the
amounts, maturity dates, and
interest rates.
Question Accounting Information Analysis & Decision
Is the company
involved in any
litigation?
Notes to the financial
statements
Companies are required to
disclose all contingencies,
including litigation, with at least a
reasonable possibility of payment.
This information can then be used
to help estimate their potential
financial impact.
Question Accounting Information Analysis & Decision
Does the company
have enough cash
to pay current
liabilities as they
come due?
Working capital, current
ratio, and acid-test ratio
A high working capital, current
ratio, or acid-test ratio generally
indicates the ability to pay current
liabilities on a timely basis.
Career Corner
Career Corner
When comparing compensation among different career opportunities, don’t base
your final decision on salary alone. Various employers offer fringe benefits—also
called “perquisites,” or “perks”—that catch the attention of would-be employees: a
pound of coffee every month at Starbucks, free skiing for employees at Vail Ski
Resort, or scuba and kayaking in the pool at Nike’s Athletic Village in Beaverton,
Oregon. More common fringe benefits include employer coverage of family health
insurance, educational benefits, and contributions to retirement or savings plans.
However, even more important than either salary or benefits are the training
and experience the position offers. Training and experience can provide you with the
skills necessary to land that big promotion or dream job in the future.
Ethical Dilemma
Ethical Dilemma
Airport Accessories (AA) has several loans outstanding with a local bank. The loan
contract contains an agreement that AA must maintain a current ratio of at least 0.90.
Micah, the assistant controller, estimates that the year-end current assets and current
liabilities will be $2,100,000 and $2,400,000, respectively. These estimates provide a
current ratio of only 0.875. Violation of the debt agreement will increase AA’s
borrowing costs because the loans will then need to be renegotiated at higher interest
rates.
Micah proposes that AA purchase inventory of $600,000 on credit before
year-end. This will cause both current assets and current liabilities to increase by the
same amount, but the current ratio will increase to 0.90. The extra $600,000 in
inventory will be used over the next year. However, the purchase will cause
warehousing costs and financing costs to increase.
Micah is concerned about the ethics of his proposal. What do you think?
Key issues
Purchasing inventory on credit increases the current ratio above the agreement in the loan
contract that AA must maintain a current ratio of at least 0.90.
Is it ethical to manipulate the current ratio in order to meet a contract obligation?
Option 1: Purchase inventory on credit to meet the current ratio
By purchasing $600,000 of inventory on credit before year-end, the company maintains a current
ratio of 0.90 and does not violate the debt agreement.
There is nothing unethical about purchasing additional inventory on credit as long as this
transaction is properly recorded.
Micah is thinking outside the box, arriving at a creative solution to a difficult issue, a quality
highly desired in accounting.
The interest saved by not having to renegotiate the loan at higher interest rates is likely to more
than offset the costs due to the additional purchase of inventory.
Option 2: Do not intervene and report the current ratio at what it is
The purchase of additional inventory on credit results in additional costs to the company. The
additional $600,000 in inventory increases storage costs for the company. Furthermore, the
additional inventory will eventually need to be financed resulting in higher interest expense.
It just doesn’t seem right to choose an inefficient operating policy (purchasing additional
inventory) for the purpose of reporting a better financial ratio.