CHAPTER 10

Current Liabilities

Summary of Questions by STUDY Objectives
and Bloom’s Taxonomy

Note: AN = Analysis AP = Application E = Evaluation

Summary of questions by LEVEL OF DIFFICULTY (lod)

Note: E = Easy M = Medium H=Hard

CHAPTER STUDY OBJECTIVES

1. Account for determinable or certain current liabilities. Liabilities are present obligations arising from past events, to make future payments of assets or services. Determinable liabilities have certainty about their existence, amount, and timing—in other words, they have a known amount, payee, and due date. Examples of determinable current liabilities include operating lines of credit, notes payable, accounts payable, unearned revenue, current maturities of long-term debt, and accrued liabilities such as interest.

2. Account for estimated liabilities. Estimated liabilities exist, but their amount or timing is uncertain. As long as it is likely the company will have to settle the obligation, and the company can reasonably estimate the amount, the liability is recognized. Product warranties, customer loyalty programs, and gift cards result in liabilities that must be estimated. They are recorded either as an expense (or as a decrease in revenue) or a liability in the period when the sales occur. These liabilities are reduced when repairs under warranty or redemptions occur. Gift cards are a type of unearned revenue as they result in a liability until the gift card is redeemed. As some cards are never redeemed, it is necessary to estimate the liability and make adjustments.

3. Account for contingencies. A contingency is an existing condition or situation that is uncertain, where it cannot be known if a loss (and a related liability) will result until a future event happens, or does not happen. Under ASPE, a liability for a contingent loss is recorded if it is it likely a loss will occur and the amount of the contingency can be reasonably estimated. Under IFRS, the threshold for recording the loss is lower. It is recorded if a loss is probable. Under ASPE, these liabilities are called contingent liabilities, and under IFRS, these liabilities are called provisions. If it is not possible to estimate the amount, these liabilities are only disclosed. They are not disclosed if they are unlikely.

4. Prepare the current liabilities section of the balance sheet. The nature and amount of each current liability and contingency should be reported in the balance sheet or in the notes accompanying the financial statements. Traditionally, current liabilities are reported first and in order of liquidity. International companies sometimes report current liabilities on the lower section of the balance sheet and in reverse order of liquidity.

Exercises

Exercise 1

On April 1, Hoadley Company borrows $90,000 from Northwest Provincial Bank by signing a 6-month, 6%, interest-bearing note. Hoadley’s year end is August 31.

Instructions

Prepare the following entries associated with the note payable on the books of Hoadley Company:

a. The entry on April 1 when the note was issued.

b. Any adjusting entries necessary on May 31 in order to prepare the quarterly financial statements. Assume no other interest accrual entries have been made.

c. The adjusting entry at August 31 to accrue interest.

d. The entry to record payment of the note at maturity.

Exercise 2

Elliott Company had the following transactions during March:

Mar 1 Purchased computer equipment by issuing a $15,000, 6-month, 8% note payable. Interest is due at maturity.

Mar 5 Provided services to customers for $9,800 plus 5% GST; customers paid cash.

Mar 15 Purchased supplies on account from Grand and Toy for $3,500. Supplier terms are 2/10, n/30.

Mar 31 Paid the Grand and Toy account in full.

Instructions

a. Record the transactions.

b. Record any adjusting entries required at March 31 related to these liabilities.

Exercise 3

During April 2014, DMZ Company incurred the following transactions. This is DMZ’s first period of operations, and they plan to use the periodic method of accounting for inventory.

Apr 1 Purchased a new automobile for $36,500; the automobile was paid for with a 2-year 5% note payable. Interest is due monthly on the 1st day of each month and the principal due as follows: 50% due in 1 year, the remainder due in 2 years.

Apr 5 Sold merchandise to Customer A on account for $72,000 plus 5% GST; terms n/30.

Apr 6 Customer A returns one-half of the merchandise purchased on Apr 5 and receives a credit on account.

Apr 13 Customer A paid their account balance in full.

Apr 25 Sold merchandise to Customer B for $102,900 including 5% GST; terms n/30.

Apr 28 Received $22,000 from Customer C for services to be provided in May.

Apr 30 Recorded any adjusting entries required related to April transactions.

In addition to liabilities arising from the above transactions, DMZ’s Accounts Payable balance at April 30, 2014 is $65,000.

Instructions

a. Record the above transactions.

b. Prepare the current liabilities portion of DMZ’s balance sheet at April 30, 2014.

Exercise 4

Fiddler Music Company, which prepares annual financial statements, is preparing adjusting entries on December 31. Analysis indicates the following:

1. The company is the defendant in an employee discrimination lawsuit involving $50,000 of damages. Legal counsel believes it is unlikely that the company will have to pay any damages.

2. The company is a defendant in a $750,000 product liability lawsuit. Legal counsel believes the company probably will have to pay the amount requested.

3. On November 1, Fiddler signed a $10,000, 6-month, 8% note payable. No interest has been accrued to date.

Instructions

Prepare any adjusting entries necessary at the end of the year.

Exercise 5

During the month of July, Toys to Go started a new promotion. The company offered to reward their customers for all sales made on Barbie dolls or Toy Trucks during the month of July. For each sale made, the customer will receive a 1% reward of the sales price which can be redeemed on future purchases until December of the current year. During the month of July, $250,000 of Barbie dolls and Toy Trucks were sold. There was $755 worth of redemptions in August.

Instructions

a. Prepare the journal entries to record all transactions related to the reward promotion.

b. Identify any liabilities that would be reported on the August 31, 2014 balance sheet.

Exercise 6

The following situations are independent:

1. During the Christmas season, Betty’s Spa sold $15,000 worth of gift certificates for spa treatments. In accordance with Canadian legislation, these gift certificates have no expiry date. During the first year, 75% of the gift certificates are redeemed by customers.

2. Bill’s Car Service sells coupon books for oil changes. The books sell for $300 and include 10 coupons. Without a coupon, the price of an oil change is $35. During the first year of the coupon book sales, Bill’s sold 200 books, and by the end of the year, 400 coupons had been claimed. According to Bill’s research, 90% of coupons will eventually be claimed. The coupons have no expiry date.

Instructions

For each situation, calculate the related liability at the end of the first year.

Exercise 7

Duane Herman sells exercise machines for home use. The machines carry a 4-year warranty. Past experience indicates that 6% of the units sold will be returned during the warranty period for repairs. The average cost of repairs under warranty is $45 for labour and $75 for parts per unit. During 2015, 2,500 exercise machines were sold at an average price of $800. During the year, 60 of the machines that were sold were repaired at the average price per unit. The opening balance in the Warranty Liability account is zero.

Instructions

a. Prepare the journal entry to record the repairs made under warranty.

b. Prepare the journal entry to record the estimated warranty expense for the year. Determine the balance in the Warranty Liability account at the end of the year.

Exercise 8

Hardin Manufacturing began operations in January 2014. Hardin manufactures and sells two different computer monitors.

Monitor A, is a flat panel hi-definition monitor, which carries a two-year manufacturer's warranty against defects in workmanship. Hardin's management project that 8% of the monitors will require repair during the first year of the warranty while approximately 6% will require repair during the second year of the warranty. Monitor A sells for $400. The average cost to repair a monitor is $80.

Monitor B is a regular LED monitor that retails for $150. Hardin has entered into an agreement with a local electronics firm who charges Hardin $20 per monitor sold and then covers all warranty costs related to this monitor.

Sales and warranty information for 2014 is as follows:

Sold 2,000 monitors (800 monitor A and 1,200 monitor B); all sales were on account.

Actual warranty expenditures for monitor A were $4,000.

Instructions

a. Prepare journal entries that summarize the sales and any aspects of the warranty for 2014.

b. Determine the balance in the Warranty Liability account at the end of 2014.

Exercise 9

During the year, Canada Ski Cross Ltd. instituted a customer rewards program. The company sells skis which are specially used for the latest type of skiing, ski cross. For every $250 of ski cross equipment purchased by a customer, the company will rebate $50 towards the cost of purchasing a ski cross helmet. In January, the company had ski cross equipment sales of $64,000. There were no helmets purchased. In February, there were sales of $32,600 and there were 135 helmets sold.

Instructions

a. Prepare journal entries for January. What is the ending balance in the liability account for the end of January?

b. Prepare journal entries for February. What is the ending balance in the liability account for the end of February?

Exercise 10

Milner Company is preparing adjusting entries at December 31. An analysis reveals the following:

1. During December, Milner Company sold 4,900 units of a product that carries a 60-day warranty. The sales for this product totalled $100,000. The company expects 6% of the units to need repair under the warranty and it estimates that the average repair cost per unit will be $15.

2. The company has been sued by a disgruntled employee. Legal counsel believes it is likely that the company will have to pay $200,000 in damages.

3. The company has been named as one of several defendants in a $400,000 damage suit. Legal counsel believes it is unlikely that the company will have to pay any damages.

Instructions

Prepare adjusting entries, if required, for each of the three items.

Exercise 11

The following unadjusted balances are taken from the trial balance of Jackson Equipment at December 31, 2014:

Accounts payable………… $ 53,700

Salaries payable……….. 2,200

Bank demand loan payable 60,000

GST payable…………… 14,800

Note payable, maturing March 31, 2015 10,000

Note payable, maturing March 31, 2016 100,000

Jackson Equipment sells and installs security systems. Beginning on December 1, 2014, Jackson began offering a 2-year product warranty. Based on research in the industry, Jackson’s management believes that 5% of security systems will require some warranty work and that the typical costs for systems requiring warranty work will be $875 during the first year and $325 during the second year. In December, Jackson supplied and installed 80 systems.

Instructions

a. Calculate and record Jackson’s warranty liability at December 31, 2014.

b. Prepare the current liability portion of Jackson’s balance sheet at December 31, 2014.

Exercise 12

Dejong’s Drycleaning had the following events occur during December, 2014: Dejong is reporting under ASPE.

1. Dejong signed a $40,000 loan guarantee on behalf of Dejong Junior’s. At December 31, Junior’s had drawn $10,000 of loan advances. Junior’s has sufficient assets to cover its liabilities.

2. Dejong was sued by an irate customer who said the trousers that Dejong had returned to him belonged to someone else. The customer is claiming $10,000,000 in damages for distress because he mistakenly wore the ill-fitting trousers to work and suffered discomfort and embarrassment as a result. Dejong’s lawyer has advised them that the likelihood of this claim succeeding is nil, and has offered to defend them at no charge. The Dejongs have already paid the claimant $100 for replacement of the missing trousers.

3. Dejong was sued for wrongful dismissal by a former employee. The employee is claiming $2,000 in lost wages. Dejong’s lawyer has advised them that the claim, if taken to trial, is likely to be upheld.

4. In early December, some drycleaning fluid spilled and damaged equipment valued at $5,600. Dejong replaced the equipment, which is insured, and expects their insurance policy will reimburse at least $5,000 of the cost and possibly the entire amount. However the exact amount covered by insurance has not yet been determined.

Instructions

For each of the four situations above, evaluate the likelihood and measurability of any losses that Dejong may face. Indicate if any liability should be recorded or disclosed in Dejong’s December 31, 2014 financial statements.

Exercise 13

Below are several accounting transactions recorded by Lucy, accounting clerk for B&B Industrial.

1. Loss from Liability $500,000

Estimated Liability from Lawsuit $500,000

To setup a liability in which we are being sued for $500,000. The lawyers say it is unlikely that we will have to pay out this amount and the lawsuit will most likely be dismissed. I have setup the amount based on the best reasonable estimate. Even if the lawsuit is dismissed this event will have a substantial negative effect on the company’s financial position.

2. No entry

B&B Industrial provided a guarantee on a loan for the company’s owner. The owner needed to obtain a large loan for medical purposes. No entry needed to account for the loan guarantee.

3. No entry

No entry needed to setup the reduction in wages that may be incurred due to employees going on strike.

4. Loss from decline in sales $150,000

Sales Revenue $150,000

To record the decline in sales due to a recession

5. Gain on Lawsuit $365,000

Accounts Receivable $365,000

To setup the amount that will be received when we win our lawsuit.

6. No Entry

No entry created for a lawsuit that we will most likely lose because a reasonable amount cannot be estimated.

Instructions

For each transaction, determine if the accounting clerk correctly recorded the transaction. If you disagree, provide the correct transaction or disclosure requirement.

Exercise 14

Kent Company’s December 31, 2014 trial balance includes the following accounts:

Accounts payable $ 29,400

Accounts receivable 52,000

Interest payable 700

Bank demand loan payable 10,000

Cash………….. 3,000

Income taxes payable 1,200

Inventory……………. 27,000

Mortgage payable 140,000

Note payable…………. 5,000

Prepaid expenses 1,200

Other information:

The mortgage payable is due in annual principal installments of $4,000 per year.

The note payable is due in full in 18 months’ time.

Industry average working capital ratio is 2.5:1

Instructions

a. Prepare the current liabilities section of Kent’s December 31, 2014 balance sheet.

b. Calculate and comment on Kent’s working capital and current ratio.

Exercise 15

The following are all of the accounts with credit balances from Kupidy Company’s adjusted trial balance at December 31, 2014:

Accounts payable $ 66,000

Accumulated Depreciation – equipment 31,500

Allowance for doubtful accounts 1,600

Bank demand loan payable 25,000

C. Kupidy, capital 47,500

Gain on sale of equipment 600

GST payable 1,900

Interest payable 2,100

Mortgage payable 290,000

Note payable 18,000

Salaries payable 4,400

Sales discounts 3,750

Sales revenue 458,000

Unearned revenue 7,900

Other information:

The mortgage is due in monthly principal payments of $1,000 plus interest.

The note payable is a six-month, 10% note, interest due at maturity.

Instructions

Prepare the current liabilities section of Kupidy’s December 31, 2014 balance sheet.

Exercise 16

On February 28, 2014, Fidanza Company has the following selected accounts after posting adjusting entries:

Accounts payable $ 40,000

Notes payable, 3-month, 6% 80,000

Accumulated depreciation—equipment 14,000

Notes payable, 5-year, 8% 30,000

Warranty liability 34,000

Interest payable 3,000

Mortgage payable 150,000

Instructions

a. Prepare the current liability section of Fidanza Company's balance sheet, assuming $25,000 of the mortgage is payable next year. (List liabilities in order of magnitude, with largest first.)

b. Comment on Fidanza's liquidity, assuming total current assets are $400,000.