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Chapter 10
Introduction to Liabilities: Economic Consequences, Current Liabilities, and
Contingencies
Multiple Choice Questions
1. The recognition of a deferred tax liability that results from the use of straight-line
depreciation on financial statements and double-declining balance on tax returns will
a. increase the current ratio.
b. increase the debt/equity ratio.
c. increase the quick ratio.
d. decrease the debt/asset ratio.
Answer: B
2. Net worth is
a. assets plus liabilities.
b. total income since the company began operations.
c. total shareholders' equity.
d. another name for net income.
Answer: C
3. Which one of the following events increases working capital?
a. Purchase of inventory on credit
b. Payment of an installment of notes payable
c. Payment of sales taxes for the state
d. Selling merchandise on credit at a profit
Answer: D

4. An employee of Susann Inc. failed two drug tests. The employee has sued and Susann
Inc.’s. lawyers appropriately believe that, at best, it is only reasonably probable that Susann
Inc. will lose the court case. The proper accounting treatment of the lawsuit will
a. increase earnings per share.
b. increase the debt/asset ratio.
c. decrease the current ratio.
d. not affect the debt/equity ratio.
Answer: D
5. Which one of the following events does not have any impact on total working capital?
a. The board of directors declares a cash dividend to be paid next month.
b. Warranty expense is accrued.
c. Payment of salaries previously accrued.
d. Debt which was previously long-term matures next year.
Answer: C
6. If the current ratio is currently greater than 1.0, which one of the following events would
increase the current ratio?
a. Purchase of inventory on account
b. Receipt of money from a customer prior to the performance of service
c. Warranty expense is accrued
d. Sale of plant asset at a gain
Answer: D
7. If the quick ratio is currently greater than 1.0, which one of the following events would
increase the quick ratio?
a. Warranty expense is accrued.
b. A cash dividend previously declared is paid.

c. Long-term debt is paid off.
d. Inventory is purchased on account.
Answer: B
8. Which one of the following events decreases the debt/asset ratio?
a. Bonds are retired with a gain.
b. Warranty expense is accrued.
c. Some of the long-term debt matures next year.
d. The board of directors declares a cash dividend to be paid next month.
Answer: A
9. Which one of the following transactions decreases a company’s quick assets?
a. The board of directors declares a cash dividend to be paid next month.
b. Salary expense is accrued.
c. Depreciation expense is recorded.
d. A prepaid account is created due to the payment of insurance in advance.
Answer: D
10. Which one of the following is the result of the amortization of a discount on a short-term
note payable?
a. Increases assets and decreases liabilities
b. Decreases assets and increases liabilities
c. Increases liabilities and decreases shareholders' equity
d. Decreases liabilities and owners’ equity
Answer: C
11. One of Tonic Corp’s employees invented a revolutionary coffee lid that cools coffee as
you drink it in order to prevent burns. Two children ordered coffee and burned their mouths
after failing to properly secure the lids. The children’s parents sued. Tonic Corp’s. lawyers

believe that it is highly probable that judgment will be rendered against Tonic Corp and it is
likely a payment in excess of $2 million will be incurred. The proper accounting treatment of
the lawsuit will
a. decrease total liabilities.
b. increase total liabilities.
c. increase the current ratio.
d. require accountants to wait until the suit is settled to account for the event.
Answer: B
12. Accounts payable typically arise because
a. cash is received from a customer that will be paid back in the future.
b. cash is received from customers prior to the rendering of services or delivery of products.
c. the firm temporarily borrows cash for operations.
d. amounts are owed to others for goods, supplies, and services purchased on open account.
Answer: D
13. Collecting sales taxes from customers
a. decreases net income.
b. increases the debt/equity ratio.
c. increases the current ratio.
d. decreases net worth.
Answer: B
14. If a contingent loss is accrued, this would:
a. decrease the debt/equity ratio.
b. decrease the debt/asset ratio.
c. decrease the current ratio.
d. have no change on the quick ratio.

Answer: C
15. Short-term notes payable typically arise because
a. the firm temporarily requires cash for operations.
b. cash is received from customers prior to the rendering of services or delivery of products.
c. the board of directors have declared a dividend that will be paid at a later date.
d. cash is received as security that will be paid back in the future.
Answer: A
16. Dividends payable typically arise because
a. creditors want a return on funds loaned to a company.
b. cash is paid for dividends previously declared in another accounting period.
c. the board of directors declare a dividend that will be paid at a later date.
d. bond investors demand a return.
Answer: C
17. If a loss contingency related to a lawsuit against a firm is deemed to have a reasonable
probability of requiring ultimate payment, then the proper accounting treatment of the loss
contingency will
a. require note disclosure.
b. decrease the debt/asset ratio.
c. increase the accounts payable/sales ratio.
d. decrease the debt/equity ratio.
Answer: A
18. Unearned revenue typically arises because
a. cash is received as security that will be paid back in the future.
b. cash is received from customers prior to the rendering of services or delivery of products.
c. a company temporarily requires cash for operations.

d. merchandise is sold to customers prior to payment.
Answer: B
19. Deposits payable may arise because
a. cash deposits are received from customers for layaways.
b. cash is paid to a creditor as a security deposit that will be refunded in the future.
c. the company deposits sales receipts too early.
d. merchandise is delivered to customers prior to payment.
Answer: A
20. Accruing warranty expense will
a. increase the debt/equity ratio.
b. increase the current ratio.
c. reduce uncollectible accounts during the period.
d. increase inventory turnover.
Answer: A
21. If a loss contingency related to a lawsuit against a firm is deemed to have a remote
probability of requiring ultimate payment, then the proper accounting treatment of the loss
contingency will
a. increase the debt/equity ratio.
b. increase the debt/asset ratio.
c. have no effect on earnings per share.
d. increase the quick ratio.
Answer: C
22. An increase in a deferred tax liability is recognized when
a. the tax accountant omits taxable revenue from the tax returns.

b. net income measured under GAAP is greater than taxable income on tax returns because of
temporary timing differences.
c. the amount of tax paid to the government is more than that calculated by the accountant on
the company’s tax return.
d. a tax audit by the IRS causes an increase in taxes due from a previous year’s tax return.
Answer: B
23. Contingent liabilities whose ultimate payment is highly probable and can be reasonably
estimated must be
a. ignored until actual payment is made.
b. disclosed only in the footnotes to the financial statements.
c. recorded in the body of the balance sheet.
d. disclosed in the auditor's report.
Answer: C
24. Contingent liabilities whose ultimate payment is remote should be
a. recorded in the body of the balance sheet.
b. disclosed in the footnotes to the financial statements.
c. disclosed in the auditor's report.
d. ignored.
Answer: D
25. Contingent liabilities whose ultimate payment is reasonably probable should be
a. recorded in the body of the balance sheet.
b. disclosed in the footnotes to the financial statements.
c. ignored.
d. disclosed in the auditor's report.
Answer: B

26. If a loss contingency related to a lawsuit against a firm is deemed to have a high
probability of requiring ultimate payment and can be reasonably estimated, then the proper
accounting treatment of the loss contingency will
a. decrease the debt/equity ratio.
b. decrease the debt/asset ratio.
c. decrease earnings per share.
d. increase net income.
Answer: C
27. Sweeney, Inc. borrowed $30,000 from the bank by signing a 9-month note payable. The
proper accounting treatment of recording the note will
a. increase assets and liabilities.
b. decrease assets and increase liabilities.
c. increase liabilities and owners’ equity.
d. increase assets and decrease owners’ equity.
Answer: A
28. An income tax accrual at yearend will most likely
a. decrease earnings per share.
b. decrease the debt/asset ratio.
c. decrease the debt/equity ratio.
d. be a contingency.
Answer: A
29. Ranch Company estimates warranty expense as 5% of sales. On January 1, warranties
payable was $13,000. During the year Ranch paid $5,000 to meet its warranty obligations and
recorded sales of $120,000. The December 31 liability for the warranty is
a. $10,000.
b. $12,000.

c. $6,000.
d. $14,000.
Answer: D
$13,000 + ($120,000 x 5%) - $5,000 = $14,000
30. Which one of the following would increase the bonus for a CEO who is paid a bonus
equal to a percentage of current GAAP net income?
a. Recording a decrease in the company’s self-insured worker’s compensation expense
b. Decreasing the estimated life of plant and equipment by an average of 8 years
c. Increasing wages for the warehouse employees
d. Collecting payments in advance from customers
Answer: A
31. A suit for breach of contract seeking damages of $3,000,000 was filed against Clark
Corporation on March 1, 2009. Clark’s legal counsel believes that a negative outcome is
highly probable. A reasonable estimate of the court’s award to the plaintiff is $600,000.
Settlement is expected to occur during the latter part of 2009. What accounting is necessary
for the year ending June 30, 2009?
a. Note disclosure only
b. Accrue a contingent liability of $3,000,000 and provide note disclosure explaining the
contingency
c. Accrue a contingent liability of $600,000 and provide note disclosure explaining the
contingency
d. No disclosure or accrual necessary
Answer: C
32. Abbott Co. has 5 employees who worked the entire year. Each employee earns 6 paid
vacation days annually. Vacation days may be taken during December of 2009 and all of
2010. All unused vacation days are paid when the employee leaves the company. The daily
wage in 2009 per employee is $100. This is an example of

a. a definite liability.
b. a third party liability.
c. a gain contingency.
d. unearned revenue.
Answer: A
33. Which one of the following is a current liability?
a. Portions of notes payable due beyond the next accounting period
b. Sales taxes paid on new equipment acquired
c. Estimated costs of hurricanes which might develop in the Caribbean during next hurricane
season
d. Football tickets sold to customers for games in the coming season
Answer: D
34. Current liabilities include
a. amounts due from suppliers for credits on accounts given on returns which had previously
been paid.
b. taxes withheld from employees' payroll checks which must be remitted to the IRS.
c. amounts paid for warranty repairs during the current year.
d. cash dividends to be declared by the board of directors during the next six months.
Answer: B
Use the information from Cen, Inc. to answer questions 35 and 36.
Cen, Inc. reported the following on its December 31, 2010, balance sheet:

35. How much is the maturity value of the one-year note payable that is outstanding at the
end of 2010?
a. $9,500
b. $9,800
c. $10,100
d. $10,400
Answer: C
36. Which statement is True concerning Cen’s interest?
a. Central paid a total of $60 interest during 2010.
b. Interest was incurred during the year on more than one note.
c. Interest of $3,200 was accrued and paid during 2010.
d. The ‘accrued interest on notes payable’ amount relates to the one-year short-term notes
payable.
Answer: B
37. Which one of the following would most likely be reported as a current liability?
a. Frequent flyer program miles accumulated by airline travelers
b. Self insurance risks on anticipated losses
c. Customers merchandise returns exchanged for different merchandise
d. The CEO’s stock option package for the current year
Answer: A
38. Liabilities are
a. sometimes credit and other times debit balances.
b. deferred amounts which will be recognized on the balance sheet when the actual due date
arrives.
c. obligations arising from past transactions and payable in assets or services in the future.

d. obligations to transfer ownership of one company to other entities.
Answer: C
39. What business transaction must occur in order to reduce Estimated Warranty Payable?
a. Goods under warranty are repaired in the period after the sale
b. Warranty costs are accrued at the end of the accounting period
c. Sale of goods on account
d. Customers take advantage of cash discounts for early payment
Answer: A
40. A contingent liability
a. is definite in existence, but its amount and due date are not yet known.
b. has the same requirements as a contingent gain.
c. must be accrued even when it is not reasonably estimable.
d. is disclosed only in the financial statement notes if highly probable and the amount can be
estimated.
Answer: A
41. Gain contingencies
a. should be accrued when probable and the amount can be reasonably estimated.
b. are reported as revenues on the income statement.
c. should be accrued for anticipated lottery winnings.
d. are almost never accrued and are rarely disclosed.
Answer: D
42. A company has a decreasing current ratio. Creditors should be concerned
a. with long-term solvency.
b. about the company’s ability to pay current debts as they come due.
c. about the company’s profitability.

d. about whether earnings per share is increasing or decreasing.
Answer: B
43. A pension is
a. a cost such as health insurance paid on behalf of a retired or disabled employee.
b. a contingent inflow of cash anticipated from assets earning interest.
c. required of all employers.
d. usually determined by the employees’ years of service.
Answer: D
44. Alpine, Inc. sells baseball tickets for professional baseball games. Cash receipts for
baseball tickets are credited to Unearned Ticket Revenue. During 2010, Alpine collected
$30,000 for a September, 2010 baseball game and $42,000 for a March, 2011 baseball game.
The September game was played as scheduled, although $2,000 of tickets was refunded to
fans that canceled because they had been permanently kicked out of the stadium for
disorderly conduct. How much should be reported as Unearned Ticket Revenue at December
31, 2010?
a. $0
b. $42,000
c. $72,000
d. $40,000
Answer: B
45. A measure of the extent to which reported income is conservative is called
a. ERISA.
b. a gain contingency.
c. the conservatism ratio.
d. a line of credit.
Answer: C

46. Warranties should be accrued if it is
a. probable that an expense will be incurred and the amount is reasonably estimable.
b. possible that an expense will be incurred regardless of whether the amount is estimable or
not.
c. possible that an expense will be incurred and the amount is reasonably estimable.
d. remote that any costs will be incurred.
Answer: A
47. In addition to recognizing income tax expense, the accounting necessary to record income
taxes requires
a. a credit to income tax payable based on net income times the tax rate.
b. a debit to the income tax expense account for the amount of cash that must be paid for
taxes.
c. computations of the amounts to record in the deferred income tax account.
d. all companies to report taxable income on the income statement
Answer: C
48. Two types of differences exist between computing income for tax purposes and
computing income for financial accounting purposes. The differences are
a. defined benefit taxes and defined contribution taxes.
b. deferred tax assets and deferred tax liabilities.
c. revenues and expenses.
d. temporary and permanent.
Answer: D
49. The economic essence of one of the following should not be reported in the balance sheet
as a current liability. Which one is not reported?
a. Free sandwich offers printed on hockey ticket stubs
b. Amounts sued for damages associated with injuries from an allegedly defective weed eater

c. Mail-in rebates from software by software companies
d. Amounts payable to an employee for a recent expense report
Answer: B
50. A defined benefit plan differs from a defined contribution plan in that a defined benefit
plan
a. has a liability that must be actuarially computed.
b. is required by ERISA.
c. requires a corporation to make a series of payments of a specified amount to a pension
fund.
d. requires journal entries, and the defined contribution plan does not.
Answer: A
51. Pension expense is
a. accrued each period as employees require payments.
b. recognized as a long-term deferred asset.
c. accrued as employees earn their rights to future benefits.
d. calculated by dividing an employee’s annual salary into the number of years the employee
is expected to require pension payments.
Answer: C
52. Simpson Incorporated sells fishing lures and monofilament leader material. During June,
Simpson distributed 6,000 coupons to receive a free lure to each customer who purchased a
dozen spools of monofilament leader material. Through December 31, 2010, Simpson
honored 1,200 coupons redeemed. Simpson expects a total of 5,200 total coupons to be
redeemed. Simpson sells lures for $1.00 each. The cost of each lure to Simpson is 45 cents.
How much should Simpson report as a liability at December 31, 2010?
a. $6,000
b. $1,800
c. $3,600

d. $2,340
Answer: B
($5,200 - $1,200) x $0.45 = $1,800
53. Jake Company borrowed $100,000 from Guaranty Trust Bank to finance the purchase of
new equipment. The loan contract provides for a 12 percent annual interest rate and states
that the principal must be paid in full in ten years. The contract also requires that Jake
maintains a current ratio of 1.5:1. Before Jake borrowed the $100,000, the company’s current
assets and current liabilities were $120,000 and $68,000 respectively.
If Jake invests $50,000 of the borrowed funds in equipment and keeps the rest as cash or
short-term investment, what would be its current ratio?
a. 1.76
b. 2.50
c. 1.44
d. 3.24
Answer: B
Current Ratio = Current Assets ÷ Current Liabilities
= ($120,000 + $50,000) ÷ $68,000 = 2.50
54. Jake Company borrowed $100,000 from Guaranty Trust Bank to finance the purchase of
new equipment. The loan contract provides for a 12 percent annual interest rate and states
that the principal must be paid in full in ten years. The contract also requires that Jake
maintains a current ratio of 1.5:1. Before Jake borrowed the $100,000, the company’s current
assets and current liabilities were $120,000 and $68,000 respectively.
If Jake invests $50,000 of the borrowed funds in equipment and keeps the rest as cash or
short-term investment, what is the maximum amount of current liabilities it could have
without violating the debt contract?
a. $45,333
b. $146,667

c. $125,333
d. $113,333
Answer: D
Current assets cannot fall below 1.5 times current liabilities. Therefore, dividing current
assets by 1.5 indicates the maximum level that Jake can allow current liabilities to grow to
without violating the debt covenant. So current liabilities can grow to $113,333 ($170,000 ÷
1.5).
55. Jake Company borrowed $100,000 from Guaranty Trust Bank to finance the purchase of
new equipment. The loan contract provides for a 12 percent annual interest rate and states
that the principal must be paid in full in ten years. The contract also requires that Jake
maintains a current ratio of 1.5:1. Before Jake borrowed the $100,000, the company’s current
assets and current liabilities were $120,000 and $68,000 respectively.
If Jake invests $80,000 of the borrowed funds in equipment and keeps the rest as cash or
short-term investment, what would be its current ratio?
a. 2.94
b. 3.24
c. 2.06
d. 0.83
Answer: C
Current Ratio = ($120,000 + $20,000) ÷ $68,000 = 2.06
56. Jake Company borrowed $100,000 from Guaranty Trust Bank to finance the purchase of
new equipment. The loan contract provides for a 12 percent annual interest rate and states
that the principal must be paid in full in ten years. The contract also requires that Jake
maintains a current ratio of 1.5:1. Before Jake borrowed the $100,000, the company’s current
assets and current liabilities were $120,000 and $68,000 respectively.
If Jake invests $80,000 of the borrowed funds in equipment and keeps the rest as cash or
short-term investment, what is the maximum amount of current liabilities it could have
without violating the debt contract?

a. $93,333
b. $133,333
c. $146,667
d. $102,000
Answer: A
Current assets cannot fall below 1.5 times current liabilities. Therefore, dividing current
assets by 1.5 indicates the maximum level that Jake can allow current liabilities to grow to
without violating the debt covenant. So current liabilities can grow to $93,333 ($140,000 ÷
1.5).
57. Jake Company borrowed $100,000 from Guaranty Trust Bank to finance the purchase of
new equipment. The loan contract provides for a 12 percent annual interest rate and states
that the principal must be paid in full in ten years. The contract also requires that Jake
maintains a current ratio of 1.5:1. Before Jake borrowed the $100,000, the company’s current
assets and current liabilities were $120,000 and $68,000 respectively.
If Jake invests the entire $100,000 of the borrowed funds in equipment and keeps the rest as
cash or short-term investment, what would be its current ratio?
a. 3.24
b. 1.76
c. 1.31
d. 1.50
Answer: B
Current Ratio = ($120,000 + $0) ÷ $68,000 = 1.76
58. Jake Company borrowed $100,000 from Guaranty Trust Bank to finance the purchase of
new equipment. The loan contract provides for a 12 percent annual interest rate and states
that the principal must be paid in full in ten years. The contract also requires that Jake
maintains a current ratio of 1.5:1. Before Jake borrowed the $100,000, the company’s current
assets and current liabilities were $120,000 and $68,000 respectively.

If Jake invests the entire $100,000 of the borrowed funds in equipment, what is the maximum
amount of current liabilities it could have without violating the debt contract?
a. $146,667
b. $102,000
c. $80,000
d. $125,333
Answer: C
The current liabilities can grow to $80,000 ($120,000 ÷ 1.5).
59. Meadville Industries sells gift certificates that are redeemable in merchandise. During
2009, Meadville sold gift certificates for $88,000. Merchandise with the total price of
$52,000 was redeemed during the year. For Meadville, the cost of the merchandise sold was
$32,000. Meadville sold gift certificates for the first time in 2009. The journal entry recording
the sale of the gift certificates will include:
a. a debit to Certificate Liability for $88,000
b. a debit to Deferred Revenue for $88,000
c. a credit to Sales for $88,000
d. a credit to Deferred Revenue for $88,000
Answer: D

60. Meadville Industries sells gift certificates that are redeemable in merchandise. During
2009, Meadville sold gift certificates for $88,000. Merchandise with the total price of
$52,000 was redeemed during the year. For Meadville, the cost of the merchandise sold was
$32,000. Meadville sold gift certificates for the first time in 2009. Assuming that Meadville
uses the perpetual inventory method, the journal entry recording the redemption of the gift
certificates during 2009 will include:
a. a credit to Cost of Goods Sold for $32,000

b. a debit to Deferred Revenue for $88,000
c. a credit to Sales for $52,000
d. a credit to Deferred Revenue for $52,000
Answer: C

61. The following information was taken from the annual report of Jones Inc.

What is Jones’s conservatism ratio?
a. 1.02
b. 1.52
c. 2.89
d. 1.21
Answer: D

62. The following information was taken from the annual report of Jones Inc.

Based on this information, what journal entry should Jones make in 2010 to record its income
taxes?

Answer: D

63. The following information was taken from the annual report of Leno Inc.

What is Leno’s conservatism ratio?

a. 0.63
b. 0.91
c. 0.69
d. 0.86
Answer: B

64. The following information was taken from the annual report of Leno Inc.

Answer: C
Income Tax Expense 40,400

Deferred Income Tax ($59,400 – $58,300) 1,100
Income Tax Liability 41,500
65. Julia Used Cars offers a one-year warranty from the date of sale on all cars it sells. From
historic data, Bill Julia estimates that, on average, each car will require the company to incur
warranty cost of $820. The cars sold for an average of $9,500 each. The following activities
occurred during 2010.

If Julia accrued its warranty liability with a single adjusting entry at year-end, the journal
entry would include:
a. a debit to Contingent Warranty Liability for $28,700
b. a debit to Warranty Expense for $28,700
c. a credit to Parts for $17,220
d. a credit to Cash for $28,700
Answer: B

66. Julia Used Cars offers a one-year warranty from the date of sale on all cars it sells. From
historic data, Bill Julia estimates that, on average, each car will require the company to incur
warranty cost of $820. The following activities occurred during 2010.

If the January 1, 2010 beginning balance in the warranty liability account was $2,500, what
would be the year-end warranty liability balance?
a. $31,200
b. $16,200
c. $11,200
d. $13,700
Answer: B

67. Julia Used Cars offers a one-year warranty from the date of sale on all cars it sells. From
historic data, Bill Julia estimates that, on average, each car will require the company to incur
warranty cost of $820. The cars sold for an average of $9,500 each. The following activities
occurred during 2010.

Answer: D
Matching Questions
1. Select the letter of the effect on the debt/equity ratio (a through c) as a result of each
transaction listed in items 1 through 9.
Effects
a. Increase in debt/equity ratio
b. Decrease in debt/equity ratio
c. Does not change debt/equity ratio
____ 1. Amortized the discount of the long-term note payable
____ 2. A portion of long-term debt is paid
____ 3. Accrued salaries at yearend
____ 4. Paid accrued payroll taxes which were accrued last month

____ 5. Paid a bonus amounting to 5% on reported income to the CEO that was previously
accrued
____ 6. Paid costs associated with warranties that were previously accrued
____ 7. Taxes paid which are accrued
____ 8. Accrued income taxes at yearend
____ 9. Accrued estimated coupon redemptions
Answer: 1. a
2. b
3. a
4. b
5. b
6. b
7. b
8. a
9. a
2. For each item numbered 1 through 16 below, select the appropriate effect on liabilities
listed in a through e that each transaction describes. You may use each letter more than once
or not at all. In some cases, two effects are correct.
Effects on Liabilities
a. Decrease current liabilities
b. Increase current liabilities
c. No effect on recorded current liabilities
d. Accrued contingent liability
e. Contingent liability disclosed in the notes only
____ 1. Purchased supplies on account.

____ 2. Paid accounts payable.
____ 3. Issued a $1,000 short-term note payable for $970.
____ 4. Amortized the discount of the short-term note payable.
____ 5. A portion of long-term debt is due next year.
____ 6. Declared cash dividends to holders of stock.
____ 7. Paid the cash dividend previously declared.
____ 8. Received money from customers prior to delivery of the product to the customer.
____ 9. Delivered products to a customer who previously paid for that product.
____ 10. Collected sales tax on behalf of the state government.
____ 11. Accrued payroll taxes that the firm has to pay to the federal government within three
months.
____ 12. Accrued a bonus amounting to 5% on reported income to the CEO.
____ 13. In a lawsuit filed against the firm, counsel indicates that the potential $10,000 loss is
remote.
____ 14. In a lawsuit filed against the firm, counsel indicates that the potential $10,000 loss is
reasonably possible.
____ 15. In a lawsuit filed against the firm, counsel indicates that the potential $10,000 loss is
highly probable.
____ 16. Accrued warranty expense.
Answer:
1. b
2. a
3. b
4. b
5. b

6. b
7. a
8. b
9. a
10. b
11. b
12. b
13. c
14. e, c
15. b, d
16. b, d
3. Select the letter of the effect on the ratios (a through c) as a result of each transaction listed
in items 1 through 16.
Effects
a. Increase in debt/equity ratio
b. Decrease in debt/equity ratio
c. Does not change debt/equity ratio
____ 1. Purchased supplies on account to be used next month.
____ 2. Paid accounts payable.
____ 3. Issued a $1,000 short-term note payable for $970.
____ 4. Amortized the discount of the short-term note payable.
____ 5. A portion of long-term debt is due next year.
____ 6. Declared cash dividends to holders of stock.
____ 7. Paid the cash dividend previously declared.
____ 8. Received money from customer prior to delivery of the product to the customer.

____ 9. Delivered product to a customer who previously paid for that product.
____ 10. Collected sales tax on behalf of the state government.
____ 11. Accrued payroll taxes the firm has to pay to the federal government within three
months.
____ 12. Paid a bonus (not previously accrued) amounting to 5% on reported income to the
CEO for the current year.
____ 13. A large payment is remotely probable resulting from a lawsuit filed against the firm.
____ 14. A large payment is reasonably probable resulting from a lawsuit filed against the
firm.
____ 15. A $10,000 payment is highly probable resulting from a lawsuit filed against the
firm.
____ 16. Bondholder converted bond into stock through conversion feature.
Answer:
1. a
2. b
3. a
4. a
5. c
6. a
7. b
8. a
9. b
10. a
11. a
12. a

13. c
14. c
15. a
16. b
Short Problems
1. On July 1, Falcon Company borrowed $2,000 in return for a one-year note payable with a
maturity value of $2,200. Calculate the balance sheet value of the note on December 31.
Answer: ($200/12) X 6 = $100
$2,200 –$100 = $2,100
2. On October 1, Accurate Company borrowed $2,000 in return for a nine-month note
payable with a maturity value of $2,600. Calculate the amount of interest expense and the
balance sheet value for the year ending December 31.
Answer: (1/3) x ($2,600 - $2,000) = $200 expense
$2,000 + $200 = $2,200 balance sheet value
3. On October 1, 2009, Brooks Company borrowed $6,000 in return for a nine-month note
payable with a maturity value of $6,600. Fill in the partial balance sheet that appears below as
of December 31, 2009.

Answer:

4. On July 1, Gordon Company borrowed $10,000 in return for an eight-month note payable
with a maturity value of $10,600. Calculate the amount of interest expense for the current
year.

Answer: (6/8) x ($10,600 – $10,000) = $450
5. Bradley Incorporated owns a chain of retail stores. During December of 2009, a customer
slipped in a doorway of its Missouri store and broke his ribs. He is suing Bradley for
$200,000 for negligence. Bradley’s legal counsel believes that it is only reasonably probable
that Bradley will lose its defense of the lawsuit because, although the doorway was icy due to
an ice storm that was occurring at the time of the fall, a sign on the door warned customers
that the doorway was slippery when icy. On December 30, 2009, before considering the
effects of this lawsuit, Bradley’s current assets, total assets, current liabilities, and total
liabilities were $420,000, $840,000, $100,000, and $300,000, respectively. After this event is
properly accounted for, calculate Bradley’s debt/equity ratio on December 31, 2009.
Answer: The reasonably probable obligation resulting from the negligent lawsuit is not
recognized on the financial statements. It is, however, disclosed in the footnotes to the
financial statements. Therefore, the debt/equity ratio is $300,000/[$840,000 - $300,000] =
0.56.
6. Pitts Incorporated owns a chain of retail stores. During December of 2009, a customer
slipped in a doorway of its Nebraska store and broke his ribs. He is suing Pitts for $200,000
for negligence. The legal counsel of Pitts believes that it is remote that Pitts will lose its
defense of the lawsuit because the doorway recently was rebuilt with all-weather traction
stripping and a sign on the door warned customers that the doorway was slippery when icy.
On December 30, 2009, before considering the effects of this lawsuit, The company’s current
assets, total assets, current liabilities, and total liabilities were $420,000, $840,000, $100,000,
and $300,000, respectively. After this event is properly accounted for, calculate the
company’s debt/equity ratio on December 31, 2009.
Answer: The remote obligation resulting from the negligent lawsuit is not recognized on the
financial statements. The debt to equity ratio is $300,000/[$840,000 - $300,000] = .56.
7. Pacific Company estimates warranty expense as 10% of sales. On January 1, warranties
payable was $10,000. During the year, Pacific paid $8,000 to meet its warranty obligations
and recorded sales of $300,000. Calculate warranties payable on December 31.
Answer: $10,000 + [$300,000 x 10%] – $8,000 = $32,000
8. On January 1 and December 31, warranties payable were $6,000 and $4,000, respectively.
During the current year, sales were $100,000, upon which 3% was estimated to be the amount

required for future warranty payments. Calculate the amount paid for warranties during the
current year.
Answer: $6,000 + (3% x $100,000) – $4,000 = $5,000
9. Beacon Incorporated owns a chain of retail stores. During December of 2009, a customer
slipped in a doorway of its Virginia store and broke his ribs. He is suing Beacon for $200,000
for negligence. Beacon's legal counsel believes that it is remote that Beacon will lose its
defense of the lawsuit because the doorway recently was rebuilt with all-weather traction
stripping and a sign on the door warned customers that the doorway was slippery when icy.
On December 30, 2009, before considering the effects of this lawsuit, Beacon's current assets,
total assets, current liabilities, and total liabilities were $420,000, $840,000, $100,000, and
$300,000, respectively. After this event is properly accounted for, calculate Beacon’s
debt/asset ratio on December 31, 2009.
Answer: The remotely probable obligation resulting from the negligent lawsuit is not
recognized on the financial statements. Therefore, the debt/asset ratio is $300,000/$840,000 =
0.36.
10. On December 31, 2009, Roper Company had current assets of $15,000 in cash and
current liabilities of $8,000 in accounts payable, resulting in a current ratio of 1.88. The
company needs to increase its current ratio to 2.75 by December 31, 2010. Calculate the
amount of accounts payable that needs to be paid in order to boost the current ratio to 2.75.
Answer: If Roper pays $4,000 of accounts payable, then current assets and current liabilities
will be $11,000 and $4,000, respectively, resulting in a current ratio of 2.75.
11. On December 31, 2008, Seminole Co. had current assets of $25,000 in cash and current
liabilities of $8,000 in accounts payable, resulting in a current ratio of 3.13. The company
estimates that warranty expense for 2009 is 6% of sales that totaled $200,000. Calculate
Seminole’s current ratio after warranty expense is recognized.
Answer: Warranties payable of $12,000 will be recognized when warranty expense is
accrued. This results in current assets of $25,000, current liabilities of $20,000, and a current
ratio of 1.25 ($25,000/$20,000).
12. As a security analyst for Market Masters, Inc., you have chosen to invest in one high-tech
firm. You have narrowed your choice between RamTech Company or Accutrex Industries,

firms of similar size and direct competitors in the industry. The following information was
taken from their 2009 annual reports:

Answer:

13. Porter Products recognizes expenses for wages, interest and rent when cash payments are
made. The following related cash payments were made during December 2009:

As of December 31, the current assets and current liabilities reported on Porter’s balance
sheet were $36,000 and $22,500, respectively. Porter’s income statement reported net income
of $11,250.

Required: Compute Porter’s current ratio and net income if the company were to account for
wages, interest, and rent on an accrual basis.
Answer:

14. Farley Incorporated instituted a defined benefit pension plan for its employees at the
beginning of 2006. An actuarial method that is acceptable under GAAP indicates that the
company should contribute $80,000 each year to the pension fund to cover the benefits that
will be paid to the employees. Farley funded 80% in 2006 and 2007, 90% in 2008 and 2009,
and 100 percent in 2010.
Required:
(1) Prepare the journal entries to accrue the pension liability and fund it for 2006 through
2010.
(2) Compute the balance in the pension liability account as of December 31, 2010.

Answer:

Thus, the balance in the Pension Liability account as of December 31, 2010 is $48,000.
15. On December 31, 2009, 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, 2009, Barton paid its 2009 income taxes of $6,000
while its income tax expense on its 2009 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?
Answer: Tax expense of $8,000 causes a decrease in shareholders' equity from $90,000 to
$82,000. The deferred tax liability of $2,000 increases liabilities to $62,000. The post-tax
debt/equity ratio is 0.76.
16. On December 31, 2009, 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, 2009, 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?
Answer: Warranty expense of $5,000 decreases shareholders' equity from $100,000 to
$95,000. The $5,000 estimated warranty liability increases liabilities to $65,000. The
debt/equity ratio is 0.684.
17. On March 2, 2010, Knight Company’s CFO, Bob Martin, will receive a bonus equal to
6% of net income before income taxes as reported for the year ended December 31, 2009.
The current 2009 income statement shows net income before income taxes as $600,000.
Required:
(1) What journal entry should be made on December 31, 2009?
(2) What journal entry should be made on March 2, 2010?
(3) If Bob decides to postpone $50,000 of 2009 research and development expenditures until
2010, what impact would this have on his bonus? Explain and show your calculations.
Answer:

18. On December 31, 2010, 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,
2010, Stanley purchases $6,000 of inventory on account. Calculate Stanley’s current ratio
after the inventory has been purchased.
Answer: The purchase of $6,000 of inventory on account results in current assets of $26,000,
current liabilities of $15,000, and a current ratio of 1.73.
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.

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?
Answer:

B. Although the president now makes $6.3 million, the costs to the company could be very
high. Underestimating warranty expense will require larger warranty expense in the very near
future (an additional $3,000,000 of warranty expense for a total of $13,000,000 may be
needed next year). Increasing the estimated life of its computers beyond that which is
reasonable will overstate these assets and will result in major losses when they are retired or
the firm is "restructured." Cutting research and development expenditures could result in an
early death of the company. In such a competitive environment, firms live or die on the
results of their research. The employees laid off from the restructuring of R&D will be lost to
competitors. If the income boosting policies are enacted, it is suggested that the president
move on to another corporation next year (before the piper has to be paid) and that the
shareholders sell their stock before the future negative events occur.
20. On December 31, 2010, 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 2010, 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, 2010, what
is Cocoa’s debt/equity ratio after the bonus expense and what related liability is recognized?

Answer: Bonus expense of $5,000 decreases shareholders' equity from $100,000 to $95,000.
Because Cocoa pays its CEO before the end of the year, liabilities did not change. The
debt/equity ratio is 0.85.
21. Howell Incorporated current income statement and December 31 balance sheet follow:

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 probable 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.
Answer:

All ratios as an indication of solvency have deteriorated. The current ratio decreasing to less
than 1.0 puts short-term solvency in question. Howell’s long-term solvency position as
measured by the debt/equity and debt/asset ratios have also deteriorated.
Short Essay Questions
1. State laws generally require insurance companies to maintain certain debt and solvency
ratios. Those companies who fail to maintain minimum levels, are subject to severe penalties,
most often affecting the insurance company’s continuation as a going concern. How may
regulatory requirements such as these impact management decisions?
Answer: Some debt restrictions discourage management from reporting current liabilities on
the balance sheet. In order to control current and quick ratios, a company may be forced to
pay outstanding balances immediately, rather than wait until the actual due date. Often this
requires management to make costly concessions, sometimes in the form of higher interest
rates or pledging additional collateral on loans. Reporting restrictions give management an
incentive to ignore existing current liabilities, postpone them, or structure transactions so that
current liabilities do not have to be recorded.
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.
Answer: If it is highly probable that the frequent flyer credits will be exercised and the
number of tickets can be reasonably estimated, the liability should be accrued. In this case the
value would be 1/40 times 100,000, or 2,500 tickets. Because this contingent liability is
measurable and probable, it should be recognized as an increase in an expense and liability
(part current; part long-term). By not recognizing these frequent flyer credits, the airline
industry is overstating its net income and understating its liabilities.
3. What concerns might exist when a company's debt ratio increases?
Answer: A debt ratio is calculated by dividing total liabilities by total assets. This ratio tells
users the percentage of financing that is debt. A general average ranges from 40 to 60 percent.
Creditors should be concerned about increases in the debt ratio because too much debt may
be an indication the company may not be able to pay its current and long-term debts as they
become due. Shareholders generally feel more comfortable with higher levels of debt than
creditors do because of their affinity toward strategically leveraged decision making.
4. What concerns might management have with additional debt on its balance sheet?
Answer: Additional debt on the balance sheet can reduce a company's credit rating making it
difficult to attract capital in the future. If a credit rating service reduces a company's credit
rating, analysts and investors may question the reasons. Additional debt on the balance sheet
can also decrease the current ratio, increase the debt/asset ratio, and increase the debt/equity
ratio. These changes may cause a company to violate its debt covenants and cause users to
view a company as more risky. In situations where management believes it has a strong
equity position, it may wish to accelerate the recognition of liabilities by recognizing them
earlier. This latter effort helps management to "smooth" earnings over a several year period.
5. What three characteristics should all liabilities that appear on the balance sheet have in
common?
Answer: The characteristics are:
1. They should be present obligations that entail settlements by probable future transfers or
uses of cash, goods, or services.
2. They should be unavoidable obligations.

3. The transaction or event obligating the enterprise must have happened already.
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 $150 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.
Answer: Certainly it appears probable that Golden Inc. will have to pay cash in order to meet
its long-term sales contract. The maximum would be a $75 million loss and liability.
However, Golden Inc.'s position that the amount cannot be reasonably (objectively) measured
has merit, given the renegotiations of the contracts being conducted. Therefore, an effective
argument can be made that no loss or liability can be recognized prior to the results of the
renegotiations or court settlement. However, the difficulty of objectively measuring the loss
might be considered a ploy in order to delay the recognition of the loss resulting from an
extremely bad decision to enter the long-term sales contract without hedging a future longterm obligation in ore. This position would argue that the loss and liability should be
recognized and measured at a reasonable estimation of the ultimate cost to Golden, Inc.
7. Identify the primary problem related to current liabilities.
Answer: The primary problem is insuring that all existing current liabilities are reported on
the balance sheet. Failure to report all liabilities will overstate the solvency position of a
company.
8. How do ‘determinable’ current liabilities differ from ‘contingent’ liabilities?
Answer: Determinable current liabilities can be precisely measured and the amount of cash
needed to satisfy these obligations and the date of payment are reasonably certain. Contingent
liabilities possess uncertainties concerning the amount, the date, and probability of actual
required payment.

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?
Answer: A line of credit is granted to a company by a bank allowing it to borrow up to a
certain maximum dollar amount, with interest normally being charged only on the
outstanding balance. These financing arrangements should be extensively described in
financial statement footnotes. Any amount actually borrowed should be reported as a liability
on the balance sheet.
10. Identify two different third-party collections and explain why they should be reported as
liabilities.
Answer: Third party collections include payroll tax deductions, insurance premiums or union
dues deducted from employees’ paychecks, and sales taxes collected from retail customers.
Amounts deducted from employees’ paychecks must be accumulated and submitted to the
proper regulatory agencies. The amounts represent neither revenue nor an expense for the
employer, but are considered an expense of the employee. Companies also act as collection
agencies for state government entities by collecting sales taxes. Sales taxes on purchases are
an expense to a customer, but represent amounts collected by a company on behalf of the
state entity that assesses the sales taxes. An employer acts as a collecting agency for the
Internal Revenue Service and other entities, and submits these amounts once collected.
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.
Answer: The face value of a note is the amount that must be paid on the maturity date—the
date a loan is due. A financial institution will often deduct the entire interest when a debtor
signs the note. The difference, Discount on Notes Payable, represents unamortized interest
that is not yet owed to the financial institution, but will be recognized in the future.
12. How is unamortized interest on short-term notes payable reported on a balance sheet?
Answer: Financial institutions often deduct interest from the cash received by the borrower
when a short-term note is executed. The unamortized interest is not yet owed to the financial
institution, but will be recognized in the future. The borrowing company accounts for the
unearned interest in an account called ‘Discount on Notes Payable.’ This amount is a contra
liability and appears as a deduction from the face amount of the note in the liabilities section
on a company's 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?
Answer: Before the services are rendered, i.e., before the residents attend the games, they
should be reported as unearned revenues in the current liabilities section of Harrison Inc.
14. Why are gain contingencies typically omitted from financial statement disclosure?
Answer: Gain contingencies are almost never accrued and are rarely disclosed in footnotes
because they are most often not objectively determinable. Even though a company may
determine that a gain contingency is probable and reasonably estimable, disclosing
information of this nature in the financial statements may mislead investors. The approach is
sometimes referred to as, “Don’t count your chickens before they hatch.” Conservatism
encourages recognition of losses and deferrals of gains in order to avoid over statement of
assets and revenues.
15. What impact have environmental cleanup costs had on corporate disclosures?
Answer: The U.S. government established a fund to cleanup pollution and mandate
companies to cleanup existing waste sites. Many companies are now viewing environmental
costs as reality, and finding that certain business activities that occurred long before there was
much public concern about the environment have created potential liabilities. A company
must recognize the effects of the EPA's enforcement of environmental cleanup as liabilities
because they represent a future outflow of assets as a result of a past transaction.

Test Bank for Financial Accounting: In an Economic Context
Jamie Pratt, Michael F. Peters
9780470635292, 9781119537571, 9781119444367

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