CHAPTER 10



CHAPTER 10

INTRODUCTION TO LIABILITIES: ECONOMIC CONSEQUENCES, CURRENT LIABILITIES, AND CONTINGENCIES

EXERCISES

E10–2

a. Current Ratio = Current Assets ÷ Current Liabilities

= ($130,000 + $50,000) ÷ $80,000

= 2.25

Current assets cannot fall below 1.5 times current liabilities. Therefore, dividing current assets by 1.5 indicates the maximum level that Darrington and Darling can allow current liabilities to grow to without violating the debt covenant. So current liabilities can grow to $120,000 ($180,000 ÷ 1.5).

b. Current Ratio = ($130,000 + $20,000) ÷ $80,000

= 1.875

Using the same logic as in part (a), the current liabilities can grow to $100,000 ($150,000 ÷ 1.5).

c. Current Ratio = ($130,000 + $0) ÷ $80,000

= 1.625

Using the same logic as in part (a), the current liabilities can grow to $86,666.67 ($130,000 ÷ 1.5).

E10–3

Current Assets Current Liabilities Net Income

Reported amounts $ 24,000 $ 15,000 $ 7,500

Adjustments:

Rent 1,100 1,100

Wages 5,000a (5,000)a

Interest 50b (50)b

Adjusted amounts $ 25,100 $ 20,050 $ 3,550

a $5,000 = ($7,500 ÷ 15 days per pay period) ( 10 days left in December

b $50 = $10,000 ( 12% ( 15/360

Current Ratio = Current Assets ÷ Current Liabilities

= $25,100 ÷ $20,050

= 1.25

Net Income = $3,550

PROBLEMS

P10–1

a., b., and c.

Classification Amount

Item Current Long-Term Current Long-Term

(1) X $170,000

(2) X $ 60,000

(3) X X 75,000 425,000

(4) X 8,000

(5) X 25,000

(6) X 15,000

(7) X 125,000

(8) X 50,000

Total $343,000 $610,000

P10–2

The balance sheet of Linton immediately after the bank loan and purchase of equipment would be:

Assets Liabilities and Stockholders' Equity

Current assets $ 260,000a Current liabilities $ 125,000c

Noncurrent assets 1,860,000b Long-term liabilities 775,000d

Capital stock 1,000,000

Retained earnings 220,000

Total liabilities and

Total assets $2,120,000 stockholders' equity $2,120,000

a $260,000 = $120,000 + $140,000 in cash.

b $1,860,000 = $1,500,000 + $360,000 in purchased equipment.

c $125,000 = $100,000 + $25,000 in current maturities of the new note.

d $775,000 = $300,000 + $475,000 in long-term maturities of the new note.

The current ratio after recording the bank loan and the purchase of the equipment would be:

Current Ratio = Current Assets ÷ Current Liabilities

= $260,000 ÷ $125,000

= 2.08

Declaring a dividend would increase current liabilities. Current assets cannot fall below 2 x current liabilities if Linton is to avoid violating its debt covenant. Since current assets are currently $260,000, Linton could declare and pay a dividend of $5,000. This dividend would increase current liabilities to $130,000 and reduce retained earnings to $215,000.

ISSUES FOR DISCUSSION

ID10–1

a. Under the terms of its debt covenants, FedEx's current assets must be at least as great as its current liabilities. Since Federal Express had current assets of $7,116 as of May 31, 2009, the maximum amount of liabilities Federal Express could have without violating its debt covenant would also be $7,116. Therefore, FedEx could report additional current liabilities of $2,592 ($7,116 – $4,524) as of May 31, 2009.

b. There are many current liabilities where either the creation of or the amount reported for the liability is under the company's control. For example, a company's board of directors decides when to declare a dividend (which results in the current liability Dividend Payable), how much the dividend will be and when the liability will be paid. Management has discretion over the amount reported for contingent liabilities such as Contingent Warranty Liability or Contingent Promotion Liability. By altering their estimates, management can decrease the amount reported for such liabilities. Management could also control to some extent the amount reported for Unearned Revenues. That is, management could simply not take any advances from customers, or management could control when it provides the goods or services for which it collected the advances from customers.

c. Violating a debt covenant results in the borrower being in technical default on the loan. If a company is in default on a loan, the creditor could require the borrower to immediately repay the outstanding balance. Alternatively, the creditor could allow the borrower to renegotiate the loan. However, in such cases the borrower is usually forced to agree to less favorable loan terms such as a higher interest rate, providing more collateral, and so forth.

d. If FedEx purchased the aircraft for cash, its noncurrent assets would increase by $3 billion but its current assets would decrease $3 billion for the cash disbursed. With no change in its current liabilities, funding the aircraft purchase with cash would decrease the company’s current ratio from 1.57 ($7,116/$4,524) to 0.91 ([$7,116 - $3,000]/$4,524). FedEx could not fund the purchase with cash without violating its debt covenant.

Alternatively, if FedEx purchased the aircraft using long-term debt, neither current assets nor current liabilities would be affected, leaving the current ratio at 1.57 (in compliance with the debt covenant).

ID10–2

a. The account Customers' Advance Payments represents cash collected from customers in advance of providing desired goods or services to the customers. When Ingersoll-Rand makes these collections, it is implicitly promising to either provide the desired goods or services or refund the customer's money. Thus, the cash collected in advance for which Ingersoll-Rand has not yet provided the desired goods or services represents a liability to Ingersoll-Rand, and it should be reported in the liability section of the balance sheet in the account Customers' Advance Payments. In addition, the cash collections made during the year should be reported in the operating activities section of the statement of cash flows.

b. Under the revenue recognition principle, a company should not recognize revenue until (1) the company has earned the revenue, (2) the amount of revenue earned can be objectively determined, (3) any post-sale costs can be reasonably estimated, and (4) cash collection is reasonably assured. Although the cash collection is reasonably assured when Ingersoll-Rand collects cash in advance from its customers, it is not really entitled to keep the cash at the time it makes the collections. That is, the company has to provide some goods or services before it is entitled to the cash (i.e., before it has generated some revenue). Thus, Ingersoll-Rand does not earn any revenue simply from making collections in advance from its customers. It is not until the company provides some goods or services that the company should actually recognize the revenue. Once Ingersoll-Rand provides the goods or services and recognizes the revenue, the company should then match all costs—both pre-sale and post-sale costs—against the revenue in accordance with the matching principle.

c. Ingersoll-Rand should not recognize revenue for simply collecting customer advances; instead, it generates revenue when it actually ships the goods. Thus, earnings per share would increase when Ingersoll-Rand ships goods (assuming that the company sells its inventory at a profit), and it would not be affected by receiving advance payments.

Collecting advance payments would increase both Ingersoll-Rand's current assets (through the cash collected) and current liabilities (through the obligation arising from the advances). The actual effect on the company's current ratio depends on what the ratio was before the company made the advance collections. If the current ratio was less than 1, collecting advance payments would increase Ingersoll-Rand's current ratio. Alternatively, if its current ratio was greater than 1, collecting advance payments would decrease Ingersoll-Rand's current ratio. Shipping the related goods would decrease Ingersoll-Rand's current liabilities, which means that the company's current ratio would increase.

Since collecting advance payments would increase Ingersoll-Rand's current liabilities, its debt/equity ratio would increase. Shipping the related goods would both decrease the company's current liabilities and increase its stockholders' equity (through the increased

income that would be closed into Retained Earnings). Thus, the company's debt/equity ratio would decrease when the goods are shipped.

ID10–3

a. In 2008, 20.1% ($279/$1,387) of the reserve was classified as current; in 2007, 18.5% ($280/$1,513) of the reserve was current.

b. The journal entries appear below:

2006:

Other Operating Expense (E, -SE) 217

Professional Liability Reserve (+L) 217

2007:

Other Operating Expense (E, -SE) 163

Professional Liability Reserve (+L) 163

2008:

Other Operating Expense (E, -SE) 175

Professional Liability Reserve (+L) 175

c. Professional Liability Reserve– 12/31/2007 $ 1,513 million

+ Professional Liability Expense - 2008 175 million

– Cash Payments re: Liability - 2008 x

= Professional Liability Reserve-12/31/2008 $ 1,387 million

x = $301 million

d. Earnings could be managed in the healthcare industry with manipulation to the professional liability reserve (a liability account) by adjusting the annual charge taken for the expense. If the company were having a very successful year, beating analyst earnings estimates, management could “pad” the reserve by taking larger-than-necessary expenses so that in future years, when earnings might be below targets, management could then take lower-than-necessary expenses (and therefore show higher earnings).

ID10–8

a. Deferred Revenue is a liability that represents the obligation that Microsoft has to its customers for work that has been paid for but has not been performed. The liability is carried on the balance sheet until the Revenue can be recognized. When the revenue is recognized (with a credit), the liability Deferred Revenue is reduced (with a debit).

b. From a cash flow perspective, the $1.67 billion was received in prior periods when operating system upgrades were sold to customers. The current period was simply a conversion of the liability to revenue and did not (and will not in future periods) include the receipt of cash.

c. An analyst will be concerned with Microsoft’s profitability—and the $1.67 billion in revenue certainly factors into that figure. However, an analyst will also be concerned with Microsoft’s cash flow. When converting profits to cash flow, the analyst will deduct the portion of revenue that was not cash-related to get a better idea of cash coming into and leaving the company. In addition, since the conversion of the deferred revenue came from customers opting not to cash in coupons to upgrade software, an analyst might be concerned with the market’s interest in Microsoft’s new operating system.

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