Other Significant Liabilitiesmyresource.phoenix.edu/secure/resource/XACC291r1/... · of the cash payments for the lease and records that amount as an asset.Illustration F-3 indicates

AppendixFOther Significant Liabilities

After studying this appendix, you should be able to:1 Describe the accounting and disclosure requirements for

contingent liabilities.2 Contrast the accounting for operating and capital leases.3 Identify additional fringe benefits associated with employee

compensation.

S T U D Y O B J E C T I V E

CONTINGENT LIABILITIES

With notes payable, interest payable, accounts payable, and sales taxespayable, we know that an obligation to make a payment exists. But sup-pose that your company is involved in a dispute with the Internal RevenueService (IRS) over the amount of its income tax liability. Should you re-port the disputed amount as a liability on the balance sheet? Or supposeyour company is involved in a lawsuit which, if you lose, might result in bankruptcy.How should you report this major contingency? The answers to these questionsare difficult, because these liabilities are dependent—contingent—upon somefuture event. In other words, a contingent liability is a potential liability that maybecome an actual liability in the future.

How should companies report contingent liabilities? They use the followingguidelines:

1. If the contingency is probable (if it is likely to occur) and the amount can bereasonably estimated, the liability should be recorded in the accounts.

2. If the contingency is only reasonably possible (if it could happen), then it needsto be disclosed only in the notes that accompany the financial statements.

3. If the contingency is remote (if it is unlikely to occur), it need not be recordedor disclosed.

In addition to the current and long-term liabilities discussed in Chapter 10, severalmore types of liabilities may exist that could have a significant impact on a com-pany’s financial position and future cash flows. These other significant liabilitieswill be discussed in this appendix. They are: (a) contingent liabilities, (b) lease lia-bilities, and (c) additional liabilities for employee fringe benefits (paid absencesand postretirement benefits).

Describe the accounting anddisclosure requirements forcontingent liabilities.

S T U D Y O B J E C T I V E 1

F1

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Recording a Contingent LiabilityProduct warranties are an example of a contingent liability that companies shouldrecord in the accounts. Warranty contracts result in future costs that companiesmay incur in replacing defective units or repairing malfunctioning units. Generally,a manufacturer, such as Black & Decker, knows that it will incur some warrantycosts. From prior experience with the product, the company usually can reasonablyestimate the anticipated cost of servicing (honoring) the warranty.

The accounting for warranty costs is based on the matching principle. The esti-mated cost of honoring product warranty contracts should be recognized as an ex-pense in the period in which the sale occurs. To illustrate, assume that in 2011Denson Manufacturing Company sells 10,000 washers and dryers at an averageprice of $600 each.The selling price includes a one-year warranty on parts. Densonexpects that 500 units (5%) will be defective and that warranty repair costs will average $80 per unit. In 2011, the company honors warranty contracts on 300 units,at a total cost of $24,000.

At December 31, it is necessary to accrue the estimated warranty costs on the2011 sales. Denson computes the estimated warranty liability as follows.

F2 Appendix F Other Significant Liabilities

Illustration F-1Computation of estimatedproduct warranty liability

The company makes the following adjusting entry.

Dec. 31 Warranty Expense 40,000Estimated Warranty Liability 40,000

(To accrue estimated warranty costs)

Denson records those repair costs incurred in 2011 to honor warranty contractson 2011 sales as shown below.

Jan. 1– Estimated Warranty Liability 24,000Dec. 31 Repair Parts 24,000

(To record honoring of 300 warrantycontracts on 2011 sales)

The company reports warranty expense of $40,000 under selling expenses in theincome statement. It classifies estimated warranty liability of $16,000 ($40,000 �$24,000) as a current liability on the balance sheet.

In the following year, Denson should debit to Estimated Warranty Liability allexpenses incurred in honoring warranty contracts on 2011 sales. To illustrate, as-sume that the company replaces 20 defective units in January 2012, at an averagecost of $80 in parts and labor.The summary entry for the month of January 2012 is:

Cash Flowsno effect

A SEL� �

�40,000 Exp�40,000

Cash Flowsno effect

A SEL� �

�24,000�24,000

Cash Flowsno effect

A SEL� �

�1,600�1,600

Number of units sold 10,000Estimated rate of defective units � 5%

Total estimated defective units 500Average warranty repair cost � $80

Estimated product warranty liability $40,000

Jan. 31 Estimated Warranty Liability 1,600Repair Parts 1,600

(To record honoring of 20 warrantycontracts on 2011 sales)

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Disclosure of Contingent LiabilitiesWhen it is probable that a company will incur a contingent liability but it cannotreasonably estimate the amount, or when the contingent liability is only reasonablypossible, only disclosure of the contingency is required. Examples of contingenciesthat may require disclosure are pending or threatened lawsuits and assessment ofadditional income taxes pending an IRS audit of the tax return.

The disclosure should identify the nature of the item and, if known, the amount ofthe contingency and the expected outcome of the future event.Disclosure is usually ac-complished through a note to the financial statements, as illustrated by the following.

Lease Liabilities F3

YAHOO! INC.Notes to the Financial Statements

Contingencies. From time to time, third parties assert patent infringement claims againstthe company. Currently the company is engaged in several lawsuits regarding patent issuesand has been notified of a number of other potential patent disputes. In addition, from timeto time the company is subject to other legal proceedings and claims in the ordinary courseof business, including claims for infringement of trademarks, copyrights and other intellectualproperty rights.... The Company does not believe, based on current knowledge, that any ofthe foregoing legal proceedings or claims are likely to have a material adverse effect on thefinancial position, results of operations or cash flows.

Illustration F-2Disclosure of contingent liability

The required disclosure for contingencies is a good example of the use of the full-disclosure principle.The full-disclosure principle requires that companies disclose allcircumstances and events that would make a difference to financial statement users.Some important financial information, such as contingencies, is not easily reportedin the financial statements. Reporting information on contingencies in the notes tothe financial statements will help investors be aware of events that can affect thefinancial health of a company.

LEASE LIABILITIES

A lease is a contractual arrangement between a lessor (owner of a property)and a lessee (renter of the property). It grants the right to use specific prop-erty for a period of time in return for cash payments. Leasing is big business.U.S. companies leased an estimated $125 billion of capital equipment in a re-cent year. This represents approximately one-third of equipment financed that year.The two most common types of leases are operating leases and capital leases.

Operating LeasesThe renting of an apartment and the rental of a car at an airport are examples ofoperating leases. In an operating lease the intent is temporary use of the propertyby the lessee, while the lessor continues to own the property.

In an operating lease, the lessee records the lease (or rental) payments as anexpense. The lessor records the payments as revenue. For example, assume that asales representative for Western Inc. leases a car from Hertz Car Rental at the LosAngeles airport and that Hertz charges a total of $275. Western, the lessee, recordsthe rental as follows:

Contrast the accounting foroperating and capital leases.


Cash Flows

�275

A SEL� �

�275 Exp�275

Car Rental Expense 275Cash 275

(To record payment of lease rental charge)


The lessee may incur other costs during the lease period. For example, in the caseabove, Western will generally incur costs for gas. Western would report these costsas an expense.

Capital LeasesIn most lease contracts, the lessee makes a periodic payment and records that pay-ment in the income statement as rent expense. In some cases, however, the leasecontract transfers to the lessee substantially all the benefits and risks of ownership.Such a lease is in effect a purchase of the property. This type of lease is a capitallease. Its name comes from the fact that the company capitalizes the present valueof the cash payments for the lease and records that amount as an asset. IllustrationF-3 indicates the major difference between operating and capital leases.


Illustration F-3Types of leases

Operatinglease

Lessee has substantially all of thebenefits and risks of ownership

Capitallease

“Have it backby 6:00 Sunday.”

“OK!”

Lessor has substantially all of thebenefits and risks of ownership

“Only 3 morepayments and this baby

is ours!”

If any one of the following conditions exists, the lessee must record a lease asan asset—that is, as a capital lease:

1. The lease transfers ownership of the property to the lessee. Rationale: If duringthe lease term the lessee receives ownership of the asset, the lessee shouldreport the leased asset as an asset on its books.

2. The lease contains a bargain purchase option. Rationale: If during the term ofthe lease the lessee can purchase the asset at a price substantially below its fairmarket value, the lessee will exercise this option.Thus, the lessee should reportthe lease as a leased asset on its books.

3. The lease term is equal to 75% or more of the economic life of the leased prop-erty. Rationale: If the lease term is for much of the asset’s useful life, the lesseeshould report the asset as a leased asset on its books.

4. The present value of the lease payments equals or exceeds 90% of the fair marketvalue of the leased property. Rationale: If the present value of the lease pay-ments is equal to or almost equal to the fair market value of the asset, the lesseehas essentially purchased the asset. As a result, the lessee should report theleased asset as an asset on its books.

To illustrate, assume that Gonzalez Company decides to lease new equipment.The lease period is four years; the economic life of the leased equipment is estimated

H E L P F U L H I N TA capital lease situationis one that, althoughlegally a rental case, is insubstance an installmentpurchase by the lessee.Accounting standards re-quire that substance overform be used in such asituation.


before you go on...

to be five years.The present value of the lease payments is $190,000, which is equalto the fair market value of the equipment.There is no transfer of ownership duringthe lease term, nor is there any bargain purchase option.

In this example, Gonzalez has essentially purchased the equipment. Conditions3 and 4 have been met. First, the lease term is 75% or more of the economic life ofthe asset. Second, the present value of cash payments is equal to the equipment’sfair market value. Gonzalez records the transaction as follows.

Additional Liabilities for Employee Fringe Benefits F5

Cash Flowsno effect

A SEL� �

�190,000�190,000

Leased Asset—Equipment 190,000Lease Liability 190,000

(To record leased asset and lease liability)

The lessee reports a leased asset on the balance sheet under plant assets. It re-ports the lease liability on the balance sheet as a liability. The portion of the leaseliability expected to be paid in the next year is a current liability. The remainder isclassified as a long-term liability.

Most lessees do not like to report leases on their balance sheets. Why?Because the lease liability increases the company’s total liabilities. This, inturn, may make it more difficult for the company to obtain needed fundsfrom lenders. As a result, companies attempt to keep leased assets andlease liabilities off the balance sheet by structuring leases so as not to meetany of the four conditions mentioned on page F4. The practice of keepingliabilities off the balance sheet is referred to as off–balance-sheet financing.

ADDITIONAL LIABILITIES FOR EMPLOYEE FRINGE BENEFITS

In addition to the three payroll tax fringe benefits discussed in AppendixD (FICA taxes and state and federal unemployment taxes), employers in-cur other substantial fringe benefit costs. Indeed, fringe benefits have beengrowing faster than pay. In a recent year, benefits equaled 38 percent of

E T H I C S N O T E

Accounting standard-settersare attempting to rewrite ruleson lease accounting because ofconcerns that abuse of the cur-rent standards is reducing theusefulness of financial statements.

Identify additional fringe benefitsassociated with employeecompensation.


FX Corporation leases new equipment on December 31, 2011.The lease trans-fers ownership to FX at the end of the lease. The present value of the lease payments is $240,000.After recording this lease, FX has assets of $2,000,000, liabilities of $1,200,000, and stockholders’equity of $800,000. (a) Prepare the entry to record the lease, and (b) compute and discuss thedebt to total assets ratio at year-end.

Solution

Lease LiabilityDo it!

Action Plan

• Record the present value of thelease payments as an asset anda liability.

• Use the formula for the debt tototal assets ratio (total debtdivided by total assets).

(a)Leased Asset—Equipment 240,000

Lease Liability 240,000(To record leased asset and lease liability)

(b) The debt to total assets ratio � $1,200,000 � $2,000,000 � 60%. This means that 60% of thetotal assets were provided by creditors. The higher the percentage of debt to total assets, thegreater the risk that the company may be unable to meet its maturing obligations.

Related exercise material: BEF-2, EF-3, and F-1.Do it!

The Navigator✓


We discuss two of the most important fringe benefits—paid absences andpostretirement benefits—in this section.

Paid AbsencesEmployees often are given rights to receive compensation for absences when cer-tain conditions of employment are met. The compensation may be for paid vaca-tions, sick pay benefits, and paid holidays. When the payment for such absences isprobable and the amount can be reasonably estimated, a liability should be ac-crued for paid future absences.When the amount cannot be reasonably estimated,companies should instead disclose the potential liability. Ordinarily, vacation payis the only paid absence that is accrued. The other types of paid absences are onlydisclosed.1

To illustrate, assume that Academy Company employees are entitled to oneday’s vacation for each month worked. If 30 employees earn an average of $110 perday in a given month, the accrual for vacation benefits in one month is $3,300. Theliability is recognized at the end of the month by the following adjusting entry.


Jan. 31 Vacation Benefits Expense 3,300Vacation Benefits Payable 3,300

(To accrue vacation benefits expense)

This accrual is required by the matching principle.Academy would report VacationBenefits Expense as an operating expense in the income statement, and VacationBenefits Payable as a current liability in the balance sheet.

Later, when Academy pays vacation benefits, it debits Vacation BenefitsPayable and credits Cash. For example, if the above benefits for 10 employees arepaid in July, the entry is:

July 31 Vacation Benefits Payable 1,100Cash 1,100

(To record payment of vacation benefits)

1The typical U.S. company provides an average of 12 days of paid vacation for its employees, atan average cost of 5% of gross earnings.

Cash Flows

�1,100

A SEL� �

�1,100�1,100

Cash Flowsno effect

A SEL� �

�3,300 Exp�3,300

BENEFITS3% Disability and life insurance

23% Legally required benefitssuch as Social Security

24% Medical benefits

37% Vacation and other benefitssuch as parental and sick leaves, child care

13% Retirement incomesuch as pensions

Illustration F-4The fringe benefits pie

wages and salaries. While vacations and other forms of paid leave still take thebiggest bite out of the benefits pie, as shown in Illustration F-4, medical costs arethe fastest-growing item.


The magnitude of unpaid absences has gained employers’ attention. Considerthe case of an assistant superintendent of schools who worked for 20 years andrarely took a vacation or sick day. A month or so before she retired, the schooldistrict discovered that she was due nearly $30,000 in accrued benefits. Yet theschool district had never accrued the liability.

Postretirement BenefitsPostretirement benefits are benefits provided by employers to retired employeesfor (1) health care and life insurance and (2) pensions. For many years the ac-counting for postretirement benefits was on a cash basis. Companies now accountfor both types of postretirement benefits on the accrual basis. The cost of postre-tirement benefits is getting steep. For example, General Motor’s pension andhealthcare costs for retirees in a recent year totaled $6.2 billion, or approximately$1,784 per vehicle produced.

The average American has debt of approximately $10,000 (not counting themortgage on their home) and has little in the way of savings. What will happen atretirement for these people? The picture is not pretty—people are living longer,the future of Social Security is unclear, and companies are cutting back on post-retirement benefits. This situation may lead to one of the great social and moraldilemmas this country faces in the next 40 years. The more you know about post-retirement benefits, the better you will understand the issues involved in thisdilemma.

POSTRETIREMENT HEALTHCARE AND LIFE INSURANCE BENEFITSProviding medical and related healthcare benefits for retirees was at one time aninexpensive and highly effective way of generating employee goodwill. This prac-tice has now turned into one of corporate America’s most worrisome financialproblems. Runaway medical costs, early retirement, and increased longevity aresending the liability for retiree health plans through the roof.

Many companies began offering retiree healthcare coverage in the form ofMedicare supplements in the 1960s. Almost all plans operated on a pay-as-you-gobasis. The companies simply paid for the bills as they came in, rather than settingaside funds to meet the cost of future benefits. These plans were accounted for onthe cash basis. But, the FASB concluded that shareholders and creditors shouldknow the amount of the employer’s obligations. As a result, employers must nowuse the accrual basis in accounting for postretirement healthcare and life insurancebenefits.

PENSION PLANSA pension plan is an agreement whereby an employer provides benefits (payments)to employees after they retire. Over 50 million workers currently participate in pen-sion plans in the United States. The need for good accounting for pension plansbecomes apparent when one appreciates the size of existing pension funds. Mostpension plans are subject to the provisions of ERISA (Employee RetirementIncome Security Act), a law enacted to curb abuses in the administration and fund-ing of such plans.

Three parties are generally involved in a pension plan. The employer (com-pany) sponsors the pension plan.The plan administrator receives the contributionsfrom the employer, invests the pension assets, and makes the benefit payments tothe pension recipients (retired employees). Illustration F-5 (page F8) indicates theflow of cash among the three parties involved in a pension plan.

An employer-financed pension is part of the employees’ compensation.ERISA establishes the minimum contribution that a company must make eachyear toward employee pensions. The most popular type of pension plan used is the

Additional Liabilities for Employee Fringe Benefits F7


401(k) plan.A 401(k) plan works as follows:As an employee, you can contribute upto a certain percentage of your pay into a 401(k) plan, and your employer willmatch a percentage of your contribution.These contributions are then generally in-vested in stocks and bonds through mutual funds. These funds will grow withoutbeing taxed and can be withdrawn beginning at age 59-1/2. If you must access thefunds earlier, you may be able to do so, but a penalty usually occurs along with apayment of tax on the proceeds.Any time you have the opportunity to be involvedin a 401(k) plan, you should avail yourself of this benefit!

Companies record pension costs as an expense while the employees are workingbecause that is when the company receives benefits from the employees’ services.Generally the pension expense is reported as an operating expense in the company’sincome statement. Frequently, the amount contributed by the company to the pen-sion plan is different from the amount of the pension expense. A liability is recog-nized when the pension expense to date is more than the company’s contributionsto date. An asset is recognized when the pension expense to date is less than thecompany’s contributions to date. Further consideration of the accounting for pen-sion plans is left for more advanced courses.

The two most common types of pension arrangements for providing benefits toemployees after they retire are defined-contribution plans and defined-benefitplans.

Defined-Contribution Plan. In a defined-contribution plan, the plan defines theemployer’s contribution but not the benefit that the employee will receive at re-tirement. That is, the employer agrees to contribute a certain sum each periodbased on a formula. A 401(k) plan is typically a defined-contribution plan.

The accounting for a defined-contribution plan is straightforward: The em-ployer simply makes a contribution each year based on the formula established inthe plan. As a result, the employer’s obligation is easily determined. It follows thatthe company reports the amount of the contribution required each period as pen-sion expense. The employer reports a liability only if it has not made the contribu-tion in full.

To illustrate, assume that Alba Office Interiors Corp. has a defined-contributionplan in which it contributes $200,000 each year to the pension fund for itsemployees. The entry to record this transaction is:


Illustration F-5Parties in a pension plan

Contributions Benefits

Fund Assets:Investments and Earnings

Employer Plan Administrator Pension Recipients

Kear Trust Co.

Pension Expense 200,000Cash 200,000

(To record pension expense and contribution to pension fund)

To the extent that Alba did not contribute the $200,000 defined contribution, itwould record a liability. Pension payments to retired employees are made from thepension fund by the plan administrator.

Defined-Benefit Plan. In a defined-benefit plan, the benefits that the employeewill receive at the time of retirement are defined by the terms of the plan. Benefitsare typically calculated using a formula that considers an employee’s compensation

Cash Flows

�200,000

A SEL� �

�200,000�200,000


level when he or she nears retirement and the employee’s years of service. Becausethe benefits in this plan are defined in terms of uncertain future variables, an ap-propriate funding pattern is established to ensure that enough funds are availableat retirement to meet the benefits promised. This funding level depends on a num-ber of factors such as employee turnover, length of service, mortality, compensationlevels, and investment earnings. The proper accounting for these plans is complexand is considered in more advanced accounting courses.

POSTRETIREMENT BENEFITS AS LONG-TERM LIABILITIESWhile part of the liability associated with (1) postretirement healthcare and life in-surance benefits and (2) pension plans is generally a current liability, the greaterportion of these liabilities extends many years into the future. Therefore, manycompanies are required to report significant amounts as long-term liabilities forpostretirement benefits.

Self-Study Questions F9

1 Describe the accounting and disclosure requirementsfor contingent liabilities. If it is probable that the contin-gency will happen (if it is likely to occur) and the amountcan be reasonably estimated, the liability should berecorded in the accounts. If the contingency is only reason-ably possible (it could occur), then it should be disclosedonly in the notes to the financial statements. If the possibil-ity that the contingency will happen is remote (unlikely tooccur), it need not be recorded or disclosed.

2 Contrast the accounting for operating and capitalleases. For an operating lease, lease (or rental) payments

are recorded as an expense by the lessee (renter). For acapital lease, the lessee records the asset and related obli-gation at the present value of the future lease payments.

3 Identify additional fringe benefits associated with employee compensation. Additional fringe benefits as-sociated with wages are paid absences (paid vacations, sickpay benefits, and paid holidays), postretirement health careand life insurance, and pensions. The two most commontypes of pension arrangements are a defined-contributionplan and a defined-benefit plan.

SUMMARY OF STUDY OBJECTIVES

GLOSSARY

Capital lease A contractual arrangement that transferssubstantially all the benefits and risks of ownership to thelessee so that the lease is in effect a purchase of the prop-erty. (p. F4).

Contingent liability A potential liability that may becomean actual liability in the future. (p. F1).

Defined-benefit plan A pension plan in which the benefitsthat the employee will receive at retirement are defined bythe terms of the plan. (p. F8).

Defined-contribution plan A pension plan in which theemployer’s contribution to the plan is defined by the termsof the plan. (p. F8).

Lease A contractual arrangement between a lessor (ownerof a property) and a lessee (renter of the property). (p. F3).

Operating lease A contractual arrangement giving the les-see temporary use of the property, with continued owner-ship of the property by the lessor. (p. F3).

Pension plan An agreement whereby an employer providesbenefits to employees after they retire. (p. F7).

Postretirement benefits Payments by employers to retiredemployees for health care, life insurance, and pensions.(p. F7).

SELF-STUDY QUESTIONS

Answers are at the end of the appendix.

1. A contingency should be recorded in the accounts when:a. it is probable the contingency will happen but the

amount cannot be reasonably estimated.b. it is reasonably possible the contingency will happen

and the amount can be reasonably estimated.c. it is reasonably possible the contingency will happen

but the amount cannot be reasonably estimated.d. it is probable the contingency will happen and the

amount can be reasonably estimated.

2. At December 31, Anthony Company prepares an adjust-ing entry for a product warranty contract. Which of thefollowing accounts are included in the entry?a. Warranty Expense.b. Estimated Warranty Liability.c. Repair Parts/Wages Payable.d. Both (a) and (b).

3. Lease A does not contain a bargain purchase option, butthe lease term is equal to 90 percent of the estimated eco-nomic life of the leased property. Lease B does not transfer

(SO 1)

(SO 1)

(SO 2)



ownership of the property to the lessee by the end of thelease term, but the lease term is equal to 75 percent of theestimated economic life of the lease property. How shouldthe lessee classify these leases?

Lease A Lease B

a. Operating lease Capital leaseb. Operating lease Operating leasec. Capital lease Capital leased. Capital lease Operating lease

4. Which of the following is not an additional fringe benefit?a. Salaries.b. Paid absences.c. Paid vacations.d. Postretirement pensions.

(SO 3)

QUESTIONS

1. What is a contingent liability? Give an example of a con-tingent liability that is usually recorded in the accounts.

2. Under what circumstances is a contingent liability dis-closed only in the notes to the financial statements?Under what circumstances is a contingent liability notrecorded in the accounts nor disclosed in the notes to thefinancial statements?

3. (a) What is a lease agreement? (b) What are the two mostcommon types of leases? (c) Distinguish between the twotypes of leases.

4. Orbison Company rents a warehouse on a month-to-month basis for the storage of its excess inventory. Thecompany periodically must rent space when its productiongreatly exceeds actual sales.What is the nature of this typeof lease agreement, and what accounting treatment shouldbe accorded it?

5. Costello Company entered into an agreement to lease 12computers from Estes Electronics Inc. The present valueof the lease payments is $186,300. Assuming that this is acapital lease, what entry would Costello Company makeon the date of the lease agreement?

6. Identify three additional types of fringe benefits associ-ated with employees’ compensation.

7. Often during job interviews, the candidate asks the poten-tial employer about the firm’s paid absences policy. Whatare paid absences? How are they accounted for?

8. What are the two types of postretirement benefits?During what years does the FASB advocate expensing theemployer’s costs of these postretirement benefits?

9. What basis of accounting for the employer’s cost ofpostretirement healthcare and life insurance benefits hasbeen used by most companies, and what basis does theFASB advocate in the future? Explain the basic differencebetween these methods in recognizing postretirementbenefit costs.

10. Identify the three parties in a pension plan. What roledoes each party have in the plan?

11. Brenna Ottare and Caitlin Wilkes are reviewing pensionplans. They ask your help in distinguishing between a defined-contribution plan and a defined-benefit plan.Explain the principal difference to Brenna and Caitlin.

Go to the book’s companion website,www.wiley.com/college/weygandt,for Additional Self-Study Questions.

BRIEF EXERCISES

BEF-1 On December 1, Vina Company introduces a new product that includes a 1-year war-ranty on parts. In December 1,000 units are sold. Management believes that 5% of the units willbe defective and that the average warranty costs will be $60 per unit. Prepare the adjusting entryat December 31 to accrue the estimated warranty cost.

BEF-2 Prepare the journal entries that the lessee should make to record the following trans-actions.

1. The lessee makes a lease payment of $80,000 to the lessor in an operating lease transaction.2. Zander Company leases a new building from Joel Construction, Inc. The present value of the

lease payments is $900,000. The lease qualifies as a capital lease.

BEF-3 In Alomar Company, employees are entitled to 1 day’s vacation for each monthworked. In January, 50 employees worked the full month. Record the vacation pay liability forJanuary assuming the average daily pay for each employee is $120.

Prepare adjusting entry forwarranty costs.

(SO 1)

Record estimated vacation benefits.

(SO 3)

Prepare entries for operatingand capital leases.

(SO 2)


Exercises F11

F-1 James Morrison Corporation leases new equipment on December 31, 2011. Thelease transfers ownership of the equipment to James Morrison at the end of the lease. The pres-ent value of the lease payments is $192,000. After recording this lease, James Morrison has as-sets of $1,800,000, liabilities of $1,100,000, and stockholders’ equity of $700,000. (a) Prepare theentry to record the lease, and (b) compute and discuss the debt to total assets ratio at year-end.

Do it! Prepare entry for lease, andcompute debt to total assets ratio.

(SO 2)

ReviewDo it!

EF-1 Boone Company sells automatic can openers under a 75-day warranty for defectivemerchandise. Based on past experience, Boone Company estimates that 3% of the units soldwill become defective during the warranty period. Management estimates that the average costof replacing or repairing a defective unit is $15. The units sold and units defective that occurredduring the last 2 months of 2011 are as follows.

Units Units DefectiveMonth Sold Prior to December 31

November 30,000 600December 32,000 400

Instructions(a) Determine the estimated warranty liability at December 31 for the units sold in November

and December.(b) Prepare the journal entries to record the estimated liability for warranties and the costs

(assume actual costs of $15,000) incurred in honoring 1,000 warranty claims.(c) Give the entry to record the honoring of 500 warranty contracts in January at an average cost

of $15.

EF-2 Larkin Online Company has the following liability accounts after posting adjustingentries: Accounts Payable $63,000, Unearned Ticket Revenue $24,000, Estimated WarrantyLiability $18,000, Interest Payable $8,000, Mortgage Payable $120,000, Notes Payable $80,000,and Sales Taxes Payable $10,000.Assume the company’s operating cycle is less than 1 year, ticketrevenue will be earned within 1 year, warranty costs are expected to be incurred within 1 year,and the notes mature in 3 years.

Instructions(a) Prepare the current liabilities section of the balance sheet, assuming $40,000 of the mortgage

is payable next year.(b) Comment on Larkin Online Company’s liquidity, assuming total current assets are $300,000.

EF-3 Presented below are two independent situations.

1. Speedy Car Rental leased a car to Rundgren Company for 1 year. Terms of the operatinglease agreement call for monthly payments of $500.

2. On January 1, 2011, Miles Inc. entered into an agreement to lease 20 computers from HaloElectronics. The terms of the lease agreement require three annual rental payments of$40,000 (including 10% interest) beginning December 31, 2011.The present value of the threerental payments is $99,474. Miles considers this a capital lease.

Instructions(a) Prepare the appropriate journal entry to be made by Rundgren Company for the first lease

payment.(b) Prepare the journal entry to record the lease agreement on the books of Miles Inc. on

January 1, 2011.

EF-4 Bunill Company has two fringe benefit plans for its employees:

1. It grants employees 2 days’ vacation for each month worked. Ten employees worked theentire month of March at an average daily wage of $80 per employee.

2. It has a defined-contribution pension plan in which the company contributes 10% of gross earn-ings.Gross earnings in March were $30,000. The payment to the pension fund has not been made.

InstructionsPrepare the adjusting entries at March 31.

EXERCISES

Record estimated liability andexpense for warranties.

(SO 1)

Prepare the current liabilitiessection of the balance sheet.

(SO 1)

Prepare journal entries for op-erating lease and capital lease.

(SO 2)

Prepare adjusting entries forfringe benefits.

(SO 3)



PROBLEMS: SET A

PF-1A On January 1, 2011, the ledger of Shumway Software Company contains the followingliability accounts.

Accounts Payable $42,500Sales Taxes Payable 5,800Unearned Service Revenue 15,000

During January the following selected transactions occurred.

Jan. 1 Borrowed $15,000 in cash from Amsterdam Bank on a 4-month, 8%, $15,000 note.5 Sold merchandise for cash totaling $10,400 which includes 4% sales taxes.

12 Provided services for customers who had made advance payments of $9,000. (CreditService Revenue.)

14 Paid state treasurer’s department for sales taxes collected in December 2010 ($5,800).20 Sold 700 units of a new product on credit at $52 per unit, plus 4% sales tax. This new

product is subject to a 1-year warranty.25 Sold merchandise for cash totaling $12,480, which includes 4% sales taxes.

Instructions(a) Journalize the January transactions.(b) Journalize the adjusting entries at January 31 for (1) the outstanding notes payable, and

(2) estimated warranty liability, assuming warranty costs are expected to equal 5% of sales ofthe new product.

(c) Prepare the current liabilities section of the balance sheet at January 31, 2011. Assume nochange in accounts payable.

PF-2A Presented below are three different lease transactions in which Ortiz Enterprisesengaged in 2011.Assume that all lease transactions start on January 1, 2011. In no case does Ortizreceive title to the properties leased during or at the end of the lease term.

Lessor

Schoen Inc. Casey Co. Lester Inc.

Type of property Bulldozer Truck FurnitureBargain purchase option None None NoneLease term 4 years 6 years 3 yearsEstimated economic life 8 years 7 years 5 yearsYearly rental $13,000 $15,000 $4,000Fair market value of leased

asset $80,000 $72,000 $27,500Present value of the lease

rental payments $48,000 $62,000 $12,000

Instructions(a) Identify the leases above as operating or capital leases. Explain.(b) How should the lease transaction with Casey Co. be recorded on January 1, 2011?(c) How should the lease transactions for Lester Inc. be recorded in 2011?

Visit the book’s companion website at www.wiley.com/college/weygandt, and choose the StudentCompanion site, to access Exercise Set B and a set of Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES ww

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Prepare current liability entries,adjusting entries, and currentliabilities section.

(SO 1)

Analyze three different leasesituations and prepare journalentries.

(SO 2)

Prepare current liability entries,adjusting entries, and currentliabilities section.

(SO 1)

PF-1B On January 1, 2011, the ledger of Zaur Company contains the following liabilityaccounts.

Accounts Payable $52,000Sales Taxes Payable 7,700Unearned Service Revenue 16,000

PROBLEMS: SET B

(c) Total current liabilities$67,756


Broadening Your Perspective F13

Analyze three different leasesituations and prepare journalentries.

(SO 2)

Visit the book’s companion website at www.wiley.com/college/weygandt, and choose the StudentCompanion site, to access Problem Set C.

PROBLEMS: SET C ww

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Financial Reporting ProblemsBYPF-1 Refer to the financial statements of PepsiCo and the Notes to Consolidated Finan-cial Statements in Appendix A to answer the following questions about contingent liabilities,lease liabilities, and pension costs.(a) Where does PepsiCo report its contingent liabilities?(b) What is management’s opinion as to the ultimate effect of the “various claims and legal pro-

ceedings” pending against the company?

FINANCIAL REPORTING AND ANALYSIS

B R O A D E N I N G Y O U R P E R S P E C T I V E

During January the following selected transactions occurred.

Jan. 5 Sold merchandise for cash totaling $17,280, which includes 8% sales taxes.12 Provided services for customers who had made advance payments of $10,000. (Credit

Service Revenue.)14 Paid state revenue department for sales taxes collected in December 2010 ($7,700).20 Sold 600 units of a new product on credit at $50 per unit, plus 8% sales tax. This new

product is subject to a 1-year warranty.21 Borrowed $18,000 from UCLA Bank on a 3-month, 9%, $18,000 note.25 Sold merchandise for cash totaling $12,420, which includes 8% sales taxes.

Instructions(a) Journalize the January transactions.(b) Journalize the adjusting entries at January 31 for (1) the outstanding notes payable, and

(2) estimated warranty liability, assuming warranty costs are expected to equal 7% of sales ofthe new product. (Hint: Use one-third of a month for the UCLA Bank note.)

(c) Prepare the current liabilities section of the balance sheet at January 31, 2011. Assume nochange in accounts payable.

PF-2B Presented below are three different lease transactions that occurred for Milo Inc. in 2011.Assume that all lease contracts start on January 1, 2011. In no case does Milo receive title to theproperties leased during or at the end of the lease term.

Lessor

Gibson Delivery Eller Co. Louis Auto

Type of property Computer Delivery equipment AutomobileYearly rental $ 8,000 $ 4,200 $ 3,700Lease term 6 years 4 years 2 yearsEstimated economic life 7 years 7 years 5 yearsFair market value of leased asset $44,000 $19,000 $11,000Present value of the lease rental

payments $41,000 $13,000 $ 6,400Bargain purchase option None None None

Instructions(a) Which of the leases above are operating leases and which are capital leases? Explain.(b) How should the lease transaction with Eller Co. be recorded in 2011?(c) How should the lease transaction for Gibson Delivery be recorded on January 1, 2011?

(c) Total current liabilities$82,745


(c) Where did PepsiCo report the details of its lease obligations? What amount of rent expensefrom operating leases did PepsiCo incur in 2008? What was PepsiCo’s total future minimumannual rental commitment under noncancelable operating leases as of December 27, 2008?

(d) What type of employee pension plan does PepsiCo have?(e) What is the amount of postretirement benefit expense (other than pensions) for 2008?

BYPF-2 Presented below is the lease portion of the notes to the financial statements of CFIndustries, Inc.

CF INDUSTRIES, INC.Notes to the Financial Statements

Leases The present value of future minimum capital lease payments and the future minimumlease payments under noncancelable operating leases at December 31, 2008, are:

(in millions)Capital Lease Operating Lease

Payments Payments

2009 $ 7,733 $33.22010 6,791 27.22011 6,730 11.42012 6,788 7.32013 6,785 4.5Thereafter 13,441 11.3

Future minimum lease payments 48,268 $94.9Less: Equivalent interest 11,391

Present value 36,877Less: Current portion 5,570

$31,307

Rent expense for operating leases was $38.1 million for the year ended December 31, 2008,$31.2 million for 2007, and $26.5 million for 2006.

InstructionsWhat type of leases does CF Industries, Inc. use? What is the amount of the current portion ofthe capital lease obligation?


Decision Making Across the OrganizationBYPF-3 Presented below is the condensed balance sheet for Express, Inc. as of December 31,2011.

EXPRESS, INC.Balance Sheet

December 31, 2011

Current assets $ 800,000 Current liabilities $1,200,000Plant assets 1,600,000 Long-term liabilities 700,000

Common stock 400,000Retained earnings 100,000

Total $2,400,000 Total $2,400,000

Express has decided that it needs to purchase a new crane for its operations. The new cranecosts $900,000 and has a useful life of 15 years. However, Express’s bank has refused to provideany help in financing the purchase of the new equipment, even though Express is willing to payan above-market interest rate for the financing.

CRITICAL THINKING


The chief financial officer for Express, Lisa Colder, has discussed with the manufacturer ofthe crane the possibility of a lease agreement. After some negotiation, the crane manufactureragrees to lease the crane to Express under the following terms: length of the lease 7 years; pay-ments $100,000 per year. The present value of the lease payments is $548,732.

The board of directors at Express is delighted with this new lease. They reason they havethe use of the crane for the next 7 years. In addition, Lisa Colder notes that this type of financ-ing is a good deal because it will keep debt off the balance sheet.

InstructionsWith the class divided into groups, answer the following.

(a) Why do you think the bank decided not to lend money to Express, Inc.?(b) How should this lease transaction be reported in the financial statements?(c) What did Lisa Colder mean when she said “leasing will keep debt off the balance sheet”?

Answers to Self-Study Questions1. d 2. d 3. c 4. a

Broadening Your Perspective F15


Documents

Other Significant Liabilitiesmyresource.phoenix.edu/secure/resource/XACC291r1/... · of the cash payments for the lease and records that amount as an asset.Illustration F-3 indicates