Chap 011

Chapter 11
Current Liabilities and Payroll

Accounting
QUESTIONS
1.
The three questions are: (1) Who must be paid? (2) When is payment due? (3) How
much is to be paid?
2.
A current liability is expected to be paid within one year or the companys operating
cycle, whichever is longer. Any liability that is not current is considered to be longterm.
3.
An estimated liability is an obligation to make a future payment, the exact amount of

which is uncertain but it is capable of being reasonably estimated.
4.
The amount of the sale for the item only is $860 ($894.40/1.04).
5.
The combined Social Security tax rate (assuming the maximum wage amount is not
yet reached) is 12.4% (6.2% + 6.2%). The maximum level of earnings [wage base on
which taxes are due] for 2003 is $87,000.
6.
The Medicare tax rate is 1.45%. This rate is applied to all wages earned by an
employeeno maximum limit exists.
7.
An employees gross earnings along with the number of withholding allowances that
an employee claims, as well as whether they are married or single, determine the
amount deducted for federal income taxes.
8.
The employee is responsible for federal income taxes, state income taxes, local
income taxes (if any), and the employee portion of the FICA taxes. The employer is
responsible for both federal and state unemployment taxes and the employer
portion of the FICA taxes.
9.
An unemployment merit rating is based on an evaluation of an employers

experience in creating or avoiding unemployment with its employees. The merit
rating affects the state unemployment taxes that the employer must pay. Merit
ratings cause more of the cost of unemployment benefits to be paid by those who
create more unemployment.
10. The obligation to correct or replace defective products (or services) is created when
the products are sold with the warranties. Even though the seller does not know
with certainty when the obligation will be paid, to whom it will be paid, or the amount
to be paid, past experience shows that some amount will probably be paid. If the
seller can reasonably estimate that amount, the warranty liability must be reported
on the balance sheet.
Solutions Manual, Chapter 11
McGraw-Hill Companies, Inc., 2005

91
11. There are no conditions in which a probable loss tied to a future event can create a
liability, regardless of its probability. A liability is an obligation created by a past
event, not by a future event. If a disaster occurs, the company must report the loss
in the period when it occurs.
12.A A wage bracket withholding table shows for a pay period of a given length (weekly,
biweekly, semimonthly, monthly), the amounts of federal income taxes to be
withheld from the pay of an employee, at varying amounts of gross pay and varying
numbers of withholding allowances.
13.A Single employee earning $725 with two allowances has $81 taxes withheld.
Single employee earning $625 with no allowances has $86 taxes withheld.
14. Krispy Kreme does not report short-term notes payable on its balance sheet.
Instead, it appears to meet short-term borrowing needs by drawing on revolving
lines of credit.
Lines of credit differ from short-term notes in several respects. For example, notes
payable are structured with definite amounts borrowed (face value) and with a strict
repayment date (due date). Lines of credit allow flexibility by only specifying the
maximum amount that can be borrowed. A company can borrow none or something
less than the maximum, if desired. Lines of credit usually also offer flexible dates
for repayment.
15. Tastykake has two income-tax-related accounts on its balance sheet. One account
is a current Deferred Income Taxes asset account and another is a noncurrent
Deferred Income Taxes asset account. Deferred tax assets are accounts that
represent income taxes that the company has paid before the taxes have been
reported on the income statement as income tax expenses.
16. Harley-Davidson has three current liabilities: Accounts Payable, Accrued Expenses
and Other Liabilities, and Current Portion of Finance Debt. It is not clear where the
payroll-related liabilities are reported but they are probably included in Accrued
Expenses and Other Liabilities.

92
Fundamental Accounting Principles, 17th Edition
QUICK STUDIES
Quick Study 11-1 (5 minutes)
Items 1, 3, 5 and 6 are current liabilities for this company.

Sept. 30
Cash...........................................................................5,200
Sales....................................................................
Sales Taxes Payable..........................................
5,000
200
To record cash sales and 4% sales tax.
Sept. 30
Cost of Goods Sold..................................................2,900

Merchandise Inventory......................................
2,900
To record cost of Sept. 30th sales.
Oct. 15
Sales Taxes Payable................................................ 200

Cash.....................................................................
200
To record remittance of sales taxes to govt.

Oct. 31
Cash...........................................................................
4,000,000
Unearned Ticket Revenue.................................
4,000,000
To record sales in advance of concerts.
Nov. 5
Unearned Ticket Revenue.......................................

1,000,000
Earned Ticket Revenue......................................
1,000,000
To record concert revenues earned.

93

1.
Computation of interest payable at December 31, 2005:

Days from November 7 to December 31..................... 54 days
Accrued interest (8% x $150,000 x 54/360)................. $1,800
2. 2005
Dec.31 Interest Expense....................................................... 1,800
Interest Payable.................................................
1,800
To record accrual of interest

(8% x $150,000 x 54/360).
3. 2006
Feb. 5 Interest Expense....................................................... 1,200
Interest Payable........................................................ 1,800
Notes Payable...........................................................150,000
Cash.....................................................................
153,000
To record payment of note plus interest

(8% x $150,000 x 90/360).

[Note: Two months (January and February) of earnings have
already been recorded for each of the 5 employees.]
Mar. 31
Payroll Taxes Expense.............................................1,318.50

FICASocial Security Taxes Payable1..............
FICAMedicare Taxes Payable2........................
State Unemployment Taxes Payable3................
Federal Unemployment Taxes Payable4............
806.00
188.50
252.00
72.00
To record employer payroll taxes.

$13,000 x 6.2% = $806.00
2
$13,000 x 1.45% = $188.50
3
[5 x ($7,000 - ($2,600 x 2))] x 2.8% = $252.00
4
[5 x ($7,000 - ($2,600 x 2))] x 0.8% = $72.00
1

2005
July 24
Estimated Warranty Liability...................................

Repair Parts Inventory........................................
35
35
To record cost of warranty repairs.

94

Dec. 31 Employee Bonus Expense...................................... 10,000
Bonus Payable..................................................
10,000
To record expected bonus costs.

1. (b); reasonis reasonably estimated but not a probable loss.
2. (b); reasonprobable loss but cannot be reasonably estimated.
3. (a); reasoncan be reasonably estimated and loss is probable.

Times interest earned =
$1,575,000
$137,000
= 11.5 times
Interpretation: This companys times interest earned ratio of 11.5 exceeds (is
superior to) its competitors average ratio of 4.0. Moreover, a times interest
earned of 11.5 suggests sufficient income to cover interest obligations.
Quick Study 11-10B (10 minutes)

Dec. 31
Income Taxes Expense............................................ 30,000

Income Taxes Payable.......................................
Deferred Income Tax Liability...........................
22,000
8,000
To record tax expense and deferred tax liability.

95
EXERCISES
Exercise 11-1 (10 minutes)
1.
2.
C
C
3.
4.
N
C
5.
6.
C
C
7.
8.
C
C
9.
10.
L
L

[Note: All entries dated December 31, 2005.]
1.
Warranty Expense....................................................
Estimated Warranty Liability.............................
3,600
3,600
To record warranty expense [3,000 units x 8% x $15].
2.
3.
No adjusting entry can be made since the loss cannot be reasonably

estimated. Mention of the suit as a contingent liability should be made in
the notes to the financial statements.
Vacation Benefits Expense......................................

Vacation Benefits Payable.................................
2,400
2,400
To record vacation benefits expense

[20 employees x 1 day x $120].
4.
No adjusting entry is required since it is not probable that the supplier will
default on the debt. The guarantor, Yacht Company, should describe the
guarantee in its financial statement notes as a contingent liability.
5.
Cash........................................................................... 2,100,000
Sales....................................................................
2,000,000
100,000
To record sales and sales taxes.
Cost of Goods Sold.................................................. 1,000,000

1,000,000
To record cost of sales.
6.
Unearned Services Revenue...................................

Earned Services Revenue.................................
40,000
40,000
To record product revenue earned.

96

1.
B
= 0.03 ($1,000,000 B)
B
= $30,000 0.03B
1.03B = $30,000
B
= $29,126 (rounded to nearest dollar)
2.
2005
Dec. 31
Employee Bonus Expense.................................

Bonus Payable..........................................
29,126
29,126
To record expected bonus costs.
3.
2006
Jan. 19
Bonus Payable....................................................
Cash
....................................................................
29,126
29,126
To record payment of bonus.

1.
Maturity date = May 15 + 60 days = July 14, 2005
2a.
May 15
Cash........................................................................... 94,000
Notes Payable.....................................................
94,000
Borrowed cash by issuing an interest-bearing note.
2b.
July 14
Interest Expense*..................................................... 1,880

Notes Payable........................................................... 94,000
Cash.....................................................................
95,880
Repaid note plus interest.

* Principal.................................$94,000
x Interest rate......................... 12%
x Fraction of year................... 60/360
Total interest...........................$ 1,880

97

1.
Maturity date = November 1 + 90 days = January 30, 2006.
2.
Principal......................................................$150,000
x Interest rate..............................................
9%
x Fraction of year (Nov. 1 Dec. 31)......... 60/360
Total interest in 2005..................................$ 2,250
3.
Principal......................................................$150,000
x Interest rate..............................................
9%
x Fraction of year (Jan. 1 Jan. 30)......... 30/360
Total interest in 2006..................................$ 1,125
4a.
2005
Nov. 1
Cash...........................................................................150,000
Notes Payable.....................................................
150,000
Borrowed cash by issuing an interest-bearing note.
4b.
2005
Dec. 31
Interest Expense....................................................... 2,250

Interest Payable..................................................
2,250
Accrued interest on note payable.
4c.
2006
Jan. 30
Interest Expense....................................................... 1,125

Interest Payable........................................................ 2,250
Notes Payable...........................................................150,000
Cash.....................................................................
153,375

98

Subject
to Tax
Rate
Tax
Explanation
a.
FICA--Social Security........ $ 800
6.20%
FICAMedicare...............
800
1.45
11.60 Full amount is subject to tax.
FUTA...............................
600
0.80
4.80 $200 is over the maximum.
SUTA...............................
600
2.90
17.40 $200 is over the maximum.
$ 49.60 Full amount is subject to tax.
b.
FICA--Social Security........ $2,100
6.20% $130.20 Full amount is subject to tax.
2,100
1.45
FUTA...............................
0.80
0.00 Full amount is over maximum.
SUTA...............................
2.90
c.
FICA--Social Security........ $5,000
6.20%
8,000
1.45
FUTA...............................
0.80
SUTA...............................
2.90
$310.00 $3,000 is over the maximum.


Sept. 30
(1)
Salaries Expense...................................................... 800.00
FICASocial Security Taxes Payable..............
FICAMedicare Taxes Payable........................
Employee Federal Income Taxes Payable.........
Accrued Payroll Payable...................................
49.60
11.60
135.00
603.80
To record payroll for pay period ended September 30.
(2)
Sept. 30 Payroll Taxes Expense............................................. 83.40
Federal Unemployment Taxes Payable............
State Unemployment Taxes Payable................
49.60
11.60
4.80
17.40

99

1. Warranty Expense = 4% of dollar sales = 4% x $5,500 = $220
2. The December 31, 2005, balance of the liability equals the expense
because no repairs are provided in 2005. Therefore, the ending balance
of the Estimated Warranty Liability account is $220.
3. The company should report no additional warranty expense in 2006 for
this copier.
4. The December 31, 2006, balance of the Estimated Warranty Liability
account equals the 2006 beginning balance minus the costs incurred in
2006 to repair the copier:
Beginning 2005 balance.................. $220
Less parts cost................................. (199)
Ending 2006 balance........................ $ 21
5. Journal entries:
2005
(a)
Aug. 16 Cash...........................................................................
Sales....................................................................
5,500
5,500
To record cash sale of copier.
Aug. 16 Cost of Goods Sold..................................................

3,800
3,800
To record cost of August 16 sale.
(b)
Dec. 31 Warranty Expense....................................................
220
220
To record warranty expense for copier sold in 2005.
2006
(c)
Nov. 22 Estimated Warranty Liability...................................
Repair Parts Inventory.......................................
199
199
To record cost of warranty repairs.

100

(a)
Numerator
Income before
interest & taxes.....$223,000
(b)
(c)
(d)
(e)
(f)
$205,000
$218,000
$407,000
$121,000 $ 8,000
$ 15,000
8,000
$ 12,000
$ 12,000 $12,000
27.25
33.92
Denominator
Interest expense......$ 48,000
Ratio.......................
4.65
13.67
10.08
0.67
Analysis: Company (d) has the strongest ability to pay interest expense as
it comes due as evidenced by the companys times interest earned
(coverage) ratio of 33.92 times.
Exercise 11-10A (15 minutes)
Gross pay..............................................................................
Social Security tax deduction (6.2%)................................ $ 45.57
Medicare tax deduction (1.45%)........................................
10.66
Income tax deduction (from Exhibit 11A.6)...................... 100.00
Total deductions..................................................................
Net pay.................................................................................
$735.00
156.23
$578.77
Note: Trish Farqua is not subject to state income tax because her cumulative earnings
from the previous pay period exceed the $9,000 maximum.
Exercise 11-11A (15 minutes)

Regular pay (48 hours @ $12)...........................................
Overtime premium pay (8 hours @ $6.00)........................
Gross pay..........................................................................
FICASocial Security tax deduction (6.2%)....................
FICAMedicare tax deduction (1.45%)............................
Income tax deduction (from Exhibit 11A.6)......................
Total deductions................................................................
Net pay.................................................................................
$576.00
48.00
624.00
$38.69
9.05
63.00
110.74
$513.26

101
Exercise 11-12B (25 minutes)

1.
Income Taxes Payable (target balance)...............................................

$29,100
Total accrued [($27,900 + $18,200 + $32,700) x .30]............................
23,640
Adjustment (additional expense)..........................................................
$ 5,460
2.
2005
(a)
Dec. 31 Income Tax Expense................................................ 5,460
Income Taxes Payable.......................................
5,460
To adjust tax expense and liability.
2006
Jan. 20
(b)
Income Taxes Payable............................................. 29,100
Cash.....................................................................
29,100
To make the final quarterly payment

of income taxes for 2005.
PROBLEM SET A
Problem 11-1A (45 minutes)
Frier
1.
2.
3.
4.
Com. Bank
UMB
Maturity dates
Date of the note..............................May 19
Term of the note (in days).............
90
Maturity date...................................Aug. 17
July 8
120
Nov. 5
Nov. 28
60
Jan. 27
Interest due at maturity

Principal of the note.......................$30,000
Annual interest rate.......................
9%
Fraction of year.............................. 90/360
Interest expense.............................$ 675
$60,000
10%
120/360
$ 2,000
$21,000
8%
60/360
$ 280
Accrued interest on UMB note at the end of 2004

Total interest for note....................................................
Fraction of term in 2004.................................................
Accrued interest expense.............................................
.........................................................................................
Interest on UMB note in 2005
Total interest for note....................................................
Fraction of term in 2005.................................................

102
280
33/60
$ 154
280
27/60
Interest expense in 2005...............................................
126

103
Problem 11-1A (Concluded)

5.
2004
Apr. 20 Merchandise Inventory............................................ 38,500
Accounts PayableFrier...................................
38,500
Purchased merchandise on credit.
May 19 Accounts PayableFrier......................................... 38,500

Cash.....................................................................
Notes PayableFrier.........................................
8,500
30,000
Paid $8,500 cash and gave a 90-day,

9% note to extend due date on account.
July 8 Cash........................................................................... 60,000

Notes PayableCommunity.............................
60,000
Borrowed cash with a 120-day, 10% note.
Aug. 17 Interest Expense.......................................................

675
Notes PayableFrier............................................... 30,000
Cash.....................................................................
30,675
Paid note with interest.
Nov. 5 Interest Expense....................................................... 2,000

Notes PayableCommunity................................... 60,000
Cash.....................................................................
62,000
28 Cash........................................................................... 21,000
Notes PayableUMB Bank...............................
21,000
Borrowed cash with 60-day, 8% note.
Dec. 31 Interest Expense.......................................................

154
154
2005
Jan. 27 Interest Expense.......................................................
126
Notes PayableUMB Bank..................................... 21,000
Interest Payable .......................................................
154
Cash.....................................................................
21,280

104

1.
2004
Nov. 11 Cash...........................................................................
Sales....................................................................
6,000
6,000
Sold razors to customers.
11 Cost of Goods Sold..................................................

1,350
1,350
To record cost of November 11 sale (75 x $18).
30 Warranty Expense....................................................
420
420
To record razor warranty expense

and liability at 7% of selling price.
Dec. 9 Estimated Warranty Liability...................................

270
270
To record cost of razor warranty

replacements (15 x $18).
16 Cash........................................................................... 16,800
Sales....................................................................
16,800

3,780
3,780
To record cost of December 16 sale (210 x $18).
29 Estimated Warranty Liability...................................

540
540

1,176
1,176


105

2005
Jan. 5 Cash........................................................................... 10,400
Sales....................................................................
10,400

2,340
2,340
To record cost of January 5 sale (130 x $18).

900
900

728
728

2.
Warranty expense for November 2004 and December 2004

Sales
Percent Warranty Expense
November..................
$ 6,000
7%
$ 420
December..................
16,800
7
1,176
Total...........................
$22,800
$1,596
3.
Warranty expense for January 2005

Sales in January...............................$10,400
Warranty percent..............................
7%
Warranty expense............................$ 728
4.
Balance of the estimated liability as of December 31, 2004

Warranty expense for November.................................... $ 420
Warranty expense for December.................................... 1,176
Cost of replacing items in December (45 x $18)............
(810)
Estimated Warranty Liability balance............................. $ 786
1,050
Balance of the estimated liability as of January 31, 2005
Beginning balance.......................................................... $ 786
Warranty expense for January.......................................
728
Cost of replacing items in January (50 x $18)..............
( 900)
Estimated Warranty Liability balance............................ $ 614
5.

106
credit
credit
debit
credit
credit
credit
debit
credit

1. Ace Co.
Income before interest & taxes
Interest expense
$100,000
$30,000
= 3.33
$200,000
$130,000
= 1.54
2. Deuce Co.
Interest expense
3.
Sales increase by 30% (multiply prior sales by 1.3)

Sales
Variable expenses.......................
Income before interest................
Interest expense (fixed)..............
Ace Co.
$650,000
520,000
130,000
30,000
Deuce Co.
$650,000
390,000
260,000
130,000
Net income...................................
$100,000
$130,000
Net income increases by*..........
43%
86%
* Computed as the increase in net income divided by prior net income.
4.
5.

Sales
Net income...................................
Ace Co.
$750,000
600,000
150,000
30,000
$120,000
Deuce Co.
$750,000
450,000
300,000
130,000
$170,000
Net income increases by............
71%
143%

Sales
Net income...................................
Ace Co.
$900,000
720,000
180,000
30,000
$150,000
Deuce Co.
$900,000
540,000
360,000
130,000
$230,000
Net income increases by............
114%
229%

107

6.
Sales decrease by 10% (multiply prior sales by 0.9)

Ace Co.
Deuce Co.
Sales........................................
$450,000
$450,000
Variable expenses..................
360,000
270,000
Income before interest...........
90,000
180,000
Interest expense (fixed).........
30,000
130,000
Net income..............................
$ 60,000
$ 50,000
Net income decreases by......
7.
-29%
-57%

Ace Co.
Deuce Co.
Sales........................................
$300,000
$300,000
240,000
180,000
60,000
120,000
30,000
130,000
Net income..............................
$ 30,000
$ (10,000)
9.
-29%

Ace Co.
Deuce Co.
Sales........................................
$400,000
$400,000
320,000
240,000
80,000
160,000
30,000
130,000
Net income..............................
$ 50,000
$ 30,000
8.
-14%
-57%
-114%
The higher fixed cost strategy (having more fixed interest expense) of
Deuce Co. accentuates the effects of increases and decreases in sales.
That is, increases in sales produce greater increases in net income and
decreases in sales produce greater decreases in net income. The
higher fixed cost strategy of Deuce Co. is indicated by a lower value of
the times interest earned ratio.
The higher fixed cost strategy works fine if the sales level increases.
Deuce Co. enjoys greater percent increases in its net income because it
has made this choice (see parts 3, 4, and 5).
The lower fixed cost strategy protects the company if the sales level
decreases. Ace Co. experiences smaller percent decreases in its net
income because it has made this choice (see parts 6, 7, and 8).

108

1. Each employees FICA withholdings for Social Security
Dale
Ted
Kate
Chas
Maximum base.............
Earned through 8/18....
Amount subject to tax.
$87,000
86,200
$ 800
$87,000
29,700
$57,300
$87,000
6,750
$80,250
$87,000
1,050
$85,950
Earned this week.........
$ 2,000
Subject to tax...............
Tax rate.........................
800
6.20%
900
6.20%
450
6.20%
400
6.20%
Social Security tax.......
$ 49.60
$ 55.80
$ 27.90
$ 24.80
900
450
Total
400
$158.10
2. Each employees FICA withholdings for Medicare (no limits)

Dale
Ted
Kate
Chas

Tax rate.........................
$ 2,000
1.45%
$ 900
1.45%
$ 450
1.45%
$ 400
1.45%
Medicare tax.................
$ 29.00
$ 13.05
$ 6.53
$ 5.80
Kate
Chas
$ 27.90
$ 24.80
Kate
Chas
Total
$ 54.38
3. Employers FICA taxes for Social Security

Dale
Amount from part 1......
$ 49.60
Ted
$ 55.80
Total
$158.10
4. Employers FICA taxes for Medicare

Dale
$ 29.00
Ted
$ 13.05
$ 6.53
$ 5.80
Total
$ 54.38

109

5. Employers FUTA taxes
Maximum base...............
Earned through 8/18......
Amount subject to tax...
Dale
$ 7,000
86,200
0
Ted
$ 7,000
29,700
0
Kate
$ 7,000
6,750
250
Chas
$ 7,000
1,050
5,950
$ 2,000
Tax rate.........................
FUTA tax........................
0
0.8%
0.00
900
450
Total
400
0
0.8%
$ 0.00
250
0.8%
$ 2.00
400
0.8%
$ 3.20
Ted
$
0
2.15%
$ 0.00
Kate
$ 250
2.15%
$ 5.38
Chas
$ 400
2.15%
$ 8.60
10.60
Dale
$2,000.00
Ted
Kate
$900.00 $450.00
Chas
$400.00
Total
$3,750.00
(49.60)
(29.00)
(252.00)
(16.00)
$1,653.40
(55.80) (27.90)
(24.80)
(13.05)
(6.53)
(5.80)
(99.00) (54.00)
(36.00)
(16.00) (16.00)
(16.00)
$716.15 $345.57 $317.40
(158.10)
(54.38)
(441.00)
(64.00)
$3,032.52
5.20
6. Employers SUTA taxes

Dale
Subject to tax (from 5).
Tax rate.........................
SUTA tax.......................
0
2.15%
$ 0.00
Total
$ 13.98
7. Each employees net (take-home) pay

Gross earnings............
Less
FICA Social Sec. tax....
FICA Medicare taxes....
Withholding taxes........
Health insurance.........
Take-home pay............
8. Employers total payroll-related expense for each employee

Dale
Gross earnings............. $2,000.00
Plus
FICA Social Sec. tax......
49.60
FICA Medicare taxes.....
29.00
FUTA tax........................
0.00
SUTA tax........................
0.00
Health insurance...........
16.00
Pension contrib. (8%). . .
160.00
110
Ted
$ 900.00
Kate
$450.00
Chas
$400.00
Total
$3,750.00
55.80
13.05
0.00
0.00
16.00
72.00
27.90
6.53
2.00
5.38
16.00
36.00
24.80
5.80
3.20
8.60
16.00
32.00
158.10
54.38
5.20
13.98
64.00
300.00
Total payroll expense.... $2,254.60
$1,056.85
$543.81
$490.40
$4,345.66

111

Part 1
Jan.
Office Salaries Expense...........................................

11,380.00
Sales Salaries Expense...........................................
32,920.00
FICASocial Sec. Taxes Payable*...................
FICAMedicare Taxes Payable**.....................
Employee Fed. Inc. Taxes Payable...................
Employee Medical Insurance Payable.............
Employee Union Dues Payable.........................
2,746.60
642.35
6,340.00
670.00
420.00
33,481.05
To record payroll for period.

* $44,300 x 6.2%
**$44,300 x 1.45%
Part 2
Jan. 8
Payroll Taxes Expense.............................................

5,515.35
FICASocial Sec. Taxes Payable.....................
State Unemployment Taxes Payable*...............
Federal Unemployment Taxes Payable**............
2,746.60
642.35
1,772.00
354.40

* $44,300 x .04 = $1,772.00
**$44,300 x .008 = $354.40

112
Problem 11-6AA (50 minutes)

Mar. 15 FICA Social Security Taxes Payable....................3,224
FICA Medicare Taxes Payable.............................. 754
Employee Fed. Income Taxes Payable...................3,900
Cash.....................................................................
7,878
To record payment of FICA and federal

income taxes.
31 Office Salaries Expense...........................................

10,400
Shop Wages Expense..............................................
15,600
FICA Social Sec. Taxes Payable.....................
FICA Medicare Taxes Payable........................
Employee Fed. Income Taxes Payable.............
1,612
377
3,900
20,111
31 Accrued Payroll Payable.........................................

20,111
Cash.....................................................................
20,111
To record payment of payroll.*
*The check numbers may be entered in the Payroll Register.

31 Payroll Taxes Expense*............................................2,853
FICA Social Sec. Taxes Payable.....................
1,612
377
720
144

*
Amount earned through 2/28 = 2 x $2,600 = $5,200
Subject to SUTA/FUTA in March = $7,000 - $5,200 = $1,800
SUTA = $1,800 x 10 employees x 4.0% = $720
FUTA = $1,800 x 10 employees x 0.8% = $144
FICA Social Security Taxes = $1,612 (same as employees)
FICA Medicare Taxes = $377 (same as employees)

113
Problem 11-6AA (Concluded)

Apr. 15
FICA Social Security Taxes Payable....................3,224

FICA Medicare Taxes Payable.............................. 754
Employee Fed. Income Taxes Payable...................3,900
Cash.....................................................................
7,878
To record payment of FICA and

federal income taxes.
15 State Unemployment Taxes Payable......................2,800

Cash.....................................................................
2,800
To record payment of SUTA taxes [$2,080 + $720].
30 Federal Unemployment Taxes Payable.................. 560

Cash.....................................................................
560
To record payment of FUTA taxes [$416 + $144].
30 No entry required upon mailing Form 941.

114
PROBLEM SET B
Problem 11-1B (45 minutes)
Quinn
Products
1.
July 15
120
Nov. 12
Dec. 6
45
Jan. 20
$ 9,000
10%
120/360
$ 300
$16,000
9%
45/360
$ 180
Interest due at maturity

Principal of the note.........................$3,600
Annual interest rate.......................... 15%
Fraction of year................................60/360
Interest expense...............................$ 90
3.
City
Bank
Maturity dates
Date of the note................................
May 23
Term of the note (in days)................
60
Maturity date.....................................
July 22
2.
Blackhawk
Bank
Accrued interest on City Bank note at the end of 2004

Total interest for note.................................................................$ 180
Fraction of term in 2004............................................................. 25/45
Accrued interest expense..........................................................$ 100
4.
Interest in 2005
Total interest for note.................................................................$ 180
Fraction of term in 2005............................................................. 20/45
Interest expense in 2005............................................................$
80

115
Problem 11-1B (Concluded)

5.
2004
Apr. 22
Merchandise Inventory............................................
Accounts Payable Quinn Products...
4,000
4,000
Purchased merchandise on credit.
May 23
Accounts Payable Quinn Products......................

Cash.....................................................................
Notes Payable Quinn Products......................
4,000
400
3,600
Paid $400 cash and gave a 60-day,

15% note to extend due date on account.
July 15
Cash...........................................................................
Notes Payable Blackhawk Bank.....................
9,000
9,000
22
Interest Expense.......................................................
Notes Payable Quinn Products............................
Cash.....................................................................
90
3,600
3,690
Nov. 12
Notes Payable Blackhawk Bank...........................
Cash.....................................................................
300
9,000
9,300
Dec. 6
Cash........................................................................... 16,000
Notes Payable City Bank................................
16,000
31
100
100
2005
Jan. 20 Interest Expense.......................................................
80
Interest Payable........................................................
100
Notes Payable City Bank...................................... 16,000
Cash.....................................................................
16,180

116

1.
2004
Nov. 16 Cash...........................................................................
Sales....................................................................
1,750
1,750
Sold coffee grinders to customers.

700
700
To record cost of November 16 sale (50 x $14).
175
175
To record coffee grinder warranty expense

Dec. 12 Estimated Warranty Liability...................................

84
84
To record cost of coffee grinder

warranty replacements (6 x $14).
18 Cash...........................................................................
Sales....................................................................
5,250
5,250

2,100
2,100
To record cost of December 18 sale (150 x $14).

238
238

525
525


117

2005
Jan. 7 Cash...........................................................................
Sales....................................................................
2,100
2,100

840
840
To record cost of January 7 sale (60 x $14).

532
532

210
210

2.
Warranty expense for November 2004 and December 2004

Sales
Percent
Warranty Expense
November......................... $1,750
10%
$ 175
December.........................
5,250
10
525
Total................................... $7,000
$ 700
3.
Warranty expense for January 2005

Sales in January............................. $2,100
Warranty percent............................ 10%
Warranty expense........................... $ 210
4.
Balance of the estimated liability as of December 31, 2004

Warranty expense for November.................................... $ 175
Warranty expense for December....................................
525
Cost of replacing items in December (23 x $14)............ (322)
credit
credit
debit
credit
Balance of the estimated liability as of January 31, 2005

Beginning balance............................................................ $ 378
Warranty expense for January........................................
210
Cost of replacing items in January (38 x $14)............... (532)
credit
credit
debit
credit
5.

118

1. Virgo Co.
Interest expense
$60,000
$45,000
= 1.33
$30,000
$15,000
= 2.0
2. Zodiac Co.
Interest expense
3.
4.
5.

Sales........................................
Net income..............................
Virgo Co.
$132,000
66,000
66,000
45,000
$ 21,000
Zodiac Co.
$132,000
99,000
33,000
15,000
$ 18,000
Net income increases by.......
40%
20%

Sales........................................
Net income..............................
Virgo Co.
$168,000
84,000
84,000
45,000
$ 39,000
Zodiac Co.
$168,000
126,000
42,000
15,000
$ 27,000
160%
80%

Sales........................................
Net income..............................
Virgo Co.
$228,000
114,000
114,000
45,000
$ 69,000
Zodiac Co.
$228,000
171,000
57,000
15,000
$ 42,000
360%
180%

119

6.

Virgo Co.
Zodiac Co.
Sales........................................
$ 96,000
$ 96,000
48,000
72,000
48,000
24,000
45,000
15,000
Net income..............................
$ 3,000
$ 9,000
7.
-200%
-100%

Virgo Co.
Zodiac Co.
Sales........................................
$ 24,000
$24,000
12,000
18,000
12,000
6,000
45,000
15,000
Net income..............................
$(33,000)
$(9,000)
9.
-40%

Virgo Co.
Zodiac Co.
Sales........................................
$ 60,000
$ 60,000
30,000
45,000
30,000
15,000
45,000
15,000
Net income..............................
$(15,000)
$
0
8.
-80%
-320%
-160%
The higher fixed cost strategy (having more fixed interest expense) of
Virgo Co. accentuates the effects of increases and decreases in sales.
That is, increases in sales produce greater increases in net income and
decreases in sales produce greater decreases in net income. The
higher fixed cost strategy of Virgo Co. is indicated by a lower value of
the times interest earned ratio.
The higher fixed cost strategy works fine if the sales level increases.
Virgo Co. enjoys substantially greater increases in its net income
because it has made this choice (see parts 3, 4, and 5).
The lower fixed cost strategy protects the company if the sales level
decreases. Zodiac Co. experiences much smaller decreases in its net
income because it has made this choice (see parts 6, 7, and 8).

120

1. Each employees FICA withholdings for Social Security
Alli
Eve
Hong
Juan
Maximum base.............
$ 87,000
$87,000
$87,000
$87,000
Earned through 9/23....
85,400
59,085
6,650
22,200
Amount subject to tax.
$ 1,600
$27,915
$80,350
$64,800
$ 2,500
$ 1,515
475
600
$ 1,600
$ 1,515
475
600
Tax rate.........................
6.20%
6.20%
6.20%
6.20%
Social Security tax.......
$ 99.20
$ 93.93
$ 29.45
$ 37.20
Total
$259.78
2. Each employees FICA withholdings for Medicare (no limits)

Alli
Eve
Hong
$ 2,500
$ 1,515
Tax rate.........................
1.45%
1.45%
1.45%
Medicare tax.................
$ 36.25
$ 21.97
$ 6.89
475
Juan
$
Total
600
1.45%
8.70
$ 73.81
3. Employers FICA taxes for Social Security

Alli
Eve
Hong
Juan
Total
$ 99.20
$ 93.93
$ 29.45
$ 37.20
$259.78
Total
4. Employers FICA taxes for Medicare

Alli
Eve
Hong
Juan
$ 36.25
$ 21.97
$ 6.89
$ 8.70
$ 73.81

121
Problem 11-4B(Concluded)
5. Employers FUTA taxes
Alli
Maximum base............ $ 7,000
Earned through 9/23... 85,400
Amount subject to tax. $
0
Eve
$ 7,000
59,085
$
0
Hong
$ 7,000
6,650
$ 350
Juan
$ 7,000
22,200
$
0
Earned this week........ $
2,500
1,515
475
Subject to tax.............. $
Tax rate........................
FUTA tax...................... $
0
0.8%
0.00
0
0.8%
0.00
350
0.8%
$ 2.80
Hong
$ 350
1.75%
$ 6.13
Juan
$
0
1.75%
$ 0.00
Hong
$475.00
Juan
$600.00
Total
$5,090.00
(29.45)
(6.89)
(52.00)
(22.00)
$364.66
(37.20)
(259.78)
(8.70)
(73.81)
(48.00)
(480.00)
(22.00)
(88.00)
$484.10 $4,188.41
Total
600
0
0.8%
$ 0.00
2.80
6. Employers SUTA taxes

Alli
Subject to tax (from 5). $
0
Tax rate........................
1.75%
SUTA tax...................... $
0.00
Eve
$
0
1.75%
$
0.00
7. Each employees net (take-home pay)

Alli
Eve
Gross earnings............ $2,500.00 $1,515.00
Less
(99.20)
(93.93)
(36.25)
(21.97)
Withholding taxes........ (198.00)
(182.00)
(22.00)
(22.00)
Take-home pay............ $2,144.55
$1,195.10
8. Employers total payroll-related expense for each employee

Alli
Eve
Hong
Juan
Gross earnings............ $2,500.00 $1,515.00
$475.00
$600.00
Plus
99.20
93.93
29.45
37.20
36.25
21.97
6.89
8.70
FUTA tax.......................
0.00
0.00
2.80
0.00
SUTA tax......................
0.00
0.00
6.13
0.00
22.00
22.00
22.00
22.00
Pension contrib. (5%). .
125.00
75.75
23.75
30.00
Total payroll................. $2,782.45 $1,728.65
$566.02
$697.90

122
Total
6.13
Total
$5,090.00
259.78
73.81
2.80
6.13
88.00
254.50
$5,775.02

Part 1
Jan. 8 Sales Salaries Expense...........................................69,490
Office Salaries Expense...........................................42,450
Delivery Wages Expense......................................... 2,060
FICASocial Security Taxes Payable*.............
FICAMedicare Taxes Payable**.....................
Employee Med. Insurance Payable..................
Employee Union Dues Payable.........................
7,068
1,653
17,250
2,320
275
85,434

* $114,000 x 6.2% = $7,068
** $114,000 x 1.45% = $1,653
Part 2
Jan. 8 Payroll Taxes Expense.............................................13,509
7,068
1,653
3,876
912

* $114,000 x .034 = $3,876
**$114,000 x .008 = $912

123
Problem 11-6BA (50 minutes)

June 15 FICASocial Security Taxes Payable.......................
FICAMedicare Taxes Payable..............................
Employee Fed. Income Taxes Payable......................
Cash.....................................................................
744
174
900
1,818

30 Office Salaries Expense........................................... 2,000

Shop Wages Expense.............................................. 4,000
372
87
900
4,641
To record payroll period.
30 Accrued Payroll Payable......................................... 4,641

Cash.....................................................................
4,641
To record payment of payroll.*
*The check numbers may be entered in the Payroll Register.

30 Payroll Taxes Expense*............................................
FICA Social Security Taxes Payable..............
699
372
87
200
40

*
Amount earned through 5/31 = 5 x $1,200 = $6,000

Subject to SUTA/FUTA in June = $7,000 - $6,000 = $1,000
SUTA = $1,000 x 5 employees x 4.0% = $200
FUTA = $1,000 x 5 employees x 0.8% = $40
FICA Social Security Taxes = $372 (same as employees)
FICA Medicare Taxes = $87 (same as employees)

124
Problem 11-6BA (Concluded)

July 15 FICA Social Security Taxes Payable....................
FICA Medicare Taxes Payable..............................
Employee Fed. Income Taxes Payable...................
Cash.....................................................................
744
174
900
1,818

15 State Unemployment Taxes Payable......................

Cash.....................................................................
680
680
To record payment of SUTA taxes

[$480 + $200].
31 Federal Unemployment Taxes Payable..................

Cash.....................................................................
136
136
To record payment of FUTA taxes

[$96 + $40].
31 No entry required upon mailing Form 941.

125
Serial Problem
Serial Problem, Success Systems (30 minutes)
1.
Gross pay (8 days x $125 per day)......................................
$1,000.00
FICA Social Security tax deduction (6.2%)*..................... $ 62.00
FICA Medicare tax deduction (1.45%)............................... 14.50
Income tax deduction......................................................... 189.00
Total deductions..................................................................
265.50
Net Pay.................................................................................
$ 734.50
*Employee has not reached the maximum limit.
2. 2005
Feb. 26 Wages Expense........................................................
1,000.00
Employee Federal Income Taxes Payable.......
Cash.....................................................................
62.00
14.50
189.00
734.50
To record payroll period.
3. 2005
Feb. 26 Payroll Taxes Expense.............................................124.50
FICASocial Sec. Taxes Payable.....................
62.00
14.50
40.00
8.00

* $1,000 x .04 = $40.00
**$1,000 x .008 = $8.00
4. 2005
Mar. 25 Accounts Receivable Wildcat Services.............. 2,912
Sales....................................................................
2,800
112
Sold merchandise on credit and collected

sales tax of 4%.
Mar. 25 Cost of Goods Sold.................................................. 2,002

2,002
To record cost of March 25 sale.

126
Comprehensive Problem
Bug-Off Exterminators (100 minutes)
Part 1
a.
Correct ending balance of cash and the amount of the omitted check
Balance per bank..................................$15,100
Plus deposit in transit.......................... 2,450
Less outstanding checks..................... (1,800)
Reconciled balance..............................$15,750
Balance per books................................$17,000
Plus interest earned..............................
52
Less service charges............................
(15)
Balance before omitted check............. 17,037
Reconciled balance (from above)............ (15,750)
Omitted check.......................................$ 1,287
b.
Allowance for doubtful accounts

Unadjusted balance..............................
Anticipated write-off.............................
Revised unadjusted balance................
Desired ending balance........................
Necessary adjustment..........................
c.
$828
(679)
149
700
$551
credit
debit
credit
credit
credit
Depreciation expense on the truck

Cost......................................................................
$32,000
Less salvage value.............................................
(8,000)
Depreciable cost.................................................
$24,000
Useful life (years)................................................
4
Annual depreciation for 2005............................
$ 6,000
d.
Depreciation expense on the equipment

Sprayer
Cost........................................................ $27,000
Less salvage value............................... (3,000)
Depreciable cost................................... $24,000
Injector
$18,000
(2,500)
$15,500
Useful life (years)..................................

8
Depreciation for 2005........................... $ 3,000
5
$ 3,100

127
Comprehensive Problem (Continued)

e.
Adjusted revenue and unearned revenue balances

Total advance received.......................................
Months in contract..............................................
Revenue per month............................................
$ 3,840
12
$ 320
Months of services provided.............................
Total earned ($320 x 5 months).........................

Overstatement of revenue ($3,840 $1,600)....
(1,600)
$ 2,240
Extermination Services Revenue account

Unadjusted balance............................................
Overstatement.....................................................
Adjusted balance................................................
$60,000
(2,240)
$57,760
Unearned Services Revenue account

Unadjusted balance............................................
Adjustment..........................................................
Adjusted balance................................................
f.
0
2,240
$ 2,240
Warranty expense
Adjusted services revenue for the
year (from e)..................................... $57,760
Warranty percent................................
2.5%
Warranty expense (estimated).......... $ 1,444
Estimated warranty liability
Unadjusted balance............................ $ 1,400 credit
Warranty expense...............................
1,444 credit
Ending adjusted balance................... $ 2,844 credit
g.
Note payable and interest accrual

The note originated on December 31, 2005. The first time interest
will be payable is December 31, 2006. The annual interest expense
on the note is $1,200 ($15,000 x .08).
Thus, the adjusted balance for both Interest Payable and Interest Expense
at December 31, 2005, is zero.

128

Part 2
BUG-OFF EXTERMINATORS
December 31, 2005
Unadjusted Trial
Balance
Cash
(a) $1,250
$
17,000
Accounts receivable.............. 4,000
Allowance for
doubtful accounts...............
Merchandise inventory..........11,700
Adjusted Trial
Balance
Adjustments
828 (b1)
(b1)
679
$ 679 (b2)
551
(c)
Estim. warranty liability..........

Unearned services rev...........
Long-term notes
payable.................................
Interest payable....................
6,000
(a)
(d)
6,100
(f)
1,444
2,240
18,300
3,713
2,844
2,240
15,000
1,287
(e)
0
59,700
J. Newman, Capital................
0
59,700
J. Newman, Withdrawals........10,000
Extermination
services revenue.................
Interest revenue.....................
10,000
60,000
872
71,026
Sales.....................................
(e)
2,240
(a)
Deprec. expenseTrucks.......
(c)
0
Deprec. expenseEquip.........
0
Wages expense.....................35,000
Interest expense....................
0
Rent expense........................ 9,000
Bad debts expense................
0
Miscellaneous expense......... 1,226
Repairs expense.................... 8,000
Utilities expense.................... 6,800
(d)
(b2)
_______
6,000
6,100
(a)
551
15
(f)
1,444
57,760
924
71,026
52
Cost of goods sold................46,300
Warranty expense..................
700
45,000
12,200
5,000
1,400
0
15,000
Accounts payable..................
6,000
Equipment.............................45,000
Accum. deprec.Equip..........
3,321
11,700
32,000
Trucks...................................32,000
Accum. deprec.Trucks.........
$ 15,750
______
46,300
6,000
6,100
35,000
0
9,000
551
1,241
8,000
6,800
1,444
_______

129
Totals....................................
$226,026 $226,026

130
$18,316
$18,316 $238,207
$238,207

Part 3
2005
(a)
Miscellaneous Expenses............................................
15
Accounts Payable........................................................ 1,287
Interest Revenue....................................................
Cash........................................................................
52
1,250
Adjust cash account. (Separate entries are acceptable.)
(b1)
Allowance for Doubtful Accounts...............................

Accounts Receivable..............................................
679
679
Wrote off uncollectible accounts.
(b2)
Bad Debts Expense......................................................

Allowance for Doubtful Accounts.........................
551
551
Recognize bad debts expense.
(c)
Depreciation ExpenseTrucks................................... 6,000

Accumulated DepreciationTrucks.....................
6,000
Depreciation on truck.
(d)
Depreciation ExpenseEquipment............................ 6,100

Accumulated DepreciationEquipment..............
6,100
Depreciation on equipment.
(e)
Extermination Services Revenue................................ 2,240

Unearned Services Revenue.................................
2,240
Adjust for unearned revenues.
(f)
Warranty Expense......................................................... 1,444

Estimated Warranty Liability..................................
1,444
Estimate warranty expense.
(g)
No interest accrual required for 2005

131

Part 4
Income Statement
For Year Ended December 31, 2005
Revenues
Extermination services revenue............... $57,760
Sales............................................................ 71,026
Interest revenue..........................................
924
Total revenues............................................
Expenses
Cost of goods sold..................................... 46,300
Depreciation expenseTrucks................. 6,000
Depreciation expenseEquipment.......... 6,100
Wages expense........................................... 35,000
Interest expense.........................................
0
Rent expense.............................................. 9,000
Bad debts expense.....................................
551
Miscellaneous expenses........................... 1,241
Repairs expense......................................... 8,000
Utilities expense......................................... 6,800
Warranty expense....................................... 1,444
Total expenses............................................
Net income....................................................
$129,710
120,436
$ 9,274
Statement of Owners Equity
For Year Ended December 31, 2005
T. Newman, Capital, Beginning balance......................
Plus: Net income............................................................
Less: Withdrawals.........................................................
T. Newman, Capital, Ending balance............................

132
$59,700
9,274
68,974
(10,000)
$58,974
Comprehensive Problem
Part 4 (concluded)
Balance Sheet
December 31, 2005
Assets
Current assets
Cash................................................................
Accounts receivable......................................$ 3,321
Allowance for doubtful accounts.................
(700)
Merchandise inventory..................................
Total current assets.......................................
Plant assets
Trucks.............................................................. 32,000
Accumulated depreciationTrucks............. (6,000)
Equipment...................................................... 45,000
Accumulated depreciationEquipment...... (18,300)
Total plant assets...........................................
Total assets.......................................................
$15,750
2,621
11,700
30,071
26,000
26,700
52,700
$82,771
Liabilities
Current liabilities
Accounts payable..........................................$ 3,713
Estimated warranty liability.......................... 2,844
Unearned services revenue.......................... 2,240
Total current liabilities...................................
Long-term liabilities
Long-term notes payable..............................
Total liabilities...................................................
Equity
T. Newman, Capital...........................................
Total liabilities and equity................................
$ 8,797
15,000
23,797
58,974
$82,771

133
Reporting in Action
1.
BTN 11-1
Times interest earned

($ thousands)
2/2/2003
Income before income taxes..................... $54,773

Interest expense.........................................
1,781
Income before taxes and interest............. $56,554
Times interest earned ratio...................
31.8a
2/3/2002
$42,546
337
$42,883
127.2b
1/28/2001
$23,783
607
$24,390
40.2c
$56,554/ $1,781 = 31.8

$42,883/ $337 = 127.2
c
$24,390/ $607 = 40.2
b
Analysis comment: For each of these fiscal years 2001 through 2003,
it appears that Krispy Kremes risk of not being able to cover its
interest expense is low. Nevertheless, the most recent years 2003
times interest earned ratio is the lowest among the three years
examined. Accordingly, we need to monitor this potentiality.
2.
The main evidence of temporary differences between GAAP and tax

return income for Krispy Kreme would be the presence of any deferred
income tax liabilities or assets. Krispy Kremes balance sheet shows
deferred income taxes as a current asset, and it also shows deferred
tax liabilities as a noncurrent liability. Thus, there is evidence of
temporary differences. Note 9 describes these amounts in detail.
3.
The solution depends on the financial statement information accessed.

134
Comparative Analysis
BTN 11-2
1. Krispy KremeTimes interest earned

($ thousands)
Current
Year
One Year
Prior
Two Years
Prior
Net income.................................................. $33,478

Add income taxes...................................... 21,295
Income before income taxes..................... 54,773
Add interest expense.................................
1,781
$26,378
16,168
42,546
337
$42,883
$14,725
9,058
23,783
607
$24,390
31.8a
127.2b
40.2c
Times interest earned ratio...................

a
$56,554/ $1,781 = 31.8

$42,883/ $337 = 127.2
c
$24,390/ $607 = 40.2
b
TastykakeTimes interest earned

($ thousands)
Current
Year
One Year
Prior
Two Years
Prior
Net income.................................................. $2,000

Add income taxes......................................
0
Add interest expense................................. 1,066
$ 8,048
3,775
1,103
$12,926
$ 8,144
4,609
1,540
$14,293
2.9a
11.7b
9.3c
Times interest earned ratio.......................

a
$3,066/ $1,066 = 2.9

$12,926/ $1,103 = 11.7
c
$14,293/ $1,540 = 9.3
b
2. Krispy Kreme appears considerably stronger in its ability to make

interest payments should income decline. Tastykakes ability to cover
interest expense has declined significantly from 9.3 times to 2.9 times
over a period of just two years. During a comparable time frame, Krispy
Kremes ability to cover its interest expense decreased from 40.2 to 31.8
times.

135
Ethics Challenge
BTN 11-3
1. It is in Blys self-interest to maximize the amount of revenues less

warranty expenses so as to maximize his personal bonus. Since Bly
has some input into setting the warranty expense accrual percent, he
potentially faces an ethical dilemma. Specifically, the lower the
expense accrual, the lower the warranty expense, and the higher his
bonus. (The evidence indicates that Bly has tended to overestimate
warranty expense in prior years.)
2.
Although Bly might be able to affect the amount of revenues less

warranty expenses via the warranty expense accrual in the short run,
over several years the amounts should even out. The dealership
should probably adjust the warranty expense accrual to match the
usual (average) experience over time. Given the variable nature of
warranty expenses, at times it might warrant being adjusted upward
(lowering Blys bonus) or downward (increasing Blys bonus). The
accountant and others should offer input into this decision. Since the
experience with warranties has varied, a percent should perhaps be
based on a long-run average, with some additional weight given to
recent experience.

136
Communicating in Practice
BTN 11-4
MEMORANDUM
To:
From:
Date:
Subject:
Tom Pretti, General Manager

Dustin Clemens, Manager Accounting and Finance
Reporting warranties in financial statements
This memorandum is in response to your comment on my proposal for the

treatment of a contingency in our financial statements. You specifically
object to the proposed recognition of an expense and liability for
warranties. The purpose of this memorandum is to respond to your
objection.
Both the conservatism and matching principles apply to accounting for
warranties. Conservatism requires us to include an expense in this years
financial statements for costs that we may or may not pay in the future.
Another point in favor of reporting the expense and liability now is that we
offered the warranty in order to achieve the reported sales. Therefore, our
income measure would be incomplete if it did not match the cost of
fulfilling the warranty against revenues generated by offering the warranty.
This treatment would be in compliance with the matching principle.
Your comment also raised the objection that we dont know what costs will
be. If they are not reasonably estimable, generally accepted accounting
principles will allow us to leave them out of the financial statements. But
we must describe the contingency in the notes. I will be checking with the
product design engineers to get their opinion on the estimableness of
repair costs. If the product is different from others, we may have a basis
for going with only a note disclosure. However, financial statement
recognition is a more effective way to get the information into users
hands. As a result, it is usually preferred, even if we are uncertain about
the amount.

137
Taking It to the Net
BTN 11-5
1. McDonalds current liabilities include

Notes payable
Accounts payable
Income taxes
Other taxes
Accrued interest
Accrued restructuring and restaurant closing costs
Accrued payroll and other liabilities
Current maturities of long-term debt
2. The portion of long-term debt maturing in the next 12 months is
$275.5 / ($275.5 + $9,703.6) = 2.76%
3. Times interest earned for McDonalds as of 12/31/2002
12/31/2002
Net Income.................................................. $ 893.5
Plus income taxes......................................
670.0
Plus interest expense................................
374.1
Income before interest and taxes............. $1,937.6 million
Times interest earned................................
5.18 times
Comment: The 5.18 times interest earned ratio seems more than
sufficient for McDonalds to cover its interest obligations.
Teamwork in Action
BTN 11-6
1. Option A: Interest Expense = $6,000 x 10% x 90/360 = $150

Option B: Interest Expense = $6,000 x 8% x 120/360 = $160
The interest expense in option B does exceed option A. If interest cost
is the only consideration, then Option A is the preferred loan. However,
if a mere $10 more is paid in interest expense the business can use the
loan money for an additional 30 days. The decision on which loan is
preferred will ultimately depend on whether interest cost savings is
valued more than the additional time to use the loaned money.
138
Teamwork in Action (Continued)

2. Entries:
2a. Issue date, Option A
June 1 Cash........................................................................... 6,000
Notes Payable.....................................................
6,000
Borrowed cash by issuing an

interest-bearing note.
2b. Issue date, Option B

June 1 Cash........................................................................... 6,000
Notes Payable.....................................................
6,000
Borrowed cash by issuing an

interest-bearing note.
2c. Maturity date, Option A

Aug. 30 Notes Payable........................................................... 6,000
Interest Expense....................................................... 150
Cash.....................................................................
6,150
2d. Maturity date, Option B

Sep. 29 Notes Payable........................................................... 6,000
Interest Expense....................................................... 160
Cash.....................................................................
6,160
4. Entries:
4a. Adjusting entry, Option A (Dec. 31)
50
50
Accrue interest on note

payable [$6,000 x 10% x 30/360].
4b. Adjusting entry, Option B (Dec. 31)

40
40
Accrue interest on note payable

[$6,000 x 8% x 30/360].

139
Teamwork in Action (Concluded)

4c. Maturity date entry, Option A
March 1 Interest Expense....................................................... 100
50
Notes Payable........................................................... 6,000
Cash.....................................................................
6,150
4d. Maturity date entry, Option B

March 31 Interest Expense....................................................... 120
40
Notes Payable........................................................... 6,000
Cash.....................................................................
6,160
Business Week Activity
BTN 11-7
1. The tenant does not pay to stay at the motel. For 17 months the tenant
has performed handyman jobs at the motel (clean rooms, mow yard,
etc.) in lieu of rent.
2. A major risk is that the tenant could be injured while performing tasks
at the motel and then seek reimbursement or damages for the injury
sustained. Therefore, the motel owner has liability exposure. Also, the
owner feels that the tenant may at some point in the future expect to
share in profits of the motel. The fact that the tenant is not a co-owner
or joint venturer should be clarified by written agreement.
3. The state of New York would likely classify the tenant as an employee
and not as an independent contractor. An employee classification
would obligate the motel owner to pay payroll taxes and make income
tax withholdings. Failure to pay the taxes and make the withholdings
could result in substantial fines for the owner.
If the motel owner decides to classify the tenant as an employee then
the tenant should be insured by a workers compensation policy to
address the owners liability worries.

140
Entrepreneurial Decision
BTN 11-8
Part 1
Times interest earned =
Interest expense
$1,140,000
= 2.11
$540,000
Part 2
Assume: Investment is made and sales equal $3,000,000
Income Statement
Sales................................................................................ $3,000,000
Depreciation ($60,000 + $96,000)..................................
156,000
Variable expenses (45%)................................................ 1,350,000
Income before interest................................................... 1,494,000
Interest expense (fixed)................................................. 1,140,000
Net income...................................................................... $ 354,000
$1,494,000/$1,140,000 = 1.31
Part 3
Income Statement
No investment
Sales................................................................ $3,600,000
Depreciation...................................................
60,000
Variable expenses (60% vs. 45%)................. 2,160,000
Income before interest................................... 1,380,000
Interest expense ($540,000 vs. $1,140,000).....
540,000
Net income...................................................... $ 840,000
Make investment
$3,600,000
156,000
1,620,000
1,824,000
1,140,000
$ 684,000
$1,380,000/$540,000 $1,824,000/$1,140,000
= 2.56
= 1.60
Part 4
Income Statement
No investment
Sales ...........................................$4,639,998 $4,639,998
Depreciation...................................................
60,000
540,000
Net income...................................................... $1,255,999
.......................................................................
156,000
2,087,999
2,395,999
1,140,000
$1,255,999

141

142
$1,795,999/$540,000
= 3.33
$2,395,999/$1,140,000
= 2.10
Entrepreneurial Decision (Concluded)

Part 5
Income Statement
No investment
Sales ...........................................$5,400,000 $5,400,000
Depreciation...................................................
60,000
540,000
Net income...................................................... $1,560,000
.......................................................................
Make investment
156,000
2,430,000
2,814,000
1,140,000
$1,674,000
$2,100,000/$540,000 $2,814,000/$1,140,000
= 3.89
= 2.47
Part 6
The proposed investment strategy is one that would result in lower variable
costs (60% to 45%) but higher fixed costs ($540,000 to $1,140,000) and higher
depreciation ($60,000 to $156,000). A higher fixed cost strategy amplifies the
effects of increases and decreases in sales. This means increases in sales
produce greater increases in net income, but decreases in sales produce greater
decreases in net income. A higher fixed cost strategy yields a lower times interest
earned ratio.
Our recommendation in this case depends on expected future sales. If they
remain at $3,000,000 (see part 2), then the investment would yield net income of
$354,000. This is $246,000 lower than the net income of $600,000 without the
investment. Indeed, the company is better off not making the investment if
expected sales are less than approximately $4,639,998 (the turning point, see
part 4). This also means that if expected sales are greater than approximately
$4,639,998, the company is better off making the investment since it would yield a
net income exceeding that without the investment (see part 5 results when sales
are $5,400,000). However, as with proposals such as these, we must recognize the
risk element(s)that is, the risks of the prediction(s) being realized or not.

143
Hitting the Road
BTN 11-9
There is no formal solution to this problem. A discussion of the importance

of safeguarding social security information would be appropriate especially
with respect to the Administrations decision to no longer transfer benefit
information online.
Global Decision
BTN 11-10
1. Grupo Bimbo Times interest earned

Current
Year
(pesos millions)
One Year
Prior
Net income..................................................
Add income taxes......................................
Income before income taxes.....................
Add interest expense.................................
Income before taxes and interest.............
$1,003
575
1,578
703
$2,281
$1,682
805
2,487
193
$2,680
Times interest earned ratio.......................
3.2a
13.9b
$2,281/ $703 = 3.2

$2,680/ $193 = 13.9
2. Of these three companies, Krispy Kreme has the best coverage of

interest expense for both years examined. Specifically, Krispy Kremes
times interest earned of 31.8 for the current year is superior to Grupo
Bimbos value of 3.2 and Tastykakes 2.9. Moreover, Krispy Kremes
ratio is even more superior in the prior year. Thus, should income
decline, Krispy Kreme would be in the best position to continue
meeting its interest obligations.

144

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Chapter 11

Current Liabilities and Payroll

An estimated liability is an obligation to make a future payment, the exact amount of

An unemployment merit rating is based on an evaluation of an employers

Solutions Manual, Chapter 11

McGraw-Hill Companies, Inc., 2005

McGraw-Hill Companies, Inc., 2005

Fundamental Accounting Principles, 17th Edition

Quick Study 11-2 (10 minutes)

To record cash sales and 4% sales tax.

Cost of Goods Sold..................................................2,900

To record cost of Sept. 30th sales.

Sales Taxes Payable................................................ 200

To record remittance of sales taxes to govt.

Quick Study 11-3 (10 minutes)

To record sales in advance of concerts.

Unearned Ticket Revenue.......................................

To record concert revenues earned.

Solutions Manual, Chapter 11

McGraw-Hill Companies, Inc., 2005

Quick Study 11-4 (15 minutes)

Computation of interest payable at December 31, 2005:

To record accrual of interest

To record payment of note plus interest

Quick Study 11-5 (15 minutes)

Payroll Taxes Expense.............................................1,318.50

To record employer payroll taxes.

Quick Study 11-6 (10 minutes)

Estimated Warranty Liability...................................

To record cost of warranty repairs.

Fundamental Accounting Principles, 17th Edition

Quick Study 11-7 (5 minutes)

To record expected bonus costs.

Quick Study 11-8 (10 minutes)

Quick Study 11-9 (10 minutes)

Quick Study 11-10B (10 minutes)

Income Taxes Expense............................................ 30,000

To record tax expense and deferred tax liability.

Solutions Manual, Chapter 11

McGraw-Hill Companies, Inc., 2005

Exercise 11-2 (15 minutes)

To record warranty expense [3,000 units x 8% x $15].

No adjusting entry can be made since the loss cannot be reasonably

Vacation Benefits Expense......................................

To record vacation benefits expense

Cost of Goods Sold.................................................. 1,000,000

Unearned Services Revenue...................................

To record product revenue earned.

Fundamental Accounting Principles, 17th Edition

Exercise 11-3 (15 minutes)

Employee Bonus Expense.................................

To record expected bonus costs.

To record payment of bonus.

Exercise 11-4 (30 minutes)

Maturity date = May 15 + 60 days = July 14, 2005

Borrowed cash by issuing an interest-bearing note.

Interest Expense*..................................................... 1,880

Repaid note plus interest.

Solutions Manual, Chapter 11

McGraw-Hill Companies, Inc., 2005

Exercise 11-5 (30 minutes)

Maturity date = November 1 + 90 days = January 30, 2006.

Interest Expense....................................................... 2,250

Accrued interest on note payable.