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CHAPTER 14

CURRENT LIABILITIES AND


CONTINGENCIES

ASSIGNMENT CLASSIFICATION TABLE

Topics

Brief
Exercises

1. Concept of liabilities;
definition and
classification.

Writing
Assignments

Exercises

Problems

1, 20

14

1, 14

2. Accounts and notes


payable; dividends
payable.

1, 2, 3

2, 20

3. Short-term obligations
expected to be
refinanced.

6, 7

4. Deposits and advance


payments.

1, 12, 14

5. Employee-related
liabilities.

11, 12, 13,


14, 15

8, 9, 10,
11, 12, 20

2, 3, 13, 14 2

20

2, 3

3, 5

1, 14

6. Collections for third


parties.
7. Sales taxes, GST,
income and property
taxes.

6, 7, 8, 9,
10

8. Contingent liabilities
(General).

22, 23

9, 10, 12

1, 4, 5, 6

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ASSIGNMENT CLASSIFICATION TABLE (CONTINUED)

Topics
9. Guaranties and
warranties.

Brief
Exercises

Exercises

Problems

16, 17, 18

13, 14, 17

4, 5, 6, 11,
14

15, 16, 20

7, 8, 11

10. Premiums and awards 19


offered to customers.
11. Self-insurance,
litigation, claims, and
assessments.

23

12. Asset retirement


obligations.

20, 21

13. Presentation and


analysis.

Writing
Assignments
1, 5

9, 10, 12

8, 14

18
19, 20, 21,
22, 23

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ASSIGNMENT CHARACTERISTICS TABLE


Item
E14-1
E14-2
E14-3
E14-4
E14-5
E14-6
E14-7
E14-8
E14-9
E14-10
E14-11
E14-12
E14-13
E14-14
E14-15
E14-16
E14-17
E14-18
E14-19
E14-20
E14-21
E14-22
E14-23
P14-1
P14-2
P14-3
P14-4
P14-5
P14-6
P14-7
P14-8
P14-9
P14-10
P14-11

Description

Level of Time
Difficulty (minutes)

Balance sheet classification of various


liabilities.
Accounts and notes payable.
Adjusting entry for sales tax.
Liability for returnable containers.
Income Taxes.
Refinancing of short-term debt.
Refinancing of short-term debt.
Compensated absences.
Compensated absences.
Payroll tax entries.
Payroll tax entries.
Bonus computation and income
statement preparation.
Warranties.
Warranties.
Premiums entries.
Premiums.
Warranties.
Asset retirement obligation.
Contingencies and commitments.
Financial statement impact of liability
transactions.
Ratio calculations and discussion.
Ratio calculations and analysis.
Ratio calculations and effect of
transactions.

Simple

Current liability entries and adjustments.


Payroll tax entries.
Payroll tax entries.
Warranties, accrual and cash basis.
Extended sales warranties and accrual
warranties.
Warranties, accrual and cash basis.
Premium entries.
Premium entries and financial statement
presentation.
Loss contingencies: entries and essay.
Loss contingencies: entries and essays.
Warranties and premiums.

Moderate
Simple
Moderate
Moderate
Simple
Simple
Moderate
Moderate
Simple
Moderate
Complex

10-15
15-20
5-10
15-20
15-20
10-12
10-15
25-30
25-30
15-20
30-35
15-20

Simple
Moderate
Simple
Moderate
Simple
Simple
Moderate
Moderate

10-15
15-20
15-20
20-30
10-15
10-15
20-30
30-35

Simple
Simple
Moderate

15-20
20-25
15-25

Simple
Moderate
Moderate
Simple
Moderate

30-40
20-30
30-35
15-20
20-30

Moderate
Moderate
Moderate

25-35
20-30
30-45

Simple
Moderate
Moderate

25-30
45-50
20-30

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ASSIGNMENT CHARACTERISTICS TABLE (Continued)


Item
P14-12
P14-13
P14-14
W14-1
W14-2
W14-3
W14-4
W14-5
W14-6

Description
Advances, self-insurance, loss
contingencies, guarantees and
commitments.
Bonus computation.
Current liabilities: various.
Loss contingencies, warranties,
litigation.
Current versus noncurrent classification.
Refinancing of short-term debt.
Loss contingencies.
Ethical issues: warranties and
contingencies.
Loss contingency.

Level of Time
Difficulty (minutes)
Moderate 25-30
Moderate
Complex

25-30
30-40

Moderate

30-40

Moderate
Moderate
Simple
Simple

30-35
30-40
15-20
20-25

Moderate

15-20

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SOLUTIONS TO BRIEF EXERCISES


BRIEF EXERCISE 14-1
07/01 Purchases..........................................................................
40,000
Accounts Payable....................................................
40,000
Freight-in...........................................................................
1,200
Cash.................................................................
1,200
07/03 Accounts Payable.............................................................
6,000
Purchase Returns and Allowances........................
6,000
07/10 Accounts Payable.............................................................
34,000
Cash..........................................................................
33,320
Purchase Discounts................................................ 680
BRIEF EXERCISE 14-2
11/01/05

Cash ...................................................................................
50,000
Notes Payable..........................................................
50,000

12/31/05 Interest Expense...............................................................


750
Interest Payable.......................................................
750
($50,000 X 9% X 2/12)
02/01/06 Notes Payable...................................................................
50,000
Interest Payable................................................................
750
Interest Expense...............................................................
375
Cash..........................................................................
51,125

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BRIEF EXERCISE 14-3


11/01/05

Cash ...................................................................................
50,000
Discount on Notes Payable..............................................
1,125
Notes Payable..........................................................
51,125

12/31/05 Interest Expense...............................................................


750
Discount on Notes Payable....................................
750
($1,125 X 2/3)
02/01/06 Interest Expense...............................................................
375
Discount on Notes Payable....................................
375
Notes Payable...................................................................
51,125
Cash..........................................................................
51,125
BRIEF EXERCISE 14-4
(a)

Since both criteria are met (intent and ability), none of the
$500,000 would be reported as a current liability. The entire
amount would be reported as a long-term liability.

(b)

Because repayment of the note payable required the use of


existing 12/31/05 current assets, the entire $500,000
liability must be reported as current.

BRIEF EXERCISE 14-5


08/01/05 Cash ...................................................................................
180,000
Unearned Subscription
Revenue (10,000 X $18).......................................
180,000
12/31/05 Unearned Subscription Revenue....................................
75,000
Subscription Revenue.............................................
75,000
($180,000 X 5/12 = $75,000)

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BRIEF EXERCISE 14-6


(a)

Accounts Receivable........................................................
31,800
Sales.........................................................................30,000
Sales Taxes Payable................................................ 1,800
($30,000 X 6% = $1,800)

(b)

Cash ...................................................................................
19,610
Sales.........................................................................18,500
Sales Taxes Payable................................................ 1,110
($19,610 1.06 = $18,500)

BRIEF EXERCISE 14-7


Accounts Receivable........................................................
50,960
Sales.........................................................................
Sales Taxes Payable ($45,500 X 5%)......................
GST Payable ($45,500 X 7%)...................................

45,500
2,275
3,185

BRIEF EXERCISE 14-8


Purchases..........................................................................
28,800
GST Recoverable ($28,800 X 7%)....................................
2,016
Accounts Payable.................................................... 30,816
GST Payable......................................................................
3,185
Cash..........................................................................
GST Recoverable.....................................................

1,169
2,016

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BRIEF EXERCISE 14-9


Income Tax Expense.........................................................
11,600
Cash ($2,900 X 4).....................................................

11,600

Income Tax Expense ($15,000 - $11,600)........................


3,400
Income Taxes Payable.............................................

3,400

At year end, the company would report Income Taxes Payable of


$3,400 in current liabilities.
BRIEF EXERCISE 14-10
The year end entry would be changed as follows:
Income Taxes Receivable.................................................
1,400
Income Tax Expense...............................................
($11,600 - $10,200)

1,400

At year end, the company would report Income Taxes Receivable


of $1,400 in current assets.
BRIEF EXERCISE 14-11
Wage Expense...................................................................
23,000
Employee Income Tax Deductions
Payable.................................................................
CPP Contributions Payable....................................
EI Premiums Payable..............................................
Health Insurance Premiums Payable.....................
Cash..........................................................................

3,426
990
920
250
17,414

BRIEF EXERCISE 14-12


Payroll Tax Expense.........................................................
2,278
EI Premiums Payable ($920 X 1.4)..........................
CPP Contributions Payable....................................

1,288
990

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BRIEF EXERCISE 14-13


Employee Income Tax Deductions Payable...................
3,426
CPP Contributions Payable ($990 X 2)............................
1,980
EI Premiums Payable (920 X 1.4)............................
EI Premiums Payable ($920 + $1,288).............................
2,208
Cash..........................................................................

7,614

BRIEF EXERCISE 14-14


Wage Expense...................................................................
36,000
Vacation Wages Payable.........................................
(30 X 2 X $600)

36,000

BRIEF EXERCISE 14-15


12/31/05 Employees Bonus Expense............................................
450,000
Bonus Payable.........................................................
450,000
2/15/06

Bonus Payable.....................................................
450,000
Cash..........................................................................
450,000

BRIEF EXERCISE 14-16


2005

Warranty Expense.............................................................
70,000
Cash, Inventory, etc.................................................
70,000

12/31/05 Warranty Expense.............................................................


500,000
Estimated Liability Under
Warranties............................................................
500,000

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BRIEF EXERCISE 14-17


2005

Estimated Liability Under


Warranties............................................................
70,000
Cash, Inventory, etc.................................................
70,000
Warranty Expense.............................................................
570,000
Estimated Liability Under
Warranties............................................................
570,000

12/31/05 No additional adjusting entry is required.


BRIEF EXERCISE 14-18
(a)

Cash ...................................................................................
1,485,000
Unearned Warranty Revenue..................................
1,485,000
(15,000 X $99)

(b)

Warranty Expense.............................................................
180,000
Cash, Inventory, etc.................................................
180,000

(c)

Unearned Warranty Revenue...........................................


247,500
Warranty Revenue...................................................
247,500
($1,485,000 X [$180,000/$1,080,000])

BRIEF EXERCISE 14-19


Premium Expense.............................................................
36,000
Estimated Liability for Premiums...........................

36,000

UPC codes expected to be sent in..................................


300,000
(30% X 1,000,000)
UPC codes already redeemed.........................................
120,000
Estimated future redemptions......................................... 180,000
Cost of estimated claims outstanding............................ $ 36,000
(180,000 3) X ($1.50 + $1.10 $2.00)
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BRIEF EXERCISE 14-20


Off-Shore Platform............................................................
500,000
Asset Retirement Obligation.................................. 500,000
BRIEF EXERCISE 14-21
Amortization Expense......................................................
1,050,000
Accumulated Amortization.....................................1,050,000
[($10,000,000 + $500,000) 10 years]
Accretion Expense...........................................................
40,000
Asset Retirement Obligation..................................
($500,000 X 8%)

40,000

BRIEF EXERCISE 14-22


(a)

Lawsuit Loss.....................................................................
700,000
Lawsuit Liability.......................................................
700,000

(b)

No entry is necessary. The loss is not accrued because it is


not likely that a liability has been incurred at 12/31/05.

BRIEF EXERCISE 14-23


Kohlbeck should record a litigation accrual on the patent case,
since the amount is both estimable and likely.
Lawsuit Loss.....................................................................
200,000
Lawsuit Liability.......................................................

200,000

The $100,000 self-insurance allowance can be achieved by an


appropriation of retained earnings or by note disclosure.

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SOLUTIONS TO EXERCISES
EXERCISE 14-1 (10-15 minutes)
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)

(m)
(n)
(o)
(p)
(q)
(r)
(s)

Current liability; financial liability.


Current asset.
Current liability or long-term liability depending on term of
warranty; not a financial liability.
Current liability; financial liability.
Current liability; financial liability.
Current liability; financial liability.
Current or noncurrent liability depending upon the time
involved; not a financial liability.
Current liability; financial liability.
Current liability; not a financial liability.
Current liability; not a financial liability.
Current liabilities or long-term liabilities as a deduction
from face value of note; financial liability.
Footnote disclosure if assume not likely and/or not
reasonably estimable. If assume likely and reasonably
estimable then current or noncurrent liability depending
upon the time involved; financial liability.
Current liability; financial liability.
Current liability; financial liability.
Footnote disclosure; not a financial liability.
Separate presentation in either current or long-term liability
section; financial liability.
Current liability; financial liability.
Current or noncurrent liability depending upon the time
involved; financial liability.
Current liability; financial liability.

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EXERCISE 14-2 (15-20 minutes)


(a)

(b)

Sept. 1

Purchases..........................................................................
50,000
Accounts Payable....................................................
50,000

Oct. 1

Accounts Payable.............................................................
50,000
Notes Payable..........................................................
50,000

Oct. 1

Cash ...................................................................................
50,000
Discount on Notes Payable..............................................
6,000
Notes Payable..........................................................
56,000

Dec. 31 Interest Expense...............................................................


1,500
Interest Payable.......................................................
1,500
($50,000 X 12% X 3/12)
Dec. 31 Interest Expense...............................................................
1,500
Discount on Notes Payable....................................
1,500
($6,000 X 3/12)

(c)

(1)

Note payable
Interest payable

$50,000
1,500
$51,500

(2)

Note payable
Less discount ($6,000 $1,500)

$56,000
4,500
$51,500

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EXERCISE 14-3 (5-10 minutes)


(a)

(b)

June 30
Sales...........................................................................
44,510.62
Sales Tax Payable................................................ 20,543.36
GST Payable......................................................... 23,967.26
Computation :
Sales plus sales tax ($233,200 + $153,700)
Sales exclusive of tax ($386,900 1.13)
Taxes combined (GST and sales tax)

$386,900.00
342,389.38
$ 44,510.62

GST Payable ($342,389.38 X 7%)


Sales Tax Payable ($342,389.38 X 6%)

$23,967.26
$20,543.36

June 30
Sales...........................................................................
45,778.50
Sales Tax Payable................................................ 21,900.00
GST Payable......................................................... 23,878.50
Calculation:
Sales plus sales tax ($233,200 + $153,700)
Sales plus GST ($386,900 1.06)
Sales tax
Sales plus GST
Sales exclusive of GST
($365,000.00 1.07%)
GST
Alternatively:
Sales exclusive of tax
($386,900 1.1342*)
GST ($341,121.50 X 0.07)
Sales tax ([$341,121.50 + $23,878.50]
X 0.06)
* 1.07 X 1.06 = 1.1342

$386,900.00
365,000.00
$ 21,900.00
$365,000.00
341,121.50
$ 23,878.50

$341,121.50
$23,878.50
$21,900.00

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EXERCISE 14-4 (15-20 minutes)


(a)

Cash ...................................................................................
860,000
Liability for Returnable Containers........................
860,000
Liability for Returnable Containers.................................
709,000
Cash..........................................................................
709,000
Liability for Returnable Containers.................................
55,000
Revenue from Container Sales...............................55,000
($170,000 $115,000)

(b)

Liability for Returnable Containers


$650,000 12/31/04 liability
860,000
2005 deliveries
2005 returns
$709,000
2003 sales
55,000
(764,000)
not returned
$746,000 12/31/05 liability

(c)

The classification of this liability as current or long-term


depends upon the length of the companys operating cycle.
If the companys operating cycle is one year or less, then
the current/long-term break off point is expected to be
settled within one year. The remaining deposits would be
classified as long-term. If the companys operating cycle is
between one and two years, the current/long-term break off
point is the length of one operating cycle. If the companys
operating cycle is two years or more, the entire liability
($746,000) is classified as current.

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EXERCISE 14-5 (15-20 minutes)


(a)

Mar. 31

Income Tax Expense.........................................................


8,100
Cash..........................................................................
8,100

June 1

Cash ...................................................................................
11,250
Income Taxes Receivable.......................................
11,250

June 30 Income Tax Expense.........................................................


8,100
Cash..........................................................................
8,100
Sep. 30 Income Tax Expense.........................................................
8,100
Cash..........................................................................
8,100
Dec. 31 Income Tax Expense.........................................................
8,100
Cash..........................................................................
8,100
Dec. 31 Income Tax Expense.........................................................
5,400
Income Taxes Payable.............................................
5,400
Estimated income taxes
Income tax instalments paid
($8,100 X 4)
Income taxes payable
(b)

$37,800
(32,400)
$ 5,400

The income taxes payable will be shown as a current


liability.

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EXERCISE 14-6 (10-12 minutes)


Hattie Corporation
Partial Balance Sheet
December 31, 2005
Current liabilities:
Notes payable (Note 1)

$250,000

Long-term debt:
Notes payable refinanced in
February 2006 (Note 1)

950,000

Note 1: Short-term debt refinanced


As of December 31, 2005, the company had notes payable
totalling $1,200,000 due on February 2, 2006. These notes were
refinanced on their due date to the extent of $950,000 received
from the issuance of common shares on January 21, 2006. The
balance of $250,000 was liquidated using current assets.
OR
Current liabilities:
Notes payable (Note 1)
Long-term debt:
Short-term debt expected to be
refinanced (Note 1)

$250,000
950,000

(Same Footnote as above.)

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EXERCISE 14-7 (10-15 minutes)


Atkins Corporation
Partial Balance Sheet
December 31, 2005
Current liabilities:
Notes payable (Note 1)
Long-term debt:
Notes payable expected to be
refinanced in 2006 (Note 1)

$3,400,000

3,600,000

Note 1.
Under a financing agreement with Provincial Bank the
company may borrow up to 60% of the gross amount of its
accounts receivable at an interest cost of 1% above the prime
rate. The company intends to issue notes maturing in 2010 to
replace $3,600,000 of short-term, 15%, notes due periodically in
2006. Because the amount that can be borrowed may range from
$3,600,000 to $4,800,000, only $3,600,000 of the $7,000,000 of
currently maturing debt has been reclassified as long-term debt.

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EXERCISE 14-8 (25-30 minutes)


(a)

To accrue the expense and liability for vacation


entitlement:

2004

Wages Expense
Vacation Wages Payable

7,200

Wages Expense
Vacation Wages Payable

7,920

Wages Expense
Vacation Wages Payable
Cash

648
6,480(3)

2005

(1)
(2)
(3)
(4)

7,200(1)
7,920 (2)

7,128(4)

9 employees X $10.00/hr. X 8 hrs./day X 10 days =


9 employees X $11.00/hr. X 8 hrs./day X 10 days =
9 employees X $10.00/hr. X 8 hrs./day X 9 days =
9 employees X $11.00/hr. X 8 hrs./day X 9 days =

$7,200
$7,920
$6,480
$7,128

NOTE: Vacation days are paid at the employees current wage.


(b)

To accrue the expense and liability for sick days:

2004

Wages Expense
Sick Pay Wages Payable

4,320
4,320(1)

To record payment for compensated time when used by


employees:

2005

Sick Pay Wages Payable


Cash

2,880(2)

Wages Expense
Sick Pay Wages Payable

4,752

2,880
4,752 (3)

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EXERCISE 14-8 (Continued)


2005

(1)
(2)
(3)
(4)

Wages Expense
Sick Pay Wages Payable
Cash

144
3,816(4)
3,960(5)

9 employees X $10.00/hr. X 8 hrs./day X 6 days =


$4,320
9 employees X $10.00/hr. X 8 hrs./day X 4 days =
$2,880
9 employees X $11.00/hr. X 8 hrs./day X 6 days =
$4,752
9 employees X $10.00/hr. X 8 hrs./day X (64) days =
$1,440
9 employees X $11.00/hr. X 8 hrs./day X (52) days = + $2,376
$3,816

(5) 9 employees X $11.00/hr. X 8 hrs./day X 5 days =

$3,960

NOTE: Sick days are paid at the employees current wage.


(c)

Accrued liability at year-end:


2004
2005
Vacation
Sick Pay
Vacation
Sick Pay
Wages
Wages
Wages
Wages
Payable
Payable
Payable
Payable
Jan. 1 balance
$
0
$
0
$7,200
$1,440
+ accrued
7,200
4,320
7,920
4,752
paid
( 0)
(2,880)
(6,480)
(3,816)
Dec. 31 balance $7,200(1)
$1,440(2) $8,640 (3) $2,376(4)
(1)

9 employees X $10.00/hr. X 8 hrs./day X 10 days =

$7,200

(2)

9 employees X $10.00/hr. X 8 hrs./day X


(64) days =

$1,440

(3)

(4)

9 employees X $10.00/hr. X 8 hrs./day X


(109) days =
9 employees X $11.00/hr. X 8 hrs./day X 10 days =
9 employees X $11.00/hr. X 8 hrs./day X
(6 + 6 4 5) days

$ 720
+ 7,920
$8,640
$2,376

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EXERCISE 14-9 (25-30 minutes)


(a)
2004

To accrue the expense and liability for vacations:


Wages Expense
7,740 (1)
Vacation Wages Payable
7,740
To record vacation time paid:
No entry.

2005

To accrue the expense and liability for vacations:


Wages Expense
8,352 (2)
Vacation Wages Payable
8,352
To record vacation time paid:
Wage Expense
Vacation Wages Payable
Cash

(1)
(2)
(3)
(4)
(b)
2004

2005

(1)
(2)

162
6,966 (3)
7,128 (4)

9 employees X $10.75/hr. X 8 hrs./day X 10 days = $7,740


9 employees X $11.60/hr. X 8 hrs./day X 10 days = $8,352
9 employees X $10.75/hr. X 8 hrs./day X 9 days = $6,966
9 employees X $11.00/hr. X 8 hrs./day X 9 days = $7,128
To record sick time paid:
Wages Expense
Cash

2,880 (1)

To record sick time paid:


Wages Expense
Cash

3,960 (2)

2,880

3,960

9 employees X $10.00/hr. X 8 hrs./day X 4 days = $2,880


9 employees X $11.00/hr. X 8 hrs./day X 5 days = $3,960

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EXERCISE 14-9 (Continued)


(c)

Accrued liability at year-end (vacation pay only):


2004
2005
Jan. 1 balance
$
0
$7,740
+ accrued
7,740
8,352
paid
( 0)
(6,966)
Dec. 31 balance
$7,740(1)
$9,126(2)

(1)

9 employees X $10.75/hr. X 8 hrs./day X 10 days =

$7,740

(2)

9 employees X $10.75/hr. X 8 hrs./day X 1 day =


9 employees X $11.60/hr. X 8 hrs./day X 10 days =

$ 774
8,352
$9,126

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14-22
Chapter 14
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page is strictly prohibited.

EXERCISE 14-10 (15-20 minutes)


(a)

Wages and Salaries Expense..........................................


495,000
Employee Income Tax Deductions
Payable.........................................................
90,000
EI Premiums Payable*......................................
7,425
CPP Contributions Payable**..........................
18,563
Union Dues Payable.........................................
9,000
Cash...................................................................
370,012
*($495,000 $120,000) X 1.98% = $7,425
**($495,000 $120,000) X 4.95% = $18,563
Payroll Tax Expense................................................
28,951
EI Premiums Payable.......................................
($495,000 $120,000) X 2.77%
CPP Contributions Payable.............................
(See previous computation)

(b)

10,388
18,563

Employee Income Tax Deductions


Payable.........................................................................
90,000
EI Premiums Payable ($7,425 + $10,388)...............
17,813
CPP Contributions Payable...............................
37,126
($18,563 + $18,563)
Cash...................................................................
144,939
Union Dues Payable................................................
9,000
Cash...................................................................

9,000

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page is strictly prohibited.

EXERCISE 14-11 (30-35 minutes)


(a)
Wages
CPP
Contributions
EI Premiums
Total Cost

Total

Factory

Sales

$200,000

$120,000

$44,000

Administrative
$36,000
7

9,306
1,607
$210,913

1
2

5,940
1,108
$127,048

3
4

1,584
388
$45,972

5
6

1,782
111
$37,893

$188,000 X 4.95% = $9,306


$58,000 X 2.77% = $1,607
3
$120,000 X 4.95% = $5,940
4
$40,000 X 2.77% = $1,108
5
$32,000 X 4.95% = $1,584
6
$14,000 X 2.77% = $388
7
$36,000 X 4.95% = $1,782
8
$4,000 X 2.77% = $111
2

(b)
Factory Payroll:
Wages and Salaries Expense - Factory..........................
120,000
Employee Income Tax Deductions
Payable................................................................
EI Premiums Payable ($40,000 X 1.98%)...............
CPP Contributions Payable....................................
Cash .........................................................................

14,500
792
5,940
98,768

Payroll Tax Expense - Factory.........................................


7,048
EI Premiums Payable ($40,000 X 2.77%)...............
CPP Contributions Payable....................................

1,108
5,940

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page is strictly prohibited.

EXERCISE 14-11 (Continued)


Sales Payroll:
Wages and Salaries Expense - Sales..............................
44,000
Employee Income Tax Deductions
Payable................................................................
EI Premiums Payable ($14,000 X 1.98%)...............
CPP Contributions Payable....................................
Cash .........................................................................

6,000
277
1,584
36,139

Payroll Tax Expense - Sales.............................................


1,972
EI Premiums Payable ($14,000 X 2.77%)...............
CPP Contributions Payable....................................

388
1,584

Administrative Payroll:
Wages and Salaries Expense - Administrative..............
36,000
Employee Income Tax Deductions
Payable................................................................
EI Premiums Payable ($4,000 X 1.98%).................
CPP Contributions Payable....................................
Cash .........................................................................

7,500
79
1,782
26,639

Payroll Tax Expense - Administrative.............................


1,893
EI Premiums Payable ($4,000 X 2.77%).................
CPP Contributions Payable....................................

111
1,782

(c)

Wages for November 2005 = $200,000


Total payroll cost for November 2005 = $210,913
Cost per dollar of wages = ($210,913 $200,000) = $1.05

(d)

Employee Income Tax Deductions


Payable.........................................................................
28,000
EI Premiums Payable..............................................
2,755
($1,607 + $792 + $277 + $79)
CPP Contributions Payable...............................
18,612
($9,306 + $9,306)
Cash...................................................................
49,367

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Chapter 14
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page is strictly prohibited.

EXERCISE 14-12 (15-20 minutes)


Pippen Corp.
Income Statement
For the Year Ended December 31, 2005
Revenue
Cost of goods sold
Gross profit
Administrative and selling expenses
Profit-sharing bonus to employees
Income before income taxes
Income taxes (45%)
Net income

$10,000,000
7,000,000
3,000,000
$1,000,000
198,198

1,198,198
1,801,802
810,811
$ 990,991

Computation of bonus and tax:


T = .45 ($3,000,000 $1,000,000 B)
B = .20 ($2,000,000 B T)
B = .20 [$2,000,000 B .45 ($2,000,000 B)]
B = .20 ($2,000,000 B $900,000 + .45B)
B = .20 ($1,100,000 .55B)
B = $220,000 .11B
1.11B = $220,000
Bonus = $198,198.20
T = .45 ($2,000,000 $198,198.20)
T = .45 ($1,801,801.80)
Taxes = $810,810.81

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page is strictly prohibited.

EXERCISE 14-13 (10-15 minutes)


(a)

Cash (200 X $4,000)..........................................................


800,000
Sales.........................................................................
800,000
Method A:
Warranty Expense.............................................................
17,000
Cash, Inventory, Accrued Payroll...........................17,000
Warranty Expense ($66,000 $17,000)...........................
49,000
Estimated Liability Under
Warranties...........................................................49,000
Method B:
Estimated Liability Under Warranties.............................
17,000
Cash, Inventory, Accrued Payroll...........................17,000
Warranty Expense.............................................................
66,000
Estimated Liability Under
Warranties...........................................................66,000

(b)

Cash ...................................................................................
800,000
Sales.........................................................................
800,000
Warranty Expense.............................................................
17,000
Cash, Inventory, Accrued Payroll...........................17,000

(c) The cash method of accounting for warranty costs is


acceptable when the costs are not material or when the warranty
period is relatively short. It may also be acceptable when the
amount of the liability cannot be reasonably estimated or if
future costs are not likely to be incurred.

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page is strictly prohibited.

EXERCISE 14-14 (15-20 minutes)


(a)

Accounts Receivable........................................................
3,000,000
Sales.........................................................................
3,000,000
(500 X $6,000)
Method A:
Warranty Expense.............................................................
20,000
Cash, Inventory,
Accrued Payroll..................................................20,000
Warranty Expense.............................................................
100,000
Estimated Liability Under
Warranties...........................................................
100,000
($120,000 $20,000)
Method B:
Estimated Liability Under Warranties.............................
20,000
Cash, Inventory,
Accrued Payroll..................................................20,000
Warranty Expense.............................................................
120,000
Estimated Liability Under
Warranties...........................................................
120,000

(b)

Accounts Receivable........................................................
3,000,000
Sales.........................................................................
2,850,000
Unearned Warranty Revenue..................................
150,000
Warranty Expense.............................................................
20,000
Cash, Inventory,
Accrued Payroll..................................................20,000
Unearned Warranty Revenue...........................................
25,000
Warranty Revenue...................................................25,000
[$150,000 X ($20,000/$120,000)]

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page is strictly prohibited.

EXERCISE 14-15 (15-20 minutes)


Inventory of Premiums (8,800 X $1.40)...........................
12,320
Cash..........................................................................

12,320

Cash (110,000 X $4.50)......................................................


495,000
Sales.........................................................................

495,000

Method A:
Premium Expense.............................................................
6,160
Inventory of Premiums............................................
[(44,000 10) X $1.40]

6,160

Premium Expense.............................................................
3,080
Estimated Liability for Premiums...........................
[(110,000 X 60%) 44,000] 10 X $1.40

3,080

Method B:
Estimated Liability for Premiums....................................
6,160
Inventory of Premiums............................................
[(44,000 10) X $1.40]

6,160

Premium Expense.............................................................
9,240
Estimated Liability for Premiums...........................
(110,000 X 60%) 10 X $1.40

9,240

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page is strictly prohibited.

EXERCISE 14-16 (20-30 minutes)


1 (a) Total coupons issued
Redemption rate
To be redeemed
Handling charges ($480,000 X 10%)
Total cost
Total cost
Total payments to retailers
Liability for unredeemed coupons
(b) Premium expense
2 (a) Boxes sold
Redemption rate
Total redeemable coupons
Coupons to be redeemed (490,000 250,000)
Cost ($6.00 $4.00)
Liability for unredeemed coupons
(b) Total redeemable coupons
Cost ($6.00 $4.00)
Coupon expense

$800,000
60%
480,000
48,000
$528,000
$528,000
330,000
$198,000
$528,000
700,000
70%
490,000
240,000
$2.00
$480,000
490,000
$2.00
$980,000

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page is strictly prohibited.

EXERCISE 14-17 (10-15 minutes)


Estimated warranty expense for 2006:
On 2006 sales: $1,200,000 X .09* =

$ 108,000

* (2% of sales first year + 3% of sales second year + 4% of sales


third year = 9% of sales)
Estimated warranty costs:
On 2004 sales $ 800,000 X .09
On 2005 sales $1,100,000 X .09
On 2006 sales $1,200,000 X .09
Total estimated costs
Total warranty expenditures
Balance of liability, 12/31/06

$ 72,000
99,000
108,000
279,000
85,700*
$193,300

*2004$6,500; 2005$17,200, and 2006$62,000.


The liability account has a balance of $193,300 at 12/31/06 based
on the difference between the estimated warranty costs
(totalling $279,000) for the three years sales and the actual
warranty expenditures (totalling $85,700) during that same
period.

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page is strictly prohibited.

EXERCISE 14-18 (10-15 minutes)


(a)
Oil Tanker Depot
Cash

July 2, 2005

Oil Tanker Depot


Asset Retirement Obligation
(b)
December 31, 2005
Amortization Expense
Accumulated Amortization
Oil Tanker Depot
($600,000 + $41,879) 10 X 6/12
Accretion Expense
Asset Retirement Obligation
($41,879 X 6% X 6/12)
(c)
June 30, 2015
Asset Retirement Obligation
Loss on Settlement of Asset Retirement
Obligation
Cash

600,000
600,000
41,879
41,879
32,094
32,094
1,256
1,256

75,000
5,000
80,000

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page is strictly prohibited.

EXERCISE 14-19 (20-30 minutes)


1.

The CICA Handbook section 3290 requires that, when some


amount within the range appears at the time to be a better
estimate than any other amount within the range, that
amount be accrued. When no amount within the range is a
better estimate than any other amount, the dollar amount at
the low end of the range is accrued and the dollar amount
of the high end of the range is disclosed. Since the
information indicates that it is likely that a liability has been
incurred at December 31, 2005, and a range of possible
amounts can be reasonably determined, the criteria for
recording a liability are met. In this case, therefore, Salt-NPepper Inc. would report a liability of $900,000 at December
31, 2005 and would disclose that the high end of the
estimate range is $1.2 million.

2.

Su Li Corp. would not be required to make any entry. The


wage increase is for the coming two years and does not
relate to the current or prior years.

3.

The loss should be accrued since both criteria (it is likely


that a loss is incurred and the amount of the loss can be
reasonably determined) for recording the contingency are
met. Given that the loss is covered by insurance, except for
the $500,000 deductible, only the $500,000 should be
accrued.

4.

This is a gain contingency because the amount to be


received will be in excess of the book value of the plant.
Gain contingencies are not recorded and are disclosed in
the notes only when the probabilities are high that a gain
contingency will become reality.

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page is strictly prohibited.

EXERCISE 14-20 (30-35 minutes)


#

Assets

Liabilities

Owners Equity

Net Income

NE

NE

NE

NE

NE

NE

NE

NE

NE

NE

NE

NE

10

NE

NE

NE

NE

11

NE

12

NE

13

NE

14

NE

NE

15

16

NE

17

NE

18

NE

19

NE

NE

20

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page is strictly prohibited.

EXERCISE 14-21 (15-20 minutes)


(a)

Current Ratio =

Current Assets
Current Liabilities

$210,000
$80,000

= 2.63

Current ratio measures the short-term ability of the


company to meet its currently maturing obligations.
(b)

Acid-test
ratio

Cash + Marketable Securities + Receivables


Current Liabilities

$115,000
$80,000

1.44

Acid-test ratio also measures the short-term ability of the


company to meet its current maturing obligations.
However, it eliminates assets that might be slow moving,
such as inventories and prepaid expenses.
(c)

Total Liabilities
Total Assets

Debt to total assets =

$220,000
$430,000

51.16%

This ratio provides the creditors with some idea of the


corporations ability to withstand losses without impairing
the interest of creditors.
(d)

Rate of return on
assets

=
=

Net Income
Average Total Assets
$25,000
$430,000

5.81%

This ratio measures the return the company is earning on


its average total assets and provides one indication related
to the profitability of the enterprise.

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EXERCISE 14-21 (Continued)

(e)

Days payables
outstanding

Average Trade Accounts


Payable
Average Daily Cost of Goods
Sold
$80,000
$504,000/365

58 days

This ratio measures the time it takes a company to pay its


trade accounts payable and provides one indication related
to the liquidity of the enterprise if the number of days
exceeds the normal credit period for the industry, or if the
ratio reveals an increasing trend.

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page is strictly prohibited.

EXERCISE 14-22 (20-25 minutes)


(a)
1.

Current ratio =

$773,000
$240,000

2.

Acid-test ratio =

$52,000 + $198,000 + $80,000


$240,000

= 3.22 times
= 1.38 times

3.

Accounts receivable turnover =


$80,000 + $198,000
$1,640,000
= 11.8 times
2
(or approximately every 31 days)

4.

Inventory turnover =
$360,000 + $440,000
= 2 times
2
(or approximately every 183 days)
$800,000

5.

Days payables outstanding =


$145,000 + $220,000
2

6.

7.

$800,000
365

Rate of return on assets =


$1,400,000 + $1,630,000
$360,000
2

= 83 days

= 23.76%

Profit margin on sales =


$360,000 $1,640,000 = 21.95%

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EXERCISE 14-22 (Continued)


(b)

Financial ratios should be evaluated in terms of industry


peculiarities and prevailing business conditions. Although
industry and general business conditions are unknown in
this case, the company appears to have a relatively strong
current position. The main concern from a short-term
perspective is the apparently low inventory turnover and
the high days payables outstanding. The two ratios may be
linked where extended credit terms are provided by
suppliers if the inventory is slow-moving. The rate of return
on assets and profit margin on sales are extremely good
and indicate that the company is employing its assets
advantageously.

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page is strictly prohibited.

EXERCISE 14-23 (15-25 minutes)


(a) 1. $318,000 $87,000 = 3.66 times
2. $820,000

$200,000 + $170,000
= 4.43 times = 82 days
2

3. $1,400,000 $95,000 = 14.74 times


4. 365 14.74 times = 25 days
5. $32,000 $820,000 X 365 = 14 days
6. $410,000 $52,000 = $7.88
7. $410,000 $1,400,000 = 29.3%
8. $410,000 $488,000 = 84.02%
(b)

1.

No effect on current ratio.

2.

Weaken current ratio by increasing current assets


and current liabilities by a like amount.

3.

Improve current ratio by reducing current assets and


current liabilities by a like amount.

4.

No effect on current ratio.

5.

Weaken current ratio by increasing current liabilities.

6.

No effect on current ratio.

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page is strictly prohibited.

TIME AND PURPOSE OF PROBLEMS


Problem 14-1

(Time 30-40 minutes)

Purposeto present the student with an opportunity to prepare journal entries for
a variety of situations related to liabilities. The situations presented include
purchases and payments on account, and borrowing funds by giving a zerointerest-bearing note, sales taxes, deposits and income taxes. The student is
also required to prepare year-end adjusting entries and to calculate sales taxes
two ways.

Problem 14-2

(Time 20-30 minutes)

Purposeto present the student with an opportunity to prepare journal entries for
four weekly payrolls. The student must compute income tax to be withheld, CPP
premiums, and employment insurance. The student must catch the fact that in
the first week one employees pay exceeds the annual maximum for CPP
premiums. The same employees pay exceeds the maximum for employment
insurance for all four pays.

Problem 14-3

(Time 30-35 minutes)

Purposeto provide the student with the opportunity to prepare journal entries
for a monthly payroll. The student must compute income tax to be withheld, CPP
Contributions and Employment Insurance. The student must be aware that the
CPP Contributions do not apply to two employees as their earnings exceed the
statutory maximum subject to CPP. The student must also be aware that the
maximum premiums for EI apply for two employees as their earnings exceed the
statutory maximum.

Problem 14-4

(Time 15-20 minutes)

Purposeto provide the student with an opportunity to prepare journal entries


and balance sheet presentations for warranty costs under the cash basis and the
accrual basis. Entries in the sales year and one subsequent year are required.
The problem highlights the differences between the two methods in the accounts
and on the balance sheet.

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page is strictly prohibited.

TIME AND PURPOSE OF PROBLEMS (CONTINUED)


Problem 14-5

(Time 20-30 minutes)

Purposeto provide the student with a problem covering the sales warranty
method and accrual warranty expenses combined in the same sale. The student
is required to prepare journal entries in the year of sale and in subsequent years
as warranty costs are incurred. Also required are balance sheet presentations for
the year of sale and two subsequent years.

Problem 14-6

(Time 25-35 minutes)

Purposeto provide the student with an opportunity to prepare journal entries for
warranty costs under the accrual method and the cash basis method. The
student is also required to indicate the proper balance sheet disclosures under
each method for the year of sale. Finally, the student is required to comment on
the effect on net income of applying each method. The problem highlights the
differences between the two methods in the accounts and on the balance sheet.

Problem 14-7

(Time 20-30 minutes)

Purposeto provide the student with a basic problem in accounting for premium
offers. The student is required to prepare journal entries relating to sales, the
purchase of the premium inventory, and the redemption of coupons. The student
must also prepare the year-end adjusting entry reflecting the estimated liability
for premium claims outstanding. The student is required to prepare the entries
under two different approaches; the premium redemptions are recorded as
premium expense or as a decrease of the premium liability. A very basic problem.

Problem 14-8

(Time 30-45 minutes)

Purposeto present the student with a problem related to accounting for


premium offers. The problem is more complicated in that coupons redeemed are
accompanied by cash payments, and in addition to the cost of the premium item,
postage costs are also incurred. The student is required to prepare journal
entries for various transactions including sales, purchase of the premium
inventory, and redemption of coupons for two years. The second years entries
are more complicated due to the existence of the liability for claims outstanding.
Finally the student is required to indicate the amounts related to the premium
offer that would be included in the financial statements for each of two years and
determine if the liability is financial. This very realistic problem challenges the
students ability to account for all transactions related to premium offers.

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TIME AND PURPOSE OF PROBLEMS (CONTINUED)


Problem 14-9

(Time 25-30 minutes)

Purposeto present the student with the problem of determining the proper
amount of and disclosure for two contingent losses due to lawsuits. The student
is required to prepare journal entries and footnotes. The student is also required
to discuss any liability incurred by a company due to the risk of loss from lack of
insurance coverage. A straightforward problem dealing with contingent losses.

Problem 14-10 (Time 45-50 minutes)


Purposeto provide the student with a comprehensive problem dealing with
contingent losses. The student is required to prepare journal entries for each of
four independent situations. For each situation the student must also discuss the
appropriate disclosure in the financial statements. The situations presented
include a lawsuit, an environmental assessment, an expropriation, and selfinsurance situation. This problem challenges the student not only to apply the
guidelines set forth in Handbook Section 3290, but also to develop reasoning as
to how the guidelines relate to each situation. The student is also required to
discuss ethical issues inherent in contingent liabilities. A good problem to analyze
the effects of Section 3290 on a variety of situations and Section 3480 on
extraordinary items.

Problem 14-11 (Time 20-30 minutes)


Purposethe student calculates warranty expense, estimated liability for
warranties, premium expense, inventory of premiums, and estimated liability for
premiums.

Problem 14-12 (Time 25-30 minutes)


Purposeto provide a problem in determining various liabilities, including
advance payments, self insurance, litigation, commitments, guarantees, and loss
contingencies. The students must also discuss any required disclosures.

Problem 14-13 (Time 25-30 minutes)


Purposeto provide the student with experience in computing bonuses under a
variety of compensation plans. The student must compute a bonus before
deduction of bonus and income taxes, after deduction of bonus but before
deduction of income taxes, and before deduction of bonus but after deduction of
income taxes.
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TIME AND PURPOSE OF PROBLEMS (CONTINUED)


Problem 14-14 (Time 30-40 minutes)
Purposeto provide the student with experience in calculating the amounts of
various liabilities and determining the portion relating to current liabilities. The
student must calculate the interest payable on bonds payable and notes payable,
estimated liability for warranties, employee withholding amounts payable, GST
payable, and other miscellaneous payables. The student is also required to
discuss why certain items were excluded from current liabilities and which items
are considered financial liabilities. Journal entries are not required. This problem
is an excellent overview of chapter content.

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SOLUTIONS TO PROBLEMS
PROBLEM 14-1
(a)
Purchases
Accounts Payable

February 2
49,000
49,000
February 26

Accounts Payable
Purchase Discounts Lost
Cash

49,000
1,000
50,000
April 1

Trucks
Cash
Notes Payable

40,000
4,000
36,000
May 1

Cash
Discount on Notes Payable
Notes Payable

80,000
12,000
92,000
June 30

Income Tax Expense


Cash

22,000
22,000

August 14
Retained Earnings (Dividends Declared)
Dividends Payable

15,000
15,000

September 10
Dividends Payable
Cash

15,000
15,000
December 5

Cash

500
Returnable Deposit Liability

500

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PROBLEM 14-1 (Continued)


December 10
Display Cases ($9,000 X 1.05)
GST Receivable ($9,000 X .07)
Accounts Payable

9,450
630
10,080

December 31
Cash

83,500
Sales ($83,500 1.12)
Sales Taxes Payable ($74,553 X .05)
GST Payable ($74,553 X .07)

74,553
3,728
5,219

December 31
Income Tax Expense
Cash

22,000
22,000
December 31

Income Tax Expense


Income Taxes Payable
($210,000 X 25%) ($22,000 X 2)

8,500
8,500

December 31
Interest Expense ($36,000 X 12% X )
Interest Payable

3,240

December 31
Interest Expense ($12,000 X 8/12)
Discount on Notes Payable

8,000

3,240

8,000

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PROBLEM 14-1 (Continued)


(b)

Current Liabilities:
Accounts Payable
Note Payable
Interest Payable
Note Payable
Discount on Note Payable
Sales Taxes Payable
GST Payable ($5,219 - $630)
Income Taxes Payable
Returnable Deposit Liability
Total Current Liabilities

(c)
December 10
Display Cases ($9,000 + [$9,000 X 1.07 X .05])
GST Receivable ($9,000 X .07)
Accounts Payable

$10,080
$36,000
3,240
92,000
(4,000)

39,240
88,000
3,728
4,589
8,500
500
$154,637

9,482
630
10,112

December 31
Cash

83,500
Sales ($83,500 1.1235*)
Sales Taxes Payable
($74,321 X 1.07 X .05)
GST Payable ($74,321 X .07)

74,321
3,976
5,203

*The combined rate is 1.07 X 1.05 = 1.1235.

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PROBLEM 14-2
(a)
Entries for Payroll 1
Wages and Salaries Expense
Employee Income Tax Deductions
Payable (10% X $2,540)
EI Premiums Payable **
CPP Contributions Payable ***
Union Dues Payable (1% X $2,540)
Cash

2,540.00*
254.00
40.39
50.53
25.40
2,169.68

*$480 + $450 + $110 + $250 + $1,250 = $2,540


Payroll Tax Expense
EI Premiums Payable (1.4 X $40.39)
CPP Contributions Payable

107.08
56.55
50.53

** The weekly maximum for EI Premiums is $772 52 weeks =


$14.85 per week. Peter Cash exceeds the weekly maximum
($1,250 X 1.98% = $24.75), so his EI premium is limited to
$14.85.
EI Premiums = [($2,540 - $1,250) X 1.98%] + $14.85
= ($1,290 X 1.98%) + $14.85 = $40.39
***The annual income limit for CPP purposes is $39,900. Peter
Cash has exceeded that limit in his earnings to July 31. No
CPP Contributions are made on his behalf for the remainder
of the year.
CPP Contributions = [($2,540 - $1,250 ($67.31 1 X 4)) X 4.95%]
= ($1,020.76 X 4.95%) = $50.53
1

Basic exemption of $3,500 per year / 52 weeks = $67.31 per


week.

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PROBLEM 14-2 (Continued)


Entries for Payroll 2 and 3 (individually)
Vacation Wages Payable
1,810.00
($450 + $110 + $1,250)
730.00
Wages and Salaries Expense
Employee Income Tax Deductions
254.00
Payable (10% X $2,540)
EI Premiums Payable
40.39
CPP Contributions Payable
50.53
Union Dues Payable (1% X $2,540)
25.40
Cash
2,169.68
Payroll Tax Expense
EI Premiums Payable (1.4 X $40.39)
CPP Contributions Payable
Entries for Payroll 4
Wages and Salaries Expense
Employee Income Tax Deductions
Payable (10% X $2,540)
EI Premiums Payable
CPP Contributions Payable
Union Dues Payable (1% X $2,540)
Cash
Payroll Tax Expense
EI Premiums Payable (1.4 X $40.39)
CPP Contributions Payable

107.08
56.55
50.53

2,540.00
254.00
40.39
50.53
25.40
2,169.68
107.08
56.55
50.53

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PROBLEM 14-2 (Continued)


(b)
Monthly Payment of Payroll Liabilities
Employee Income Tax Deductions Payable
($254.00 X 4)
1,016.00
EI Premiums Payable
[($40.39 X 4) + ($56.55 X 4)]
387.76
CPP Contributions Payable ($50.53 X 8)
404.24
Union Dues Payable ($25.40 X 4)
101.60
Cash
1,909.60
(c)
Vacation Entitlement for August
Wages and Salaries Expense
261.60
Vacation Wages Payable
$2,540 X 2 weeks X 4% =
$730 X 2 weeks X 4% =

261.60

$203.20
58.40
$261.60

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PROBLEM 14-3
(a)
Name

Earnings
to Aug. 31

B. D. Williams
D. Prowse
K. Baker
F. Oz
A. Daniels *
P. Mayhew *
Total

$ 6,800
6,300
7,600
13,600
105,000
112,000
$251,300

Income
Tax
WithSept.
Earnings holding
$ 800
700
1,100
1,900
15,000
16,000
35,500

$ 80
70
110
190
1,500
1,600
$3,550

CPP

EI

Union
Dues

$ 39.60 $15.84
$8.00
34.65
13.86
7.00
54.45
21.78
11.00
94.05
37.62
19.00
64.35 150.00
64.35 160.00
$222.75 $217.80 $355.00

* The annual income limit for CPP purposes is $39,900. A.


Daniels and P. Mayhew have exceeded that limit before the
month of September. No CPP Contributions are made on their
behalf for the remainder of the year.
The maximum monthly pay subject to EI Premiums is $39,000
12 months = $3,250.00 per month. A. Daniels and P. Mayhew
exceed the monthly maximum. Their monthly EI Premiums
will be limited to $3,250 X 1.98% = $64.35.
Wages and Salaries Expense
Employee Income Tax
Deductions Payable
EI Premiums Payable
CPP Contributions Payable
Union Dues Payable
Cash
(b)

Payroll Tax Expense


EI Premiums Payable
(1.4 X $217.80)
CPP Contributions Payable

35,500.00
3,550.00
217.80
222.75
355.00
31,154.45
527.67
304.92
222.75

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PROBLEM 14-3 (Continued)


(c)

Employee Income Tax Deductions


Payable
EI Premiums Payable
($217.80 + $304.92)
CPP Contributions Payable
($222.75 + $222.75)
Union Dues Payable
Cash

(d) Wages and Salaries Expense


Payroll tax expense
Total cost for September 2004

3,550.00
522.72
445.50
355.00
4,873.22
$35,500.00
527.67
$36,027.67

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PROBLEM 14-4

(a)
(b)

Cash (300 X $3,500)


Sales

1,050,000

Cash (300 X $3,500)


Sales

1,050,000

Warranty Expense
Estimated Liability Under
Warranties
(300 X [$155 + $185])

1,050,000
1,050,000
102,000
102,000

(c)

No liability would be disclosed under the cash basis


method relative to future costs due to warranties on past
sales.

(d)

Current Liabilities:
Estimated Liability Under Warranties

$51,000

Long-term Liabilities:
Estimated Liability Under Warranties

$51,000

(e)

(f)

(g)

Warranty Expense
Parts Inventory
Accrued Payroll

46,300

Estimated Liability Under Warranties


Parts Inventory
Accrued Payroll

46,300

21,400
24,900
21,400
24,900

The company should apply the accrual basis. This would


result in better matching of warranty costs with the
revenues that generate them. The cash basis would be
acceptable only where the warranty costs are immaterial or
when the warranty period is relatively short. This is not the
case for Davey Corporation.

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PROBLEM 14-5
(a)

Cash

245,250
Sales (300 X $750)
Unearned Warranty Revenue
(270 X $75)

Warranty Expense
Estimated Liability Under
Warranties
(300 X $15)
(b)

(c)

(d)

225,000
20,250
4,500
4,500

Current Liabilities:
Estimated Liability Under
Warranty

$ 4,500

Long-term Liabilities:
Unearned Warranty Revenue

$20,250

Estimated Liability Under


Warranties
Parts Inventory
Accrued Payroll

4,410
1,470
2,940

Current Liabilities:
Unearned Warranty Revenue*

$ 6,750

Long-term Liabilities:
Unearned Warranty Revenue

$13,500

* The extended warranty costs are expected to be incurred


uniformly over the warranty period ($20,250 / 3 = $6,750).
The company would also have a remaining balance of $90
($4,500 less $4,410) in Estimated Liability Under Warranties.
This balance would be included in the new liability generated
from current year sales of televisions. If the remaining amount
is considered substantial, it would lead to a revision of the
estimate of warranty costs for the current year.
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PROBLEM 14-5 (Continued)


(e)

(f)

Unearned Warranty Revenue


Warranty Revenue

6,750

Warranty Expense**
Parts Inventory
Accrued Payroll

5,000

6,750
2,000
3,000

Current Liabilities:
Unearned Warranty Revenue

$ 6,750

Long-term Liabilities:
Unearned Warranty Revenue

$ 6,750

** The remaining $90 from $4,500 Estimated Liability Under


Warranties for 2005 sales is assumed included with the liability
for 2006 sales. Also note that estimated warranty expense
should be revised upwards, given costs for 2 years ($4,410 +
$5,000) is greater than the original $4,500 estimate.

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PROBLEM 14-6
(a)
1.
2.

Cash or Accounts Receivable


Sales (650 X $7,400)
Method A:
Warranty Expense
Parts Inventory
($170 X 650 X 1/2)
Accrued Payroll
($200 X 650 X 1/2)
Method B:
Estimated Liability Under Warranties
Parts Inventory
Accrued Payroll

3.

Method A:
Warranty Expense
Estimated Liability Under
Warranties
([650 machines X $370] $120,250)
Method B:
Warranty Expense
Estimated Liability Under
Warranties
(650 machines X $370)

4.

Estimated Liability Under Warranties


Parts Inventory
Accrued Payroll

4,810,000
4,810,000
120,250
55,250
65,000

120,250
55,250
65,000
120,250
120,250

240,500
240,500
120,250
55,250
65,000

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PROBLEM 14-6 (Continued)


(b)
1.
2.

Cash or Accounts Receivable


Sales
Warranty Expense
Parts Inventory
Accrued Payroll

4,810,000
4,810,000
120,250
55,250
65,000

3.

Under the cash basis method, the total warranty expense is


recorded through entries 2 and 4 that recognize warranty
costs as incurred. Warranty expense for 2005 is $120,250
under the cash basis.

4.

Warranty Expense
Parts Inventory
Accrued Payroll

120,250
55,250
65,000

(c)

Cash basis method:


No liability for future costs to be incurred under
outstanding warranties is recorded or normally
disclosed under the cash basis method.
Accrual method:
As of 12/31/05 the balance sheet would disclose a
current liability in the amount of $120,250 for
Estimated Liability Under Warranties.

(d)

In the case of Belle Limited, the expense warranty accrual


method reflects properly the income resulting from
operations in 2005 and 2006 because the warranty costs
are matched with the revenues resulting from the sale,
which required such costs to be incurred. Under the cash
basis method, the warranty costs appearing on the 2006
income statement are charged against unrelated revenues;
2005 net income is overstated and 2006 net income is
understated.

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PROBLEM 14-6 (Continued)


(e)

If the warranty costs are considered to be immaterial, the


cash basis method could be used and warranty costs
recognized in the year they are incurred.
However, if the warranty costs are considered material to
the companys financial statements, the company may have
to defer recognizing the revenue from the sale of the
product until all costs can be measured and matched
against the related revenues.

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PROBLEM 14-7
(a)
Inventory of Premium Puppets........................................
60,000
Cash..........................................................................
(To record purchase of 40,000
puppets at $1.50 each)

60,000

Cash ...................................................................................
1,650,000
Sales......................................................................... 1,650,000
(To record sales of 440,000 boxes
at $3.75 each)
Premium Expense.............................................................
31,500
Inventory of Premium Puppets...............................
[To record redemption of 105,000
coupons. Computation:
(105,000 5) X $1.50 = $31,500]
Premium Expense.............................................................
21,300
Estimated Liability for Premiums...........................
[To record estimated liability for
premium claims outstanding at
December 31, 2005.]

31,500

21,300

Computation: Total coupons issued in 2005

440,000

Total estimated redemptions (40%)


Coupons redeemed in 2005
Estimated future redemptions

176,000
105,000
71,000

Cost of estimated claims outstanding


(71,000 5) X $1.50 = $21,300

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PROBLEM 14-7 (Continued)


(b)
Inventory of Premium Puppets........................................
60,000
Cash..........................................................................
(To record purchase of 40,000
puppets at $1.50 each)

60,000

Cash ...................................................................................
1,650,000
Sales......................................................................... 1,650,000
(To record sales of 440,000 boxes
at $3.75 each)
Premium Expense.............................................................
52,800
Estimated Liability for Premiums...........................
[To record premium expense for
the full estimated cost of the
premium plan]
Computation:
Total coupons issued in 2005
Redemption rate
Total estimated redemptions (40%)
Number of coupons per premium
Number of premium claims
Cost of premium
Total premium expense for the year 2005
Estimated Liability for Premiums....................................
31,500
Inventory of Premium Puppets...............................
[To record redemption of 105,000
coupons. Computation:
(105,000 5) X $1.50 = $31,500]

52,800

440,000
X
40%
176,000

5
35,200
X $1.50
$52,800
31,500

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PROBLEM 14-8
(a) 2005
Inventory of Premium CDs
Cash
(To record the purchase of 250,000
CDs at $1.80 each)
Cash

450,000
450,000

868,620
Sales
(To record the sale of 2,895,400
candy bars at 30 cents each)

Cash ($480,000 $120,000)


Premium Expense
Inventory of Premium CDs
[To record the redemption of
1,200,000 wrappers, the receipt of
$480,000 (1,200,000 5) X $2.00,
and the mailing of 240,000 CDs]
Computation of premium expense:
240,000 CDs X $1.80 each =
Postage240,000 X $.50 =
Less: Cash received
240,000 X $2.00
Premium expense for CDs issued

868,620

360,000
72,000
432,000

$432,000
120,000
$552,000
480,000
$ 72,000

Premium Expense
17,400*
Estimated Liability for Premiums
(To record the estimated liability for
premium claims outstanding at
12/31/05)
*(290,000 5) X ($1.80 + $.50 $2.00) = $17,400

17,400

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PROBLEM 14-8 (Continued)


2006
Inventory of Premium CDs
Cash
(To record the purchase of 330,000 CDs
at $1.80 each)

594,000

Cash

823,080

594,000

Sales
(To record the sale of 2,743,600 candy
bars at 30 cents each)
Cash ($600,000 $150,000)
Estimated Liability for Premiums
Premium Expense
Inventory of Premium CDs
(To record the redemption of 1,500,000
wrappers, the receipt of $600,000
[(1,500,000 5) X $2.00], and the
mailing
of 300,000 CDs.)
Computation of premium expense:
300,000 CDs X $1.80 =
Postage300,000 X $0.50 =
Less: Cash received
(1,500,000 5) X $2.00
Premium expense for CDs issued
Less: Outstanding claims at 12/31/05
charged to 2005 but redeemed in 2006
Premium expense chargeable to 2006

823,080

450,000
17,400
72,600
540,000

$540,000
150,000
690,000
600,000
90,000
17,400
$ 72,600

Premium Expense
21,000*
Estimated Liability for Premiums
21,000
*(350,000 5) X ($1.80 + $.50 $2.00) = $21,000
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PROBLEM 14-8 (Continued)


(b)
Account
Inventory of Premium
CDs
Estimated Liability for
Premiums
Premium Expense
1
2
3
4

Amount
2005
2006
Classification
$18,0001 $72,0002 Current asset
17,400
89,4003

21,000 Current liability


93,6004 Selling expense

$1.80 (250,000 240,000)


$1.80 (10,000 + 330,000 300,000)
$72,000 + $17,400
$72,600 + $21,000

(c) The Estimated Liability for Premiums is a financial liability


since it must be satisfied through a payment of cash for
postage. The amount represents the difference between the
cash received from the customer for the CD and the cost of
the CD and the cash paid for postage.

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PROBLEM 14-9
(a) 1. It is likely a loss and liability have been incurred and a
reasonable estimate can be made of the amount. The loss
and liability should be recorded as follows:
Loss from Accident
Liability for Accident

800,000
800,000

Note to the Financial Statements


The corporation is a defendant in a personal injury suit for
$4,000,000. The corporation is charging the year of the accident
with $800,000 in estimated losses, which represents the amount
the company estimates will likely be awarded.
2. Because the cause for litigation occurred before the date of
the financial statements and because an unfavourable
outcome is likely and reasonably estimable, Paris Airlines
should report a loss and a liability in the December 31,
2005, financial statements. The loss and liability might be
recorded as follows:
Loss from Uninsured Accident
Liability for Uninsured Accident
($5,000,000 X 60%)

3,000,000
3,000,000

Note to the Financial Statements


Due to an accident that occurred during 2003, the
corporation is a defendant in personal injury suits totalling
$5,000,000. The corporation is charging the year of the casualty
with $3,000,000 in estimated losses, which represents the
amount the company estimates will finally be awarded.

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PROBLEM 14-9 (Continued)


(b)

Paris Airlines need not establish a liability for risk of loss


from lack of insurance coverage itself. CICA Handbook
Section 3290 does not require or allow the establishment of
a liability for expected future injury to others or damage to
the property of others even if the amount of the losses is
reasonably estimable. The cause for a loss must occur on
or before the balance sheet date for a loss contingency to
be recorded. However, the fact that Paris is self-insured
should be disclosed in a note.

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PROBLEM 14-10
(a)
1.

2.

3.

4.
(b)
1.

Loss from Uninsured Accident


Liability for Uninsured
Accident

225,000

Loss Due to Environmental Clean-up


Liability for Environmental
Clean-up

500,000

Loss Due to Expropriation


Allowance for Expropriation
[$5,725,000 (40% X $8,700,000)]

225,000

500,000
2,245,000
2,245,000

No entry required.

A loss and a liability have been recorded in the first case


because (i) information is available prior to the issuance of
the financial statements that indicates it is likely that a
liability had been incurred at the date of the financial
statements and (ii) the amount is reasonably estimable.
That is, the occurrence of the uninsured accidents during
the year plus the outstanding injury suits and the legal
counsels estimate of probable loss required recognition of
a loss contingency.
No journal entry is recorded in the case of the $60,000
injury suit since it is considered unlikely that a liability has
been incurred at the date of the financial statements. If the
amount were considered material it would be desirable to
disclose the existence of the lawsuit in the notes to the
financial statements.

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PROBLEM 14-10 (Continued)


2.

A loss and a liability have been recorded because


information is available prior to the issuance of the
financial statements that indicates it is likely that a liability
had been incurred at the date of the financial statements.
Where a range of possible amounts is determined and no
one amount within the range is more likely than another,
the bottom of the range is usually accrued with the amount
of the remaining exposure disclosed in the notes.

3.

An entry to record a loss and establish an allowance due to


threat of expropriation is necessary because the
expropriation is imminent as evidenced by the foreign
governments communicated intent to expropriate and the
prior settlements for properties already expropriated. That
is, enough evidence exists to reasonably estimate the
amount of the probable loss resulting from impairment of
assets at the balance sheet date. The amount of the loss is
measured by the amount that the carrying value (book
value) of the assets exceeds the expected compensation.
At the time the expropriation occurs, the related assets are
written off against the allowance account. In this problem,
we established a valuation account because certain
specific assets were impaired. A valuation account was
established rather than a liability account because the net
realizable value of the assets affected has decreased. A
more appropriate presentation would, therefore, be
provided for balance sheet purposes on the realizable value
of the assets. It does not seem appropriate at this point to
write off the assets involved because it may be difficult to
determine all the specific assets involved, and because the
assets still have not been expropriated.

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PROBLEM 14-10 (Continued)


4.

Even though Shoyos chemical product division is


uninsurable due to high risk and has sustained repeated
losses in the past, as of the balance sheet date no assets
have been impaired or liabilities incurred nor is an amount
reasonably estimable. Therefore, this situation does not
satisfy the criteria for recognition of a loss contingency.
Also, unless a casualty has occurred or there is some
other evidence to indicate impairment of an asset prior to
the issuance of the financial statements, there is no
disclosure required relative to a loss contingency. The
absence of insurance does not of itself result in the
impairment of assets or the incurrence of liabilities.
Expected future injuries to others or damage to the
property of others, even if the amount is reasonably
estimable, does not require recording a loss or a liability.
The cause for loss or litigation or claim must have
occurred on or prior to the balance sheet date and the
amount of the loss must be reasonably estimable in order
for a loss contingency to be recorded. Disclosure is
required when one or both of the criteria for a loss
contingency are not satisfied and there is a reasonable
possibility that a liability may have been incurred or an
asset impaired, or, it is probable that a claim will be
asserted and there is a reasonable possibility of an
unfavourable outcome.

(c)

In contingencies related to legal proceedings, the accrual


for contingencies and the related disclosure can be
construed as an admission of guilt and could weaken the
companys position. Companys management has to
balance the need for full disclosure with the need for
careful management of the legal proceedings and
protecting shareholders interests by avoiding costly
lawsuit damages. The ethical issues also involve the
interpretation of terms such as likely and reasonably
estimable in determining when and how much is shown
on financial statements.

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PROBLEM 14-11
1.

Sales of musical instruments and sound


equipment
Estimated warranty rate
Warranty expense for 2005

$5,400,000
.02
$ 108,000

2.

Estimated liability for warranties1/1/05


2005 warranty expense (Requirement 1)
Subtotal
Actual warranty costs during 2005
Estimated liability for warranties12/31/05

$ 136,000
108,000
244,000
164,000
$ 80,000

3.

Coupons issued (1 coupon/$1 sale)


Estimated redemption rate
Estimated number of coupons to be redeemed
Exchange rate (200 coupons for a CD player)

1,800,000
.60
1,080,000

200
5,400
14
$ 75,600

Estimated number of CD players to be issued


Net cost of CD players ($34 $20)
Premium expense for 2005
4.

5.

Inventory of premium CD players1/1/05


Premium CD players purchased during 2005
(6,500 X $34)
Premium CD players available
Premium CD players exchanged for coupons
during 2005 (1,200,000/200 X $34)
Inventory of premium CD players12/31/05

Estimated premium claims liability1/1/05


2005 premium expense (Requirement 3)
Subtotal
Actual redemptions during 2005
[1,200,000/200 X ($34 $20)]
Estimated premium claims liability12/31/05

39,950
221,000
260,950

$ 204,000
$ 56,950

44,800
75,600
120,400
84,000
36,400

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PROBLEM 14-12
(a)

Magazine Subscriptions Collected in


Advance
Magazine Subscriptions Revenue
(To record subscriptions earned
during 2005)

400,000

Book balance of liability account at 12/31/05


Adjusted balance ($600,000 + $500,000
+ $800,000)
Credit to revenue account

400,000

$2,300,000
1,900,000
$ 400,000

(b)

No entry should be made to accrue for an expense,


because the absence of insurance coverage does not mean
that an asset has been impaired or a liability has been
incurred as of the balance sheet date. The company may,
however, appropriate retained earnings for self-insurance
as long as actual costs or losses are not charged to the
appropriation of retained earnings and no part of
appropriation is transferred to income. Appropriation of
retained earnings and/or disclosure in the notes to the
financial statements are not required, but are
recommended.

(c)

Estimated Loss from Pending Lawsuit


300,000
Estimated Liability from Pending Lawsuit
300,000
(To record estimated minimum damages
on breach-of-contract litigation)
Note disclosure would also be required indicating the
nature of the loss contingency and that there is an
exposure to loss in excess of the amount recorded.

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PROBLEM 14-12 (Continued)


(d)

No entry should be made for this loss contingency,


because it is not likely that an asset has been impaired or a
liability has been incurred and the loss cannot be
reasonably estimated as of the balance sheet date. The
company must however disclose the guarantee in the
notes to its financial statements, even if the likelihood of
loss is remote. The note disclosure should include the
nature of the guarantee, the maximum potential amount of
future payments, the nature and extent of any recourse
provisions and the carrying amount of any liability.

(e)

No entry should be made since it does not represent a


liability at the balance sheet date. The company should
have a note disclosure for this contractual obligation since
it represents a major capital expenditure commitment.

(f)

No entry should be made for this loss contingency,


because it is not likely that an asset has been impaired or a
liability has been incurred and the loss cannot be
reasonably estimated as of the balance sheet date. The
loss contingency should be disclosed in the notes to
financial statements.

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PROBLEM 14-13
(B = bonus; T = taxes)
(a)

B
B
T
T

=
=
=
=

0.12 ($250,000)
$30,000
.40 ($250,000 $30,000)
$88,000

(b)

B
B
1.12B
B
T
T

=
=
=
=
=
=

0.12 ($308,000 B)
$36,960 .12B
$36,960
$33,000
0.40 ($308,000 $33,000)
$110,000

(c)

B
T
B
B
B
0.952B
B
T
T

=
=
=
=
=
=
=
=
=

0.12 ($350,000 T)
0.40 ($350,000 B)
0.12 [$350,000 0.40 ($350,000 B)]
0.12 ($350,000 $140,000 + .4B)
$25,200 + .048B
$25,200
$26,470.59
.40 ($350,000 $26,470.59)
$129,411.76

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PROBLEM 14-14
(a)
Current Liabilities:
Trade payables ($414,000 $23,000)
Liability to affiliated company
Notes payable ($150,000 + $200,000)
GST payable (Schedule 5)
Dividends payable
Bonus payable (75% X $25,000)
Unearned revenue (1/3 X $330,000)
Accrued liabilities (Schedule 1)
Total current liabilities
Schedule 1:
Interest payable (Schedule 2)
Warranty liability (Schedule 3)
Salaries and wages payable
Employee withholdings payable (Schedule 4)
Union dues payable
Audit fee payable
Total accrued liabilities
Schedule 2:
Interest on the bond
($4,000,000 X 7% X 3/12)
Interest on Note due 04/01/05
($150,000 X 8% X 11/12)
Interest on Note due 01/31/06 ($200,000 X 9% X 1/12)
Interest on Note due 03/15/06
($500,000 X 7% X 11.5/12)
Interest on Note due 10/30/07 ($250,000 X 8% X 4/12)
Total interest payable

$ 391,000
23,000
350,000
11,900
50,000
18,750
110,000
545,749
$1,500,399

$ 122,709
1,240
220,000
105,300
21,500
75,000
$545,749

$ 70,000
11,000
1,500
33,542
6,667
$ 122,709

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PROBLEM 14-14 (Continued)


Schedule 3:
Warranty liability 02/28/04
Less warranty claims on 2003-2004 sales
Remaining warranty liability
Warranty liability on 2004-2005 sales for following
12 months ($154,000 X 1%)
Less warranty claims on 2004-2005 sales
Current warranty liability 02/28/05

$5,700
(4,900)
800
1,540
(1,100)
$1,240

Schedule 4:
EI premiums payable (2.4 X $9,500)
CPP contributions payable (2 X $16,900)
Employee income tax deductions payable
Employee withholdings payable

$ 22,800
33,800
48,700
$105,300

Schedule 5:
Net GST payable, 01/31/05 ($60,000 $34,000)
Less payment to government on 15th of Feb./05
GST charged on February sales
GST paid on February purchases
Net GST payable, 02/28/05

$ 26,000
(26,000)
39,900
(28,000)
$11,900

(b)

All current liabilities listed with the exception of the


unearned revenues and the warranty liability, the employee
withholdings payable (employee income tax deductions
payable, EI premiums payable and CPP contributions
payable) and GST payable are financial liabilities.

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PROBLEM 14-14 (Continued)


A financial liability is any liability that is a contractual
obligation to deliver cash or another financial asset to
another party. A contractual obligation refers to an
agreement between two or more parties that has clear
economic consequences that the parties have little, if any,
discretion to avoid, usually because the agreement is
enforceable at law. Contracts, and thus financial
instruments, may take a variety of forms and need not be in
writing.
Items such as deferred revenue and most warranty
obligations are not financial liabilities because the
probable outflow of economic benefits associated with
them is the delivery of goods and services rather than cash
or another financial asset.
GST payable and employee withholdings payable are not
considered financial liabilities because they are not
contractual in nature. They are created as a result of
statutory requirements imposed by governments.
(c)

Items excluded from current liabilities:


1. Bonds payable were excluded based on the
assumption that the bonds will not be redeemed in
the coming period or operating cycle, whichever is
longer.
2. Notes payable due 03/15/06 and 10/30/07 were
excluded because their due date is beyond the
coming period.
3. Warranty Liability for costs of 1.5% of 2004-2005 sales
(1.5% X $154,000 = $2,310) would be shown as a longterm liability. The costs of honouring the warranty
would occur beyond the coming period.
4. Bonus payable in March 2006 ($25,000 X 25% =
$6,250).
5. Unearned revenue earned in July 2006 and 2007 (2/3
X $330,000 = $220,000)

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TIME AND PURPOSE OF WRITING ASSIGNMENTS


Assignment 14-1

(Time 30-40 minutes)

Purposeto present the student a comprehensive problem in determining


various liabilities and present findings in writing. Issues addressed relate to
contingencies, warranties, litigation and unethical behaviour on the part of
management.

Assignment 14-2

(Time 30-35 minutes)

Purposeto provide the student with the opportunity to define liability, to


distinguish between current and long-term liabilities and to distinguish between
financial and non-financial liabilities. The student must also think about when
typical short-term items might not be classified as current.

Assignment 14-3

(Time 30-40 minutes)

Purposeto provide the student with a comprehensive case covering refinancing


of short-term debt. Four situations are presented in which the student must
determine the proper classification and disclosure of the debt in the financial
statements. In order to thoroughly resolve the issues presented, the student is
expected to research CICA Handbook section 1510.

Assignment 14-4

(Time 15-20 minutes)

Purposeto provide the student with an opportunity to comment on the proper


treatment in the financial statements of a contingent loss incurred after the
balance sheet date but before issuance of the financial statements.

Assignment 14-5

(Time 20-25 minutes)

Purposeto provide an opportunity for the student to discuss the ethical issues
of changing estimates for warranty and contingencies in order to trigger a bonus
for management.

Assignment 14-6

(Time 15-20 minutes)

Purposeto provide the student with an opportunity to specify the conditions by


which a loss contingency can be recorded in the accounts. The student is also
required to indicate the proper disclosure in the financial statements of the
situations where the amount of loss cannot be reasonably estimated or the
likelihood of loss is unknown.
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SOLUTIONS TO WRITING ASSIGNMENTS


ASSIGNMENT 14-1
(a)
1.

Memo prepared by:


Date:
ProVision Corporation
December 31, 2005
Recognition of Warranty Expense

During June of this year, the client began manufacture and sales
of a new line of dishwasher. Sales of 100,000 dishwashers
during this period amounted to $50,000,000. These dishwashers
were sold under a one-year warranty, and the client estimates
warranty costs to be $25 per appliance.
As of the balance sheet date, the client paid out $1,000,000 in
warranty expenditures that was also the amount expensed in its
income statement. No recognition of any further liability
associated with the warranty had been made.
Because ProVision accounts for warranties on the accrual basis,
it must recognize the entire $2,500,000 as warranty expense in
the year of sale. I advised the client to make the following
journal entries:
1.

Cash/Accounts Receivable
50,000,000
Sales
50,000,000
(To record sale of 100,000 dishwashers)

2.

Warranty Expense
1,000,000
Cash, Inventory, Accrued Payroll
1,000,000
(To record warranty costs incurred)

3.

Warranty Expense
1,500,000
Estimated Liability Under Warranties
1,500,000
(To accrue estimated warranty costs)

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ASSIGNMENT 14-1 (Continued)


2.

Memo prepared by:


Date:
ProVision Corporation
December 31, 2005
Rental Charges of Retail Division Based on Retail Profits

In reviewing the estimates used for bad debts expense and


warranty costs, I noticed an increase from previous years. Mr.
Burt Wilson, ProVisions accountant, informed me that he had
been instructed to increase these estimates in order to keep the
retail divisions profits at $475,000. Since a portion of the rental
costs are based on retail profits in excess of $500,000, the
increase in estimates results in lower rent expense.
The increases in the estimates do not seem to be justified by
changes in economic conditions, the credit-worthiness of
customers, past experience or changes to products.
I have advised the client to reduce the estimates used to levels
more consistent with those used in previous years unless they
can substantially justify the new estimates. They should also
record the additional expense and liability related to the rental
costs.
3.

Memo prepared by:


Date:
ProVision Corporation
December 31, 2005
Loss Contingency from Toxic Waste Dumping

I contacted the clients counsel via a routine legal letter, asking


for information about possible litigation in which the company
might be involved. Robert Dowski, ProVisions legal counsel,
informed me about court action taken against ProVision for
dumping toxic waste in the Salmon River.
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ASSIGNMENT 14-1 (Continued)


Although the litigation is pending, Dowski believes that the suit
will likely be lost. A reasonable estimate of clean up costs and
fines is $3,330,000. The client neither disclosed nor accrued this
loss in the financial statements
Because this loss is both likely and reasonably estimable, it
must be accrued as a contingent liability. I advised the client to
record the following entry to accrue this liability.
Loss from Cleanup and Fines
3,330,000
Liability for Cleanup and Fines
3,330,000
4.

Memo prepared by:


Date:
ProVision Corporation
December 31, 2005
Loss Contingency on
Patent Infringement Litigation

In answer to my legal letter requesting information about any


possible litigation associated with the client, Robert Dowski
informed me that the client is in the middle of a patent
infringement suit with Heidi Golder over a hydraulic compressor
used in several of ProVisions appliances. The likelihood of loss
of this suit is not determinable. ProVision did not in any way
disclose this information.
Because the likelihood of loss is not determinable, it must be
disclosed in the notes to the financial statements. I advised the
client to include as a footnote to the financial statements a
discussion of this pending litigation along with the lawyers
assessment that the likelihood of loss is not determinable. In
addition, I advised the client to disclose the estimated amount of
this loss contingency.

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ASSIGNMENT 14-1 (Continued)


(b) For items 1, 3 and 4, it is difficult to determine whether the
issues relate to errors on the part of management or from
unethical behaviour. For item 2 however, the increase in
estimates is clearly unethical and is meant to decrease
rental costs by showing lower profits. The benefits of this
type of behaviour are short-term in nature and will cause
long-term difficulties for the company. The trend of higher
estimates cannot be maintained indefinitely. The results can
include losing the rental location, civil action against the
company as well as criminal action for fraudulent behaviour.
In addition, the current shareholders are harmed because
the lower net income reduces the current value of their
holdings.

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ASSIGNMENT 14-2
(a) A liability is defined as obligations of an enterprise arising
from past transactions, the settlement of which may result in
the transfer of assets, provision of services or other yielding
of economic benefits in the future. In other words, it is an
obligation to transfer some type of resource in the future as
a result of a past transaction.
(a)Current liabilities are obligations whose liquidation is
reasonably expected to require use of existing resources
properly classified as current assets or the creation of other
current liabilities. In other words, they are liabilities
generally payable within one year or the operating cycle,
whichever is longer.
(b)A financial liability is any liability that is a contractual
obligation to deliver cash or another financial asset to
another party. A contractual obligation refers to an
agreement between two or more parties that has clear
economic consequences that the parties have little, if any,
discretion to avoid, usually because the agreement is
enforceable at law. Contracts, and thus financial
instruments, may take a variety of forms and need not be in
writing.
(d)
1. Generally, accounts payable would be classified as a current
liability. In this case, since the due date is January 2006, the
amount would be classified as a current liability.
2 and 5.
Since the notes payable and bonds payable are due in less
than one year from the balance sheet date, they would
generally be reported as current liabilities. The only situation
in which these short-term obligations could possibly be
excluded from current liabilities is if Antigonish Corporation
intends to refinance it. For those notes to qualify for
exclusion from current liabilities, the company must meet the
following criteria:
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ASSIGNMENT 14-2 (Continued)


(1) It must intend to refinance the obligation on a long-term
basis, and
(2) It must demonstrate an ability to consummate the
refinancing.
The second criteria, ability to refinance, can be
demonstrated either by actually refinancing before the
balance sheet is issued or by entering into a non-cancellable
financing agreement, which has not been violated, with a
capable lender. Only that portion of the notes and bond
payable that has been refinanced can be reclassified.
3. Generally, deposits from customers would be classified as a
current liability. However, the classification of deposits as
current or non-current depends on the time involved between
the date of deposit and the termination of the relationship
that required the deposit. In this case, the $250,000 would be
excluded from current liabilities only if the equipment would
not be delivered for more than one year (or one operating
cycle, if longer).
4. Salaries payable is an accrued liability that in almost all
circumstances would be reported as a current liability (could
not be excluded).

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ASSIGNMENT 14-3
(a) No. Refinancing a short-term obligation on a long-term basis
means either replacing it with a long-term obligation or with
equity securities, or renewing, extending, or replacing it with
short-term obligations for an uninterrupted period extending
beyond one year (or the operating cycle, if applicable) from
the date of an enterprises balance sheet.
Managements intent to refinance the obligation on a longterm basis is not enough to warrant reclassification of the
short-term obligation. CICA Handbook, Section 1510, par. 06,
indicates that a contractual arrangement must have been
made before an otherwise current liability may be classified
as non-current.
(b) Yes. The events described will have an impact on the
financial statements. Since Eshkol Corporation refinanced
the long-term debt maturing in March 2006 in a manner that
meets the conditions set forth in CICA Handbook Section
1510, that obligation should be excluded from current
liabilities. The $11,000,000 should be classified as long-term
at December 31, 2005.
A short-term obligation, other than one classified as a
current liability shall be excluded from current liabilities if
the enterprises intent to refinance the short-term obligation
on a long-term basis is supported by an ability to
consummate the refinancing. This can be demonstrated
through the issuance of long-term debt or equity securities
after the date of the balance sheet but before that balance
sheet is issued. The issuance of the long-term debt or equity
securities must be for the purpose of refinancing the shortterm obligation on a long-term basis.
(c) No. Since Eshkol Corporation refinanced the long-term debt
maturing in March 2006 in a manner that meets the
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conditions set forth in CICA Handbook Section 1510.06, that


obligation should be excluded from current liabilities.
ASSIGNMENT 14-3 (Continued)
(d) 1. No. The $11,000,000 should be shown under the caption of
either Long-Term Debt, Interim Debt, Short-Term
Debt Expected to Be Refinanced, or Intermediate Debt.
2. Yes. If a short-term obligation is excluded from current
liabilities the notes to the financial statements shall
include a general description of the financing agreement
and the terms of any new obligation incurred or expected
to be incurred or equity securities issued or expected to
be issued as a result of a refinancing.

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ASSIGNMENT 14-4
Because the casualty occurred subsequent to the balance sheet
date, it does not meet the criteria of a loss contingency; that is,
an asset had not been impaired or a liability incurred at the date
of the balance sheet. Therefore, a loss contingency should not
be accrued by a charge to expense due to the explosion.
However, because it had become known before the financial
statements were issued that assets were impaired and liabilities
were incurred after the balance sheet date, disclosure is
necessary to keep the financial statements from being
misleading. The financial statements should indicate the nature
of and an estimate of the loss to the companys assets as a
result of the explosion and the nature of and an estimate of the
loss contingency anticipated from suits that will be filed and
claims asserted for injuries and damages.
If the loss to assets or the liability incurrence can be reasonably
estimated, disclosure may best be made by supplementing the
historical financial statements with pro forma financial data
giving effect to the loss as if it had occurred at the date of the
financial statements.

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ASSIGNMENT 14-5
(a) and (b)
No, Don Street, the controller, should not manipulate net
income in view of any compensation plan the company
may have.
(c)

The economic interests of the management and the


potential for their bonus payments conflict with the
shareholders interest that financial statements clearly and
accurately reflect net income. If the warranty expense is
reduced and the lower range for the contingent loss is
used, and the original estimates turn out to be accurate,
the shareholders are harmed because the company pays
an unmerited bonus. In addition, shareholders would also
potentially be affected since they would rely on potentially
overstated income on which to base their investment
decisions.

(d)

VP Finance Dickinson acts unethically. His action serves


his self-interest and has no clear basis in proper
accounting procedures.

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ASSIGNMENT 14-6
(a) Two conditions must exist before a loss contingency is
recorded:
1. Information available prior to the issuance of the financial
statements indicates that it is likely that a liability has
been incurred at the date of the financial statements.
2. The amount of the loss can be reasonably estimated.
(b) When some amount within the range appears at the time to
be a better estimate than any other amount within the range,
that amount is accrued. When no amount within the range is
a better estimate than any other amount, the dollar amount at
the low end of the range is accrued and the dollar amount at
the high end of the range is disclosed.
(c) If the amount of the loss is uncertain, the following
disclosure in the notes is required:
1. The nature of the contingency.
2. An estimate of the possible loss or range of loss or a
statement that an estimate cannot be made.
(d) If the likelihood of the loss is unknown, the same disclosure
in the notes as detailed in part (c) is required.

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SUGGESTED CASE SOLUTIONS


See the Case Primer on the Digital Tool, as well as the
suggested outline for case solutions. Note that the first few
chapters lay the foundation for financial reporting decision
making.
CA 14-1 ENVIROCOMPANY LIMITED
Overview
Two sets of statements are required, one for public presentation
and one for management decision making. The information
content of each will differ since they will be used for different
decisions, and since different roles will be adopted for each.
External Financial Statements
These will be seen by shareholders who may not want the
problem overemphasized since it might drive the share price
down. Employees will likely feel the same way since they could
lose their jobs if the company were forced to close. Management
might be reluctant to disclose too much for the same reasons,
especially until they figure out a plan of action. Furthermore, any
negative disclosures reflect poor stewardship. Potential
investors, on the other hand, would want full disclosure in order
to assess the risks before investing. Whatever is disclosed
could be used against the company by the public at large in an
effort to protect themselves and the environment.
Other users would be the government environmental agencies
who might use the information against EL. The Board of
Directors might resist disclosures that imply negligence or guilt
since they might be held personally liable.
In all likelihood, the financial statements will likely play the
problem down and not overemphasize it even though this is a
short-term solution. Traditional GAAP will be a constraint since
the company is public.
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Internal Statements for Decision Making


These will be seen only by the Board and will be used to assess
the situation and the true costs of running the business. These
statements will disclose the full extent of the problem and
attempt to grapple with the liability from a broader perspective,
ignoring the political implications of any disclosures since the
financial statements will not be publicly released. Traditional
GAAP will not be a constraint.
Analysis and Recommendations
External financial statements
Technically (and based on a traditional interpretation of GAAP),
there is no liability here until the company is sued. EL has no
duty or responsibility to the person suing the company until it is
proven in a court of law that EL is guilty. Likewise, until the
person actually sues the company, and a court rules against the
company, there is a chance to avoid the potential obligation (i.e.,
hire good lawyers, present a good defence). The event that
potentially obligates the entity may be the act of polluting, or the
act of the person getting sick and, therefore, this may have
already happened. However, as noted above, the obligation has
not yet been established.
Therefore, if anything, this could be construed as a contingent
liability, given that there is uncertainty (as to possible loss) that
will not be resolved until some future confirming event happens
(i.e., lawsuit lost). Note that, at this time, the outcome of the
situation is unknown. Will EL be sued? If sued, will they lose? If
they lose, what will the cost be?
At most, note disclosure might be prudent; however, given that
the person has only threatened to sue and has not actually done
it, traditionally this would not be disclosed, as it is difficult to
assess the probability that the person or others will actually sue.
What about potential investors? Does management in all good
conscience have to warn them? Given the increasing onus on
Boards of Directors to take full responsibility for the actions of
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the company, should they disclose the problem in order to


protect themselves?
Regarding the specific lawsuit threat, it is likely unnecessary to
disclose it for the above-noted reasons (primarily the
uncertainty and the fact that the loss from a potential lawsuit is
not measurable). However, regarding the larger problem (i.e., the
inescapable fact that the pollution is harmful), it could be argued
that they should. However, since the information will already be
in the newspapers (i.e., the environmental studies are likely
public and politicians are involved) and since the problem is
industry-wide, chances are that there is no additional need to
disclose anything further.
In conclusion, no disclosure is required since, at best, the
threatened lawsuit is a contingent liability and it could be argued
that it is unlikely that the company will suffer a material loss
from it, especially since ELs insurance will cover up to $1
million. There is no reason to alarm people unless there is a real
problem and no reason to overemphasize this episode to the
point of putting the company out of business.
Internal Financial Statements
Since the traditional GAAP constraint may be relaxed, the issue
may be looked at from a broader perspective. The following is a
time line that may be used to establish if and when a liability
arose.
Traditionally, as shown by above analysis for external financial
statements, in this type of situation, a potential liability is not
usually recognized until there is a lawsuit or a fine. Even then, a
liability is only acknowledged if the company is likely to lose, or
the outcome is not determinable (meaning that there is a 50/50
chance of suffering a loss). The reasoning behind this, as it
relates to polluting the environment, is that (a) the issue has, in
the past, never been taken seriously by most people and (b) it is
difficult to attribute air or water pollution to any one company
since most companies and people do in fact pollute the
environment.
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If we examine the time line more closely, it may be argued that a


liability exists at point 4. At this point, it might be argued that
there is a direct relationship between EL polluting the
surrounding area and a person in close proximity (i.e.,
downstream from the company) getting sick. Does EL owe that
person anything? That is a matter of opinion, but as times
change, it is becoming more acceptable to acknowledge that
pollution is harmful to life and that the offending parties must
somehow be held accountable. Therefore, as long as it can be
established that EL is the offending party, then it can be argued
that they have a duty to compensate individuals who are harmed
by their actions. It is only a matter of time until they do get sued
and over time, after a few precedent cases, it will become likely
that these lawsuits will indeed result in a loss. Therefore, the
critical matter becomes linking damage done by the pollution
directly to the company.
Taking this a bit further, perhaps a liability exists at point 3.
Maybe it is acceptable to harm wildlife but not humans and,
therefore, anytime that a company undertakes actions that harm
humanity in general, it must be held accountable. The link that
must be made is whether EL pollutes the environment in such a
way as to harm individuals in general. Environmental studies
have shown that the pollutants released by EL do affect
humanity (e.g., birth defects) so this link has perhaps already
been established.
It is not out of the question to assume that if wildlife is being
harmed then human beings are also being harmed since we are
all linked by the food chain. Therefore, we might argue that 2 is
the point where liability arises.
Finally, we might just as well acknowledge that any pollutant will
affect the environment in a negative way by definition and,
therefore, why wait until it has been proven that specific wildlife
or humans have been harmed? The act of polluting creates a
liability. And that brings us to point 1. Perhaps in reality, the real
liability arises once a company takes it upon itself to disturb the
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ecosystem and place the natural order of the environment in


jeopardy.
If this is so, perhaps this whole issue is a question of cost
versus benefit. Does the benefit of having EL produce paper
outweigh the costs to society as a whole including the
deterioration of the ecological environment? What exactly are
the costs to society? What are the benefits? How can they be
measured? Who should measure them? Should these costs be
accrued on the income statement and matched against revenues
as ongoing costs of doing business?
It might be easy to measure damages that a court may award to
one person who has suffered an illness as a direct result of
pollution from a company. But what about those that do not take
the company to court? What does the company owe them? What
does the company owe society at large if it pollutes the water or
cuts down irreplaceable rain forests, etc.? These costs become
extremely difficult, if not impossible, to measure.
Conclusion
In all reality, a liability to society probably exists at point 1.
However, it is impossible to measure the costs to society of
polluting the environment. Therefore, it is impossible to prepare
financial statements that reflect this cost. These costs cannot be
ignored, however. If EL acknowledges responsibility for
polluting the environment to the point where it is contributing to
the deterioration of the ecosystem, then this factor must be
considered in any decision about the companys future, even if it
cannot be quantified. It should be considered along with
declining prices and demand for the product, the jobs that are at
stake, and the invested funds. Perhaps EL should be looking at
gradually shifting over to recycling newspaper using newer
methods that do not pollute the environment, etc. At this stage,
the case moves beyond financial accounting.

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CA 14-2 ABC AIRLINES


Overview
The company is in a highly competitive and risky industry. The
economic environment over the past few years has caused
many airlines to restructure or fold in the face of declining sales,
increased competition and falling seat prices. ABC has held its
own by undergoing two restructurings, the most recent of which
revolves around increases in network profitability and cutting
costs. Even so, the company is in a very precarious position
with a debt to equity ratio of 3.2 to 1 and a current ratio of .6 to 1.
Losses for the past two years have been significant at close to
$200 million each year.
Users of the statements will be existing creditors and
shareholders who will be monitoring the liquidity of the
company given the ratios identified above. Employees, who are
also shareholders, will be watching the statements for
information about financial and job stability. GAAP is a
constraint due to the fact that the shares are publicly traded.
Management would be concerned with full disclosure of the
situation, due to the liquidity issues which are apparent in the
statements and yet will also be concerned with assuring the
stakeholders that the company will continue to operate.
Analysis and Recommendations
The issue here is accounting for the free flights. As already
noted, these flights are similar to the Frequent Flyer Points, the
cost of which is accrued in the financial statements as part of
accrued liabilities.
One option is to treat them the same as the Frequent Flyer
Points since they are, in substance, the same i.e., the more you
fly, the more free flights you earn. In this case, the company
assumes that there is a cost to providing these free flights,
which must be accrued and matched with the revenues. The
revenues would be the revenues from the paid flights that would
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be recorded in the current period. The cost of the free flights


should be tied to the current revenues as they are seen as an
inducement to buy tickets and are therefore like advertising
costs. Also, the program creates a liability to the customers
since, as the customers fly more, ABC has a duty to them that
they cannot avoid and the event obligating the company is the
fact that the customers have taken the flight. There is a
measurement issue here since not all customers will complete
the requirement for a free flight i.e., five flights and, even if they
do, not all customers will indeed take the free flight.
Another option is to note disclose the program only. This option
would be based on the fact that there is minimal incremental
cost for free flights. The plane will be flying anyway. The only
possible cost might be if a paying customer is bumped. Given
increased competition, it is unlikely that the planes will always
be full and ABC might protect itself against this by only allowing
the free flights on certain flights that might not normally ever
reach capacity. Note, however, that part of the latest
restructuring strategy is to increase network profitability, which
means filling up each plane. This might result in paying
passengers being bumped in the future and therefore a real
cost.
The accrual option increases the current liabilities, which
worsens the current ratio-a very sensitive ratio for the company
at this time.
Finally, note that the companys policy of accruing for
incremental cost really leaves the door open for either treatment.
They might concur that a liability is created in principle, but if
there is no incremental cost, i.e., if the planes are not full, then
the accrual would be zero. In practice, different companies use
different methods for accounting for free flights so there is really
no GAAP. As management, this leaves a bit of manoeuvring
room. The policy itself is a conservative one, yet the
measurement of the cost is left open to judgement. Conservative
accounting in this situation, along with full disclosure, would be
prudent for the company.
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IC 14-1 LANDFILL LIMITED


Overview
LL is in the waste disposal business and as such environmental
concerns increase the business risk. The company has many
users of its financial statements. The bank, which financed the
acquisitions, will use the statements to assess cash flows. The
government might use the statements to assess whether the
company is in compliance with regulations with respect to
closure and post-closure activities, etc. The statements will also
be used by existing and potential customers who will look to see
if the company is stable and in compliance with environmental
standards. A final user is the purchasers lawyers who will use
the statements to perhaps assess what the company is worth in
terms of negotiating a potential settlement re the toxins that are
leaking (since LL has guaranteed toxin free land).
Even though the company is a private company, GAAP will likely
be a constraint given the number of users of the information
who will want reliable and relevant info. As the auditor, this is a
new client and so the risk is greater especially given the number
of users and the potential lawsuit. Care must be taken to ensure
that conservative accounting is applied so as not to overstate
income or net assets.
Analysis and recommendations
Issue: Asset retirement obligations
Since the government regulations require capping, closure and
post closure activities, a legal obligation exists and a liability
must be recognized as soon as measurable.
It is also prudent to ensure that the liability is accrued since LL
must pay for cleanup where toxins are found upon sale of land.
There is an additional risk here since the land sold by the
company recently has been found to contain toxins. The costs
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would be added to the cost of the land. Care should be taken to


assess the existing landfill sites to ensure that the value is not
impaired. The potential lawsuit represents a change in
circumstances that might signal impairment.
Issue: Depreciation
Depreciate sites
No depreciation
- The garbage sites have a
- The Land has historically
life of 20 years (finite life)
held its value and
- Since they contribute to
therefore, an estimate of
revenues, the cost should
salvage value might be
be allocated to the
based on past land
periods in which
values.
revenues are generated
- Currently, it is in the best
(matching).
interest of the company to
- Since varying amounts of
deal with environmental
garbage are dumped,
issues given that existing
perhaps a unit of
and future customers
production type method
assess this on an
might be used. This will
ongoing basis. The bank
allow the costs to be
will also watch for this
better matched with the
since toxins will destroy
revenues generated.
the value.
- Although the land holds
- The government will
its value, it is difficult to
assess for compliance
measure salvage value.
with regulations.
- Given the potential
liability for cleanup costs,
the land may be
worthless at the end of its
life if the company does
not manage the
environmental issues
properly.
- The current lawsuit would
support this.

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Conclusion
It might be more prudent to depreciate the land values.
Environmental standards change (and are increasing) and
therefore, given the potential liability if toxins are subsequently
found, the value of the land could be wiped out.
Issue: Lawsuits
Must be disclosed as could be material. Alternatively, given that
LL has already agreed to be responsible for these costs, if
measurable, they should be accrued. It would be more prudent
to accrue the costs if they are measurable. The company should
contact the lawyers and verify the status.

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RESEARCH AND FINANCIAL ANALYSIS


RA14-1

INTRAWEST CORPORATION

(a) The current liabilities of Intrawest Corporation at June 30,


2003 are detailed below. The deferred revenue consists of
deposits on real estate sales, government assistance, club
initiation deposits, season pass revenue and other deferred
amounts. The bank and other indebtedness Resorts
consists of the current portion of mortgages, bank loans,
capital lease obligations, interim financing debt, notes
receivable credit facilities, general corporate debt and
unsecured debentures.
Current Liabilities

2003

Amounts payable

218,444

Current portion of deferred revenue


Current portion of bank and other
indebtedness - Resort

134,878

Total

287,176
640,498

(b) The basis on which deferred revenue is recognized in income


depends on the type of deferred revenue as described in the
following excerpt from note 1 (k). Deferred revenue which
relates to the sale of season passes is recognized throughout
the season based on the number of skier visits. Deferred
revenue which relates to club initiation deposits is recognized
on a straight line basis over the estimated membership terms.
Deferred revenue which relates to government grants for ski
and resort operations assets is recognized on the same basis
as the related assets are amortized. Deferred revenue which
relates to government grants for properties under
development is recognized as the properties are sold. The
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basis of revenue recognition appears reasonable for all types


listed.
(c) If Intrawest does not borrow any additional funds during its
year ended June 30, 2004, one would expect the amount of
$278,300 to be reported as the current portion of long-term
debt on its June 30, 2004 balance sheet. This is the amount
of repayments scheduled for 2005 as per note 9 to the
financial statements. If no new debt is added, this amount
will become current as of June 30, 2004 since it will be due
within one year of that balance sheet date.
(d) Banks and/or other suppliers of long-term credit have
imposed requirements on the company to maintain certain
financial ratios. Note 9 to the financial statements states that
The Company is subject to certain covenants in respect of
some of the bank and other indebtedness which require the
company to maintain certain financial ratios. The company is
in compliance with these covenants at June 30, 2003.

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(e) Intrawests current ratio and quick ratio for each year
presented are reported below. Both ratios show a positive
trend indicating that the companys liquidity has improved
from 2002 to 2003. This is due to the level of current and
quick assets increasing by a greater proportion than the level
of current liabilities. The improvement in the current ratio is
more substantial than the improvement in the quick ratio
since a significant amount of the increase in the current
assets is due to an increase in resort properties which is
excluded from the calculation of the quick ratio.
2003
Current
assets
Quick
assets
Current
liabilities
Current
ratio
Quick
ratio

2002

1,049,983 681,807
253,557

186,637

640,498

576,785

1.64

1.18

0.40

0.32

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RA14-2

CANADIAN TIRE CORPORATION LIMITED

(a) Canadian Tires current liabilities include the following


amounts:

(In thousands)
Accounts payable and other
Income taxes payable
Current portion of long-term
debt

2002
Balance
$ 1,294,700
80,700
208,200
$1,583,600

Accounts payable and other could include liabilities such as


wages and salaries payable, trade accounts payable, GST and
sales taxes payable, dividends payable, vacation pay accruals
and interest payable.
(b) (1) Working capital = Current assets less current
liabilities.
2002: $730.6 = $2,314.2 $1,583.6
2001: $883.1 = $1,993.2 - $1,110.1
1997: $316.0 = $1,483.3 - $1,167.3
(2)

Acid-test ratio =

Cash + short-term investments


+ net receivables
Current liabilities

2002: 1.13 times =

$628.2 + $584.1 + $579.8


$1,583.6

2001: 1.39 times =

$578.8 + $433.9 + $525.3


$1,110.1

(3)

Current ratio =

Current assets

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Current liabilities
2002: 1.46 times =

$2,314.2
$1,583.6

2001: 1.80 times =

$1,993.2
$1,110.1

1997: 1.27 times =

$1,483.3
$1,167.3

Canadian Tire Corporations liquidity is good since it has


sufficient current assets to meet current liabilities. Its strong
working capital position is reflected in its acid-test and current
ratio. Its acid-test ratio also indicates that the company has a
high proportion of liquid current assets. The company shows a
trend of increasing liquidity from 5 years ago with an increasing
amount of working capital and increasing current ratio from
1997 to 2001, with a slight decrease in 2002 but remaining well
above the 1997 level. This is due substantially to a higher level
of current assets being maintained in recent years.
(4)

Inventory turnover =

2002: 11.38 times =

COGS and all expenses*


Average inventory
$5,369.5
($503.0 + $440.9)/2

* Except for interest, amortization and employee profit sharing


program expense.
(5)

Accounts receivable turnover =

2002: 5.6 times =

Sales
Average receivables*

$5,944.5
($584.1 + $579.8 + $433.9 + $525.3)/2

* Average receivables include accounts receivable and credit


charge receivables.
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The inventory and receivables tend to be a large proportion of


current assets used to assess liquidity using working capital
and the current ratio. Calculating the turnover of receivables and
inventory provides information about the quality of these current
assets. In the case of receivables, the turnover provides
information about the collectibility of receivables and the timing
of cash flow receipts. A turnover of 5.6 times indicates that it
takes 65 days to collect receivables. In the case of Canadian Tire
Corporation, this figure is not indicative of the true turnover of
receivables since the sales amount represents total sales,
including cash sales. To get a true measure of the receivables
turnover, only credit sales should be used.
The inventory turnover provides information about the
saleability of the inventory and the number of days it takes to
sell. A turnover of 11.38 times represents 32 days that the
inventory is held before being sold. The company sells many
different types of inventory items, and the turnover figure
calculated is an average for all inventories. Calculating the
amount over several years and comparing it to other companies
in the same industry would provide more meaningful
information. When making these comparisons, one must be
careful that the numerator in the ratio calculation is consistent
with that used above, and must include all expenses from
operations, excluding specific expenses as noted above.
(c)

Current portion of long-term debt:

This amount represents the portion of long-term debt that is


payable from current assets in the coming year. The amount
would include only the principal portion of the long-term debt
and would not include interest payable during the coming year.
In this case, the current portion amount of $208.2 includes $200
of medium term notes due in 2003 plus $6.7 of capital lease
obligations and $1.5 of other debt due within one year.
If the companys long-term debt does not increase, the current
portion of long-term debt will be $242.9 in the 2003 balance
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sheet. This amount consists of $235 of medium term notes due


in 2004 plus $4.9 of capital lease obligations and $3.0 of other
debt due within one year. This information is disclosed in Note 7
to the financial statements as the debt repayment requirements
for 2004.
(d)

Commitments and Contingencies:

Note 13 discloses commitments relating to the minimum


annual lease payments for equipment and property under
operating leases. Note 14 discloses commitments relating to
acquisition of property and equipment and expansion of store
facilities and commitments to third parties for credit card
processing services and information technology services. Note
14 discloses
contingencies
relating
to
potential
reimbursements to banks relating to letters of credit as well as
contingencies relating to routine legal proceedings.
Management has accounted for the contingencies in accordance
with Canadian GAAP. Contingent liabilities are required to be
recorded in the financial statements when the criteria for accrual
are met. If the criteria are not met, note disclosure is required. In
the case of the letters of credit related contingencies, the
companys management has determined that the potential loss
would be minimal and thus has not recognized a liability in the
financial statements.
Similarly, with respect to the legal
proceedings, the note in the financial statements of Canadian
Tire states the Corporation believes that each such proceeding
constitutes routine litigation incident to the business conducted
by the Corporation and that the ultimate disposition of the
matters will not have a material adverse effect on its
consolidated earnings, cash flow or financial position.
Although this note does not contain information describing in
detail the contingencies or the amount of potential liabilities, it
does indicate that management estimates the amounts of
contingent liabilities relating to these legal proceedings to be
not material, so further disclosure is not required.

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RA14-3
(a)

NORTHLAND CRANBERRIES

Working capital is calculated as (current assets current


liabilities), while the current ratio is calculated as (current
assets/current liabilities). For Northland Cranberries these
ratios are calculated as follows:
Current year

Prior year

Working
capital
$6,745,759 $10,168,685 $5,598,054 $4,484,687
(deficiency) = ($3,422,926)
= $1,113,367
Current
ratio

($6,745,759/$10,168,685)
= .66

($5,598,054/$4,484,687)
= 1.25

Historically, it was generally believed that a company


should maintain a current ratio of at least 2.0. In recent
years, because companies have been able to better
maintain their inventory, receivables and cash, many
healthy companies have ratios well below 2.0. However,
Northland Cranberries has negative working capital in the
current year, and current ratios in both years are very low.
This would be cause for concern and additional
investigation. As shown in the next discussion point, there
may well be a reasonable explanation.
(b)

This illustrates a potential problem with ratios like the


current ratio, that rely on balance sheet numbers that
present a companys financial position at a particular point
in time. That point in time may not be representative of the
average position of the company during the course of the
year, and also, that point in time may not be the most
relevant point for evaluating the financial position of the
company. If the company does not like the representation
that these commonly used measures give of the
companys position, it could change its year-end or
suggest other measures that it considers to be more
relevant for a company in this business. Also, it is possible

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that by using averages calculated across quarterly data


some of this problem might be alleviated.
The ratios do indicate some cause for concern that is not
addressed in the portion of Management Discussion and
Analysis presented. The working capital and current ratio
have deteriorated independent of the $3 million short-term
borrowing. In the following calculations, the current
liabilities have been restated to remove the $3 million
short-term borrowing:
Current year

Prior year

Working
capital
$6,745,759 $7,168,685 $5,598,054 $4,484,687
(deficiency) = ($422,926)
= $1,113,367
Current
ratio

($6,745,759/$7,168,685) ($5,598,054/$4,484,687)
= .94
= 1.25

In addition, the income statement information provided


shows substantially decreasing profit margins.
Current year

Prior year

Gross
($21,783,966 $13,057,275) ($18,051,355 $8,751,220)
margin
$18,051,355
$21,783,966
percentage = 40%
= 52%
Profit
margin

($1,581,707/ $21,783,966)
= 7.3%

($2,942,954/$18,051,355)
= 16%

This information combined with managements comments


that current short-term debt is paid out of future cash
inflows, as opposed to current assets, indicate a need for
further analysis of the companys cash flows.

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RA14-4

DANIER LEATHER INC. versus COSTCO


WHOLESALE CORPORATION

1.

Current Assets
Current Liabilities
Current Ratio

Danier Leather
($ thousands)
2003
2002
46,899 44,154
10,559 10,552
4.44
4.18

Costco
($ thousands)
2003
2002
5,711,538 4,630,539
5,011,107 4,449,733
1.14
1.04

Cash & short term


investments
Accounts
receivable
Total Quick Assets

7,254

3,777

1,545,439

805,518

683

484

556,090

474,861

7,937

4,261

2,101,529

1,280,379

Quick Ratio

0.752

0.404

0.419

0.288

Both the current ratios and the quick ratios indicate that Danier
Leather has better liquidity than Costco by a considerable
margin in both years presented. The difference between the two
companies quick ratios is less significant than the difference
between their current ratios because Daniers inventory is a
significantly higher proportion (79%) of its total current assets
than is Costcos (58%). The exclusion of this major item results
in the quick ratio of Costco being much closer to that of Danier
than its current ratio. The higher proportion of inventory shown
by Danier makes sense in relation to the two businesses
differing strategies with respect to inventory turnover. By
comparing their quick ratios instead of their current ratios, this
difference is somewhat isolated from the analysis. Both
companies show an increase in their liquidity from 2002 to 2003
using both ratios.

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2.

COGS
Accounts Payable
A/P Turnover
Payment Period
(365/ A/P Turnover)
Inventory
Inventory Turnover
# of days in
inventory
(365/ Inv. Turnover)
Sales
Accounts
receivable
A/R Turnover
Collection Period
(365/ A/R Turnover)

Danier Leather
($ thousands)
2003
2002
88,788
10,559 10,472
8.44
43 days
37,029
2.35

Costco
($ thousands)
2003
2002
37,235,383
3,131,320 2,884,269
12.38
29 days

38,662

3,339,428
11.52

155 days

32 days

175,487
600

41,692,699
556,090

484

324

81

1.1 day

4.5 days

3,127,221

474,861

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Danier Leather Inc.:

0
Receive
goods

43
Payment
for goods

Sale of
goods
155
156
Collection

Costco Wholesale Corporation:


Sale of
goods Collection
32
0
Receive
goods

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37

29
Payment
for
goods

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From the above charts, we can see that Costco Wholesale has a
much shorter cash-to-cash cycle. Danier Leather has 113 days
(156 days for collection less 43 days since payment of goods)
from the time cash is paid out for inventory until cash is
collected from customers.
Costco has 8 days (37 days for collection less 29 days since
payment of goods) from the time cash is paid out for inventory
until cash is collected from its customers.
This analysis shows that Costco is more liquid than Danier if
liquidity is measured purely in terms of the cash to cash
operating cycle since its inventory is converted to cash more
quickly. A higher inventory turnover also involves less risk of
non-saleability of inventory. Considering the proportion of
inventory that is perishable food for Costco, this is of major
concern for management. All necessary steps would be taken to
ensure this result. Note that this measure of liquidity is different
than the purely balance sheet perspective taken in part a) which
indicated that Danier was more liquid than Costco.

RA14-5

LOBLAW COMPANIES LIMITED VERSUS SOBEYS


INC.

(a)

Current
Assets
Current
Liabilities

Loblaw
($ millions)
2002 2001
3,526 3,086

Sobeys
($ millions)
2003 2002
1,094
985

3,154 2,796

1,181

990

1.
12

1.
10

0.
93

0.
99

Cash
Short-term
investments

823
304

575
426

123.1
191.4

196.7
77.7

Accounts
receivable
Current
portion of
mortgages
and loans
receivable

605

472

285.4
15.4

251.
0
23.2

615

549

0.
52

0.
55

Current
Ratio

Total Quick
Assets
Acid-test
Ratio

1,732 1,473
0.
55

0.
53

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The current and acid-test ratios are very low. Current liabilities
exceed current assets for Sobeys and are very close to
exceeding current assets for Loblaw. The companies operate in
the grocery business. Since the business is cash-intensive, cash
management is important to success and highly liquid assets
are kept to a minimum. Because of the volume of business that
these companies generate, they can negotiate preferential
payment terms with their suppliers that allow them to operate
with more modest liquidity positions.

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(b)

Cash from
operations
Total liabilities

Loblaw
($ millions)
2002
2001
981
6,986 6,456

Cash debt
coverage*
Current liabilities

0.15
3,154 2,796

Current debt cash


coverage**

0.33

Sales
Accounts
receivable
A/R Turnover

23,082
605

472

42.9
Collection period
(365/AR turnover)
COGS selling and
administrative
exp.
Inventory

Sobeys
($ millions)
2003
2002
348.1

8.51
21,425

1,75
5.7
0
.21
1,18
0.5
0
.32
10,41
4.5
28
5.4
3
8.8
9
.41
9,964.40

1,702 1,512

1,591.
9
990.
4

251.
0

394.6
444.0

Inventory
Turnover
Days in Stock
Accounts payable
Accounts
Payable Turnover
Days payables
outstanding

13.33
27.38
2,336 2,291

23
.76
15
.36
971.9

9.26

10
.52

39.42

34
.70

922.9

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* Cash Debt Coverage = Cash from operations


Average total liabilities
** Current Cash Debt Coverage =

Cash from operations


Average current liabilities

The relatively small difference between the cash debt coverage


ratio and the current cash debt coverage ratio for Sobeys
indicates that the company does not have a significant amount
of long-term debt. A large portion of their liabilities are current.
Loblaw has a more significant difference between the two ratios
indicating a higher proportion of long-term debt.
Receivable turnover is very high, with Sobeys showing a slightly
lower turnover. This indicates a high quality of receivables with
a short collection period (8.5 days for Loblaw and 9.4 days for
Sobeys). For a cash-intensive business, the receivables turnover
seems high due to outstanding receivables from franchised,
associated and independent stores. The inventory turnover is
high at 13 times for Loblaw (27 days in inventory) and 24 times
for Sobeys (15 days in inventory). Loblaws lower inventory
turnover would most likely be due to a higher quantity of nongrocery products held in its stores. These ratios indicate that the
companies pay their current liabilities from current assets and
cash inflows in the coming period. Even though liquidity based
on the current and quick ratios appears low, the receivables and
inventory turnovers indicate a high quality of current assets to
meet current liabilities. Overall liquidity is low due to a carefully
managed cash position and the preferential terms negotiated
with suppliers. In the case of Loblaw, many of the suppliers of
goods are related companies within the Weston group of
corporations.

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(c)

The current portion of long-term debt for Loblaw


represents the long-term debentures due in 2003. For
Sobeys, the current portion consists of a medium term
note due later in 2003 and the current portion of capital
lease obligations.
Year
2003
2004
2005
2006
2007
2008

Loblaw
($ millions)
$106
106
215
129
5

Sobeys
($ millions)
Debt retirement
Capital lease
payments
obligations
$ 148.7
28.5
183.5
7.1
8.4

$ 1.4
1.5
1.5
1.6
1.1

Both companies have long-term debt maturing in the next


five years that will require significant cash flows, as shown
above. Sobeys has note and bank loans maturing in addition to
capital and operating lease commitments over the next five
years. Loblaw has notes and debentures maturing, with the
highest amount being in 2005. Sobeys has proportionately
higher debt payments over the next five years, in relation to its
cash flow generated from operations, with very high payments
in 2004 and 2006 due to large loans becoming due in those
years. Both companies will have to ensure that significant
sources of cash are available to meet these commitments, but
given the size of Sobeys commitments in relation to its cash
flow, this will be more of an issue for Sobeys.

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RA14-6

RESEARCH TOPIC

Note: The following sample solution is based on the province of


Nova Scotia. Content of student responses will vary based on
province.
The workers compensation plan in Nova Scotia is
administered by a provincial board entitled the Workers
Compensation Board (WCB). The purpose of the plan is to
provide insurance to registered employers and their workers
against financial loss due to workplace injuries and illnesses.
Registration is mandatory for employers in certain industries
who have three or more employees. Coverage is also
available to other employers who register voluntarily and
premiums and benefits are the same for these employers as
for those for whom registration is mandatory.
Employees of registered employers may be eligible to receive
short-term and long-term benefits as well as health care
required to treat their condition. In the case of workplace
accident or illness resulting in death, WCB may pay spousal
benefits, dependent child benefits, educational benefits and
funeral expenses.
The insurance premium rates are according to industry and
further according to company based on experience rates of
both. By improving safety and reducing the rate of claims, an
industry or individual company has the opportunity to lower
its premium rates. The premiums are paid to the WCB on the
same timing basis as employers payroll related remittances
to CRA, which may be monthly, semi-monthly, bi-weekly or
four times a month. Each employer has its annual premium
rate set in September and this rate times the total insurable
gross payroll of wages paid during the remittance period is
the amount of the premium paid for the year.
The cost of workers compensation plans vary from province
to province, from industry to industry and from company to
company. In 2003, Nova Scotia had one of the highest
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average premiums of $2.54 per hundred dollars of insured


earnings. This is a significant expense incurred by the
employer and is a consideration for companies when
considering growth in terms of number of employees and
gross payroll.
Being registered in a workers compensation plan impacts a
companys financial statements in a number of ways. The
premiums paid are recognized on the income statement as
part of wage related benefits expense. It may also result in an
accrued liability amount at each reporting date for premiums
related to wages earned but not yet paid. The insurance also
impacts financial statements in that companies who
participate in such plans have fewer contingent liabilities
relating to workplace illness and injury claims than
companies not insured for such losses.

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