Chapter 10 PPT

Report
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 10
Reporting and Interpreting Liabilities
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Fred Phillips, Ph.D., CA
Learning Objective 1
Explain the role of liabilities in
financing a business.
10-3
The Role of Liabilities
Liabilities are created when a company:
Buys goods
and services
on credit
Obtains
short-term
loans
Issues
long-term
debt
Current liabilities are short-term obligations that will
be paid with current assets within the company’s
current operating cycle or within one year of the
balance sheet date, whichever is longer.
10-4
The Role of Liabilities
The liability section of the General Mills 2007 and 2008
comparative balance sheets.
10-5
Learning Objective 2
Explain how to account for
common types of current
liabilities.
10-6
Measuring Liabilities
Initial Amount of the Liability
Cash Value
Additional Liability Amounts
Increase Liability
Cash Payments Made
10-7
Decrease Liability
Current Liabilities
Accounts Payable
Decreases
(Debited)
Increases
(Credited)
when a company
pays on its account
when a company
receives goods or
services on credit
Accrued Liabilities
Liabilities that have been incurred but not yet paid.
10-8
Calculating Payroll
Payroll Deductions
Payroll
Liabilities
Payroll deductions are either required by law or voluntarily
1.
Payroll
requested
by Deductions
employees and create a current liability for the
company. Examples include:
1. Income tax
2.
Employer Payroll Taxes
2. FICA tax
3. Other deductions (charitable donations, union dues, etc.)
10-9
Calculating Payroll
Gross Pay
Payroll Deductions:
Federal Income Taxes
FICA Taxes
Other
Total Payroll Deductions
Net Pay
10-10
$ 600.00
$ 58.00
48.80
10.00
116.80
$ 483.20
Recording Payroll
Adam Palmer earned gross pay of $600 in the current payroll period.
General Mills withheld $58 in Federal income taxes, $48.80 for FICA, and
$10 for United Way, resulting in net pay of $483.20.
1
Analyze
Assets
=
Liabilities
+ Stockholders' Equity
Cash (-A) -$483.20
FIT Withheld (+L) +$58.00
Payroll Expense
FICA Payable (+L) +$48.80
(+E, -SE)
-$600.00
United Way (+L)
+$10.00
2
Record
Wages and Salaries Expense (+E, -SE)
Withheld Income Taxes Payable (+L)
FICA Payable (+L)
United Way Payable (+L)
Cash (-A)
10-11
600.00
58.00
48.80
10.00
483.20
Payroll Taxes
Employer Payroll Taxes
Employers have other liabilities related to payroll.
1. FICA tax (a “matching” contribution)
2. Federal unemployment tax
3. State unemployment tax
Assume General Mills was required to contribute $16,400 for FICA, $250
for federal unemployment tax, and $1,350 for state unemployment tax.
1 Analyze
Assets
2
=
Liabilities
+ Stockholders' Equity
FICA Payable (+L) +16,400
Payroll Tax Expense
FUTA Payable (+L)
+250
(+E, -SE) -18,000
SUTA Payable (+L) +1,350
Record
Payroll Tax Expense (+E, -SE)
FICA Tax Payable (+L)
Federal Unemployment Tax Payable (+L)
State Unemployment Tax Payable (+L)
10-12
18,000
16,400
250
1,350
Accrued Income Taxes
Corporations calculate taxable income by subtracting tax-allowed
expenses from revenues. This taxable income is then multiplied by a tax
rate, which for most large corporations is about 35 percent.
General Mill calculated taxable income to be $1,000,000, and is subject to
a 35% tax rate, so income taxes owed are $350,000 ($1,000,000 × 35%)
1 Analyze
Assets
2
=
Liabilities
Income Tax Payable
(+L)
+350,000
Record
Income Tax Expense (+E, -SE)
Income Tax Payable (+L)
10-13
+ Stockholders' Equity
Income Tax Expense
(+E, -SE) +350,000
350,000
350,000
Notes Payable
Four key events occur with any note payable:
1. establishing the note,
2. accruing interest incurred but not paid,
3. recording interest paid, and
4. recording principal paid.
10-14
Notes Payable
1. Establish the note on November 1, 2009.
Assume that on November 1, 2009, General Mills borrowed $100,000 cash
on a one-year note that required General Mills to pay 6 percent interest and
$100,000 principal, both on October 31, 2010.
1 Analyze
Assets
Cash (+A) $100,000
2
=
Liabilities
Notes Payable (+L) $100,000
Stockholders' Equity
Record
Cash (+A)
Notes Payable (+L)
10-15
+
100,000
100,000
Notes Payable
Accrue interest owed but not paid on December 31, 2009.
$100,000 × 6% × 2/12 = $1,000 accrued interest
P
x I
x T
1 Analyze
Assets
2
=
Liabilities
Interest Payable (+L) $1,000
Stockholders' Equity
Interest Expense
(+E, -SE)
$1,000
Record
Interest Expense (+E, -SE)
Interest Payable (+L)
10-16
+
1,000
1,000
Notes Payable
Record interest accrued in 2010
$100,000 × 6% × 10/12 = $5,000 interest
P
x I
x
T
1 Analyze
Assets
2
=
Liabilities
+ Stockholders' Equity
Interest Payable (-L) +$5,000
Interest Expense
(+E, -SE)
$5,000
Record
Interest Expense (+E)
Interest Payable (+L)
10-17
5,000
5,000
Notes Payable
4. Record principal paid of $100,000 on October 31, 2010.
1 Analyze
Assets
=
Liabilities
Cash (-A) -$106,000
NotePayable (-L) -$100,000
Interest Payable (-L) -6,000
2
Stockholders' Equity
Record
Interest Payable (-L)
Note Payable (-L)
Cash (-A)
10-18
+
6,000
100,000
106,000
Current Portion of
Long-Term Debt
Long-Term Debt
Current Portion of
Long-term Debt
Noncurrent Portion
of Long-term Debt
Borrowers must report in Current Liabilities the portion of
long-term debt that is due to be paid within one year.
10-19
Additional Current Liabilities
10-20
Sales Tax
Payable
Payments collected from
customers at time of sale create
a liability that is due to the state
government.
Unearned
Revenue
Cash received in advance of
providing services creates a
liability of services due to the
customer .
Additional Current Liabilities
Best Buy sells a television for $1,000 cash plus 5 percent sales tax.
$1,000 × 5% = $50 sales tax collected
1 Analyze
Assets
Cash (+A) +$1,050
2
=
Liabilities
+ Stockholders' Equity
Sales Tax Payable (+L) +$50
Sales Revenue
(+R, +SE)
Record
Cash (+A)
Sales Tax Payable (+L)
Sales Revenue (+R, +SE)
1,050
50
1,000
When Best Buy pays the sales tax to the state government, its accountants
will reduce Sales Tax Payable (with a debit) and reduce Cash (with a credit).
10-21
Additional Liabilities
On October 1 IAC, an internet provider, received $30 cash for threemonths of internet access, paid in advance.
1 Analyze
Assets
Cash (+A) +$30
2
=
Liabilities
Unearned Revenue (+L) $30
Record
Cash (+A)
Unearned Revenue (+L)
10-22
+ Stockholders' Equity
30
30
Additional Liabilities
At the end of October, IAC provided one month of internet service
to its customer.
$30 ÷ 3 months = $10 per month
1 Analyze
Assets
2
=
Liabilities
Unearned Revenue (-L) $10
Record
Unearned Revenue (-L)
Subscription Revenue (+R, +SE)
10-23
+ Stockholders' Equity
Subscription Revenue
(+R, +SE)
$10
10
10
Learning Objective 3
Analyze and record bond liability
transactions.
10-24
Long-Term Liabilities
Common Long-Term Liabilities
1. Long-term notes payable
2. Deferred income taxes
3. Bonds payable
Bonds are financial instruments that outline the
future payments a company promises to make
in exchange for receiving a sum of money now.
10-25
Bonds
Key Elements of a Bond
1. Maturity date
2. Face value
3. Stated interest rate
Interest Computation
12
$1,000 × 6% × 12 = $60
Bond Pricing
The bond price involves present value computations and is the amount
that investors are willing to pay on the issue date for the bonds.
10-26
Bonds
Balance Sheet Reporting of Bond Liability
Relationships between Interest Rates and Bond Pricing
10-27
Bonds
Bonds Issued at Face Value
General Mills receives $100,000 cash in exchange for issuing
100 bonds at their $1,000 face value, so the bonds are issued at
total face value (1,000 × $1,000 = $100,000).
1 Analyze
Assets
=
Liabilities
+ Stockholders' Equity
Cash (+A) +$100,000
Bonds Payable (+L) $100,000
2
Record
Cash (+A)
Bonds Payable (+L)
10-28
100,000
100,000
Bonds
Bonds Issued at a Premium
General Mills issues 100 of its $1,000 bonds at a price of
107.26 (percent) of face value, the company will receive
$107,260 (100 × $1,000 × 1.0726).
1 Analyze
Assets
=
Liabilities
+ Stockholders' Equity
Cash (+A) +$107,260
Bonds Payable (+L) $100,000
Premium on Bonds Payable
(+L)
$7,260
2
Record
Cash (+A) (100,000 x 1.0726)
Bonds Payable (+L) face value
Premium on Bonds Payable (+L)
10-29
107,260
100,000
7,260
Bonds
Bonds Issued at a Discount
General Mills receives $93,376 for bonds with a total face value of
$100,000,sold at 93.376 the cash-equivalent amount is $93,376, which
represents the liability on that date. These bonds are issued at a
discount because the cash received is less than the face value of the
bonds.
1 Analyze
Assets
=
Liabilities
+ Stockholders' Equity
Cash (+A) +$93,376
Payable=(+L)
$100,000
$100,000 Bonds
- $93,376
$6,624
discount
Discount on Bonds Payable
(+xL, -L)
<$6,624>
2
Record
Cash (+A) (100,000 x 93.376)
Discount on Bonds Payable (+xL)
Bonds Payable (+L) face value
10-30
93,376
6,624
100,000
Interest on Bonds Issued at Face Value
General Mills issues bonds on January 1, 2010, at their total face
value of $100,000. The bonds have an annual stated interest rate of
6 percent payable in cash on December 31 of each year, General
Mills will need to accrue an expense and liability for interest at the
end of each accounting period. The end of the first accounting
period is January 31, 2010.
1 Analyze
$100,000 × 6% × 1/12 = $500 interest
Assets
2
=
Liabilities
+
Stockholders' Equity
Interest Payable (+L) $500
Interest Expense (+E, -SE) $500
Record
Interest Expense (+E, -SE)
Interest Payable (+L)
10-31
500
500
Interest on Bonds Issued at a Premium
Cash proceeds > Face value
Cash proceeds – Face value = Premium
Interest expense < Cash interest paid
Interest expense = Cash interest paid – Premium amortization
10-32
Interest on Bonds Issued at a Discount
Cash proceeds < Face value
Face value – Cash proceeds = Discount
Interest expense > Cash interest paid
Interest expense = Cash interest paid+ Discount amortization
10-33
Bond Retirement
The early retirement of bonds has three financial effects. The company
1. pays cash,
2. eliminates the bond liability, and
3. reports either a gain or a loss.
Assume that in 2000, General Mills issued $100,000 of bonds at face value.
Ten years later, in 2010, the company retired the bonds early. At the time,
the bond price was 103, so General Mills made a payment of $103,000.
1 Analyze
Cash Payment
$103,000
Assets
=
Liabilities
+ Stockholders' Equity
Carrying Value
100,000
Cash (-A) -$103,000
Bonds Payable (-L) $100,000
Loss on Bond
Loss on Retirement
$3,000 Retirement (+E, -SE)
$3,000
2
Record
Bonds Payable (-L) face value
Loss on Bond Retirement (+E, -SE)
Cash (-A)
10-34
100,000
3,000
103,000
Learning Objective 4
Describe how to account for
contingent liabilities.
10-35
Contingent Liabilities
Contingent liabilities are potential liabilities that arise from past
transactions or events, but their ultimate resolution depends
(is contingent) on a future event.
10-36
Learning Objective 5
Calculate and interpret the
quick ratio and the times
interest earned ratio.
10-37
Evaluate the Results
Two financial ratios are commonly used to assess a
company’s ability to generate resources to pay
future amounts owed:
1. Quick ratio
2. Times interest earned ratio
Quick Ratio =
(Cash + Short-term Investments + Accounts Receivable, Net)
Current Liabilities
Times Interest
=
Earned Ratio
10-38
(Net Income + Interest Expense + Income Tax Expense)
Interest Expense
Evaluate the Results
In 2008, General Mills reported $661 million of cash and cash
equivalents, no short-term investments, and $1,082 million of net
accounts receivable. The company reported $4,856 million in total current
liabilities.
Quick Ratio =
(Cash + Short-term Investments + Accounts Receivable, Net)
Current Liabilities
$661 + 0 + 1,082
4,856
=
0.359
A quick ratio of 0.359 implies that General Mills would
be able to pay only 35.9 percent of its current
liabilities, if forced to pay them immediately. However,
not all current liabilities are to be paid immediately.
10-39
Evaluate the Results
In 2008, General Mills reported net income of $290 million and interest
expense of $100 million, and income tax expense of $230 million. Let’s
calculate the times interest earned for 2008.
Times Interest
=
Earned Ratio
(Net Income + Interest Expense + Income Tax Expense)
Interest Expense
$290 + $100 + $230
$100
=
6.20 times
The ratio means that General Mills generates $6.20 of income
(before the costs of financing and taxes) for each dollar of
interest expense. No doubt this ratio is part of the reason that
General Mills has earned a favorable credit rating of BBB+.
10-40
Chapter 10
Supplement 10A
Straight-Line Method of Amortization
Bond Premium
Bond premium or discount decreases each year, until it is completely
eliminated on the bond’s maturity date. This process is called amortizing
the bond premium or discount. The straight-line method of amortization
reduces the premium or discount by an equal amount each period.
Recall our example when General Mills received $107,260 on the issue date
(January 1, 2010) but repays only $100,000 at maturity (December 31, 2013).
Under the straight-line method, this $7,260 is spread evenly as a reduction in
interest expense over the four years ($7,260 ÷ 4 = $1,815 per year).
1 Analyze
Cash
$6,000
Assets
= Interest Liabilities
+ Stockholders' Equity
(1,815)
Cash (-A) -$6,000Amortization
Premiumof
onPremium
Bonds Payable
Interest Expense
(-L)Expense -$1,815 $4,185
(+E, -SE)
$4,185
Interest
2
Record
Interest Expense (+E, -SE)
Premium on Bonds Payable (-L)
Cash (-A)
10-42
4,185
1,815
6,000
Bond Premium
Amortization Schedule of Bonds Issued at a Premium
$7,260 - $1,815 = $5,445
$7,260 ÷ 4 = $1,815
$100,000 × 6% × 12/12 = $6,000
face value x stated int x T
$107,260 – $1,815 = $105,445
$6,000 - $1,815 = $4,185
Notice that each of these amounts would plot as a straight-line!
10-43
Bond Discount
Recall our example where General Mills received $93,376 for four-year
bonds with a total face value of $100,000, implying a discount of $6,624.
The annual amortization of the discount is $1,656 ($6,624 ÷ 4).
1 Analyze
Cash
$6,000
Assets
= Interest Liabilities
+ Stockholders' Equity
ofBonds
Discount
Cash (-A) -$6,000Amortization
Discont on
Payable 1,656
Interest Expense
(-xL,
+L)
-1,656
Interest
Expense
$7,656(+E, -SE) +$7,656
2
Record
Interest Expense (+E, -SE)
Discount on Bonds Payable (-xL, +L)
Cash (-A)
10-44
7,656
1,656
6,000
Bond Discount
Amortization Schedule of Bonds Issued at a Discount
$6,624 - $1,656 = $4,968
$6,624 ÷ 4 = $1,656
$100,000 × 6% × 12/12 = $6,000
Face value x stated int x T
$93,376 + $1,656 = $95,032
$6,000 + $1,656 = $7,656
10-45
Chapter 10
Supplement 10B
Effective-Interest Method of
Amortization
Effective Interest Amortization
The effective-interest method of amortization is considered a conceptually superior
method of accounting for bonds because it correctly calculates interest expense by
multiplying the market interest rate times the carrying value of the bonds.
When General Mills adds this $7,260 premium to the $100,000 face value,
it reports a carrying value of $107,260 ($100,000 + $7,260) on January 1,
2010. The proceeds indicates that the market interest rate was 4 percent.
Interest (I) = Principal (P) × Rate (R) × Time (T)
Interest Expense = Carrying Value × Market Rate × n/12
$4,290 = $107,260 × 4% × 12/12
10-47
Effective Interest Amortization
General Mills issued 6% stated rate bonds for $107,260. The market
rate of interest on these bonds is 4%. The face amount of the bonds,
$100,000, results in cash interest is $6,000 ($100,000 × 6%). Let’s
amortize the premium on the bonds at the first interest payment date.
1 Analyze
Interest (I)= = Principal
(P) × Rate (R)+× Stockholders'
Time (T)
Assets
Liabilities
Equity
Expense
= Carrying
Value
× MarketInterest
Rate ×Expense
n/12
CashInterest
(-A) -$6,000
Premium
on Bonds
Payable
(-L) = $107,260
-1,710
(+E, -SE)
+$4,290
$4,290
× 4% × 12/12
2
Record
Cash Interest
$ 6,000
Interest Expense (+E, -SE)
Effective Interest
4,290
Premium on Bonds Payable (-L)
Amortization of Premium $1,710
Cash (-A)
10-48
4,290
1,710
6,000
Effective Interest Amortization
$6,000 - $4,290 = $1,710
$7,290 - $1,710 = $5,550
Effective Interest Amortization of Bonds Issued at a Premium
$107,260 × 4% × 12/12 = $4,290
$100,000 × 6% × 12/12 = $6,000
Face value x stated int x time
$107,260 - $1,710 = $105,550
Interest Expense decreases and Premium Amortization
increases each period. Cash interest is unchanged.
10-49
Effective Interest Amortization
General Mills issued $100,000 face value, 6%, 4-year bonds at a market
price to yield investors 8%. The bonds were issued at a discount of $6,624.
Let’s determine the effective interest for the first interest payment period.
1 Analyze
Interest (I)= = Principal
(P) × Rate (R)+× Stockholders'
Time (T)
Assets
Liabilities
Equity
Expense
= Carrying
Value
× MarketInterest
Rate ×Expense
n/12
CashInterest
(-A) -$6,000
Discount
on Bonds
Payable
$7,470
× 12/12
(-xL, =
+L)$93,376 × 8%
-1,470
(+E, -SE)
+$7,470
2
Record
Cash Interest
$ 6,000
Interest Expense (+E, -SE)
Effective Interest
7,470 7,470
Discount
on Bonds Payable
(+xL, -L)$ 1,470
Amortization
of Discount
Cash (-A)
10-50
1,470
6,000
Effective Interest Amortization
$7,470 - $6,000 = $1,470
$7,470 - $1,470 = $5,154
Effective Interest Amortization of Bonds Issued at a Discount
$93,376 × 8% × 12/12 = $7,470
$100,000 × 6% × 12/12 = $6,000
Face value x stated int x time
$93,376 + $1,470 = $94,846
Both Interest Expense and Discount Amortization
increase each period. Cash interest is unchanged.
10-51
Chapter 10
Solved Exercises
M10-5, E10-2, E10-3, E10-8, E10-10,
PA10-3
M10-5 Reporting Current and Noncurrent Portions of Long-Term
Debt
Assume that on December 1, 2010, your company borrowed $14,000, a
portion of which is to be repaid each year on November 30.
Specifically, your company will make the following principal payments:
2011, $2,000; 2012, $3,000; 2013, $4,000; and 2014, $5,000. Show how
this loan will be reported in the December 31, 2011 and 2010 balance
sheets, assuming that principal payments will be made when required.
As of December 31,
2011
2010
10-53
Current Liabilities:
Current Portion of Long-term Debt
$
Long-term Debt
Total Liabilities
9,000
$ 12,000
3,000
$
2,000
12,000
$ 14,000
E10-2 Recording a Note Payable through Its Time to Maturity
Many businesses borrow money during periods of increased business
activity to finance inventory and accounts receivable. Target
Corporation is one of America’s largest general merchandise retailers.
Each Christmas, Target builds up its inventory to meet the needs of
Christmas shoppers. A large portion of Christmas sales are on credit.
As a result, Target often collects cash from the sales several months
after Christmas. Assume that on November 1, 2010, Target borrowed
$6 million cash from Metropolitan Bank and signed a promissory note
that matures in six months. The interest rate was 7.5 percent payable
at maturity. The accounting period ends December 31.
Required:
1. Give the journal entry to record the note on November 1, 2010.
2. Give any adjusting entry required on December 31, 2010.
3. Give the journal entry to record payment of the note and interest
on the maturity date, April 30, 2011, assuming that interest has not
been recorded since December 31, 2010.
10-54
E10-2 Recording a Note Payable through Its Time to Maturity
November 1, 2010:
Borrowed on 6-month, 7.5%, note payable.
December 31, 2010 (end of the accounting period):
Adjusting entry for 2 months’ accrued interest ($6,000,000 x 7.5% x 2/12 = $75,000).
April 30, 2011 (maturity date):
Paid note plus interest at maturity.
10-55
E10-3 Recording Payroll Costs with Discussion
McLoyd Company completed the salary and wage payroll for March
2010. The payroll provided the following details:
Salaries and wages earned
Employee income taxes withheld
FICA taxes withheld
Unemployment taxes
$ 230,000
50,200
16,445
1,600
Required:
1. Considering both employee and employer payroll taxes, use the
preceding information to calculate the total labor cost for the
company.
2. Prepare the journal entry to record the payroll for March, including
employee deductions (but excluding employer payroll taxes).
3. Prepare the journal entry to record the employer’s FICA taxes and
unemployment taxes.
10-56
E10-3 Recording Payroll Costs with Discussion
Req. 1 The total labor cost was $248,045, made up of the $230,000 in gross
salaries and wages plus the $16,445 for employer FICA taxes and
$1,600 for unemployment taxes.
Req. 2 March 31, 2010
dr Salaries and Wages Expense (+E, -SE) 230,000
cr Withheld Income Taxes Payable (+L)
50,200
cr FICA Taxes Payable—employees (+L)
16,445
cr Cash (-A)
163,355
Payroll for March including employee deductions.
Req. 3 March 31, 2010
dr Payroll Tax Expense (+E,-SE)
cr FICA Taxes Payable—employer (+L)
cr Unemployment Taxes Payable (+L)
Employer payroll taxes on March payroll.
10-57
18,045
16,445
1,600
E10-8 Preparing Journal Entries to Record Issuance of
Bonds at Face Value, Payment of Interest, and Early
Retirement
On January 1, 2010, Innovative Solutions, Inc., issued $200,000
in bonds at face value. The bonds have a stated interest rate of
6 percent. The bonds mature in 10 years and pay interest once
per year on December 31.
Required:
1. Prepare the journal entry to record the bond issuance.
2. Prepare the journal entry to record the interest payment on
December 31, 2010. Assume no interest has been accrued
earlier in the year.
3. Assume the bonds were retired immediately after the first
interest payment at a quoted price of 102. Prepare the
journal entry to record the early retirement of the bonds.
10-58
E10-8 Preparing Journal Entries to Record Issuance of Bonds
at Face Value, Payment of Interest, and Early Retirement
Req. 1 dr Cash (+A)
200,000
cr Bonds Payable (+L)
200,000
Req. 2
dr Interest Expense (+E, -SE)
cr Cash (-A)
12,000
12,000
($200,000 x 6% x 12/12) = $12,000
Req. 3
dr Bonds Payable (-L)
200,000
dr Loss on Bonds Retired (+E, -SE) 4,000
cr Cash (-A)
204,000
($200,000 x 102%) = $204,000
10-59
E10-10 Calculating and Interpreting the Quick Ratio and Times
Interest Earned Ratio
According to its Web site, Kraft Foods Inc. sells enough Kool-Aid® mix to
make 1,000 gallons of the drink every minute during the summer and over
560 million gallons each year. At December 31, 2008, the company
reported no short-term investments but did report the following amounts (in
millions) in its financial statements:
Cash and Cash Equivalents
Accounts Receivable, Net
Total Current Liabilities
Interest Expense
Income Tax Expense
Net Income
2008
$ 1,244
4,704
11,044
1,240
728
2,901
2007
$ 567
5,197
17,086
604
1,002
2,590
Required:
1. Compute the quick ratio and times interest earned ratio (to two
decimal places) for 2008 and 2007.
2. Did Kraft appear to have increased or decreased its ability to pay
current liabilities and future interest obligations as they become due?
How can you explain the seemingly conflicting findings of your ratio
analysis?
10-60
E10-10 Calculating and Interpreting the Quick Ratio and Times
Interest Earned Ratio
Req. 1
Req. 2
10-61
E10-10 Calculating and Interpreting the Quick Ratio and Times
Interest Earned Ratio
Req. 3 The times interest earned ratio has decreased from 6.95 to 3.93,
suggesting a decline in Kraft’s ability to cover its interest through
profitable operations. The quick ratio has increased from 0.34 in
2007 to 0.54 in 2008, suggesting Kraft is in a better position to
quickly pay its current liabilities at the end of 2008. These findings
seem to conflict, but can be explained as follows. In 2008, when the
economy was suffering, Kraft realized that it could no longer rely as
much on obtaining short-term financing to cover cash needs.
Consequently, Kraft borrowed more funds through long-term debt,
which doubled the amount the company held in Cash and Cash
Equivalents. Obtaining more long-term debt financing came at a
cost, however, as indicated by the doubling of Interest Expense. The
results of these shifts were an increase in the quick ratio (associated
with the increase in Cash) and a decrease in the times interest
earned ratio (associated with the increase in Interest Expense).
10-62
PA10-3 Recording and Reporting Current Liabilities
During 2010, Lakeview Company completed the following two transactions. The annual
accounting period ends December 31.
a. On December 31, 2010, calculated the payroll, which indicates gross earnings for
wages ($80,000), payroll deductions for income tax ($8,000), payroll deductions
for FICA ($6,000), payroll deductions for American Cancer Society ($2,000),
employer contributions for FICA (matching), state unemployment taxes ($500),
and federal unemployment taxes ($100). Employees were paid in cash, but these
payments and the corresponding payroll deductions and employer taxes have not
yet been recorded.
b. Collected rent revenue of $3,600 on December 10, 2010, for office space that
Lakeview rented to another business. The rent collected was for 30 days from
December 11, 2010, to January 10, 2011, and was credited in full to Rent
Revenue.
Required:
1. Give the journal entries to record payroll on December 31, 2010.
2. Give ( a ) the journal entry for the collection of rent on December 10, 2010, and ( b )
the adjusting journal entry on December 31, 2010.
3. Show how any liabilities related to these items should be reported on the
company’s balance sheet at December 31, 2010.
4. Explain why the accrual basis of accounting provides more relevant information to
financial analysts than the cash basis.
10-63
PA10-3 Recording and Reporting Current Liabilities
Req. 1 dr Wage Expense (+E, -SE)
80,000
cr Withheld Income Tax Payable (+L)
8,000
cr FICA Payable (+L)
6,000
cr American Cancer Society Payable (+L)
2,000
cr Cash (-A)
64,000
dr Payroll Tax Expense (+E, -SE)
6,600
cr FICA Payable (+L)
cr State Unemployment Tax Payable (+L)
cr Federal Unemployment Tax Payable (+L)
December 10, 2010:
Req. 2 (a)
dr Cash (+A)
cr Rent Revenue (+R, +SE)
6,000
500
100
3,600
3,600
Collection of rent revenue for one month.
(b)
December 31, 2010:
dr Rent Revenue (-R, -SE)
cr Unearned Rent Revenue (+L)
1,200
1,200
Earned 20 days of rent but initially recorded as if all was earned. Need to
reduce revenue for 10 days unearned (10/30 x $3,600 = $1,200).
10-64
PA10-3 Recording and Reporting Current Liabilities
Req. 3 Balance sheet at December 31, 2010:
Current Liabilities:
Withheld Income Taxes Payable
FICA Payable
American Cancer Society Payable
State Unemployment Tax Payable
Federal Unemployment Tax Payable
Unearned Rent Revenue
8,000
12,000
2,000
500
100
1,200
Req. 4 Accrual basis accounting is beneficial to financial analysts because it
records revenues when they are earned and expenses when they are
incurred, regardless of when the related cash is received or paid. Cash
basis accounting only records revenues when they are received and
expenses when they are paid. A financial analyst is looking towards the
future of the company, so it is helpful to know how much cash will be
coming into and out of the company at later dates. Cash basis
accounting limits financial analysts to only what has happened in prior
periods and tells them very little about future events and cash flows that
will affect the financial health of the company.
10-65
End of Chapter 10

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