Chapter 8

Current Liabilities

QUESTIONS

Question 8-1
Liabilities have three essential characteristics. Liabilities are: (1) probable future sacrifices of
economic benefits; (2) arising from present obligations to other entities; (3) resulting from past
transactions or events. The definition of liabilities touches on the present, the future, and the past. A
liability is a present responsibility to sacrifice assets in the future due to a transaction or other event
that happened in the past.

Question 8-2
In most cases, current liabilities are payable within one year from the date of the balance sheet
and long-term liabilities are payable in more than one year. Current liabilities are usually, but not
always, due within one year. For example, if a company has an operating cycle longer than one year
(a winery, for example), its current liabilities are defined by the operating cycle rather than by the
length of a year.

Question 8-3
Distinguishing between current and long-term liabilities is important in helping investors and
creditors assess the riskiness of a business’ obligations. Given a choice, most companies would
prefer to report a liability as long-term rather than current because it may cause the firm to appear
less risky. In turn, less risky firms may enjoy lower interest rates on borrowing and command higher
stock prices for new stock listings.

Question 8-4
Current liabilities common to the airline industry include payroll liabilities, deferred revenue in
the form of advance ticket sales, and contingent liabilities due to litigation.

Question 8-5
The accrual basis requires expenses to be recorded when incurred. The cash basis requires
expenses to be recorded when the cash is paid. Financial accounting requires use of the accrual basis
rather than the cash basis as this best reflects the timing of the expense in the same period as the
associated benefits.

Question 8-6
A line of credit is an informal agreement that permits a company to borrow up to a prearranged
limit without having to follow formal loan procedures and paperwork. The line of credit works like a
note payable except the company is able to borrow without having to go through a formal loan
approval process each time it borrows money.

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Solutions Manual, Chapter 8 8-1
answers to Questions (continued)
Question 8-7
If a company borrows from another company rather than from a bank, the note is referred to as
commercial paper. The interest rate is often lower for commercial paper than a bank loan as the
company is effectively bypassing the additional mark-up in interest rates by the bank.

Question 8-8
Four items commonly withheld from employee payroll checks include (1) federal and state
income taxes, (2) Social Security and Medicare (FICA), (3) health, dental, disability, and life
insurance premiums, and (4) employee investments to retirement or savings plans. The first two are
required by law and the second two are voluntary.

Question 8-9
Four common employer costs in addition to the employee’s salary include (1) federal and state
unemployment taxes, (2) the employer portion of Social Security and Medicare (FICA), (3)
employer contributions for health, dental, disability, and life insurance, and (4) employer
contributions to retirement or savings plans. The first two are required by law and the last two are
voluntary benefits paid by a company on behalf of its employees.

Question 8-10
Both the employer and the employee pay equal portions of social security taxes. Employers
withhold from employee paychecks a 6.2% Social Security tax up to a maximum base amount and a
1.45% Medicare tax with no maximum. Therefore, the total FICA tax is 7.65% (6.2% + 1.45%) on
income up to a base amount for Social Security ($128,400 in 2018) and 1.45% on all income above
the base amount. Employers then pay an additional (matching) amount equal to the amount withheld
from employee paychecks so the government actually is collecting 15.3% (7.65% employee + 7.65%
employer) on each employee’s salary.

Question 8-11
When a company receives cash in advance through the sale of gift cards, it debits cash and
credits a current liability account called deferred revenue. When it provides the goods or services
already paid for, the company debits deferred revenue and credits revenue.

Question 8-12
(a) When Sports Illustrated sells magazine subscriptions, the company will debit cash and credit
deferred revenue. (b) As the subscription is provided through the distribution of magazines, the
company debits deferred revenue and credits revenue.

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8-2 Financial Accounting, 5e
answers to Questions (continued)
Question 8-13
The sales tax rate for Hollister is 6.5% calculated as $325 in sales taxes divided by sales of
$5,000. The journal entry to record the transaction would debit cash for $5,325, credit sales for
$5,000, and credit sales taxes payable for $325.

Question 8-14
Dell will include $10 million as a current note payable and the remaining $120 million as part of
long-term notes payable.

Question 8-15
A contingent liability is an existing, uncertain situation that might result in a loss. Examples
include lawsuits, product warranties, environmental problems, and premium offers.

Question 8-16
The likelihood of the loss occurring can be probable, reasonably possible, or remote. Probable
means likely to occur while remote means the chance is slight. Reasonably possible fits somewhere
in between—more than remote but less than probable.

Question 8-17
A loss contingency is recorded only if a loss is probable and the amount is reasonably estimable.

Question 8-18
If the likelihood of loss is reasonably possible rather than probable, we record no entry but make
full disclosure in a disclosure note to the financial statements to describe the contingency. Finally, if
the likelihood of loss is remote, disclosure is usually not required.

Question 8-19
If one amount within a range of potential losses appears more likely than other amounts within
the range, we record that amount. When no amount within the range appears more likely than others,
we record the minimum amount and disclose information about the potential loss including the
potential range of loss.

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Solutions Manual, Chapter 8 8-3
answers to Questions (continued)

Question 8-20
In a pending lawsuit, one side—the defendant—faces a loss contingency, while the other side—
the plaintiff—has a gain contingency. The $2 million is a gain contingency and the outcome, while
promising, is not yet certain. We do not record gain contingencies of this type until the gain is
certain. Though firms do not record gain contingencies in the accounts, they sometimes disclose
them in notes to the financial statements.

Question 8-21
Liquidity measures the ability of a company to pay current liabilities as they come due. Liquidity
can be evaluated by examining the current ratio or the more specific acid-test ratio.

Question 8-22
Working capital is simply the difference between current assets and current liabilities. The
current ratio is calculated by dividing current assets by current liabilities. The acid-test ratio is
similar to the current ratio but is based on a more conservative measure of current assets available to
pay current liabilities. We calculate the acid-test ratio by dividing “quick assets” by current
liabilities. Quick assets include only cash, short-term investments, and accounts receivable. By
eliminating current assets such as inventories and prepaid expenses that are less readily convertible
into cash, the acid-test ratio may provide a better indication of a company’s liquidity than does the
current ratio.

Question 8-23
(a) The purchase of inventory with cash would have no effect on the current ratio as one current
asset (inventory) would increase while another current asset (cash) would decrease. The purchase of
inventory with cash would decrease the acid-test ratio due to the decrease in cash. (b) The sale of
inventory for more than its cost would increase the current ratio because the increase in cash or
accounts receivable from the sale would more than offset the reduction of inventory at its cost. The
sale of inventory for more than its cost would also increase the acid-test ratio due to the increase in
cash or accounts receivable from the sale.

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8-4 Financial Accounting, 5e
BRIEF EXERCISES
Brief Exercise 8-1
November 1 Debit Credit
Cash 4,000,000
Notes Payable 4,000,000

December 31
Interest Expense (4,000,000 × 0.06 × 2/12) 40,000
Interest Payable 40,000

Brief Exercise 8-2

November 1 Debit Credit
Notes Receivable 4,000,000
Cash 4,000,000

December 31
Interest Receivable 40,000
Interest Revenue (4,000,000 × 0.06 × 2/12) 40,000

Brief Exercise 8-3

Interest Face Annual Fraction
= × ×
Expense value interest rate of the year
$4,800 = $160,000 × 6% × 6/12

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Solutions Manual, Chapter 8 8-5
Brief Exercise 8-4
April 1 Debit Credit
Cash 13,000,000
Notes Payable - Commercial Paper 13,000,000

December 31
Notes Payable - Commercial Paper 13,000,000
Interest Expense ($13,000,000 × 0.09 × 9/12) 877,500
Cash 13,877,500

Brief Exercise 8-5

Total withheld for:
Social Security $128,400 × 0.062 = $ 7,961
Medicare $652,800 × 0.0145 = 9,466
Total $17,427

The employer will contribute an additional (matching) $17,427.

Brief Exercise 8-6

December 18 Debit Credit
Cash 260,000
Deferred Revenue 260,000
(to record advance receipt of cash)

January 23
Cash 2,340,000
Deferred Revenue 260,000
Sales Revenue 2,600,000
Cost of Goods Sold 1,600,000
Inventory 1,600,000
(to complete the sale)

Brief Exercise 8-7

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8-6 Financial Accounting, 5e
 June $1,200
July 2,100
August 1,700*
* Includes gift cards redeemed ($1,400) and gift cards unlikely to be redeemed ($300).

Brief Exercise 8-8

Debit Credit
Accounts Receivable 3,472
Sales Revenue 3,200
Sales Taxes Payable (0.085 × $3,200) 272

Brief Exercise 8-9

Southwest Airlines
Partial Balance Sheet
December 31, 2021
Current Liabilities:
Current portion of long-term debt $ 10,000,000
Long-Term Liabilities:
Notes payable 31,000,000
Total Liabilities $41,000,000

Brief Exercise 8-10

Debit Credit
Warranty Expense ($31,000,000 x 3%) 930,000
Warranty Liability 930,000

Warranty Liability 300,000

Cash 300,000

The Warranty Liability at the end of the year is $630,000, calculated using a T-
account as follows:

Warranty Liability
300,000 930,000
630,000 balance

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Solutions Manual, Chapter 8 8-7
Brief Exercise 8-11
The loss contingency is probable and reasonably estimable, so a loss and a liability for
$8 million must be recorded. The entry will reduce income before taxes on the income
statement and increase total liabilities on the balance sheet by $8 million.

Brief Exercise 8-12

Electronic Innovators has a contingent liability that is probable, and reasonably
estimable within a range between $6 and $10 million. Electronic Innovators should
record a loss and a liability for the minimum amount ($6 million) and disclose the
range between $6 and $10 million in the notes to the financial statements.

Brief Exercise 8-13

Aviation Systems has a contingent gain that is probable and reasonably estimable,
within a range between $6 and $10 million. Contingent gains are not recorded until
the gain is certain. Though firms do not record contingent gains in the accounts, they
sometimes disclose them in the notes to the financial statements.

Brief Exercise 8-14

Northwest Forest Products has a contingent liability that is reasonably possible and
reasonably estimable, within a range between $20 and $30 million. Since the loss is
reasonably possible, but not probable, we will carefully disclose the situation, but not
record the potential loss and liability in the financial records. Details regarding the
investigation by the EPA, the reasonable possibility of an assessment, and the range of
settlements should be included in the disclosure.

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8-8 Financial Accounting, 5e
Brief Exercise 8-15
(1) Not recorded (disclosure only) as the loss is reasonably possible, but not probable.

(2) Not recorded (disclosure only) as the loss is not reasonably estimable.

(3) Recorded because the warranty costs are probable and reasonably estimable.

Brief Exercise 8-16

Current Assets ÷ Current Liabilities = Current Ratio
($112 + 104 + 192 + 28) ÷ ($118 + 45) = 2.67

Quick Assets ÷ Current Liabilities = Acid-Test Ratio

($112 + 104) ÷ ($118 + 45) = 1.33

Brief Exercise 8-17

Current Acid-Test
Ratio Ratio
1. Provide services to customers on account. Increase Increase
2. Borrow cash from the bank by signing a Increase Increase
long-term note payable.
3. Purchase office supplies with cash No change Decrease
4. Pay rent for the current period. Decrease Decrease

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Solutions Manual, Chapter 8 8-9
EXERCISES
Exercise 8-1
Reporting Method
C. Current liability
L. Long-term liability
D. Disclosure note only
N. Not reported

Item
__C__ 1. Accounts payable.
__C__ 2. Current portion of long-term debt.
__C__ 3. Sales tax collected from customers.
__C__ 4. Notes payable due next year.
__L__ 5. Notes payable due in two years.
__C__ 6. Advance payments from customer.
__C__ 7. Commercial paper.
__D__ 8. Unused line of credit.
__C__ 9. A contingent liability with a probable likelihood of
occurring within the next year and can be estimated.
__D__ 10. A loss contingency with a reasonably possible
likelihood of occurring within the next year and can be
estimated.

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8-10 Financial Accounting, 5e
Exercise 8-2
1. November 1, 2021 Debit Credit
Cash 60,000
Notes Payable 60,000
(Issuance of notes payable)

2. December 31, 2021

Interest Expense ($60,000 × 7% × 2/12) 700
Interest Payable 700
(Interest expense incurred, but not paid)

3. January 31, 2022

Notes Payable 60,000
Interest Payable ($60,000 × 7% × 2/12) 700
Interest Expense ($60,000 × 7% × 1/12) 350
Cash 61,050
(Payment of notes payable and interest)

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Solutions Manual, Chapter 8 8-11
Exercise 8-3
1. August 1, 2021 Debit Credit
Cash 21,000,000
Notes Payable 21,000,000
(Issuance of notes payable)

2. December 31, 2021

Interest Expense ($21 million × 9% × 5/12) 787,500
Interest Payable 787,500
(Interest expense incurred, but not paid)

3. January 31, 2022

Notes Payable 21,000,000
Interest Payable ($21 million × 9% × 5/12) 787,500
Interest Expense ($21 million × 9% × 1/12) 157,500
Cash 21,945,000
(Payment of notes payable and interest)

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8-12 Financial Accounting, 5e
Exercise 8-4
1. August 1, 2021 Debit Credit
Notes Receivable 21,000,000
Cash 21,000,000
(Issuance of notes receivable)

2. December 31, 2021

Interest Receivable ($21 × 9% × 5/12) 787,500
Interest Revenue 787,500
(Interest revenue earned, but not received)

3. January 31, 2022

Cash 21,945,000
Notes Receivable 21,000,000
Interest Receivable ($21 × 9% × 5/12) 787,500
Interest Revenue ($21 × 9% × 1/12) 157,500
(Collection of notes receivable and interest)

Exercise 8-5

1. $6,000,000 × 0.11 × 6/12 = $330,000

2. $6,000,000 × 0.09 × 3/12 = $135,000
3. $6,000,000 × 0.10 × 4/12 = $200,000
4. $6,000,000 × 0.07 × 7/12 = $245,000

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Solutions Manual, Chapter 8 8-13
Exercise 8-6

January 13
No Entry

February 1
Cash 5,000,000
Notes Payable 5,000,000

May 1
Notes Payable 5,000,000
Interest Expense ($5,000,000 × 0.07 ×
3/12) 87,500
Cash 5,087,500

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8-14 Financial Accounting, 5e
Exercise 8-7

Requirement 1
Total Salary Expense (100 × 40 hours × $20) $80,000
Less: Withholdings
Federal Income Taxes ($80,000 × 0.15) $12,000
State Income Taxes ($80,000 × 0.05) 4,000
FICA Taxes ($80,000 × 0.0765) 6,120
Total Withholdings 22,120
Actual Direct Deposit $57,880

Requirement 2
FICA Taxes ($80,000 × 0.0765) $ 6,120
Unemployment Taxes ($80,000 × 0.062) 4,960
Total Payroll Tax Expense $11,080

Requirement 3
The company does not make an accounting entry to record the free skiing given to
employees on their days off; no additional costs are directly incurred by the company
to provide this benefit.

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Solutions Manual, Chapter 8 8-15
Exercise 8-8

Requirement 1
January 31
Salaries Expense 3,000,000
Income Tax Payable 637,500
FICA Tax Payable 229,500
Accounts Payable (to Blue Cross/Blue Shield) 30,000
Salaries Payable (to balance) 2,103,000
(Employee salary expense and withholdings)

Requirement 2
January 31
Salaries Expense (fringe benefits) 90,000
Accounts Payable (to Blue Cross/Blue Shield) 90,000
(Employer-provided fringe benefits)

Requirement 3
January 31
Payroll Tax Expense 415,500
FICA Tax Payable 229,500
Unemployment Tax Payable 186,000
(Employer payroll taxes)

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8-16 Financial Accounting, 5e
Exercise 8-9

January 31
Salaries Expense 600,000
Income Tax Payable 120,000
FICA Tax Payable ($600,000 × 0.0765) 45,900
Salaries Payable (to balance) 434,100
(Employee salary expense)

January 31
Payroll Tax Expense (total) 83,100
FICA Tax Payable ($600,000 × 0.0765) 45,900
Unemployment Tax Payable ($600,000 × 0.062) 37,200
(Employer payroll tax expense)

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Solutions Manual, Chapter 8 8-17
Exercise 8-10

Requirement 1
November 30
Cash 21,000,000
Deferred Revenue 21,000,000
(Advance collection for gift cards)

Requirement 2
December 31
Deferred Revenue 14,000,000
Sales Revenue 14,000,000
(Revenue recognized when gift cards are redeemed)

Requirement 3
The ending balance in Deferred Revenue is $7,000,000.

Deferred Revenue
14,000,000 21,000,000
7,000,000 Ending balance

Exercise 8-11

Requirement 1
October 1, 2021
Cash 100,000
Deferred Revenue 100,000
(Sale of gift cards)

Requirement 2
December 31, 2021
Deferred Revenue 20,000
Sales Revenue 20,000
(Revenue recognized when gift cards are redeemed)
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8-18 Financial Accounting, 5e
Requirement 3
March 31, 2022
Deferred Revenue 70,000
Sales Revenue 70,000
(Revenue recognized when gift cards are redeemed)
($70,000 = $30,000 + $25,000 + $15,000)

Requirement 4
April 1, 2022
Deferred Revenue 10,000
Sales Revenue 10,000
(Revenue expiration of gift cards)
($10,000 = $100,000 − $20,000 − $70,000)

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Solutions Manual, Chapter 8 8-19
Exercise 8-12

Requirement 1
The contingent liability is probable and reasonably estimable, so it must be reported.

Requirement 2
A $4 million loss should be reported in its 2021 income statement.

Requirement 3
A $4 million liability should be reported in its 2021 balance sheet.

Requirement 4

Loss 4,000,000
Contingent Liability 4,000,000
(Record the contingent liability)

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8-20 Financial Accounting, 5e
Exercise 8-13

Requirement 1
The contingent liability is probable and reasonably estimable, so it must be recorded
as follows:

Loss 1,300,000
Contingent Liability 1,300,000
(Record the contingent liability)

Requirement 2
Pacific Cruise Lines should record a loss and a liability for the minimum amount ($1.1
million) and disclose the nature of the contingency in the disclosure notes to the
financial statements. The journal entry is as follows:

Loss 1,100,000
Contingent Liability 1,100,000
(Record the contingent liability)

Requirement 3
If the likelihood of loss is reasonably possible rather than probable, we record no entry
but make full disclosure in a note to the financial statements to describe the
contingency.

Requirement 4
If the likelihood of loss is remote, disclosure is usually not required.

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Solutions Manual, Chapter 8 8-21
Exercise 8-14
Requirement 1
Yes, it’s probable that costs for warranties will be incurred and based on previous
experience the amount is reasonably estimable.

Requirement 2
December 31
Warranty Expense ($600,000 × 6%) 36,000
Warranty Liability 36,000
(Record contingent liability for warranties)

Requirement 3
January 31
Warranty Liability 13,000
Cash 13,000
(Record actual warranty expenditures)

Requirement 4

Warranty Liability
36,000 Expense
Payment 13,000
23,000 Balance

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8-22 Financial Accounting, 5e
Exercise 8-15
Requirement 1
December 31, 2021
Warranty Expense ($1,600,000 × 2%) 32,000
Warranty Liability 32,000
(Record contingent liability for warranties)

Requirement 2
Summary entry in 2022
Warranty Liability 25,000
Cash 25,000
(Record actual warranty expenditures)

Requirement 3
December 31, 2022
Warranty Expense 29,000
Warranty Liability 29,000
(Record contingent liability for warranties)
($36,000 = $2,400,000 × 1.5%)
($29,000 = $36,000 − $7,000 current balance in Warranty Liability)

Requirement 4

Warranty Liability
0
32,000 Adjusting entry
32,000 Balance in 2021
Payment in 2022 25,000
7,000
29,000 Adjusting entry
36,000 Balance in 2022

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Solutions Manual, Chapter 8 8-23
Exercise 8-16
Requirement 1
Yes, a contingent liability is an existing, uncertain situation that might result in a loss.
The environmental remediation and restoration costs represent an existing uncertain
situation that will likely result in a loss to the company.

Requirement 2
Dow would record a contingency if the loss is probable and is reasonably estimable.

Requirement 3

Loss 381,000,000
Contingent Liability 381,000,000
(Record the contingent liability)

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8-24 Financial Accounting, 5e
Exercise 8-17
Requirement 1
Current Assets ÷ Current Liabilities = Current Ratio
$875 ÷ $2,638 = 0.33

Quick Assets ÷ Current Liabilities = Acid-Test Ratio

$331 + 63 + 230 ÷ $2,638 = 0.24

Requirement 2
Queen’s Line has a lower current ratio and a lower acid-test ratio than either United
Airlines or American Airlines reported in the text. Queen’s Line appears more likely
to have difficulty paying its currently maturing debts.

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Solutions Manual, Chapter 8 8-25
Exercise 8-18
Requirement 1 Transactions during January, 2021
January 2 Debit Credit
Cash 8,000
Deferred Revenue 8,000
(Sell gift cards for cash)
January 6 Debit Credit
Inventory 147,000
Accounts Payable 147,000
(Purchase inventory on account)
January 15 Debit Credit
Accounts Receivable 135,000
Sales Revenue 135,000
(Sell inventory on account)
Cost of Goods Sold 73,800
Inventory 73,800
(Record cost of inventory sold)
January 23 Debit Credit
Cash 125,400
Accounts Receivable 125,400
(Receive cash on account)
January 25 Debit Credit
Accounts Payable 90,000
Cash 90,000
(Pay cash on account)
January 28 Debit Credit
Allowance for Uncollectible Accounts 4,800
Accounts Receivable 4,800
(Write off uncollectible accounts)

January 30 Debit Credit

Cash 11,000
Accounts Receivable 132,000
Sales Revenue 143,000
(Sell inventory for cash and on account)
Cost of Goods Sold 79,500
Inventory 79,500
(Record cost of inventory sold)

January 31 Debit Credit

Salaries Expense 52,000
Cash 52,000
(Pay monthly salaries)

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8-26 Financial Accounting, 5e
Exercise 8-18 (continued)
Requirement 2 Adjusting entries at end of January, 2021
(a) January 31 Debit Credit
Depreciation Expense 500
Accumulated Depreciation 500
(Record depreciation for January)
($500 = [$15,000−$3,000] / 24 months)

(b) January 31 Debit Credit

Bad Debt Expense 12,500
Allowance for Uncollectible Accounts 12,500
(Adjust uncollectible accounts)
($12,500 = [$11,000×30%]+[$172,000a×5%]+$600b)
a $172,000 = $46,200+$135,000−$125,400−$4,800+$132,000−$11,000
b $600 = $4,800−$4,200

(c) January 31 Debit Credit

Interest Expense 250
Interest Payable 250
(Adjust interest expense)
($250 = $50,000 × 6% × 1/12)

(d) January 31 Debit Credit

Income Tax Expense 13,000
Income Tax Payable 13,000
(Adjust income taxes)

(e) January 31 Debit Credit

Deferred Revenue 3,000
Sales Revenue 3,000
(Adjust revenue for gift cards redeemed)

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Solutions Manual, Chapter 8 8-27
Exercise 8-18 (continued)
Requirement 3

ACME Fireworks
Adjusted Trial Balance
January 31, 2021
Accounts Debit Credit
Cash $ 27,500
Accounts Receivable 183,000
Inventory 13,700
Land 46,000
Equipment 15,000
Allowance for Uncollectible Accounts $ 11,900
Accumulated Depreciation 2,000
Accounts Payable 85,500
Deferred Revenue (gift cards liability) 5,000
Interest Payable 250
Income Tax Payable 13,000
Notes Payable 50,000
Common Stock 35,000
Retained Earnings 33,100
Sales Revenue 281,000
Cost of Goods Sold 153,300
Salaries Expense 52,000
Bad Debt Expense 12,500
Depreciation Expense 500
Interest Expense 250
Income Tax Expense 13,000
Totals $516,750 $516,750

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8-28 Financial Accounting, 5e
Exercise 8-18 (continued)
Requirement 3 (concluded)

Accounts Ending Beginning balance in bold, entries during January in blue,

Balance and adjusting entries in red.
Cash $ 27,500 = 25,100+8,000+125,400−90,000+11,000−52,000
Accounts Receivable 183,000 = 46,200+135,000−125,400−4,800+132,000
Inventory 13,700 = 20,000+147,000−73,800−79,500
Land 46,000 = 46,000
Equipment 15,000 = 15,000
Allow for Unc. Accounts 11,900 = 4,200−4,800+12,500
Accumulated Depreciation 2,000 = 1,500+500
Accounts Payable 85,500 = 28,500+147,000−90,000
Deferred Revenue 5,000 = 8,000−3,000
Interest Payable 250 = 250
Income Tax Payable 13,000 = 13,000
Notes Payable 50,000 = 50,000
Common Stock 35,000 = 35,000
Retained Earnings 33,100 = 33,100
Sales Revenue 281,000 = 135,000+143,000+3,000
Cost of Goods Sold 153,300 = 73,800+79,500
Salaries Expense 52,000 = 52,000
Bad Debt Expense 12,500 = 12,500
Depreciation Expense 500 = 500
Interest Expense 250 = 250
Income Tax Expense 13,000 = 13,000

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Solutions Manual, Chapter 8 8-29
Exercise 8-18 (continued)
Requirement 4
ACME Fireworks
Multiple-Step Income Statement
For the year ended January 31, 2021
Sales revenue $281,000
Cost of goods sold 153,300
Gross profit $127,700
Salaries expense 52,000
Bad debt expense 12,500
Depreciation expense 500
Total operating expenses 65,000
Operating income 62,700
Interest expense 250
Income before taxes 62,450
Income tax expense 13,000
Net income $ 49,450

Requirement 5
ACME Fireworks
Classified Balance Sheet
January 31, 2021
Assets Liabilities
Accounts payable $ 85,500
Cash $ 27,500 Deferred revenue 5,000
Accounts receivable 183,000 Interest payable 250
Less: Allowance (11,900) 171,100 Income tax payable 13,000
Inventory 13,700 Total current liabilities 103,750
Total current assets 212,300 Notes payable 50,000
Total liabilities 153,750
Land 46,000 Stockholders’ Equity
Equipment 15,000 Common stock 35,000
Less: Accumulated Depreciation (2,000) Retained earnings 82,550 *
Total stockholders’ equity 117,550
Total liabilities and
Total assets $271,300 stockholders’ equity $271,300

* Retained earnings = Beginning retained earnings + Net income − Dividends

= $33,100 + $49,450 − $0
= $82,550

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8-30 Financial Accounting, 5e
Exercise 8-18 (concluded)
Requirement 6

January 31, 2021 Debit Credit

Sales Revenue 281,000
Retained Earnings 281,000
(Close revenue accounts)

Retained Earnings 231,550

Cost of Goods Sold 153,300
Salaries Expense 52,000
Bad Debt Expense 12,500
Depreciation Expense 500
Interest Expense 250
Income Tax Expense 13,000
(Close expense accounts)

Requirement 7
(a) The current ratio is:

Current Assets $212,300

Current Ratio = = = 2.05
Current Liabilities $103,750

ACME Fireworks is more liquid than the industry average. ACME Fireworks has a greater
proportion of current assets to pay current liabilities compared to the industry average of 1.8.

(b) The acid-test ratio is:

Quick Assets* $27,500 + $0 + $171,100

Acid-Test Ratio = = = 1.91
Current Liabilities $103,750

*Quick Assets = Cash + Current Investments + Accounts Receivable

ACME Fireworks is less likely to have difficulty paying its currently maturing debts. ACME
Fireworks has a greater proportion of quick assets to pay current liabilities compared to the industry
average of 1.5.

(c) The current ratio, assuming the notes payable are current liabilities, is:

Current Assets $212,300

Current Ratio = = = 1.38
Current Liabilities $153,750

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Solutions Manual, Chapter 8 8-31
Assuming the notes payable were due on April 1, 2021, they would be included in total current
liabilities. This would increase current liabilities and decrease the current ratio, since dividing by a
larger number reduces the ratio.

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8-32 Financial Accounting, 5e
PROBLEMS: SET A
Problem 8-1A
List A List B
_i__ 1. An IOU promising to repay the amount a. Recording of a
borrowed plus interest. contingent liability
_d__ 2. Payment amount is reasonably possible and is b. Deferred revenue
reasonably estimable.
_h__ 3. Mixture of liabilities and equity a business c. The riskiness of a
uses. business’s obligations
_a__ 4. Payment amount is probable and is reasonably d. Disclosure of a
estimable. contingent liability
_b__ 5. A liability that requires the sacrifice of e. Interest on debt
something other than cash.
_j__ 6. Long-term debt maturing within one year. f. Payroll taxes

_f__ 7. FICA and FUTA. g. Line of credit

_g__ 8. Informal agreement that permits a company to h. Capital structure

borrow up to a prearranged limit
_c__ 9. Classifying liabilities as either current or long- i. Notes payable
term helps investors and creditors assess this.
_e__ 10. Amount of note payable x annual interest rate j. Current portion of
x fraction of the year. long-term debt

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Solutions Manual, Chapter 8 8-33
Problem 8-2A
Requirement 1
(a). October 1, 2021
Cash 41,000,000
Notes Payable 41,000,000
(Issuance of notes payable)

(b). October 1, 2021

Notes Receivable 41,000,000
Cash 41,000,000
(Acceptance of notes receivable)

Requirement 2
(a). December 31, 2021
Interest Expense ($41 million × 9% × 3/12) 922,500
Interest Payable 922,500
(Interest expense incurred, but not paid)

(b). December 31, 2021

Interest Receivable 922,500
Interest Revenue 922,500
(Interest revenue earned, but not received)

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8-34 Financial Accounting, 5e
Requirement 3
(a) September 30, 2022
Notes Payable 41,000,000
Interest Payable ($41 million × 9% × 3/12) 922,500
Interest Expense ($41 million × 9% × 9/12) 2,767,500
Cash 44,690,000
(Payment of notes payable and interest)

(b). September 30, 2022

Cash 44,690,000
Interest Receivable ($41 million × 9% × 3/12) 922,500
Interest Revenue ($41 million × 9% × 9/12) 2,767,500
Notes Receivable 41,000,000
(Collection of notes receivable and interest)

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Solutions Manual, Chapter 8 8-35
Problem 8-3A
Requirement 1
January 31
Salaries Expense 600,000
Income Tax Payable 60,000
FICA Tax Payable 45,900
Salaries Payable (to balance) 494,100
(Employee salary expense and withholdings)

Requirement 2
January 31
Salaries Expense (fringe benefits) 34,800
Accounts Payable (to Blue Cross) 10,800
Accounts Payable (to Fidelity) 24,000
(Employer-provided fringe benefits)

Requirement 3
January 31
Payroll Tax Expense (total) 83,100
FICA Tax Payable 45,900
Unemployment Tax Payable 37,200
(Employer payroll taxes)

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8-36 Financial Accounting, 5e
Problem 8-4A
Requirement 1
February 14
Salaries Expense 1,500,000
Income Tax Payable 375,000
FICA Tax Payable 114,750
Accounts Payable (Retirement Plan) 63,000
Salaries Payable (to balance) 947,250
(Employee salary expense and withholdings)

Requirement 2
February 14
Salaries Expense (fringe benefits) 100,500
Accounts Payable (Medical Insurance) 31,500
Accounts Payable (Life Insurance) 6,000
Accounts Payable (Retirement Plan) 63,000
(Employer-provided fringe benefits)

Requirement 3
February 14
Payroll Tax Expense (total) 207,750
FICA Tax Payable 114,750
Unemployment Tax Payable 93,000
(Employer payroll taxes)

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Solutions Manual, Chapter 8 8-37
Problem 8-5A

Requirement 1
$102,600,000
= $900 per season ticket
114,000
$900
= $150 per individual game ticket
6 games

Requirement 2
Cash 102,600,000
Deferred Revenue 102,600,000
(Advance collection of ticket sales)

Requirement 3
Deferred Revenue 17,100,000
Sales Revenue ($102,600,000/6) 17,100,000
(Revenue recognized after first home game)

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8-38 Financial Accounting, 5e
Problem 8-6A
Requirement 1
Cash 3,500
Deferred Revenue 3,500
(Sale of gift cards)

Requirement 2
Deferred Revenue 728
Sales Revenue ($728 / 1.04) 700
Sales Taxes Payable 28
(Redemption of gift certificates)

Requirement 3
Deferred Revenue
3,500
728
2,772 Balance

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Solutions Manual, Chapter 8 8-39
Problem 8-7A
Requirement 1
The likelihood of loss is reasonably possible rather than probable, so no journal entry
is recorded. However, full disclosure of the contingent liability is made in a note to the
financial statements.

Requirement 2
Environmental Printing has a contingent gain that is probable, and is reasonably
estimable within a range between $6.5 and $9 million. Contingent gains are not
recorded until the gain is certain. Though firms do not record contingent gains in the
accounts, they sometimes disclose them in notes to the financial statements.

Requirement 3
Environmental Printing should record a loss and a liability for the minimum amount
($500,000) and disclose the range between $500,000 and $900,000 in the notes to the
financial statements. The entry is as follows:

Loss 500,000
Contingent Liability 500,000
(Record the contingent liability)

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8-40 Financial Accounting, 5e
Problem 8-8A
Requirement 1
The reporting for this situation depends on the likelihood of loss occurring. If the
likelihood of loss is reasonably possible rather than probable, no journal entry is
recorded. However, if the likelihood of loss is probable, the following entry would be
recorded:

Loss 130,000,000
Contingent Liability 130,000,000
(Record the contingent liability)

Requirement 2
The contingent loss is probable and reasonably estimable, so it would be recorded as
follows:

Loss 150,000,000
Contingent Liability 150,000,000
(Record the contingent liability)

Requirement 3
Dinoco has a contingent gain that is probable, and is reasonably estimable at $150
million. Contingent gains are not recorded until the gain is certain. Though firms do
not record contingent gains in the accounts, they sometimes disclose them in notes to
the financial statements.

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Solutions Manual, Chapter 8 8-41
Problem 8-9A
Requirement 1
Total Total
Current ÷ Current = Current
($ in millions) Assets Liabilities Ratio

ACME Corporation $15,372 ÷ $11,462 = 1.34

Wayne Enterprises $9,784 ÷ $7,708 = 1.27

ACME Corporation has a better current ratio than Wayne Enterprises.

Requirement 2
Total
Quick ÷ Current = Acid-Test
($ in millions) Assets Liabilities Ratio

ACME Corporation $3,889 ÷ $11,462 = 0.34

Wayne Enterprises $883 ÷ $7,708 = 0.11

ACME Corporation also has a higher acid-test ratio than Wayne Enterprises.

Requirement 3
The purchase of additional inventory on credit would increase current assets
(inventory) and current liabilities (accounts payable) by the same amount. This
transaction would cause the current ratios for ACME Corporation and Wayne
Enterprises to decrease towards 1.0. This transaction would also cause the acid-test
ratios to decrease as quick assets would remain the same, but current liabilities would
increase.

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8-42 Financial Accounting, 5e
PROBLEMS: SET B
Problem 8-1B

List A List B
_i__ 1. Interest expense is recorded in the period a. The riskiness of a
interest is incurred rather than in the period business’s obligations
interest is paid.
_d__ 2. Payment is reasonably possible and is b. Current portion of long-
reasonably estimable. term debt
_h__ 3. Cash, current investments, and accounts c. Recording a contingent
receivable all divided by current liabilities. liability
_c__ 4. Payment is probable and is reasonably d. Disclosure of a
estimable. contingent liability
_j__ 5. Gift cards. e. Interest expense
_b__ 6. Long-term debt maturing within one year. f. FICA
_f__ 7. Social Security and Medicare. g. Commercial paper
_g__ 8. Unsecured notes sold in minimum h. Acid-test ratio
denominations of $25,000 with maturities up
to 270 days.
_a__ 9. Classifying liabilities as either current or long- i. Accrual accounting
term helps investors and creditors assess this.
_e__ 10. Incurred on a notes payable. j. Deferred revenue

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Solutions Manual, Chapter 8 8-43
Problem 8-2B
Requirement 1
(a). November 1, 2021
Cash 21,000,000
Notes Payable 21,000,000
(Issuance of notes payable)

(b). November 1, 2021

Notes Receivable 21,000,000
Cash 21,000,000
(Acceptance of notes receivable)

Requirement 2
(a). December 31, 2021
Interest Expense ($21 million × 7% × 2/12) 245,000
Interest Payable 245,000
(To record interest expense incurred, but not paid)

(b). December 31, 2021

Interest Receivable ($21 million × 7% × 2/12) 245,000
Interest Revenue 245,000
(Interest revenue earned, but not received)

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8-44 Financial Accounting, 5e
Requirement 3
(a). April 30, 2022
Notes Payable 21,000,000
Interest Payable ($21 million × 7% × 2/12) 245,000
Interest Expense ($21 million × 7% × 4/12) 490,000
Cash 21,735,000
(Payment of notes payable and interest)

(b). April 30, 2022

Cash 21,735,000
Notes Receivable 21,000,000
Interest Receivable ($21 million × 7% × 2/12) 245,000
Interest Revenue ($21 million × 7% × 4/12) 490,000
(Collection of notes receivable and interest)

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Solutions Manual, Chapter 8 8-45
Problem 8-3B

Requirement 1
January 31
Salaries Expense 500,000
Income Tax Payable 135,000
FICA Tax Payable 38,250
Salaries Payable (to balance) 326,750
(Employee salary expense and withholdings)

Requirement 2
January 31
Salaries Expense (fringe benefits) 73,000
Accounts Payable (to Blue Cross) 13,000
Accounts Payable (to Fidelity) 60,000
(Employer-provided fringe benefits)

Requirement 3
January 31
Payroll Tax Expense (total) 69,250
FICA Tax Payable 38,250
Unemployment Tax Payable 31,000
(Employer payroll taxes)

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8-46 Financial Accounting, 5e
Problem 8-4B
Requirement 1
January 24
Salaries Expense 2,500,000
Income Tax Payable 537,500
FICA Tax Payable 191,250
Accounts Payable (Retirement Plan) 125,000
Salaries Payable (to balance) 1,646,250
(Employee salary expense and withholdings)

Requirement 2
January 24
Salaries Expense (fringe benefits) 201,250
Accounts Payable (Medical Insurance) 50,000
Accounts Payable (Dental Insurance) 17,500
Accounts Payable (Life Insurance) 8,750
Accounts Payable (Retirement Plan) 125,000
(Employer-provided fringe benefits)

Requirement 3
January 24
Payroll Tax Expense (total) 346,250
FICA Tax Payable 191,250
Unemployment Tax Payable 155,000
(Employer payroll taxes)

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Solutions Manual, Chapter 8 8-47
Problem 8-5B

Requirement 1
$9,128,000
= $560 per season ticket
16,300
$560
= $35 per individual game ticket
16 games

Requirement 2
Cash 9,128,000
Deferred Revenue 9,128,000
(Advance collection of ticket sales)

Requirement 3
Deferred Revenue 570,500
Sales Revenue ($9,128,000/16) 570,500
(Revenue recognized after first home game)

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8-48 Financial Accounting, 5e
Problem 8-6B
Requirement 1
Cash 2,300
Deferred Revenue 2,300
(Sale of gift cards)

Requirement 2
Deferred Revenue 742
Sales Revenue ($742/1.06) 700
Sales Taxes Payable 42
(Redemption of gift certificates)

Requirement 3
Deferred Revenue
2,300
742
1,558 Balance

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Solutions Manual, Chapter 8 8-49
Problem 8-7B
Requirement 1
Bad Debt Expense ($29 million × 3%) 870,000
Allowance for Uncollectible Accounts 870,000
(Estimated uncollectible accounts)

Requirement 2
Compact Electronics has a contingent gain that is probable and reasonably estimable.
Contingent gains are not recorded until the gain is certain. Though firms do not record
contingent gains in the accounts, they sometimes disclose them in notes to the
financial statements.

Requirement 3
Loss 600,000
Contingent Liability 600,000
(Record the loss contingency)

Requirement 4
The likelihood of loss is reasonably possible rather than probable, so no journal entry
is recorded. However, full disclosure of the contingent liability and the estimated
range of loss between $2.5 and $3.5 million is disclosed in notes to the financial
statements.

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8-50 Financial Accounting, 5e
Problem 8-8B
Requirement 1
The contingent liability is reasonably possible and can be reasonably estimated within
a range. Because the loss is not probable, no journal entry for a loss and liability is
required. Authors Academic Press must disclose a description of the loss contingency
in its notes to the financial statements.

Requirement 2
The contingent liability is probable and reasonably estimable, so it must be reported.
Because the estimate of the loss is a range where no amount within the range is a
better estimate than any other amount, the minimum amount of the range will be
recorded as follows:

Loss 1,500,000
Contingent Liability 1,500,000
(Record the loss contingency)

The range of the potential loss (from $1.5 to $2.25 million) should also be disclosed.

Requirement 3
Authors Academic Press has a contingent gain that is probable and can be reasonably
estimated at $3 million. Contingent gains are not recorded until the gain is certain.
Though firms do not record contingent gains in the accounts, they sometimes disclose
them in notes to the financial statements.

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Solutions Manual, Chapter 8 8-51
Problem 8-9B
Requirement 1
Total Total
Current ÷ Current = Current
($ in millions) Assets Liabilities Ratio

Ferris Air $4,227 ÷ $4,650 = 0.91

Oceanic Airlines $8,272 ÷ $13,270 = 0.62

Ferris Air has a better current ratio than Oceanic Airlines.

Requirement 2
Total
Quick ÷ Current = Acid-Test
($ in millions) Assets Liabilities Ratio

Ferris Air $3,548 ÷ $4,650 = 0.76

Oceanic Airlines $5,905 ÷ $13,270 = 0.44

Ferris Air also has a better acid-test ratio than Oceanic Airlines.

Requirement 3
The purchase of additional inventory with cash would not affect the current ratio as
total current assets would remain unchanged. One current asset (inventory) would
increase while another current asset (cash) would decrease by the same amount. The
purchase of additional inventory with cash would decrease the acid-test ratio due to
the decrease in cash. Recall that inventory is excluded from the acid-test ratio.

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8-52 Financial Accounting, 5e
ADDITIONAL PERSPECTIVES
Continuing Problem: Great Adventures
AP8-1
Requirement 1
Interest Expense 750
Interest Payable 750
(Accrue interest on note)
($750 = $30,000 × 6% × 5/12)

Notes Payable (long-term) 10,000

Notes Payable (current) 10,000
(Reclassify portion of long-term debt
as current)

Deferred Revenue 20,000

Sales Revenue 20,000
(Record gift cards redeemed)

Loss 12,000
Contingent Liability 12,000
(Record a contingent liability)

Warranty Expense 4,000

Warranty Liability 4,000
(Estimate future warranty costs)

Requirement 2
No entry would be required.

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Solutions Manual, Chapter 8 8-53
Additional Perspective 8-1 (in General Ledger)
Students will be given the following existing trial balance.

Great Adventures, Inc.

Trial Balance
December 31, 2022

Accounts Debit Credit

Cash $ 89,070
Accounts Receivable 50,000
Allowance for Uncollectible Accounts $ 2,400
Inventory 7,000
Prepaid Insurance 900
Equipment 62,000
Accumulated Depreciation 25,250
Accounts Payable 20,800
Deferred Revenue 25,000
Warranty Liability -0-
Contingent Liability -0-
Income Tax Payable 14,500
Interest Payable -0-
Notes Payable (current) -0-
Notes Payable (long-term) 30,000
Common Stock 20,000
Retained Earnings 33,450
Service Revenue 44,500
Sales Revenue 100,000
Interest Revenue 120
Sales Discounts 350
Cost of Goods Sold 38,500
Depreciation Expense 17,250
Insurance Expense 5,700
Rent Expense 2,400
Salaries Expense 24,000
Supplies Expense 500
Bad Debt Expense 2,400
Repairs and Maintenance Expense 400
Warranty Expense -0-
Loss -0-
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8-54 Financial Accounting, 5e
 Interest Expense 1,050
Income Tax Expense 14,500
Totals $316,020 $316,020

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distribution permitted without the prior written consent of McGraw-Hill Education
Solutions Manual, Chapter 8 8-55
Additional Perspective 8-1 (in General Ledger, continued)

Interest Expense 750

Interest Payable 750
(Accrue interest on note)
($750 = $30,000 × 6% × 5/12)

Notes Payable (long-term) 10,000

Notes Payable (current) 10,000
(Reclassify portion of long-term debt
as current)

Deferred Revenue 20,000

Sales Revenue 20,000
(Record gift cards redeemed)

Loss 12,000
Contingent Liability 12,000
(Record a contingent liability)

Warranty Expense 4,000

Warranty Liability 4,000
(Estimate future warranty costs)

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8-56 Financial Accounting, 5e
Additional Perspective 8-1 (in General Ledger, continued)

Great Adventures, Inc.

Income Statement
For the period ended December 31, 2022
Service revenue $ 44,500
Sales revenue 120,000
Sales discounts (350)
Net sales 164,150
Cost of goods sold 38,500
Gross profit $125,650
Depreciation Expense 17,250
Insurance Expense 5,700
Rent Expense 2,400
Salaries Expense 24,000
Supplies Expense 500
Bad Debt Expense 2,400
Repairs and Maintenance Expense 400
Warranty Expense 4,000
Loss 12,000
Total operating expenses 68,650
Operating income (loss) 57,000
Interest revenue 120
Interest expense (1,800)
Income before income taxes 55,320
Income tax expense 14,500
Net income $ 40,820

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distribution permitted without the prior written consent of McGraw-Hill Education
Solutions Manual, Chapter 8 8-57
 Additional Perspective 8-1 (in General Ledger, continued)

Great Adventures, Inc.

Balance Sheet
December 31, 2022
Assets Liabilities
Current assets: Current liabilities:
Cash $ 89,070 Accounts payable $ 20,800
Accounts receivable 50,000 Deferred Revenue 5,000
Allow for Uncoll Accts (2,400) Warranty Liability 4,000
Inventory 7,000 Contingent Liability 12,000
Prepaid Insurance 900 Income tax payable 14,500
Total current assets 144,570 Interest payable 750
Notes Payable (current) 10,000
Total current liabilities 67,050
Notes payable (long-term) 20,000
Total liabilities 87,050
Long-term assets:
Equipment 62,000 Stockholders’ Equity
Accumulated depreciation (25,250) Common stock 20,000
Retained earnings 74,270
Total stockholders’ equity 94,270
Total liabilities and
Total assets $181,320 stockholders’ equity $181,320

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8-58 Financial Accounting, 5e
Additional Perspective 8-1 (in General Ledger, concluded)

Dec. 31, 2022 Debit Credit

Service Revenue 44,500
Sales Revenue 120,000
Interest Revenue 120
Sales Discounts 350
Retained Earnings 164,270
(Close revenue accounts)
Dec. 31, 2022
Retained Earnings 123,450
Cost of Goods Sold 38,500
Depreciation Expense 17,250
Insurance Expense 5,700
Rent Expense 2,400
Salaries Expense 24,000
Supplies Expense 500
Bad Debt Expense 2,400
Repairs and Maintenance Expense 400
Warranty Expense 4,000
Loss 12,000
Interest Expense 1,800
Income Tax Expense 14,500
(Close expense accounts)

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Solutions Manual, Chapter 8 8-59
Financial Analysis: American Eagle
AP8-2
($ in thousands)
Requirement 1
Total Current Total Current Current
Assets ÷ Liabilities = Ratio
2018 $968,530 ÷ $485,221 = 2.00
2017 $901,229 ÷ $493,783 = 1.83
The current ratio improved in the more recent year.

Requirement 2
Quick Total Current Acid-Test
Assets ÷ Liabilities = Ratio
2018 $491,917 ÷ $485,221 = 1.01
2017 $465,247 ÷ $493,783 = 0.94
The acid-test ratio also improved in the more recent year.

Requirement 3
If American Eagle used $100 million in cash to pay $100 million in accounts payable,
its current ratio and acid-test ratio will improve since they are greater than 1. The
calculations are provided as follows:

Total Current Total Current Current

Assets ÷ Liabilities = Ratio
Before $968,530 ÷ $485,221 = 2.00
After $968,530 − $100,000 ÷ $485,221 − $100,000 = 2.25

Quick Total Current Acid-Test

Assets ÷ Liabilities = Ratio
Before $491,917 ÷ $485,221 = 1.01
After $491,917 − $100,000 ÷ $485,221 − $100,000 = 1.02

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8-60 Financial Accounting, 5e
Financial Analysis: The Buckle
AP8-3
($ in thousands)
Requirement 1
Total Current Total Current Current
Assets ÷ Liabilities = Ratio
2018 $360,584 ÷ $97,906 = 3.68
2017 $386,457 ÷ $98,616 = 3.92
The current ratio weakens in the more recent year.

Requirement 2
Quick Total Current Acid-Test
Assets ÷ Liabilities = Ratio
2018 $224,507 ÷ $97,906 = 2.29
2017 $254,740 ÷ $98,616 = 2.58
The acid-test ratio also weakens in the more recent year.

Requirement 3
If Buckle purchased $50 million of inventory by debiting inventory and crediting
accounts payable, its current ratio and acid-test ratio would weaken. The calculations
are provided as follows:

Total Current Total Current Current

Assets ÷ Liabilities = Ratio
Before $360,584 ÷ $97,906 = 3.68
After $360,584 + $50,000 ÷ $97,906 + $50,000 = 2.78

Quick Total Current Acid-Test

Assets ÷ Liabilities = Ratio
Before $224,507 ÷ $97,906 = 2.29
After $224,507 + $50,000 ÷ $97,906 + 50,000 = 1.86

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Solutions Manual, Chapter 8 8-61
Comparative Analysis: American Eagle vs. The Buckle
AP8-4
($ in thousands)
Requirement 1
Total Total
Current ÷ Current = Current
Assets Liabilities Ratio

American Eagle $968,530 ÷ $485,221 = 2.00

Buckle $360,584 ÷ $97,906 = 3.68
Buckle has a better current ratio. Both American Eagle and Buckle have better ratios
than United and American Airlines. The clothing industry maintains a higher current
ratio.

Requirement 2
Total
Quick ÷ Current = Acid-Test
Assets Liabilities Ratio

American Eagle $491,917 ÷ $485,221 = 1.01

Buckle $224,507 ÷ $97,906 = 2.29
Buckle also has a better acid-test ratio. Both American Eagle and Buckle have better
ratios than United and American Airlines. The clothing industry maintains a higher
acid-test ratio.

Requirement 3
The purchase of additional inventory with accounts payable will decrease the current
ratio for American Eagle and Buckle because their current ratio is above 1.0.

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8-62 Financial Accounting, 5e
Ethics
AP8-5
1. Eugene’s decision will have no effect on current assets but will understate current
liabilities.
Under either assumption, cash (current asset) is collected. Deferred revenue is a
liability. Eugene’s decision not to record the deferred revenue will understate current
liabilities.

2.
($ in millions) Total Total
Current ÷ Current = Current
Treatment Assets Liabilities Ratio
Service
Revenue $10.1 ÷ $10 = 1.01
Deferred
Revenue $10.1 ÷ $10 + $1 = 0.92

3. Yes.
By recording the cash received as revenue, the reported current ratio remains above
1.0. First Federal Bank will not consider Caribbean Cruise Lines to be in violation of
its debt covenant.

4. No.
Receiving cash in advance from customers is considered a liability. While Caribbean
Cruise Line has received the cash, it remains obligated to provide services to
customers in the following year. By not recording this obligation, the company
provides the false appearance of adequate liquidity. Eugene may justify his decision
based on the company’s history and the fact that cash has been received. These factors
may suggest a high likelihood that the bank will be fully repaid. However, at this point
there are no guarantees that the economy will not worsen further, preventing loan
repayment by even the most well-meaning borrowers.

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Solutions Manual, Chapter 8 8-63
Internet Research
AP8-6
This case provides an opportunity for students to research stock price and accounting
information on a publicly traded company of their choice. This case also allows
students to access key statistics on companies and compare accounting information
with competitors in the same industry. Answers to the assignment will vary depending
on the company chosen.

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8-64 Financial Accounting, 5e
Written Communication
AP8-7
a. In order to record a contingent liability, the loss must be probable and the amount
must be reasonably estimable. A loss and liability will not be recorded for the
employee strikes, even though the likelihood of loss is probable (virtually certain),
because the loss cannot be reasonably estimated. However, careful disclosure of
the situation should be provided in the notes to the financial statements.

b. Western should record warranty expense of $40,000 (2% x $2 million in sales)

rather than just the $25,000 in warranty expense recorded for expenditures incurred
so far. It is probable that costs for warranties will be incurred and, based on their
experience with previous product introductions, the company can reasonably
estimate the amount. Therefore, the following additional amount should be
recorded:

Warranty Expense 15,000

Warranty Liability 15,000
(Loss contingency for warranties)

c. The likelihood of loss is reasonably possible rather than probable, so a contingent

liability is not recorded. However, full disclosure of the contingent liability is made
in a note to the financial statements.

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Solutions Manual, Chapter 8 8-65
Earnings Management
AP8-8
Requirement 1
Yes.
Quattro can use the estimate for warranty expense to manage the reported amount of
net income. Quattro can report lower net income in 2021 by recording more warranty
expense and building up the warranty liability in that year. The company can then run
down the warranty liability in 2022 and record less warranty expense, boosting net
income in that year. Total net income over the two-year period is unaffected, but the
reported amount of net income in each year is affected.

Requirement 2
Net Income Before Warranty
($ in millions) Warranty Expense − Expense = Net Income

2021 $210 − $50 = $160

2022 $210 − $30 = $180

Requirement 3
Yes.
By recording $50 million in warranty expense in 2021 and $30 million in warranty
expense in 2022, rather than $40 million each year, Quattro is able to report steadier
growth in net income. Net income increases by $20 million each year over the four
year period ($120, $140, $160, and $180 million). Using $40 million in warranty
expense in 2021 and 2022 would have resulted in reported net income of $120, $140,
$170, and $170 million over the four-year period, which provides a less stable,
upward pattern.

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8-66 Financial Accounting, 5e