# Module 7 Application Problems

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Module 7 Application Problems

P = Problems   E = Exercises   ID = Discussion Issues

Chapter 10

E10-4, E10-10
P10-1
ID10-4, ID10-11

Chapter 11

E11-5, E11-6, E11-9, E11-22(a, b), E11-23(a, b, c)

Chapter 10

E10-4

## Short-term notes payable and the actual rate of interest

On December 1, Spencer Department Store borrowed \$19,250 from First Bank and Trust. Spencer signed a 90-day note with a face amount of \$20,000. The interest rate stated on the face of the note is 15 percent per year.

Provide the journal entry recorded by Spencer on December 1.

Provide the adjusting entry recorded by Spencer on December 31 before financial statements are prepared. Show how the note payable would be disclosed on the December 31 balance sheet.

Compute the actual annual interest rate on the note. (Hint:Note that Spencer had the use of \$19,250 only over the period of the loan.)

Why is the actual interest rate different from the rate stated on the face of the note?

E10-10

### Warranty costs: Contingent losses or expense as incurred?

During 2017, Seagul Outboards sold 200 outboard engines for \$250 each. The engines are under a one-year warranty for parts and labor, and from past experience, the company estimates that, on average, warranty costs will equal \$20 per engine.

As of December 31, 2017, 50 engines had been serviced at a total cost of \$1,400. During 2018, engines were serviced at a total cost of \$2,600. Assume that all repairs used cash.

Prepare the journal entries that would be recorded at the following times:

During 2017 to record the sale of the engines.

During 2017 to accrue the contingent loss on warranties.

During 2017 and 2018 to record the actual warranty cost incurred.

Assume that Seagul chose not to treat the warranty costs as contingent losses. Instead, it chose to expense warranty costs as they were paid. Compute the total net income for 2017 and 2018 for each of the two accounting treatments.

P10-1

#### Distinguishing current liabilities from long-term liabilities

Beth Morgan, controller of Boulder Corporation, is currently preparing the 2017 financial report. She is trying to decide how to classify the following items:

Account payable of \$170,000 owed to suppliers for inventory.
A \$60,000 note payable that matures in three months. The company is planning to acquire a five-year loan from its bank to pay off the note. The bank has agreed to finance the note.

A \$500,000 mortgage: \$75,000 payable within twelve months, and the remaining \$425,000 to be paid over the next six years.
The sum of \$8,000 owed to the phone company for service during December.

Advances of \$25,000 received from a customer. The contract between the customer and Boulder Corporation states that if the company does not deliver the goods within six months, the \$25,000 is to be returned to the customer.

The sum of \$15,000 due the federal government for income tax withheld from employees during the last quarter of 2017. The government requires that withholdings be submitted by the end of the next quarter to the Internal Revenue Service.

A \$125,000 note payable: \$30,000 is payable within 12 months, and the remaining \$95,000 is to be paid over the next two years. Boulder Corporation plans to issue common stock to the creditor for the portion due during the next 12 months.

The company declared a cash dividend of \$50,000 on December 29, 2017. The dividend is to be paid on January 21, 2018.

REQUIRED:

Classify each of the items as a current liability or as a long-term liability. (Note:Some items may be classified partially as current and partially as long term.)

Compute the total amount that should be classified as current liabilities.

Compute the total amount that should be classified as long-term liabilities.

ID10-4

### Contingency reporting in the tobacco industry

Several years ago in its annual report, Philip Morris Companies, a major manufacturer of tobacco and food products, included footnote 16, which was almost five pages long. It consisted of a number of separate sections covering such topics as an overview of tobacco-related litigation, the type and number of cases, pending and upcoming trials, verdicts in individual cases, litigation settlements, smoking and health litigation, healthcare and cost-recovery litigation, and certain other tobacco-related litigation.

During the year, over 500 smoking and health-related cases had been filed against the company, an increase of 30 percent over the previous year and 200 percent over the year before that. The company booked a pretax charge of over \$3 billion, reducing reported net income to slightly over \$5 billion.

#### REQUIRED:

Discuss Philip Morris’s disclosure and accrual in terms of (1) the methods used to account for loss contingencies, and (2) the potential economic consequences associated with the disclosure and accounting treatment.

ID10-11

## “Taking a bath” during bankruptcy proceedings

A major defence contractor, LTV, faced with huge liabilities, once declared Chapter 11 bankruptcy protection. Under Chapter 11, a company continues to operate but is protected from creditors while it tries to work out a reorganization plan. At that time, the company’s management chose to accrue a \$2.26 billion liability to reflect the potential cost of medical and life insurance benefits for its 118,000 current and retired employees, which was not required by generally accepted accounting principles.

The Wall Street Journal reported that the company chose to recognize the charge because “if the company waited until after it negotiated new credit agreements and emerged from bankruptcy law proceedings before taking the \$2 billion charge, the additional liability could trigger violations of its debt covenants.”

#### REQUIRED:

Provide the journal entry to record the \$2.26 billion charge recognized by LTV.

Explain how taking the charge before negotiating new credit agreements could avoid violating debt covenants.

It was also reported that LTV took several other significant charges while it was under bankruptcy proceedings.

In addition to its concern about debt covenants, in general, why might management have chosen to take these charges at this time?

Chapter 11

E11-5

### Notes issued at a discount and the movement of interest expense

Tradewell Rentals purchased a piece of equipment with an FMV of \$11,348 in exchange for a five-year, non-interest-bearing note with a face value of \$20,000.

Compute the effective interest rate on the note payable.
Prepare the journal entry to record the purchase.

How much interest expense should Tradewell recognize on the note payable during the first year?

What is the balance sheet value of the note at the end of the first year?

Will the interest expense recognized by Tradewell in the second year be greater than, equal to, or less than the interest expense recognized in the first year? Why?

Will the interest expense recognized in the third year be greater than, equal to, or less than the interest expense recognized in the second year?

E11-6

#### Accounting for notes payable with various stated interest rates

Candleton borrowed cash, signing a two-year, interest-bearing note payable with a face value of \$8,000 and an effective interest rate of 8 percent. Interest payments on the note are made annually.

Provide the journal entries that would be recorded over the life of the note, assuming the following stated interest rates:

8 percent
0 percent
6 percent

E11-9

### Inferring an effective interest rate from the financial statements

The following information was extracted from the financial records of Leong Cosmetics:

2019

2018

Balance Sheet

Notes payable

\$200,000

\$200,000

Less: Discount on notes payable

12,000

14,400

Income Statement

Interest expense

\$ 16,400

\$ 16,200

What is the effective interest rate on the notes payable?
Prepare the journal entry to record interest expense during 2019.

E11-22

#### Accounting for leases

On January 1, 2017, Q-Mart entered into a five-year lease agreement requiring annual payments of \$10,000 on December 31 of each year. The fair market value of the building was estimated by appraisers to be \$39,927.

Record the journal entries required over the five-year period, assuming that Q-Mart accounts for this arrangement as an operating lease.

Compute the effective interest rate on the lease, and record the journal entries required over the five-year period if Q-Mart accounts for this arrangement as a capital lease. Assume that the capitalized asset is depreciated over a five-year period, using the straight-line method with no salvage value.

E11-23

##### Accounting for leases and the financial statements

Tradeall Inc., leases automobiles for its sales force. On January 1, 2017, the company leased 100 automobiles and agreed to make lease payments of \$10,000 per automobile each year. The lease agreement expires on December 31, 2021, at which time the automobiles can be purchased by Tradeall for a nominal price. Assume an effective rate of 10 percent.

Compute the annual rental expense if the lease is treated as an operating lease.

Prepare the journal entry on January 1, 2017, if the lease is treated as a capital lease. What dollar amount represents an approximation of the fair market value of the automobiles?

Assume that the automobiles are depreciated over a five-year life, using the straight-line method with no salvage value. Compute the total rental expense (interest and depreciation) associated with the lease during the first year if the lease is treated as a capital lease.

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