Chapter 9: Reporting and Interpreting

Liabilities

Extra Questions with Solutions

Question 1
Dudley Corporation is preparing its year-end balance sheet. The company records show the following selected amounts at the
end of the year:
Total assets $344,500
Total noncurrent assets 235,300
Liabilities:
Notes payable (8%, due in 5 years) 9,750
Accounts payable 36,400
Income taxes payable 9,100
Liability for withholding taxes 1,950
Rent revenue collected in advance 4,550
Bonds payable (due in 15 years) 58,500
Wages payable 4,550
Property taxes payable 1,950
Note payable (10%, due in 6 months) 7,800
Interest payable 260
Common Stock 65,000

Required:
1. Identify current liabilities and compute working capital. Why is working capital important to management?
2. Would your computation be different if the company reported $200,000 worth of contingent liabilities in the notes to its
financial statements? Explain.
Answer to Question 1
1. Identify current liabilities and compute working capital. Why is working capital important to management?

Current assets: ($344,500 – $235,300) $109,200

Current liabilities:
Accounts payable $36,400
Income taxes payable 9,100
Liability for withholding taxes 1,950
Rent revenue collected in advance 4,550
Wages payable 4,550
Property taxes payable 1,950
Note payable (10%, due in 6 months) 7,800
Interest payable 260 (66,560)
Working capital $ 42,640

Working capital is important to both managers and financial analysts because it has a significant impact on the
health and profitability of a company. Working capital reflects the amount a company would have left over if it used
all of its current assets to pay off all of its current liabilities. The working capital accounts are actively managed to
achieve a balance between a company’s short-term obligations and the resources to satisfy those obligations.
Changes in working capital accounts are also important to managers and analysts because they have a direct impact
on the cash flows from operating activities reported in the statement of cash flows.
Answer to Question 1 (Continued)

2. Would your computation be different if the company reported $200,000 worth of

contingent liabilities in the notes to its financial statements? Explain.

If the company has reported $200,000 worth of contingent liabilities in the notes to its financial
statements, it will not affect the working capital computation. Some transactions or events create
only a reasonably possible (but not probable) future sacrifice of economic benefits. These
situations create contingent liabilities that are reported in the footnotes, but not on a company’s
balance sheet. Since these are not reported in the balance sheet, these contingent liabilities will
not have any effect on the computation of working capital.
 Question 2
Many businesses borrow money during periods of increased business activity to finance inventory and accounts receivable. Southport
Boutiques is a nationwide retailer. Each Christmas season, Southport Boutiques builds up its inventory to meet the needs of Christmas
shoppers. A large portion of these Christmas sales are on credit. As a result, Southport often collects cash from the sales several
months after Christmas. Assume that on November 1 of this year, Southport borrowed $5.4 million cash from Wells Fargo Bank to
meet short-term obligations. Southport signed an interest-bearing note and promised to repay the $5.4 million in six months. The
annual interest rate was 8%. All interest will accrue and be paid when the note is due in six months. Southport’s accounting period ends
December 31.

Required:
1. Provide the journal entry to record the note on November 1, Year 1.
2. Provide any adjusting entry required at the end of the accounting period on December 31, Year 1.
3. Provide the journal entry to record payment of the note and interest on the maturity date, April 30, Year 2.
4. Determine the financial statement effects for each of the following:
(a) the issuance of the note on November 1,
(b) the impact of the adjusting entry at the end of the accounting period, and
(c) payment of the note and interest on April 30, Year 2 (the next year).
Indicate the effects (e.g., cash + or −) using the schedule below.
Date Assets Liabilities Stockholders’ Equity
Answer to Question 2
Requirement 1
Debit Credit
November 1, Year 1
Cash (+A) 5,400,000
Notes Payable (+L) 5,400,000
Borrowed on 6-month, 8%, notes payable.

Requirement 2
December 31, Year 1 (end of the accounting period):
Interest Expense (+E, −SE) ($5,400,000 0.08 2/12 = $72,000) 72,000
Interest Payable (+L) 72,000
Adjusting entry for 2 months’ accrued interest.

Requirement 3

April 30, Year 2 (maturity date):

Notes Payable (−L) 5,400,000
Interest Payable (−L) 72,000
Interest Expense (+E, −SE) ($5,400,000 0.08 4/12) 144,000
Cash (−A) 5,616,000
Paid note plus interest at maturity.
Answer to Question 2 (Continued)
Requirement 4

Date Assets Liabilities Stockholders’ Equity

November 1, Year 1 Cash + Notes Payable + Not Affected

December 31, Year 1 Not Affected Interest Payable + Interest Expense −

Notes Payable −
April 30, Year 2 Cash − Interest Expense −
Interest Payable −
 Question 3
Marvel Soda is a regional soda manufacturer. Marvel is currently facing three lawsuits, summarized
below:
a. A customer is suing Marvel for $1 million because he claims to have found a piece of glass in his soda.
Management deems the probability that Marvel will lose the lawsuit and have to pay $1 million as
reasonably possible.
b. An employee is suing Marvel for $500,000 for an injury she incurred in the parking lot while walking to
work. Management deems the probability that Marvel will lose the lawsuit as probable but estimates
that a reasonable payout will be $100,000, not $500,000.
c. A customer is suing Marvel for $300,000 because her last name is Marvel and she claims Marvel stole
her name. Management deems the probability that Marvel will lose the lawsuit and have to pay
$300,000 as remote.

Required:
How should Marvel report each of the lawsuits in its financial statements and footnotes?
Answer to Question 3

a. The probability of a contingent liability is reasonably possible. Therefore, Marvel

Soda must disclose the liability as a footnote. Recognizing a liability in the balance sheet
is not required.
• A liability that is 1) probable but the amount cannot be reasonably estimated, or
2) reasonably possible regardless of whether the amount can be estimated,
must be disclosed in a footnote.

b. The probability of a contingent liability is probable, the future event or events are
likely to occur, and a reasonable payout is estimated. In this case Marvel Soda is
required to record a liability on the balance sheet.
• A liability that is both probable and the amount can be reasonably estimated
must be recorded and reported on the balance sheet.

c. As the probability of contingent liability is remote. Therefore, this lawsuit does not
require any type of disclosure.
Question 4
On January 1, Year 1, Bernard Hamilton decided to deposit $117,600 in a savings account that will
provide funds four years later to send his son to college. The savings account will earn 8%
annually. Any interest earned will be added to the fund each year-end.

Required: (show computations and round to the nearest dollar)

1. How much will be available in four years?
2. Provide the journal entry that Bernard should make on January 1, Year 1.
3. What is the total interest for the four years?
4. Provide the journal entry that Bernard should make on (a) December 31, Year 1, and (b)
December 31, Year 2 (the next year).
Answer to Question 4
Requirement 1
Amount deposited FVIF(4 years, 8%) Value after 4 years
$117,600 1.36049 = $159,994
Requirement 2
Debit Credit
Savings Account (+A) 117,600
Cash (−A) 117,600

Requirement 3
Total interest earned over four years
$159,994 − $117,600 = $42,394
Requirement 4

End of Year
Year 1 Year 2
Debit Credit Debit Credit
Savings Account (+A) 9,408 10,161
Interest Revenue (+R, +SE) 9,408 10,161
Computations:
Year 1: $117,600 0.08 = $9,408
Year 2: ($117,600 + $9,408) 0.08 = $10,161
Question 5

Outerwear Inc., is one of the world’s most popular outdoor apparel companies.
Assume that Outerwear, Inc. borrows $1.5 million from First National Bank and signs a
note promising to pay the $1.5 million back in nine months, at which time Outerwear
will also pay any accrued interest. The interest rate on the note is 10%.

Required:
1. Prepare the journal entry Outerwear will record when it signs the note and
receives the cash.
2. Prepare the journal entry that Outerwear will record when it pays off the note and
any accrued interest after nine months.
Answer to Question 5

Assume that Outerwear borrows $1.5 million from First National Bank and signs a
note promising to pay the $1.5 million back in nine months, at which time Outerwear
will also pay any accrued interest. The interest rate on the note is 10%.

Requirement 1
Debit Credit
Cash (+A) 1,500,000
Notes Payable(+L) 1,500,000
Signed a nine-month note with an interest rate of 10%

Requirement 2
Interest on note = $1,500,000 x 0.10 x 9/12 = $112,500

Interest Expense (+E, −SE) 112,500

Notes Payable (−L) 1,500,000
Cash (−A) 1,612,500
Paid off note plus nine months of accrued interest
Question 6

An investment will pay $7,425 at the end of the first year, $20,250 at
the end of the second year, and $33,750 at the end of the third year.
Determine the present value of this investment using a 10% annual
interest rate.
Answer to Question 6
An investment will pay $7,425 at the end of the first year, $20,250 at the end of the second year, and
$33,750 at the end of the third year. Determine the present value of this investment using a 10%
annual interest rate.

Present value of unequal payments:

Return on
Investment PVIF(n years, 10%) Present Value
Year 1 $7,425 0.90909 (n = 1) = $ 6,750
Year 2 $20,250 0.82645 (n = 2) = 16,736
Year 3 $33,750 0.75131 (n = 3) = 25,357
Total present value = $48,843
Question 7
On January 1 of this year, Red Springs Company completed the following transactions (assume a 10% annual
interest rate):

a. Bought a delivery truck and agreed to pay $42,500 at the end of three years.
b. Rented an office building and was given the option of paying $8,500 at the end of each of the next three
years or paying $23,000 immediately.
c. Established a savings account by depositing a single amount that will increase to $34,000 at the end of
seven years.
d. Decided to deposit a single sum in the bank that will provide 10 equal annual year-end payments of
$12,750 to a retired employee (payments starting December 31 of this year).

Required (show computations and round to the nearest dollar):

1. In (a), what is the cost of the truck that should be recorded at the time of purchase?
2. In (b), which option for the office building results in the lowest present value?
3. In (c), what single amount must be deposited in this account on January 1 of this year?
4. In (d), what single sum must be deposited in the bank on January 1 of this year?
Answer to Question 7
Requirement 1

Value after 3 years PVIF(3yrs,10%) Value at the time of purchase

$ 42,500 0.75131 = $ 31,931

Requirement 2
Yearly installments PVIFA(3yrs,10%) Economic Value
$ 8,500 2.48685 = $ 21,138
It is better to pay in three installments as the economic cost is less

Requirement 3
Value after 7 years PVIF(7yrs,10%) Single amount deposit

$34,000 0.51316 = $17,447

Requirement 4
Yearly withdrawal PVIFA(10yrs,10%) Single amount deposit

$12,750 6.14457 = $78,343

Question 8

At the end of each year, you plan to deposit $4,000 in a savings account. The account will earn 9%
annual interest, which will be added to the fund balance at year-end. The first deposit will be
made at the end of Year 1.

Required (show computations and round to the nearest dollar):

1. Give the required journal entry at the end of Year 1.
2. What will be the balance in the savings account at the end of the 10th year
(i.e., after 10 deposits)?
3. What is the interest earned on the 10 deposits?
4. How much interest revenue did the fund earn in the second year? In the third year?
5. Give all required journal entries at the end of the second and third years.
Answer to Question 8
Requirement 1
End of Year 1 Debit Credit
Savings Account (+A) 4,000
Cash (−A) 4,000
Requirement 2
Amount deposited FVIF(10 years, 9%) Balance
$ 4,000 15.19293 = $ 60,772
Requirement 3
Total interest earned on 10 deposits
$60,772 − $40,000 = $20,772
Requirement 4
Interest for Year 2: $4,000 0.09 = $360
Interest for Year 3: ($4,000 + $4,000 + $360) 0.09 = $ 752
Requirement 5
End of Year
Year 2 Year 3
Debit Credit Debit Credit
Savings Account (+A) 4,360 4,752
Cash (−A) 4,000 4,000
Interest Revenue (+R, +SE) 360 752