Solution manual intermediate accounting 9e by nicolai ch12

Q12-15 The two criteria that must be met before a loss contingency is accrued in a company's accounts are: 1 it is probable that one or more future events will confirm the fact that a lo

CHAPTER 12

CURRENT LIABILITIES AND CONTINGENCIES

CONTENT ANALYSIS OF EXERCISES AND PROBLEMS

E12-1 Cash Discounts Accounts payable, perpetual inventory

system Net-of-cash discount approach Journal entries 5-10 E12-2 Notes Payable Periodic inventory system, interest-bearing

E12-3 Notes Payable Non-interest-bearing Journal entries, balance

sheet disclosure Effective interest rate calculation 10-15 E12-4 Notes Payable Discounted, present value techniques Journal

E12-5 Compensated Absences No sick leave taken Journal entries,

E12-6 Sales Taxes Journal entries to record various transactions 5-10 E12-7 Payroll Payroll taxes Journal entries to record payroll

E12-13 Premium Obligation Journal entries to record sale, premium

E12-14 Premium Obligation Journal entries to record premium

Number Content Time Range (minutes) E12-15 Gift Certificates Journal entries to record transactions

E12-16 Loss Contingency Necessary journal entries and/or disclosures 15-20 E12-17 Gain Contingency Discussion of accounting treatment as

E12-18 Serial Bonds Balance sheet disclosure of serial bonds payable 5-10 E12-19 Short-Term Debt Expected to be refinanced Balance sheet

P12-2 Notes Payable Interest-bearing, non-interest-bearing

Computation of cash received, effective interest rate, interest expense Journal entries

20-30

P12-3 Trade Note Transactions Interest-bearing Journal entries to

record transactions Year-end adjusting entries 20-30 P12-4 Compensated Absences Sick pay, vacation pay Journal

P12-5 Sales Taxes Journal entries, balance sheet disclosure 10-20 P12-6 Payroll Payroll taxes Calculation of tax amount Journal

P12-7 Bonus Obligation Computation of total compensation and

P12-8 Property Taxes Monthly journal entries Balance sheet

P12-11 Premium Obligation Journal entries to record sales, purchases,

redemptions Closing entries Month-end balance sheet disclosures

30-40

P12-12 Contingencies Journal entries for various types of

Number Content Time Range (minutes) P12-13 (AICPA adapted) Contingencies Determine journal entries or

note disclosures for subscriptions, self-insurance, and two lawsuits

20-30

P12-14 Short-Term Debt Expected to be refinanced Balance sheet

P12-15 Short-Term Debt Expected to be refinanced Balance sheet

P12-16 Notes Payable Non-interest-bearing Present value

techniques Journal entries, balance sheet disclosure 30-40 P12-17 Comprehensive Various current liabilities Journal entries 30-40 P12-18 Comprehensive Various current liabilities Journal entries 30-45

ANSWERS TO QUESTIONS

Q12-1 Liabilities are probable future sacrifices of economic benefits arising from present

obligations of a company to transfer assets or provide future services to other entities

in the future as a result of past transactions or events Probable refers to what can reasonably be expected or believed based on available evidence or logic but is neither certain nor proved Obligations refer to duties imposed legally or socially which one is bound to do by contract, promise, moral responsibility, and so forth Q12-2 A legal liability is a liability legally requiring payment to others These liabilities are

incurred in exchange transactions that are contractual in nature and require

payment of cash or provision of services to specified or determinable entities on demand at specified or determinable dates on occurrence of specific events Examples are accounts payable, notes payable, and sales taxes payable Nonlegal liabilities are those where there is no legal requirement for assets to be transferred, yet

a transfer of assets typically occurs as a part of the normal operations of a business Examples of nonlegal liabilities are obligations for vacation pay and year-end

bonuses to employees

Q12-3 The three essential characteristics of a liability identified in FASB Statement of

Financial Accounting Concepts No 6 are:

1 It involves a present duty or responsibility of a company to one or more other entities that will be settled by the probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand

2 The duty or responsibility obligates the company, leaving it little or no discretion to avoid the future sacrifice

3 The transaction or other event obligating the company has already happened

Q12-3 (continued)

The main features of these 3 characteristics are the transfer or use of assets, the requirement for settlement of the obligation, and the fact that the liability transaction must have already occurred

Q12-4 False As long as payment or other transfer of assets to settle an existing obligation is

probable, a company does not need to know the identity of the recipient before the time of settlement

Q12-5 The primary issues include: (a) the identification of liabilities the detection of a

company's obligations; (2) the measurement or valuation of the liabilities and the related expense the determination of an amount to attach to each debt and to match as an expense against revenues; (3) the reporting of the liabilities on the balance sheet the specific disclosures in both the company's financial statements and the related notes

Q12-6 The operating cycle of a company is the period of time that elapses between the

use of cash to buy inventory; the sale of this inventory resulting in accounts

receivable; and the collection of these receivables in cash

Q12-7 The liquidity of liabilities is important in accounting for them because investors,

creditors, and other decision makers evaluate future cash flows in their making processes In part, these cash flows are predicted based on the nearness to cash of liabilities and assets

decision-Q12-8 Conceptually, a company should record and report on its balance sheet all liabilities

at the present value of the future outlays they will require; however, current liabilities are valued at their face amount Due to the short time period involved, the

difference between the maturity amount and the present value of current liabilities is not material The slight overstatement which results from recording at their maturity amount is justified on the basis of cost/benefit and materiality constraints

Q12-9 A non-interest-bearing note is an unconditional written agreement whereby the

borrower receives the face value of the note less the interest deducted in advance The proceeds are computed by multiplying the face value times the interest rate times the fraction of a year until maturity, and then subtracting this amount from the maturity value

Q12-10 Compensated absences are employee absences for which pay is received,

including vacation, holiday, illness, or other personal activities Such items as

severance pay, stock options, and long-term fringe benefits are not included A company accounts for compensated absences by recording an expense and accruing a liability if: (1) the obligation is attributable to employee services already rendered, (2) it relates to rights that accumulate, (3) payment is probable, and (4) the amount can be reasonably estimated If all conditions are met except the ability

to make a reasonable estimate, the company discloses the facts relating to the other conditions in the notes to its financial statements

Q12-11 A new current liability arises for a company selling inventory and agreeing to

repurchase it later A liability is recorded for the proceeds received

Q12-12 Under the expense warranty accrual method, a company recognizes in the period of

sales the estimated warranty expense and a liability for future performance under the warranty provisions Under the sales warranty accrual method, a company assumes that its revenue from the implied warranty contract is equal to the estimated

warranty costs, and it defers and recognizes revenue in an amount equal to the warranty costs incurred Under the modified cash basis, a company records

warranty costs as an expense during the period in which the repairs are made to merchandise under warranty

Q12-13 A contingency is an existing condition, situation, or set of circumstances involving

uncertainty as to possible gain or loss that will ultimately be resolved when one or more future events occur or fail to occur

Here, "uncertainty" means that a company is uncertain about the outcome of the future event which will either confirm or deny that a liability exists due to an event that has already taken place

Q12-14 The matching principle refers to the fact that a company should match expenses

arising from an existing condition with current revenues To wait until the contingency

is confirmed to account for it would overstate current income and understate future income

Accounting for contingencies is conservative because generally only loss

contingencies are allowed to be accrued Gain contingencies are usually not recognized until they are actually realized

Q12-15 The two criteria that must be met before a loss contingency is accrued in a

company's accounts are: (1) it is probable that one or more future events will

confirm the fact that a loss has been incurred, and (2) the amount of the loss can be reasonably estimated

Q12-16 The event giving rise to a possible loss must have occurred by the balance sheet

date A company has until the date of issuance of the financial statements to assess the probability of loss

Q12-17 The conditions that must be met for a company to accrue the loss from an unfiled

lawsuit include:

1 The event giving rise to the possible lawsuit must have occurred prior to the date

of the financial statements

2 It is probable that a claim will be filed

3 It is probable that the outcome of the suit will be unfavorable

4 The loss can be reasonably estimated

Q12-18 A gain contingency is an existing condition involving uncertainty as to a possible gain

that will be resolved when one or more future events occur or fail to occur

Resolution of the uncertainty may confirm the acquisition of an asset, or the

reduction of a liability A gain contingency usually is disclosed in the notes to the company's financial statements

Q12-19 The two criteria that must be met before a company can classify a short-term debt

that is expected to be refinanced as a noncurrent liability are (1) the company intends to refinance on a long-term basis, and (2) it has the ability to refinance on a long-term basis

Q12-20 A company demonstrates the ability to refinance currently maturing short-term debt

in one of two ways:

1 The company has issued long-term debt or equity for the short-term debt after the date of its balance sheet but before that balance sheet is issued

2 The company has entered into a bona fide long-term financing agreement before the balance sheet is issued that clearly permits the company to refinance the short-term debt on a long-term basis

Q12-21 This question could be answered in two different ways First, the student could agree

with provisions of FASB Statement No 78 on the legal basis that the payments can in fact be required to be made within one year (or operating cycle, if longer) and therefore a company should report the amounts as current liabilities Or, the student could disagree with the Statement and use the conceptual framework argument that if the obligations are not reasonably expected (i.e., is not probable to be paid)

to require either the use of existing current assets or the creation of other current liabilities within a year or an operating cycle, whichever is longer, then a company should not classify them as current liabilities

ANSWERS TO CASES

C12-1

1 Yes, because (a) it has borrowed money before the due date of the short-term note, thereby establishing the intent to refinance on December 31, 2004; and (b) it has

demonstrated the ability to refinance

Only $60,000 could be reclassified as noncurrent because this is the maximum amount borrowed or available to be borrowed under the agreement

2 No, the effect would not be the same The short-term debt would have to be paid by use

of current assets after the balance sheet date (on February 19) and the assets later replaced by issuing long-term debt (on February 26) FASB Interpretation No 8 states that

in this case the short-term obligation cannot be excluded from current liabilities at the balance sheet date

C12-2 (continued)

2 The refinancing agreement must allow Warder to borrow for the entire amount of the note

to be able to exclude the full amount from current liabilities Since the refinancing

agreement was entered into before the statement issuance date this treatment would be proper

3 If the stockholders will confirm that they will not make demand for payment within the next year or operating cycle, then the notes payable may be omitted

4 If Warder plans to hold the deposits for longer than one year or one operating cycle, whichever is longer, after the balance sheet date, then it can exclude this amount from current liabilities

C12-3 (AICPA adapted solution)

a The two basic requirements for the accrual of a loss contingency (probability of loss and reasonable estimation) are the results of the interaction of several concepts of accounting theory Three of these concepts are (1) periodicity (time periods), (2) measurement, and (3) objectivity The first of these concepts relates to the first characteristic of an event necessary before accruing a loss contingency, and the second and third concepts listed relate to the second necessary requirement for the accrual of a loss contingency

The first requirement that must be satisfied for the accrual of a loss contingency is that at a time prior to the issuance of the financial statements there is an indication that it is

probable that an asset has been impaired or a liability has been incurred at the date of the financial statements A basic objective in the recognition of losses is to record them in the particular period in which they are incurred With respect to the accrual of a loss contingency, a probable loss should be recognized in the same period in which it resulted

in the probable impairment of an asset or the probable incurrence of a liability The failure

to accrue the loss contingency in the period of occurrence will generally overstate

earnings initially and understate earnings in future periods

The second requirement for the accrual of a loss contingency states that the amount of the loss must be reasonably estimable The concept of measurement requires that the event must be quantifiable in terms of a standard unit of measure (dollars) In the case of

a loss contingency related to the period covered in the current financial statements, the exact timing and magnitude of the loss may not be known in advance, but based on past experience or other methods of analysis, a reasonable estimate of the loss contingency can be made In making the estimate, the probability that a reasonable amount will be determined statistically is enhanced by a large population of accounts from which the probable loss will occur (law of large numbers)

Also related to the reasonable estimation of the probable future loss, the concept of objectivity requires that the estimate be supported by quantitative data The basis for the estimate must yield essentially the same estimate when computed by different individuals using the available supporting data The concept of objectivity is supportive of the

contention that future events will confirm the occurrence of a loss at the date of the financial statements Of course the loss must be probable as well as estimable and

justified in light of future events

C12-3 (continued)

b Situation I

When a company sells a product subject to a warranty, it is probable that there will be expenses incurred in future accounting periods relating to revenues recognized in the current period As such, a liability has been incurred to honor the warranty at the same date as the recognition of the revenue Based on prior experience or technical analysis, the occurrence of warranty claims can be reasonably estimated and a probable dollar estimate of the liability can be made The contingent liability for warranties meets both of the requirements for the accrual of a loss contingency, and the estimated amount of the loss should be reflected in the financial statements In addition to recording the accrual, it may be advisable to disclose the factors used in arriving at the estimate by means of a note especially when there is a possibility of a greater loss than was accrued

Situation II

Even though (1) there is a probable loss on the contract, (2) the amount of the loss can be reasonably estimated, and (3) the likelihood of the loss was discovered prior to the

issuance of the financial statements, the fact that the contract was entered into

subsequent to the date of the financial statements precludes accrual of the loss

contingency in financial statements for periods prior to the incurrence of the loss

However, the fact that a material loss has been incurred subsequent to the date of the financial statements but prior to their issuance should be disclosed by means of a note to the financial statements The disclosure should contain the nature of the contingency and

an estimate of the amount of the probable loss or a range into which the loss will probably fall

Situation III

The fact that a company chooses to self-insure the contingency of injury to others caused

by its vehicles is not basis enough to accrue a loss contingency that has not occurred at the date of the financial statements An accrual or "reserve" cannot be made for the amount of insurance premium that would have been paid had a policy been obtained to insure the company against this particular risk A loss contingency may only be accrued if prior to the date of the financial statements a specific event has occurred that will impair

an asset or create a liability and an amount related to that specific occurrence can be reasonably estimated The fact that the company is self-insuring this risk should be

disclosed by means of a note to alert the financial statement reader to the exposure created by the lack of insurance

C12-4 (AICPA adapted solution)

1 An estimated loss from a loss contingency shall be accrued by a charge to income if both

of the following conditions are met:

a Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss

b The amount of loss can be reasonably estimated

C12-4 (continued)

2 Disclosure should be made for an estimated loss from a loss contingency that need not be accrued by a charge to income when there is at least a reasonable possibility that a loss may have been incurred The disclosure should indicate the nature of the contingency and should estimate the possible loss or range of loss or state that such an estimate

cannot be made

Disclosure of a loss contingency involving an unasserted claim is required when it is

probable that the claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable

C12-5 (AICPA adapted solution)

1 (a) Notes to Supey's 2004 financial statements should disclose the nature of the loss on

cleanup and indicate that an estimate of the loss, or range of the loss, cannot be made No accrual should be made because the loss cannot be reasonably

estimated and accrual of an uncertain amount would impair the integrity of the financial statements

(b) Supey should disclose the nature of Gap's claim in the notes to the 2004 financial statements Disclosure should include an estimate of the potential loss Supey should not accrue the loss because it is only reasonably possible that it will have to pay for Gap's losses

2 An estimated loss on the purchase commitment, equal to the unrecoverable amount

of the contract price, should be reported as part of 2004 income from continuing operations and as a current liability at December 31, 2004 The net loss on the

purchase commitment should be measured and recognized in the period in which it occurs Since Supey did not hedge this contract, reporting this loss recognizes the commitment's impact on future cash flows

C12-6 (AICPA adapted solution)

1 Angela should report the estimated loss from the safety hazard as an expense in the income statement and a liability in the balance sheet because both of the following conditions were met:

a It is considered probable that liabilities have been incurred

b Based on past experience, a reasonable estimate of the amount of loss can be made

In addition, Angela should disclose the nature of the safety hazard in the notes to the financial statements

2 Angela should not report the estimated loss from the noninsurable flood risk as an expense

in the income statement or a liability in the balance sheet because no losses have

occurred since the warehouse has been uninsured and the asset has not been impaired Thus, a loss has not been recognized and a liability does not exist Furthermore, disclosure

of the noninsurable risk in the notes to the financial statements is not required because no losses have occurred since the warehouse has been uninsured Disclosure in the notes to the financial statements is permitted, however

C12-6 (continued)

3 The purchase of the movie tickets should be accounted for by debiting an asset -movie tickets inventory and crediting cash An accrual for the estimated promotion expense and liability should be accounted for by debiting promotion expense and

account-crediting an accrued liability for those costs associated with 60 percent of the coupons issued The coupons actually redeemed this year should be accounted for by debiting the accrued liability and crediting the asset account movie tickets inventory for 40 percent of the coupons

C12-7

Since the wreck occurred on January 15, 2005 and not on or before December 31, 2004,

no asset has been impaired or liability incurred at the balance sheet date If the accident had occurred on or before the balance sheet date, the loss would have been accrued and a liability established, given that the damages were subject to reasonable estimation Note: As discussed in Chapter 3, however, since this is a "subsequent event" it would be disclosed in a note to the financial statements

C12-8

The loss should be accrued and a liability recorded because:

1 A liability has been incurred at December 31, 2004 due to the faulty Stallions

2 The amount of the loss is reasonably estimable

The journal entry to record the contingency is as follows:

C12-9 (AICPA adapted solution)

1 Skinner should report the potential costs due to the discovery of a possible product defect

as an expense or loss in the income statement and as a liability in the balance sheet In addition, Skinner should disclose the nature of the costs due to the discovery of a possible product defect

Accrual and disclosure are required if both of the following conditions are met:

(a) It is considered probable that a liability has been incurred

(b) The amount of loss can be reasonably estimated

In this case both conditions are met

2 Skinner should not report the potential claim for damages that may be received next year

in the current year's income statement or balance sheet Gain contingencies usually are not recorded in the accounts in advance of their realization However, adequate

disclosure should be made of gain contingencies, but care should be exercised to avoid misleading implications as to the likelihood of realization

C12-9 (continued)

3 This year, Skinner should account for the potential costs due to the promotion campaign

as a premium expense and as a liability for 70 percent of the dollar amount of the

coupons issued The amount of the liability at the end of this year would be 30 percent of the dollar amount of the coupons issued This amount represents 70 percent of the dollar amount of the coupons issued this year less 40 percent of the dollar amount of the

coupons redeemed and for which cash refunds were sent

C12-10 (AICPA adapted solution)

1 For the safety hazard, Niki should accrue for a loss and a liability equal to the most likely cost The most likely loss is the best estimate of the expected loss Accrual of a loss is appropriate because the loss is both probable and can be reasonably estimated In addition, Niki should separately disclose in the notes to the 2004 financial statements the nature of the hazard and the range of possible loss

2 Niki should accrue for a loss and a liability for the note sold to a bank The accrual should equal the amount due on the note plus related costs and less any expected settlement from the bankruptcy Accrual is appropriate because it is probable that a loss has

occurred, as evidenced by the bankruptcy filing, even though this note is not yet due

3 Niki should disclose the possible loss on the assigned lease in notes to the 2004 financial statements Disclosures should include details of the assigned lease and the amounts due, estimates of any revenues that might be earned on the property, and any amounts

recoverable from Pro Although disclosure is appropriate for the financial statements not

to be misleading, accrual of a loss is inappropriate because the loss is only reasonably possible

C12-11 (AICPA adapted solution)

1 For Type A merchandise, the estimated product warranty costs should be accrued by a charge to income and a credit to a liability because both of the following conditions were met:

a It is probable that a liability has been incurred based on past experience Thus, the matching principle is being followed

b The amount of loss can be reasonably estimated as 1 percent of sales

For Type B merchandise, the estimated product warranty costs should not be accrued by

a charge to income because the amount of loss cannot be reasonably estimated

2 The probable judgment ($400,000) should be accrued by a charge to income and a credit to a liability because both of the following conditions were met:

a It is probable that a liability has been incurred because Reese's lawyer states that it is probable that Reese will lose the suit

b The amount of loss can be reasonably estimated because Reese's lawyer states that the most probable judgement is $400,000

C12-11 (continued)

2 b (continued)

Thus, the principle of conservatism is being followed Reese should disclose the following in its financial statements or notes:

The amount of the suit ($2 million)

The nature of the accrual

The nature of the contingency

The range of loss ($200,000 to $900,000)

$3,679 million (note 4, p 67)

3 The total loans and notes payable were $3,743 million at the end of 2001 (balance sheet,

p 59) They consisted primarily of commercial paper issued in the United States (note 5,

p 67) At the end of 2001, the company had $2,468 million in lines of credit and other short-term credit facilities available, of which approximately $382 million was outstanding (note 5, p 67) The company disclosed the lines of credit information to give users more information about its liquidity and financial flexibility

4 At the end of 2001, the company was contingently liable for guarantees of indebtedness owed by third parties of $436 million, of which $10 million is related to the company’s equity investee bottlers This means if these third parties do not pay their indebtedness, the company is responsible for paying them It is the opinion of management, that it is not probable that the company will be required to satisfy these guarantees (note 10, p 72) C12-13

Note to Instructor: This case does not have a definitive answer From a financial reporting perspective, GAAP is identified and summarized From an ethical perspective, various issues are raised for discussion purposes

From a financial accounting perspective, this situation involves a loss contingency An estimated loss from a loss contingency is accrued and reported as a reduction of income and as a liability if it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated When there is a range of possible amounts, and some amount is the best estimate, then this amount is accrued If either of the two conditions is not met, but there is a reasonable possibility that a loss may have been incurred, then the loss contingency (and amount) is disclosed in the notes to the financial statements Consideration must be given to Stan Hart's knowledge of company operations It may be helpful, from an operations standpoint, to ascertain why Stan feels the way he does Consideration also must be given to Bob Brandt's knowledge of the legal process To be

"probable" that a loss has occurred, it is implicit that it must be probable that a future event will occur confirming the occurrence of the loss More information must be

gathered

C12-13 (continued)

about the meaning of Bob's comment that there is a pretty good chance of losing the lawsuit in the future and that the amount will be at least $400,000 Does "pretty good chance" mean "probable" or "reasonably probable?" Furthermore, since the lawsuit is for

$1 million, is "at least $400,000" the best estimate to use in the lawsuit? Or, is $640,000 (the joint probability of $400,000 x 0.60 + $1 million x 0.40) the most prudent number to use? Also, how reliable are Bob Brandt's estimates? These issues must be resolved to determine whether to record and report the loss in the financial statements or to disclose the lawsuit (and amount) in the related notes

From an ethical perspective, the issue involves which alternative (recording and reporting the loss in the financial statements versus disclosing the loss contingency in a note) is the most fair to the stakeholders In this case, the stakeholders include Stan Hart, the

stockholders, the town, the EPA, and the region through which the river runs While Stan may claim the company has not caused the fish kills, the EPA thinks it did Stan may be biased in his thinking, because his bonus is based on a percent of pretax income

Reporting of the loss in income will either significantly reduce his bonus or eliminate it, depending on the amount of the loss Reporting the loss will significantly reduce income, which may decrease the market price of the company's stock and have an adverse effect on stockholders' investments Since Hart Corporation is the major employer in the small town, a shutdown may cause harmful economic effects but we don't know the likelihood of a shutdown Furthermore, the EPA must consider these economic factors in its decisions The region through which the river runs also must be considered because of the impact on the fish and fishing (both leisure and commercial), as well as the possible costs

I have researched the issue of how to account for the "sale" of $42,000 of inventory for

$50,000 on November 1, 2004 and agreement to "repurchase" the inventory at the end of July, 2005 This agreement may fall under the category of a product financing

arrangement According to the FASB Current Text, par D18.101 (FASB Original

Pronouncements, FAS 49, par 3), a product financing arrangement includes an

agreement in which a company (the sponsor) seeking to finance a product sells the product to another company (the company through which the financing flows) and in a related transaction agrees to repurchase the product D18.102 and 103 (FAS 49, par 4 and 5) identify other characteristics commonly found in such arrangements, including: (1) the company that purchases the product was established solely for that purpose, (2) the debt of the company that purchases the product being financed is guaranteed by the sponsor, (3) the sponsor is required to repurchase the product at specified prices, and (4) the established payments received by the company from the sponsor are sufficient to

C12-14 (continued)

cover the costs incurred in purchasing and holding the product (including interest) For an arrangement that has both characteristics (3) and (4), D18.106 (FAS 49, par 8) states that the sponsor shall record a liability at the time the proceeds are received from the other company, shall not record the transaction as a sale, and shall not remove the covered product from its balance sheet

In my opinion, Bogan Company's agreement with Hall Company is a product financing arrangement that includes all characteristics (1) through (4) Hall appears to be created solely to purchase the inventory and its debt (collateralized by the inventory) is

guaranteed by Bogan Furthermore, Bogan has agreed to repurchase the inventory at a specified price and to pay Hall a sufficient amount to cover storage and interest costs

On this basis, I recommend the November 1, 2004 transaction be recorded by Bogan as a liability and that the inventory continue to be reported on its balance sheet To do so, I recommend the following journal entries be made:

Generally Accepted Accounting Principles

The generally accepted accounting principles relating to advertising costs are contained in AICPA Statement of Position 93-7 (SOP), which states that advertising costs should be

expensed either when incurred or the first time the advertising takes place, unless the advertising is direct-response advertising and results in probable future benefits (par 26) The costs of the future benefits of direct response advertising should be reported as an asset (capitalized) Direct-response advertising is expected to result in a customer's decision to buy the product, and requires documentation (such as a returned coded-coupon) that a customer responded to the advertising, to show the benefits have been received (par 34) Costs of direct-response advertising that should be reported as an asset include only: (1) the incremental direct costs incurred in transactions with independent third parties (such as costs of idea development, writing copy, artwork, printing, magazine space and mailing) and (2) payroll costs of employees directly associated with and devoting time to internal advertising activities (these costs should include only that portion of total compensation

C12-15 (continued)

and fringe benefits directly related to time spent performing those advertising activities) (par 41) Allocated administrative costs, rent, depreciation, and other occupancy costs are not costs of direct-response advertising activities The costs of direct-response

advertising that are reported as assets should be amortized to income (as an expense) over the period during which the future benefits are expected to be received (par 46) Costs of communicating advertisements (such as the costs of magazine space and television

airtime) should not be reported as expenses before the item or service has been received (par 44)

The generally accepted accounting principles relating to revenue recognition for sales involving the $5-off coded-coupon are contained in sections R75 (APB 10) and C59 (FAS 5)

of the FASB Current Text (FASB Original Pronouncements) R75.101 (APB 10, par 12) states that revenues ordinarily are recognized when realized at the time a transaction is

completed, while C59.118 (FAS 5, par 17) states that gain contingencies (e.g., expected additional future sales from coded-coupons) usually are not reflected in the accounts because to do so might be to recognize revenue prior to realization

Recommendations

Based on the GAAP cited above, I recommend reporting the various advertising costs in the

2004 financial statements as follows:

(1) $10,000 supervisor's salary: Report as expense on 2004 income statement

(2) $40,000 payroll: Initially capitalize as a direct-response advertising asset Since 8,000 units of the new product were sold at the coded-coupon price in 2004 and a total of 20,000 are expected to be sold, report $16,000 [$40,000 x 0.40 (8,000 20,000)] of the payroll as advertising expense on 2004 income statement and report $24,000 as

direct-response advertising asset on 2004 ending balance sheet

(3) $7,500 depreciation expense: Report as expense on 2004 income statement

(4) $480,000 ($180,000 + $300,000) of television commercials: Report as expense on 2004 income statement because commercials have been aired (Note that par 35 of SOP 93-7 states that a television commercial announcing that coupons will be available is not direct-response advertising because it is directed to a broad audience.)

(5) $100,000 of magazine advertising space: Initially capitalize as a direct-response advertising asset Report $40,000 ($100,000 x 0.40 of expected total unit sales) as advertising expense on 2004 income statement and report $160,000 as direct-

response advertising asset on 2004 ending balance sheet

I recommend that the sales revenue involving the new product be reported at the amount realized in the 2004 income statement Since 8,000 units were sold at the $45 coded-

coupon price and 5,000 units were sold at the $50 regular price, a total of $610,000 net sales revenue should be reported, consisting of $360,000 net sales revenue ($400,000 gross sales less $40,000 sales discounts) for the discounted sales and $250,000 sales revenue ($50 x 5,000) on the regular sales

ANSWERS TO MULTIPLE CHOICE

2004

Dec 31 Interest Expense (½ x $700) 350

Partial Balance Sheet December 31, 2004 Current liabilities

3

$19,000

$700 = 3.627% rate for 90 days

X 4 (90-day periods per year)

14.51% effective annual rate

$6,000 P

$24,000.00

$ 871.17 666.02 452.66 230.78*

$2,220.63

$ 5,128.83 5,333.98 5,547.34 5,769.22

$21,779.37

$21,779.37

16,650.54 11,316.56 5,769.22 -0-

*Difference due to rounding

Partial Balance Sheet December 31, 2004 Property, Plant, and Equipment

E12-5

1 2004

Mar 31 Salaries and Wages Expense

Compensated Absences for

Liability for Employee Compensation for Future Absences (5 employees x

$96 daily rate x 3/12 of

31 Salaries and Wages Expense

Compensated Absences for

Liability for Employee Compensation for Future Absences (5 employees x

$96 daily rate x 3 days/

Partial Balance Sheet March 31, 2004 Current Liabilities

Liability for Employee Compensation

E12-7

Employees' Income Taxes

F.I.C.A Taxes Payable [($500,000 -

Federal Unemployment Taxes Payable

B = $23,755.66

2 T = 0.30 ($250,000 - $23,755.66)

= 0.30 ($226,244.34)

= $67,873.30 Check:

B = 0.15 ($250,000 - $23,755.66 - $67,873.30)

= 0.15 ($158,371.04)

= $23,755.66

E12-9

Four monthly entries: May 31 - Aug 31, 2004

Sept 1, 2004

Sept 30, 2004 (and at end of each of next 3 months)

There will be no property tax liability at December 31,

2004 The taxes have been prepaid, and are a prepaid asset

E12-10

Two monthly entries: May 31 - June 30, 2004

July 10, 2004

Two monthly entries: July 31 - Aug 31, 2004

Sept 10, 2004

Sept 30, 2004

2005

Partial Balance Sheet December 31, 2004 Current Liabilities

E12-12

1 Sale of 1,600 instruments during August-December, 2004

Cash or Accounts Receivable ($460 x 1,600) 736,000

Warranty Expense for August-December, 2004

Earnings of Warranty Revenue for August-December, 2004