Question & Answer

Hincapie Co. manufactures specialty bike accessories. The company is most well known for its product quality, and it has offered one of the best warranties in the industry on its higher-priced products—a lifetime guarantee. The warranty on these products is included in the sales price. Hincapie has a contract with a service company, which performs all warranty work on Hincapie products. Under the contract, Hincapie guarantees the service company at least $200,000 of warranty work for each year of the 3-year contract.

The recent economic recession has been hard on Hincapie’s business, and sales for its higher-end products have been especially adversely impacted. As a result, Hincapie is planning to restructure its high-quality lines by moving manufacturing for those products into one of its other factories, shutting down assembly lines, and terminating workers. In order to keep some workers on-board, Hincapie plans to bring all warranty work in-house. It can terminate the current warranty contract by making a one-time termination payment of $75,000.

The restructuring plans have been discussed by management during November 2013; they plan to get approval from the board of directors at the December board meeting and execute the restructuring in early 2014. Given the company’s past success, the accounting for restructuring activities has never come up. Hincapie would like you to do some research on how it should account for this restructuring according to IFRS.

Instructions

Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/ ). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)

(a) Identify the accounting literature that addresses the accounting for the various costs that will be incurred in the restructuring.

(b) Advise Hincapie on the restructuring costs. When should Hincapie recognize liabilities arising from the restructuring? What costs can be included? What costs are excluded?

(c) Does Hincapie have a liability related to the service contract? Explain. If Hincapie has a liability, at what amount should it be recorded?

Kobayashi Corporation reports in the current liability section of its statement of financial position at December 31, 2014 (its year-end), short-term obligations of $15,000,000, which includes the current portion of 12% long-term debt in the amount of $10,000,000 (matures in March 2015). Management has stated its intention to refinance the 12% debt whereby no portion of it will mature during 2015. The date of issuance of the financial statements is March 25, 2015.

Instructions

(a) Is management’s intent enough to support long-term classification of the obligation in this situation?

(b) Assume that Kobayashi Corporation issues $13,000,000 of 10-year debentures to the public in January 2015 and that management intends to use the proceeds to liquidate the $10,000,000 debt maturing in March 2015. Furthermore, assume that the debt maturing in March 2015 is paid from these proceeds prior to the authorization to issue the financial statements. Will this have any impact on the statement of financial position classification at December 31, 2014? Explain your answer.

(c) Assume that Kobayashi Corporation issues ordinary shares to the public in January and that management intends to entirely liquidate the $10,000,000 debt maturing in March 2015 with the proceeds of this equity securities issue. In light of these events, should the $10,000,000 debt maturing in March 2015 be included in current liabilities at December 31, 2014?

The following situations relate to Bolivia Company.

1. Bolivia provides a warranty with all its products it sells. It estimates that it will sell 1,000,000 units of its product for the year ended December 31, 2014, and that its total revenue for the product will be $100,000,000. It also estimates that 60% of the product will have no defects, 30% will have major defects, and 10% will have minor defects. The cost of a minor defect is estimated to be $5 for each product sold, and the cost for a major defect cost is $15. The company also estimates that the minimum amount of warranty expense will be $2,000,000 and the maximum will be $10,000,000.

2. Bolivia is involved in a tax dispute with the tax authorities. The most likely outcome of this dispute is that Bolivia will lose and have to pay $400,000. The minimum it will lose is $20,000 and the maximum is $2,500,000.

Instructions

Prepare the journal entry to record provisions, if any, for Bolivia at December 31, 2014.

Presented below are two different situations related to Mckee Corporation’s debt obligations.

Mckee’s next financial reporting date is December 31, 2014. The financial statements are authorized for issuance on March 1, 2015.

1. Mckee has a long-term obligation of $400,000, which is maturing over 4 years in the amount of $100,000 per year. The obligation is dated November 1, 2014, and the first maturity date is

November 1, 2015.

2. Mckee has a short-term obligation due February 15, 2015. Its lender agrees to extend the maturity date of this loan to February 15, 2017. The agreement for extension is signed on January 15, 2015.

On December 31, 2014, Alexander Company had $1,200,000 of short-term debt in the form of notes payable due February 2, 2015. On January 21, 2015, the company issued 25,000 ordinary shares for

$36 per share, receiving $900,000 proceeds after brokerage fees and other costs of issuance. On February

2, 2015, the proceeds from the share sale, supplemented by an additional $300,000 cash, are used to liquidate the $1,200,000 debt. The December 31, 2014, statement of financial position is authorized for issue on February 23, 2015.

Instructions

Show how the $1,200,000 of short-term debt should be presented on the December 31, 2014, statement of financial position.

What is an onerous contract? Give two examples of an onerous contract.

Distinguish between a current liability, such as accounts payable, and a provision.

Under what conditions should a provision be recorded?

Define a provision, and give three examples of a provision.

What evidence is necessary to demonstrate the ability to defer settlement of short-term debt?

Under what conditions should a short-term obligation be excluded from current liabilities?

Pleasant Co. manufactures specialty bike accessories. The company is known for product quality, and it has offered one of the best warranties in the industry on its higher-priced products—a lifetime guarantee,performing all the warranty work in its own shops. The warranty on these products is included in the sales price.

Due to the recent introduction and growth in sales of some products targeted to the low-price market,

Pleasant is considering partnering with another company to do the warranty work on this line of products, if customers purchase a service contract at the time of original product purchase. Pleasant has called you to advise the company on the accounting for this new warranty arrangement.

Instructions

If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

(a) Identify the accounting literature that addresses the accounting for the type of separately priced warranty that Pleasant is considering.

(b) When are warranty contracts considered separately priced?

(c) What are incremental direct acquisition costs and how should they be treated?

The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www.

wiley.com/college/kieso.

Instructions

Refer to these financial statements and the accompanying notes to answer the following questions.

(a) What was P&G’s 2011 short-term debt and related weighted-average interest rate on this debt?

(b) What was P&G’s 2011 working capital, acid-test ratio, and current ratio? Comment on P&G’s liquidity.

(c) What types of commitments and contingencies has P&G’s reported in its financial statements? What is management’s reaction to these contingencies?

The Dotson Company, owner of Bleacher Mall, charges Rich Clothing Store a rental fee of $600 per month plus 5% of yearly profits over $500,000. Matt Rich, the owner of the store, directs his accountant, Ron Hamilton, to increase the estimate of bad debt expense and warranty costs in order to keep profits at $475,000.

Instructions

Answer the following questions.

(a) Should Hamilton follow his boss’s directive?

(b) Who is harmed if the estimates are increased?

(c) Is Matt Rich’s directive ethical?

The following two independent situations involve loss contingencies.

Part 1: Benson Company sells two products, Grey and Yellow. Each carries a one-year warranty.

1. Product Grey—Product warranty costs, based on past experience, will normally be 1% of sales.

2. Product Yellow—Product warranty costs cannot be reasonably estimated because this is a new product line. However, the chief engineer believes that product warranty costs are likely to be incurred.

Instructions

How should Benson report the estimated product warranty costs for each of the two types of merchandise above? Discuss the rationale for your answer. Do not discuss disclosures that should be made in Benson’s financial statements or notes.

Part 2: Constantine Company is being sued for $4,000,000 for an injury caused to a child as a result of alleged negligence while the child was visiting the Constantine Company plant in March 2014. The suit was filed in July 2014. Constantine’s lawyer states that it is probable that Constantine will lose the suit and be found liable for a judgment costing anywhere from $400,000 to $2,000,000. However, the lawyer states that the most probable judgment is $1,000,000.

Instructions

How should Constantine report the suit in its 2014 financial statements? Discuss the rationale for your answer. Include in your answer disclosures, if any, that should be made in Constantine’s financial statements or notes.

Presented below is a note disclosure for Matsui Corporation.

Litigation and Environmental: The Company has been notified, or is a named or a potentially responsible party in a number of governmental (federal, state and local) and private actions associated with environmental matters, such as those relating to hazardous wastes, including certain sites which are on the United States EPA National Priorities List (“Superfund”). These actions seek clean-up costs, penalties and/or damages for personal injury or to property or natural resources.

In 2014, the Company recorded a pre-tax charge of $56,229,000, included in the “Other expense (income)—net” caption of the Company’s consolidated income statements, as an additional provision for environmental matters. These expenditures are expected to take place over the next several years and are indicative of the Company’s commitment to improve and maintain the environment in which it operates. At December 31, 2014, environmental accruals amounted to $69,931,000, of which

$61,535,000 are considered noncurrent and are included in the “Deferred credits and other liabilities” caption of the Company’s consolidated balance sheets.

While it is impossible at this time to determine with certainty the ultimate outcome of environmental matters, it is management’s opinion, based in part on the advice of independent counsel (after taking into account accruals and insurance coverage applicable to such actions) that when the costs are finally determined they will not have a material adverse effect on the financial position of the Company.

Instructions

Answer the following questions.

(a) What conditions must exist before a loss contingency can be recorded in the accounts?

(b) Suppose that Matsui Corporation could not reasonably estimate the amount of the loss, although it

could establish with a high degree of probability the minimum and maximum loss possible. How

should this information be reported in the financial statements?

(c) If the amount of the loss is uncertain, how would the loss contingency be reported in the financial

statements?

On February 1, 2015, one of the huge storage tanks of Viking Manufacturing

Company exploded. Windows in houses and other buildings within a one-mile radius of the explosion were severely damaged, and a number of people were injured. As of February 15, 2015 (when the December 31, 2014, financial statements were completed and sent to the publisher for printing and public distribution), no suits had been filed or claims asserted against the company as a consequence of the explosion.

The company fully anticipates that suits will be filed and claims asserted for injuries and damages. Because the casualty was uninsured and the company considered at fault, Viking Manufacturing will have to cover the damages from its own resources.

Instructions

Discuss fully the accounting treatment and disclosures that should be accorded the casualty and related contingent losses in the financial statements dated December 31, 2014.

Dumars Corporation reports in the current liability section of its balance sheet at December 31, 2014 (its year-end), short-term obligations of $15,000,000, which includes the current portion of 12% long-term debt in the amount of $10,000,000 (matures in March 2015). Management has stated its intention to refinance the 12% debt whereby no portion of it will mature during 2015.

The date of issuance of the financial statements is March 25, 2015.

Instructions

(a) Is management’s intent enough to support long-term classification of the obligation in this situation?

(b) Assume that Dumars Corporation issues $13,000,000 of 10-year debentures to the public in January2015 and that management intends to use the proceeds to liquidate the $10,000,000 debt maturing in March 2015. Furthermore, assume that the debt maturing in March 2015 is paid from these proceeds prior to the issuance of the financial statements. Will this have any impact on the balance sheet classification at December 31, 2014? Explain your answer.

(c) Assume that Dumars Corporation issues common stock to the public in January and that management intends to entirely liquidate the $10,000,000 debt maturing in March 2015 with the proceeds of this equity securities issue. In light of these events, should the $10,000,000 debt maturing in March 2015 be included in current liabilities at December 31, 2014?

(d) Assume that Dumars Corporation, on February 15, 2015, entered into a financing agreement with a commercial bank that permits Dumars Corporation to borrow at any time through 2016 up to $15,000,000 at the bank’s prime rate of interest. Borrowings under the financing agreement mature three years after the date of the loan. The agreement is not cancelable except for violation of a provision with which compliance is objectively determinable. No violation of any provision exists at the date of issuance of the financial statements. Assume further that the current portion of long-term debt does not mature until August 2015. In addition, management intends to refinance the $10,000,000 obligation under the terms of the financial agreement with the bank, which is expected to be financially capable of honoring the agreement.

(1) Given these facts, should the $10,000,000 be classified as current on the balance sheet at December 31, 2014?

(2) Is disclosure of the refinancing method required?

Rodriguez Corporation includes the following items in its liabilities at December 31, 2014.

1. Notes payable, $25,000,000, due June 30, 2015.

2. Deposits from customers on equipment ordered by them from Rodriguez, $6,250,000.

3. Salaries and wages payable, $3,750,000, due January 14, 2015.

Instructions

Indicate in what circumstances, if any, each of the three liabilities above would be excluded from current liabilities.

Presented below is the current liabilities section of Micro Corporation.

($000)

2015 2014

Current liabilities

Notes payable $ 68,713 $ 7,700

Accounts payable 179,496 101,379

Compensation to employees 60,312 31,649

Accrued liabilities 158,198 77,621

Income taxes payable 10,486 26,491

Current maturities of long-term debt 16,592 6,649

Total current liabilities $493,797 $251,489

Instructions

Answer the following questions.

(a) What are the essential characteristics that make an item a liability?

(b) How does one distinguish between a current liability and a long-term liability?

(c) What are accrued liabilities? Give three examples of accrued liabilities that Micro might have.

(d) What is the theoretically correct way to value liabilities? How are current liabilities usually valued?

(e) Why are notes payable reported first in the current liabilities section?

(f) What might be the items that comprise Micro’s liability for “Compensation to employees”?

Schmitt Company must make computations and adjusting entries for the following independent situations at December 31, 2015.

1. Its line of amplifiers carries a 3-year warranty against defects. On the basis of past experience the estimated warranty costs related to dollar sales are first year after sale—2% of sales revenue; second year after sale—3% of sales revenue; and third year after sale—5% of sales revenue. Sales and actual warranty expenditures for the first 3 years of business were:

Sales Warranty

Revenue Expenditures

2013 $ 800,000 $ 6,500

2014 1,100,000 17,200

2015 1,200,000 62,000

Instructions

Compute the amount that Schmitt Company should report as a liability in its December 31, 2015, balance sheet. Assume that all sales are made evenly throughout each year with warranty expenses also evenly spaced relative to the rates above.

2. With some of its products, Schmitt Company includes coupons that are redeemable in merchandise.

The coupons have no expiration date and, in the company’s experience, 40% of them are redeemed.

The liability for unredeemed coupons at December 31, 2014, was $9,000. During 2015, coupons worth $30,000 were issued, and merchandise worth $8,000 was distributed in exchange for coupons redeemed.

Instructions

Compute the amount of the liability that should appear on the December 31, 2015, balance sheet.

You are the independent auditor engaged to audit Millay Corporation’s December 31, 2014, financial statements. Millay manufactures household appliances. During the course of your audit, you discovered the following contingent liabilities.

1. Millay began production of a new dishwasher in June 2014 and, by December 31, 2014, sold 120,000 to various retailers for $500 each. Each dishwasher is under a one-year warranty. The company estimates that its warranty expense per dishwasher will amount to $25. At year-end, the company had already paid out $1,000,000 in warranty expenses. Millay’s income statement shows warranty expenses of $1,000,000 for 2014. Millay accounts for warranty costs on the accrual basis.

2. In response to your attorney’s letter, Morgan Sondgeroth, Esq., has informed you that Millay has been cited for dumping toxic waste into the Kishwaukee River. Clean-up costs and fines amount to $2,750,000. Although the case is still being contested, Sondgeroth is certain that Millay will most probably have to pay the fine and clean-up costs. No disclosure of this situation was found in the financial statements.

3. Millay is the defendant in a patent infringement lawsuit by Megan Drabek over Millay’s use of a hydraulic compressor in several of its products. Sondgeroth claims that, if the suit goes against

Millay, the loss may be as much as $5,000,000. However, Sondgeroth believes the loss of this suit to be only reasonably possible. Again, no mention of this suit is made in the financial statements.

As presented, these contingencies are not reported in accordance with GAAP, which may create problems in issuing a favorable audit report. You feel the need to note these problems in the work papers.

Instructions

Heading each page with the name of the company, balance sheet date, and a brief description of the problem,

write a brief narrative for each of the above issues in the form of a memorandum to be incorporated in the audit work papers. Explain what led to the discovery of each problem, what the problem really is, and what you advised your client to do (along with any appropriate journal entries) in order to bring thesecontingencies in accordance with GAAP.

Garison Music Emporium carries a wide variety of musical instruments, sound reproduction equipment, recorded music, and sheet music. Garison uses two sales promotion techniques—warranties and premiums—to attract customers.

Musical instruments and sound equipment are sold with a one-year warranty for replacement of parts and labor. The estimated warranty cost, based on past experience, is 2% of sales.

The premium is offered on the recorded and sheet music. Customers receive a coupon for each dollar spent on recorded music or sheet music. Customers may exchange 200 coupons and $20 for a digital MP3 player. Garison pays $32 for each player and estimates that 60% of the coupons given to customers will be redeemed.

Garison’s total sales for 2014 were $7,200,000—$5,700,000 from musical instruments and sound reproduction equipment and $1,500,000 from recorded music and sheet music. Replacement parts and labor for warranty work totaled $164,000 during 2014. A total of 6,500 players used in the premium program were purchased during the year and there were 1,200,000 coupons redeemed in 2014.

The accrual method is used by Garison to account for the warranty and premium costs for financial reporting purposes. The balances in the accounts related to warranties and premiums on January 1, 2014, were as shown below.

Inventory of Premiums $ 37,600

Premium Liability 44,800

Warranty Liability 136,000

Instructions

Garison Music Emporium is preparing its financial statements for the year ended December 31, 2014.

Determine the amounts that will be shown on the 2014 financial statements for the following.

(a) Warranty Expense. (d) Inventory of Premiums.

(b) Warranty Liability. (e) Premium Liability.

(c) Premium Expense.

Polska Corporation, in preparation of its December 31, 2014, financial statements, is attempting to determine the proper accounting treatment for each of the following situations.

1. As a result of uninsured accidents during the year, personal injury suits for $350,000 and $60,000 have been filed against the company. It is the judgment of Polska’s legal counsel that an unfavorable outcome is unlikely in the $60,000 case but that an unfavorable verdict approximating $250,000 will probably result in the $350,000 case.

2. Polska Corporation owns a subsidiary in a foreign country that has a book value of $5,725,000 and an estimated fair value of $9,500,000. The foreign government has communicated to Polska its intention to expropriate the assets and business of all foreign investors. On the basis of settlements otherfirms have received from this same country, Polska expects to receive 40% of the fair value of its properties as final settlement.

3. Polska’s chemical product division consisting of five plants is uninsurable because of the special risk of injury to employees and losses due to fire and explosion. The year 2014 is considered one of the safest (luckiest) in the division’s history because no loss due to injury or casualty was suffered.

Having suffered an average of three casualties a year during the rest of the past decade (ranging from $60,000 to $700,000), management is certain that next year the company will probably not be so fortunate.

Instructions

(a) Prepare the journal entries that should be recorded as of December 31, 2014, to recognize each of the situations above.

(b) Indicate what should be reported relative to each situation in the financial statements and accompanying notes. Explain why.

On November 24, 2014, 26 passengers on Windsor Airlines Flight No. 901 were injured upon landing when the plane skidded off the runway. Personal injury suits for damages totaling $9,000,000 were filed on January 11, 2015, against the airline by 18 injured passengers. The airline carries no insurance. Legal counsel has studied each suit and advised Windsor that it can reasonably expect to pay 60% of the damages claimed. The financial statements for the year ended December 31, 2014, were issued February 27, 2015.

Instructions

(a) Prepare any disclosures and journal entries required by the airline in preparation of the December 31, 2014, financial statements.

(b) Ignoring the November 24, 2014, accident, what liability due to the risk of loss from lack of insurance coverage should Windsor Airlines record or disclose? During the past decade, the company has experienced at least one accident per year and incurred average damages of $3,200,000. Discuss fully.