Financial Accounting Module 12

Module 12Current Liabilities

Classification of liabilities

Liabilities are probable future sacrifices of economic benefits. They arise from present obligations of an entity to transfer assets or provide services to others in the future. The obligations are present because of past transactions or events.

Current liabilities must be settled within one year (or one operating cycle, if longer). The operating cycle is the time it takes to purchase or make a product, sell it, and collect cash from the customer (that is, the time it takes to go from cash to finished goods to accounts receivable to cash). Noncurrent liabilities include obligations which will be settled beyond one year (or one operating cycle, if longer).

Classification of liabilities as current or noncurrent is important. This is because such classification affects the amount of working capital (defined as current assets minus current liabilities) and ratios, such as current ratio (ratio of current assets to current liabilities) and quick ratio (ratio of quick assets to current liabilities). These ratios and amounts are useful in evaluating the liquidity or short-term solvency of a company.

Current liabilities may be determinable or contingent. For some types of current liabilities, the amount of the liability is definite in amount and is known with certainty. For example, accounts payable, dividends payable, advances and deposits received from customers, short-term notes payable, and current maturities of long term debt involve specific amounts.

For some other liabilities, the exact amount is not known but must be estimated. For example, warranties and premiums/coupons involve liability amounts that must be estimated.

In addition, there are current liabilities that depend on the extent of operations. For example, bonuses, income taxes, sales taxes, and payroll taxes depend on the level of operations.

Accounts Payable

Accounts payable arise from purchase of goods or services on credit. The liability is recorded when an invoice is received from the supplier. Errors may arise when items are purchased towards the end of a fiscal period, and care must be taken to record the liabilities in the proper period. The recording of accounts payable may depend on terms of shipping, such as FOB shipping or FOB destination.

Some suppliers may grant cash discounts for prompt payment. In such instances, as with accounts receivable, there are two ways of recording the liability. In the gross method, the invoice price is recorded as the liability and the assumption is that the company will not take advantage of the cash discount (and pay early, within the cash discount period). In the net method, it is assumed that the company will pay within the cash discount period, and the amount recorded as the liability is the net amount that will have to be paid (invoice price less the cash discount).

Current Maturities of Long-Term Debt

Long-term debt that is due within the next 12 months is listed as a current liability in the balance sheet. There are three exceptions: The debt is to be retired using assets classified as noncurrent The debt will be refinanced from the proceeds of a long-term debt issue. The debt will be converted into capital stock.If any of the above three conditions exist, then the liability will remain in the noncurrent section of the balance sheet, and the relevant information is disclosed in footnotes.

If the company classifies long-term debt maturing within 12 months as a noncurrent liability because it the company intends to refinance the debt, then two conditions need to be met: The Company intends to refinance the debt on a long-term basis, and The Company has the ability to refinance on a long-term basis.

The “ability to refinance” criterion can be satisfied by showing that the long-term debt or equity securities have been issued after the balance sheet date

but before the financial statements are issued, or a financing agreement has been entered into that permits the refinancing to a long-

term basis. The financing agreement must be noncancellable and must not expire within one year of the balance sheet date, and the company must not be in violation (as of the balance sheet date) of any conditions related to the financing agreement.

Compensated Absences

Compensated absences are absences, such as vacation leave and sick leave, for which the employee will be paid. Usually, such leaves are vested and may be accumulated. Vested leave means the employer will pay for any unused leave. Accumulated leave means unused leave from one period can be carried over to the next period.

If leaves are vested, then they must be recognized as accrued liabilities. This is because it is probable that the employer will have to pay and the amounts can be reasonably estimated (using current wage rates). Thus, a liability must be recognized at the end of the period for leaves that have been vested but not yet used. In the next period, when leave is taken, the liability is reduced.

In some instances, leaves may not vest but may accumulate. In such instances, depending on the circumstances, a liability may have to be recognized. For example, if vacation leave accumulates then the employer will have to estimate the amount of vacation days that will be taken in the future and accordingly record a liability. For sick leave, some employers may not insist on employees actually being sick to use a sick leave. In such instances a liability must be recognized for any unused leave.

Usually, companies record a liability for all vested leave during the year. The liability is reduced as employees use their eligible leaves. Thus, the unused leave during the year corresponds to the increase in the liability account during the period.

Example.Berger Company has 100 employees who are entitled to 10 days vacation per year. The employees work five days a week for eight hours, and the average wage is $10 per hour. During the year ending December 31, 2002, employees took a total of 700 vacation days. Calculate the compensated absences expense and the accrued liability.

Total eligible leave = 100 employees x 10 days per year = 1,000 daysAt $10 per hour and 8 hours per day, this equals a liability of $80,000 ($10 x 8 x 1,000).The journal entry to record recognition of this liability during the year is:

Debit CreditWages expense $80,000 Vacation Pay Payable $80,000

The employees took 700 vacation days, and are paid at $10 per hour for 8 hours on each of these days. The journal entry to record payment is:

Debit CreditVacation Pay Payable $56,000 Cash $56,000

Thus, the total compensated expense during the year is $80,000 out of which $56,000 has been paid during the year. Hence the accrued liability at the end of the year is $24,000 ($80,000 – $56,000).

Premiums and Coupons

Premiums are items such as toys and small appliances offered by companies in exchange for labels or wrappers from products. For example, a cereal manufacturer may offer a toy if the customer sends three labels from cereal boxes. Coupons are used to give cash discount at the time of purchase, or cash rebates after purchase.

Companies use premiums and coupons to increase the sales of their products. The expenses associated with such premiums and coupons must be recognized as expense in the period in which the associated sales are made. (This is because of the matching principle.)

All premiums and coupons redeemed during a period are recognized in that period. In addition, there may be some coupons from current period sales that may be redeemed only in the next period. For example, if customers purchase some cereal boxes in the last week of December, they may wait for the boxes to become empty and then mail the labels to the manufacturer sometime in January. Thus, a contingent liability must be created for coupons from current period sales expected to be redeemed in the future.

In addition, some customers may wait for some time before mailing the labels while other customers may not use the coupons. In other words, redemption rates on

coupons are usually less than 100 percent, and an estimate of the expected redemption must be made.

Example.Healthy Cereals sells organic cereals, and had a promotion that began on November 1, 2002. In return for the return of two labels from its cereal boxes and $2.00, customers will receive a special glass bowl. The company purchases the glass bowls in from a supplier for $3.00 each, and expects a redemption rate of 80 percent. During the period ending December 31, 2002, the Company sold 2,000 cereal boxes and received back 1,200 labels from its customers. Determine the premium expense for the period.

To record the labels received this period:At two labels per bowl, 1,200 labels = 600 bowls.Cash received is $1,200 ($2 x 600).Cost of 600 bowls is $1,800 ($3 x 600, so premium inventory is credited for this amountPremium Expense is the “plug” number, and is $600.

Debit CreditCash $ 1,200Premium Expense 600 Premium Inventory $ 1,800

However, an estimated liability for the labels (relating to current period sales) expected to be redeemed in the future also must be recognized.Packages sold in period ending December 31, 2002 = 2,000.At 80% expected redemption rate, labels expected to be redeemed = 1,600.Labels actually redeemed as of December 31, 2002 = 1,200.Thus, labels from current period sales expected to be redeemed in future = 400.At two labels per bowl, mugs expected to be given for current period sales = 200.Since customers pay $2.00 per bowl that costs $3.00, the extra cost per mug is $1.00. Extra cost of 200 bowls is $200.

Debit CreditPremium Expense $ 200 Estimated Liability for Premiums $ 200

Thus, total premium expense for the period is $600 + $200 = $800.

Note that in the next period, when labels are redeemed, the Estimated Liability account is reduced. If the premium promotion continues in the next period, then Premium Expense is debited only after first reducing the Estimated Liability account to zero.

Warranties

Manufacturers offer warranties on their products. A warranty is a guarantee or promise about the quality or performance of a product, and is usually for a specified period of time.

From an accounting perspective, warranties entail future costs. Thus, when a product is sold revenue is recognized in the current period but some of the costs associated with the product may be incurred only in the future. Under the matching principle, if some

revenue is recognized in a period, then all expenses associated with those revenues must also be recognized in the same period. Hence, warranty expenses must be recognized in the period of sale of the underlying item even though the actual amount of the expenses is not known (because the actual warranty related expenses will be incurred only in the future).

Under accrual accounting, there are two methods of accounting for warranties. The expense warranty method is used when the item sold and the warranty are considered inseparable. That is, the company charges one single sales price which covers product and the underlying warranty.

In the expense warranty method, an estimate is made of future expenses associated with the warranty for the product sold. This amount is debited to Warranty Expense account and credited to Estimated Liability for Warranty account. In subsequent periods, when actual expenses are incurred to repair the product, the Estimated Liability account is debited and Cash and various accounts (such as Inventory, Wages Payable) are credited.

Some companies may charge a sales price which usually includes a basic warranty, and then offer a separate warranty contract which covers an extended period. Thus, a CD system may be sold for $299 and may come with a basic warranty for one month. Then, the salesperson may offer the seller an extended warranty for $99, which will cover the product for three years. This is an example where the warranty is sold separately from the underlying product. In such instances, the sales warranty method is used. In this method, the amount received under the extended warranty is recorded in the Unearned Revenue account. As time goes by, a part of the unearned revenue is recognized as revenue each period.

Bonus and Profit-Sharing Some companies may grant bonuses to some or all employees. Other companies may have profit-sharing arrangements. Usually, bonus and profit-sharing are based on some form of income (income from operations, income before taxes, or net income).

The amount paid out as bonus or profit-sharing is a tax-deductible expense (part of employee compensation expense). Hence, if the bonus is to be based on the net income, then the calculations can become complex.

Example.The operating income, before subtracting bonus and income tax expense, of Victor Company is $200,000. The tax rate is 30 percent, and the bonus will be 10 percent of net income. Calculate the amount of the bonus.

Let the amount of the bonus be “B.” Since bonus is subtracted to get the income before taxes, the income before taxes = $200,000 – B. Since the tax rate is 30 percent, tax expense = 0.3x($200,000 – B).Hence, net income = income before taxes – tax expense

= ($200,000 – B – 0.3x[$200,000 – B])Bonus is 10 percent of net income, so

B = 0.1x($200,000 – B – 0.3x[$200,000 – B])= 0.1x($200,000 – B – $60,000 +0.3B)= $20,000 – 0.1B – $6,000 + 0.03B= $14,000 – 0.07B

Hence, 1.07B = $14,000, or B = $13,084

The amount of the bonus may also be based on the income before tax and before bonus, or on income before tax but after bonus. Once the bonus or profit-sharing amount is calculated, the journal entry is:

Debit Bonus and Profit-Sharing ExpenseCredit Bonus and Profit-Sharing Payable

Once the amount due is paid, the liability is debited and cash is credited.

Glossary

Accounts payable arise from purchase of goods or services on credit.

Accumulated leave means unused leave from one period can be carried over to the next period.

Cash discounts are granted by suppliers for prompt payment.

Compensated absences are absences, such as vacation leave and sick leave, for which the employee will be paid.

Coupons are used to give cash discount at the time of purchase, or cash rebates after purchase.

Current liabilities must be settled within one year (or one operating cycle, if longer).

Current ratio is the ratio of current assets to current liabilities.

Expense warranty method is used when the item sold and the warranty are considered inseparable. That is, the company charges one single sales price for the product and the underlying warranty.

Gross method assumes that the buyer will not take advantage of the cash discount (and pay early, within the cash discount period). In this case, the invoice price is recorded as the liability (accounts payable).

Net method assumes that the buyer will pay within the cash discount period. In this case, the amount recorded as the liability is the net amount that will have to be paid (invoice price less the cash discount).

Noncurrent liabilities are obligations which will be settled beyond one year (or one operating cycle, if longer).

Premiums are items such as toys and small appliances offered by companies in exchange for labels or wrappers from products.

Quick ratio is the ratio of quick assets to current liabilities.

Sales warranty method is used when the warranty is sold separately from the underlying product.

Vested leave means the employer will pay for any unused leave.

Warranty is a guarantee or promise about the quality or performance of a product, and is usually for a specified period of time.

Working capital is the amount of current assets minus current liabilities.

Demonstration Problem 1Mackay Company

Mackay Company employs 100 workers who work eight-hour days, five days a week. The employees earn five sick days (vested) and ten vacation days (vested each year. Relevant data about the years 2002 and 2003 are given below:

2002 2003 Average hourly wage $14 $15 Average vacation days earned 10 10 Average vacation days used 7 8 Average sick days earned 5 5 Average sick days used 3 4Prepare relevant journal entries for 2002 and 2003.

Solution to Demonstration Problem 1, Mackay Company

1. To record sick and vacation days earned in 2002.Vacation pay earned in 2002 = 10 days x 8 hours x $14 x 100 employees = $112,000Sick pay earned in 2002 = 5 days x 8 hours x $14 x 100 employees = $56,000

Debit CreditWages expense $168,000 Vacation Pay Payable $112,000 Sick Pay Payable 56,000

2. To record sick and vacation days taken in 2002.Vacation pay taken in 2002 = 7 days x 8 hours x $14 x 100 employees = $78,400Sick pay earned in 2002 = 3 days x 8 hours x $14 x 100 employees = $33,600

Debit CreditVacation Pay Payable $ 78,400 Sick Pay Payable 33,600 Cash $ 112,000Note that, on average, vacation days earned during the year was ten, but only seven days were used. This means the remainder of the vested days carry over to the next year. Thus, on average, the first three vacation days taken during 2003 come from the balance carried over from 2002. Any subsequent vacation days taken during 2003 come from the vacation days earned in 2003.

Similarly, on average, only three of the five sick days have been used in 2002. This means the remaining two vested sick days carry over to 2003, and the first two sick days taken during 2003 will come from the balance carrying over from 2002.



4. To record sick and vacation days taken in 2003.Total vacation pay paid in 2003 = 8 days x 8 hours x $15 per hour x 100 employees

= $96,000Total sick pay paid in 2003 = 4 days x 8 hours x $15 per hour x 100 employees

= $48,000So the total credit to cash is $144,000 ($96,000 + $48,000).

There are three vacation days and two sick days left over from 2002, for which a liability was created in 2002. These left-over days are assumed to be taken first, and the associated liabilities are reduced first.

However, the liabilities were created using $14 per hour as the wage rate, but the actual wage rate paid in 2003 is $15 per hour.So the difference (due to higher rate) must be charged to wage expense in 2003.

Average total vacation days taken in 2003 is 8. As noted above, three of these eight days are from days vested (and carried over) in 2002. This means the remaining 5 days (8 – 3 = 5) were taken from the vacation days earned in 2003.Total reduction (debit) from Vacation Pay Payable account:Vacation pay used from 2002 leftover days + Vacation pay used from 2003 vesting

= (3 days x 8 hours x $14 x 100) + (5 days x 8 hours x $15 x 100)= $33,600 + $60,000= $93,600

Similarly, two of the four sick days relate to days earned in 2002, and the remaining two (4 – 2 = 2) sick days were taken from the sick days earned in 2003. Total reduction (debit) from Sick Pay Payable account:Sick pay used from 2002 leftover days + Sick pay used from 2003 vesting


Finally, as noted above, we need an extra debit to wages expense because the vested liability was created in 2002 at the rate of $14 per hour, but the actual pay in 2003 was at $15 per hour. This difference arises for the three vacation days and two sick days carried from 2002 and used in 2003. Thus, the extra debit to wages expense:

= (3 + 2) days x 8 hours x ($15 – $14) per hour x 100 employees= 5 days x 8 hours x $1 per hour x 100 employees= $4,000

Debit CreditVacation Pay Payable (step 2) $ 93,600 Sick Pay Payable (step 3) 46,400Wages expense (step 4) 4,000 Cash (step 1) $ 144,000

Demonstration Problem 2Krisp Donuts

Krisp Donuts had a promotion that began on November 1, 2002 and ended on March 1, 2003. Krispy Donuts sells its dozen-donut packages for $3 each. In return for the return of four labels from its dozen-donut packages and $1.50, customers will receive a coffee mug. Krisp Donuts purchased the coffee mugs at $2 each, and expects the redemption rate of the labels to be 60%. The number of dozen-donut packages sold, coffee mugs purchased, and labels received are given below:

November 1 to December 31, 2002

January 1 to March 1, 2003

Dozen-donut packages sold 10,000 12,000Coffee mugs purchased 1,500 1,800Labels received 5,000 8,000Krispy Donuts has a December 31 fiscal year-end. Any mugs remaining as of March 1, 2003 were kept for possible future use. Prepare the necessary journal entries.

Solution to Demonstration Problem 2, Krisp Donuts

1. Sale of 10,000 dozen-donut packages in period ending December 31, 2002. Debit Credit

Cash $ 30,000 Sales Revenue $ 30,000

2. Purchase of 1,500 coffee mugs @ $2 each in period ending December 31, 2002.Debit Credit

Premium Inventory $ 3,000 Cash $ 3,000

3. Receipt of 5,000 labels in period ending December 31, 2002.At four labels per mug, 5,000 labels = 1,250 coffee mugs.Cash received is $1,875 (1,250 x $1.50), so debit Cash for $1,875.Cost of 1,250 mugs is $2,500 ($2 x 1,250), so credit Premium Inventory for $2,500.Hence, Premium Expense (“plug” number) = $2,500 – $1,875 = $625.

Debit CreditCash $ 1,875Premium Expense 625 Premium Inventory $ 2,500

4. To record estimated liability at December 31, 2002 (fiscal year-end).Packages sold in period ending December 31, 2002 = 10,000.At 60% expected redemption rate, labels expected to be redeemed = 6,000.Labels actually redeemed as of December 31, 2002 = 5,000.Thus, labels from current period sales expected to be redeemed in future = 1,000.At four labels per mug, mugs expected to be given for current period sales = 250.Since customers pay $1.50 per mug which costs $2.00, the extra cost per mug is $0.50. Extra cost of 250 mugs = $125.


5. Sale of 12,000 dozen-donut packages in period from January 1, 2003 to March 1, 2003.

Debit CreditCash $ 36,000 Sales Revenue $ 36,000

6. Purchase of 1,800 coffee mugs @ $2 each in period from January 1, 2003 to March 1, 2003.

Debit CreditPremium Inventory $ 3,600

Cash $ 3,600

7. Receipt of 8,000 labels in period from January 1, 2003 to March 1, 2003.At four labels per mug, 8,000 labels = 2,000 coffee mugs.Cash received is $3,000 (2,000 x $1.50), so debit Cash for $3,000.Cost of 2,000 mugs is $4,000 ($2 x 2,000), so credit Premium Inventory for $4,000.However, 1,000 of the labels relate to sales from last period, so $125 of the Estimated Liability account (set up at the end of last year) must first be eliminated.Premium Expense (“plug” number) = $875 ($4,000 – $3,000 – $125).

Debit CreditCash (step 1) $ 3,000Estimated Liability for Premiums (step 3) 125Premium Expense (step 4) 875 Premium Inventory (step 2) $ 4,000

Demonstration Problem 3Weld Company

Weld Company had operating income before bonus and income tax of $2,000,000 for the year ending December 31, 2002. The tax rate for the Company was 30 percent, and the bonus rate is 10 percent. What is the amount of the bonus, if the bonus is based on income(A) before tax and before bonus.(B) before tax and after bonus.(C) after tax and after bonus.(Round the answer to the nearest dollar.)

Solution to Demonstration Problem 3, Weld Company

In the calculations, the following notation will be used: B = Bonus; T = Tax expense.

A. Bonus based on income before tax and before bonusBonus = $2,000,000 x 0.10 = $200,000

B. Bonus based on income before tax and after bonusB = 0.10 ($2,000,000 – B) = $200,000 – 0.1B Hence, 1.1B = $200,000So Bonus = $181,818

C. Bonus based on income after tax and after bonusB = 0.10 ($2,000,000 – B – T)However, taxes are given to be 30 percent, and bonus is deducted before calculating income taxes.T = 0.30 ($2,000,000 – B) = $600,000 – 0.3BPlugging this value of T in the equation in the first line, we getB = 0.10 ($2,000,000 – B – [$600,000 – 0.3B]), orB = 0.10 ($1,400,000 – 0.7B) = $140,000 – 0.07BThus, 1.07B = $140,000, or Bonus = $130,841

Practice Problem 1Chiles Company

Chiles Company employs 50 workers who work eight-hour days, five days a week. The employees earn six sick days (vested) and ten vacation days (vested each year. Relevant data about the years 2002 and 2003 are given below:

2002 2003 Average hourly wage $12 $14 Average vacation days earned 10 10 Average vacation days used 8 9 Average sick days earned 6 6 Average sick days used 5 4Prepare relevant journal entries for 2002 and 2003.

Solution to Practice Problem 1, Chiles Company



2. To record sick and vacation days taken in 2002.Vacation pay taken in 2002 = 8 days x 8 hours x $12 x 50 employees = $38,400Sick pay earned in 2002 = 5 days x 8 hours x $12 x 50 employees = $24,000

Debit CreditVacation Pay Payable $ 38,400 Sick Pay Payable 24,000 Cash $ 62,400Note that, on average, vacation days earned during the year was ten, but only eight days were used. This means the remainder of the vested days carry over to the next year. Thus, on average, the first two vacation days taken during 2003 come from the balance carried over from 2002. Any subsequent vacation days taken during 2003 come from the vacation days earned in 2003.

Similarly, on average, only five of the six sick days have been used in 2002. This means the remaining one vested sick day carries over to 2003, and the first sick day taken during 2003 will come from the balance carrying over from 2002.


Debit CreditWages expense 89,600 Vacation Pay Payable $56,000 Sick Pay Payable 33,600

4. To record sick and vacation days taken in 2003.Total vacation pay paid in 2003 = 9 days x 8 hours x $14 per hour x 50 employees

= $50,400Total sick pay paid in 2003 = 4 days x 8 hours x $14 per hour x 50 employees

= $22,400So the total credit to cash is $72,800 ($50,400 + $22,400).

There are two vacation days and one sick day left over from 2002, for which a liability was created in 2002. These left-over days are assumed to be taken first, and the associated liabilities are reduced first.

However, the liabilities were created using $12 per hour as the wage rate, but the actual wage rate paid in 2003 is $14 per hour.So the difference (due to higher rate) must be charged to wage expense in 2003.

Average total vacation days taken in 2003 is 9. As noted above, two of these nine days are from days vested (and carried over) in 2002. This means the remaining 7 days (9 – 2 = 7) were taken from the vacation days earned in 2003.Total reduction (debit) from Vacation Pay Payable account:Vacation pay used from 2002 leftover days + Vacation pay used from 2003 vesting


Similarly, one of the four sick days relate to days earned in 2002, and the remaining three (4 – 1 = 3) sick days were taken from the sick days earned in 2003. Total reduction (debit) from Sick Pay Payable account:Sick pay used from 2002 leftover days + Sick pay used from 2003 vesting

= (1 day x 8 hours x $12 x 50) + (3 days x 8 hours x $14 x 50)= $4,800 + $16,800= $21,600

Finally, as noted above, we need an extra debit to wages expense because the vested liability was created in 2002 at the rate of $12 per hour, but the actual pay in 2003 was at $14 per hour. This difference arises for the two vacation days and one sick day carried from 2002 and used in 2003. Thus, the extra debit to wages expense:

= (2 + 1) days x 8 hours x ($14 – $12) per hour x 50 employees= 3 days x 8 hours x $2 per hour x 50 employees= $2,400

Debit CreditVacation Pay Payable (step 2) $ 48,800 Sick Pay Payable (step 3) 21,600Wages expense (step 4) 2,400 Cash (step 1) $ 72,800

Practice Problem 2Kwik Clean

Kwik Clean sells a new type of detergent that can be used to clean many types of surfaces. Kwik Clean had a promotion that began on September 1, 2002 and ended on April 1, 2003. If customers return two labels from its Kwiky packages (each of which sells for $5) along with $2.00 and a self-addressed stamped envelope, they will receive a vase. Kwik Clean purchased the vases at $5.00 each, and expects the redemption rate of the labels to be 70%. The number of Kwiky packages sold, vases purchased, and labels received are given below:

September 1 to December 31, 2002

January 1 to April 1, 2003

Kwiky packages sold 6,000 5,000Vases purchased 2,100 1,750Labels received 3,200 4,000Kwik Clean has a December 31 fiscal year-end. Any vases remaining as of April 1, 2003 were kept for possible future use. Prepare the necessary journal entries.

Solution to Practice Problem 2, Kwik Clean

1. Sale of 6,000 Kwiky packages in period ending December 31, 2002. Debit Credit


2. Purchase of 2,100 vases @ $5.00 each in period ending December 31, 2002.Debit Credit


3. Receipt of 3,200 labels in period ending December 31, 2002.At two labels per vase, 3,200 labels = 1,600 vases.Cash received @ $2 per vase is $3,200, so debit Cash for $3,200.Cost of 1,600 vases is $8,000 ($5 x 1,600), so credit Premium Inventory for $8,000.Hence, Premium Expense (“plug” number) = $8,000 – $3,200 = $4,800.

Debit CreditCash $ 3,200Premium Expense 4,800 Premium Inventory $ 8,000

4. To record estimated liability at December 31, 2002 (fiscal year-end).Packages sold in period ending December 31, 2002 = 6,000.At 70% expected redemption rate, labels expected to be redeemed = 4,200.Labels actually redeemed as of December 31, 2002 = 3,200.Thus, labels from current period sales expected to be redeemed in future = 1,000.At two labels per vase, vases expected to be given for current period sales = 500.Since customers pay $2 per vase that costs $5, the extra cost per vase is $3.Extra cost of 500 vases = $1,500.

Debit CreditPremium Expense $ 1,500 Estimated Liability for Premiums $ 1,500

5. Sale of 5,000 Kwiky packages in period from January 1, 2003 to March 1, 2003. Debit Credit


6. Purchase of 1,750 vases @ $5 each in period from January 1, 2003 to March 1, 2003.Debit Credit


7. Receipt of 4,000 labels in period from January 1, 2003 to March 1, 2003.At two labels per vase 4,000 labels = 2,000 vases.Cash received @ $2 per vase is $4,000, so debit Cash for $4,000.Cost of 2,000 vases is $10,000 ($5 x 2,000), so credit Premium Inventory for $10,000.However, 1,000 of the labels relate to sales from last period, so $1,500 of the Estimated Liability account (set up at the end of last year) must first be eliminated.

Premium Expense (“plug” number) = $4,500 ($10,000 – $4,000 – $1,500).Debit Credit

Cash (step 1) $ 4,000Estimated Liability for Premiums (step 3) 1,500Premium Expense (step 4) 4,500 Premium Inventory (step 2) $ 10,000

Practice Problem 3Cellucci Company

Cellucci Company will provide a bonus to its Chief Executive as follows: (1) The bonus will be based on the Company’s net income after deducting all expenses, including the bonus and taxes. (2) The amount of the bonus will be 5 percent of the net income in excess of $4 million. (3) The maximum amount of the bonus will be $2,000,000. The income tax rate is 40 percent.A. If the bonus for the year ending December 31, 2002 was $1,000,000, what was the Company’s net income before tax and before the bonus?B. How much should the Company earn before taxes and bonus in the year ending December 31, 2003 for the bonus to be $700,000?

Solution to Practice Problem 3, Cellucci Company

A. Bonus is 5 percent of net income, and is $1,000,000.Hence, net income on which bonus was based = $1,000,000/0.05 = $20,000,000.Since bonus begins only after net income exceeds $4 million, net income = $24 million.

If income before tax (but after bonus) is Y, then income after tax = (1 – 0.4)Y = 0.6Y.We know income after tax is $24 million, so Y = $24 million/0.6 = $40 million.

Bonus is subtracted (from operating income) to arrive at income before taxes.

Income before taxes and before bonus = $40 million + Bonus = $41,000,000.

B. Bonus is 5 percent of net income, and is $700,000.Hence, net income on which bonus was based = $700,000/0.05 = $14,000,000.Since bonus begins only after net income exceeds $4 million, net income = $18 million.

If income before tax (but after bonus) is Y, then income after tax = (1 – 0.4)Y = 0.6Y.We know income after tax is $18 million, so Y = $18 million/0.6 = $30 million

Income before taxes and before bonus = $30,700,000.

Homework Problem 1Graham Company

Employees at Graham Company work eight-hour days and earn vacation days (vested) and sick days (vested) each year. Relevant data about the years 2002 and 2003 are given below:

2002 2003Average hourly wage $10 $12Total vacation days earned 250 300Total vacation days used 225 250Total sick days earned 150 180Total sick days used 120 160Prepare relevant journal entries for 2002 and 2003.

Solution to Homework Problem 2, Graham Company

1. To record sick and vacation days earned in 2002.Debit Credit

Wages expense $32,000 Vacation Pay Payable $20,000 Sick Pay Payable 12,000

2. To record sick and vacation days taken in 2002.Debit Credit

Vacation Pay Payable $ 18,000 Sick Pay Payable 9,600 Cash $ 27,600

3. To record sick and vacation days earned in 2003.Debit Credit

Wages expense $ 46,080 Vacation Pay Payable $ 28,800 Sick Pay Payable 17,280

4. To record sick and vacation days taken in 2003.Total credit to cash = (250 days x 8 hours x $12) + (160 days x 8 hours x $12)

= $39,360

Total reduction (debit) from Vacation Pay Payable account:= (25 days x 8 hours x $10) + (225 days x 8 hours x $12) = $2,000 + $21,600= $23,600

Total reduction (debit) from Sick Pay Payable account:= (30 days x 8 hours x $10) + (130 days x 8 hours x $12) = $2,400 + $12,480= $14,880

Extra debit to wages expense because of higher cost in 2003:= (25 + 30) days x 8 hours x ($12 – $10) per hour = $880

Debit CreditVacation Pay Payable $ 23,600 Sick Pay Payable 14,880Wages expense 880 Cash $ 39,360

Homework Problem 2Corner Coffee

Corner Coffee sells its gourmet five-pound coffee bags for $20 each. Corner Coffee had a promotion that began on October 1, 2002 and ended on March 1, 2003. If customers return two labels from its five-pound bags along with $3.00, they will receive a special cup. Corner Coffee purchased the cups at $5.00 each, and expects the redemption rate of the labels to be 80%. The number of five-pound bags sold, cups purchased, and labels received are given below:

October 1 to December 31, 2002

January 1 to March 1, 2003

Five-pound bags sold 2,000 1,500Cups purchased 800 600Labels received 1,200 1,400Kwik Clean has a December 31 fiscal year-end. Any vases remaining as of April 1, 2003 were kept for possible future use. Prepare the necessary journal entries.

Solution to Homework Problem 2, Corner Coffee

1. Sale of 2,000 five-pound bags in period ending December 31, 2002. Debit Credit


2. Purchase of 800 cups @ $5 each in period ending December 31, 2002.Debit Credit


3. Redemption of 1,200 labels (600 cups) in period ending December 31, 2002.Debit Credit

Cash $ 1,800Premium Expense 1,200 Premium Inventory $ 3,000

4. To record estimated liability at December 31, 2002 (fiscal year-end).Labels from current period expected to be redeemed in future = 400 (1,600 – 1,200).At $2 extra cost per cup, cost of 200 cups = $400.


5. Sale of 1,500 five-pound bags in period from January 1, 2003 to March 1, 2003. Debit Credit


6. Purchase of 600 cups @ $5 each in period from January 1, 2003 to March 1, 2003.Debit Credit


7. Receipt of 1,400 labels in period from January 1, 2003 to March 1, 2003.Debit Credit

Cash (step 1) $ 1,400Estimated Liability for Premiums (step 3) 400Premium Expense (step 4) 1,700 Premium Inventory (step 2) $ 3,500

Homework Problem 3King Company

King Company had operating income before bonus and income tax of $500,000 for the year ending December 31, 2002. The tax rate for the Company was 40 percent, and the bonus rate is 10 percent. What is the amount of the bonus, if the bonus is based on income(A) before tax and before bonus.(B) before tax and after bonus.(C) after tax and after bonus.(Round the answer to the nearest dollar.)

Solution to Homework Problem 3, King Company

In the calculations, the following notation will be used: B = Bonus; T = Tax expense.

A. Bonus based on income before tax and before bonusBonus = $500,000 x 0.10 = $50,000

B. Bonus based on income before tax and after bonusB = 0.10 ($500,000 – B) = $50,000 – 0.1B Hence, 1.1B = $50,000So Bonus = $45,455

C. Bonus based on income after tax and after bonusB = 0.10 ($500,000 – B – T)However, taxes are given to be 40 percent, and bonus is deducted before calculating income taxes.T = 0.40 ($500,000 – B) = $200,000 – 0.4BPlugging this value of T in the equation in the first line, we getB = 0.10 ($500,000 – B – [$200,000 – 0.4B]), orB = 0.10 ($300,000 – 0.6B) = $30,000 – 0.06BThus, 1.06B = $30,000, or Bonus = $28,302

Documents

Financial Accounting Module 12