Financial Accounting Exam 4

What is the fundamental definition of a liability?

An obligation of a company to transfer some economic benefit in the future.

Besides cash, what might a company be obligated to transfer to settle a liability like deferred revenue?

Inventory or services to customers.

Under the general rule, liabilities due within _____ from the balance sheet date are classified as current liabilities.

one year

Liabilities due in more than one year from the balance sheet date are classified as _____ liabilities.

long-term

What is an operating cycle in accounting?

The length of time from spending cash to provide goods and services until collecting cash from that customer.

If a company's operating cycle is longer than one year, how is the classification of current liabilities affected?

Current liabilities are defined by the operating cycle's length rather than by one year.

A winery has a 15-month operating cycle. A liability due in 14 months would be classified as a _____ liability.

current

What is the formula for calculating interest on a note payable?

Interest = Face value × Annual interest rate × Fraction of the year.

What is the journal entry to record the issuance of a $100,000 note payable in exchange for cash?

Debit Cash for $100,000 and credit Notes Payable for $100,000.

According to the key accounting principle for interest, we record interest expense in the period in which we _____ it.

incur

A company signs a note on Sep 1, 2027, and its fiscal year ends on Dec 31. How many months of interest must be accrued at year-end?

Four months (September, October, November, December).

What adjusting journal entry is made at year-end to record interest that has been incurred but not yet paid?

Debit Interest Expense and credit Interest Payable.

On Oct 1, a company signs a $10,000, 5%, 6-month note. How much interest expense is recorded by Dec 31?

The interest is $125 ($10,000 × 5% × 3/12).

When repaying a note that had interest previously accrued, what two liability accounts are typically debited?

Notes Payable (for the face value) and Interest Payable (for the accrued portion).

What is a line of credit?

A prearranged borrowing limit that a company can draw from, with interest only charged on the funds accessed.

What is commercial paper?

A form of short-term borrowing from another company, typically with maturities from 30 to 270 days.

Amounts owed to suppliers of merchandise or services are recorded in an account called _____.

Accounts Payable (or Trade Accounts Payable)

What are FICA taxes?

Taxes for Social Security and Medicare contributions, paid by both employees and employers.

Name two types of taxes that are typically paid only by the employer, not the employee.

Federal and state unemployment taxes (FUTA and SUTA).

The FICA tax rate is composed of a 6.2% Social Security tax and a 1.45% _____ tax.

Medicare

A common mistake is thinking that FICA taxes are paid only by the employee. In reality, the employer is required to _____ the amount withheld.

match

When recording employee salaries, what account is debited for the total payroll amount?

Salaries Expense.

Amounts withheld from employee paychecks for taxes are credited to _____ accounts.

payable (e.g., Employee Income Tax Payable, FICA Tax Payable)

What is the net pay for an employee with a gross salary of $100,000, income tax withholding of $24,000, and FICA tax of $7,650?

The net pay is $68,350 ($100,000 - $24,000 - $7,650).

What are fringe benefits in the context of payroll?

Additional employee benefits paid for by the employer, such as health insurance or retirement plan contributions.

When an employer pays for fringe benefits like health insurance, what account is debited?

Salaries Expense.

The employer's matching FICA taxes and unemployment taxes are recorded as a debit to what account?

Payroll Tax Expense.

A company receives cash from a customer in advance for services to be provided later. This transaction creates a liability called _____.

Deferred Revenue

What type of account is Deferred Revenue?

It is a liability account, not a revenue account.

When a customer uses a $100 gift card to purchase $15 of merchandise, what is the journal entry for the seller?

Debit Deferred Revenue for $15 and credit Sales Revenue for $15.

Sales tax collected by a seller from customers represents a _____ payable to the government.

current liability

Are sales taxes collected from customers considered an expense for the seller?

No, they are a liability owed to the government.

A restaurant sells a meal for $15 plus 10% sales tax. What amount is credited to the Sales Tax Payable account?

$1.50 ($15 × 10%).

What is the current portion of long-term debt?

The amount of long-term debt that will be paid within one year from the balance sheet date.

What is the journal entry to reclassify $200,000 of long-term debt as current?

Debit Notes Payable (long-term) for $200,000 and credit Notes Payable (short-term) for $200,000.

What is a contingent liability?

An existing uncertain situation that might result in a loss.

What are the two criteria used to determine the accounting treatment for a contingent liability?

The likelihood of payment and the ability to reasonably estimate the amount of payment.

The three levels of likelihood for a contingent liability are probable, reasonably possible, and _____.

remote

Under what two conditions must a contingent liability be recorded on the balance sheet?

When the loss is both probable and the amount is reasonably estimable.

What is the accounting treatment for a contingent liability that is reasonably possible but not probable?

It should be disclosed in the financial statement notes but not recorded as a liability.

When a contingent liability is recorded, a loss is debited and a _____ is credited.

Contingent Liability

Product warranties are a common example of a _____.

contingent liability

When a company estimates its future warranty costs at the end of a period, what journal entry does it make?

Debit Warranty Expense and credit Warranty Liability.

When a customer makes a warranty claim and the company pays for the repair, what account is debited?

Warranty Liability.

True or False: The balance in the Warranty Liability account is always equal to the Warranty Expense for the period.

False; the liability is increased by the expense estimate and decreased by actual repairs.

An existing uncertain situation that might result in a gain is called a _____.

contingent gain

When are contingent gains recorded in the financial statements?

They are not recorded until the gain is known with certainty and is no longer a contingency.

What does the term 'liquidity' refer to in financial analysis?

Having sufficient cash or other current assets to pay currently maturing debts.

What is the formula for calculating working capital?

Working capital = Current assets − Current liabilities.

The measure of current assets remaining after paying current liabilities is called _____.

working capital

What is the formula for the current ratio?

Current Ratio = Current assets ÷ Current liabilities.

What does a current ratio of 1.5 signify?

The company has $1.50 of current assets for every $1.00 of current liabilities.

What is the formula for the acid-test ratio (or quick ratio)?

Acid-test ratio = (Cash + Current investments + Accounts receivable) ÷ Current liabilities.

What are the three components of 'quick assets' used in the acid-test ratio?

Cash, current investments, and accounts receivable.

Which two common current assets are excluded from the calculation of quick assets?

Inventory and prepaid expenses (like prepaid rent).

Generally, a higher current ratio is considered better, but what could be a negative signal associated with a very high ratio?

The company may be having difficulty collecting receivables or may be holding excessive inventory.

How can management increase the current ratio if it is currently above 1.0 (e.g., 1.25)?

By delaying the receipt of inventory on credit until the next period, which lowers both current assets and current liabilities.

How can management increase the current ratio if it is currently below 1.0 (e.g., 0.75)?

By making additional purchases of inventory on credit, which increases both current assets and current liabilities.

What are the two primary sources of funds a company relies upon for growth?

Internal financing (profits) and external financing (funds from outside the company).

What are the two main types of external financing?

Debt financing (borrowing from creditors) and equity financing (obtaining investment from stockholders).

A company's _____ is the mixture of liabilities and stockholders' equity it uses to finance its operations.

capital structure

What is the cost of financing associated with debt?

Interest expense.

What is the cost of financing associated with equity?

Dividends.

What is the key tax advantage of debt financing over equity financing?

The interest expense paid on debt is tax-deductible, whereas dividends paid to stockholders are not.

What are the two components included in each installment payment on a loan?

An amount representing interest expense and an amount representing a reduction of the outstanding loan balance.

In an amortization schedule for an installment note, how is the interest expense for a period calculated?

By multiplying the prior period's carrying value by the periodic interest rate.

How do you calculate the portion of an installment payment that reduces the principal (decrease in carrying value)?

Subtract the interest expense for the period from the total cash payment.

What is the journal entry to record the issuance of a $25,000 installment note payable in exchange for cash?

Debit Cash for $25,000 and credit Notes Payable for $25,000.

A company makes the first payment on an installment note. What three accounts are typically affected in the journal entry?

Interest Expense (debit), Notes Payable (debit), and Cash (credit).

For the first monthly payment on a $24,000, 5% installment loan, how is the interest expense calculated?

The interest is $100, calculated as $24,000 \times 5\% \times (1/12)$.

What is a lease?

A contractual arrangement where a lessor (owner) provides a lessee (user) the right to use an asset for a specified period.

At the beginning of a lease term, how does the lessee record the transaction?

The lessee debits a Lease Asset and credits a Lease Payable for the present value of the lease payments.

What is one primary advantage of leasing an asset rather than purchasing it?

Leasing reduces the upfront cash needed to use an asset.

List two other advantages of leasing besides reducing upfront cash needed.

Flexibility in asset disposal, lower payments than installments, and protection against declining asset values.

The _____ of a lease gives the lessee the right to use an asset, and the _____ represents the obligation to make payments.

Lease Asset; Lease Payable

What is a bond?

A formal debt instrument issued by a company to borrow money from investors.

What two things does a company that issues a bond promise to pay back to the investor?

The principal (or face amount) at a specified maturity date, and periodic interest payments over the life of the bond.

How frequently is interest on bonds traditionally paid?

Twice a year (semiannually).

How is the cash interest payment for a bond calculated for each period?

By multiplying the face amount of the bond by the stated interest rate for the period (e.g., annual rate \times 1/2 for semiannual).

What is the journal entry for issuing a $100,000 bond at its face amount?

Debit Cash for $100,000 and credit Bonds Payable for $100,000.

What is the journal entry to record a semiannual interest payment on a $100,000, 7% bond issued at face amount?

Debit Interest Expense for $3,500 and credit Cash for $3,500.

What is the journal entry to retire a $100,000 bond at its maturity date?

Debit Bonds Payable for $100,000 and credit Cash for $100,000.

A _____ bond is backed by collateral, whereas an _____ bond is not.

secured; unsecured

What is the difference between a term bond and a serial bond?

A term bond issue matures on a single date, while a serial bond issue matures in installments over a series of years.

What feature allows an issuing company to pay off bonds before their maturity date?

A callable feature.

What is a convertible bond?

A bond that allows the investor to convert it into the issuing company's common stock.

Which ratio measures financial risk by comparing total liabilities to stockholders' equity?

The debt to equity ratio.

What is the formula for the debt to equity ratio?

Debt to equity ratio = Total Liabilities / Stockholders' Equity.

A higher debt to equity ratio generally indicates a higher risk of what?

Bankruptcy.

What does the times interest earned ratio measure?

A company's ability to meet its interest payments as they become due.

What is the formula for the times interest earned ratio?

Times interest earned = (Net Income + Interest Expense + Tax Expense) / Interest Expense.

A _____ times interest earned ratio indicates a greater ability of a company to meet its interest obligations.

higher

Under what condition are bonds issued at a discount?

When the market interest rate is higher than the bond's stated interest rate.

Under what condition are bonds issued at a premium?

When the market interest rate is lower than the bond's stated interest rate.

Under what condition are bonds issued at face amount?

When the market interest rate is equal to the bond's stated interest rate.

When a bond is issued at a discount, how is its carrying value presented on the balance sheet?

As Bonds Payable less the Discount on Bonds Payable.

When a bond is issued at a premium, how is its carrying value presented on the balance sheet?

As Bonds Payable plus the Premium on Bonds Payable.

Using the effective-interest method, how is interest expense calculated for a bond?

By multiplying the carrying value of the bond by the market interest rate per period.

What is the difference between the interest expense and the cash paid for interest on a discount bond?

The difference represents the amortization (reduction) of the bond discount for the period.

For a bond issued at a discount, what is the effect of amortization on the carrying value over time?

The carrying value increases over time until it reaches the face amount at maturity.