E13-13 (Contingencies) Presented below are threeindependent situations. Answer the question atthe end of each situation.
1. During 2010, Maverick Inc. became involved in a tax dispute withthe IRS. Maverick’s attorneys
have indicated that they believe it is probable that Maverick willlose this dispute. They
also believe that Maverick will have to pay the IRS between$800,000 and $1,400,000. After
the 2010 financial statements were issued, the case was settledwith the IRS for $1,200,000.
What amount, if any, should be reported as a liability for thiscontingency as of December 31,
2010?
2. On October 1, 2010, Holmgren Chemical was identified as apotentially responsible party by the
Environmental Protection Agency. Holmgren’s management along withits counsel have concluded
that it is probable that Holmgren will be responsible for damages,and a reasonable estimate of
these damages is $6,000,000. Holmgren’s insurance policy of$9,000,000 has a deductible clause
of $500,000. How should Holmgren Chemical report this informationin its financial statements at
December 31, 2010?
3. Shinobi Inc. had a manufacturing plant in Darfur, which wasdestroyed in the civil war. It is not
certain who will compensate Shinobi for this destruction, butShinobi has been assured by governmental officials that itwill receive a definite amount for this plant. The amount of thecompensation will be less than the fair value of the plant,but more than its book value. How should the
contingency be reported in the financial statements of ShinobiInc.?
P13-9 (Premium Entries and Financial StatementPresentation) Sycamore Candy Company offers a CDsingle as a premium for every five candy bar wrappers presented bycustomers together with $2.50. The candy bars are sold by thecompany to distributors for 30 cents each. The purchase priceof each CD to the company is $2.25; in addition it costs 50cents to mail each CD. The results of the premium plan for theyears 2010 and 2011 are as follows. (All purchases and sales arefor cash.)
2010 2011
CDs purchased 250,000 330,000
Candy bars sold 2,895,400 2,743,600
Wrappers redeemed 1,200,000 1,500,000
2010 wrappers expected to be redeemed in 2011 290,000
2011 wrappers expected to be redeemed in 2012 350,000
Instructions
(a) Prepare the journal entries that should be made in 2010 and2011 to record the transactions related
to the premium plan of the Sycamore Candy Company.
(b) Indicate the account names, amounts, and classifications of theitems related to the premium plan
that would appear on the balance sheet and the income statement atthe end of 2010 and 2011.
*E14-21 (Term Modification without Gain—Debtor’s Entries)On December 31, 2010, the American Bank enters into adebt restructuring agreement with Barkley Company, which is nowexperiencing financial trouble. The bank agrees to restructurea 12%, issued at par, $3,000,000 note receivable bythe following modifications:
1. Reducing the principal obligation from $3,000,000 to$2,400,000.
2. Extending the maturity date from December 31, 2010, to January1, 2014.
3. Reducing the interest rate from 12% to 10%.
Barkley pays interest at the end of each year. On January 1, 2014,Barkley Company pays $2,400,000 in cash to Firstar Bank.
Instructions
(a) Will the gain recorded by Barkley be equal to the loss recordedby American Bank under the debt
restructuring?
(b) Can Barkley Company record a gain under the term modificationmentioned above? Explain.
(c) Assuming that the interest rate Barkley should use to computeinterest expense in future periods
is 1.4276%, prepare the interest payment schedule of the note forBarkley Company after the debt
restructuring.
(d) Prepare the interest payment entry for Barkley Company onDecember 31, 2012.
(e) What entry should Barkley make on January 1, 2014?
E21-7 (Lessee-Lessor Entries, Sales-Type Lease) On January1, 2011, Palmer Company leased equipment to WoodsCorporation. The following information pertains to this lease.
1. The term of the noncancelable lease is 6 years, with no renewaloption. The equipment reverts to
the lessor at the termination of the lease.
2. Equal rental payments are due on January 1 of each year,beginning in 2011.
3. The fair value of the equipment on January 1, 2011, is $200,000,and its cost is $150,000.
4. The equipment has an economic life of 8 years, with anunguaranteed residual value of $10,000.
Woods depreciates all of its equipment on a straight-linebasis.
5. Palmer sets the annual rental to ensure an 11% rate of return.Woods’s incremental borrowing rate
is 12%, and the implicit rate of the lessor is unknown.
6. Collectibility of lease payments is reasonably predictable, andno important uncertainties surround
the amount of costs yet to be incurred by the lessor.
Instructions
(Both the lessor and the lessee’s accounting period ends onDecember 31.)
(a) Discuss the nature of this lease to Palmer and Woods.
(b) Calculate the amount of the annual rental payment.
(c) Prepare all the necessary journal entries for Woods for2011.
(d) Prepare all the necessary journal entries for Palmer for2011.
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