Before adjustments and closing on December 31, 2011, the current accounts of Seymour and Associates indicated the following balances:
The terms of an outstanding long-term note payable state that Seymour must maintain a current ratio of 2:1 or the note will become due immediately. The following items are not reflected in the balances above:
1. Bad debt losses in the amount of 6 percent of the outstanding accounts receivable balance are expected.
2. The warranty liability on outstanding warranties is estimated to be $12,000.
3. Forty percent of the unearned revenue had been earned as of December 31.
4. Five thousand dollars, listed above under “other current liabilities,” is part of a line of credit and is expected to be immediately refinanced on a long-term basis when due.
5. The total income tax liability for 2011 was estimated at year-end to be $23,000. Estimated tax payments during the year totaled $20,000.
6. Trademans, Inc. brought suit against Seymour early in 2011. As of December 31, Seymour’s legal counsel estimates that there is a 60 percent probability that the suit will be lost in the amount of $10,000. If the suit is lost, payment will most likely be due in the next year.
a. Prepare the journal entries that would be recorded (if necessary) for each of the six items listed.
b. After preparing the journal entries, compute the company’s current ratio, assuming that the contingent liability described in (6) is not accrued.
c. After preparing the journal entries, compute the company’s current ratio, assuming that the contingent liability described in (6) is accrued.
d. If you were Seymour’s auditor, would you require that the contingent liability be accrued? Discuss.
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