anthonyIM_03

CHAPTER 3 BASIC ACCOUNTING CONCEPTS: THE INCOME STATEMENT Changes from Eleventh Edition The chapter has been updated. The principal addition is a discussion of the Sarbanes-Oxley Act’s CEO and CFO certification requirements. Additional topics include proforma earnings, EBITDA and SEC financial report certification and affirmation requirements. Approach Undoubtedly, the accrual idea is the most difficult of all basic accounting matters for the student to grasp. As a matter of fact, we sometimes say that the proper recognition of revenue and expense is the only important accounting problem. Although this is an exaggeration, it is not far from the truth. The text and cases in this chapter constitute only a beginning in understanding and it is to be expected that students will understand the matter thoroughly only after they have attacked it from several different angles. Sometimes we ask the class “Suppose a company received a lawyer’s bill for $1,000. Explain all the different ways in which this bill could be recorded in the accounts.” The answer is that if the bill relates to services rendered in a prior year (or accounting period) but not recorded in that time, it is nevertheless an expense of the current year; if it represents a charge for a previous year that was recorded in that year, the payment of the bill merely represents a decrease in a liability; if it represents a charge in the current year, it is recorded as an expense; and if it represents a retainer for services to be rendered in the following year it is recorded as an asset, prepaid expense. It may be desirable to introduce a number of short questions of this type in order to hammer home the accrual concept. It is suggested, however, that problems relating to depreciation be deferred, as this is an intricate matter which is perhaps best left until Chapter 7. Students should always be required to use the word “revenue” rather than the word “income.” They may find it difficult to do this because “income” is still used erroneously in some published statements and in tax forms. Some students confuse the special meaning of “consistency” in accounting with the general meaning of this term. In accounting, “consistency” means only that the same practice is followed this year as was followed last year. It does not mean that, for example, the treatment of inventories is consistent with the treatment of fixed assets. Cases

Maynard Company (B) is a straightforward problem, although students may have some difficulty in deducing how the amounts are to be transformed from the cash basis to the accrual basis.

Lone Pine Cafe (B) requires an income statement of the same company whose balance sheet was prepared in Chapter 2; it is fairly straightforward. Dispensers of California introduces the entire accounting cycle, with some judgmental issues.

1

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Pinetree Motel provides practice in applying the accrual concept. National Association of Accountants provides the opportunity to explore income concepts in the setting of a nonprofit organization.

Problems Problem 3-1 Not an expense for June - not incurred. Expense for June Expense for June Expense for June Expense for June Not an expense for June - asset acquired. Problem 3-2 Revenues

$275,000

a. Expenses –

Cost of goods sold.................................................................................................................................... $164,000 Rent.......................................................................................................................................................... 3,300 Salaries..................................................................................................................................................... 27,400 Taxes........................................................................................................................................................ 1,375 Other......................................................................................................................................................... 50,240 246,315

Net income $28,685 Problem 3-3

Beginning inventory........................................................................................................................................................................ $27,000 Purchases........................................................................................................................................................................................ 78,000 Available for sale............................................................................................................................................................................. Ending inventory............................................................................................................................................................................. ($31,000) Cost of goods sold........................................................................................................................................................................... $74,000 Problem 3-4 a. (1)

Sales............................................................................................................................................................................... $85,000 Cost of goods sold.......................................................................................................................................................... 45,000 Gross margin................................................................................................................................................................... $40,000

2

©2007 McGraw-Hill/Irwin

Chapter 3

(2) 47 percent gross margin ($40,000 / $85,000) (3) 11 percent profit margin (9000/85000) The Woden Corporation had a tax rate of 40 percent ($6,000 / $15,000) on its pretax profit that represented 17.7 percent of its sales ($15,000 / $85,000). The company’s operating expenses were 82.3 percent of sales ($70,000 / $85,000) and its cost of goods sold was 53 percent of sales. The company’s gross margin was 47 percent of sales ($40,000 / $85,000). Problem 3-5 Depreciation. Each year for the next 5 years depreciation will be charged to income. No income statement charge. Land is not depreciated. Cost of goods sold. $3,500 charged to current year’s income. $3,500 charged to next year’s income. Subscription expense. $36 charged to current year. $36 charged to next year. Alternatively, $72 charged to current year on grounds $72 is immaterial. Problem 3-6 Asset value: October 1, 20X5 December 31, 20X5 December 31, 20X6 December 31, 20X7

$30,000 26,250 11,250 0

Expenses: 20X5 $3,750 ($1,250 x 3 months) 20X6 $15,000 ($1,250 x 12 months) 20X7 $11,250 ($1,250 x 9 months) One month’s insurance charge is $1,250 ($30, 000 / 24 months)

3

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Problem 3-7

QED ELECTRONICS COMPANY Income Statement for the month of April, ----. Sales......................................................................................................................................................... $33,400 Expenses: Bad debts............................................................................................................................................. $ 645 Parts..................................................................................................................................................... 3,700 Interest................................................................................................................................................. 880 Wages.................................................................................................................................................. 10,000 Utilities................................................................................................................................................ 800 Depreciation........................................................................................................................................ 2,700 Selling.................................................................................................................................................. 1,900 Administrative..................................................................................................................................... 4,700 ______ 25,325 Profit before taxes.................................................................................................................................... 8,075 Provision for taxes.................................................................................................................................... 2,800. Net income $5,275 Truck purchase has no income statement effect. It is an asset. Sales are recorded as earned, not when cash is received. Bad debt provision of 5 percent related to sales on credit ($33,400 - $20,500) must be recognized. Wages expense is recognized as incurred, not when paid. March’s utility bill is an expense of March when the obligation was incurred. Income tax provision relates to pretax income. Must be matched with related income. Problem 3-8

First calculate sales: Sales ($45,000 / (1 - .45))................................................................................................................................................................ $81,818+ Beginning inventory........................................................................................................................................................................ $35,000 Purchases........................................................................................................................................................................................ $40,000 Total available................................................................................................................................................................................. 75,000 Ending inventory............................................................................................................................................................................. 30,000 Cost of goods sold........................................................................................................................................................................... $45,000 Gross margin................................................................................................................................................................................... $36,818 If the gross margin percentage is 45 percent, the cost of goods sold percentage must be 55 percent. Once sales are determined, calculate net income: Net income ($81,818 x .1) $8,182

4

©2007 McGraw-Hill/Irwin

Chapter 3

Next, prepare balance sheet:

Assets Liabilities Current assets ($50,000 x 1.6)................................................................................................................................................................... $ 80,000 Current liabilities................................................................................ $ 50,000 Other assets Long term debt 40,000 ($218,182 - $50,000).......................................................................................................................................................... 138,182 Total liabilities.................................................................................... $ 90,000

Owners’ equity Beginning balance............................................................................... $120,000 Plus net income................................................................................... 8,182 Ending balance.................................................................................... $128,182 Total liabilities Total assets............................................................................................................................................................ $218,182+ and owners’ equity.............................................................................. $218,182 +

Total assets = Total liabilities and Owner’s equity.

Problem 3-9 Sales LC 26,666,667 [LC 20,000,000 x (200 / 150)] January cash LC 1,000,000 [LC 500,000 x (200 / 100)] December cash LC 600,000 At year-end the company was more liquid in terms of nominal currency (LC 600,000 versus LC 500,000) but in terms of the purchasing power of its cash it was worse off (LC 1,000,000 versus LC 600,000).

Cases

Case 3- 1: Maynard Company (B) Note: This case is unchanged from the Eleventh Edition. Question 1

See below.

Question 2 This question brings out the difference between cash accounting and accrual accounting. Cash increased by $31,677 whereas net income was $19,635. Explaining the exact difference may be too difficult at this stage, but students should see that: 1. The bank loan, a financing transaction, increased cash by $20,865 but did not affect net income. Cash collected on credit sales made last period ($21,798) also increased cash, but did not affect net income this period. (The same is true of the collection of the $11,700 note receivable from Diane Maynard, but it was offset by the payments of the $11,700 dividend to Diane Maynard, the sole shareholder.)

5

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

2.

MAYNARD COMPANY INCOME STATEMENT, JUNE Sales ($44,420 cash sales + $26,505 credit sales)........................................................................................................................... $70,925 Less: Cost of sales *................................................................................................................................................................. 39,345 Gross Margin................................................................................................................................................................................... 31,580 Expenses Wages($5,660+$2,202-$1,974)................................................................................................................................................. $5,888 Utilities..................................................................................................................................................................................... 900 Supplies ($5,559+$1,671-$6,630)............................................................................................................................................. 600 Insurance($3,150-$2,826)......................................................................................................................................................... 324 Depreciation ($157,950-$156,000)+($5,928-$5,304).............................................................................................................. 2,574 Miscellaneous........................................................................................................................................................................... 135 10,421 Income before income tax............................................................................................................................................................... 21,159 Income tax expense ($7,224 - $5,700)...................................................................................................................................... 1,524 Net Income...................................................................................................................................................................................... 19,635 Less: Dividends........................................................................................................................................................................ 11,700 Increase in retained earnings........................................................................................................................................................... $ 7,935

*Cost of sales: Merchandise purchased for cash............................................................................................................................................... $14,715 Merchandise purchased on credit.............................................................................................................................................. 21,315 [$21,315+($8,517-$8,517)] Inventory, June 1....................................................................................................................................................................... 29,835 Total goods available during June...................................................................................................................................... 65,865 Inventory, June 30..................................................................................................................................................................... 26,520 Cost of Sales....................................................................................................................................................................... $39,345 3. The purchase of equipment ($23,400) and other assets ($408) decreased cash but did not affect net income (at least not by this full amount) this period. 4. Credit sales made this period ($26,505) increased net income, but did not affect cash. 5. Noncash expenses such as depreciation ($2,574) and insurance ($324) decreased net income but did not affect cash as they relate largely, if not wholly, to cash outflows made for asset acquisition in prior periods. (Exception: such expenses on an entity’s first income statement are not related to prior period expenditures but they will be a much smaller amount than the first accounting period’s expenditures. Question 3 (a) $14,715 is incorrect because it is the amount of cash purchases rather than the cost of sales. The cost of cash purchases and cost of sales amounts would be equal for a period in which all purchases were for cash, and in which the dollar amount of beginning inventory was the same as the dollar amount of ending inventory, since Cost of Sales = Beginning Inventory + Purchases Ending Inventory. (b) $36,030 is the sum of cash purchases ($14,715) and credit purchases ($21,315). As explained above, purchases equal cost of sales for the period only if beginning and ending inventory amounts are the same.

6

©2007 McGraw-Hill/Irwin

Chapter 3

Case 3-2: Lone Pine Café (B) Note: This case is updated from the Eleventh Edition. Approach This case introduces students to preparation of an income statement based on analyzing transactions. At this stage, students are not expected to set up accounts in the formal sense. However, in effect they do so for those income statement items that did not coincide exactly with cash flows. Question 1 A suggested income statement as required by Question 1 is shown below. The following notes apply to the income statement. 1. The student needs to refer back to Lone Pine Café (A) in order to construct the income statement on the accrual basis. Amounts for sales on credit, purchases on credit, beginning and ending inventory, beginning and ending prepaid operating license, and depreciation expense are to be found there. Specifically: a. Sales revenues = $43,480 cash sales + $870 credit sales to ski instructors = $44,350. b. Food and beverage expense = $2,800 beginning inventory + $10,016 cash purchases + $1,583 credit purchases - $2,430 ending inventory = $11,969. 2. Since the entity is unincorporated, it is also correct (though less meaningful for evaluative purposes) to treat the $23,150 partners’ salaries as owners’ drawings. This treatment would result in an income of $12,296 and a decrease in equity (after drawings) of $10,854.

LONE PINE CAFE (B) INCOME STATEMENT FOR NOVEMBER 2, 2005, THROUGH MARCH 30, 2006 Sales......................................................................................................................................................... $ 44,350 Expenses: Salaries to partners............................................................................................................................... $23,150 Part-time employee wages................................................................................................................... 5,480 Food and beverage supplies................................................................................................................. l1,969 Telephone and electricity..................................................................................................................... 3,270 Rent expense........................................................................................................................................ 7,500 Depreciation........................................................................................................................................ 2,445 Operating license expense................................................................................................................... 595 Interest................................................................................................................................................. 540 Miscellaneous expenses....................................................................................................................... 255 Total expenses.......................................................................................................................................... 55,204 (Loss)........................................................................................................................................................ $(10,854)

7

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Question 2 The income statement tells Mrs. Antoine that the partnership has suffered a $10,854 loss for the first five months of operation. This $10,854 loss is the correct figure for evaluative purposes, not the $12,296 income before partners’ salaries. This assumes, of course, that nonowner salaries for the cook and table servers would also have been $23,150, which is questionable. It would appear that Lone Pine Cafe cannot support three partners, even at a bare level of sustenance ($23,150 was only an average of $1,543 per partner/employee per month). Of course the three owner/employees did receive room and board, for which no value has been imputed here. Case 3-3: Dispensers of California, Inc. Note: This is a new case for the Twelfth Edition. Approach The case can be used for two class sessions. The first day is devoted to analyzing the accounting transactions, including a preliminary discussion of Hynes’ accounting policy decisions. The second class deals with preparing the financial statements and an analysis of how they may change if alternative accounting procedures had been adopted by Hynes. The first class should start with the case Question 1. Its purpose is to give the students a sense of the managerial purpose of profit plans and a context for the later accounting discussions. The use of the asset equals liability plus equity structure to answer Question 2 is recommended so that the instructor can 1) highlight the retained earnings link between net income and the balance sheet 2) illustrate how any accounting transaction can be analyzed using the basic accounting equation and 3) to lay the foundation for the debit-credit framework material in Chapter 4. (At this point in the course debit and credit terminology and analysis should not be used.) Questions 3 and 4 require the preparation of an income statement and balance sheet, respectively. Some instructors prefer to end the first class with a discussion of the balance sheet, including a completed balance sheet. Typically, these instructors want to leave time in the second class to discuss the relationship between net income and the change in cash on the balance sheet. Question 5 is designed to illustrate the role of judgment in accounting for transactions. Answers to Questions Question 1 Profit plans are used for a variety of purposes. These include:       

To force short range planning As a basis for evaluating performance and determining compensation. To encourage coordination and communication between different organization units and levels. As a challenge to improve performance. As a means for training managers As an early warning system and As a guide to spending.

8

©2007 McGraw-Hill/Irwin

Chapter 3

Question 2 TN-Exhibit 1 presents an analysis of the planned transactions using the basic accounting equation framework. This analysis follows Hynes’ accounting policy. Question 3 TN-Exhibit 2 presents Hynes’ profit plan using the Question 1 transaction analysis. The instructor should expect that most students will not calculate the cost of goods sold figure correctly. The instructor will have to explain that the components of the cost of manufactured goods includes direct materials and their conversion costs, including manufacturing equipment depreciation. The distinction between operating and finance costs in the income statement is another accounting practice most students will miss. Again, the instructor will have to explain this format and its rationale, which is to permit statement users to evaluate how well management has operated the company before considering the impact of their financing decisions. Question 4 TN-Exhibit 3 presents the year-end balance sheet using the Question 1 transaction analysis. Equipment is reported net. Most students will follow this presentation. A better presentation is: Equipment (cost) $85,000 Accumulated depreciation (8,500) Equipment (net) $76,500 The patent is reported net. This is the correct presentation for intangible assets. TN-Exhibit 4 presents a reconciliation of beginning (zero) and ending ($47,500) retained earnings. The instructor may want to share this exhibit with the students. It links the income statement to the balance sheet. It also illustrates that dividends are distributions of capital and not an expense. The instructor should point out to students that many intra period transactions, such as the borrowing and repaying of the bank loan, do not appear on the end of the period balance sheet. Question 5 There are three accounting decisions that require Hynes to exercise judgment. They are:   

Patent valuation Patent amortization period Equipment depreciation period

Students might believe Hynes must exercise judgment in the accounting for the redesign and incorporation costs. Under current GAAP this is not the case. Redesign and organization costs must be expensed as incurred.

9

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

The patent can not be valued directly. There is no current liquid market for this type of patent. Hynes must value it indirectly. He chose to use the value of the company’s equity he received based on the cash paid by the investors for their equity interest to value the patent. This is an acceptable approach. Hopefully, the patent amoralization and depreciation periods represent Hynes’ best estimate of the related assets’ useful life (useful to Dispensers of California.) Students should be asked what would be the impact on the balance sheet and income statement if different lives had been used. So that students do not get the impression that differences in judgment are driven by a desire to manage earnings, the instructor should be careful during the discussion to remind the students that different reasonable life estimates can be made by responsible managers acting in good faith. Cash Flow Analysis If the instructor wishes to incorporate some aspect of cash flows in the case discussion, TN-Exhibit 5 and 6 present two analysis of cash flows. TN-Exhibit 5 uses a cash receipts and distribution format. TNExhibit 6 uses a direct method statement of cash flows format. Instructors should not use the indirect method at this point in the course. It confuses students. Chapter 11 introduces students to indirect method statement of cash flows.

10

Exhibit 1 Dispensers of California, Inc Balance Sheet Transaction Analysis Transactions

Assets =

1a 1b 2 3

Hynes’ investment Other investors Incorporation costs Equipment purchase

4 5

Redesign costs Component parts purchase

6

Bank loan Bank loan repaid Loan interest Manufacturing payroll Other manufacturing costs Selling general and administration Ending inventory (cost of goods sold) * Sales Incorporation and redesign costs (expenses as incurred) Depreciation Patent amortization Ending work-in-progress and completed inventory (none) (cost of goods sold)** Dividends Income Taxes

7 8 9 10 11 12 13 14 15 16 17

* Beginning component parts inventory Purchases Total available Ending component parts inventory Components parts used

$0 212,100 212,100 15,100 197,000

Liabilities

+ Patent $120,000 + Cash 80,000 - Cash $2,500 -Cash $85,000 + Equipment 85,000 - Cash $25,000 + Inventory $212,100 - Cash 212,100 + Cash $30,000 - Cash 30,000 - Cash 500 - Cash $145,000 - Cash 62,000 - Cash $63,000 - Inventory $197,000 + Cash $598,500 See 2 and 4

+ Common Stock $120,000 + Common Stock 80,000 - Retained earnings $2,500 - Retained earnings $25,000 +Bank loan $30,000 - Bank loan 30, 000 - Retained earnings $500 - Retained earnings $145,000 - Retained earnings $62,000 - Retained earnings $63,000 - Retained earnings $197,000 + Retained earnings $598,500

- Equipment $8,500 - Patent $20,000 See 5, 7, 8, 10 and 13

- Retained earnings $8,500 - Retained earnings $20,000

- Cash $5,000 +Taxes payable $22,500 **Component parts used Manufacturing payroll Other manufacturing costs Depreciation Cost of goods sold

11

Equity

$197,000 145,000 62,000 8,500 412,500

- Retained earnings $5,000 - Retained earnings $22,500

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Exhibit 2 Dispensers of California, Inc. 12-month Profit Plan Sales Cost of goods sold Components Mfg payroll Other Mfg. Depreciation Gross margin Selling, general and Administration Patent Redesign costs Incorporation costs Operating profit Interest Profit before taxes Tax expense Net Income

$598,500 $197,000 145,000 62,000 8,500

412,500 $186,000 63,000 20,000 25,000 2,500 $75,500 500 $75,000 22,500 $52,500

Exhibit 3 Dispensers of California, Inc. Projected Year-end Balance Sheet

Assets Cash Components inventory Current assets Equipment (net) Patent (net)

Liabilities Taxes payable Current liabilities

$78,400 15,100 $93,500 76,500 100,000 ___ $270,000

Owner’s Equity Capital stock Retained earnings

12

$22,500 $22,500 $200,000 47,500 $270,000

©2007 McGraw-Hill/Irwin

Chapter 3

Exhibit 4 Dispensers of California, Inc. Change in Retained Earnings

Beginning retained earnings Net income Dividends Ending retained earnings

$0 52,500 (5,000) $47,500

Exhibit 5 Dispensers of California, Inc. Cash Reconciliation

New equity capital Incorporation Equipment Redesign Component parts Bank loan Bank loan Loan interest Manufacturing payroll Other manufacturing SG&A Sales Dividend Total Cash Reconciliation Receipts Disbursements Ending Balance

Receipts $80,000

Disbursements $2,500 85,000 25,000 212,100

30,000 30,000 500 145,000 62,000 63,000 598,500 5,000 $630,100

$708,500

$708,500 630,100 $78,400

13

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Exhibit 6 Dispensers of California, Inc. Statement of Cash Flows (Direct Method) Collections from customers Payments to suppliers Payments to employees Legal payments Interest Operating cash flow Equipment purchases Investing cash flow Bank loan Repayment of bank loan Capital Dividends Financing cash flow Change in cash Beginning cash Ending cash

$598,500 (212,100) (295,000) (2,500) (500) $89,400 (85,000) $(85,000) 30,000 (30,000) 80,000 (5,000) $75,000 $78,400 0 $78,400

Case 3- 4: Pinetree Motel Note: This case is updated from the Eleventh Edition. Approach This case treats the transition from cash to accrual accounting; also, the inherent difficulties in comparison of data with industry averages are illustrated. The case does not require a full 80 minutes of class time, so I use the final portion of time for review. Comments on Questions The operating statement called for in Question I is shown below. For many terms—e.g., revenues, advertising, depreciation is no difficulty in fitting Pinetree’s account names with the journal’s standard format; but for other items, there are problems: 1. The Kims’ drawings conceptually should be divided between payroll costs and administrative/general, since the Kims’ apparently perform both operating and administrative tasks. 2. Some students may treat replacement of glasses, bed linens, and towels as general expense rather than as direct operating expense (although I feel the latter is more appropriate). 3. Some students may treat payroll taxes and insurance as a general expense; nevertheless, it properly is part of payroll costs.

14

©2007 McGraw-Hill/Irwin

Chapter 3

Question 2 Based on profit as a percent of sales, Pinetree Motel is only about one-third as profitable as the survey average return on sales. The key percentage disparity is on payroll costs, which may reflect two things: (1) the Kims’ tasks could be done by two employees who would work for less than $86,100 a year (which is equivalent to saying the Kims’ drawings reflect both a fair salary and a distribution of entity profits); or (2) the survey data are dominated by motels having twice as many rooms as Pinetree Motel does, thus spreading fixed labor costs over a higher volume (e.g., a motel of 20 units and one of 40 units each needs only one desk clerk). Of course, there is probably a lot of “noise” in the survey data for payroll and administrative/general costs: owner-operators responding to the journal’s survey would encounter the same problems as a student does in answering Question 1.

PINETREE MOTEL OPERATING STATEMENT FOR 2005 (in industry trade journal format)

Dollars

Percentages *

Revenues: Room rentals ($236,758- $1,660)...................................................................................................................................... $235,098 96.8 Other revenue.................................................................................................................................................................... 7,703 3.2 Total Revenues............................................................................................................................................................ 242,801 100.0

Operating Expenses: Payroll costs ($86,100+$26,305+$2,894-$795-$84+$1,128+ $126).................................................................................................................................................................................. 115,674 47.6 Administrative and general................................................................................................................................................ — — Direct operating expense ($8,800 + $1,660 + $6,820)....................................................................................................... 17,280 7.1 Fees and commissions....................................................................................................................................................... — — Advertising and promotion($2,335 - $600 + $996)............................................................................................................ 2,731 1.1 Repairs and maintenance................................................................................................................................................... 8,980 3.7 Utilities ($12,205+$2,789+$5,611-$933-$105-$360+$840+$75+ $153+ 492)......................................................................................................................................................................... 20,767 8.6 Total............................................................................................................................................................................ 165,432 68.1

Fixed expenses: Property taxes, fees ($9,870 - $1,005 + $1,119)................................................................................................................. 9,984 4.1 Insurance ($11,584 - $2,025)............................................................................................................................................. 9,559 3.9 Depreciation....................................................................................................................................................................... 30,280 12.5 Interest ($10,605 - $687 + $579)....................................................................................................................................... 10,497 4.3 Rent................................................................................................................................................................................... — — Total............................................................................................................................................................................ 60,320 24.8 Profit(pretax) ........................................................................................................................................................................... $ 17,049 7.1 *May not add exactly owing to rounding.

15

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

As a rough composition that attempts to adjust for the Kims’ (and probably other survey respondents’) dual roles as owners and operators, I suggest adding three accounts:

Pinetree

Average

Payroll costs.................................................................................................................................................................. 47.6 22.5 Administrative/general.................................................................................................................................................. — 4.2 Profit............................................................................................................................................................................. 7.1 20.7 Total.............................................................................................................................................................................. 54.7 47.4 This tends to substantiate the hypothesis that hired employees would perform the Kims’ task for less than $86,100. Pinetree’s other operating costs do not seem to be out of line compared with the survey averages. the higher-than-average utilities may reflect a location with cold winters. Insurance and taxes are essentially uncontrollable. Repairs and maintenance may be below average because the Kims’ personally do some of this work, whereas other motels pay outsiders to do it. Note that both rent and depreciation are shown in the journal’s survey data. This also causes comparison problems. For Pinetree, there is no rent, but the motel buildings are depreciated, whereas for some motels the depreciation would include only furnishings. Adding the rent and depreciation percentages may be more meaningful than working at either one in isolation; but, of course, building depreciation is only a very rough proxy for fair rental value. No final conclusion on the success of their operation can be made as information on the following is lacking: Capital (re: the average) Location Pricing

Occupancy rate Seasonality (re: Florida annual season vs. New England) Efficiency in using their own time

Check on income calculation:

Receipts in 2005............................................................................................................................................................. $244,461 Less: 2004 revenue collected.................................................................................................................................... 1,660 Revenues in 2005............................................................................................................................................................ $242,801 Checks written in 2005................................................................................................................................................... 196,558 Plus: 2005 expenses not paid.......................................................................................................................................... 5,508 Depreciation....................................................................................................................................................... 30,280 232,346 Less: 2004 expenses paid.......................................................................................................................................... 6,594 Expenses in 2005............................................................................................................................................................ 225,752 Profit............................................................................................................................................................................... $ 17,049

16

©2007 McGraw-Hill/Irwin

Chapter 3

Case 3- 5: National Association of Accountants Note: This case has been updated since the Eleventh Edition. Approach This case describes a typical problem in the management of membership associations and of many other nonprofit organizations. Each year a new governing board is elected and becomes responsible for the operations of the organization for that year. As a general rule, the governing board should so conduct affairs that the organization breaks even financially. If it operates at a deficit, it is eating into resources intended for future members, as suggested in the case. If it operates at a surplus, it is not providing the members with as many services as they are entitled to. Thus, the difference between the concept of income described in the text for business organization and the income concept appropriate for a nonprofit membership organization is that a business organization should earn satisfactory net income, while the membership organization should break even. The measurement of revenues and expenses follows the same principles in both types of organizations (at least with respect to the transactions given in this case.) The case is based, loosely, on experiences of the American Accounting Association, and instructors may wish to refer to the AAA financial statements. The case relates to the “general fund,” which is the portion of the financial statements that reports normal operations. The other columns in these statements can be disregarded. (The NAA is no longer in existence.) In the interest of simplicity, students are not given balance sheets. The case can be made more complicated by assuming a beginning balance sheet, perhaps showing only cash and equity of $55,000 each. Students can then be asked to set up assets and liabilities that result from the transactions described in the case. Answers to Question Various “correct” answers are possible. One set is given in Exhibit A and discussed below. 1. The grant relates to services to be performed in 2006, so it should not be counted as 2005 revenue. However, the $2,700 already spent must be matched against the grant in some way. This can be done either by subtracting it from 2005 expenses and setting it up as a prepaid asset or, more simply, by transferring $51,300 of the grant to 2006 revenue. The effect on the bottom line is the same. The fact that the president obtained the grant is irrelevant. The principle is to recognize the revenue in the period in which the services are performed. The legal question is probably also irrelevant; the intention was to perform the services in 2006, and that probably would be the governing factor. This is a debatable point, however, because it gives no credit to the 2005 president for the fine work he or she has done in obtaining the grant. 2. The desktop publishing system is not an expense of 2005. It will be an expense of future years and is therefore an asset on December 31, 2005. Because it was acquired so near the end of the year, there is no need to deal with depreciation. The question can be asked about depreciation in future years, and this raises the question of estimating the future life. Desktop publishing systems are a “hot” item. They are likely to improve in performance and decrease in price fairly rapidly. The useful life is therefore probably not more than five years. Note that although this is not an expense of 2005, and the 2005 board has created a depreciation cost that will affect the surplus of future boards.

17

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

3. The $32,400 of 2006 membership dues probably is not revenue of 2005. Members will receive services in 2006 for the 2006 dues. (It can be argued that early receipt of these dues avoids the necessity of incurring expense for dues notices and follow-ups that would otherwise be needed in 2006. However, there is no feasible way of measuring this.) The fact that these members will receive a free book is probably irrelevant. The cost of the book is a 2006 expense, and when the associated revenue from dues is moved to 2006, they match the expense. 4. The membership directory is a real tough one. The services for the 3,000 copies were provided in 2005, but charging this as a cost in 2005, seems unfair to the 2005 board (and to boards of each year when a new directory is published.) It can be argued that members refer to the directory for two years, and hence the cost should be spread over both years. The 1,000 extra copies is probably an expense of 2006, but this assumes that they will in fact be used in 2006 and are not simply extras that eventually will be discarded. (The proportion of 1,000 extra copies to the membership seems large.) Exhibit A takes the easy way out and assigns one-half the cost to each year, but other solutions are equally defensible. 5. The conversion of subscription revenue from a cash basis to an accrual basis is straightforward. The revenue in 2005 should be decreased by $2,700. 6. If the Association is likely to be reimbursed for the $10,800, it is not an expense of 2005. The likelihood is that there will be a profit, but at this stage, one can’t be sure, even though there was a profit in 2004. It seems unlikely in any event that there would be a profit that wiped out the whole deficit. Exhibit A removes the whole $10,800 as an expense; it becomes an account receivable from the Annual Meeting Committee. Students who argue strongly for conservatism might leave it as an expense. This transaction shows how difficult it is to arrive at the “true” results, as is also the case with some of the others. The 2004 annual meeting profit, not now known, is conceptually a revenue of 2004. (But read on.) 7. The $3,400 annual meeting profit is revenue for 2004, conceptually. However, there seems to be no feasible way of recording this revenue in the year of the annual meeting because of the problem of paying outstanding bills for some months after the annual meeting has taken place. It therefore can be argued that it is appropriately left in 2005, which is done in Exhibit A. This practice can be justified on the grounds of materiality. If eliminated from 2005, some corresponding adjustment for an estimated profit on the 2005 annual meeting should be made. With the adjustments made above, the 2005 results has been changed from a surplus to a deficit. It is easy to visualize how discussions of this type can become quite heated. They can be avoided in the future by preparing an accounting manual that describes how each of these transactions should be handled. This illustrates the importance of the consistency concept. Question 2 The Administration’s policy says there should be a dues increase. If there were some unusual expenses in 2005, the deficit might be tolerated, but we have no indication that there are unusual expenses. The association had to take special steps to obtain the cash needed for the desktop publishing system, which means there was no cash surplus to draw on. Once a deficit like this occurs, the prudent course of action is to increase the dues.

18

©2007 McGraw-Hill/Irwin

Chapter 3

Exhibit A NATIONAL ASSOCIATION OF ACCOUNTANTS ADJUSTED INCOME STATEMENT, 2005

Revenues: As Reported Adjustments Adjusted Membership dues............................................................................................................................................................... $287,500 $-32,400 $255,100 Journal subscriptions.......................................................................................................................................................... 31,000 -2,700 28,300 Publication sales................................................................................................................................................................ 11,900 11,900 Foundation grant................................................................................................................................................................ 54,000 -51,300 2,700 Annual meeting profit, 2004.............................................................................................................................................. 3,400 ________ 3,400 Total revenue............................................................................................................................................................... 387,800 -86,400 301,400

Expenses: Printing.............................................................................................................................................................................. 92,400 -11,600 80,800 Committee meeting expenses............................................................................................................................................. 49,200 49,200 Annual meeting advance.................................................................................................................................................... 10,800 -10,800 0 Desktop publishing system................................................................................................................................................ 27,000 -27,000 0 Administrative salaries and expenses....................................................................................................................................... 171,500 171,500 Miscellaneous........................................................................................................................................................................... 25.000 ________ 25,000 Total expenses............................................................................................................................................................. 375,900 $-49,400 326,500 Surplus or (deficit)................................................................................................................................................................... $ 11,900 $-37,000 $(25,100)

19