Accounting for LawyersProfessor BradfordFall 2001

Exam 2001

The following answer outlines are not intended to be model answers, nor are they intended to include every issue that students discussed. They merely attempt to identify the major issues in each question and some of the problems or questions arising under each issue. They should provide a pretty good idea of the kinds of things I was looking for. If you have any questions about the exam or your performance on the exam, feel free to contact me to talk about it.

I graded each question separately. Those grades appear on the front cover of your blue books. To determine your overall average, each question was then weighted in accordance with the time allocated to that question.

Question 1

Journal entries:

11/1 Cash 5,000Partner’s Equity: George 5,000

11/1 Rent Expense 1,000Prepaid Rent Expense 1,000

Cash 2,000

11/1 Cash 2,000Note Payable 2,000

11/2 Cash 4,000Furniture and Fixtures 2,000

Partner’s Equity: Mary 6,000

11/2 Supply Expense 50Cash 50

11/5 Purchases 300Cash 300

11/7 Purchases 220Cash 220

11/11 Cash 150Sales 150

11/13 Cash 280Sales 280

11/17 Cash 160Sales 160

11/18 Purchases 90Cash 90

11/20 Partner’s Equity: George 500Cash 500

11/26 Cash 130Sales 130

11/30 Purchases 240Accounts Payable 240

11/30 Telephone Expense 75Cash 75

11/30 Interest Expense 10Interest Expense Payable 10

11/30 Cost of Goods Sold 850Purchases 850

11/30 Inventory 300Cost of Goods Sold 300

11/30 Theft Loss 100Inventory 100

11/30 Profit and Loss 1,785Theft Loss 100Rent Expense 1000Interest Expense 10Supply Expense 50Telephone Expense 75Cost of Goods Sold 550

11/30 Sales 720Profit and Loss 720

11/30 Partner’s Equity: George 532.50Partner’s Equity: Mary 532.50

Profit and Loss 1,065

[T-accounts on separate spreadsheet.]

ZuZu’s Petals PartnershipBalance Sheet

As of Nov. 30, 2001

Assets

CashPrepaid Rent ExpenseInventoryFurniture and Fixtures

TOTAL

$8,4851,000

2002,000

$11,685

Liabilities and Partners’ Equity

LiabilitiesAccounts PayableInterest Expense PayableNote PayablePartners’ EquityGeorgeMary

TOTAL

$ 24010

2,000

3,967.505,467.50

$11,685

ZuZu’s PetalsIncome Statement

For the Month of November, 2001

Sales Less: Cost of Goods SoldGross Profit on SalesOperating Expenses: Rent Interest Supplies Telephone TheftTotal Operating Expenses

NET LOSS

$720550

$1,000105075

100

170

1,235

($1,065)

Question 2

To decide whether this is a good investment for Alice, we must compare the present value of all the payments Alice must make to the present value of the payments she will receive, using as the discount rate the 7% return she can earn in her best alternative investment. If the discounted returns exceed the sum of the discounted payments, this is a good investment. The calculations are easiest if we look at the present values as of January 1, 2002.

Alice’s Payments. The present value of Alice’s first payment is simply $2,600. We can consider the other nine $2,600 payments as an annuity in arrears (payable at the end of each year). From Table IV in Appendix B of the book, the present value factor for a nine-year annuity with a 7% discount rate is 6.51523. Thus, the present value of these nine payments is $2,600 x 6.51523 = $16,939.60. The total present value of Alice’s payments is therefore $2,600 + $16,939.60 = $19,539.60.

Alice’s Return. In return for her investment, Alice receives two payments. The first payment is $10,000 paid 5 years from Jan. 1, 2002. From Table III in Appendix B, the present value factor for a payment in 5 years with a 7% discount rate is .71299. Thus, the present value of this first receipt is $10,000 x .71299 = $7,129.90. Alice also receives a second payment of $24,000 in ten years. From Table III, the present value factor for a payment in ten years with a 7% discount rate is .50835. Thus, the present value of this second receipt is $24,000 x .50835 = $12,200.40. The total present value of the investment return is therefore $7,129.90 + $12,200.40 = $19,330.30.

Comparison. The present value of the payments, $19,539,60, is greater than the present value of the return, $19,330.30. Therefore, this is not a good investment for Alice.

Question 3

When to Recognize Revenue and Expenses:

The revenue recognition principle says to recognize revenue when (1) there is an exchange transaction and (2) the seller has substantially completed the earnings process. The first requirement is met by the contract. The more difficult issue is determining when Inter substantially completed the earnings process.

Arguably, Inter has completed everything it is required to do as of Dec. 15, when Geekway is supposed to pick up the processors. The shipment is segregated and ready for pickup at that point, so there’s an excellent argument for revenue recognition, even stronger than in Pacific Grape. Usually, substantial completion occurs as of shipment, but not here, where Inter is not required to ship. Nevertheless, revenue is usually recognized when the risk of loss and title pass and that probably would not be until Geekway picks up the processors in 2001.

The possibility of return does not preclude revenue recognition under SFAS No. 48. SFAS No. 48 lists several requirements that must be met for revenue to be recognized before a right of return expires. Several of these are clearly met: the price is fixed; as far as we know, the buyer has economic substance apart from resources provided by Inter; Inter has no significant future obligations under the contract; and, given its past experience, Inter can reasonably estimate future returns. However, one requirement is problematic. It’s not clear that the risk of loss has passed to Geekway when the processors were segregated. If not, SFAS precludes revenue recognition in 2000, and revenue would not be recognized until 2001, when Geekway picked up the processors.

Even if revenue is not recognized for most of the contract until 2001, an argument can be made that revenue should be recognized for the initial shipment of 500 processors because that portion of the contract clearly has been substantially completed and the risk of loss has passed as to those processors. If this is done, the related expenses, including estimated returns for that portion, must also be recognized in 2000.

When revenue is recognized, the amount of future returns must be estimated and taken as an expense. This is a contingency which must be recognized under Paragraph 8 of SFAS No. 5. Given past history (5-10%), it is probable that a liability of at least 5% has been incurred and the amount of that loss (at least the 5%) can be reasonably estimated. As to the remainder, the likelihood is less certain, but disclosure is still required by Paragraph 10 of SFAS No. 5.

Whenever, the revenue is recognized, the corresponding shipping expense should also be recognized under the matching principle.

Journal Entries (if revenue recognized in 2001):

Nov. 1 Deferred Shipping Expense $700Cash $700

Dec. 1 Deferred Shipping Expense $500Cash $500

Dec. 15 Cash $100,000Deferred Sales $100,000

Jan. 2 Cash $400,000Deferred Sales $400,000

Jan. 5 Deferred Sales $500,000Sales $500,000

Jan. 5 Shipping Expense $1,200Deferred Shipping Expense $1,200

Jan. 5 Sales Returns $25,000Estimated Liability: Sales Returns $25,000

Dec. 31 Estimated Liability: Sales Returns $20,000Cash $20,000

[If they are certain this is all the returns—that their initial estimate was too high, they should also make the following entry to get rid of the remaining estimated liability:

Estimated Liability: Sales Returns $5,000Sales Returns $5,000]

Journal Entries (if revenue recognized in 2000):

Nov. 1 Deferred Shipping Expense $700Cash $700

Dec. 1 Deferred Shipping Expense $500Cash $500

Dec. 15 Cash $100,000Deferred Sales $100,000

Dec. 31 Deferred Sales $100,000Accounts Receivable $400,000

Sales $500,000

Dec. 31 Shipping Expense $1,200Deferred Shipping Expense $1,200

Dec. 31 Sales Returns $25,000Estimated Liability: Sales Returns $25,000

Jan. 2 Cash $400,000Deferred Sales $400,000

Dec. 31 Estimated Liability: Sales Returns $20,000Cash $20,000

[If they are certain this is all the returns—that their initial estimate was too high, they should also make the following entry to get rid of the remaining estimated liability:

Estimated Liability: Sales Returns $5,000Sales Returns $5,000]

Journal Entries (if only part of revenue recognized in 2000):

Nov. 1 Shipping Expense $700Cash $700

Nov. 1 Accounts Receivable $25,000Sales $25,000

Nov. 1 Sales Returns $1,250Estimated Liability: Sales Returns $1,250

Dec. 1 Deferred Shipping Expense $500Cash $500

Dec. 15 Cash $100,000Accounts Receivable $25,000Deferred Sales $75,000

Jan. 2 Cash $400,000Deferred Sales $400,000

Jan. 5 Deferred Sales $475,000Sales $475,000

Jan. 5 Shipping Expense $500Deferred Shipping Expense $500

Jan. 5 Sales Returns $23,750Estimated Liability: Sales Returns $23,750

Dec. 31 Estimated Liability: Sales Returns $20,000Cash $20,000

[If they are certain this is all the returns—that their initial estimate was too high, they should also make the following entry to get rid of the remaining estimated liability:

Estimated Liability: Sales Returns $5,000Sales Returns $5,000]

Question 4

A. To calculate the depreciation expense, we must first determine the depreciable cost of the machine, its useful life, and its salvage value.

Depreciable Cost. The depreciable cost of the machine includes all expenses to acquire the machine and to bring it to the location and condition of its intended use. That would include the $50,000 purchase price, the $3,000 to ship the machine to Ajax, and the $2,000 to modify the machine for its intended use by Ajax. It would not include expenditures for ordinary repairs and maintenance (the $500), which are period costs. The depreciable cost of the Widget 990 is therefore $50,000 + $3,000 + $2,000 = $55,000.

Useful Life and Salvage Value. The relevant useful life is the useful life to Ajax, not how long the machine will last. The useful life of the machine to Ajax is only 10 years, after which it will upgrade. The salvage value to Ajax at the end of this useful life is $15,000.

Straight-line depreciation. The expense for both 2001 and 2002 will be ($55,000 - $15,000) 10 = $4,000.

Double-declining balance method:

Year Expense Balance2001 $55,000 x 1/10 x 200% = $11,000 $44,0002002 $44,000 x 1/10 x 200% = $8,800 $35,200

B. The depreciation expense in 2001, using the straight-line method, is $4,000. Thus, the net book value of the machine on the balance sheet is $55,000 - $4,000 = $51,000. This book value must be written down to fair value if the asset is impaired pursuant to FASB No. 144 (which replaces No. 121). The machine is used in Ajax’s operations, so that portion of FASB No. 144 is used.

FASB No. 144 uses a three-part analysis. First, some event or change in circumstances must trigger an impairment review. A significant decrease in an asset’s market value is one such trigger; a drop to $40,000 probably qualifies. However, we must believe that it is a permanent, not a temporary, decline in value for it to trigger an impairment review.

If this drop in market value triggers a review, the second step is a cash-flow analysis to determine if the asset is impaired and a write-down is necessary. You compare the total undiscounted cash flows the machine is expected to produce to the undiscounted cash outflows to produce them. Here, Ajax expects the machine to generate cash of $10,000 a year over its ten-year life, plus the $15,000 Ajax expects upon disposal of the asset. The total cash inflow is ($10,000 x 10) + $15,000 = $115,000. The

total cash outflow to produce that revenue is $3,000 x 10 = $30,000. The net undiscounted cash flow is a positive $85,000. A write-down is triggered only if the net cash flow is less than the book value of the machine. The book value is $51,000, so we do not need to write down the machine to its fair value. We don’t get to the third part of the analysis.

Question 5

A. Return on Sales = Net Income Net Sales= $27,000 $150,000= 0.18

B. Inventory Turnover = Cost of Goods Sold Average Inventory

Average Inventory = [Inventory(1999) + Inventory(2000)] 2= ($210,000 + $170,000) 2= $190,000

Inventory Turnover = $60,000 $190,000= .316

C. Debt to Total Assets Ratio = Total Liabilities Total Assets= $182,000 $527,000= .345

Question 6

If, as here, circumstances do not reasonably assure that a company will collect the full sales price reflected in a receivable, APB No. 10 allows the company to use either the installment method or the cost recovery method. The question indicates that Armadillo uses the installment method. The installment method allocates part of each cash payment received from the buyer to cost recovery and the rest to profit. The proportion allocated to each is the proportion of the total sales price each represents.

Here, the total sales price is $7 million. The book value of the land when Armadillo sold it was $3 million. Thus, $4 million, or 4/7 of the total price, is profit. For each cash payment, 4/7 of the payment will be recognized as gain. Therefore, the journal entries are as follows:

9/1 Cash $2,000,000Note Receivable $5,000,000

Land $3,000,000Gain on Sale of Land $1,142,857Deferred Gain on Sale of Land $2,857,143

12/1 Cash $1,000,000Note Receivable $1,000,000

Deferred Gain on Sale of Land $571,429Gain on Sale of Land $571,429

Question 7

This transaction will add no goodwill to Alpha’s balance sheet. Under the purchase method, the purchase price is first allocated to the assets purchased, using their fair market values. Only after that is done is any excess allocated to goodwill. Here, the $810,000 purchase price paid exactly equals the combined fair market values of the assets purchased. There is no excess, so the transaction does not result in the creation of goodwill.