CHAPTER 3BASIC ACCOUNTING CONCEPTS:

THE INCOME STATEMENT

Changes from Tenth Edition

The chapter has been updated. Additional topics include proforma earnings, EBITDA and SEC financial report certification and affirmation requirements for CEO’s and CFO’s.

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.

Data Saver Inc. is the widely used case that introduces the entire accounting cycle, with some judgmental issues.

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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.

Cape Cod Novelty Shop can be used to review the basic accounting concepts and economic income concepts such as opportunity costs and imputed costs. It has been used in the first class of the second year Harvard Business School MBA accounting course.

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...................................................................................................................................................................................$164,000Rent.........................................................................................................................................................................................................3,300Salaries....................................................................................................................................................................................................27,400Taxes.......................................................................................................................................................................................................1,375Other........................................................................................................................................................................................................50,240

Net income $28,685

Problem 3-3

Beginning inventory................................................................................................................................................................................$27,000Purchases................................................................................................................................................................................................. 78,000Available for sale.....................................................................................................................................................................................Ending inventory.....................................................................................................................................................................................($31,000)Cost of goods sold...................................................................................................................................................................................$74,000

Problem 3-4

a. (1) Sales.........................................................................................................................................................................................................$85,000Cost of goods sold...................................................................................................................................................................................45,000Gross margin...........................................................................................................................................................................................$40,000

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(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 82.3percent 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, 20X1 $30,000December 31, 20X1 26,250December 31, 20X2 11,250December 31, 20X3 0

Expenses:20X1 $3,750 ($1,250 x 3 months)20X2 $15,000 ($1,250 x 12 months)20X3 $11,250 ($1,250 x 9 months)

One month’s insurance charge is $1,250 ($30, 000 / 24 months)

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Problem 3-7

QED ELECTRONICS COMPANYIncome Statement for the month of April, ----.

Sales.........................................................................................................................................................................................................$33,400Expenses:

Bad debts............................................................................................................................................................................................$ 645Parts....................................................................................................................................................................................................3,700Interest................................................................................................................................................................................................880Wages.................................................................................................................................................................................................10,000Utilities...............................................................................................................................................................................................800Depreciation.......................................................................................................................................................................................2,700Selling.................................................................................................................................................................................................1,900Administrative....................................................................................................................................................................................4,700 ______

Profit before taxes 25,325Taxes....................................................................................................................................................................................................... 8,075Net 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................................................................................................................................................................................$35,000Purchases.................................................................................................................................................................................................$40,000Total available.........................................................................................................................................................................................75,000Ending inventory..................................................................................................................................................................................... 30,000Cost of goods sold...................................................................................................................................................................................$45,000Gross 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

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Next, prepare balance sheet:

Assets LiabilitiesCurrent assets($50,000 x 1.6)........................................................................................................................................................................................$ 80,000 Current liabilities.....................................................................................................................................................................................$ 50,000Other assets($218,182 - $50,000)...............................................................................................................................................................................138,182

Long term debt 40,000

Total liabilities.........................................................................................................................................................................................$ 90,000

Owners’ equityBeginning balance...................................................................................................................................................................................$120,000Plus net income....................................................................................................................................................................................... 8,182Ending balance........................................................................................................................................................................................$128,182

Total assets.................................................................................................................................................................................$218,182+Total liabilitiesand 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 Tenth 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.)

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2.

MAYNARD COMPANY

INCOME STATEMENT, JUNE

Sales ($44,420 cash sales + $26,505 credit sales)...................................................................................................................................$70,925Less: Cost of sales *.......................................................................................................................................................................... 39,345

Gross Margin...........................................................................................................................................................................................31,580Expenses

Wages($5,660+$2,202-$1,974)........................................................................................................................................................$5,888Utilities..............................................................................................................................................................................................900Supplies ($5,559+$1,671-$6,630)....................................................................................................................................................600Insurance($3,150-$2,826).................................................................................................................................................................324Depreciation ($157,950-$156,000)+($5,928-$5,304).......................................................................................................................2,574Miscellaneous................................................................................................................................................................................... 135 10,421

Income before income tax.......................................................................................................................................................................21,159Income tax expense ($7,224 - $5,700)..............................................................................................................................................1,524

Net Income..............................................................................................................................................................................................19,635Less: Dividends................................................................................................................................................................................. 11,700

Increase in retained earnings...................................................................................................................................................................$ 7,935

*Cost of sales:Merchandise purchased for cash.......................................................................................................................................................$14,715Merchandise purchased on credit.....................................................................................................................................................21,315 [$21,315+($8,517-$8,577)]Inventory, June 1............................................................................................................................................................................... 29,835

Total goods available during June..............................................................................................................................................65,865Inventory, 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.

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Case 3-2: Lone Pine Café (B)

Note: This case is unchanged fro the Tenth 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, 2001, THROUGH MARCH 30, 2002

Sales.........................................................................................................................................................................................................$ 44,350Expenses:

Salaries to partners.............................................................................................................................................................................$23,150Part-time employee wages..................................................................................................................................................................5,480Food and beverage supplies................................................................................................................................................................l1,969Telephone and electricity...................................................................................................................................................................3,270Rent expense.......................................................................................................................................................................................7,500Depreciation.......................................................................................................................................................................................2,445Operating license expense..................................................................................................................................................................595Interest................................................................................................................................................................................................540Miscellaneous expenses..................................................................................................................................................................... 255

Total expenses.........................................................................................................................................................................................55,204(Loss).......................................................................................................................................................................................................$(10,854)

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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: Data Saver Inc.

Note: This classic case was updated for the Tenth Edition and otherwise remains the same for the Eleventh Edition.

Approach

I use this case for two 80-minute sessions. On Day l, I quickly show how the balance sheet in Exhibit l was developed and then spend the rest of the class answering Question 1. On Day 2, we develop an income statement and (without concern for format) a cash flow statement; these are based entirely on information from Day l in the far left (Cash) and far right (Retained Earnings) columns in the matrix described below. I then do Question 3.

I have found it very effective in teaching this case to record the transactions on the board using a balance sheet “matrix.” I put the basic equation, Assets = Liabilities + Owners’ Equity, at the top of the board, and put a column heading for each balance sheet account immediately thereafter. I then record the transactions leading up to the beginning balance sheet (Exhibit l) in rows, using parentheses if an account has decreased. I then add the columns to get Exhibit l, then proceed to “post” the other transactions, again summing the columns to get the desired ending balance sheet. With this approach, an income statement can be prepared from the last column, Retained Earnings. This is a good way to “set up” the mechanics covered in Chapter 4. At the end of Day l, I add to the Day 2 assignment preparation of a cash flow statement, telling students not to refer to the chapter on this topic.

I give special attention to the problem of the valuation of the patent. This discussion makes the point that the true worth of the patent does not matter; the important thing is what did the company pay for it? In this case, the company paid stock, so the question becomes one of valuing the stock. Aspects of this question are discussed in Note 4 under Question 2, and under Question 3. The other transactions giving rise to the beginning balance sheet can be traced briefly.

Before class starts, I have put the beginning balance sheet on the board, as described above. We then go through the transactions one by one, showing the effect of each on the balance sheet. I write increases and decreases (using plus and minus signs) for each balance sheet change. I lump all the income statement items under retained earnings so that I am working solely with the balance sheet. This procedure helps to drive home the point that any transaction can be resolved into its effect on the balance sheet and helps lay the groundwork for debit and credit (although I never mention, or permit students to mention, debit or credit at this stage). After the analysis of each transaction has been concluded, I flash up Vugraphs showing the final balance sheet and income statement. Alternatively, these can be put on the board. I try to re-emphasize that there may legitimately be many differences in terminology and format between my balance sheet and those that students have prepared. Also, I am never critical of students who do not include depreciation in cost of goods sold. Not only is the product vs. period cost distinction new to them—it also happens that some manufacturing firms treat all depreciation as a period cost, even though conceptually depreciation on plant and equipment is a product cost that should flow through inventory.

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DATA SAVER INC.

ESTIMATED BALANCE SHEET AS OF END OF FIRST YEAR

AssetsCurrent assets:

Cash [11,400+336,000-106,000-650-148,000-4,000-11,000-(16,960-1,696)] $ 62,486Inventories...............................................................................................................................................................................................18,000Total current assets..................................................................................................................................................................................80,486Machinery, at cost (20,000 + 4,000).......................................................................................................................................................$24,000Less: Accumulated depreciation............................................................................................................................................................. 2,400 21,600Patent.......................................................................................................................................................................................................56,470Total assets $158,556

Liabilities and Owners’ EquityTaxes payable..........................................................................................................................................................................................$1,696Capital stock............................................................................................................................................................................................100,000Retained earnings....................................................................................................................................................................................56,860Total equities...........................................................................................................................................................................................$158,556

DATA SAVER INC.

ESTIMATED INCOME STATEMENT FOR FIRST YEAR OF OPERATIONS

Sales.........................................................................................................................................................................................................$336,000Less: Cost of goods sold (per schedule below)....................................................................................................................................... 218,200Gross margin...........................................................................................................................................................................................117,800Less: Selling and administrative expenses..............................................................................................................................................21,000Operating income....................................................................................................................................................................................96,800Less: Other expenses:Interest expense.......................................................................................................................................................................................$ 650Organization costs...................................................................................................................................................................................6,600Experimental costs..................................................................................................................................................................................1,200Amortization of patent............................................................................................................................................................................. 3,530 11,980Income before taxes.................................................................................................................................................................................84,820Income tax expense................................................................................................................................................................................. 16,960Net income..............................................................................................................................................................................................$67,860

Comments on Questions

Question 1

(1) Cash increased $336,000Retained earnings increased $336,000

(2) Raw materials inventory increased S106,000Cash decreased $106,000

(3) Cash decreased $650|Retained earnings decreased $650(See also Note 1 below)

(4) Cash decreased $148,000Retained earnings decreased $148,000 ($127,000 of this could be shown temporarily as an increase in inventory.)

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(5) Raw material inventory decreased $88,800 (the difference between $106,800 and $18,000)Retained earnings decreased $88,800

(6) (No entry)

(7) Machinery increased $4,000Cash decreased $4,000

(8) Experimental costs decreased $1,200Organization costs decreased $6,600Retained earnings decreased $7,800

(9) Machinery decreased $2,400 (at this stage, the student is not expected to handle the separate accumulated depreciation account)Retained earnings decreased $2,400

(10)Retained earnings decreased $11,000Cash decreased $11,000

(11)Retained earnings decreased $3,530Patent decreased $3,530(See Note 4)

(12)Retained earnings decreased $16,960Taxes payable increased $1,696Cash decreased $15,264

Notes

1. The bank loan of $8,000 does not appear on the balance sheet since it has been paid off. It does not appear on the income statement since it does not affect owners’ equity. This illustrates the point that there may well be events occurring within the year that do not appear on the balance sheet and income statement. Nevertheless, I encourage students to record this as three transactions rather than just one.

2. Product costs included in cost of goods sold include only manufacturing costs, not selling and administrative costs. This is a good opportunity to introduce the product vs. period costs distinction. It is important at this early stage not to criticize students who immediately expensed all production costs; they have not been formally exposed to inventory accounting, and the case assumptions of no WIP or finished goods inventories means that all production costs incurred (except raw material costs) will be expensed the first year.

3. The decision to charge off experimental and organizational costs in the first year is arbitrary. Some companies would choose to write them off over a longer period of time. Probably the fact that these costs were relatively small influenced the decision here. I point out that under today’s GAAP, capitalizing the experimental costs is questionable, since the FASB does not permit capitalization of R&D costs.

4. The patent must be valued indirectly. Since the retired manufacturer is willing to pay par value for the stock, in his opinion (which he backs up with his own money) the stock is worth par. We are therefore justified in valuing the patent at the par value of the stock given for it, $60,000. It must be recognized, however, that this is not a market valuation; it is only one person’s opinion. Presumably, however, it meets the test of an arm’s-length agreement. The patent should be written off over its useful life. In the absence of other information, I wrote off 1/17 of its cost, or $3,530; this is a minimum amount, since 17 years, the legal life of the patent, is its longest possible useful life. Students should discuss, however, whether the protector is likely to remain unique for 17 years, and hence whether the patent’s useful life may be much less.

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5. The income taxes are an expense of the first year, even though part of the expense is not remitted until the second year.

6. As a practical matter, the format of the statements shown here is overelaborate for the little Data Saver Inc. The format is chosen to illustrate terminology. Practice may differ at several points. For example, interest expense may be shown as an operating expense, or conceivably even the write-off of intangibles may be shown as an operating expense. Accumulated depreciation is shown separately, even though there is no logical reason for doing so based on the text material given up to this point.

Question 3

Students tend to focus on the value of the patent. We now have evidence that the stock is worth 4/3 of par. It seems reasonable, therefore, that the value of the patent is 4/3 of $60,000, or $80,000. The equities section of the balance sheet would then appear as:

Capital stock, at par.................................................................................................................................................................................$ 90,000Additional paid-in capital........................................................................................................................................................................ 30,000

Contributed capital............................................................................................................................................................................$120,000

The asset amount for the patent would be $80,000.

However, an argument can be made that the patent should be listed at $60,000, the par value of the stock, in which case the additional paid-in capital is only $10,000.

DATA SAVER INC.

Estimated Cost of Goods SoldMaterial and supplies:

Inventory, beginning of year.............................................................................................................................................................$ 800Plus: purchases........................................................................................................................................................................... 106,000

106,800Less: Inventory, end of year ...................................................................................................................................................... 18,000

Material used...........................................................................................................................................................................................$ 88,800Payroll and other cash manufacturing costs............................................................................................................................................127,000Depreciation of machinery*.................................................................................................................................................................... 2,400

Cost of goods sold......................................................................................................................................................................$218,200

*Could be treated as a period cost although product cost treatment is preferable.

DATA SAVER INC.

Estimated Retained Earnings ReconciliationRetained earnings at beginning of year...................................................................................................................................................$ 0

Add: Net income........................................................................................................................................................................67,860Subtract: Dividends.................................................................................................................................................................... 11,000

Retained earnings at end of year.............................................................................................................................................................$56,860

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3 - 4: Pinetree Motel

Note: This was updated for the Tenth 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, depreciationis 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.

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.

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PINETREE MOTEL

OPERATING STATEMENT FOR 2001

(in industry trade journal format)

Dollars Percentages*Revenues:

Room rentals ($236,758- $1,660).....................................................................................................................................................$235,098 96.8Other 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 47.6Administrative and general...............................................................................................................................................................— —Direct operating expense ($8,800 + $1,660 + $6,820).....................................................................................................................17,280 7.1Fees and commissions......................................................................................................................................................................— —Advertising and promotion($2,335 - $600 + $996)..........................................................................................................................2,731 1.1Repairs and maintenance..................................................................................................................................................................8,980 3.7Utilities ($12,205+$2,789+$5,611-$933-$105-$360+$840+$75+$153)................................................................................................................................................................................................. 20,275 8.4

Total........................................................................................................................................................................................... 164,940 67.9

Fixed expenses:Property taxes, fees ($9,870 - $1,005 + $492)..................................................................................................................................9,357 3.9Insurance ($11,584 - $2,025 + $1,119).............................................................................................................................................10,678 4.4Depreciation......................................................................................................................................................................................30,280 12.5Interest ($10,605 - $687 + $579)......................................................................................................................................................10,497 4.3Rent................................................................................................................................................................................................... — —

Total........................................................................................................................................................................................... 60,812 25.1Profit(pretax) ..........................................................................................................................................................................................$ 17,049 7.0

*May not add exactly owing to rounding.

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 AveragePayroll costs............................................................................................................................................................................................47.6 22.5Administrative/general............................................................................................................................................................................— 4.2Profit........................................................................................................................................................................................................ 7.1 20.7Total.........................................................................................................................................................................................................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.

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

Check on income calculation:

Receipts in 2001......................................................................................................................................................................................$244,461Less: 2000 revenue collected............................................................................................................................................................ 1,660

Revenues in 2001....................................................................................................................................................................................$242,801Checks written in 2001............................................................................................................................................................................196,558Plus: 2001 expenses not paid...................................................................................................................................................................5,508

Depreciation............................................................................................................................................................................... 30,280 232,346

Less: 2000 expenses paid.................................................................................................................................................................. 6,594Expenses in 2001.....................................................................................................................................................................................225,752Profit........................................................................................................................................................................................................$ 17,049

Case 3 - 5: National Association of Accountants

Note: This case has been updated since the Tenth 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 much 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.)

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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 2002, so it should not be counted as 2001 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 2001 expenses and setting it up as a prepaid asset or, more simply, by transferring $51,300 of the grant to 2002 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 2002, and that probably would be the governing factor. This is a debatable point, however, because it gives no credit to the 2001 president for the fine work he or she has done in obtaining the grant.

2. The desktop publishing system is not an expense of 2001. It will be an expense of future years and is therefore an asset on December 31, 2001. 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 2001, and the 2001 board has created a depreciation cost that will affect the surplus of future boards.

3. The $32,400 of 2002 membership dues probably is not revenue of 2001. Members will receive services in 2002 for the 2002dues. (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 2002. 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 2002 expense, and when the associated revenue from dues is moved to 2002 they match the expense.

4. The membership directory is a real tough one. The services for the 3,000 copies were provided in 2001, but charging this as a cost in 2001, seems unfair to the 2001 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 2002, but this assumes that they will in fact be used in 2002 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 2001 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 2001. 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 2000. 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

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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 2001 annual meeting profit, not now known, is conceptually a revenue of 2001. (But read on.)

7. The $3,400 annual meeting profit is revenue for 2000, 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 2001, which is done in Exhibit A. This practice can be justified on the grounds of materiality. If eliminated from 2001, some corresponding adjustment for an estimated profit on the 2001 annual meeting should be made. With the adjustments made above, the 2001 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 2001, 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.

Exhibit A

NATIONAL ASSOCIATION OF ACCOUNTANTS

ADJUSTED INCOME STATEMENT, 1995

Revenues: As Reported Adjustments AdjustedMembership dues..............................................................................................................................................................................$287,500 $-32,400 $255,100Journal subscriptions.........................................................................................................................................................................31,000 -2,700 28,300Publication sales...............................................................................................................................................................................11,900 11,900Foundation grant...............................................................................................................................................................................54,000 -51,300 2,700Annual meeting prof1t, 1991............................................................................................................................................................ 3,400 ________ 3,400

Total revenue..............................................................................................................................................................................387,800 -86,400 301,400

Expenses:Printing..............................................................................................................................................................................................92,400 -11,600 80,800Committee meeting expenses...........................................................................................................................................................49,200 49,200Annual meeting advance...................................................................................................................................................................10,800 -10,800 0Desktop publishing system...............................................................................................................................................................27,000 -27,000 0

Administrative salaries and expenses......................................................................................................................................................171,500 171,500Miscellaneous.......................................................................................................................................................................................... 25.000 ________ 25,000

Total expenses............................................................................................................................................................................ 375,900 $ - 49,400 326,500Surplus or (deficit)...................................................................................................................................................................................$ 11,900 $ - 37,000 $(25,100)

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Case 3-6: Cape Cod Novelty Shop *

Note: This is a new case for the Eleventh Edition.

This case focuses on the entity on which a report is to be made. Several separable entities can proprietor or business owner. The profit shown in Exhibit 1 in the case is the result of this combined business activity of all three entities, Exhibit 2 in the case presents the same statement restated on the basis that the business operation is separable from the other entities and that the costs attributable to the business entity are those which would be incurred if capital and labor was obtained from third parties (imputed costs).

The following questions should be addressed in the case discussion:

1. Did Mr. Stone make a profit? How much?

2. What is profit?

3. What is the objective of the Research Division?

4. Should Mr. Stone remain in the novelty business?

5. How useful is data prepared by accounting conventions? For management? Stockholders? Potential purchasers of equity? Creditors?

1. Is Mr. Stone’s business profitable?

It is necessary to consider at this point both Mr. Stone’s own statement of profitability and that provided by the Research Division. The Research Division has imputed “opportunity costs.” These are the revenues which Mr. Stone has foregone by using his resource in his own business rather than renting his real estate to an independent party, investing his available funds at 6% interest and working as the manager of a firm not owned by him.

The following Exhibit TN1 shows the reconciliation of these two statements.

* Copyright © 1997 by the President and Fellows of Harvard College, Harvard Business School Teaching Note 5-196-042.

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Mr. Stone’s Revenues from

Store Real Estate “Investment” Management

Net profit as reported $10,627.98

Rent (3,900.00) $3,900.00

2,616.30 (2,616.30)

Salary (10,400.00) $10,400.00

Tax paid 1,125.30 (1,125.30)

Interest (5,920.68) ___________ $5,920.68 ____________

$5,851.10 $1,283.70 $5,920.68 $9,274.70

2. What is the objective of the Research Division?

The Research Division has translated Mr. Stone’s business results from the accounts of a proprietorship into a set of accounts which would be comparable with those of all novelty stores, whether owned by one person or by a corporation. Mr. Stone’s profit from Cape Cod’s operations investment in the business. However, it should be noted that the imputation of interest on capital invested in the business is not a part of generally accepted accounting principles. Therefore, it would be necessary for the Research Division to also impute interest on capital invested in other businesses to keep the results comparable with that of the Cape Cod Novelty Shop.

3. Should Mr. Stone remain tin the novelty business?

The discussion here should revolve around the various concepts of earnings which can be obtained from the statements and their relevance to Stone’s continuing in business.

Mr. Stone himself appears to be using a “tax” concept of earnings except that he had deducted his personal income tax payment form the net income of Cape Cod. Under the tax concept of being included. All the income form the business after payment of expenses is proprietor’s taxable income (or earnings). Under this concept of earnings, the net income on which Mr. Stone would be taxed would be.

$10,627.98 Income as reported

+ 1,125.30 Tax added back

$11,753.28 Taxable income

In this particular case, taxable income and the accounting earnings would be essentially the same. It should be pointed out, however, that this is not always the case.

Mr. Stone’s $4,500 withdrawal appears to be adequate cash for his purposes. It is probably the measure of his success that Mr. Stone would look to when deciding if he should remain in the novelty business.

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An economic concept of profit would consider the total profits earned by all the activities as compared with what might be earned, (opportunity cost). Mr. Stone is worse off through his efforts as an owner manager than he would be as an investor, landlord, and manager for another employer.

It is then possible to discuss “psychic income.” Is it worth it for Mr. Stone to be his own boss? It would appear that he might find that a $5,851.10 “loss” was a small price for his independence.

Question 1

In an accounting sense Stone made a profit. He did not from the point of view of economics. The statements in Exhibit 1 of the teaching note reflect the accounting “profit.” Exhibit 2 of the teaching note shows an economic “profit.” Businesspeople cannot afford to ignore opportunity costs, but accounting conventions do not permit the inclusion of these items in accounting statements. The Research Division was not bound by these conventions. Students should be asked to identify which conventions the Research Division ignored.

Question 2

Success in business is measured by more than accounting statements. The freedom, independence, and other “psychic income” items accruing to Stone must all be considered in any evaluation of his success.

Question 3

If Stone could have used his capital and time as the Research Division assumed, he might have made more money by selling his business. However, the intangibles that neither the economic or accounting statements measured may be more important to Stone.

Question 4

Perhaps one advantage of the Research Division statements was that they forced Stone to look at the economic cost of his seeking freedom, etc. The accounting statements did not raise this issue. This is a real limitation of accounting conventions.

If time permits, the discussion may be continued into such subsidiary issues as:

1. Was the Research Division correct in using book values to compute the interest charge? Should they have used market values? Market values more closely reflect the funds tied up in the business.

2. Would Stone be better off as a corporation? Would this make any difference to his statements? It may help Stone to sort out his business and personal affairs better. Depending on how he set up his employment and real estate relationship with the corporation, the transactions recorded might be different.

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