Financial Accounting: Assets
Question 1
As the auditor for Flyby Ltd., you have noted the following items in your review of the
June 30, 20X5, financial statements:
a. A €200 office chair purchased for the marketing manager on May 31, 20X5, has been
fully expensed.
b. No accrual has been done for unpaid salaries amounting to €9,200.
c. The president of the company does not want to include any notes to the financial
statements, stating that notes are “a waste of time and money.”
d. The company has changed from a periodic inventory system to a perpetual inventory
system.
e. The company has changed the depreciation method on its building from the
declining-balance method to the straight-line method.
Required
For each of items (a) through (e), identify the relevant accounting principle(s), if any, and
explain how it would apply to the item.
Question 2
Multiple choice
a. What is the principal purpose of financial statements?
1)
2)
3)
4)
To disclose the market value of the firm’s assets and liabilities
To determine compliance with tax laws
To make forecasts about the economy
To help users make decisions
b. The IASB follows “due process” when developing or modifying its International
Financial Reporting Standards. Which of the following is not one of the “due
process” steps?
1)
2)
3)
4)
Prepare a Draft Statement of Principles.
Hold public hearings.
Conduct liaison between the IASB and national standard setting bodies.
Make no revisions to the exposure draft.
c. The branch of accounting designed to provide information to users that are external to
the entity, such as investors and creditors, is referred to as which of the following?
1)
2)
3)
4)
Management accounting
Current value accounting
Financial accounting
Management consulting
d. Who is responsible for promulgating International Financial Reporting Standards?
1)
The Financial Accounting Standards Board (FASB)
2)
3)
4)
The European Commission (EC)
The Securities and Exchange Commission (SEC)
The International Accounting Standards Board (IASB)
e. Which of the following statements is not true with respect to the development of a
conceptual framework for accounting?
1)
2)
3)
4)
Most of the work in developing a conceptual framework for accounting was
carried out by the FASB.
The first step in developing a conceptual framework for accounting is
deciding who the users are.
There were no problems with accounting standards prior to the development
of a comprehensive conceptual framework for financial reporting.
Qualitative characteristics of accounting information are an important part of
the conceptual framework for accounting.
f. Which of the following statements regarding international accounting standards is not
true?
1)
2)
3)
4)
The purpose of the IASB is to reduce the diversity of practices in financial
reporting among countries.
Harmonization of international accounting standards will provide benefits to
both preparers and users of financial statements.
As international trade and ownership barriers are removed, the need for
harmonization of international accounting standards will decrease.
Since different countries use financial statements for different purposes, some
countries may not adopt the international accounting standards.
g. UVW Ltd. adopted a depreciation policy by which the depreciation method used each
year would be selected in accordance with the company’s ability to maintain and
report a 20% rate of return on shareholder’s equity. This is a violation of which of the
following?
1)
2)
3)
4)
Matching principle
Reliability characteristic
Comparability characteristic
All of the above
h. The assumption that a business enterprise will not be sold or liquidated in the near
future is called what?
1)
2)
3)
4)
Entity assumption
Going concern assumption
Accrual accounting assumption
Time period assumption
i. J. Perth is the sole owner and manager of ABC Tree Services. Perth purchased a new
van for personal use. Perth uses a dump truck in the business. Which of the following
assumptions, principles, or constraints would be violated if Perth recorded the cost of
the van as an asset of ABC Tree Services?
1)
2)
3)
Entity assumption
Going concern assumption
Full disclosure principle
4)
Matching principle
j. A corporation is approaching a bank for a large loan to finance an ambitious
expansion plan. Land is recorded on the company’s balance sheet at its original cost
of €20,000,000? Since the company plans to use the land as collateral for the loan, it
decides to restate the land on its balance sheet to its current fair market value of
€50,000,000 before it approaches the bank. What assumption of accounting or basis
of measurement is violated?
1)
2)
3)
4)
Going concern assumption
Historical cost basis of measurement
Time period assumption
Accrual accounting assumption
k. A corporation purchased merchandise inventory for €100,000 cash in April. All
inventory was sold on account to a customer in May for €150,000. The customer paid
the €150,000 owing to the corporation in June. How much profit would this
corporation record in its financial statements for the month of May?
1)
2)
3)
4)
(€100,000)
€0
€50,000
€150,000
l. A corporation owns a piece of land. The land is recorded on the balance sheet at its
original cost of €250,000. An independent appraisal has been done that shows the
land is now worth €500,000. Why will the land continue to be recorded on the
company’s balance sheet at its historic cost of €250,000?
1)
2)
3)
4)
Time period assumption
Cost/benefit constraint
Reliability more important than relevance
Relevance more important than reliability
m. In classifying the elements of financial statements, what is the primary distinction
between revenues and gains?
1)
2)
3)
4)
The materiality of the amount involved
The likelihood that the transactions involved will recur in the future
The nature of the activities that gave rise to the transactions involved
Management’s involvement in the decision to sell
n. Companies usually record as expenses all expenditures for equipment that do not
exceed a specified amount. This is an application of which of the following?
1)
2)
3)
4)
Matching principle
Historic cost principle
Materiality constraint
Cost-benefit constraint
o. A corporation received €14,000 cash from a customer as an advance for consulting
work to be done by the corporation. At its fiscal year end the corporation has not yet
performed any of the consulting services. How should the corporation report the
€14,000 in the year-end financial statements?
1)
2)
3)
4)
As revenue
As an asset
As an expense
As a liability
p. The bookkeeper for Axo Corporation incorrectly recorded a €400 cash purchase of
supplies as a debit to supplies of €40 and a credit to cash of €40. What best describes
the resulting trial balance?
1)
2)
3)
4)
The trial balance will not balance because debits will be greater than credits
by €360.
The trial balance will not balance because credits will be €360 greater than
debits.
The trial balance will still balance but the amounts for both cash and supplies
will be in error.
The trial balance will not balance because debits will be €40 greater than
credits.
q. If D is the sum of the debit column of a firm’s unadjusted trial balance and C is the
sum of the credit column, which of the following statements is true?
1)
2)
3)
4)
D typically does not equal C because the adjusting journal entries have not yet
been recorded.
D equals the sum of all assets and expenses.
If D does not equal C, it is possible that no errors were committed.
If D equals C there is still a chance that the firm made a recording error.
r. The following four adjusting journal entries were recorded by a firm at the end of its
fiscal year:
#1 Bank service charge expense
Cash
#2 Bad debt expense
Allowance for doubtful accounts
#3 Insurance expense
Prepaid insurance
#4 Wages expense
Wages payable
The firm uses reversing journal entries to simplify certain journal entries in the next
accounting period. Which of the four adjusting journal entries would be reversed at
the beginning of the next fiscal year?
1)
2)
3)
4)
All four entries should be reversed
#1, #3, #4 should be reversed
#3, #4 should be reversed
#4 only should be reversed
(2 marks each)
s. The balance of accounts receivable for a corporation at the beginning of the year was
€85,000 and the closing balance was €140,000. Total sales for the year were
€400,000. Assuming cash sales of €45,000 were included in total sales, how much
cash was received from customers during the year?
1)
2)
€455,000
€345,000
3)
4)
€500,000
€390,000
t. A corporation commenced operations on January 1, year 1 when it issued ordinary
stock for €150,000 cash. At the end of year 1 the corporation had total assets of
€240,000, total liabilities of €40,000 and accumulated profits of €50,000. If profit for
the year was €180,000, what was the amount of dividends declared during the year?
1)
2)
3)
4)
€190,000
€90,000
€130,000
€110,000
u. A corporation had €45,000 of inventory at the beginning of the year and €65,000 of
inventory at the end of the year. Net purchases for the year were €525,000. What
would cost of goods sold for the year be?
1)
2)
3)
4)
€505,000
€545,000
€480,000
€460,000
v. At the end of year 3, Zada Corp. had a working capital balance of €420,000. Other
balances were €140,000 of current liabilities, €200,000 of non current assets, and
€240,000 of capital and reserves. What was the amount of non-current liabilities at
the end of year 3?
1)
2)
3)
4)
€100,000
€520,000
€380,000
€620,000
w. During its first year of operations, a small software consulting company engaged in
the following transactions:
 Purchased supplies for €8,000 on account.
 Provided consulting services to a number of clients who were billed a total of
€28,000. During the year, €18,000 of the fees billed was collected. The remainder
of the fees are expected to be collected in the following year
 €12,000 of wages was paid to employees during the year and the employees were
still owed €2,000 at the end of the year.
 Paid €6,000 of the amount owing from the purchase of supplies
 There was €3,000 of supplies left on hand at the end of the year.
What is the pretax profit for this company for the year?
1)
2)
3)
4)
( € 2,000)
€0
€9,000
€8,000
x. A corporation had total revenue in its first year of operations of €460,000. Its
accounts payable balance (for expense items only) at the end of the year was €24,000
and its prepaid expense balance at the end of the year was €14,000. During the year,
the corporation paid a total of €340,000 for purchases and other expenses. There was
no inventory on hand at the end of the year.
What was the amount of the corporation’s pretax profit for its first year of operations?
1)
2)
3)
4)
€130,000
€110,000
€96,000
€106,000
Question 3 (16 marks)
Jonco Inc. is in the process of finalizing its financial statements for the year ended
December 31, year 5. The following issues are still unresolved:
A. For insurance purposes, Jonco Inc. has recently had an appraisal done on its
manufacturing facility. The appraisal gives the manufacturing facility a current value
of €5,500,000. The depreciated cost of the manufacturing facility is €3,400,000. The
Vice President of Finance feels strongly that the manufacturing facility should be
valued at €5,500,000 in the December 31, year 5 balance sheet because it is a much
more accurate estimate of the worth of the asset than the depreciated cost.
B. Jonco introduced a very successful new product, the Wiz machine, during year 5.
Demand for the Wiz far exceeded the company’s estimates. Everything that the
company could produce was immediately sold to eager customers. Anticipating
continued strong demand, the company employees worked 24 hours a day during the
last week of December to produce 100,000 more Wiz machines. These machines
were completed late on December 31. Although these 100,000 machines were not
made for a particular customer, the company thinks it would be appropriate to record
the revenue of €6,000,000 (100,000 units × €60/unit) in the year ended December 31,
year 5 because the demand is still high and the company has already sold the rest of
its inventory of Wiz machines.
C. During the year a competitor of Jonco, Allied Machine Ltd., filed a lawsuit against
Jonco claiming that Jonco’s Wiz machine infringed on a patent held by Allied. Since
the Wiz machine was proving so profitable to Jonco, the Jonco lawyers were
instructed to defend their client at all costs. Even though the amount of the lawsuit is
material to Jonco, they do not believe there is any need to advise readers of its
financial statements about the lawsuit since they are so confident that they will be
successful in defending against it.
D. Near the end of the year, Jonco made a large sale of Wiz machines to a new
customer, Donzi Industries Ltd. The sale was for €400,000 and the machines were
delivered to Donzi on December 21, year 5. Since the company had never dealt with
Donzi before, it did extensive credit checks on Donzi before authorizing the sale on
credit. Satisfied that Donzi was a good credit risk, Jonco thinks that it is acceptable to
record the sale and the related cost of goods sold of €280,000 in December rather
than waiting to record the revenue and cost of goods sold when the cash is received,
hopefully, in late January, year 6.
Required
For each of the above unresolved issues, provide your recommended accounting
treatment. Support your answers by reference to the appropriate accounting assumption,
qualitative characteristic, or measurement principle.
Question 4 (27 marks)
The balance sheet of Wiley Ltd. at June 30, 20X5, is as follows:
WILEY LTD.
Balance Sheet
June 30, 20X5
ASSETS
Non-current assets
Buildings and equipment
Less: Accumulated depreciation
€ 800,000
280,000
€
Current assets
Cash
Accounts receivable (less Allowance for
doubtful accounts of €4,000)
Inventory
Prepaid expenses
150,000
100,000
234,000
16,000
500,000
€ 1,020,000
Total assets
EQUITY AND LIABILITIES
Capital and reserves
Capital stock
Accumulated profits
€ 200,000
600,000
€
Current liabilities
Accounts payable
520,000
800,000
220,000
Total equity and liabilities
220,000
€ 1,020,000
The following summary transactions occurred during the company’s subsequent fiscal
year (the year ended June 30, 20X6):
a. Purchased merchandise inventory for €120,000 on account. Wiley uses the perpetual
inventory system.
b. Paid accounts payable of €180,000.
c. Sold merchandise for €240,000 on account and €80,000 cash. The merchandise sold
originally cost €220,000.
d. Paid regular operating expenses of €46,000.
e. Collected €140,000 of accounts receivable.
f. Purchased merchandise inventory for €140,000 on account.
g. Paid accounts payable of €130,000.
h. Sold merchandise for €220,000 on account and €60,000 cash. The merchandise sold
originally cost €190,000.
i. Issued new ordinary shares for €200,000 cash.
j. Collected accounts receivable of €300,000.
k. Paid operating expenses of €64,000.
l. Purchased merchandise inventory for €180,000 on account.
m. Sold merchandise for €260,000 on account and €90,000 cash. The merchandise
originally cost €260,000.
Required
1. (8 marks)
Prepare the journal entries to record transactions (a) to (m).
2. (5 marks)
Prepare the adjusting journal entries at June 30, 20X6. Assume a bad debt rate of ½% of
credit sales for the period ended June 30, 20X6. Accrued wages at June 30 were €12,000.
The prepaid expense of €16,000 on the June 30, 20X5, balance sheet represented 16
months of prepaid rent. The buildings and equipment are being depreciated on a straight
line basis over 20 years and it is estimated that there will be no salvage value for the
buildings and equipment. Income tax expense (at 40%) is €43,360. You should check
your work by making sure that you get this number for income tax expense.
3. (6 marks)
Prepare the income statement in good format for the year ended June 30, 20X6.
4. (8 marks)
Indicate the balance in each of the following accounts that would appear on the June 30,
20X6 unadjusted trial balance, adjusted trial balance, and post-closing trial balance:
i)
ii)
iii)
iv)
Cash
Allowance for doubtful accounts
Accumulated profits
Tax expense
Question 5 (12 marks)
The following are examples of companies following generally accepted accounting
principles:
A. A software development company follows the policy of expensing all development
costs incurred in developing new software products until the technological feasibility
of the new product is established. Once the technological feasibility of the new
software product is established, future development costs will be capitalized as assets.
B. A computer services firm provides software maintenance to customers under
three-year service contracts. The customers pay for the service contract at the
beginning of the three-year period. The computer services firm recognizes revenue
from these contracts pro rata over the term of the contract.
C. A high tech firm is being sued by a number of its shareholders on the grounds that the
company failed to disclose information that would have indicated the company’s
share price was too high. The amount of the lawsuit is material but the firm expects
that it will be successful in its defence. Details of the lawsuit are provided in the notes
to the financial statements, but no amount for possible loss has been recorded in the
financial statements.
Required
For each of the above cases, provide a detailed explanation as to why the accounting
being followed by the company is appropriate. Make specific references to the parts of
the Conceptual framework that support the company’s choice of accounting method.
(Note: 4 marks for each part; of the 4 marks for each part, one mark will be awarded for
writing skills — that is, proper sentence structure, grammar, spelling, and so on.)
100
Answers
Suggested solutions
Question 1 (15 marks — 3 marks each)
a. The materiality principle would dictate that fully expensing the item is appropriate
when the amount is not significant to the financial statements.
b. The matching principle would dictate that salaries should be matched with the
revenue they helped generate, thus the salary expense should be accrued.
c. The full disclosure principle would dictate that notes to the financial statements must
be included to ensure all relevant information is provided.
d. It is appropriate to change inventory systems (not methods). The inventory system
chosen should have no impact on the financial statements — assuming prices are
stable.
e. The consistency principle would dictate that depreciation methods should not be
changed as the expense will not be comparable across years.
Question 2 (30 marks)
Multiple choice (1 mark each)
a. 4)
The IASB’s Framework for the Preparation and Presentation of Financial Statements
states that the principal objective of financial statements is to provide information to
users to enable them to make economic decisions.
b. 4)
Feedback received on the exposure draft could and often does result in changes to the
exposure draft before it is adopted as a new IFRS or IAS.
c. 3)
Financial accounting is designed to provide information to external users of the
organization, such as investors and creditors.
d. 4)
The IASB is the body which develops International Financial Reporting Standards.
e. 3)
The reason that the accounting professions commenced work on a Conceptual framework
for accounting was precisely because the accounting standards of the time were not
proving satisfactory for the reporting of the results of operations.
f. 3)
As international trade and ownership barriers are removed, there will be more
international trade and more need for international accounting standards because these
international companies will want to be able to use one set of financial statements no
matter where they are operating in the world.
g. 4)
It would be a violation of the matching principle because there would not necessarily be
any relationship between the revenue produced by the assets and the cost that is expensed
in the period. It would be a violation of the reliability characteristic because there would
be no relationship to the original cost of the assets. It would be a violation of the
comparability characteristic because the basis of the depreciation calculation would
change every year.
h. 2)
The assumption that a business enterprise will not be sold or liquidated in the near future
is called the going concern assumption.
i. 1)
Financial statements are prepared for the company as a separate entity distinct from the
owner. Therefore, the dump truck (but not the owner’s personal van) should be reported
as an asset of the company.
j. 2)
Property, plant and equipment are generally recorded at the actual cost paid by the entity
and not at the estimated current value.
k. 3)
The accrual accounting assumption says that the revenue should be recorded when it is
earned (goods sold in this case) and any costs incurred to earn the revenue should be
recorded as expense in the same period. In April, revenue of €150,000 is recognized from
the sale of inventory and expense of €100,000 is recognized as the cost of inventory used
up to generate the sale, resulting in profit of €50,000 in April.
l. 3)
In general, accountants have considered reliability to be more important than relevance
when a trade-off between the two is required. Historical cost, since it is a known amount,
is considered the most reliable figure.
m. 3)
Revenue is income that is generated by regular operating activities of the enterprise.
Gains are income that is not generated by regular operating activities of the enterprise.
n. 3)
Although the expenditures for equipment should be recorded as assets and depreciated
over their useful lives, it is more practicable to expense these costs as incurred. Users are
not being misled because the amounts involved are so small that the expensing instead of
capitalizing would not change the decision of the user, which is the definition of
materiality.
o. 4)
The company has an obligation (to provide a service) that has arisen from a past event
(the receipt of the €14,000 cash). Therefore, there is a liability.
p. 3)
Although the recorded amounts are incorrect, the trial balance will still balance because
debits were equal to credits.
q. 4)
Debits must equal credits in the unadjusted trial balance. This equality does not guarantee
there are no recording errors — an error in recording could have been made that didn’t
result in an inequality of debits and credits.
r. 4)
Reversing entries are applicable when the adjusting entries occur prior to the cash being
received or disbursed for the items in question. Entry #4 is the only adjusting entry where
there will be cash following.
(2 marks each)
s. 2)
€85,000 + €400,000 – €140,000
t. 3)
€180,000 – €50,000
u. 1)
€45,000 + €525,000 – €65,000
v. 1)
(€420,000  €140,000) + €200,000  €140,000 – €240,000
w. 3)
€28,000  (€12,000 + €2,000) €8,000 – €3,000)
x. 2)
€460,000  (€24,000 + €340,000  €14,000)
Question 3 (16 marks)
A. (4 marks)
The manufacturing facility should be recorded at its depreciated cost, or book value, of
€3,400,000. This is consistent with the historical cost basis of measurement. Additional
support for recording at the historic cost comes from the going concern assumption of
accounting. This assumes that the entity will not be liquidated in the near future.
Consequently, it makes sense from an economic perspective to record the asset at its
historic cost (along with depreciation to calculate the cost over its useful life) rather than
at its current value, since there is no intention of disposing of the asset under the going
concern assumption. Note that the qualitative characteristic of reliability supports the
recording of the asset at its historical cost, since there is proof of that number. Although
the current value of the asset may be more relevant, the qualitative characteristic of
reliability has generally won out in the trade-off between reliability and relevance.
Finally, be aware that IAS 16 does allow revaluation subsequent to acquisition, but most
companies choose not to use that alternative.
B. (4 marks)
The company should not record the revenue of €6,000,000 in year 5, but should record
the revenue in the period that the Wiz machines are actually sold. The reliability
qualitative characteristic supports the recording of the revenue only in the period that the
machines are actually sold. Although it may be relevant to show the revenue when the
goods are ready to sell (since most of the work has been done and it is likely there is a
buyer) it is always possible that there won’t be a buyer. The risk that there won’t be a
buyer in the future means that reliability wins in the trade-off over relevance. Also, the
accrual accounting concept would tend to support recording the revenue at the time of
sale. The significant activity in a manufacturing enterprise is the selling of the product,
not just the production of the product. Finally, the revenue recognition principles (which
will be dealt with in a future lesson) have not been met.
C. (4 marks)
The fact that the company is being sued for a material amount should probably be
disclosed in the notes to the financial statements under the full disclosure principle which
says that sufficient information should be disclosed in financial statements so that a
prudent investor will no be misled. The recognition criteria says that elements should be
recognized in the financial statements when it is probable that a future economic benefit
will flow to or from the enterprise and the cost or value of the benefit can be measured
with reliability. In this case, since the outcome of the lawsuit is not known and any
possible settlement amount is also not known, it is reasonable that no amount be accrued
in the financial statements. But, since the potential settlement amount is material and
there is some possibility of losing the lawsuit, there must be financial statement
disclosure of the nature of the lawsuit.
D. (4 marks)
The sale of €400,000 and the related cost of goods sold should be recorded in year 5. The
recognition criteria says that elements should be recognized in the financial statements
when it is a probable there will be an economic benefit to the firm and the item has a
value that can be measured with reliability. In this case, since the customer appears to be
a good credit risk, it is probable that Jonco will eventually receive the cash from the sale.
The amount of the sale is known because there was a sale price established at the time of
the sales transaction. Although it is not certain that the cash will be collected, there is
enough evidence in this case that relevance outweighs reliability. The matching principle
supports the recording of the cost of goods sold (the sales expense) in the same period as
the related revenue is recognized. Therefore, cost of goods sold should also be recorded
in year 5.
Question 4 (27 marks)
Note:
Debits and credits are not identified by DR and CR in these suggested solutions, but students should format
journal entries of debits and credits by using DR and CR, as suggested in the Notes at the start of this
assignment.
Requirement 1 (8 marks)
Current entries
a. (1/2 mark)
Inventory ................................................................................
Accounts payable .............................................................
120,000
120,000
b. (1/2 mark)
Accounts payable ...................................................................
Cash .................................................................................
180,000
180,000
c. (1 mark)
Cash .......................................................................................
Accounts receivable ...............................................................
Sales revenue ...................................................................
80,000
240,000
Cost of goods sold .................................................................
Inventory ..........................................................................
220,000
d. (1/2 mark)
320,000
220,000
Operating expenses ................................................................
Cash .................................................................................
46,000
46,000
e. (1/2 mark)
Cash .......................................................................................
Accounts receivable .........................................................
140,000
140,000
f. (1/2 mark)
Inventory ................................................................................
Accounts payable .............................................................
140,000
140,000
g. (1/2 mark)
Accounts payable ...................................................................
Cash .................................................................................
130,000
130,000
h. (1 mark)
Cash .......................................................................................
Accounts receivable……………………………… ...............
Sales revenue ...................................................................
60,000
220,000
Cost of goods sold .................................................................
Inventory ..........................................................................
190,000
280,000
190,000
i. (1/2 mark)
Cash .......................................................................................
Ordinary shares ................................................................
200,000
200,000
j. (1/2 mark)
Cash .......................................................................................
Accounts receivable .........................................................
300,000
300,000
k. (1/2 mark)
Operating expenses ................................................................
Cash .................................................................................
64,000
64,000
l. (1/2 mark)
Inventory ................................................................................
Accounts payable .............................................................
180,000
180,000
m. (1 mark)
Cash .......................................................................................
Accounts receivable………………………………… ...........
Sales revenue ...................................................................
90,000
260,000
Cost of goods sold ................................................................
Inventory ..........................................................................
260,000
350,000
260,000
Requirement 2 (5 marks)
Adjusting entries
a. (1 mark)
Operating expense (bad debt expense) ..................................
Allowance for doubtful accounts .....................................
(€240,000 + €220,000 + €260,000) 1/2 = €3,600
3,600
3,600
b. (1 mark)
Operating expense (wages) ....................................................
Wages payable .................................................................
12,000
12,000
c. (1 mark)
Operating expense (rent)........................................................
Prepaid expense ...............................................................
€16,000 12/16€12,000
12,000
12,000
d. (1 mark)
Operating expense (depreciation) ..........................................
Accumulated depreciation, buildings & equipment
€800,000 ÷ 20 years = €40,000 ....................................
40,000
40,000
e. (1 mark)
Tax expense ..........................................................................
Taxes payable .................................................................
43,360
43,360
Computation of income tax:
Revenues (i) ...................................................................................................
Expenses (ii) ..................................................................................................
Profit before tax .............................................................................................
Tax expense (€108,400  40%) .....................................................................
Net income .....................................................................................................
€950,000
841,600
108,400
43,360
€ 65,040
(i) €240,000 + €80,000 + €220,000 + €60,000 + €260,000 + €90,000
(ii) Cost of goods sold of €670,000 (€220,000 + €190,000 + €260,000) plus Operating
expenses of €171,600 (€46,000 + €64,000 + €3,600 + €12,000 + €12,000 + €40,000)
Note:
Perpetual inventory system — no adjusting entry is needed for inventory and cost of goods sold because
they are correctly stated.
Requirement 3 (6 marks)
WILEY LTD.
Income Statement
for year ended June 30, 20X6
Sales revenue .................................................................................................
Cost of goods sold .........................................................................................
Gross profit ....................................................................................................
Operating expenses ........................................................................................
Operating profit before tax ............................................................................
Tax expense (40%) ........................................................................................
Net profit ........................................................................................................
€950,000
670,000
280,000
171,600
108,400
43,360
€ 65,040
Requirement 4 (8 marks)
Accounts
Unadjusted
trial balance
Debit
Credit
i) Cash ............................. 300,000
ii) Allowance for
doubtful accounts ......
4,000
iii) Accumulated profits......
600,000
iv) Tax expense ..................
Adjusted
trial balance
Debit Credit
300,000
Post-closing
trial balance
Debit Credit
300,000
7,600
600,000
7,600
665,040
43,360
(2 marks each for the first two entries; 3 marks for the third entry; and 1 mark for the
fourth entry.)
Question 5 (12 marks)
A
The issue here is whether, and/or when, the expenditures on software development
should be capitalized as an asset. The part of the definition of an asset that is relevant
here is that an asset is a resource from which future economic benefits are expected to
flow to the enterprise. Prior to establishing technological feasibility, there can be no
guarantee (and probably not even reasonable assurance) that the development costs will
produce future benefits to the enterprise in the form of sales of new products. This relates
to the recognition criterion for assets that says it must be probable that future economic
benefits will come to the enterprise. Since it is not probable, because the company
doesn’t yet know if a successful product will result, the expenditure is correctly
expensed. Once the technological feasibility of the product has been established, the
enterprise may conclude that it is probable that future economic benefits will flow to it
from sales of new products. If that is the assessment, then the expenditures may be
capitalized and an asset recognized.
B
The revenue recognition principle states that revenue should be recognized when the
earnings process is virtually complete. In this case, where the computer services firm
provides service under a three-year contract, the earnings process is not completed until
the end of the three-year period. However, it would not be relevant to wait until the end
of the three-year period to record any revenue. Income is defined as an increase in
economic benefits during the accounting period. Since the enterprise completes one third
of its work each year, there has been an increase in economic benefits. The enterprise has
performed a service for which it has already been paid. In other words, the enterprise has
now earned the money that it was previously paid. The matching principle also comes
into play here. It wouldn’t make any sense to record all of the revenue when the cash was
received at the beginning of the contract and then to record the related expenses of
providing the service over the three years as they are incurred. As noted in our
discussions of accrual accounting versus cash accounting, this would not give results that
matched economic reality. Each year, the company is better off by the difference between
what it earns (one third of the contract) and the expenses incurred in that year to service
the contract.
C
The liability for the lawsuit should be recognized only if it meets the recognition criteria.
According to the recognition criteria, the liability should be recognized if it is probable
that there will be a future flow of economic benefits out of the enterprise and if the
amount of that outflow can be measured with reliability. In this case, the enterprise feels
that it will be successful in defending against the lawsuit. There is nothing in the question
to suggest that the enterprise’s lawyers disagree with this assessment. Therefore, it is not
probable that there will be a future outflow of economic benefits. In addition, the second
criterion is not met because there is no estimate of what amount the lawsuit might
involve. Therefore, it seems appropriate that no liability is recorded in the financial
statements for a potential loss from the lawsuit. However, since the amount is material,
details about the nature of the lawsuit should be disclosed, as they have been, in the notes
to the financial statements. This is following the full disclosure principle.
Note:
3 marks (1 per case) should be awarded for writing skills — that is, proper sentence structure, grammar,
spelling, and so on.
100