Accounting for Lawyers
Professor Bradford
Fall 2001
Exam 2001
The following answer outlines are not intended to be model answers, nor are they
intended to include every issue that students discussed. They merely attempt to identify
the major issues in each question and some of the problems or questions arising under
each issue. They should provide a pretty good idea of the kinds of things I was looking
for. If you have any questions about the exam or your performance on the exam, feel free
to contact me to talk about it.
I graded each question separately. Those grades appear on the front cover of your
blue books. To determine your overall average, each question was then weighted in
accordance with the time allocated to that question.
Question 1
Journal entries:
11/1
Cash
5,000
Partner’s Equity: George
11/1
11/1
5,000
Rent Expense
Prepaid Rent Expense
Cash
1,000
1,000
Cash
2,000
2,000
Note Payable
11/2
11/2
11/5
11/7
11/11
2,000
Cash
Furniture and Fixtures
Partner’s Equity: Mary
4,000
2,000
Supply Expense
Cash
50
Purchases
Cash
300
Purchases
Cash
220
Cash
150
6,000
50
300
220
Sales
11/13
Cash
150
280
Sales
11/17
Cash
280
160
Sales
11/18
11/20
11/26
160
Purchases
Cash
90
Partner’s Equity: George
Cash
500
Cash
130
Sales
90
500
130
11/30
11/30
11/30
11/30
11/30
11/30
11/30
11/30
Purchases
Accounts Payable
240
Telephone Expense
Cash
75
Interest Expense
Interest Expense Payable
10
Cost of Goods Sold
Purchases
850
Inventory
Cost of Goods Sold
300
Theft Loss
Inventory
100
Profit and Loss
Theft Loss
Rent Expense
Interest Expense
Supply Expense
Telephone Expense
Cost of Goods Sold
1,785
Sales
720
240
75
10
850
300
100
100
1000
10
50
75
550
Profit and Loss
11/30
Partner’s Equity: George
Partner’s Equity: Mary
Profit and Loss
[T-accounts on separate spreadsheet.]
720
532.50
532.50
1,065
ZuZu’s Petals Partnership
Balance Sheet
As of Nov. 30, 2001
Liabilities and Partners’
Equity
Assets
Cash
Prepaid Rent Expense
Inventory
Furniture and Fixtures
TOTAL
$8,485
1,000
200
2,000
$11,685
Liabilities
Accounts Payable
Interest Expense Payable
Note Payable
Partners’ Equity
George
Mary
TOTAL
$
240
10
2,000
3,967.50
5,467.50
$11,685
ZuZu’s Petals
Income Statement
For the Month of November, 2001
Sales
Less: Cost of Goods Sold
Gross Profit on Sales
Operating Expenses:
Rent
Interest
Supplies
Telephone
Theft
Total Operating Expenses
NET LOSS
$720
550
170
$1,000
10
50
75
100
1,235
($1,065)
Question 2
To decide whether this is a good investment for Alice, we must compare the
present value of all the payments Alice must make to the present value of the payments
she will receive, using as the discount rate the 7% return she can earn in her best
alternative investment. If the discounted returns exceed the sum of the discounted
payments, this is a good investment. The calculations are easiest if we look at the present
values as of January 1, 2002.
Alice’s Payments. The present value of Alice’s first payment is simply $2,600.
We can consider the other nine $2,600 payments as an annuity in arrears (payable at the
end of each year). From Table IV in Appendix B of the book, the present value factor for
a nine-year annuity with a 7% discount rate is 6.51523. Thus, the present value of these
nine payments is $2,600 x 6.51523 = $16,939.60. The total present value of Alice’s
payments is therefore $2,600 + $16,939.60 = $19,539.60.
Alice’s Return. In return for her investment, Alice receives two payments. The
first payment is $10,000 paid 5 years from Jan. 1, 2002. From Table III in Appendix B,
the present value factor for a payment in 5 years with a 7% discount rate is .71299. Thus,
the present value of this first receipt is $10,000 x .71299 = $7,129.90. Alice also receives
a second payment of $24,000 in ten years. From Table III, the present value factor for a
payment in ten years with a 7% discount rate is .50835. Thus, the present value of this
second receipt is $24,000 x .50835 = $12,200.40. The total present value of the
investment return is therefore $7,129.90 + $12,200.40 = $19,330.30.
Comparison. The present value of the payments, $19,539,60, is greater than the
present value of the return, $19,330.30. Therefore, this is not a good investment for
Alice.
Question 3
When to Recognize Revenue and Expenses:
The revenue recognition principle says to recognize revenue when (1) there is an
exchange transaction and (2) the seller has substantially completed the earnings process.
The first requirement is met by the contract. The more difficult issue is determining
when Inter substantially completed the earnings process.
Arguably, Inter has completed everything it is required to do as of Dec. 15, when
Geekway is supposed to pick up the processors. The shipment is segregated and ready
for pickup at that point, so there’s an excellent argument for revenue recognition, even
stronger than in Pacific Grape. Usually, substantial completion occurs as of shipment,
but not here, where Inter is not required to ship. Nevertheless, revenue is usually
recognized when the risk of loss and title pass and that probably would not be until
Geekway picks up the processors in 2001.
The possibility of return does not preclude revenue recognition under SFAS No.
48. SFAS No. 48 lists several requirements that must be met for revenue to be
recognized before a right of return expires. Several of these are clearly met: the price is
fixed; as far as we know, the buyer has economic substance apart from resources
provided by Inter; Inter has no significant future obligations under the contract; and,
given its past experience, Inter can reasonably estimate future returns. However, one
requirement is problematic. It’s not clear that the risk of loss has passed to Geekway
when the processors were segregated. If not, SFAS precludes revenue recognition in
2000, and revenue would not be recognized until 2001, when Geekway picked up the
processors.
Even if revenue is not recognized for most of the contract until 2001, an argument
can be made that revenue should be recognized for the initial shipment of 500 processors
because that portion of the contract clearly has been substantially completed and the risk
of loss has passed as to those processors. If this is done, the related expenses, including
estimated returns for that portion, must also be recognized in 2000.
When revenue is recognized, the amount of future returns must be estimated and
taken as an expense. This is a contingency which must be recognized under Paragraph 8
of SFAS No. 5. Given past history (5-10%), it is probable that a liability of at least 5%
has been incurred and the amount of that loss (at least the 5%) can be reasonably
estimated. As to the remainder, the likelihood is less certain, but disclosure is still
required by Paragraph 10 of SFAS No. 5.
Whenever, the revenue is recognized, the corresponding shipping expense should
also be recognized under the matching principle.
Journal Entries (if revenue recognized in 2001):
Nov. 1
Dec. 1
Dec. 15
Jan. 2
Deferred Shipping Expense
Cash
$700
Deferred Shipping Expense
Cash
$500
Cash
Deferred Sales
$100,000
$100,000
Deferred Sales
$400,000
$400,000
Cash
$700
$500
Jan. 5
Deferred Sales
Sales
$500,000
$500,000
Jan. 5
Shipping Expense
Deferred Shipping Expense
$1,200
Jan. 5
Sales Returns
Estimated Liability: Sales Returns
$25,000
$25,000
Dec. 31
Estimated Liability: Sales Returns
Cash
$20,000
$20,000
$1,200
[If they are certain this is all the returns—that their initial estimate was too high, they
should also make the following entry to get rid of the remaining estimated liability:
Estimated Liability: Sales Returns
Sales Returns
$5,000
$5,000]
Journal Entries (if revenue recognized in 2000):
Nov. 1
Dec. 1
Dec. 15
Deferred Shipping Expense
Cash
$700
Deferred Shipping Expense
Cash
$500
Cash
$100,000
$100,000
Deferred Sales
Dec. 31
Deferred Sales
Accounts Receivable
Sales
$700
$500
$100,000
$400,000
$500,000
Dec. 31
Shipping Expense
Deferred Shipping Expense
$1,200
Dec. 31
Sales Returns
Estimated Liability: Sales Returns
$25,000
$25,000
Jan. 2
Cash
$400,000
$400,000
Deferred Sales
Dec. 31
Estimated Liability: Sales Returns
Cash
$1,200
$20,000
$20,000
[If they are certain this is all the returns—that their initial estimate was too high, they
should also make the following entry to get rid of the remaining estimated liability:
Estimated Liability: Sales Returns
Sales Returns
$5,000
$5,000]
Journal Entries (if only part of revenue recognized in 2000):
Nov. 1
Shipping Expense
Cash
$700
Nov. 1
Accounts Receivable
Sales
$25,000
$25,000
Nov. 1
Sales Returns
Estimated Liability: Sales Returns
$1,250
Deferred Shipping Expense
Cash
$500
Cash
Accounts Receivable
Deferred Sales
$100,000
$25,000
$75,000
Deferred Sales
$400,000
$400,000
Dec. 1
Dec. 15
Jan. 2
Jan. 5
Cash
Deferred Sales
Sales
$700
$1,250
$500
$475,000
$475,000
Jan. 5
Shipping Expense
Deferred Shipping Expense
$500
Jan. 5
Sales Returns
Estimated Liability: Sales Returns
$23,750
$23,750
Dec. 31
Estimated Liability: Sales Returns
Cash
$20,000
$20,000
$500
[If they are certain this is all the returns—that their initial estimate was too high, they
should also make the following entry to get rid of the remaining estimated liability:
Estimated Liability: Sales Returns
Sales Returns
$5,000
$5,000]
Question 4
A.
To calculate the depreciation expense, we must first determine the depreciable
cost of the machine, its useful life, and its salvage value.
Depreciable Cost. The depreciable cost of the machine includes all expenses to
acquire the machine and to bring it to the location and condition of its intended use. That
would include the $50,000 purchase price, the $3,000 to ship the machine to Ajax, and
the $2,000 to modify the machine for its intended use by Ajax. It would not include
expenditures for ordinary repairs and maintenance (the $500), which are period costs.
The depreciable cost of the Widget 990 is therefore $50,000 + $3,000 + $2,000 =
$55,000.
Useful Life and Salvage Value. The relevant useful life is the useful life to
Ajax, not how long the machine will last. The useful life of the machine to Ajax is only
10 years, after which it will upgrade. The salvage value to Ajax at the end of this useful
life is $15,000.
Straight-line depreciation. The expense for both 2001 and 2002 will be
($55,000 - $15,000)  10 = $4,000.
Double-declining balance method:
Year
2001
2002
$55,000 x 1/10 x 200% =
$44,000 x 1/10 x 200% =
Expense
$11,000
$8,800
Balance
$44,000
$35,200
B.
The depreciation expense in 2001, using the straight-line method, is $4,000.
Thus, the net book value of the machine on the balance sheet is $55,000 - $4,000 =
$51,000. This book value must be written down to fair value if the asset is impaired
pursuant to FASB No. 144 (which replaces No. 121). The machine is used in Ajax’s
operations, so that portion of FASB No. 144 is used.
FASB No. 144 uses a three-part analysis. First, some event or change in
circumstances must trigger an impairment review. A significant decrease in an asset’s
market value is one such trigger; a drop to $40,000 probably qualifies. However, we
must believe that it is a permanent, not a temporary, decline in value for it to trigger an
impairment review.
If this drop in market value triggers a review, the second step is a cash-flow
analysis to determine if the asset is impaired and a write-down is necessary. You
compare the total undiscounted cash flows the machine is expected to produce to the
undiscounted cash outflows to produce them. Here, Ajax expects the machine to
generate cash of $10,000 a year over its ten-year life, plus the $15,000 Ajax expects upon
disposal of the asset. The total cash inflow is ($10,000 x 10) + $15,000 = $115,000. The
total cash outflow to produce that revenue is $3,000 x 10 = $30,000. The net
undiscounted cash flow is a positive $85,000. A write-down is triggered only if the net
cash flow is less than the book value of the machine. The book value is $51,000, so we
do not need to write down the machine to its fair value. We don’t get to the third part of
the analysis.
Question 5
A. Return on Sales
= Net Income  Net Sales
= $27,000  $150,000
= 0.18
B. Inventory Turnover
= Cost of Goods Sold  Average Inventory
Average Inventory
= [Inventory(1999) + Inventory(2000)]  2
= ($210,000 + $170,000)  2
= $190,000
Inventory Turnover
= $60,000  $190,000
= .316
C. Debt to Total Assets Ratio = Total Liabilities  Total Assets
= $182,000  $527,000
= .345
Question 6
If, as here, circumstances do not reasonably assure that a company will collect the
full sales price reflected in a receivable, APB No. 10 allows the company to use either the
installment method or the cost recovery method. The question indicates that Armadillo
uses the installment method. The installment method allocates part of each cash payment
received from the buyer to cost recovery and the rest to profit. The proportion allocated
to each is the proportion of the total sales price each represents.
Here, the total sales price is $7 million. The book value of the land when
Armadillo sold it was $3 million. Thus, $4 million, or 4/7 of the total price, is profit. For
each cash payment, 4/7 of the payment will be recognized as gain. Therefore, the journal
entries are as follows:
9/1
12/1
Cash
Note Receivable
Land
Gain on Sale of Land
Deferred Gain on Sale of Land
$2,000,000
$5,000,000
Cash
$1,000,000
$3,000,000
$1,142,857
$2,857,143
Note Receivable
Deferred Gain on Sale of Land
Gain on Sale of Land
$1,000,000
$571,429
$571,429
Question 7
This transaction will add no goodwill to Alpha’s balance sheet. Under the
purchase method, the purchase price is first allocated to the assets purchased, using their
fair market values. Only after that is done is any excess allocated to goodwill. Here, the
$810,000 purchase price paid exactly equals the combined fair market values of the assets
purchased. There is no excess, so the transaction does not result in the creation of
goodwill.