Fall 2012 (all except Question 1)

Accounting for Lawyers
Professor Bradford
Fall 2012
Exam Answer Outline
The following answer outlines are not intended to be model answers,
nor are they intended to include every issue 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. In
some cases, the result is unclear; the position taken by the answer
outline is not necessarily the only justifiable conclusion.
I graded each question separately. Those grades appear on your
printed exam. To determine your overall average, each question was
then weighted in accordance with the time allocated to that question.
The following distribution will give you some idea how you did in
comparison to the rest of the class:
Total Exam Score (70% of grade): Range 4.68-8.18; Average = 6.05
Homework (30% of grade): Range 8-9; Average = 8.48
All of these grades are on the usual law school scale, with 9 being an
A+ and 0 being an F.
If you have any questions about the exam or your performance on the
exam, feel free to contact me to talk about it.
Question 1
The answers to Question 1 are contained in a separate Excel file.
Question 2
One important aspect of the auditing process is independence.
Auditors are supposed to provide an independent check on the
accuracy of the financial statements prepared by a company ’s
management. If the auditor is “captured” by management, that
independent check is lacking.
Auditing firms are already required to rotate the lead and reviewing
partners assigned to a particular company at least every five years.
But the firm itself may continue to audit the company year after year;
the company is not required to change auditing firms.
If companies are required to rotate their audit firms every few years,
the auditors are less likely to become “cozy” with the audited
company’s management and therefore will press them harder on
questionable transactions and procedures. Audit firm rotation also
reduces the financial incentives to go along with management; the
potential loss of revenue is less if the auditor is going to lose the
client in less than five years anyway. In addition, if an auditor knows
someone else will be reviewing its work when the change occurs, it is
more likely to exercise care and take an aggressive stance against
management positions.
However, a rotation requirement like this would undoubtedly increase
the expense of auditing. Each time a chan ge was made, the new
auditor would have to familiarize itself with the client company ’s
business and accounting systems. The cumulative expertise and
knowledge that is gained by auditing a company over a long period of
time would be lost.
In addition, firm rotation could possibly affect independence in the
opposite direction than intended. Currently, the expectation is that a
company will continue to use the same auditing firm. If the company
hires a new auditor, that is extraordinary and may signal a probl em.
This makes it difficult for an audited company to change auditors if
the existing firm is too aggressive in challenging management
Under the proposed system, auditor change would be regular and
expected. A company could more easily get rid of an aggressive
auditor and find a less aggressive firm. Further, to get new business
when changes are made, auditors might have an incentive to develop
a reputation for going along with management, because management
might be more inclined to choose an audit firm with a lax reputation
when the time for change arises.
Question 3
The depreciable cost of a long-lived asset is its purchase price plus
the cost to bring it to the location and condition of its intended use.
In this case, the depreciable cost would be the purchase price of
$100,000, plus the shipping cost of $5,000, plus the installation cost
of $3,000, for a total of $108,000.
The double-declining-balance method applies the applicable rate to
the full cost, without subtracting its salvage value. The depreciation
rate is twice the normal straight-line rate. Since the machine has a
useful life to Acme of eight years, the normal straight -line rate would
be 12.5% (1/8). Thus, the double-declining-balance rate is 25%.
Depreciable Depreciation Depreciation Book Value
Depreciation Expense
2012 = $27,000
2013 = $20,250
The balance sheet listing for machinery would look like this:
Less: Accumulated Depreciation
Machinery (Net)
$ 60,750
Question 4
It is, of course, impossible to know, simply by looking at these
financial statements, if the numbers presented are accurate. For all we
know, Acme simply made up these numbers. These financial
statements are unaudited, so an auditor has not even reviewed Acme ’s
accounting to see if Acme has sufficient internal controls or if Acme
has complied with generally accepted accounting principles.
Having said that, however, even assuming these figures are accurate, a
couple of things cast doubt on the extent of Acme ’s “improvement.”
First, in the past year, the value of Acme’s inventory has dropped
dramatically. Acme uses the LIFO (last-in, first-out) method of
valuing inventory. The last inventory items Acme made or purchased
are assumed to be the first sold, so the remaining inventory that
appears on the balance sheet consists of the oldest items. If, as is
usually the case, the cost of inventory to Acme is rising, the value on
the balance sheet is less than the current replacement cost to Acme.
The reduction of inventory from 2011 to 2012 means that Acme has
sold some of its existing inventory without totally replacing it. The
Cost of Goods Sold, an expense that reduces net incom e, is thus
lower because it’s based on the older inventory costs of that existing
inventory, not current costs. Acme’s net income for 2012 is higher in
part simply because the expenses are lower due to the inventory sell off.
Second, Acme’s accounts receivable increased significantly from 2012
to 2012, indicating that many of Acme’s sales were credit sales. Acme
may be boosting its income by selling to people who don’t currently
have the cash to pay. If so, Acme may at some point have to charge
off those accounts and take a loss. Note that Acme took no bad debt
expense in 2012 to reflect the possible uncollectibility of those
accounts, even though its accounts receivable increased by over $1
million. Even if most of those accounts are collectible, certainly some
of them will not be. Acme is estimating that only 2.9% ($40,000 of
$1,365,000) of all its accounts receivable will not be collected. Given
that most of these accounts are new, that’s certainly within the realm
of reason, but the corresponding percentage in 2011 was 14%.
Question 5
Earnings per share
= Net Income/Number of Shares
= $1,132,000/200,000
= $5.66/share
Interest Coverage Ratio
=Earnings Before Interest and Taxes (EBIT)/Interest Expense
[EBIT = Net Income (After Taxes) + Income Taxes + Interest
= $1,132,000 + 126,000 + 79,000
= $1,337,000]
Interest Coverage Ratio = $1,337,000/$79,000
= 16.924
Return on Equity = Net Income/Equity, Prior Year
= $1,132,000/$1,349,000
= .839 (83.9%)
Inventory Turnover Ratio
= Cost of Goods Sold/Average Inventory
= $690,000/(($214,000 + $879,000)/2)
= $690,000/$546,500
Cash Return on Assets
= Net Increase (Decrease) in Cash/Total Assets, Prior Period
= $697,000 - $250,000/$2,239,000
= .1996 (19.96%)
Question 6
The lead partner is wrong. Because money has time value, it matters
when Omega pays the various sums, even if in both cases the total
payment is $500,000. In general, the later the payment the better,
because Omega can earn a return on the funds it holds prior to
The easiest way to compare the two options is to determ ine the
present value of each. The one with the lowest present value is the
better option for Omega.
Option 1
The present value of $170,000 paid now is simply $170,000.
We can determine the present value of the ten annual payments using
the annuity table on p. 254 of the textbook. The number of years is 10
and the discount rate is 5%. The present value factor from the table is
therefore 7.722. Thus, the present value of these payments is $33,000
x 7.722 = $254,826.
The total present value of Option 1 is the refore $170,000 + $254,826
= $424,826.
Option 2
The present value of this option can be determined by separating it
into two components, an annual payment of $75,000 for five years
and a lump-sum payment of $125,000 at the end of six years.
The first component is an annuity that we can value using the table
on p. 254 of the textbook. The number of years is 5 and the discount
rate is 5%, so the present value factor is 4.329. Thus, the present
value of this annuity is $75,000 x 4.329 = $324,675.
We can determine the present value of the lump-sum payment using
the table on p. 252 of the textbook. The period is 6 years and the
discount rate is 5%, so the present value factor is .7462. Thus, the
present value of this payment is $125,000 x .7462 = $93,275.
[Alternatively, we could determine this using the present value
formula: PV = $x/(1 + r) n , where x = the amount to be paid; r = the
discount rate; and n = number of periods.
= $125,000/(1+ .05) 6
= $125,000/1.34010
= $93,276.62]
The total present value of Option 2 is therefore $324,675 + $93,275 =
Option 2 is the preferable settlement. Its cost to Omega is $6,876
less in present value terms.
Question 7
This is a contingent gain that Alpha may or may not realize. Under
the FASB standards, gain contingencies are never accrued and
recognized in the financial statements. Alpha should not recognize
the gain until after it wins the case, not matter how certain it is of
Since the contingency is material, Alpha should, however, disclose
the contingency in the notes to its financial statements. The standard
for disclosing contingent gains is unclear, but presumably it mirrors
the standard for losses, which should be disclosed if they are at least
“reasonably possible.” A contingency is at least reasonably possible if
its likelihood is more than remote. “Remote” means the chance of it
occurring is slight. If, as the attorney indicates, this gain is “almost
certain,” its likelihood is clearly more than slight, and i t should be
disclosed. However, Alpha should be careful not to mislead people as
to the likelihood of a win.