Chap 3 Accounting For Managers

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Chapter 03 - Basic Accounting Concepts: The Income Statement

CHAPTER 3

BASIC ACCOUNTING CONCEPTS:

THE INCOME STATEMENT

Changes from Twelfth Edition

The chapter has been updated from the Twelfth Edition.

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 onlyimportant accounting problem. Although this is an exaggeration, it is not far from the truth. The text andcases in this chapter constitute only a beginning in understanding and it is to be expected that studentswill understand the matter thoroughly only after they have attacked it from several different angles.

Sometimes we ask the class Suppose a company received a lawyers bill for $1,000. Explain all thedifferent ways in which this bill could be recorded in the accounts. The answer is that if the bill relates toservices rendered in a prior year (or accounting period) but not recorded in that time, it is nevertheless anexpense of the current year; if it represents a charge for a previous year that was recorded in that year, thepayment 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 yearit 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 theaccrual concept. It is suggested, however, that problems relating to depreciation be deferred, as this is anintricate 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 mayfind it difficult to do this because income is still used erroneously in some published statements and intax forms.

Some students confuse the special meaning of consistency in accounting with the general meaning ofthis term. In accounting, consistency means only that the same practice is followed this year as wasfollowed last year. It does not mean that, for example, the treatment of inventories is consistent with thetreatment of fixed assets.

Cases

Maynard Company (B) is a straightforward problem, although students may have some difficulty indeducing 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 wasprepared in the (A) case in Chapter 2; it is fairly straightforward.

Dispensers of California introduces the entire accounting cycle, with some judgmental issues.

Pinetree Motelprovides practice in applying the accrual concept.

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National Association of Accountants provides the opportunity to explore income concepts in thesetting of a nonprofit organization.

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

246,315

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 thatrepresented 17.7 percent of its sales ($15,000 / $85,000). The companys operating expenses were 82.3percent of sales ($70,000 / $85,000) and its cost of goods sold was 53 percent of sales. The companys

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 years income. $3,500 charged to next years income.

Subscription expense. $36 charged to current year. $36 charged to next year. Alternatively, $72 chargedto current year on grounds $72 is immaterial.

Problem 3-6

Asset value:October 1, 20X5 $30,000December 31, 20X5 26,250December 31, 20X6 11,250December 31, 20X7 0

Expenses:20X5 $3,750 ($1,250 x 3 months)20X6 $15,000 ($1,250 x 12 months)20X7 $11,250 ($1,250 x 9 months)

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

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Problem 3-7

QED ELECTRONICS COMPANY

Income Statement for the month of April, ----.

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

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

25,325Profit before taxes......................................................................................................................8,075Provision for taxes......................................................................................................................2,800.Net 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 saleson credit ($33,400 - $20,500) must be recognized. Wages expense is recognized as incurred, not whenpaid.

Marchs 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 Liabilities

Current 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 Owners 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 Twelfth Edition.

Question 1 See below.

Question 2

This question brings out the difference between cash accounting and accrual accounting. Cashincreased by $31,677 whereas net income was $19,635. Explaining the exact difference may be toodifficult 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 affectnet income this period. (The same is true of the collection of the $11,700 note receivable fromDiane Maynard, but it was offset by the payments of the $11,700 dividend to Diane Maynard, thesole 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-$8,517)]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 affectnet 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 butdid not affect cash as they relate largely, if not wholly, to cash outflows made for assetacquisition in prior periods. (Exception: such expenses on an entitys first income statement arenot related to prior period expenditures but they will be a much smaller amount than the firstaccounting periods expenditures.

Question 3

(a) $14,715 is incorrect because it is the amount of cash purchases rather than the cost of sales. Thecost of cash purchases and cost of sales amounts would be equal for a period in which allpurchases 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 explainedabove, purchases equal cost of sales for the period only if beginning and ending inventoryamounts are the same.

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Case 3-2: Lone Pine Cafe (B)

Note:This case is updated from the Twelfth 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 sofor 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 applyto the income statement.

1. The student needs to refer back to Lone Pine Caf (A) in order to construct the income statementon the accrual basis. Amounts for sales on credit, purchases on credit, beginning and endinginventory, beginning and ending prepaid operating license, and depreciation expense are to befound 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 evaluativepurposes) to treat the $23,150 partners salaries as owners drawings. This treatment would resultin an income of $12,296 and a decrease in equity (after drawings) of $10,854.

LONE PINE CAFE (B)

INCOME STATEMENT FOR NOVEMBER 2, 2009, THROUGH

MARCH 30, 2010

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 firstfive 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 thecook 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 anaverage of $1,543 per partner/employee per month). Of course the three owner/employees did receiveroom and board, for which no value has been imputed here.

Case 3-3: Dispensers of California, Inc.

Note: This case is unchanged from the Twelfth Edition. .

Approach

The case can be used for two class sessions. The first day is devoted to analyzing the accountingtransactions, including a preliminary discussion of Hynes accounting policy decisions. The second classdeals with preparing the financial statements and an analysis of how they may change if alternativeaccounting procedures had been adopted by Hynes.

The first class should start with the case Question 1. Its purpose is to give the students a sense of themanagerial purpose of profit plans and a context for the later accounting discussions.

The use of the asset equals liability plus equity structure to answer Question 2 is recommended sothat the instructor can 1) highlight the retained earnings link between net income and the balance sheet 2)illustrate how any accounting transaction can be analyzed using the basic accounting equation and 3) tolay the foundation for the debit-credit framework material in Chapter 4. (At this point in the course debitand credit terminology and analysis should not be used.)

Questions 3 and 4 require the preparation of an income statement and balance sheet, respectively.

Some instructors prefer to end the first class with a discussion of the balance sheet, including a completedbalance sheet. Typically, these instructors want to leave time in the second class to discuss therelationship between net income and the change in cash on the balance sheet.

Question 5 is designed to illustrate the role of judgment in accounting for transactions.

Answers to Questions

Question 1

Profit plans are used for a variety of purposes. These include:

To force short range planning

As a basis for evaluating performance and determining compensation.

To encourage coordination and communication between different organization units andlevels.

As a challenge to improve performance.

As a means for training managers

As an early warning system and

As a guide to spending.

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Question 2

TN-Exhibit 1 presents an analysis of the planned transactions using the basic accounting equationframework. This analysis follows Hynes accounting policy.

Question 3

TN-Exhibit 2 presents Hynes profit plan using the Question 1 transaction analysis.

The instructor should expect that most students will not calculate the cost of goods sold figurecorrectly. The instructor will have to explain that the components of the cost of manufactured goodsincludes direct materials and their conversion costs, including manufacturing equipment depreciation.

The distinction between operating and finance costs in the income statement is another accountingpractice most students will miss. Again, the instructor will have to explain this format and its rationale,which is to permit statement users to evaluate how well management has operated the company before

considering the impact of their financing decisions.

Question 4

TN-Exhibit 3 presents the year-end balance sheet using the Question 1 transaction analysis.Equipment is reported net. Most students will follow this presentation. A better presentation is:

Equipment (cost) $85,000Accumulated depreciation (8,500)Equipment (net) $76,500

The patent is reported net. This is the correct presentation for intangible assets.

TN-Exhibit 4 presents a reconciliation of beginning (zero) and ending ($47,500) retained earnings.The instructor may want to share this exhibit with the students. It links the income statement to thebalance sheet. It also illustrates that dividends are distributions of capital and not an expense.

The instructor should point out to students that many intra period transactions, such as the borrowingand repaying of the bank loan, do not appear on the end of the period balance sheet.

Question 5

There are three accounting decisions that require Hynes to exercise judgment. They are:

Patent valuation Patent amortization period

Equipment depreciation period

Students might believe Hynes must exercise judgment in the accounting for the redesign andincorporation costs. Under current GAAP this is not the case. Redesign and organization costs must beexpensed as incurred.

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The patent can not be valued directly. There is no current liquid market for this type of patent. Hynesmust value it indirectly. He chose to use the value of the companys equity he received based on the cashpaid by the investors for their equity interest to value the patent. This is an acceptable approach.

Hopefully, the patent amoralization and depreciation periods represent Hynes best estimate of the

related assets useful life (useful to Dispensers of California.)

Students should be asked what would be the impact on the balance sheet and income statement ifdifferent lives had been used. So that students do not get the impression that differences in judgment aredriven by a desire to manage earnings, the instructor should be careful during the discussion to remind thestudents that different reasonable life estimates can be made by responsible managers acting in good faith.

Cash Flow Analysis

If the instructor wishes to incorporate some aspect of cash flows in the case discussion, TN-Exhibit 5and 6 present two analysis of cash flows. TN-Exhibit 5 uses a cash receipts and distribution format. TN-Exhibit 6 uses a direct method statement of cash flows format. Instructors should not use the indirect

method at this point in the course. It confuses students. Chapter 11 introduces students to indirect methodstatement of cash flows.

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Exhibit 1

Dispensers of California, Inc

Balance Sheet Transaction Analysis

Transactions Assets = Liabilities Equity

1a1b

Hynes investmentOther investors

+ Patent $120,000+ Cash 80,000

+ Common Stock $120,000+ Common Stock 80,000

2 Incorporation costs - Cash $2,500 - Retained earnings $2,500

3 Equipment purchase -Cash $85,000

+ Equipment 85,0004 Redesign costs - Cash $25,000 - Retained earnings $25,000

5 Component parts purchase + Inventory $212,100- Cash 212,100

6 Bank loanBank loan repaidLoan interest

+ Cash $30,000- Cash 30,000

- Cash 500

+Bank loan $30,000- Bank loan 30, 000

- Retained earnings $500

7 Manufacturing payroll - Cash $145,000 - Retained earnings $145,000

8 Other manufacturing costs - Cash 62,000 - Retained earnings $62,000

9 Selling general and administration - Cash $63,000 - Retained earnings $63,000

10 Ending inventory (cost of goods sold) * - Inventory $197,000 - Retained earnings $197,000

11 Sales + Cash $598,500 + Retained earnings $598,500

12 Incorporation and redesign costs (expenses asincurred)

See 2 and 4

13 Depreciation - Equipment $8,500 - Retained earnings $8,500

14 Patent amortization - Patent $20,000 - Retained earnings $20,000

15 Ending work-in-progress and completedinventory (none) (cost of goods sold)** See 5, 7, 8, 10 and 13

16 Dividends - Cash $5,000 - Retained earnings $5,000

17 Income Taxes +Taxes payable $22,500 - Retained earnings $22,500

* Beginning component parts inventory $0 **Component parts used $197,000Purchases 212,100 Manufacturing payroll 145,000Total available 212,100 Other manufacturing costs 62,000Ending component parts inventory 15,100 Depreciation 8,500Components parts used 197,000 Cost of goods sold 412,500

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Exhibit 2

Dispensers of California, Inc.

12-month Profit Plan

Sales $598,500

Cost of goods soldComponents $197,000Mfg payroll 145,000Other Mfg. 62,000Depreciation 8,500 412,500

Gross margin $186,000Selling, general andAdministration 63,000Patent 20,000Redesign costs 25,000Incorporation costs 2,500Operating profit $75,500

Interest 500Profit before taxes $75,000Tax expense 22,500Net Income $52,500

Exhibit 3


Projected Year-end Balance Sheet

Assets LiabilitiesCash $78,400 Taxes payable $22,500Components inventory 15,100 Current liabilities $22,500Current assets $93,500Equipment (net) 76,500 Owners EquityPatent (net) 100,000 Capital stock $200,000

___ Retained earnings 47,500$270,000 $270,000

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Exhibit 4


Change in Retained Earnings

Beginning retained earnings $0Net income 52,500Dividends (5,000)Ending retained earnings $47,500

Exhibit 5


Cash Reconciliation

Receipts DisbursementsNew equity capital $80,000Incorporation $2,500Equipment 85,000Redesign 25,000Component parts 212,100Bank loan 30,000Bank loan 30,000Loan interest 500Manufacturing payroll 145,000

Other manufacturing 62,000S G & A 63,000Sales 598,500Dividend 5,000

Total $708,500 $630,100

Cash ReconciliationReceipts $708,500Disbursements 630,100Ending Balance $78,400

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Exhibit 6


Statement of Cash Flows (Direct Method)

Collections from customers $598,500

Payments to suppliers (212,100)Payments to employees (295,000)Legal payments (2,500)Interest (500)

Operating cash flow $89,400Equipment purchases (85,000)

Investing cash flow $(85,000)Bank loan 30,000Repayment of bank loan (30,000)Capital 80,000Dividends (5,000)

Financing cash flow $75,000

Change in cash $78,400Beginning cash 0Ending cash $78,400

Case 3 - 4: Pinetree Motel

Note: This case is unchanged from the Twelfth Edition.

Approach

This case treats the transition from cash to accrual accounting; also, the inherent difficulties incomparison of data with industry averages are illustrated. The case does not require a full 80 minutes ofclass 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 termse.g., revenues,advertising, depreciationis no difficulty in fitting Pinetrees account names with the journals standard

format; but for other items, there are problems:

1. The Kims drawings conceptually should be divided between payroll costs andadministrative/general, since the Kims apparently perform both operating and administrativetasks.

2. Some students may treat replacement of glasses, bed linens, and towels as general expense ratherthan 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, itproperly is part of payroll costs.

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Question 2

Based on profit as a percent of sales, Pinetree Motel is only about one-third as profitable as the surveyaverage 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 (whichis 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, thusspreading fixed labor costs over a higher volume (e.g., a motel of 20 units and one of 40 units each needsonly one desk clerk). Of course, there is probably a lot of noise in the survey data for payroll andadministrative/general costs: owner-operators responding to the journals survey would encounter thesame problems as a student does in answering Question 1.

PINETREE MOTEL

OPERATING STATEMENT FOR 2005

(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+ 492)....................................................................................................................................................20,767 8.6

Total........................................................................................................................................................165,432 68.1

Fixed expenses:Property taxes, fees ($9,870 - $1,005 + $1,119)............................................................................................9,984 4.1Insurance ($11,584 - $2,025)........................................................................................................................9,559 3.9Depreciation..................................................................................................................................................30,280 12.5Interest ($10,605 - $687 + $579)..................................................................................................................10,497 4.3Rent...............................................................................................................................................................

Total........................................................................................................................................................60,320 24.8Profit(pretax) .......................................................................................................................................................$ 17,049 7.1

*May not add exactly owing to rounding.

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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.............................................................................................................................................. 4.2

Profit.....................................................................................................................................................................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.

Pinetrees other operating costs do not seem to be out of line compared with the survey averages. thehigher-than-average utilities may reflect a location with cold winters. Insurance and taxes are essentiallyuncontrollable. Repairs and maintenance may be below average because the Kims personally do some ofthis work, whereas other motels pay outsiders to do it.

Note that both rent and depreciation are shown in the journals survey data. This also causes comparison

problems. For Pinetree, there is no rent, but the motel buildings are depreciated, whereas for some motelsthe depreciation would include only furnishings. Adding the rent and depreciation percentages may bemore meaningful than working at either one in isolation; but, of course, building depreciation is only avery rough proxy for fair rental value.

No final conclusion on the success of their operation can be made as information on the following islacking:

Capital (re: the average) Occupancy rateLocation Seasonality (re: Florida annual season vs. New England)Pricing Efficiency in using their own time

Check on income calculation:

Receipts in 2005.....................................................................................................................................................$244,461Less: 2004 revenue collected...........................................................................................................................1,660

Revenues in 2005....................................................................................................................................................$242,801Checks written in 2005...........................................................................................................................................196,558Plus: 2005 expenses not paid..................................................................................................................................5,508

Depreciation...............................................................................................................................................30,280232,346

Less: 2004 expenses paid.................................................................................................................................6,594Expenses in 2005....................................................................................................................................................225,752Profit.......................................................................................................................................................................$ 17,049

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Case 3 - 5: National Association of Accountants

Note:This case is unchanged from the Twelfth 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 theoperations of the organization for that year. As a general rule, the governing board should so conductaffairs that the organization breaks even financially. If it operates at a deficit, it is eating into resourcesintended for future members, as suggested in the case. If it operates at a surplus, it is not providing themembers with as many services as they are entitled to.

Thus, the difference between the concept of income described in the text for business organization and theincome concept appropriate for a nonprofit membership organization is that a business organizationshould earn satisfactory net income, while the membership organization should break even. Themeasurement of revenues and expenses follows the same principles in both types of organizations (at leastwith respect to the transactions given in this case.)

The case is based, loosely, on experiences of the American Accounting Association, and instructors maywish to refer to the AAA financial statements. The case relates to the general fund, which is the portionof the financial statements that reports normal operations. The other columns in these statements can bedisregarded. (The NAA is no longer in existence.)

In the interest of simplicity, students are not given balance sheets. The case can be made morecomplicated by assuming a beginning balance sheet, perhaps showing only cash and equity of $55,000each. Students can then be asked to set up assets and liabilities that result from the transactions describedin 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 2006, so it should not be counted as 2005revenue. However, the $2,700 already spent must be matched against the grant in some way. Thiscan be done either by subtracting it from 2005 expenses and setting it up as a prepaid asset or,more simply, by transferring $51,300 of the grant to 2006 revenue. The effect on the bottom lineis the same. The fact that the president obtained the grant is irrelevant. The principle is torecognize the revenue in the period in which the services are performed. The legal question isprobably also irrelevant; the intention was to perform the services in 2006, and that probablywould be the governing factor. This is a debatable point, however, because it gives no credit tothe 2005 president for the fine work he or she has done in obtaining the grant.

2. The desktop publishing system is not an expense of 2005. It will be an expense of future years

and is therefore an asset on December 31, 2005. Because it was acquired so near the end of theyear, there is no need to deal with depreciation. The question can be asked about depreciation infuture years, and this raises the question of estimating the future life. Desktop publishing systemsare 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 anexpense of 2005, and the 2005 board has created a depreciation cost that will affect the surplus offuture boards.

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3.

4. The $32,400 of 2006 membership dues probably isnot revenue of 2005. Members will receiveservices in 2006 for the 2006 dues. (It can be argued that early receipt of these dues avoids thenecessity of incurring expense for dues notices and follow-ups that would otherwise be needed in2006. 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 2006 expense, and when theassociated revenue from dues is moved to 2006, they matchthe expense.

5. The membership directory is a real tough one. The services for the 3,000 copies were provided in2005, but charging this as a cost in 2005, seems unfair to the 2005 board (and to boards of eachyear when a new directory is published.) It can be argued that members refer to the directory fortwo years, and hence the cost should be spread over both years. The 1,000 extra copies isprobably an expense of 2006, but this assumes that they will in fact be used in 2006 and are notsimply extras that eventually will be discarded. (The proportion of 1,000 extra copies to themembership seems large.) Exhibit A takes the easy way out and assigns one-half the cost to eachyear, but other solutions are equally defensible.

6. The conversion of subscription revenue from a cash basis to an accrual basis is straightforward.The revenue in 2005 should be decreased by $2,700.

7. If the Association is likely to be reimbursed for the $10,800, it is not an expense of 2005. Thelikelihood is that there will be a profit, but at this stage, one cant be sure, even though there wasa profit in 2004. It seems unlikely in any event that there would be a profit that wiped out thewhole deficit. Exhibit A removes the whole $10,800 as an expense; it becomes an accountreceivable from the Annual Meeting Committee. Students who argue strongly for conservatismmight leave it as an expense. This transaction shows how difficult it is to arrive at the trueresults, as is also the case with some of the others. The 2004 annual meeting profit, not nowknown, is conceptually a revenue of 2004. (But read on.)

8. The $3,400 annual meeting profit is revenue for 2004, conceptually. However, there seems to be

no feasible way of recording this revenue in the year of the annual meeting because of theproblem of paying outstanding bills for some months after the annual meeting has taken place. Ittherefore can be argued that it is appropriately left in 2005, which is done in Exhibit A. Thispractice can be justified on the grounds of materiality. If eliminated from 2005, somecorresponding adjustment for an estimated profit on the 2005 annual meeting should be made.With the adjustments made above, the 2005 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 avoidedin the future by preparing an accounting manual that describes how each of these transactionsshould be handled. This illustrates the importance of the consistency concept.

Question 2

The Administrations policy says there should be a dues increase. If there were some unusualexpenses in 2005, the deficit might be tolerated, but we have no indication that there are unusualexpenses. The association had to take special steps to obtain the cash needed for the desktoppublishing 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.

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Exhibit A

NATIONAL ASSOCIATION OF ACCOUNTANTS

ADJUSTED INCOME STATEMENT, 2005

Revenues: As Reported Adjustments Adjusted

Membership 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 profit, 2004.........................................................................................................................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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Chap 3 Accounting For Managers

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