Midterm "Solution"

Spring 1998

ACCT 250B: Core Concepts of Accounting Information

Professor Ted Mock

EXAM 1 : Solution Guide

I. Confidential Peer Evaluations ( 25 points will be assigned to each student based on these evaluations): First, please list the names of the other "N" members in your group where "N" refers to how many other students there are in your group. ( E.G., You do not rate yourself!). Then, based on all of the theme III group projects you did during the semester, allocate 5*N points so that the allocation reflects each student’s contribution to group assignments. Thus if each student contributed equally, each should get 5 points. Or if one student did all of the work, he or she should get 5*N points and everyone else zero.

What is your group number?
Other student names	Points Allocated (Must sum to 25 for 6 person groups, to 30 for 7 person groups, etc. )
1.
2.
3.
4.
5.
6.
7.
*Sum of the points allocated. (Should equal 5 N )**

Part I: Short problems and questions

1. [ 5 pts. ] What are SIC codes? A federally-designed coding system that assigns each industry group a unique code number.

Give one example where they are useful to accountants or auditors.

The classification of similar firms facilitates finding comparable firms with which to compare ROI, Days Sales, etc. and to calculate industry data.

2. [ 5 pts ] From an accounting perspective, what is an asset?

"probable future economics benefits obtained or controlled by a particular entity as a result of past transactions or events" ( FASB Concepts statement #6).

Thus an object must possess 3 essential characteristics to qualify as an asset"

	Probable future economic benefit
	Ownership or control
	Identifiable past transaction or events

3. [ 16 pts, 2 each ] Based on USA GAAP, fill out the following table

Economic Resource	Typically Included in USA financial statements? (Yes or No)	If included, how is the resource measured within the financial statements?
Goodwill	Yes	Goodwill is recorded at the excess of purchase price over fair value of acquired recognized assets
Product development expenditures	R&D expenditures normally not included on Bal Sheet, expense included in Inc Stmt.	Expense measured at cost.
Manufactured work-in-process	Yes	At Cost which may be measured using several cost accounting approaches and include both direct and indirect costs
Main frame (large) Computers	Yes	At Depreciated Cost
Deferred taxes	Yes	Difference between F/S income and Taxable income times the appropriate tax rate.
Human capital	Not as an asset, but salary & wages included in Income Stmt.	Expense measured at cost
Allowance for Uncollectibles	Not an asset, but a contra-asset account	Usually estimated by using aging or percent-of-sales methods.
Manufactured goods	Yes	At Cost which normally includes direct labor an dmaterials costs plus some allowance for "overhead" or indirect manufacturing costs
Purchased goods & merchandise	Yes	Lower of Cost or "Market". Cost is measured using FIFO, LIFO, Ave. Cost or other methods

4. [ 10 pts ]You have just graduated from USC and have arranged with a prominent movie star (e.g. Brad Pitts ) to work with a new company you have started. You recall from your introductory accounting class that Professor Picus argues that there are two prominent ways of capturing (measuring) the value of such a resource within the financial statement.

a. What are these two methods?

At historical cost or estimated current value.

b. Briefly state how one would measure such a value (using each method) within the financial statements.

Under the historical cost approach, the value would be a compilation (and amorization) of the costs incurred to obtain the contract and for services provided (e.g. via salaries paid). More specifically:

Acqusition costs (if material) are capitalized and amortized

Recurring operating costs (e.g. salaries) are expensed

Costs that enhance service potential are capitalized and amortized

Under the current value approach one would attempt to estimate the (discounted) present value of cash generated from the services of the star.

5. [ 8 pts ] Theme III discusses some of the changes in information technology that are affecting how organizations conduct business and design accounting information systems. However, as I.T. affects organizations, the kinds of risks faced by an organization also change. List two examples of new risks that have resulted from changes in I.T. Also, list a control that an organizations might use to help manage each risk.

Example of a new type of risk	Example of a control that would help prevent, detect and correct the control.
Scanning errors	Use check digits built into bar codes
Unauthorized access	Passwords
Loss of data via computer viruses	Obtain and use virus protection software

6. [ 6 pts ] Theme 3 group project: One of the objectives of the Theme III special project was to identify and research a real example from a real company of one or more of the accounting themes discussed.

What was the name of the organization that your group studied?

E.G. Kraft Foods or BofA

Briefly describe the theme III topic that was investigated by your group and also your findings, observation concerning that topic:

Intellectual capital was investigated and it was found that Kraft provided essentially no information related to this in their F/Ss

7. [ 16 pts. ] When managers of public companies prepare financial statements they make several "assertions" (audit terminology) concerning these statements. List the four assertions not listed below and then illustrate what each assertion means by using an example related to inventory accounting

Assertion	Illustration based on the Inventory account
Completeness	Management asserts that the inventory balance is complete, that is that it includes all inventory owned by the company as of December 31, 19xx.
Existence	Management asserts that all inventory reported in the F/Ss is real, valid.
Rights & Obligations	Management asserts that the firm owns or controls all reported inventory.
Valuation	Management asserts that the inventory is valued accurately using generally accepted methods
Presentation & Disclosure	Management asserts that inventory is reported using proper presentation and using full disclosure of material categories (e.g. WIP & Fin. Goods) and valuation methods (e.g. LIFO).

8. [ 12 pts ] Return on Investment Questions

a. Define ROI

ROI = net income (from continuing operations) / Ave. Assets or Equity

b. Define the du Pont formula or version of ROI

ROI = Net Income/ Sales * Sales/Ave. Assets = Gross margin % * sales velocity

c. Discuss the components of du Pont’s ROI. For each component list 1 business or economic factor which would cause du Pont ROI to increase and a different factor that would cause it to decrease.

Components	IncreaseFactors	Decrease Factors
Net Income	Price increases, decreases in average product or service costs	Price decreases, increases in average product or service costs
Average Assets	Equipment Purchase	Sale of land
Sales	Marketing Campaign	Foreign Competition

9. [ 8 pts ] Describe the concept of inventory profits. Why do they occur?

Inventory profits (see Diamond, p. 404) are "holding gains" the firm realizes just from holding goods in inventory as replacement cost and selling prices for the goods increase (e.g. Cabbage patch dolls ). The price increase can arise from a number of economic factors such as a lengthy strike at a competitors, general inflationary factors, etc.

10. [ 6 pts ] Describe the aging and the percentage of sales methods of estimating bad debts expense.

.a. Aging method: Estimate is based on the length of time (the age) that various accounts have been outstanding. Accounts are often classified as being > 30 days, < 30 days, < 60 days, etc.

b. Percentage of Sales method: The estimate is based on a percentage of current sales (based on historical experience, perhaps adjusted for changing economic conditions).

11. [ 8 pts ] Explain the meaning of a capital expenditure. From an accounting perspective, describe the consequences of recording a capital expenditure as a current expense.

A capital expenditure is an expenditure that results in an accounting asset (an item that has future economic value beyond the current accounting period). If such an expenditure is expensed rather than capitalized it violates the matching principal, understates assets and understates current income.

Part II: Problems and cases:

12. [ 20 pts ] If the ending inventory of a company using LIFO is overstated by $1,000 in year 1, what is the effect of this error on:

a. Beginning Inventory Year 2:	Overstated by $1,000
b. Gross profits year 1:	Overstated by $1,000
c. Gross profits year 2:	Understated by $1,000
d. Retained earnings at the end of year 2:	No effect (unless you make an explicit assumption that the error occurs again at the end of year 2. Then the answers to both c. and d. change )

13. [ 10 pts ] Safeway stores uses FIFO and Vons uses LIFO to value their inventories. In periods of rising prices, how does this effect each firm’s total assets and net income?

	Safeway Stores FIFO	Vons LIFO
Total assets	Relatively higher, better approximate current prices or current replacement costs	Relatively lower, a poor approximation of current prices or current replacement costs if pries are rising rapidly.
Net Income for current year	Relatively higher as older, presumable lower prices are matched against current prices.	Relatively lower as new, presumable higher prices are matched against current sales prices.

14. [ 20 pts ] E5 – Determining the Cost of Ending Inventories

The following data were taken from the records of the Merchant Co. regarding the purchases of its main inventory item, instant gold:

April 1: Beginning inventory 400 units @ $10.00 per unit

April 4: Purchase 900 units @ $10.20 per unit

April 10: Purchase 850 units @ $10.25 per unit

April 18: Purchase 600 units @ $10.25 per unit

April 30: Purchase 650 units @ $10.40 per unit

At the end of the month, there were 1,100 units remaining in the ending inventory. Determine the cost of the ending inventory and the cost of goods sold under each of the following cost flow assumptions, assuming the periodic inventory system is used:

Cost of goods available for sale = $ 34,803. There are 1,100 units of ending inventory

FIFO. Ending Inv. = 650 x 10.40 + 450 x 10.25 = 11,373

CGS = 34,803 – 11,373 = $ 23,430

LIFO. Ending Inv. = 400 x 10.00 + 700 x 10.20 = $ 11,140

CGS = 34,803 – 11,140 = $23,663

Average cost. Ave. cost/unit = 34,803/3,400 = $10.24 per unit

Ending Inventory = $10.24 x 1,100 = $11,264

CGS = 34,803 – 11,264 = $ 23,539

[ Note there is very little difference in this case ]

15. [ 20 pts. ] The High Tech Company uses the periodic inventory system. The accountant for the company prepared the following condensed income statements for the years ended June 30, 1995 and 1996.

	1995	1995 Corrected	1996
Net sales Cost of goods sold Beginning inventory Purchases, net Goods available for sale Less: Ending inventory Cost of goods sold Gross profit on sales Operating expenses Net income	$700,000 80,000 580,000 660,000 110,000 550,000 150,000 70,000 $ 80,000	$705,400 80,000 580,000 660,000 114,500 545,500 159,900 70,000 $ 89,900	$950,000 110,000 770,000 880,000 150,000 730,000 220,000 100,000 $120,000

During 1997, the accountant found that several errors had been made in determining the amount of ending inventories in the prior two years. For example, in 1995:

On June 30 the company had several personal computers being held on consignment (computers held by others but owned by High Tech) by some retailers that were not included in High Tech’s ending inventory. These computers had a cost of $8,400.
A sale was made in late June; the customer did not take delivery of the equipment until sometime in July. As a result, ending inventory was overstated by $3,900, and sales were understated by $5,400.

REQUIRED: Prepare a correct set of income statements for the year ended June 30, 1995.

16. [ 20 pts. ] Retirement of Operating Assets

On March 31, 1998, Shirt Tails, Inc., retired a machine used in manufacturing designer jeans. The machine was acquired on May 1, 1995. Straight-line depreciation was used. The asset had an estimated salvage value of $200 and a five-year life. On December 31, 1997, the balance in the accumulated depreciation account was $3,200. The machine was scrapped without Shirt Tails receiving any consideration.

REQUIRED:

Make the entry to record the depreciation expense for the period January through March 1998. Depreciation is calculated from the date of acquisition.

Debit Credit

3/31/98 Depreciation Exense 300

Accum. Depreciation-Machinery 300

To record 3 months depreciation

(Monthly depreciation = $3,200//32 months = $100/month )

Make the entry to record the retirement of the asset of March 31, 1998. (Hint: You must first determine the acquisition cost of the machine.)

( Acquisition cost = 60 month x $100 + $200 salvage value = $ 6,200 )

3/31/98 Accum. Depreciation-Machinery 3,500

Loss on Machine Retirement 2,700

Machinery 6,200

To record retirement of machinery

17. [ 20 pts. ] Product, Job & Service Costing

You are the newly hired office manager at ABC CPAs, a large national accounting and auditing firm. Like many accounting firms, ABC has been experiencing increasing competitive pressures in recent years. Prices must be set to meet market rates; they cannot simply be raised to cover higher costs. If the costs of doing a new job are too great, the firm may be better off declining to bid on the job. Thus, the managing partner of the firm, is particularly concerned with obtaining a good measure (estimate) of the average cost per job for the three basic services offered by the firm:

- auditing services

- tax services, and

- management advisory services (MAS).

These average costs will be used to estimate the costs of new jobs being bid, with adjustments as needed, for any unique aspects of a new job (for example, the need for specialized training in an industry where the firm has no other clients).

In each of its service areas, the firm tries to serve a particular client niche, so the jobs tend to be very similar in size and scope. To maintain quality control, the firm assigns the same mix of partners, managers and associates to each job other than new jobs. New jobs require about 20% more manager and partner time the first year.

Last year, the firm worked on 8,000 audit jobs. The firm has many public companies as audit clients. The firm has an extensive mid-sized business tax return preparation practice, with 6,000 jobs completed last year. In addition, the firm performed 2,500 MAS jobs, mostly for its audit clients.

In the past, the firm has used the following method to calculate its average cost per job in each service category:

- Direct costs--consisting of professional staff labor dollars charged to jobs and other job-related costs--are assigned to each service area, as appropriate.

- All non-job-related costs--including continuing professional education (CPE) costs, administrative costs, client development costs, and unassigned professional staff-time--are accumulated in a single overhead pool. The overhead is allocated to service areas (audit, tax, and MAS) in proportion to the direct labor dollars charged to that area.

- The total cost for each area (the sum of the direct and allocated costs) is divided by the number of jobs performed in the area to determine an average cost per job.

However, the firm is considering allocating non-job-related costs using activity-based costing. A group of partners has suggested that the non-job related costs be accumulated into 4 overhead pools, with the following cost drivers:

- Pool: continuing professional education (CPE) costs

Cost driver: direct labor hours charged to a service area by professional staff

- Pool: administrative costs

Cost driver: number of jobs in a service area

- Pool: client development costs (costs of marketing services to new clients and maintaining good relations with current clients)

Cost driver: number of jobs in a service area

- Pool: unassigned professional staff time

Cost driver: direct labor dollars charged to a service area by professional staff

ALLOCATION BASE USED FOR NON-JOB-RELATED COSTS		Average Cost per Audit Job	Average Cost per Tax Job	Average Cost per MAS Job
Current system: Direct labor dollars charged to service areas	Direct	$ 17, 400	$ 2,340	$ 23,550
	Non-Job-Related	7,400	??	$ 14,050
	Total	$ 24,800	$2,873	$37,600
Proposed new ABC system with multiple cost drivers: direct labor hours charged to service areas, number of jobs, direct labor dollars charged to service areas	Direct	$ 17, 400	$ 2,340	$ 23,550
	Non-Job-Related	??	??	4,050
	Total	$ 20,480	$ 3,880	$ 27,600

Required:

1. List two pros and two cons related to the possibility of moving to the new costing system. For each pro and con generate (you may need to be a bit creative here) a specific example of that pro or con based on the ABC CPAs situation as described above.

Pro or Con	Specific Example
ABC can lead to more accurate cost measures	Client development costs are clearly more directly related to number of clients (jobs) than total direct labor costs of a service area
ABC can promote better cost control	If partners are made aware of costs such as CPE that are directly related to their decisions, they may be better able to control such costs.
ABC is more costly and complex	It is clearly more complex and costly to use the proposed ABC system with four cost pools and three cost drivers.
ABS may lead to more conflict between service areas.	Parners in charge of each area may argue over the appropriateness of various cost drivers. This may lead to gaming and other dysfunctional behaviors.

2. For each of the cost drivers proposed above, give an example of an indirect cost where it would logically make sense to use that driver and a cost where it would not make logical sense.

Cost Driver	Indirect Cost logically related to the driver	Cost which would be unrelated to the cost driver
Direct salary and labor costs	Company contribution to Soc. Sec. Costs.	Marketing costs
No . of jobs completed	Report preparation support activities (Gaphics design, computer costs)	General Accounting costs
Direct labor hours	Supervision costs	Marketing costs

3. ABC recently was approached by an potential new client to do an audit and to provide tax services and has offered ABC a fixed fee of $17,500 for the audit and $ 2,700 for the tax job. ABC’s managing partner would like to know exactly what costs should be considered when making this decision. He also wants your recommendation as to whether he should take the job.

Costs relevant to decision to accept or decline job	Examples from case
Incremental or marginal costs of conducting the proposed audit	$ 17, 400 is ave. direct cost for an audit plus allowance for 20% new client partner time. The bid price slightly exceeds the direct cost and probably should be accepted
Incremental or marginal costs of conducting the proposed Tax job	$ 2,340 plus allowance for 20% new partner time is ave. direct cost for a tax job. This is less than bid price and should be accepted.