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
!ndoubtedl"# the accrual idea is the most difficult of all basic accounting matters for the student to grasp
As a matter of fact# we sometimes sa" that the proper recognition of re$enue and e%pense is the only
important accounting problem Although this is an e%aggeration# it is not far from the truth The te%t and
cases in this chapter constitute onl" a beginning in understanding and it is to be e%pected that students
will understand the matter thoroughl" onl" after the" ha$e attac&ed it from se$eral different angles
Sometimes we as& the class 'Suppose a compan" recei$ed a law"er(s bill for )*#000 E%plain all the
different wa"s in which this bill could be recorded in the accounts+ The answer is that if the bill relates to
ser$ices rendered in a prior "ear ,or accounting period- but not recorded in that time# it is ne$ertheless an
e%pense of the current "ear. if it represents a charge for a pre$ious "ear that was recorded in that "ear# the
pa"ment of the bill merel" represents a decrease in a liabilit". if it represents a charge in the current "ear#
it is recorded as an e%pense. and if it represents a retainer for ser$ices to be rendered in the following "ear
it is recorded as an asset# prepaid e%pense
It ma" be desirable to introduce a number of short /uestions of this t"pe in order to hammer home the
accrual concept It is suggested# howe$er# that problems relating to depreciation be deferred# as this is an
intricate matter which is perhaps best left until Chapter 0
Students should alwa"s be re/uired to use the word 're$enue+ rather than the word 'income+ The" ma"
find it difficult to do this because 'income+ is still used erroneousl" in some published statements and in
ta% forms
Some students confuse the special meaning of 'consistenc"+ in accounting with the general meaning of
this term In accounting# 'consistenc"+ means onl" that the same practice is followed this "ear as was
followed last "ear It does not mean that# for e%ample# the treatment of in$entories is consistent with the
treatment of fi%ed assets
Cases
Maynard Company (B- is a straightforward problem# although students ma" ha$e some difficult" in
deducing how the amounts are to be transformed from the cash basis to the accrual basis
Lone Pine Cafe (B) re/uires an income statement of the same compan" whose balance sheet was
prepared in the ,A- case in Chapter 1. it is fairl" straightforward
Dispensers of California introduces the entire accounting c"cle# with some 2udgmental issues
Pinetree Motel pro$ides practice in appl"ing the accrual concept
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Chapter 03 - Basic Accounting Concepts: The Income Statement
National Association of Accountants pro$ides the opportunit" to e%plore income concepts in the
setting of a nonprofit organi3ation
Problems
Problem 3-1
4ot an e%pense for 5une - not incurred
E%pense for 5une
E%pense for 5une
E%pense for 5une
E%pense for 5une
4ot an e%pense for 5une - asset ac/uired
Problem 3-2
6e$enues)107#000
a E%penses 8 Cost of goods sold )*9:#000
6ent 3#300
Salaries 10#:00
Ta%es *#307
;ther 70#1:0
1:9#3*7
4et income )1<#9<7
Problem 3-3
Beginning in$entor" )10#000
=urchases 0<#000
A$ailable for sale
Ending in$entor" ,)3*#000-
Cost of goods sold )0:#000
Problem 3-4
a ,*- Sales )<7#000
Cost of goods sold :7#000
>ross margin ):0#000
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Chapter 03 - Basic Accounting Concepts: The Income Statement
,1- :0 percent gross margin ,):0#000 ? )<7#000-
,3- ** percent profit margin ,@000?<7000-
The Aoden Corporation had a ta% rate of :0 percent ,)9#000 ? )*7#000- on its preta% profit that
represented *00 percent of its sales ,)*7#000 ? )<7#000- The compan"(s operating e%penses were <13
percent of sales ,)00#000 ? )<7#000- and its cost of goods sold was 73 percent of sales The compan"(s
gross margin was :0 percent of sales ,):0#000 ? )<7#000-
Problem 3-5
Bepreciation Each "ear for the ne%t 7 "ears depreciation will be charged to income
4o income statement charge Cand is not depreciated
Cost of goods sold )3#700 charged to current "ear(s income )3#700 charged to ne%t "ear(s income
Subscription e%pense )39 charged to current "ear )39 charged to ne%t "ear Alternati$el"# )01 charged
to current "ear on grounds )01 is immaterial
Problem 3-6
Asset $alue:
;ctober *# 10D7 )30#000
Becember 3*# 10D7 19#170
Becember 3*# 10D9 **#170
Becember 3*# 10D0 0
E%penses:
10D7 )3#070 ,)*#170 % 3 months-
10D9 )*7#000 ,)*#170 % *1 months-
10D0 )**#170 ,)*#170 % @ months-
;ne month(s insurance charge is )*#170 ,)30# 000 ? 1: months-
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Chapter 03 - Basic Accounting Concepts: The Income Statement
Problem 3-
!E" E#ECT$%&'C( C%)PA&*
'ncome (tatement for the month of April+ ----,
Sales )33#:00
E%penses:
Bad debts ) 9:7
=arts 3#000
Interest <<0
Aages *0#000
!tilities <00
Bepreciation 1#000
Selling *#@00
Administrati$e :#000 EEEEEE
17#317
=rofit before ta%es <#007
=ro$ision for ta%es 1#<00
4et income )7#107
Truc& purchase has no income statement effect It is an asset
Sales are recorded as earned# not when cash is recei$ed Bad debt pro$ision of 7 percent related to sales
on credit ,)33#:00 - )10#700- must be recogni3ed Aages e%pense is recogni3ed as incurred# not when
paid
Farch(s utilit" bill is an e%pense of Farch when the obligation was incurred
Income ta% pro$ision relates to preta% income Fust be matched with related income
Problem 3--
Girst calculate sales:
Sales ,):7#000 ? ,* - :7-- )<*#<*<H
Beginning in$entor" )37#000
=urchases ):0#000
Total a$ailable 07#000
Ending in$entor" 30#000
Cost of goods sold ):7#000
>ross margin )39#<*<
If the gross margin percentage is :7 percent# the cost of goods sold percentage must be 77 percent
;nce sales are determined# calculate net income:
4et income ,)<*#<*< % *- )<#*<1
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Chapter 03 - Basic Accounting Concepts: The Income Statement
4e%t# prepare balance sheet:
Assets #iabilities
Current assets
,)70#000 % *9- ) <0#000 Current liabilities ) 70#000
;ther assets
,)1*<#*<1 - )70#000- *3<#*<1
Cong term debt :0#000
Total liabilities ) @0#000
;wners( e/uit"
Beginning balance )*10#000
=lus net income <#*<1
Ending balance )*1<#*<1
Total assets )1*<#*<1
H
Total liabilities
and owners( e/uit" )1*<#*<1
H
Total assets I Total liabilities and ;wner(s e/uit"
Problem 3-.
Sales CC 19#999#990 JCC 10#000#000 % ,100 ? *70-K
5anuar" cash CC *#000#000 JCC 700#000 % ,100 ? *00-K
Becember cash CC 900#000
At "ear-end the compan" was more li/uid in terms of nominal currenc" ,CC 900#000 $ersus CC 700#000-
but in terms of the purchasing power of its cash it was worse off ,CC *#000#000 $ersus CC 900#000-
Cases
Case 3 -1: Maynard Company (B)
&ote/ This case is unchanged from the Twelfth dition!
"uestion # See below
"uestion $
This /uestion brings out the difference between cash accounting and accrual accounting Cash
increased b" )3*#900 whereas net income was )*@#937 E%plaining the e%act difference ma" be too
difficult at this stage# but students should see that:
* The ban& loan# a financing transaction# increased cash b" )10#<97 but did not affect net income
Cash collected on credit sales made last period ,)1*#0@<- also increased cash# but did not affect
net income this period ,The same is true of the collection of the )**#000 note recei$able from
Biane Fa"nard# but it was offset b" the pa"ments of the )**#000 di$idend to Biane Fa"nard# the
sole shareholder-
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Chapter 03 - Basic Accounting Concepts: The Income Statement
1
)A*&A$" C%)PA&*
'&C%)E (TATE)E&T+ 01&E
Sales ,)::#:10 cash sales H )19#707 credit sales- )00#@17
Cess: Cost of sales L 3@#3:7
>ross Fargin 3*#7<0
E%penses
Aages,)7#990H)1#101-)*#@0:- )7#<<<
!tilities @00
Supplies ,)7#77@H)*#90*-)9#930- 900
Insurance,)3#*70-)1#<19- 31:
Bepreciation ,)*70#@70-)*79#000-H,)7#@1<-)7#30:- 1#70:
Fiscellaneous *37 *0#:1*
Income before income ta% 1*#*7@
Income ta% e%pense ,)0#11: - )7#000- *#71:
4et Income *@#937
Cess: Bi$idends **#000
Increase in retained earnings ) 0#@37
LCost of sales:
Ferchandise purchased for cash )*:#0*7
Ferchandise purchased on credit 1*#3*7 J)1*#3*7H,)<#7*0-)<#7*0-K
In$entor"# 5une * 1@#<37
Total goods a$ailable during 5une 97#<97
In$entor"# 5une 30 19#710
Cost of Sales )3@#3:7
3 The purchase of e/uipment ,)13#:00- and other assets ,):0<- decreased cash but did not affect
net income ,at least not b" this full amount- this period
: Credit sales made this period ,)19#707- increased net income# but did not affect cash
7 4oncash e%penses such as depreciation ,)1#70:- and insurance ,)31:- decreased net income but
did not affect cash as the" relate largel"# if not wholl"# to cash outflows made for asset
ac/uisition in prior periods ,E%ception: such e%penses on an entit"(s first income statement are
not related to prior period e%penditures but the" will be a much smaller amount than the first
accounting period(s e%penditures
"uestion %
,a- )*:#0*7 is incorrect because it is the amount of cash purchases rather than the cost of sales The
cost of cash purchases and cost of sales amounts would be e/ual for a period in which all
purchases were for cash# and in which the dollar amount of beginning in$entor" was the same as
the dollar amount of ending in$entor"# since Cost of Sales I Beginning In$entor" H =urchases -
Ending In$entor"
,b- )39#030 is the sum of cash purchases ,)*:#0*7- and credit purchases ,)1*#3*7- As e%plained
abo$e# purchases e/ual cost of sales for the period onl" if beginning and ending in$entor"
amounts are the same
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Chapter 03 - Basic Accounting Concepts: The Income Statement
Case 3-2: Lone Pine Cafe (B)
&ote/ This case is updated from the Twelfth dition!
Approach
This case introduces students to preparation of an income statement based on anal"3ing transactions At
this stage# students are not e%pected to set up accounts in the formal sense Mowe$er# in effect the" do so
for those income statement items that did not coincide e%actl" with cash flows
"uestion #
A suggested income statement as re/uired b" Nuestion * is shown below The following notes appl"
to the income statement
* The student needs to refer bac& to Cone =ine CafO ,A- in order to construct the income statement
on the accrual basis Amounts for sales on credit# purchases on credit# beginning and ending
in$entor"# beginning and ending prepaid operating license# and depreciation e%pense are to be
found there Specificall":
a Sales re$enues I ):3#:<0 cash sales H )<00 credit sales to s&i instructors I )::#370
b Good and be$erage e%pense I )1#<00 beginning in$entor" H )*0#0*9 cash purchases H )*#7<3
credit purchases - )1#:30 ending in$entor" I )**#@9@
1 Since the entit" is unincorporated# it is also correct ,though less meaningful for e$aluati$e
purposes- to treat the )13#*70 partners( salaries as owners( drawings This treatment would result
in an income of )*1#1@9 and a decrease in e/uit" ,after drawings- of )*0#<7:
#%&E P'&E CA2E 345
'&C%)E (TATE)E&T 2%$ &%6E)4E$ 2+ 277.+ T8$%198
)A$C8 37+ 2717
Sales ) ::#370
E%penses:
Salaries to partners )13#*70
=art-time emplo"ee wages 7#:<0
Good and be$erage supplies l*#@9@
Telephone and electricit" 3#100
6ent e%pense 0#700
Bepreciation 1#::7
;perating license e%pense 7@7
Interest 7:0
Fiscellaneous e%penses 177
Total e%penses 77#10:
,Coss- ),*0#<7:-
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Chapter 03 - Basic Accounting Concepts: The Income Statement
"uestion $
The income statement tells Frs Antoine that the partnership has suffered a )*0#<7: loss for the first
fi$e months of operation This )*0#<7: loss is the correct figure for e$aluati$e purposes# not the
)*1#1@9 income before partners( salaries This assumes# of course# that nonowner salaries for the
coo& and table ser$ers would also ha$e been )13#*70# which is /uestionable It would appear that
Cone =ine Cafe cannot support three partners# e$en at a bare le$el of sustenance ,)13#*70 was onl" an
a$erage of )*#7:3 per partner?emplo"ee per month- ;f course the three owner?emplo"ees did recei$e
room and board# for which no $alue has been imputed here
Case 3-3: Dispensers of California, Inc.
&ote/ This case is unchanged from the Twelfth dition! !
Approach
The case can be used for two class sessions The first da" is de$oted to anal"3ing the accounting
transactions# including a preliminar" discussion of M"nes( accounting polic" decisions The second class
deals with preparing the financial statements and an anal"sis of how the" ma" change if alternati$e
accounting procedures had been adopted b" M"nes
The first class should start with the case Nuestion * Its purpose is to gi$e the students a sense of the
managerial purpose of profit plans and a conte%t for the later accounting discussions
The use of the asset e/uals liabilit" plus e/uit" structure to answer Nuestion 1 is recommended so
that the instructor can *- highlight the retained earnings lin& between net income and the balance sheet 1-
illustrate how an" accounting transaction can be anal"3ed using the basic accounting e/uation and 3- to
la" the foundation for the debit-credit framewor& material in Chapter : ,At this point in the course debit
and credit terminolog" and anal"sis should not be used-
Nuestions 3 and : re/uire the preparation of an income statement and balance sheet# respecti$el"
Some instructors prefer to end the first class with a discussion of the balance sheet# including a completed
balance sheet T"picall"# these instructors want to lea$e time in the second class to discuss the
relationship between net income and the change in cash on the balance sheet
Nuestion 7 is designed to illustrate the role of 2udgment in accounting for transactions
Answers to Nuestions
"uestion #
=rofit plans are used for a $ariet" of purposes These include:
To force short range planning
As a basis for e$aluating performance and determining compensation
To encourage coordination and communication between different organi3ation units and
le$els
As a challenge to impro$e performance
As a means for training managers
As an earl" warning s"stem and
As a guide to spending
3-<
Chapter 03 - Basic Accounting Concepts: The Income Statement

"uestion $
T4-E%hibit * presents an anal"sis of the planned transactions using the basic accounting e/uation
framewor& This anal"sis follows M"nes( accounting polic"
"uestion %
T4-E%hibit 1 presents M"nes( profit plan using the Nuestion * transaction anal"sis
The instructor should e%pect that most students will not calculate the cost of goods sold figure
correctl" The instructor will ha$e to e%plain that the components of the cost of manufactured goods
includes direct materials and their con$ersion costs# including manufacturing e/uipment depreciation
The distinction between operating and finance costs in the income statement is another accounting
practice most students will miss Again# the instructor will ha$e to e%plain this format and its rationale#
which is to permit statement users to e$aluate how well management has operated the compan" before
considering the impact of their financing decisions
"uestion &
T4-E%hibit 3 presents the "ear-end balance sheet using the Nuestion * transaction anal"sis
E/uipment is reported net Fost students will follow this presentation A better presentation is:
E/uipment ,cost- )<7#000
Accumulated depreciation ,<#700-
E/uipment ,net- )09#700
The patent is reported net This is the correct presentation for intangible assets
T4-E%hibit : presents a reconciliation of beginning ,3ero- and ending ,):0#700- retained earnings
The instructor ma" want to share this e%hibit with the students It lin&s the income statement to the
balance sheet It also illustrates that di$idends are distributions of capital and not an e%pense
The instructor should point out to students that man" intra period transactions# such as the borrowing
and repa"ing of the ban& loan# do not appear on the end of the period balance sheet
"uestion '
There are three accounting decisions that re/uire M"nes to e%ercise 2udgment The" are:
=atent $aluation
=atent amorti3ation period
E/uipment depreciation period
Students might belie$e M"nes must e%ercise 2udgment in the accounting for the redesign and
incorporation costs !nder current >AA= this is not the case 6edesign and organi3ation costs must be
e%pensed as incurred
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Chapter 03 - Basic Accounting Concepts: The Income Statement
The patent can not be $alued directl" There is no current li/uid mar&et for this t"pe of patent M"nes
must $alue it indirectl" Me chose to use the $alue of the compan"(s e/uit" he recei$ed based on the cash
paid b" the in$estors for their e/uit" interest to $alue the patent This is an acceptable approach
Mopefull"# the patent amorali3ation and depreciation periods represent M"nes( best estimate of the
related assets( useful life ,useful to Bispensers of California-
Students should be as&ed what would be the impact on the balance sheet and income statement if
different li$es had been used So that students do not get the impression that differences in 2udgment are
dri$en b" a desire to manage earnings# the instructor should be careful during the discussion to remind the
students that different reasonable life estimates can be made b" responsible managers acting in good faith
Cash Glow Anal"sis
If the instructor wishes to incorporate some aspect of cash flows in the case discussion# T4-E%hibit 7
and 9 present two anal"sis of cash flows T4-E%hibit 7 uses a cash receipts and distribution format T4-
E%hibit 9 uses a direct method statement of cash flows format Instructors should not use the indirect
method at this point in the course It confuses students Chapter ** introduces students to indirect method
statement of cash flows
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Chapter 03 - Basic Accounting Concepts: The Income Statement
E:hibit 1
"ispensers of California+ 'nc
4alance (heet Transaction Anal;sis
Transactions Assets < #iabilities E=>it;
*a
*b
M"nes( in$estment
;ther in$estors
? =atent )*10#000
? Cash <0#000
H Common Stoc& )*10#000
H Common Stoc& <0#000
1 Incorporation costs - Cash )1#700 - 6etained earnings )1#700
3 E/uipment purchase -Cash )<7#000
H E/uipment <7#000
: 6edesign costs - Cash )17#000 - 6etained earnings )17#000
7 Component parts purchase H In$entor" )1*1#*00
- Cash 1*1#*00
9 Ban& loan
Ban& loan repaid
Coan interest
H Cash )30#000
- Cash 30#000
- Cash 700
HBan& loan )30#000
- Ban& loan 30# 000
- 6etained earnings )700
0 Fanufacturing pa"roll - Cash )*:7#000 - 6etained earnings )*:7#000
< ;ther manufacturing costs - Cash 91#000 - 6etained earnings )91#000
@ Selling general and administration - Cash )93#000 - 6etained earnings )93#000
*0 Ending in$entor" ,cost of goods sold- L - In$entor" )*@0#000 - 6etained earnings )*@0#000
** Sales H Cash )7@<#700 H 6etained earnings )7@<#700
*1 Incorporation and redesign costs ,e%penses as
incurred-
See 1 and :
*3 Bepreciation - E/uipment )<#700 - 6etained earnings )<#700
*: =atent amorti3ation - =atent )10#000 - 6etained earnings )10#000
*7 Ending wor&-in-progress and completed
in$entor" ,none- ,cost of goods sold-LL
See 7# 0# <# *0 and *3
*9 Bi$idends - Cash )7#000 - 6etained earnings )7#000
*0 Income Ta%es HTa%es pa"able )11#700 - 6etained earnings )11#700
L Beginning component parts in$entor" )0 LLComponent parts used )*@0#000
=urchases 1*1#*00 Fanufacturing pa"roll *:7#000
Total a$ailable 1*1#*00 ;ther manufacturing costs 91#000
Ending component parts in$entor" *7#*00 Bepreciation <#700
Components parts used *@0#000 Cost of goods sold :*1#700
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Chapter 03 - Basic Accounting Concepts: The Income Statement
E:hibit 2
"ispensers of California+ 'nc,
12-month Profit Plan
Sales )7@<#700
Cost of goods sold
Components )*@0#000
Ffg pa"roll *:7#000
;ther Ffg 91#000
Bepreciation <#700 :*1#700
>ross margin )*<9#000
Selling# general and
Administration 93#000
=atent 10#000
6edesign costs 17#000
Incorporation costs 1#700
;perating profit )07#700
Interest 700
=rofit before ta%es )07#000
Ta% e%pense 11#700
4et Income )71#700
E:hibit 3
"ispensers of California+ 'nc,
Pro@ected *ear-end 4alance (heet
Assets Ciabilities
Cash )0<#:00 Ta%es pa"able )11#700
Components in$entor" *7#*00 Current liabilities )11#700
Current assets )@3#700
E/uipment ,net- 09#700 ;wner(s E/uit"
=atent ,net- *00#000 Capital stoc& )100#000
EEE 6etained earnings :0#700
)100#000 )100#000
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Chapter 03 - Basic Accounting Concepts: The Income Statement
E:hibit 4
"ispensers of California+ 'nc,
Change in $etained Earnings
Beginning retained earnings )0
4et income 71#700
Bi$idends ,7#000-
Ending retained earnings ):0#700
E:hibit 5
"ispensers of California+ 'nc,
Cash $econciliation
6eceipts Bisbursements
4ew e/uit" capital )<0#000
Incorporation )1#700
E/uipment <7#000
6edesign 17#000
Component parts 1*1#*00
Ban& loan 30#000
Ban& loan 30#000
Coan interest 700
Fanufacturing pa"roll *:7#000
;ther manufacturing 91#000
S > P A 93#000
Sales 7@<#700
Bi$idend 7#000
Total )00<#700 )930#*00
Cash 6econciliation
6eceipts )00<#700
Bisbursements 930#*00
Ending Balance )0<#:00
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Chapter 03 - Basic Accounting Concepts: The Income Statement
E:hibit 6
"ispensers of California+ 'nc,
(tatement of Cash 2lows 3"irect )ethod5
Collections from customers )7@<#700
=a"ments to suppliers ,1*1#*00-
=a"ments to emplo"ees ,1@7#000-
Cegal pa"ments ,1#700-
Interest ,700-
;perating cash flow )<@#:00
E/uipment purchases ,<7#000-
In$esting cash flow ),<7#000-
Ban& loan 30#000
6epa"ment of ban& loan ,30#000-
Capital <0#000
Bi$idends ,7#000-
Ginancing cash flow )07#000
Change in cash )0<#:00
Beginning cash 0
Ending cash )0<#:00

Case 3 -: Pine!ree Mo!el
&ote: This case is unchanged from the Twelfth dition!
Approach
This case treats the transition from cash to accrual accounting. also# the inherent difficulties in
comparison of data with industr" a$erages are illustrated The case does not re/uire a full <0 minutes of
class time# so I use the final portion of time for re$iew
Comments on !>estions
The operating statement called for in "uestion ( is shown below Gor man" termsQeg# re$enues#
ad$ertising# depreciationis no difficult" in fitting =inetree(s account names with the 2ournal(s standard
format. but for other items# there are problems:
* The Rims( drawings conceptuall" should be di$ided between pa"roll costs and
administrati$e?general# since the Rims( apparentl" perform both operating and administrati$e
tas&s
1 Some students ma" treat replacement of glasses# bed linens# and towels as general e%pense rather
than as direct operating e%pense ,although I feel the latter is more appropriate-
3 Some students ma" treat pa"roll ta%es and insurance as a general e%pense. ne$ertheless# it
properl" is part of pa"roll costs
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Chapter 03 - Basic Accounting Concepts: The Income Statement
"uestion $
Based on profit as a percent of sales# =inetree Fotel is onl" about one-third as profitable as the sur$e"
a$erage return on sales The &e" percentage disparit" is on pa"roll costs# which ma" reflect two things:
,*- the Rims( tas&s could be done b" two emplo"ees who would wor& for less than )<9#*00 a "ear ,which
is e/ui$alent to sa"ing the Rims( drawings reflect both a fair salar" and a distribution of entit" profits-. or
,1- the sur$e" data are dominated b" motels ha$ing twice as man" rooms as =inetree Fotel does# thus
spreading fi%ed labor costs o$er a higher $olume ,eg# a motel of 10 units and one of :0 units each needs
onl" one des& cler&- ;f course# there is probabl" a lot of 'noise+ in the sur$e" data for pa"roll and
administrati$e?general costs: owner-operators responding to the 2ournal(s sur$e" would encounter the
same problems as a student does in answering Nuestion *
P'&ET$EE )%TE#
%PE$AT'&9 (TATE)E&T 2%$ 2775
3in ind>str; trade @o>rnal format5
Dollars Percentages
)
6e$enues:
6oom rentals ,)139#07<- )*#990- )137#0@< @9<
;ther re$enue 0#003 31
Total 6e$enues 1:1#<0* *000
;perating E%penses:
=a"roll costs ,)<9#*00H)19#307H)1#<@:-)0@7-)<:H)*#*1<H
)*19- **7#90: :09
Administrati$e and general Q Q
Birect operating e%pense ,)<#<00 H )*#990 H )9#<10- *0#1<0 0*
Gees and commissions Q Q
Ad$ertising and promotion,)1#337 - )900 H )@@9- 1#03* **
6epairs and maintenance <#@<0 30
!tilities ,)*1#107H)1#0<@H)7#9**-)@33-)*07-)390H)<:0H)07H
)*73H :@1- 10#090 <9
Total *97#:31 9<*
Gi%ed e%penses:
=ropert" ta%es# fees ,)@#<00 - )*#007 H )*#**@- @#@<: :*
Insurance ,)**#7<: - )1#017- @#77@ 3@
Bepreciation 30#1<0 *17
Interest ,)*0#907 - )9<0 H )70@- *0#:@0 :3
6ent Q Q
Total 90#310 1:<
=rofit,preta%- ) *0#0:@ 0*
LFa" not add e%actl" owing to rounding
3-*7
Chapter 03 - Basic Accounting Concepts: The Income Statement
As a rough composition that attempts to ad2ust for the Rims( ,and probabl" other sur$e" respondents(-
dual roles as owners and operators# I suggest adding three accounts:
Pinetree A*erage
=a"roll costs :09 117
Administrati$e?general Q :1
=rofit 0* 100
Total 7:0 :0:
This tends to substantiate the h"pothesis that hired emplo"ees would perform the Rims( tas& for less than
)<9#*00
=inetree(s other operating costs do not seem to be out of line compared with the sur$e" a$erages the
higher-than-a$erage utilities ma" reflect a location with cold winters Insurance and ta%es are essentiall"
uncontrollable 6epairs and maintenance ma" be below a$erage because the Rims( personall" do some of
this wor&# whereas other motels pa" outsiders to do it
4ote that both rent and depreciation are shown in the 2ournal(s sur$e" data This also causes comparison
problems Gor =inetree# there is no rent# but the motel buildings are depreciated# whereas for some motels
the depreciation would include onl" furnishings Adding the rent and depreciation percentages ma" be
more meaningful than wor&ing at either one in isolation. but# of course# building depreciation is onl" a
$er" rough pro%" for fair rental $alue
4o final conclusion on the success of their operation can be made as information on the following is
lac&ing:
Capital ,re: the a$erage- ;ccupanc" rate
Cocation Seasonalit" ,re: Glorida annual season $s 4ew England-
=ricing Efficienc" in using their own time
Chec+ on income calculation,
6eceipts in 1007 )1::#:9*
Cess: 100: re$enue collected *#990
6e$enues in 1007 )1:1#<0*
Chec&s written in 1007 *@9#77<
=lus: 1007 e%penses not paid 7#70<
Bepreciation 30#1<0
131#3:9
Cess: 100: e%penses paid 9#7@:
E%penses in 1007 117#071
=rofit ) *0#0:@
3-*9
Chapter 03 - Basic Accounting Concepts: The Income Statement
Case 3 -": #a!ional $ssocia!ion of $cco%n!an!s
&ote/ This case is unchanged from the Twelfth dition!
Approach
This case describes a t"pical problem in the management of membership associations and of man" other
nonprofit organi3ations Each "ear a new go$erning board is elected and becomes responsible for the
operations of the organi3ation for that "ear As a general rule# the go$erning board should so conduct
affairs that the organi3ation brea&s e$en financiall" If it operates at a deficit# it is eating into resources
intended for future members# as suggested in the case If it operates at a surplus# it is not pro$iding the
members with as man" ser$ices as the" are entitled to
Thus# the difference between the concept of income described in the te%t for business organi3ation and the
income concept appropriate for a nonprofit membership organi3ation is that a business organi3ation
should earn satisfactor" net income# while the membership organi3ation should brea& e$en The
measurement of re$enues and e%penses follows the same principles in both t"pes of organi3ations ,at least
with respect to the transactions gi$en in this case-
The case is based# loosel"# on e%periences of the American Accounting Association# and instructors ma"
wish to refer to the AAA financial statements The case relates to the 'general fund#+ which is the portion
of the financial statements that reports normal operations The other columns in these statements can be
disregarded ,The 4AA is no longer in e%istence-
In the interest of simplicit"# students are not gi$en balance sheets The case can be made more
complicated b" assuming a beginning balance sheet# perhaps showing onl" cash and e/uit" of )77#000
each Students can then be as&ed to set up assets and liabilities that result from the transactions described
in the case
Answers to !>estion
Sarious 'correct+ answers are possible ;ne set is gi$en in E%hibit A and discussed below
* The grant relates to ser$ices to be performed in 1009# so it should not be counted as 1007
re$enue Mowe$er# the )1#000 alread" spent must be matched against the grant in some wa" This
can be done either b" subtracting it from 1007 e%penses and setting it up as a prepaid asset or#
more simpl"# b" transferring )7*#300 of the grant to 1009 re$enue The effect on the bottom line
is the same The fact that the president obtained the grant is irrele$ant The principle is to
recogni3e the re$enue in the period in which the ser$ices are performed The legal /uestion is
probabl" also irrele$ant. the intention was to perform the ser$ices in 1009# and that probabl"
would be the go$erning factor This is a debatable point# howe$er# because it gi$es no credit to
the 1007 president for the fine wor& he or she has done in obtaining the grant
1 The des&top publishing s"stem is not an e%pense of 1007 It will be an e%pense of future "ears
and is therefore an asset on Becember 3*# 1007 Because it was ac/uired so near the end of the
"ear# there is no need to deal with depreciation The /uestion can be as&ed about depreciation in
future "ears# and this raises the /uestion of estimating the future life Bes&top publishing s"stems
are a 'hot+ item The" are li&el" to impro$e in performance and decrease in price fairl" rapidl"
The useful life is therefore probabl" not more than fi$e "ears 4ote that although this is not an
e%pense of 1007# and the 1007 board has created a depreciation cost that will affect the surplus of
future boards
3-*0
Chapter 03 - Basic Accounting Concepts: The Income Statement
3
: The )31#:00 of 1009 membership dues pro-a-ly is not re$enue of 1007 Fembers will recei$e
ser$ices in 1009 for the 1009 dues ,It can be argued that earl" receipt of these dues a$oids the
necessit" of incurring e%pense for dues notices and follow-ups that would otherwise be needed in
1009 Mowe$er# there is no feasible wa" of measuring this- The fact that these members will
recei$e a free boo& is probabl" irrele$ant The cost of the boo& is a 1009 e%pense# and when the
associated re$enue from dues is mo$ed to 1009# the" match the e%pense
7 The membership director" is a real tough one The ser$ices for the 3#000 copies were pro$ided in
1007# but charging this as a cost in 1007# seems unfair to the 1007 board ,and to boards of each
"ear when a new director" is published- It can be argued that members refer to the director" for
two "ears# and hence the cost should be spread o$er both "ears The *#000 e%tra copies is
probabl" an e%pense of 1009# but this assumes that the" will in fact be used in 1009 and are not
simpl" e%tras that e$entuall" will be discarded ,The proportion of *#000 e%tra copies to the
membership seems large- E%hibit A ta&es the eas" wa" out and assigns one-half the cost to each
"ear# but other solutions are e/uall" defensible
9 The con$ersion of subscription re$enue from a cash basis to an accrual basis is straightforward
The re$enue in 1007 should be decreased b" )1#000
0 (f the Association is li&el" to be reimbursed for the )*0#<00# it is not an e%pense of 1007 The
li&elihood is that there will be a profit# but at this stage# one can(t be sure# e$en though there was
a profit in 100: It seems unli&el" in an" e$ent that there would be a profit that wiped out the
whole deficit E%hibit A remo$es the whole )*0#<00 as an e%pense. it becomes an account
recei$able from the Annual Feeting Committee Students who argue strongl" for conser$atism
might lea$e it as an e%pense This transaction shows how difficult it is to arri$e at the 'true+
results# as is also the case with some of the others The 100: annual meeting profit# not now
&nown# is conceptuall" a re$enue of 100: ,But read on-
< The )3#:00 annual meeting profit is re$enue for 100:# conceptuall" Mowe$er# there seems to be
no feasible wa" of recording this re$enue in the "ear of the annual meeting because of the
problem of pa"ing outstanding bills for some months after the annual meeting has ta&en place It
therefore can be argued that it is appropriatel" left in 1007# which is done in E%hibit A This
practice can be 2ustified on the grounds of materialit" If eliminated from 1007# some
corresponding ad2ustment for an estimated profit on the 1007 annual meeting should be made
Aith the ad2ustments made abo$e# the 1007 results has been changed from a surplus to a deficit
It is eas" to $isuali3e how discussions of this t"pe can become /uite heated The" can be a$oided
in the future b" preparing an accounting manual that describes how each of these transactions
should be handled This illustrates the importance of the consistenc" concept
"uestion $
The Administration(s polic" sa"s there should be a dues increase If there were some unusual
e%penses in 1007# the deficit might be tolerated# but we ha$e no indication that there are unusual
e%penses The association had to ta&e special steps to obtain the cash needed for the des&top
publishing s"stem# which means there was no cash surplus to draw on ;nce a deficit li&e this occurs#
the prudent course of action is to increase the dues
3-*<
Chapter 03 - Basic Accounting Concepts: The Income Statement
E:hibit A
&AT'%&A# A((%C'AT'%& %2 ACC%1&TA&T(
A"01(TE" '&C%)E (TATE)E&T+ 2775
6e$enues: As 6eported Ad2ustments Ad2usted
Fembership dues )1<0#700 )-31#:00 )177#*00
5ournal subscriptions 3*#000 -1#000 1<#300
=ublication sales **#@00 **#@00
Goundation grant 7:#000 -7*#300 1#000
Annual meeting profit# 100: 3#:00 EEEEEEEE 3#:00
Total re$enue 3<0#<00 -<9#:00 30*#:00
E%penses:
=rinting @1#:00 -**#900 <0#<00
Committee meeting e%penses :@#100 :@#100
Annual meeting ad$ance *0#<00 -*0#<00 0
Bes&top publishing s"stem 10#000 -10#000 0
Administrati$e salaries and e%penses *0*#700 *0*#700
Fiscellaneous 17000 EEEEEEEE 17#000
Total e%penses 307#@00 ) -:@#:00 319#700
Surplus or ,deficit- ) **#@00 ) -30#000 ),17#*00-
3-*@