CHAPTER 1

Accounting and Organizations

THINKING BEYOND THE QUESTION What do we need to know to start a business? Service businesses and most nonprofit organizations provide services rather than goods. A service business attempts to earn a profit by selling services that its customers need at prices greater than the costs of providing the services. Nonprofit organizations attempt to provide these services but do not attempt to earn a profit from them. However, most nonprofit organizations must still earn sufficient amounts from the services to cover their costs. Knowledge of services demanded by customers, members, or other constituents and knowledge of the costs associated with providing these services is important to any service-oriented organization. Most of the decisions made by managers of retail businesses must also be made by managers of other organizations. Understanding the factors that affect risk and return are important. All managers require information to make good decisions that will create value for stakeholders. QUESTIONS Q1-1 The purpose of accounting is to help people make decisions about economic activities. This is accomplished by providing information to decision makers that maximizes their likelihood of making decisions that have favorable economic consequences. The availability of reliable information upon which to base decisions reduces the risk that unfavorable economic outcomes will occur. Q1-2 Accounting provides information about results that owners and other decision makers should expect will occur. By understanding past activities, investors may make informed predictions about future events. Thus, accounting information helps reduce risks associated with investing decisions.

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Q1-3 The purpose of merchandising companies is to sell goods, that are produced by others, to customers. Customers might include either individuals or other businesses. The purpose of merchandising firms is only to transfer goods produced by others. They do not produce goods themselves but create value by providing a convenient selection of goods desired by customers. Manufacturing companies produce goods that they sell to consumers, merchandising companies or other businesses. They create value by combining the goods and services produced by others into products more highly valued than the resources used. Service companies neither produce nor sell goods. They sell services to customers, such as consumers or other businesses. Service companies create value by providing services that customers are willing to pay for. Q1-4 a. b. Merchandising organizations sell goods to customers for a profit. The goods are obtained from other organizations. Examples include most retail stores: grocery, hardware, department, etc. Manufacturing organizations sell goods they produce to customers for a profit. Examples include many major corporations that manufacture cars and trucks, equipment, textiles and clothing, and paper products. Service organizations that are businesses sell services to customers for a profit. Examples include banks, insurance companies, accounting firms, for-profit health care and educational institutions, and so on. Governmental organizations provide goods and services to citizens without the intent of earning a profit from their overall operations. Governments include city, county, state, and federal governments. Health care and educational institutions often are controlled by governmental organizations. Nonprofit organizations are organizations other than governments that provide services (and sometimes goods) without the intent of earning a profit. Examples include religious, civic, and social organizations. Health care and educational services may be provided by nonprofit organizations.

c.

d.

e.

Q1-5

Transformation involves converting resources from one form to an other. The goal of organizations is to create value and meet the needs of society while transforming resources. Accounting meas ures the value created by transforming resources. An accounting system should create value. If it does not create value, it is a waste of resources. Value is created when resources in existing form are transformed to another more valuable form. An ac counting system consumes many resources: from personnel to sup plies to extensive and expensive computer systems. Unless these resources are being transformed to information more valuable than

Q1-6

Accounting and Organizations

the underlying resources consumed, accounting has no reason to exist. It is probably (but sadly) true that not all accounting systems create value. A poorly designed, implemented, or operated accounting system will generate information that is less valuable than the resources consumed in doing so. In that case, an organization is better off not spending its resources in this way.

Q1-7 A return on investment is a return of profits over and above the amount initially invested. A return of investment is a return of a portion of the original investment. Of the $2,000 received by Phillip, the difference between the amount he invested and the amount the investment grew to ($4,100 $3,000 = $1,100) is the return on investment. The amount by which the check sent to him exceeded his earnings ($2,000 $1,100 = $900) is a return of investment. Q1-8 First, the underlying interest of investors is the return on investment. They seek to invest in businesses that have the ability to earn and distribute profits. Second, a business must be both effective and efficient to earn and distribute profits. Third, accounting information helps investors to assess the efficiency and effectiveness of a business. Therefore, accounting provides information about effectiveness and efficiency which, in turn, drives the return on investment. Q1-9 A contract is an agreement among parties wishing to exchange resources. It is the vehicle by which the expectations and responsibilities of each party are established. Subsequently, it is the vehicle to which all parties look for confirmation that the others responsibilities were met. Business simply could not function without contracts. If one business could not join up with others through contracts, business would be more risky because one could not depend on others to perform as needed when needed. Ultimately, the transformation process would be less efficient without contracts. Q1-10 Risk is the uncertainty about whether a particular outcome will occur. It could be said that risk is the chance that a desired outcome will not occur. To make a decision is to take a risk. That is, a different decision could have led to a more favorable outcome. Thus, all decision makers are risk takers. Accounting helps reduce risk by providing information to decision makers. A prudent decision maker seeks to reduce risk and increases the likelihood that a favorable outcome will occur. Q1-11 The major purpose of business is to transform resources. Accordingly, resources of different types are exchanged among a business and its suppliers, investors, creditors, and employees. Contracts establish the

Chapter 1

rules by which these exchanges will take place. They provide each party to the contract with expectations of their respective rights and responsibilities. Whether contracts have been fulfilled or not is often decided by reference to accounting information. Therefore, accounting information is important in the formation and evaluation of contracts among parties in the transformation process, an important aspect of accounting. Q1-12 It is not possible to avoid risk. It is present in any investment. Risk is not necessarily bad because greater returns are possible when greater risk is taken. Some investment opportunities are safer than others (e.g., an investment in Coca-Cola Corp. versus an investment in a Russian gold mine). Whats bad is not understanding the degree of risk you have accepted. If the government banned risky investments, it would have to ban all investments even those in government securities. Even U.S. government securities are risky because of the possibility (though small) that there will be a revolution and all government debts will be cancelled. Q1-13 The risk-return tradeoff is readily observable regarding investments that students are aware of. For example, they may know that the return on an FDIC-insured savings account is less than that available from moneymarket mutual funds. They may know that the return on U.S. savings bonds is less than that available from corporate bonds. They may know (implicitly) that the return on bonds is less than the return on equities. In everyday life they may see this relationship also. Putting all ones eggs in one basket for a shot at the NBA is an example of high risk, high reward. Applying for admission to the local diploma mill college is a low risk, low reward strategy. Choosing a life of selling drugs is an example of a high risk, high reward approach. Students will probably come up with many others. Q1-14 Owners invest in (risky) businesses rather than U.S. Savings Bonds because they seek a greater return on investment than is available from (safer) U.S. Savings Bonds. In order to obtain a greater return, they are willing to take on more risk. The decision of whether to invest in (risky) businesses or in (safer) U.S. Savings Bonds would depend on factors such as (1) ones tolerance for risk, (2) ones need for the money, or (3) the penalty one might incur from losing the money. Q1-15 Risk is uncertainty. Moral hazard arises when setting executive compensation because owners must rely on accounting information that is controlled by management to make those decisions. Management may be tempted to provide accounting information that presents its performance in a more favorable light than justified. Accordingly, there is uncertainty as to whether the compensation awards made to

Accounting and Organizations

management are consistent with managements performance. One purpose of generally accepted accounting principles is to reduce moral hazard and the risk it generates. An outside audit is required to verify that the information reported by management is consistent with an accepted set of reporting rules. Q1-16 First, an audit is a detailed examination of the firms financial reports. Second, the audit is conducted by highly trained personnel supervised by a CPA. Third, the CPA must be independent of the company and have no vested interest in the success or failure of the firm being audited. Fourth, an audit includes an examination of the information system to ensure that it produces reliable information. Finally, an audit reports whether the financial statements have been prepared according to GAAP. Q1-17 Actually, there are probably many cases where the classmates point is well taken. In most cases, GAAP is designed to reveal and report important economic information. And in some (many?) cases, it probably accomplishes that. The underlying issue here is not that GAAP is not useful even in certain managerial reporting cases but that managerial accounting is not limited to GAAP-approved techniques. When financial accounting information is sent out to the public, it is important that a specific set of measurement and reporting rules be observed so that knowledgeable users can properly interpret the information. The reason that GAAP is not required for managerial accounting is that management controls this set of information, and if management distorts it, only the companys managers will be misled. EXERCISES E1-1 Definitions of all terms are listed in the glossary. E1-2 DATE: TO: FROM: SUBJECT: (todays date) Edwina Polinder (students name) Inquiry about accounting

The purpose of accounting is to help people make decisions about economic activities. Accounting is a system that records, summarizes, and reports information about resources and how resources change during a period. The steps in the accounting process are as follows: (1) an event (transaction) occurs affecting a persons or organizations resources, (2) the transaction is recorded in accounts, (3) the account balances are computed, and (4) a summary report is prepared about the effect of transactions for a period.

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E1-3 If Wilma and other stockholders are concerned about the future operations of Essex International, they may sell their stock or may be unwilling to buy additional shares at current prices. Creditors may be unwilling to provide additional loans or may charge higher interest rates for loans they are willing to make. Suppliers may be more careful about selling to Essex on credit. These types of actions would restrict the availability of capital and materials to the company and make it more difficult for the company to obtain the cash needed for operations. To offset these problems, Essexs management may attempt to cut its costs by reducing operations, laying off workers, or selling unprofitable operations. It might attempt to increase revenues by developing new markets. These actions would be aimed at increasing profitability to regain investor and supplier confidence and access to capital and materials. E1-4 1. 2. 3. 4. c b d a $1,050

E1-5

Resources created from selling sundials Resources consumed: Rent $425 Supplies 250 Wages 175 Total cost of resources consumed Profit earned

850 $ 200

E1-6

Resources created from sale of lamps (40,000 $70) $2,800,000 Resources consumed: Production and distribution (40,000 $25) $1,000,000 Salaries and facilities 1,200,000 2,200,000 Profit $ 600,000 The steps in determining profits are (1) compute total sales to customers from the average unit price and volume, (2) compute production and distribution resources consumed from the average unit cost and volume, (3) compute total resources consumed by adding production and distribution expense to salaries and facilities cost, and (4) subtract total resources consumed from sales to customers.

E1-7 Amount of profit earned at each step: a. Sales price of cotton Cost to produce cotton Profit from producing cotton b. Sales price of fabric Cost to produce fabric Profit from producing fabric $ 5.50 5.00 $ 0.50 $17.00 13.25 3.75

Accounting and Organizations

c. Sales price of slacks Cost to produce slacks Profit from producing slacks d. Sales price to customers Cost to retailer Profit from sale of slacks Total profit (value added)

$30.00 25.00 5.00 $56.00 34.00 22.00 $31.25

Customers are willing to pay for the cost and profits involved in producing and selling the pants because the pants are more valuable than are the costs of the raw cotton, fabric, and the production and distribution process to the buyer of the pants. Customers would rather pay the price of the pants than grow their own cotton, produce their own fabric, and manufacture their own slacks. The farmer, textile manufacturer, slacks maker, and retailer add value to society by transforming resources from one form to a different, more desirable form. E1-8 Sales price per glove Costs of producing each glove: Leather ($80 2) $40.00 Padding ($6 2) 3.00 Thread and other materials ($16 8 gloves) 2.00 Rent and utilities ($650 8 gloves) 81.25 Shipping 4.50 Total cost per glove Profit per glove Average profit per month ($344.25 8) Antonios Restaurant Profit Earned For June Resources created from sales to customers Resources consumed: Food products $6,250 Building and equipment rental 4,376 Wages 4,050 Maintenance and utilities 2,000 Total resources consumed Profit E1-10 The Quick Stop Profit Earned For March Resources created from sales to customers $20,500 $475.00

130.75 $344.25 $ 2,754

E1-9

16,676 $ 3,824

$4,400

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Resources consumed: Food products Building and equipment rental Wages Maintenance and utilities Total resources consumed Loss E1-11

$2,100 1,250 1,000 600 4,950 $ (550)

Pam Lucass Paper Route Profit Earned For May Resources created from papers delivered Resources consumed: Papers $300 Use of car 45 Gas 30 Total resources consumed Profit $ 20.00 20.10 20.20 $ 60.30 $ 19,500 17,000 $ 2,500 3,000 $ (500)

$450

375 $ 75

E1-12 Return on investment: January ($4,020 $4,000) February ($4,040.10 $4,020) March ($4,060.30 $4,040.10) Total return for three months E1-13 Ending value of Smiths investment Beginning value of Smiths investment Return on Smiths investment Amount paid to Smith Return of investment

The company did not maintain its capital during the year because the amount paid out ($3,000) exceeded the amount earned ($2,500). Whenever there is a return of investment, the capital base of a company is shrinking. E1-14 J-Mart was more effective and efficient than Buy-Lo in providing goods to consumers. The two companies sold the same products, so J-Mart was apparently more effective in selecting a location that created greater demand for these products since its sales were greater. In addition, JMart was more efficient in controlling its costs, resulting in a higher profit than Buy-Lo. J-Mart was more efficient since its total cost as a percentage of sales was 64% ($16,000* cost $25,000 sales) versus 84% ($16,000 cost $19,000 sales) for Buy-Lo. *Cost = J-Mart Revenue $25,000 Buy-Lo $19,000

Accounting and Organizations

Profit

9,000 $16,000

3,000 $16,000

E1-15 Rogers was more effective since it was able to sell more of its product. Consumer preference might reflect a preferred taste or better marketing. Hornsby was more efficient since it was able to produce its product at a lower cost and earn a higher profit per bottle than Rogers. Perhaps Hornsby incurred lower marketing expenses than Rogers. Hornsby was more profitable: Hornsbys profits (425,000 $0.15) Rogers profits (500,000 $0.10) $63,750 50,000

E1-16 Beta appears to be more efficient and effective. It is selling more of its product and earning a higher profit on the units sold than is Alpha (Alpha: $420,000 $4,700,000 = 9%; Beta: $913,500 $6,525,000 = 14%). Students should choose Beta because it is more efficient and effective and is earning a higher return than Alpha. Perhaps Beta is making a better product, managing its resources to control its costs better, or marketing its product better. E1-17 a. b. c. d. e. f. g. h. i. j. corporations corporations or partnerships corporations corporations proprietorships or partnerships corporations partnerships corporations corporations proprietorships and (to a lesser degree) partnerships

E1-18 Yashiko should be concerned about the reliability of the information. Even if she has no reason to doubt Hendricks honesty, she should want verification of the information. Also, she might be concerned about how the information was prepared. What measurement and reporting rules were used to prepare the reports? Are the reports complete? Do they contain all of the information necessary to evaluate the companys financial condition? To address these concerns, Yashiko could ask Swindler for an independent audit of the reports or to have the reports prepared or reviewed by an independent auditor. She could ask for additional information about the way the reports were prepared. She should require whatever information she believes necessary to verify the reliability of the reports before approving a loan.

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E1-19 Several factors might be considered in evaluating the products. Market The laser printer is an established product with an established market. The projector is a new product without an established market. Therefore, it is a riskier product. CompetitionThe printer will be sold in a highly competitive market. The projector will be sold in a market with little competition. Therefore, the printer is riskier if a market develops for the projector. TechnologyBoth products are in a high-technology industry. Products tend to become obsolete quickly, and market demand is uncertain. The printer uses a proven technology and should be less risky to produce than the projector. The projector probably will require greater effort and care in design and production to ensure a quality product. The marketing effort for the product will also be large because it is a new product without an established market. The projector is a riskier investment than the printer. The potential for a high return is probably greater. On the other hand, the potential for loss also is greater. E1-20 The bonus arrangement provides an incentive for managers to report a higher return than they actually have earned. Net income could be increased by overreporting revenues or underreporting expenses. Total assets could be decreased by omitting some assets. Therefore, the board of directors and stockholders should be concerned about the reliability of the financial information. To ensure the financial information is reliable, the board can require that certain measurement and reporting rules be used by management when it prepares the financial reports. These rules will specify which revenues, expenses, assets, and so on, will be included and how the amounts will be measured. The rules used by most major corporations are specified by GAAP. In addition, the board can require that the financial reports be audited by an independent accountant. The accountant will verify that the appropriate measurement and reporting rules have been used. E1-21 If Andy confronts Meredith or informs the auditors of Merediths actions, he will likely lose his job. Andy is in a tough situation. He simply did as he was told by the owner of the company. Andy should have concerns about continuing his employment with Meredith because he is an individual who cannot be trusted. If the banker makes a loan based on false information, a number of individuals could be harmed. If Meredith is unable to repay the loan, the bank will lose its money. Thus, the banks owners (or investors) and possibly the banks employees will be economically worse off.

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11

PROBLEMS P1-1 A. Betsy could borrow money from a bank or other financial institution. She could go into partnership with other individuals who are interested in investing in the business. She might form a corporation and sell stock to interested investors. Or, she could use a combination of methods. The potential creditors and investors will need information to help them decide what amount of return they will obtain from their investments and the risk they are taking of losing their investments. Information that might be useful in making these decisions includes the expected demand for the companys products and the expected costs that will be incurred by the company in the transformation process.

B.

P1-2 Organization Type Merchandising companies JCPenney Amazon.com Sears Manufacturing companies Dow Chemical Company PepsiCo DaimlerChrysler Service companies United Parcel Service (UPS) Federal Express (FedEx) Verizon Communications Governmental or nonprofit organizations United States Postal Service (USPS) Internal Revenue Service (IRS) March of Dimes P1-3 A. Linda Greenes Car Dealership Profit Earned For July Resources created from sales to customers Resources consumed: Cars $189,000 Rent 2,550 Utilities 800 Insurance 825 Maintenance 700 Advertising 1,250 Taxes and license 200

$230,000

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Total resources consumed Profit B.

195,325 $ 34,675

C.

Linda earned $34,675 in July. This amount may be used by Linda to pay for personal expenses, food, housing, taxes, and so on. Some of it may be reinvested in the business. Lindas return on investment for the month would be 2.89% ($34,675 $1,200,000). At this pace, her annual rate of return would be approximately 35% (2.89% 12 months). Sales Wages for occasional labor Utilities Rent on land and buildings Advertising Supplies Delivery costs Total Profit $4,500 $ 700 100 1,200 300 75 225 2,600 $1,900

P1-4

A.

B.

Expected return on investment = $22,800 $152,000 = 15% ($1,900 12 months) = $22,800

P1-5 A. Tender Sender Company Profit Earned For February Resources created: Sale of gift items Sale of novelty items Shipping services Mail box services Total resources created Resources consumed: Cost of gift items Cost of novelty items Rent Advertising Utilities Supplies used Miscellaneous Total resources consumed Profit B. $7,000 3,200 1,588 1,640 $13,428 $3,100 1,450 2,200 1,500 525 384 500 9,659 $ 3,769

Yes, the company created value. Organizations transform resources from one form into another. Value is created when the value of the

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13

new resources created exceeds the value of resources consumed in the transformation. In accounting, profit is defined as the difference between the value of resources created and the cost of resources consumed. Therefore, profit is a useful measure of the value created by the transformation process.

P1-6

A.

Resources created from sales ($8 1,000) Resources consumed: T-shirt costs ($5.50 1,000) $5,500 Paint ($0.50 1,000) 500 Rent 300 Utilities 150 Wages 800 Total cost of resources consumed Estimated profit earned for one month Estimated profit for first year

$8,000

7,250 $ 750 $9,000

B.

The loan officer would look at the financial information to see if the company is expected to be profitable. If the estimates of revenues and expenses are correct, the T-shirt store will enjoy resources created that exceed resources consumed. The loan officer would compare your predictions with actual results of similar businesses to determine whether the income projections are reasonable. T. Edison Profit Earned For September

P1-7

A.

Resources created from inventions Resources consumed: Rent $550 Clerical salaries 300 Legal services 130 Office supplies 100 Utilities 90 Fuel 70 Insurance 250 Total cost of resources consumed Profit earned

$3,600

1,490 $2,110

B.

The information is useful because it permits Edison to understand the amount of resources created and consumed in operating her business. The report also categorizes the resources consumed by type.

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C.

Edison may decide to increase or decrease her resource consumption. For example, if she hires a research assistant she may eventually expect to earn more royalties from inventions. However, the research assistant will expect a salary. Thus, Edison will increase her resource consumption. She may use financial information to determine whether her decisions improve profits over time. Betsys Flag Co. Profit Earned For September

P1-8

Resources created from flag sales Resources consumed: Rent Supplies Fabric License Utilities Repairs Wages Total cost of resources consumed Profit earned P1-9 A. B.

$24,000 $ 650 3,000 8,750 500 250 1,750 2,500 17,400 $ 6,600

The CFO should prepare a document such as this in order to help predict future profits or losses. If the company came to your bank requesting a loan, you would consider many factors before making a final decision. The company is predicting a loss for the month of August; however, other information suggests the companys sales are growing. With additional sales, will the company become profitable or become even more unprofitable? A lender would ask to see reports that explain how the money will be repaid from profits generated by the business. Return on investment = $27,000* $250,000 = 10.8% Since return on investment exceeds the amount John is withdrawing, return of investment is $0. *($2,250 12) Partnership: Reasons for: 1. It is simple to set up. 2. The life of this business is expected to be short. 3. There will be no need to raise additional capital. 4. There is little need for limited liability as the owners have no assets to lose. Reasons against:

P1-10 A. B.

P1-11

A.

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15

1. Mutual agencyany partner can obligate the others. B. Corporation: Reasons for: 1. The company will have need for additional financing which could occur through the sale of stock to new owners. 2. Limited liability: both sisters (particularly Vicky) are likely to have substantial personal assets that would be at risk without corporate protection. 3. Unlimited life: this firm is being set up for the long term with substantial expansion and diversification anticipated. 4. Professional management: at some point, after significant expansion, the sisters may wish to withdraw from day-to-day operations and employ professional managers. 5. Avoidance of mutual agency: if Molly is a bit of a flake, she can ruin the business perhaps, but she cant ruin Vickys personal finances. Reasons against: 1. More difficult to set up. 2. More paperwork and reporting each year. 3. Double taxation: the profits of the corporation will be taxed, and any profits paid out to the sisters will be taxed (again) as personal income. 4. Moral hazard: if they hire professional managers someday, there will be the risk that managers are acting in their own best interest rather than in the best interest of the owners. Corporation: Reasons for: 1. Limited liability: this situation has disaster written all over it. The number one consideration is to protect the remainder of their money. 2. Professional management: in the unlikely event that there really is a successful product here, they need professional managers to operate the company. They are not qualified. Reasons against: 1. More difficult to set up. 2. More paperwork and reporting each year. 3. Double taxation: the profits of the corporation will be taxed, and any profits paid out to the siblings will be taxed (again) as personal income.

C.

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4. Moral hazard: if they hire professional managers someday, there will be the risk that managers are acting in their own best interest rather than in the best interest of the owners. P1-12 A. B. Mary is interviewing with a corporation, as evidenced by the structure that requires a board of directors. The advantages of the corporate organizational structure include continuous lives and limited liability. The corporate form also allows organizations to gain access to investors and resources through capital markets. Management ultimately is responsible to the shareholders, the owners of the company. There are exchanges and contracts between the following parties: i. Sonny and the corporation ii. Sonnys mother and the corporation iii. Sonnys friends and the corporation iv. The bank and the corporation v. The corporation and the landlord vi. The corporation and the manufacturer vii. The corporation and the employee viii. The corporation and its commercial customers ix. The corporation and its retail customers x. The corporation and the city, state, and federal governments Every party has taken on risk by becoming party to a contract with the corporation. i. Sonnys investment of $5,000 is at risk that the business will lose money his. ii. Mothers $8,000 loan is at risk that the business will lose money hers. iii. Friends investments of $10,000 in stock are at risk that the company will lose money theirs. iv. The banks loan of $25,000 is at risk that the business will lose money its. v. The landlord is at risk that he/she will not be able to collect the monthly rent or the 1% of sales as called for by the contract. vi. The manufacturer is at risk that goods purchased on credit will not be paid for. vii. The employee is at risk that her salary and profit-sharing will not be paid. viii. Customers are at risk that Sonny will not assist in honoring the manufacturers warranty or not make good on his own secondary warranty.

C. P1-13 A.

B.

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17

ix.

The various governments are at risk of not receiving tax payments after having provided services that benefit the company (e.g., police protection, legal system, roads).

C.

The following will rely on accounting information to determine compliance with the contract. i. The contract with Sonnys mother to determine when the company is first profitable. ii. The contract with Sonnys friends to determine when the company is first profitable. iii. The contract with the bank to determine when the company is first profitable. iv. The contract with the landlord to determine the extra rental payment (1% of sales). v. The contract with the manufacturer to determine how much must be paid. vi. The contract with the employee to determine the amount of profit-sharing. vii. The contracts with various governments to determine the amount of taxable income and the amount of inventory tax payable.

P1-14

A.

The concept of risk in this context means "variability in earnings." The greater the variability in earnings the greater is the risk of lost investment. The ultimate risk is that one of the "down" years might be so bad that it would wipe out the company. Generally it is more prudent to have less volatile swings in earnings. Risk and return are related in most situations. Investors expect to earn higher returns on riskier investments to compensate them for taking on the higher risk. Therefore, higher potential rewards must be offered to attract investors to riskier investments. Given that Nancy is a bank loan officer, her only interest is in determining the probability that the loan will be repaid on time. Hill Country Enterprises has a history of steadily growing earnings. To the extent that the past is indicative of the future, it is likely that the firm will continue its steady earnings pattern and pay off the loan on time. Low Land Associates, however, presents a wildly fluctuating earnings pattern. Some years it earns gangbuster profits (as compared to Hill Country), but in other years it has losses. The risk to Nancys bank is that the loan will come due during a year when the company is unprofitable and unable to repay the loan. A loan to Hill Country Enterprises is less risky to the bank and is preferable.

B.

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C.

(Note: Students should be expected to vary in their answers to this question.) Mauro is an equity (stock) investor. Given that different role, he will use this accounting information differently than Nancy. He may or may not come to the same conclusion. Unlike the bank, an investor in stock stands to gain a great deal if the company is successful and lose everything if it is not. Clearly, Hill Country Enterprises is the less risky investment because the volatility of earnings is less. This may appeal to Mauro if he is a conservative investor, or it may not. Mauro may prefer to make the riskier investment in Low Land Associates in the expectation of higher rewards. Over the last seven years, for example, the earnings of Low Land have been 21% higher than those of Hill Country ($2,249 versus $1,856). This situation presents a problem to Nancy. If Hill Countrys financial information cannot be confirmed as conforming to GAAP, there is additional unknown risk. That is, Nancy cant tell for sure what Hill Countrys earnings pattern (variability) really is. When prepared under an unknown set of procedures, the pattern of earnings may be adjusted to whatever pattern the preparer wants it to look like. Under these new facts, the automatic choice of Hill Country Enterprises is no longer automatic. Nancys job becomes much tougher. Its impossible to tell, from the facts given, which choice is best. This new set of facts may also make Mauros choice more difficult. If he is a conservative investor and would have chosen Hill Country, he faces the same problem as Nancy. If he were a more aggressive investor and would have chosen Low Land, the new information is probably unimportant and wouldnt affect his decision. If he chose Low Land under the original facts, he would now too. If the risk-return tradeoff was favorable before, it is more so under the new facts.

D.

P1-15

A.

Selling to Company B appears less risky than selling to Company A. Company B reported steadily growing earnings, while Company A reported volatile earnings. Thus, Company A may be unable to pay for goods purchased if earnings and cash flows decline during difficult economic times. A customer would be interested in assessing its suppliers financial condition. Customers depend on suppliers to provide high-quality products on time. If a supplier is in a strong financial position, it is more likely to meet its customers expectations for reliable delivery. $1,600,000 0.03 = $48,000 $2,400,000 0.03 = $72,000

B.

P1-16

A.

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19

Taylor would increase his bonus by $24,000 if he decides to inappropriately include the incomplete sale in the current years revenues and profits. B. Owners, or directors who represent them, need information to evaluate how well managers are performing. Financial information provides incentives for managers to perform well. There may be a short-term incentive for Taylor to misrepresent profits in order to obtain a larger bonus. However, unethical behavior ultimately will be discovered by high-level managers or by the companys auditor. Taylor should accurately report sales and profits to prevent misleading owners, investors, and creditors. The audit adds value because an independent third party evaluates whether the financial statements are prepared in accordance with GAAP. Since investors rely on financial information to make decisions, they want assurance that the information is accurate. An audit reduces risk for investors. Though the financial information looks comparable, Hoffstetters data may not have used GAAP. The audit would provide independent verification that the financial information was prepared in accordance with GAAP. The SEC is the Securities and Exchange Commission. It is responsible for ensuring companies report their financial information consistent with GAAP and SEC requirements. Companies must report financial information consistent with GAAP. Full and fair disclosure of business activities is necessary for stakeholders to evaluate the risks and returns they anticipate from investing in and contracting with business organizations. Without reliable information about a companys business activities, investors cannot determine which companies are most efficient and effective and are making the best use of resources. Without good information, contracts cannot be evaluated and markets cannot function properly. Thus, if investors had known the financial information was misleading, they may have reached a different conclusion about whether to invest in the company. Students answers will vary. Use Part B to identify consequences of answers to Part A. In the short run, you may be better off by selling the low-quality product. It is unlikely customers will be able to determine the prod-

C.

P1-17

A.

B.

P1-18

A.

B.

C.

P1-19

A. B.

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ucts are of poor quality for some time. In the long run, customers are likely to be unhappy with the product. Therefore, your sales, reputation, and customer loyalty may suffer. One alternative for dealing with the problem would be to offer the product for sale at cost, near cost, or below cost with ample disclosure that the product is of lower quality than others you sell. If the product is really poor, your best bet might simply be to scrap the product and write it off as a loss. P1-20 A. B. Using the lower-priced parts would increase profits by $7.50 per unit ($30 $22.50) or $5,250 per month ($7.50 700). This increase probably would be temporary because customers are likely to determine the product is lower in quality than others sold at a comparable price. They probably would take their business elsewhere if they felt they had been cheated, so profits may drop in the long run. The ethical issue is whether a lower-quality product should be substituted at the same price charged for a better-quality product when customers have come to expect the higher quality. Many companies sell the same type of products but with differing quality. If customers are aware of the differences, and the products are priced to reflect the differences, an ethical problem does not exist. The ethical issue is whether a company has an obligation to provide information to its customers that will enable them to make appropriate decisions.

C.

P1-21

The Book Wermz Profit Earned For September 2007 Sales Cost of goods sold Wages Supplies Rent Utilities Profit $ 40,000 (28,000) (4,200) (2,000) (1,500) (300) $ 4,000

P1-22

1. 2. 3. 4. 5. 6. 7. 8.

b d c c b b b d

Accounting and Organizations

21

9. b 10. d

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CASE C1-1 Resources Logs Other building materials Human resources: Construction Assembly Maintenance Marketing and service Management and office staff Transformation Cut logs to dimension Ship logs and materials to site Assemble logs and materials Goods Log homes