Prof Ane Tamayo

Problem Set 3

Question 1

Understated/ Overstated (Accrual vs. Cash Accounting)

In the following questions please state in the space provided if the accounting figures are
understated (U) or overstated (O) and, if so, by how much. If the accounting figures are not
affected, please write NE.

1. Marco Corp., a maker of fine Italian wine, did not record any entries during the current
accounting year regarding its only insurance policy. At the beginning of the period, January
1st, the balance sheet showed $750 of current “prepaid fire insurance” for an insurance
policy that expires on June 30 th. On July 1st, the firm paid $2,000 in cash to renew this
policy for a further 12 months (Reminder: the firm’s fiscal year ends on December 31).

Current Assets ____________ Long-term assets ____________

Current Liabilities ____________ Long-term liabilities ____________
Capital Stock ____________ Retained Earnings ____________
Net Income ____________

2. On December 1st, 2020, Wyms Enterprises increased Prepaid Rent (Advances to Car Rental
Agency) by £600 for six months of rent on an automobile. The firm did not make any
adjusting entries on December 31st, 2020.

Current Assets ____________ Long-term assets ____________

Current Liabilities ____________ Long-term liabilities ____________
Capital Stock ____________ Retained Earnings ____________
Net Income ____________

3. Dustin Dangerous Dance Studio Corp. (DDDS) received a $12,500 deposit from a customer
for services to be performed next year (e.g., a deposit for a class), and incorrectly recorded
this deposit as revenue. As of the end of the year, DDDS had not yet performed any of the
service required to satisfy the contract (the student had not taken any classes), and did not
make any year-end adjustments to correct the mistaken entry.
Current Assets Long-term assets
Current Liabilities Long-term liabilities
Capital Stock Retained Earnings
Net Income
Question 2

Multiple Choice (Accrual vs. Cash Accounting)

Please circle the right answer.

1. What is the effect on the basic accounting equation of an entry recording the cash payment of
salaries that were previously accrued?

(a) Decrease liabilities, decrease assets.

(b) Decrease liabilities, decrease stockholders' equity.
(c) Decrease assets, decrease stockholders' equity.
(d) Decrease assets, increase stockholders' equity.

2. Which of the following circumstances would result in a decrease in income under accrual-based
accounting but not under cash-based accounting?

(a) Purchase of inventory on account.

(b) Payment of two months’ rent in advance.
(c) The use of prepaid rent.
(d) The return of defective inventory purchased on account, where full credit was given.
(e) The payment of the current period's utility bill.

3. On December 1st, 2020, Oliver Television Channel Inc. received $30,000 for a television
campaign. Commercials ran evenly in December, January and February. How was this
transaction reflected in Oliver’s financial statements for the fiscal year ended December 31 st,
2020? (Please ignore any costs that Oliver Television Channel Inc. had in running the
campaign.)

(a) Assets increased by $30,000, liabilities increased by $20,000 and shareholders’ equity
increased by $10,000.
(b) Assets increased by $10,000, liabilities were unchanged, and shareholders’ equity
increased by $10,000.
(c) Assets increased by $30,000, liabilities were unchanged, and shareholders’ equity
increased by $30,000.
(d) Assets increased by $30,000, liabilities decreased by $20,000 and shareholders’ equity
increased by $ 10,000.

4. Puck Ltd started the fiscal year 2020 with a balance of $15,000 of prepaid rent. This
prepayment covers the fiscal year of 2020 and the first 6 months of fiscal year 2021. Puck Ltd
did not record any transactions related to this rent during fiscal year 2020. As a result:

(a) Assets are overstated by $15,000 and shareholders’ equity is overstated by $15,000.
(b) Assets are overstated by $10,000 and shareholders’ equity is overstated by $10,000.
(c) Assets are understated by $15,000 and shareholders’ equity is understated by $15000.
(d) Assets are understated by $ 10,000 and shareholders’ equity is understated by $10,000.
(e) None of the above.
Question 3: Revenues, Cash Flows and Accruals

Costco Wholesale Corporation is an American multinational corporation that operates a chain of

membership-only warehouse clubs. Upon purchase of one-year memberships, Costco members can
buy at discounted prices a selection of products in a wide range of categories (e.g., groceries &
household, health & beauty, wines & spirits, appliances, electronics, computers etc.). Costco’s
objective is to generate high sales volumes and rapid inventory turnover while achieving operating
efficiencies by volume purchasing, efficient distribution and reduced handling of merchandise in
no-frills, self-service warehouse facilities.

Using the information contained in the excerpts of Costco’s annual report on pages 5-7, please
answer the following questions.

Note:
 (Fiscal) year 2019 refers to the 52 weeks ending in September 1, 2019.
 The amounts are in millions.

REQUIRED:

a) Briefly describe how Costco accounts for membership fees.

b) How much revenue did Costco recognise in fiscal year 2019? Out of this revenue, what
percentage was due to recognition of membership fees?

c) What percentage of the membership fees recorded as revenue in 2019 is due to memberships
initiated or renewed during fiscal year 2019?

d) How much did Costco collect in membership fees in fiscal year 2019 for membership initiations
and renewals?
e) Costco has agreements to receive rebates (money back) from their suppliers upon reaching pre-
specified sale volumes. Discuss the alternative ways in which Costco could report these
rebates. In your opinion, which of these alternatives reflects better the economic substance of
the rebates? Explain.
Excerpts from Costco’s revenue recognition policy:
Question 5: Mini Essays on Revenue Recognition

1. Layaway Goodies recognises revenues from layaway transactions (putting merchandise aside
for customers who make partial payment) when the merchandise is placed on layaway.

1.1. What do you think of Layaway Goodies’ revenue recognition policy? Does the company
face any unique issues in the recognition of expenses?

1.2. Should Layaway Goodies use a different revenue recognition method if the customer has
made a firm commitment to buy the merchandise and Layaway Goodies does not have to
refund any money to the customer if (s)he does not buy the product? Justify your answer.

2. Xerox often includes a service contract when it sells a copier (typically for one year). How do
you think Xerox should recognize the revenue of this sale?