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Chapter 03 - Basic Accounting Concepts: The Income Statement

CHAPTER 3
BASIC ACCOUNTING CONCEPTS:
THE INCOME STATEMENT
Changes from Twelfth Edition
The chapter has been updated from the Twelfth Edition.
Approach
Undoubtedly, the accrual idea is the most difficult of all basic accounting matters for the student to grasp.
As a matter of fact, we sometimes say that the proper recognition of revenue and expense is the only
important accounting problem. Although this is an exaggeration, it is not far from the truth. The text and
cases in this chapter constitute only a beginning in understanding and it is to be expected that students
will understand the matter thoroughly only after they have attacked it from several different angles.
Sometimes we ask the class Suppose a company received a lawyers bill for $1,000. Explain all the
different ways in which this bill could be recorded in the accounts. The answer is that if the bill relates to
services rendered in a prior year (or accounting period) but not recorded in that time, it is nevertheless an
expense of the current year; if it represents a charge for a previous year that was recorded in that year, the
payment of the bill merely represents a decrease in a liability; if it represents a charge in the current year,
it is recorded as an expense; and if it represents a retainer for services to be rendered in the following year
it is recorded as an asset, prepaid expense.
It may be desirable to introduce a number of short questions of this type in order to hammer home the
accrual concept. It is suggested, however, that problems relating to depreciation be deferred, as this is an
intricate matter which is perhaps best left until Chapter 7.
Students should always be required to use the word revenue rather than the word income. They may
find it difficult to do this because income is still used erroneously in some published statements and in
tax forms.
Some students confuse the special meaning of consistency in accounting with the general meaning of
this term. In accounting, consistency means only that the same practice is followed this year as was
followed last year. It does not mean that, for example, the treatment of inventories is consistent with the
treatment of fixed assets.
Cases

Maynard Company (B) is a straightforward problem, although students may have some difficulty in
deducing how the amounts are to be transformed from the cash basis to the accrual basis.

Lone Pine Cafe (B) requires an income statement of the same company whose balance sheet was
prepared in the (A) case in Chapter 2; it is fairly straightforward.
Dispensers of California introduces the entire accounting cycle, with some judgmental issues.

Pinetree Motel provides practice in applying the accrual concept.

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Chapter 03 - Basic Accounting Concepts: The Income Statement

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

Problems
Problem 3-1
Not an expense for June - not incurred.
Expense for June
Expense for June
Expense for June
Expense for June
Not an expense for June - asset acquired.
Problem 3-2
Revenues

$275,000

a. Expenses

Cost of goods sold....................................................................................................................................


$164,000
Rent..........................................................................................................................................................
3,300
Salaries.....................................................................................................................................................
27,400
Taxes........................................................................................................................................................
1,375
Other.........................................................................................................................................................
50,240
246,315

Net income $28,685


Problem 3-3

Beginning inventory........................................................................................................................................................................
$27,000
Purchases........................................................................................................................................................................................
78,000
Available for sale.............................................................................................................................................................................
Ending inventory.............................................................................................................................................................................
($31,000)
Cost of goods sold...........................................................................................................................................................................
$74,000
Problem 3-4
a. (1)

Sales...............................................................................................................................................................................
$85,000
Cost of goods sold..........................................................................................................................................................
45,000
Gross margin...................................................................................................................................................................
$40,000

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Chapter 03 - Basic Accounting Concepts: The Income Statement

(2) 47 percent gross margin ($40,000 / $85,000)


(3) 11 percent profit margin (9000/85000)
The Woden Corporation had a tax rate of 40 percent ($6,000 / $15,000) on its pretax profit that
represented 17.7 percent of its sales ($15,000 / $85,000). The companys operating expenses were 82.3
percent of sales ($70,000 / $85,000) and its cost of goods sold was 53 percent of sales. The companys
gross margin was 47 percent of sales ($40,000 / $85,000).
Problem 3-5
Depreciation. Each year for the next 5 years depreciation will be charged to income.
No income statement charge. Land is not depreciated.
Cost of goods sold. $3,500 charged to current years income. $3,500 charged to next years income.
Subscription expense. $36 charged to current year. $36 charged to next year. Alternatively, $72 charged to
current year on grounds $72 is immaterial.
Problem 3-6
Asset value:
October 1, 20X5
December 31, 20X5
December 31, 20X6
December 31, 20X7

$30,000
26,250
11,250
0

Expenses:
20X5 $3,750 ($1,250 x 3 months)
20X6 $15,000 ($1,250 x 12 months)
20X7 $11,250 ($1,250 x 9 months)
One months insurance charge is $1,250 ($30, 000 / 24 months)

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Chapter 03 - Basic Accounting Concepts: The Income Statement

Problem 3-7

QED ELECTRONICS COMPANY


Income Statement for the month of April, ----.
Sales.........................................................................................................................................................
$33,400
Expenses:
Bad debts.............................................................................................................................................
$ 645
Parts.....................................................................................................................................................
3,700
Interest.................................................................................................................................................
880
Wages..................................................................................................................................................
10,000
Utilities................................................................................................................................................
800
Depreciation........................................................................................................................................
2,700
Selling..................................................................................................................................................
1,900
Administrative.....................................................................................................................................
4,700
______
25,325
Profit before taxes....................................................................................................................................
8,075
Provision for taxes....................................................................................................................................
2,800.
Net income
$5,275
Truck purchase has no income statement effect. It is an asset.
Sales are recorded as earned, not when cash is received. Bad debt provision of 5 percent related to sales
on credit ($33,400 - $20,500) must be recognized. Wages expense is recognized as incurred, not when
paid.
Marchs utility bill is an expense of March when the obligation was incurred.
Income tax provision relates to pretax income. Must be matched with related income.
Problem 3-8

First calculate sales:


Sales ($45,000 / (1 - .45))................................................................................................................................................................
$81,818+
Beginning inventory........................................................................................................................................................................
$35,000
Purchases........................................................................................................................................................................................
$40,000
Total available.................................................................................................................................................................................
75,000
Ending inventory.............................................................................................................................................................................
30,000
Cost of goods sold...........................................................................................................................................................................
$45,000
Gross margin...................................................................................................................................................................................
$36,818
If the gross margin percentage is 45 percent, the cost of goods sold percentage must be 55 percent.
Once sales are determined, calculate net income:
Net income ($81,818 x .1) $8,182

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Chapter 03 - Basic Accounting Concepts: The Income Statement

Next, prepare balance sheet:

Assets
Liabilities
Current assets
($50,000 x 1.6)...................................................................................................................................................................
$ 80,000
Current liabilities................................................................................
$ 50,000
Other assets
Long term debt
40,000
($218,182 - $50,000)..........................................................................................................................................................
138,182
Total liabilities....................................................................................
$ 90,000

Owners equity
Beginning balance...............................................................................
$120,000
Plus net income...................................................................................
8,182
Ending balance....................................................................................
$128,182
Total liabilities
Total assets............................................................................................................................................................
$218,182+
and owners equity..............................................................................
$218,182
+

Total assets = Total liabilities and Owners equity.

Problem 3-9
Sales LC 26,666,667 [LC 20,000,000 x (200 / 150)]
January cash LC 1,000,000 [LC 500,000 x (200 / 100)]
December cash LC 600,000
At year-end the company was more liquid in terms of nominal currency (LC 600,000 versus LC 500,000)
but in terms of the purchasing power of its cash it was worse off (LC 1,000,000 versus LC 600,000).

Cases

Case 3- 1: Maynard Company (B)


Note: This case is unchanged from the Twelfth Edition.
Question 1

See below.

Question 2
This question brings out the difference between cash accounting and accrual accounting. Cash
increased by $31,677 whereas net income was $19,635. Explaining the exact difference may be too
difficult at this stage, but students should see that:
1. The bank loan, a financing transaction, increased cash by $20,865 but did not affect net income.
Cash collected on credit sales made last period ($21,798) also increased cash, but did not affect
net income this period. (The same is true of the collection of the $11,700 note receivable from
Diane Maynard, but it was offset by the payments of the $11,700 dividend to Diane Maynard, the
sole shareholder.)

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Chapter 03 - Basic Accounting Concepts: The Income Statement

2.

MAYNARD COMPANY
INCOME STATEMENT, JUNE
Sales ($44,420 cash sales + $26,505 credit sales)...........................................................................................................................
$70,925
Less: Cost of sales *.................................................................................................................................................................
39,345
Gross Margin...................................................................................................................................................................................
31,580
Expenses
Wages($5,660+$2,202-$1,974).................................................................................................................................................
$5,888
Utilities.....................................................................................................................................................................................
900
Supplies ($5,559+$1,671-$6,630).............................................................................................................................................
600
Insurance($3,150-$2,826).........................................................................................................................................................
324
Depreciation ($157,950-$156,000)+($5,928-$5,304)..............................................................................................................
2,574
Miscellaneous...........................................................................................................................................................................
135
10,421
Income before income tax...............................................................................................................................................................
21,159
Income tax expense ($7,224 - $5,700)......................................................................................................................................
1,524
Net Income......................................................................................................................................................................................
19,635
Less: Dividends........................................................................................................................................................................
11,700
Increase in retained earnings...........................................................................................................................................................
$ 7,935

*Cost of sales:
Merchandise purchased for cash...............................................................................................................................................
$14,715
Merchandise purchased on credit..............................................................................................................................................
21,315
[$21,315+($8,517-$8,517)]
Inventory, June 1.......................................................................................................................................................................
29,835
Total goods available during June......................................................................................................................................
65,865
Inventory, June 30.....................................................................................................................................................................
26,520
Cost of Sales.......................................................................................................................................................................
$39,345
3. The purchase of equipment ($23,400) and other assets ($408) decreased cash but did not affect
net income (at least not by this full amount) this period.
4. Credit sales made this period ($26,505) increased net income, but did not affect cash.
5. Noncash expenses such as depreciation ($2,574) and insurance ($324) decreased net income but
did not affect cash as they relate largely, if not wholly, to cash outflows made for asset acquisition
in prior periods. (Exception: such expenses on an entitys first income statement are not related to
prior period expenditures but they will be a much smaller amount than the first accounting
periods expenditures.
Question 3
(a) $14,715 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 equal for a period in which all
purchases were for cash, and in which the dollar amount of beginning inventory was the same as
the dollar amount of ending inventory, since Cost of Sales = Beginning Inventory + Purchases Ending Inventory.
(b) $36,030 is the sum of cash purchases ($14,715) and credit purchases ($21,315). As explained
above, purchases equal cost of sales for the period only if beginning and ending inventory
amounts are the same.

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Chapter 03 - Basic Accounting Concepts: The Income Statement

Case 3-2: Lone Pine Cafe (B)


Note: This case is updated from the Twelfth Edition.
Approach
This case introduces students to preparation of an income statement based on analyzing transactions. At
this stage, students are not expected to set up accounts in the formal sense. However, in effect they do so
for those income statement items that did not coincide exactly with cash flows.
Question 1
A suggested income statement as required by Question 1 is shown below. The following notes apply
to the income statement.
1. The student needs to refer back to Lone Pine Caf (A) in order to construct the income statement
on the accrual basis. Amounts for sales on credit, purchases on credit, beginning and ending
inventory, beginning and ending prepaid operating license, and depreciation expense are to be
found there. Specifically:
a. Sales revenues = $43,480 cash sales + $870 credit sales to ski instructors = $44,350.
b. Food and beverage expense = $2,800 beginning inventory + $10,016 cash purchases + $1,583
credit purchases - $2,430 ending inventory = $11,969.
2. Since the entity is unincorporated, it is also correct (though less meaningful for evaluative
purposes) to treat the $23,150 partners salaries as owners drawings. This treatment would result
in an income of $12,296 and a decrease in equity (after drawings) of $10,854.

LONE PINE CAFE (B)


INCOME STATEMENT FOR NOVEMBER 2, 2009, THROUGH
MARCH 30, 2010
Sales.........................................................................................................................................................
$ 44,350
Expenses:
Salaries to partners...............................................................................................................................
$23,150
Part-time employee wages...................................................................................................................
5,480
Food and beverage supplies.................................................................................................................
l1,969
Telephone and electricity.....................................................................................................................
3,270
Rent expense........................................................................................................................................
7,500
Depreciation........................................................................................................................................
2,445
Operating license expense...................................................................................................................
595
Interest.................................................................................................................................................
540
Miscellaneous expenses.......................................................................................................................
255
Total expenses..........................................................................................................................................
55,204
(Loss)........................................................................................................................................................
$(10,854)

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Chapter 03 - Basic Accounting Concepts: The Income Statement

Question 2
The income statement tells Mrs. Antoine that the partnership has suffered a $10,854 loss for the first
five months of operation. This $10,854 loss is the correct figure for evaluative purposes, not the
$12,296 income before partners salaries. This assumes, of course, that nonowner salaries for the cook
and table servers would also have been $23,150, which is questionable. It would appear that Lone
Pine Cafe cannot support three partners, even at a bare level of sustenance ($23,150 was only an
average of $1,543 per partner/employee per month). Of course the three owner/employees did receive
room and board, for which no value has been imputed here.
Case 3-3: Dispensers of California, Inc.
Note: This case is unchanged from the Twelfth Edition. .
Approach
The case can be used for two class sessions. The first day is devoted to analyzing the accounting
transactions, including a preliminary discussion of Hynes accounting policy decisions. The second class
deals with preparing the financial statements and an analysis of how they may change if alternative
accounting procedures had been adopted by Hynes.
The first class should start with the case Question 1. Its purpose is to give the students a sense of the
managerial purpose of profit plans and a context for the later accounting discussions.
The use of the asset equals liability plus equity structure to answer Question 2 is recommended so
that the instructor can 1) highlight the retained earnings link between net income and the balance sheet 2)
illustrate how any accounting transaction can be analyzed using the basic accounting equation and 3) to
lay the foundation for the debit-credit framework material in Chapter 4. (At this point in the course debit
and credit terminology and analysis should not be used.)
Questions 3 and 4 require the preparation of an income statement and balance sheet, respectively.
Some instructors prefer to end the first class with a discussion of the balance sheet, including a completed
balance sheet. Typically, these instructors want to leave time in the second class to discuss the relationship
between net income and the change in cash on the balance sheet.
Question 5 is designed to illustrate the role of judgment in accounting for transactions.
Answers to Questions
Question 1
Profit plans are used for a variety of purposes. These include:

To force short range planning


As a basis for evaluating performance and determining compensation.
To encourage coordination and communication between different organization units and
levels.
As a challenge to improve performance.
As a means for training managers
As an early warning system and
As a guide to spending.

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Chapter 03 - Basic Accounting Concepts: The Income Statement

Question 2
TN-Exhibit 1 presents an analysis of the planned transactions using the basic accounting equation
framework. This analysis follows Hynes accounting policy.
Question 3
TN-Exhibit 2 presents Hynes profit plan using the Question 1 transaction analysis.
The instructor should expect that most students will not calculate the cost of goods sold figure
correctly. The instructor will have to explain that the components of the cost of manufactured goods
includes direct materials and their conversion costs, including manufacturing equipment depreciation.
The distinction between operating and finance costs in the income statement is another accounting
practice most students will miss. Again, the instructor will have to explain this format and its rationale,
which is to permit statement users to evaluate how well management has operated the company before
considering the impact of their financing decisions.
Question 4
TN-Exhibit 3 presents the year-end balance sheet using the Question 1 transaction analysis.
Equipment is reported net. Most students will follow this presentation. A better presentation is:
Equipment (cost)
$85,000
Accumulated depreciation (8,500)
Equipment (net)
$76,500
The patent is reported net. This is the correct presentation for intangible assets.
TN-Exhibit 4 presents a reconciliation of beginning (zero) and ending ($47,500) retained earnings.
The instructor may want to share this exhibit with the students. It links the income statement to the
balance sheet. It also illustrates that dividends are distributions of capital and not an expense.
The instructor should point out to students that many intra period transactions, such as the borrowing
and repaying of the bank loan, do not appear on the end of the period balance sheet.
Question 5
There are three accounting decisions that require Hynes to exercise judgment. They are:

Patent valuation
Patent amortization period
Equipment depreciation period

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

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Chapter 03 - Basic Accounting Concepts: The Income Statement

The patent can not be valued directly. There is no current liquid market for this type of patent. Hynes
must value it indirectly. He chose to use the value of the companys equity he received based on the cash
paid by the investors for their equity interest to value the patent. This is an acceptable approach.
Hopefully, the patent amoralization and depreciation periods represent Hynes best estimate of the
related assets useful life (useful to Dispensers of California.)
Students should be asked what would be the impact on the balance sheet and income statement if
different lives had been used. So that students do not get the impression that differences in judgment are
driven by 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 by responsible managers acting in good faith.
Cash Flow Analysis
If the instructor wishes to incorporate some aspect of cash flows in the case discussion, TN-Exhibit 5
and 6 present two analysis of cash flows. TN-Exhibit 5 uses a cash receipts and distribution format. TNExhibit 6 uses a direct method statement of cash flows format. Instructors should not use the indirect
method at this point in the course. It confuses students. Chapter 11 introduces students to indirect method
statement of cash flows.

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Chapter 03 - Basic Accounting Concepts: The Income Statement

Exhibit 1
Dispensers of California, Inc
Balance Sheet Transaction Analysis
Transactions

Assets =

1a
1b
2
3

Hynes investment
Other investors
Incorporation costs
Equipment purchase

4
5

Redesign costs
Component parts purchase

Bank loan
Bank loan repaid
Loan interest
Manufacturing payroll
Other manufacturing costs
Selling general and administration
Ending inventory (cost of goods sold) *
Sales
Incorporation and redesign costs (expenses as
incurred)
Depreciation
Patent amortization
Ending work-in-progress and completed
inventory (none) (cost of goods sold)**
Dividends
Income Taxes

7
8
9
10
11
12
13
14
15
16
17

* Beginning component parts inventory


Purchases
Total available
Ending component parts inventory
Components parts used

$0
212,100
212,100
15,100
197,000

Liabilities

+ Patent $120,000
+ Cash 80,000
- Cash $2,500
-Cash $85,000
+ Equipment 85,000
- Cash $25,000
+ Inventory $212,100
- Cash 212,100
+ Cash $30,000
- Cash 30,000
- Cash 500
- Cash $145,000
- Cash 62,000
- Cash $63,000
- Inventory $197,000
+ Cash $598,500
See 2 and 4

+ Common Stock $120,000


+ Common Stock 80,000
- Retained earnings $2,500
- Retained earnings $25,000
+Bank loan $30,000
- Bank loan 30, 000
- Retained earnings $500
- Retained earnings $145,000
- Retained earnings $62,000
- Retained earnings $63,000
- Retained earnings $197,000
+ Retained earnings $598,500

- Equipment $8,500
- Patent $20,000
See 5, 7, 8, 10 and 13

- Retained earnings $8,500


- Retained earnings $20,000

- Cash $5,000
+Taxes payable $22,500
**Component parts used
Manufacturing payroll
Other manufacturing costs
Depreciation
Cost of goods sold

3-11

Equity

$197,000
145,000
62,000
8,500
412,500

- Retained earnings $5,000


- Retained earnings $22,500

Chapter 03 - Basic Accounting Concepts: The Income Statement

Exhibit 2
Dispensers of California, Inc.
12-month Profit Plan
Sales
Cost of goods sold
Components
Mfg payroll
Other Mfg.
Depreciation
Gross margin
Selling, general and
Administration
Patent
Redesign costs
Incorporation costs
Operating profit
Interest
Profit before taxes
Tax expense
Net Income

$598,500
$197,000
145,000
62,000
8,500

412,500
$186,000
63,000
20,000
25,000
2,500
$75,500
500
$75,000
22,500
$52,500

Exhibit 3
Dispensers of California, Inc.
Projected Year-end Balance Sheet

Assets
Cash
Components inventory
Current assets
Equipment (net)
Patent (net)

Liabilities
Taxes payable
Current liabilities

$78,400
15,100
$93,500
76,500
100,000
___
$270,000

Owners Equity
Capital stock
Retained earnings

3-12

$22,500
$22,500
$200,000
47,500
$270,000

Chapter 03 - Basic Accounting Concepts: The Income Statement

Exhibit 4
Dispensers of California, Inc.
Change in Retained Earnings

Beginning retained earnings


Net income
Dividends
Ending retained earnings

$0
52,500
(5,000)
$47,500

Exhibit 5
Dispensers of California, Inc.
Cash Reconciliation

New equity capital


Incorporation
Equipment
Redesign
Component parts
Bank loan
Bank loan
Loan interest
Manufacturing payroll
Other manufacturing
SG&A
Sales
Dividend
Total
Cash Reconciliation
Receipts
Disbursements
Ending Balance

Receipts
$80,000

Disbursements
$2,500
85,000
25,000
212,100

30,000
30,000
500
145,000
62,000
63,000
598,500
5,000
$630,100

$708,500

$708,500
630,100
$78,400

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Chapter 03 - Basic Accounting Concepts: The Income Statement

Exhibit 6
Dispensers of California, Inc.
Statement of Cash Flows (Direct Method)
Collections from customers
Payments to suppliers
Payments to employees
Legal payments
Interest
Operating cash flow
Equipment purchases
Investing cash flow
Bank loan
Repayment of bank loan
Capital
Dividends
Financing cash flow
Change in cash
Beginning cash
Ending cash

$598,500
(212,100)
(295,000)
(2,500)
(500)
$89,400
(85,000)
$(85,000)
30,000
(30,000)
80,000
(5,000)
$75,000
$78,400
0
$78,400

Case 3- 4: Pinetree Motel


Note: This case is unchanged from the Twelfth Edition.
Approach
This case treats the transition from cash to accrual accounting; also, the inherent difficulties in
comparison of data with industry averages are illustrated. The case does not require a full 80 minutes of
class time, so I use the final portion of time for review.
Comments on Questions
The operating statement called for in Question I is shown below. For many termse.g., revenues,
advertising, depreciation is no difficulty in fitting Pinetrees account names with the journals standard
format; but for other items, there are problems:
1. The Kims drawings conceptually should be divided between payroll costs and
administrative/general, since the Kims apparently perform both operating and administrative
tasks.
2. Some students may treat replacement of glasses, bed linens, and towels as general expense rather
than as direct operating expense (although I feel the latter is more appropriate).
3. Some students may treat payroll taxes and insurance as a general expense; nevertheless, it
properly is part of payroll costs.

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Chapter 03 - Basic Accounting Concepts: The Income Statement

Question 2
Based on profit as a percent of sales, Pinetree Motel is only about one-third as profitable as the survey
average return on sales. The key percentage disparity is on payroll costs, which may reflect two things:
(1) the Kims tasks could be done by two employees who would work for less than $86,100 a year (which
is equivalent to saying the Kims drawings reflect both a fair salary and a distribution of entity profits); or
(2) the survey data are dominated by motels having twice as many rooms as Pinetree Motel does, thus
spreading fixed labor costs over a higher volume (e.g., a motel of 20 units and one of 40 units each needs
only one desk clerk). Of course, there is probably a lot of noise in the survey data for payroll and
administrative/general costs: owner-operators responding to the journals survey would encounter the
same problems as a student does in answering Question 1.

PINETREE MOTEL
OPERATING STATEMENT FOR 2005
(in industry trade journal format)

Dollars

Percentages
*

Revenues:
Room rentals ($236,758- $1,660)................................................................................................................................
$235,098
96.8
Other revenue..............................................................................................................................................................
7,703
3.2
Total Revenues......................................................................................................................................................
242,801
100.0

Operating Expenses:
Payroll costs ($86,100+$26,305+$2,894-$795-$84+$1,128+
$126)............................................................................................................................................................................
115,674
47.6
Administrative and general..........................................................................................................................................

Direct operating expense ($8,800 + $1,660 + $6,820).................................................................................................


17,280
7.1
Fees and commissions.................................................................................................................................................

Advertising and promotion($2,335 - $600 + $996)......................................................................................................


2,731
1.1
Repairs and maintenance.............................................................................................................................................
8,980
3.7
Utilities ($12,205+$2,789+$5,611-$933-$105-$360+$840+$75+
$153+ 492)...................................................................................................................................................................
20,767
8.6
Total......................................................................................................................................................................
165,432
68.1

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

Total......................................................................................................................................................................
60,320
24.8
Profit(pretax) .....................................................................................................................................................................
$ 17,049
7.1
*May not add exactly owing to rounding.

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Chapter 03 - Basic Accounting Concepts: The Income Statement

As a rough composition that attempts to adjust for the Kims (and probably other survey respondents)
dual roles as owners and operators, I suggest adding three accounts:

Pinetree

Average

Payroll costs........................................................................................................................................................................
47.6
22.5
Administrative/general........................................................................................................................................................

4.2
Profit...................................................................................................................................................................................
7.1
20.7
Total....................................................................................................................................................................................
54.7
47.4
This tends to substantiate the hypothesis that hired employees would perform the Kims task for less than
$86,100.
Pinetrees other operating costs do not seem to be out of line compared with the survey averages. the
higher-than-average utilities may reflect a location with cold winters. Insurance and taxes are essentially
uncontrollable. Repairs and maintenance may be below average because the Kims personally do some of
this work, whereas other motels pay outsiders to do it.
Note that both rent and depreciation are shown in the journals survey data. This also causes comparison
problems. For Pinetree, there is no rent, but the motel buildings are depreciated, whereas for some motels
the depreciation would include only furnishings. Adding the rent and depreciation percentages may be
more meaningful than working at either one in isolation; but, of course, building depreciation is only a
very rough proxy for fair rental value.
No final conclusion on the success of their operation can be made as information on the following is
lacking:
Capital (re: the average)
Location
Pricing

Occupancy rate
Seasonality (re: Florida annual season vs. New England)
Efficiency in using their own time

Check on income calculation:

Receipts in 2005....................................................................................................................................................................
$244,461
Less: 2004 revenue collected..........................................................................................................................................
1,660
Revenues in 2005..................................................................................................................................................................
$242,801
Checks written in 2005..........................................................................................................................................................
196,558
Plus: 2005 expenses not paid................................................................................................................................................
5,508
Depreciation.............................................................................................................................................................
30,280
232,346
Less: 2004 expenses paid................................................................................................................................................
6,594
Expenses in 2005..................................................................................................................................................................
225,752
Profit.....................................................................................................................................................................................
$ 17,049

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Chapter 03 - Basic Accounting Concepts: The Income Statement

Case 3- 5: National Association of Accountants


Note: This case is unchanged from the Twelfth Edition.
Approach
This case describes a typical problem in the management of membership associations and of many other
nonprofit organizations. Each year a new governing board is elected and becomes responsible for the
operations of the organization for that year. As a general rule, the governing board should so conduct
affairs that the organization breaks even financially. 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 providing the
members with as many services as they are entitled to.
Thus, the difference between the concept of income described in the text for business organization and the
income concept appropriate for a nonprofit membership organization is that a business organization
should earn satisfactory net income, while the membership organization should break even. The
measurement of revenues and expenses follows the same principles in both types of organizations (at least
with respect to the transactions given in this case.)
The case is based, loosely, on experiences of the American Accounting Association, and instructors may
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 NAA is no longer in existence.)
In the interest of simplicity, students are not given balance sheets. The case can be made more
complicated by assuming a beginning balance sheet, perhaps showing only cash and equity of $55,000
each. Students can then be asked to set up assets and liabilities that result from the transactions described
in the case.
Answers to Question
Various correct answers are possible. One set is given in Exhibit A and discussed below.
1. The grant relates to services to be performed in 2006, so it should not be counted as 2005
revenue. However, the $2,700 already spent must be matched against the grant in some way. This
can be done either by subtracting it from 2005 expenses and setting it up as a prepaid asset or,
more simply, by transferring $51,300 of the grant to 2006 revenue. The effect on the bottom line
is the same. The fact that the president obtained the grant is irrelevant. The principle is to
recognize the revenue in the period in which the services are performed. The legal question is
probably also irrelevant; the intention was to perform the services in 2006, and that probably
would be the governing factor. This is a debatable point, however, because it gives no credit to the
2005 president for the fine work he or she has done in obtaining the grant.
2. The desktop publishing system is not an expense of 2005. It will be an expense of future years
and is therefore an asset on December 31, 2005. Because it was acquired so near the end of the
year, there is no need to deal with depreciation. The question can be asked about depreciation in
future years, and this raises the question of estimating the future life. Desktop publishing systems
are a hot item. They are likely to improve in performance and decrease in price fairly rapidly.
The useful life is therefore probably not more than five years. Note that although this is not an
expense of 2005, and the 2005 board has created a depreciation cost that will affect the surplus of
future boards.

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Chapter 03 - Basic Accounting Concepts: The Income Statement

3.
4. The $32,400 of 2006 membership dues probably is not revenue of 2005. Members will receive
services in 2006 for the 2006 dues. (It can be argued that early receipt of these dues avoids the
necessity of incurring expense for dues notices and follow-ups that would otherwise be needed in
2006. However, there is no feasible way of measuring this.) The fact that these members will
receive a free book is probably irrelevant. The cost of the book is a 2006 expense, and when the
associated revenue from dues is moved to 2006, they match the expense.
5. The membership directory is a real tough one. The services for the 3,000 copies were provided in
2005, but charging this as a cost in 2005, seems unfair to the 2005 board (and to boards of each
year when a new directory is published.) It can be argued that members refer to the directory for
two years, and hence the cost should be spread over both years. The 1,000 extra copies is
probably an expense of 2006, but this assumes that they will in fact be used in 2006 and are not
simply extras that eventually will be discarded. (The proportion of 1,000 extra copies to the
membership seems large.) Exhibit A takes the easy way out and assigns one-half the cost to each
year, but other solutions are equally defensible.
6. The conversion of subscription revenue from a cash basis to an accrual basis is straightforward.
The revenue in 2005 should be decreased by $2,700.
7. If the Association is likely to be reimbursed for the $10,800, it is not an expense of 2005. The
likelihood is that there will be a profit, but at this stage, one cant be sure, even though there was
a profit in 2004. It seems unlikely in any event that there would be a profit that wiped out the
whole deficit. Exhibit A removes the whole $10,800 as an expense; it becomes an account
receivable from the Annual Meeting Committee. Students who argue strongly for conservatism
might leave it as an expense. This transaction shows how difficult it is to arrive at the true
results, as is also the case with some of the others. The 2004 annual meeting profit, not now
known, is conceptually a revenue of 2004. (But read on.)
8. The $3,400 annual meeting profit is revenue for 2004, conceptually. However, there seems to be
no feasible way of recording this revenue in the year of the annual meeting because of the
problem of paying outstanding bills for some months after the annual meeting has taken place. It
therefore can be argued that it is appropriately left in 2005, which is done in Exhibit A. This
practice can be justified on the grounds of materiality. If eliminated from 2005, some
corresponding adjustment for an estimated profit on the 2005 annual meeting should be made.
With the adjustments made above, the 2005 results has been changed from a surplus to a deficit.
It is easy to visualize how discussions of this type can become quite heated. They can be avoided
in the future by preparing an accounting manual that describes how each of these transactions
should be handled. This illustrates the importance of the consistency concept.
Question 2
The Administrations policy says there should be a dues increase. If there were some unusual
expenses in 2005, the deficit might be tolerated, but we have no indication that there are unusual
expenses. The association had to take special steps to obtain the cash needed for the desktop
publishing system, which means there was no cash surplus to draw on. Once a deficit like this occurs,
the prudent course of action is to increase the dues.

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Chapter 03 - Basic Accounting Concepts: The Income Statement

Exhibit A
NATIONAL ASSOCIATION OF ACCOUNTANTS
ADJUSTED INCOME STATEMENT, 2005

Revenues:
As Reported
Adjustments
Adjusted
Membership dues.........................................................................................................................................................
$287,500
$-32,400
$255,100
Journal subscriptions....................................................................................................................................................
31,000
-2,700
28,300
Publication sales..........................................................................................................................................................
11,900
11,900
Foundation grant..........................................................................................................................................................
54,000
-51,300
2,700
Annual meeting profit, 2004........................................................................................................................................
3,400
________
3,400
Total revenue.........................................................................................................................................................
387,800
-86,400
301,400

Expenses:
Printing........................................................................................................................................................................
92,400
-11,600
80,800
Committee meeting expenses.......................................................................................................................................
49,200
49,200
Annual meeting advance..............................................................................................................................................
10,800
-10,800
0
Desktop publishing system..........................................................................................................................................
27,000
-27,000
0
Administrative salaries and expenses.................................................................................................................................
171,500
171,500
Miscellaneous.....................................................................................................................................................................
25.000
________
25,000
Total expenses.......................................................................................................................................................
375,900
$-49,400
326,500
Surplus or (deficit).............................................................................................................................................................
$ 11,900
$-37,000
$(25,100)

3-19