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					Accounting for Lawyers
Professor Bradford
Fall 2001


                                Exam 2001
        The following answer outlines are not intended to be model answers, nor are they
intended to include every issue that students discussed. They merely attempt to identify
the major issues in each question and some of the problems or questions arising under
each issue. They should provide a pretty good idea of the kinds of things I was looking
for. If you have any questions about the exam or your performance on the exam, feel free
to contact me to talk about it.

       I graded each question separately. Those grades appear on the front cover of your
blue books. To determine your overall average, each question was then weighted in
accordance with the time allocated to that question.
                                     Question 1

Journal entries:

11/1          Cash                                5,000
                     Partner’s Equity: George             5,000

11/1          Rent Expense                        1,000
              Prepaid Rent Expense                1,000
                     Cash                                 2,000

11/1          Cash                                2,000
                     Note Payable                         2,000

11/2          Cash                                4,000
              Furniture and Fixtures              2,000
                     Partner’s Equity: Mary               6,000

11/2          Supply Expense                      50
                     Cash                                 50

11/5          Purchases                           300
                     Cash                                 300

11/7          Purchases                           220
                     Cash                                 220

11/11         Cash                                150
                     Sales                                150

11/13         Cash                                280
                     Sales                                280

11/17         Cash                                160
                     Sales                                160

11/18         Purchases                           90
                     Cash                                 90

11/20         Partner’s Equity: George            500
                     Cash                                 500

11/26         Cash                                130
                     Sales                                130
11/30         Purchases                          240
                     Accounts Payable                     240

11/30         Telephone Expense                  75
                    Cash                                  75

11/30         Interest Expense                   10
                      Interest Expense Payable            10

11/30         Cost of Goods Sold                 850
                     Purchases                            850

11/30         Inventory                          300
                     Cost of Goods Sold                   300

11/30         Theft Loss                         100
                     Inventory                            100

11/30         Profit and Loss                    1,785
                      Theft Loss                          100
                      Rent Expense                        1000
                      Interest Expense                    10
                      Supply Expense                      50
                      Telephone Expense                   75
                      Cost of Goods Sold                  550

11/30         Sales                              720
                      Profit and Loss                     720

11/30         Partner’s Equity: George           532.50
              Partner’s Equity: Mary             532.50
                     Profit and Loss                      1,065


[T-accounts on separate spreadsheet.]
                               ZuZu’s Petals Partnership
                                    Balance Sheet
                                  As of Nov. 30, 2001

Assets                                    Liabilities and Partners’
                                          Equity
Cash                            $8,485
Prepaid Rent Expense             1,000    Liabilities
Inventory                          200    Accounts Payable                   $     240
Furniture and Fixtures           2,000    Interest Expense Payable                  10
                                          Note Payable                           2,000
                                          Partners’ Equity
                                          George                             3,967.50
                                          Mary                               5,467.50

TOTAL                          $11,685    TOTAL                               $11,685



                                      ZuZu’s Petals
                                    Income Statement
                            For the Month of November, 2001

Sales                                                                 $720
 Less: Cost of Goods Sold                                              550
Gross Profit on Sales
Operating Expenses:                                                               170
 Rent                                                             $1,000
 Interest                                                             10
 Supplies                                                             50
 Telephone                                                            75
 Theft                                                               100
Total Operating Expenses                                                         1,235

NET LOSS                                                                     ($1,065)
                                      Question 2

        To decide whether this is a good investment for Alice, we must compare the
present value of all the payments Alice must make to the present value of the payments
she will receive, using as the discount rate the 7% return she can earn in her best
alternative investment. If the discounted returns exceed the sum of the discounted
payments, this is a good investment. The calculations are easiest if we look at the present
values as of January 1, 2002.

        Alice’s Payments. The present value of Alice’s first payment is simply $2,600.
We can consider the other nine $2,600 payments as an annuity in arrears (payable at the
end of each year). From Table IV in Appendix B of the book, the present value factor for
a nine-year annuity with a 7% discount rate is 6.51523. Thus, the present value of these
nine payments is $2,600 x 6.51523 = $16,939.60. The total present value of Alice’s
payments is therefore $2,600 + $16,939.60 = $19,539.60.

        Alice’s Return. In return for her investment, Alice receives two payments. The
first payment is $10,000 paid 5 years from Jan. 1, 2002. From Table III in Appendix B,
the present value factor for a payment in 5 years with a 7% discount rate is .71299. Thus,
the present value of this first receipt is $10,000 x .71299 = $7,129.90. Alice also receives
a second payment of $24,000 in ten years. From Table III, the present value factor for a
payment in ten years with a 7% discount rate is .50835. Thus, the present value of this
second receipt is $24,000 x .50835 = $12,200.40. The total present value of the
investment return is therefore $7,129.90 + $12,200.40 = $19,330.30.

       Comparison. The present value of the payments, $19,539,60, is greater than the
present value of the return, $19,330.30. Therefore, this is not a good investment for
Alice.
                                      Question 3

When to Recognize Revenue and Expenses:

        The revenue recognition principle says to recognize revenue when (1) there is an
exchange transaction and (2) the seller has substantially completed the earnings process.
The first requirement is met by the contract. The more difficult issue is determining
when Inter substantially completed the earnings process.

        Arguably, Inter has completed everything it is required to do as of Dec. 15, when
Geekway is supposed to pick up the processors. The shipment is segregated and ready
for pickup at that point, so there’s an excellent argument for revenue recognition, even
stronger than in Pacific Grape. Usually, substantial completion occurs as of shipment,
but not here, where Inter is not required to ship. Nevertheless, revenue is usually
recognized when the risk of loss and title pass and that probably would not be until
Geekway picks up the processors in 2001.

        The possibility of return does not preclude revenue recognition under SFAS No.
48. SFAS No. 48 lists several requirements that must be met for revenue to be
recognized before a right of return expires. Several of these are clearly met: the price is
fixed; as far as we know, the buyer has economic substance apart from resources
provided by Inter; Inter has no significant future obligations under the contract; and,
given its past experience, Inter can reasonably estimate future returns. However, one
requirement is problematic. It’s not clear that the risk of loss has passed to Geekway
when the processors were segregated. If not, SFAS precludes revenue recognition in
2000, and revenue would not be recognized until 2001, when Geekway picked up the
processors.

        Even if revenue is not recognized for most of the contract until 2001, an argument
can be made that revenue should be recognized for the initial shipment of 500 processors
because that portion of the contract clearly has been substantially completed and the risk
of loss has passed as to those processors. If this is done, the related expenses, including
estimated returns for that portion, must also be recognized in 2000.

       When revenue is recognized, the amount of future returns must be estimated and
taken as an expense. This is a contingency which must be recognized under Paragraph 8
of SFAS No. 5. Given past history (5-10%), it is probable that a liability of at least 5%
has been incurred and the amount of that loss (at least the 5%) can be reasonably
estimated. As to the remainder, the likelihood is less certain, but disclosure is still
required by Paragraph 10 of SFAS No. 5.

        Whenever, the revenue is recognized, the corresponding shipping expense should
also be recognized under the matching principle.

Journal Entries (if revenue recognized in 2001):
Nov. 1         Deferred Shipping Expense                       $700
                      Cash                                              $700

Dec. 1         Deferred Shipping Expense                       $500
                      Cash                                              $500

Dec. 15        Cash                                            $100,000
                       Deferred Sales                                 $100,000

Jan. 2         Cash                                            $400,000
                       Deferred Sales                                 $400,000

Jan. 5         Deferred Sales                                  $500,000
                      Sales                                           $500,000

Jan. 5         Shipping Expense                                $1,200
                      Deferred Shipping Expense                         $1,200

Jan. 5         Sales Returns                                   $25,000
                      Estimated Liability: Sales Returns              $25,000

Dec. 31        Estimated Liability: Sales Returns              $20,000
                      Cash                                            $20,000

[If they are certain this is all the returns—that their initial estimate was too high, they
should also make the following entry to get rid of the remaining estimated liability:

               Estimated Liability: Sales Returns              $5,000
                      Sales Returns                                     $5,000]

Journal Entries (if revenue recognized in 2000):

Nov. 1         Deferred Shipping Expense                       $700
                      Cash                                              $700

Dec. 1         Deferred Shipping Expense                       $500
                      Cash                                              $500

Dec. 15        Cash                                            $100,000
                       Deferred Sales                                 $100,000

Dec. 31        Deferred Sales                                  $100,000
               Accounts Receivable                             $400,000
                      Sales                                           $500,000
Dec. 31        Shipping Expense                                $1,200
                      Deferred Shipping Expense                         $1,200

Dec. 31        Sales Returns                                   $25,000
                      Estimated Liability: Sales Returns              $25,000


Jan. 2         Cash                                            $400,000
                       Deferred Sales                                 $400,000


Dec. 31        Estimated Liability: Sales Returns              $20,000
                      Cash                                            $20,000

[If they are certain this is all the returns—that their initial estimate was too high, they
should also make the following entry to get rid of the remaining estimated liability:

               Estimated Liability: Sales Returns              $5,000
                      Sales Returns                                     $5,000]

Journal Entries (if only part of revenue recognized in 2000):

Nov. 1         Shipping Expense                                $700
                      Cash                                              $700

Nov. 1         Accounts Receivable                             $25,000
                     Sales                                            $25,000

Nov. 1         Sales Returns                                   $1,250
                      Estimated Liability: Sales Returns                $1,250

Dec. 1         Deferred Shipping Expense                       $500
                      Cash                                              $500

Dec. 15        Cash                                            $100,000
                       Accounts Receivable                            $25,000
                       Deferred Sales                                 $75,000



Jan. 2         Cash                                            $400,000
                       Deferred Sales                                 $400,000

Jan. 5         Deferred Sales                                  $475,000
                      Sales                                           $475,000
Jan. 5         Shipping Expense                                $500
                      Deferred Shipping Expense                         $500

Jan. 5         Sales Returns                                   $23,750
                      Estimated Liability: Sales Returns              $23,750

Dec. 31        Estimated Liability: Sales Returns              $20,000
                      Cash                                            $20,000

[If they are certain this is all the returns—that their initial estimate was too high, they
should also make the following entry to get rid of the remaining estimated liability:

               Estimated Liability: Sales Returns              $5,000
                      Sales Returns                                     $5,000]
                                       Question 4

A.      To calculate the depreciation expense, we must first determine the depreciable
cost of the machine, its useful life, and its salvage value.

        Depreciable Cost. The depreciable cost of the machine includes all expenses to
acquire the machine and to bring it to the location and condition of its intended use. That
would include the $50,000 purchase price, the $3,000 to ship the machine to Ajax, and
the $2,000 to modify the machine for its intended use by Ajax. It would not include
expenditures for ordinary repairs and maintenance (the $500), which are period costs.
The depreciable cost of the Widget 990 is therefore $50,000 + $3,000 + $2,000 =
$55,000.

         Useful Life and Salvage Value. The relevant useful life is the useful life to
Ajax, not how long the machine will last. The useful life of the machine to Ajax is only
10 years, after which it will upgrade. The salvage value to Ajax at the end of this useful
life is $15,000.

       Straight-line depreciation. The expense for both 2001 and 2002 will be
($55,000 - $15,000)  10 = $4,000.

       Double-declining balance method:

Year                                           Expense                Balance
2001           $55,000 x 1/10 x 200% =         $11,000                $44,000
2002           $44,000 x 1/10 x 200% =         $8,800                 $35,200

B.     The depreciation expense in 2001, using the straight-line method, is $4,000.
Thus, the net book value of the machine on the balance sheet is $55,000 - $4,000 =
$51,000. This book value must be written down to fair value if the asset is impaired
pursuant to FASB No. 144 (which replaces No. 121). The machine is used in Ajax’s
operations, so that portion of FASB No. 144 is used.

       FASB No. 144 uses a three-part analysis. First, some event or change in
circumstances must trigger an impairment review. A significant decrease in an asset’s
market value is one such trigger; a drop to $40,000 probably qualifies. However, we
must believe that it is a permanent, not a temporary, decline in value for it to trigger an
impairment review.

       If this drop in market value triggers a review, the second step is a cash-flow
analysis to determine if the asset is impaired and a write-down is necessary. You
compare the total undiscounted cash flows the machine is expected to produce to the
undiscounted cash outflows to produce them. Here, Ajax expects the machine to
generate cash of $10,000 a year over its ten-year life, plus the $15,000 Ajax expects upon
disposal of the asset. The total cash inflow is ($10,000 x 10) + $15,000 = $115,000. The
total cash outflow to produce that revenue is $3,000 x 10 = $30,000. The net
undiscounted cash flow is a positive $85,000. A write-down is triggered only if the net
cash flow is less than the book value of the machine. The book value is $51,000, so we
do not need to write down the machine to its fair value. We don’t get to the third part of
the analysis.
                                     Question 5

A. Return on Sales    = Net Income  Net Sales
                      = $27,000  $150,000
                      = 0.18

B. Inventory Turnover         = Cost of Goods Sold  Average Inventory

   Average Inventory          = [Inventory(1999) + Inventory(2000)]  2
                              = ($210,000 + $170,000)  2
                              = $190,000

   Inventory Turnover         = $60,000  $190,000
                              = .316

C. Debt to Total Assets Ratio = Total Liabilities  Total Assets
                              = $182,000  $527,000
                              = .345
                                      Question 6

         If, as here, circumstances do not reasonably assure that a company will collect the
full sales price reflected in a receivable, APB No. 10 allows the company to use either the
installment method or the cost recovery method. The question indicates that Armadillo
uses the installment method. The installment method allocates part of each cash payment
received from the buyer to cost recovery and the rest to profit. The proportion allocated
to each is the proportion of the total sales price each represents.

        Here, the total sales price is $7 million. The book value of the land when
Armadillo sold it was $3 million. Thus, $4 million, or 4/7 of the total price, is profit. For
each cash payment, 4/7 of the payment will be recognized as gain. Therefore, the journal
entries are as follows:

9/1    Cash                                           $2,000,000
       Note Receivable                                $5,000,000
             Land                                                            $3,000,000
             Gain on Sale of Land                                            $1,142,857
             Deferred Gain on Sale of Land                                   $2,857,143

12/1   Cash                                           $1,000,000
               Note Receivable                                               $1,000,000

       Deferred Gain on Sale of Land                  $571,429
              Gain on Sale of Land                                           $571,429
                                     Question 7

       This transaction will add no goodwill to Alpha’s balance sheet. Under the
purchase method, the purchase price is first allocated to the assets purchased, using their
fair market values. Only after that is done is any excess allocated to goodwill. Here, the
$810,000 purchase price paid exactly equals the combined fair market values of the assets
purchased. There is no excess, so the transaction does not result in the creation of
goodwill.

				
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