CHAPTER 4 • INCOME MEASUEMENT AND ACCRUAL ACCOUNTING 4-75
PROBLEM 4-13A (Continued)
(b) TENFOUR TRUCKING COMPANY
STATEMENT OF RETAINED EARNINGS
FOR THE MONTH ENDED JANUARY 31, 2016
Beginning balance, January 1, 2016 ……………………………….. $ 40,470
(c) TENFOUR TRUCKING COMPANY
BALANCE SHEET
JANUARY 31, 2016
Assets
Current assets:
Cash …………………………………………………………….. $ 27,340
Accounts receivable ……………………………………….. 41,500
Liabilities
Current liabilities:
Accounts payable …………………………………………… $ 32,880
Notes payable ……………………………………………….. 50,000
Stockholders’ Equity
Capital stock ………………………………………………………. $100,000
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PROBLEM 4-13A (Concluded)
5. Current Ratio = Current Assets/Current Liabilities
$86,090/$106,692 = 0.81 to 1
6. Tenfour cannot compute a gross profit ratio because it does not report cost of sales.
It is a service business rather than a product company. One possible measure of
profitability for any company is the profit margin, which is net income divided by
DECISION CASES
READING AND INTERPRETING FINANCIAL STATEMENTS
LO 3 DECISION CASE 4-1 COMPARING TWO COMPANIES IN THE SAME INDUSTRY:
CHIPOTLE AND PANERA BREAD
1. Chipotle recognizes revenue from restaurant sales at the time food and beverages
are sold. Panera Bread’s bakery-cafe sales are recognized when the products are
2. Chipotle reports $34,839,000 of accounts receivable on its balance sheet and this
represents $34,839/$878,479, or 4.0% of total current assets. Panera Bread reports
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LO 3 DECISION CASE 4-2 READING AND INTERPRETING NORDSTROM’S NOTES—
REVENUE RECOGNITION
1. Revenue from retail stores is recognized at the point of sale. Revenue from sales to
customers shipped directly from stores, as well as from website and catalog sales, is
recorded as revenue upon estimated receipt by the customers. The way in which the
2. Nordstrom recognizes revenue from gift cards when they are redeemed. When a gift
card is purchased, Nordstrom debits Cash and credits a gift card liability. When the
friend redeems the card, Nordstrom debits this liability account and credits Revenue.
LO 3 DECISION CASE 4-3 READING AND INTERPRETING SEARS HOLDINGS
CORPORATION’S NOTES—REVENUE RECOGNITION
1. Under the accrual basis, revenue should be recognized when a performance obliga-
tion is satisfied rather than when cash is received. Over the life of a service contract,
2. Revenue to be recognized each year:
Year 1 Year 2 Year 3 Total
Sales revenue $2,320* $ 0 $ 0 $2,320
Service contract revenue 60** 60 60 180
Total revenue $2,380 $60 $60 $2,500
*$2,500 – $180
**$180/3 years
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MAKING FINANCIAL DECISIONS
LO 2,3,4 DECISION CASE 4-4 THE USE OF NET INCOME AND CASH FLOW TO
EVALUATE A COMPANY
1. DUKE INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2016
Operating activities:
Cash received from services
provided to clients ………………………………… $1,020,000*
Cash paid for:
Salaries and wages ……………………………….. $440,000**
mentary schedule.
2. One important question to be asked is whether it is possible for the company to con-
tinue to generate service revenues in succeeding years at the level attained in its
first year. The ability to collect the revenues billed in 2016, but not yet collected
($230,000), should also be a concern. On the basis of the cash flows generated in
CHAPTER 4 • INCOME MEASUEMENT AND ACCRUAL ACCOUNTING 4-79
LO 4 DECISION CASE 4-5 DEPRECIATION
The decision to purchase or lease long-term assets is a difficult one for all businesses
and requires an analysis of all the relevant facts. Rapidly changing technology may
make it less risky to lease computer equipment than to purchase it. This is certainly a
key consideration in this particular case. Jensen also needs to consider maintenance
costs. The case does not indicate whether or not Jensen would be responsible for main-
tenance if it leases the equipment. Another relevant factor would be whether or not the
equipment would have any salvage value at the end of its useful life.
ETHICAL DECISION MAKING
LO 2,3,4,5 DECISION CASE 4-6 REVENUE RECOGNITION AND THE MATCHING
PRINCIPLE
1. Recognize an ethical dilemma:
If sales are recorded but the commissions associated with these sales are not rec-
orded during the month of June, net income will be larger by the understatement of
commissions expense. The failure to record advertising expense for the month of
June will also result in an understatement of expense and an overstatement or
increase in net income. Finally, an increase in the estimated useful life of the auto-
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estimated useful lives of depreciable assets, but the changes must be justified on
sound economic grounds. For example, changes in technology might prompt a com-
pany to decrease the estimated useful lives of its computers. The need to increase
the net income for the year is certainly not an acceptable reason under GAAP to
change the estimated useful lives of depreciable assets.
Each of the three suggestions involves a question of ethics. You must decide
whether to confront the two owners with your concerns about the proper treatment
for these items.
2. Analyze the key elements in the situation:
a. The owners of the company may benefit in the short term, because the bank may
be more likely to give them a loan based on the inflated net income. The bank
will be harmed, because the financial information it receives does not represent
the underlying reality of the situation.
3. List alternatives and evaluate the impact of each on those affected:
As controller, your options are to either go along with the changes proposed by the
owners or confront them with your concerns. If the proposed changes are made, the
CHAPTER 4 • INCOME MEASUEMENT AND ACCRUAL ACCOUNTING 4-81
4. Select the best alternative:
You should confront the owners with your concerns about the proper treatment for
these items. All three proposed changes involve an attempt to consciously overstate
income for the purpose of obtaining a loan. There is an attempt on the part of the
vice president of sales to deceive a user of the accounting information. The banker
relies on the trustworthiness of the company to accurately report its income, and
each of the three suggestions would violate that trust. The company would not be
acting in good faith if it were to report income as has been suggested.
First, each of the suggestions for improving profits for the month of June is a
clear violation of generally accepted accounting principles. The recognition of June
sales, but the deferral of commission expenses on these same sales until July vi-
olates the matching principle. Similarly, the deferral of advertising expense, which is
directly related to the month of June, until the following fiscal year in July is likewise
at odds with the matching principle. Finally, it is not acceptable practice under ac-
counting standards to alter the estimated useful lives of depreciable assets for the
sole purpose of increasing income. We would need to be able to justify the changes
on sound economic grounds.
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LO 4 DECISION CASE 4-7 ADVICE TO A POTENTIAL INVESTOR
The financial statements contain two major errors that prevent them from being in ac-
cordance with generally accepted accounting principles. First, if the normal balance of
supplies on hand is $1,000, Century should recognize supplies expense on its income
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SOLUTION TO INTEGRATIVE PROBLEM
1. and 2. T accounts:
Cash Billings Receivable (net)
77,400 151,000
(f) 16,000
Bal. 167,000
Building
Accumulated
Depreciation—Building
200,000 50,000
10,000 (d)
60,000 Bal.
Accounts Payable Interest Payable
22,000 3,000 (g)
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Dividends Medical Services Revenue
10,000 550,000
16,000 (f)
566,000 Bal.
Salary and Wages Expense Supplies Expense
288,000 (b) 64,347
(a) 800
Bal. 288,800
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3. MOUNTAIN HOME HEALTH INC.
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2016
Revenues:
Medical services revenue …………………………………….. $566,000
Expenses:
Salary and wages expense ………………………………….. $288,800
Supplies expense ……………………………………………….. 64,347
Gasoline expense ……………………………………………….. 137,500
Utilities expense …………………………………………………. 12,000
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4. MOUNTAIN HOME HEALTH INC.
BALANCE SHEET
AS OF DECEMBER 31, 2016
Assets
Current assets:
Cash ………………………………………………………… $ 77,400
Billings receivable (net) ………………………………. 167,000
Medical supplies ………………………………………… 8,653
Total current assets ……………………………….. $253,053
Total liabilities ……………………………………………. $135,800
Stockholders’ Equity
Capital stock ………………………………………………….. $100,000
Additional paid-in capital ………………………………….. 50,000
Retained earnings …………………………………………… 107,253
Total stockholders’ equity ……………………………. 257,253
Total liabilities and stockholders’ equity ……………… $393,053
5. a. Working capital: $253,053 – $35,800 = $217,253
b. Current ratio: $253,053/$35,800 = 7.07 to 1
6. By their nature, all adjusting entries cause a difference between the amount of in-
come recognized on an accrual basis and that recognized on a cash basis. The ad-
justing entries for wages and salaries and interest result in decreases in income in
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7. Supply of cash needed:
Salaries: $800 per day × 7 days per week × 7 weeks = $39,200