Download Accounting in Action: CM2

Chapter 1
Accounting in Action: CM Corporation (CMC)
CM Corporation (CMC) was founded in 2000 by Eric Conner and Phil Martin. The
company designs, installs, and services security systems for high-tech
companies. The founders, who describe themselves as "entrepreneurial geeks,"
met in a computer lab when they were teenagers and found they had common
interests in working on security systems for critical industries. In January 2012,
CMC hired you as an accounting intern.
Lately Conner and Martin have been working with “radio frequency
identification” (RFID) technology. They have developed a detailed system
designed to track inventory items using RFID tags embedded invisibly in
products. This technology has numerous inventory applications in multiple
industries. One of the most basic applications is tracking manufacturing
components; if tagged components "go walking" (if employees attempt to take
them), companies can easily track and find them. Conner and Martin have sold
their system to several high-tech companies in the area. These companies have
a number of government contracts that require extensive security systems to
protect sensitive data from infiltration by terrorists and others. To date, CMC’s
cash flow from sales and services has adequately funded its operations.
CMC anticipates growth potential for its products. As a result, it is
planning to go to the market with a new common stock issue at the end of 2013.
Many of the issues you will address in this continuing problem involve choices
that are affected by preparing for this anticipated stock issue.
Continuing Case
1
Instructions
Conner and Martin have asked you to explain to them the importance of SEC
regulations and FASB standards to a non-public company like CMC. Prepare a
brief memorandum with responses to the following questions.
(a)
As a non-public company, with no securities traded on a stock exchange,
is CMC subject to SEC regulations? Explain.
(b)
Since CMC’s stock is privately held and not traded on any stock
exchange, must a CPA audit the company’s books? Must these audited
statements be prepared in accordance with GAAP? Support your answer.
Continuing Case
2
Chapter 2
Accounting in Action: CM Corporation (CMC)
As indicated in Chapter 1, CMC intends to issue stock to the public. Potential
investors will be concerned about the company's operating results, cash flows,
and financial position. Conner and Martin have heard words such as “relevant,”
“faithful representation,” “comparability,” and “consistency” used in discussions
about financial statements. They have no clue as to what these words mean.
They ask you to explain.
Instructions
Prepare a brief memorandum to Conner and Martin describing the elements of
the FASB conceptual framework. Specifically address the following:
(a)
What is the basic objective of financial reporting? How do general purpose
financial statements help achieve this objective?
(b)
Exactly what do “relevant” and “faithful representation” mean when applied
to financial statements? If they are both important, can information always
have both of these characteristics? Why or why not?
(c)
What other characteristics of financial accounting information might
contribute to its usefulness?
Continuing Case
3
Chapter 3
Accounting in Action: CM Corporation (CMC)
In anticipation of growing demand for their products and services, Conner and
Martin hired two new directors, Suzanne Lopez and Allison Knepp, giving them
stock in the company as part of their hiring bonus. The founders, Conner and
Martin, along with the two new directors, will be the management “team.”
Conner and Martin consider themselves "upper management" and the two new
directors "middle management." Conner and Martin have little accounting or
business training so they are relying on Lopez and Knepp, both of whom have
MBAs, to provide the business background. With the additions to the
management team, CMC changed the company name to CM2.
Given the lack of any trained accountant on board, an accounting intern
can be of great value to CM2. To familiarize you with the company's operations,
Conner and Martin have provided an unadjusted trial balance from the end of last
year (2012) on an Excel spreadsheet. When you look at it, you find that the
accounts are not in any particular order, which surprises you.
Instructions
(a)
Download file 3a from the website. Prepare a trial balance in good form.
(b)
From the website, access file 3b, which has the unadjusted trial balance
with the accounts in proper order. This file also contains an accounting
“system” comprised of a series of linked spreadsheets. The linkages
enable the effects of all accounting entries (journal, adjusting, and closing)
to flow through to spreadsheets for the income statement, balance sheet,
Continuing Case
4
and statement of cash flows. You notice that for the fiscal year ended
December 31, 2012, someone has made all the journal entries but none of
the adjusting or closing entries.
The following information is provided for adjustments prior to
closing the books. Lopez and Knepp ask you to enter the adjustments into
the spreadsheet, in the two columns to the right of the unadjusted trial
balance. (CM2 uses a perpetual inventory system.)
1.
Wages earned by employees during December and to be paid in
January are $33,875; associated payroll taxes on these wages are
$2,710.
2.
On July 1, a client paid CM2 $205,720 in advance for a year of
consulting services.
3.
You discover that a product sale was made and recorded in
December for $128,600; the product had not yet been shipped. The
cost of the product was $68,742.
4.
Bad debt expense has been calculated to be $17,508 but has not
yet been recorded.
5.
The Prepaid Expense account has a balance of $22,774. This
balance includes $11,200 for a two-year insurance policy
purchased on January 1, 2012.
6.
Depreciation expense for the year is $82,620.
7.
Interest expense accrued on its long-term liabilities is $7,765.
Continuing Case
5
8.
On December 15, CM2 declared a dividend of $110,000, to be paid
on January 15, 2013.
9.
(c)
Income tax expense is $201,109.
After making the adjusting entries in (b), make the appropriate
closing entries on the spreadsheet provided.
(d)
Prepare a memo to management explaining the importance of the
adjusting entries made in part (b). As part of this discussion, explain how
accrual accounting improves the usefulness of the company’s financial
statements.
Additional Activity: Extend your accounting knowledge
You know that CM2 is going to the market with a stock offering at the
end of 2013. You have heard that investors look at certain relationships (or
ratios) on the financial statements to understand the financial health of a
company in which they plan to invest. You decide to examine several of these
ratios to get a feel for how this company is doing. You know the following:
(1) The relationship of current assets to current liabilities is important to assess
the liquidity of the company and its ability to pay its current bills.
(2) The total debt to total assets relationship describes where the money came
from to acquire the assets.
(3) The net income to sales relationship tells how much of each sales dollar ends
up as profit.
Continuing Case
6
Instructions
Calculate these three relationships for CM2 for 2012 and the prior year, and write
a short assessment of CM2’s financial position and performance.
Continuing Case
7
Chapter 4
Accounting in Action: CM2
With the books closed for the prior year (thanks to your work), the four CM2
owners are meeting to discuss what they expect to happen in 2013. They include
you in this meeting since they consider you an important part of the decision
"team."
The company generates revenue from two sources, sales of RFID
systems and service of those systems. After much discussion, Conner and
Martin settle on the following revenue estimates: sales of RFID systems are
predicted to be $9,100,000, and service revenue will be $975,000. All forecasted
revenue and expenses are recorded to the appropriate balance sheet and
income statement accounts.
Instructions
[Note: From Chapter 4 on, the linked Excel spreadsheets contained in the
various chapters already have programmed income tax expense at 35%.
Therefore, you do not need to worry about making adjustments to income tax
expense.]
(a)
Access file 4a on the website. The file contains worksheets with the final
balance sheet for 2012 and a worksheet with the forecasts for 2013.
Examine the 2013financial statements based on management’s
projections. Calculate the gross margin ratio (Gross margin ÷ Sales), and
operating income and net income as a percentage of sales. Calculate the
same ratios for 2011 and 2012, and compare the three sets of measures.
Discuss similarities and differences and what the changes indicate.
Continuing Case
8
(b)
Assume, instead, that the sales and service revenue are 10% higher than
projected and that all the additional revenue is on account. Assume also
that the gross margin ratio will remain the same and that operating
expenses will increase 8%. Where appropriate, assume these expenses
are not yet paid and are to be credited to accrued liabilities. [Note: Other
income (expense) items such as interest expense, investment income,
and gain (loss) on sale of assets are not operating expenses.]
Make these adjustments in the spreadsheet file in the columns
labeled Proposed Adjustments. Recalculate the ratios described above in
light of the new assumptions. Comment on the difference in trends over
the three years, including the effects of these assumptions.
(c)
Now assume that the sales were 5% lower than projected, and repeat the
above requirements. Use a similar decrease in operating expenses of 8%.
Recalculate the ratios based on the decreased expectations, and
comment on the difference in trends across the three years of income
statements under these circumstances.
(d)
During the budget meeting, there is a discussion of the possibility
of acquiring a company with a strong distribution system which would be
helpful in selling their existing product. CM2 expects to sell off any parts of
the business not central to the development of the RFID product line. CM2
has asked you to research the current GAAP for:
(1)
Reporting the effects of discontinuing a business component.
Continuing Case
9
(2)
“Pro-forma” reporting of the restructuring charges associated with
integrating the new business into CM2. Management would like to
report these expenses below “Income from operations” to avoid
distorting income from operations.
Prepare a memo to management explaining the accounting and reporting
for these two items. Include in your memo discussion of how irregular
items, such as discontinued operations, affect the quality of earnings.
Continuing Case
10
Chapter 5
Accounting in Action: CM2
As indicated in Chapter 4, you have been participating in a forecasting meeting
with CM2 management. You know you are going to be responsible for information
on liquidity and future cash flows. You want to be sure to appear knowledgeable,
so you carry out the following analysis.
Part I: Analysis of Balance Sheet and Statement of Cash Flows
Instructions
Access file 4a at the website. This file contains spreadsheets for 2011 and 2012,
along with the original projections for 2013.
(a)
Calculate the liquidity ratios (current ratio, quick ratio) and the solvency
ratios (total debt to equity, total debt to total assets) for each of the three
years. The current ratio is useful in assessing the liquidity of the firm since
it shows the firm’s ability to pay off its short-term liabilities with short-term
(readily accessible) assets. The debt ratios described are useful in
assessing the firm’s ability to pay off all of their debt in that they show the
relationship of the debt obligations both to the firm’s equity and to their
total asset position. Discuss possible causes of any changes you observe
in these relationships over time.
(b)
Compute free cash flow for each of the three years. Comment on
investment decisions and cash management, using the three years of
statements of cash flows provided.
Part II: Transparent Reporting
Continuing Case
11
CM2 is a technology company in the computer software and services industry.
These companies, which often are run by individuals who have little accounting
experience, typically must attract investments from venture capitalists and other
investors to provide financing for their businesses. These investors depend on
financial statements to evaluate alternative investments. Conner and Martin ask
you to consider some ways the company can provide information that better
presents the company’s financial position.
Assume that you discovered the following items.
1. One quarter of the reported long-term debt is actually due in 10 months.
Assume this same amount is due 10 months from each of the year-ends
(2011-2013).
2. The contract with a customer representing 20% of net accounts
receivable calls for full payment in 18 months but is classified in the
current assets section. Assume this applies to each of the year-ends
(2011-2013).
3. CM2 owes a substantial amount to its suppliers for raw materials. In fact,
about 80% of the accounts payable balance is with three suppliers who
are concerned about a downturn in the general economy and have asked
for faster payment from CM2. Assume this applies to each of the yearends (2011-2013).
Instructions
(a)
Describe how the company should report this additional information on the
balance sheet. Recalculate the ratios from Part I (a) after adjusting for the
Continuing Case
12
new information you have discovered. Describe the effects of the
information on the balance sheet ratios.
(b)
Do you think the company should disclose this information? Cite the
authoritative literature that supports your answer.
Continuing Case
13
Chapter 7
Accounting in Action: CM2
The CM2 management team is discussing how it can “put its best foot forward” in
regards to the anticipated stock offering at the end of 2013. They recognize that
the financial statements will be extremely important in determining the success or
failure of this stock offering. They also recognize that the higher CM2’s reported
net income and the stronger its balance sheet, the more likely that CM2 will
achieve a higher stock price in this initial offering
Part I
One accounting issue the management team is discussing relates to the
accounting for bad debt expense. CM2 currently charges bad debt expense
based on a percentage of receivables. The rate used is 13% of ending accounts
receivable. Two of the management team want to forget about bad debt expense
altogether. They argue that there is no cash flow effect related to this expense.
Therefore, they ask, why increase expenses and reduce net income? The other
two members of the management team take a different position. They believe
bad debt expense has to be recorded but believe it should be recorded only
when the receivable is declared to be uncollectible. Using this direct write-off
approach will lead to less bad debt expense in the current year and therefore
higher net income.
You are surprised by this entire discussion. You thought everyone
understood the accrual system of accounting. You jump into the discussion to
explain the proper accounting for bad debts. The management team is skeptical
Continuing Case
14
and asks you to explain in writing why bad debt expense should continue to be
reported on an accrual basis.
Instructions
Write a memo to the management team explaining why the approaches
they suggest are not in conformance with generally accepted accounting
principles. Be sure to explain why the present accounting is correct.
Part II
Another approach to increase net income is also being considered. Some
members of the CM2 management team believe that the company might provide
incentives to present and potential customers to purchase its products. Presently
only a few select customers receive a small sales discount if they pay promptly.
CM2 is considering offering this sales incentive to all its customers and changing
the present terms from 1/10, n/ 20 either to 2/10, n/30 or to 4/15, n/45. In addition
the CM2 managers wonder whether the use of trade discounts might increase
sales significantly.
Instructions
Write a memorandum to management, explaining what the terms 2/10,
n/30 and 4/15, n/45 mean. What will be the likely effect on the balance sheet if
one or the other of these discount terms is used? What does the term “trade
discount” mean? What might be the advantage of using trade discounts rather
than sales discounts to enhance sales revenue?
Continuing Case
15
Additional Activity: Extend your accounting knowledge
Note - (Access the original spreadsheet from Chapter 4 Excel File to address the
following.
Assume that CM2 management believes that product sales will go up by an
additional 5% from its original projections if the company offers one of these new
discount terms to all customers. Management believes service revenue would be
unaffected by the discounts. In addition, Knepp and Lopez believe that the Sales
Discounts taken would quadruple, from management’s projected $50,000 to
$200,000. Do not record any changes to the cost of goods sold accounts.
Conner and Martin want to see what the effect on the income statement
and balance sheet would be if this change were made to the discount terms.
They project that at the end of the year, half of the 5% increase in sales would
still be in Accounts Receivable (uncollected) and half would have been collected
and would be recorded as Cash. The additional sales discounts of $150,000
would also reduce Accounts Receivable and Cash by an equal amount.
Instructions
(a)
On the spreadsheet, make adjustments in the specified column (proposed
AJEs) to reflect the anticipated changes caused by the change in sales
discount terms.
(b)
Having made these adjustments to management’s projections,
write a memo describing your assessment of the effectiveness of the
management of Accounts Receivable. Explain to Conner and Martin how
the effectiveness can be measured by certain ratios and changes in the
Continuing Case
16
ratios over time. In developing your assessment of accounts receivable,
examine any changes in the following ratios to illustrate their use:
accounts receivable turnover and average collection period. In addition to
the ratios reflecting liquidity and solvency, look at changes in the
relationship of sales discounts to sales and allowance for doubtful
accounts to Accounts Receivable. To further support your argument, find a
real-company competitor (e.g., Cisco or Nortel) on the Web and examine
the relationships for accounts receivable turnover and average collection
period. Write a memo reflecting your assessment and findings.
Continuing Case
17
Chapter 8
Accounting in Action: CM2
You thought that things had settled down after you left the meeting at which the
managers had discussed bad debts and sales discounts. However, when you
arrived today there was another heated discussion going on about how inventory
should be recorded. Upon your arrival, Conner and Martin request that you help
them understand the various ways that inventory can be recorded. Also, they
wonder whether it makes sense to change from LIFO (the company’s present
method) to another method. You thought this would be an easy explanation—
after all, you learned about inventory cost flow methods in your first accounting
course.
Instructions
(a)
Prepare a written report for CM2’s management, explaining the
differences between allowable cost flow assumptions. Provide an example
of how a change from LIFO to FIFO in times of rising prices affects the
balance sheet and income statement.
(b)
Conner, Martin, Lopez, and Knepp are trying to figure out how, if
they do not change inventory methods, the company can take advantage
of a LIFO liquidation this year so that the income statement “looks better.”
They ask your opinion about whether they should do this. Prepare a
memorandum to CM2’s management about the dangers of managing
earnings in this manner.
Continuing Case
18
(c)
After submitting your report on earnings management, you find
that Lopez agrees with your position. She asks how the company might
ensure that it can minimize LIFO liquidations in the future. As the
discussion continues, you realize that the best option for the company is to
change to dollar-value LIFO to minimize LIFO liquidations. You decide to
research this tonight as well and make a recommendation to the
management team at tomorrow’s meeting. Prepare a report on dollarvalue LIFO, explaining how it might minimize LIFO liquidations.
Continuing Case
19
Continuing Case
20
Chapter 9
Accounting in Action: CM2
In anticipation of further discussion of inventory procedures and their effects, you discover that the price of most technical
equipment has declined. This raises the concern that the value of some of CM2’s inventory has declined and that a lowerof-cost-or-market (LCM) adjustment is required.
Instructions
(a)
Prepare a report explaining how the lower-of-cost-or-market is computed. In this report, explain the
rationale used to justify the floor and the ceiling computation.
(b)
Inventory
Scanners
Optical Readers
Card Digitizers
Servers
Routers
Network Cards
Fire Wire
USB Cable
Fiber Optic Cabling
The following information regarding current costs is provided for the calculation:
Current
Cost
$143,320
116,900
125,460
120,870
175,980
262,150
95,610
86,240
77,590
Continuing Case
Replacement
Cost
Sales Price
$144,200
115,500
127,400
118,300
195,000
260,500
94,600
86,400
78,100
$180,000
135,000
140,000
145,000
200,000
270,000
100,000
95,000
80,000
Disposal
Costs
$5,400
4,050
4,200
4,350
6,000
8,100
3,000
2,850
2,400
Ceiling
$174,600
$130,950
$135,800
$140,650
$194,000
$261,900
$97,000
$92,150
$77,600
Normal Profit
$27,000
20,250
21,000
21,750
30,000
40,500
15,000
14,250
12,000
Floor
Market
$147,600
110,700
114,800
118,900
164,000
221,400
82,000
77,900
65,600
$147,600
115,500
127,400
118,900
194,000
260,500
94,600
86,400
77,600
21
Calculate what the inventory value would be using LCM. In your calculation, compute LCM under each of three
different scenarios: by individual item, by category (category 1: scanners, optical readers, card digitizers; category
2: servers, routers, network cards; category 3: fire wire, USB cable, fiber optic cabling), and in total.
Continuing Case
22
Continuing Case
23
Chapter 10
Accounting in Action: CM2
CM2 is considering a significant equipment replacement. Conner and Martin
believe that the best time for this equipment replacement is at the end of 2013.
However, they are concerned about the effects this replacement might have on
their financial statements. The equipment originally cost $440,000 and after
depreciation expense is recorded in 2013, the equipment’s accumulated
depreciation balance will be $390,000. At this point the equipment will be fully
depreciated to its salvage value.
Conner, Martin, Knepp, and Lopez tell you that they have thought of four
options regarding the replacement of the old equipment. They could (1) construct
the new equipment themselves and then sell the old equipment, (2) exchange
the old equipment for new equipment that is more efficient, (3) purchase new
equipment and sell the old equipment, or (4) overhaul the old equipment. When
you heard this, you wondered about the current employees and whether
acquiring new equipment will result in shifting jobs within the business and
possibly lead to some layoffs. Because you are not sure how Conner and Martin
will react to this concern, you decide not to bring up the subject at this time.
Conner and Martin appear increasingly confident in your analysis skills,
and they have asked you to determine the effects of the above alternatives for
replacing or upgrading this equipment. Knepp and Lopez have gathered the
following information to help with this analysis.
Continuing Case
24
Option 1: Construct the new equipment in-house and sell the old equipment for
cash at a fair value of $60,000. CM2 would take out a one-year construction loan
for $350,000 at the beginning of 2013 at a short-term borrowing rate of 10% for
the construction. CM2 ‘s present debt composition is as follows: (1) a $200,000
note at a 9% rate, (2) a $308,500 note at a 8% rate.
Anticipated actual expenditures for constructing the equipment are
$650,000, and on a weighted-average basis the expenditures are approximately
$425,000. The bulk of the $650,000 will be financed with the construction loan,
and the balance will be financed through accounts payable. The interest on the
short-term note is due and payable by year-end. (Note: Construction is assumed
to be completed at year-end.)
Option 2: Exchange the equipment for a similar piece of equipment with a fair
value of $685,000. Knepp and Lopez have checked the secondary market and
have found that the fair value of the old equipment is $60,000. They estimate that
CM2 can borrow $350,000 on a one-year, 10% note at the end of 2013; the
balance will be funded with an accounts payable arrangement with the supplier.
(Assume the exchange has commercial substance.)
Option 3: Purchase the new equipment by giving a non-interest-bearing note with
five payments of $164,000 to the supplier (starting on the first day of note’s term
and each year thereafter) and selling the old equipment for $60,000 cash. The
first $164,000 payment would be made in late December 2013. The prevailing
interest rate for obligations of this nature is 10%.
Continuing Case
25
Option 4: Overhaul the existing equipment. The following expenses are
anticipated under this approach: (1) The normal annual cost for lubrication and
replacement of minor parts to maintain the integrity of the exterior body would be
$27,000. (2) The cost of re-wiring interior components in an overhaul would be
$125,000. (3) Replacing old worn components would cost $82,000 with
associated labor costs of $210,000 for installation. The overhaul is estimated to
extend the useful life of the equipment another four years. (The present
equipment’s original useful life was eight years, starting January 1, 2006.) The
costs will be financed at the end of 2013 through a one-year loan for $350,000 at
10%, and the balance will be charged on account.
Instructions
(a)
Access File 10a on the website, Excel File. For each of the four options
presented, prepare journal entry(ies) in proper form in the proposed
adjustments columns on the trial balance. This will require four separate
spreadsheet files for the four options. For any loans created, record the
current portion to the accounts payable line on the trial balance, and
change the description to accounts payable and short-term debt (both on
the trial balance and on the balance sheet). Record any long-term portion
to long-term liabilities. Write a brief memo on how each option affects the
financial statements. Include your journal entry(ies) in the body of your
memo for each option. Discuss the strengths and weaknesses of each
option.
Continuing Case
26
(b)
Since you are now in the process of analyzing the quantitative
effects of this decision, you decide to also consider whether the
acquisition of any new equipment will cause any employees to lose jobs.
Also you wonder if there are other non-financial and/or ethical
considerations you should include in your analysis. Write a memo
describing other qualitative or subjective issues that you think Conner and
Martin should consider in their analysis.
Continuing Case
27
Chapter 11
Accounting in Action: CM2
In Chapter 10, you helped CM2 evaluate alternatives for replacing or overhauling
the old equipment. Recall that the original cost of the equipment was $440,000
and it was depreciated over an eight-year life. CM2 used the double-decliningbalance method to depreciate these assets and estimated a residual value of
$50,000. The equipment is now fully depreciated to its salvage value of $50,000.
Going forward, Conner and Martin are questioning the accounting for
depreciation. They argue that they don't think it is necessary to record
depreciation expense on the income statement because it does not involve a
cash outlay. In addition, they do not see the necessity for reducing the equipment
value on the balance sheet. They wonder whether CM2 should just stop
depreciating its equipment from this point forward.
Instructions
(a)
Research the accounting literature (e.g., access the FASB
Codification) and gather the official accounting guidance regarding
depreciation. Determine the following concerning depreciation: (1) What is
the general concept underlying depreciation? (2) How does depreciating
an asset portray a more realistic picture of both the performance of the
company and its financial position? (3) What is the effect on CM2’s
financial statements if Conner and Martin decide not to depreciate the
equipment? Write a memo to Conner and Martin addressing these issues.
Continuing Case
28
(b)
Use a computer spreadsheet to prepare a depreciation schedule for the
old equipment over its eight-year life, using the double-declining-balance
method. Record the journal entry for depreciation that would be made in
the third year of the equipment’s useful life.
(c)
Write a short report to explain the merits of an accelerated
depreciation method, such as double-declining-balance. In your answer
address the following issues: Does the type of company or industry have
anything to do with the choice of depreciation method selected? What
effect does matching have on the decision to use double-decliningbalance depreciation versus straight-line depreciation?
(d)
At the next management team meeting, Conner and Martin
express some concern that any new equipment acquired to replace the
old equipment may become obsolete within the next two to five years. A
number of popular-press articles have recently discussed the increasing
number of asset impairments occurring in their industry. Conner and
Martin therefore want to know how the accounting rules for impairments
would apply to any new equipment. Research the accounting literature
(e.g., access the FASB Codification), to determine the official guidance for
information on impairments including the timing and calculation of the
amount. Recall that Conner and Martin think that expenses that do not
involve cash outflow should not be recorded; be sure you describe the
reasons for recording impairments and how recording any impairment
actually can benefit the financial statements.
Continuing Case
29
Additional Activities: Extend your accounting knowledge
You recall from one of your class discussions that asset impairments
could be used to “manage earnings.” Search the Internet for recent stories in the
business press about asset impairments and earnings management. Prepare a
memo explaining how earnings might be managed through asset impairments.
Continuing Case
30
Chapter 12
Accounting in Action: CM2
With its continuing interest in going public, CM2 is concerned about its level of
reported earnings. In particular, Conner and Martin have expressed concern
about the amount of research and development (R&D) expense they see on the
forecasted financial statements. They are arguing that this is all “asset
development” and should be capitalized—“putting this significant expense on the
income statement is hurting the bottom line!” In addition, Conner and Martin are
also puzzled by the accounting for goodwill and other intangibles. As Conner
noted, “Intangibles don’t have any physical presence, so why should they be part
of the asset base?”
Part I: Goodwill
CM2 reports goodwill on its balance sheet. Knepp and Lopez indicate that the
goodwill was from the acquisition of small “garage-type” software development
companies purchased a few years ago. CM2 purchased the software companies
so that it could incorporate their software into the CM2 product line as well as to
gain the expertise of their employees.
Conner and Martin argue that no amortization should be recorded for
goodwill because they have heard there is no reliable way to establish a useful
life for the goodwill. However, they also know that a number of lawsuits have
been filed against companies that have accounted for intangible assets
incorrectly. So they want to know if CM2 is doing the right accounting in regard to
its goodwill.
Continuing Case
31
In addition, they have heard that company names often have “value”
similar to a brand. They believe that the CM2 name is becoming well-known in the
industry and believe that recognizing this brand name in the financial statements
makes sense for a fair presentation. They believe that the name is worth at least
$125,000. They wonder, though, what effect the recording of this intangible will
have on net income.
Instructions
Write a memo to CM2 management about the proper treatment of
goodwill and company names or brands. Remember to write for nonaccountants, but include citations of the authoritative literature so they know that
you know what you are talking about.
* Part II: Research and Development Costs
In reviewing CM2 financial projections Excel File, which contains the forecasted
financial statements for 2013), you note that R&D expenses are projected to be
$200,000. Knepp and Lopez indicate that 15% of this figure is related to software
costs on a project that the project manager claims has reached “technological
feasibility.” In addition, $70,000 are for employee wages in developing a patent
for the newly developed software; $59,000 represent attorneys fees for filing a
patent on the software, and patent filing fees were $1,000. The patent is
expected to be approved in late December 2013. The remaining amount of R&D
cost is for projects whose success is highly uncertain.
Continuing Case
32
Instructions
Search the authoritative literature (e.g., using the FASB Codification) to
determine the official guidance on software costs. Prepare a memo to CM2
management explaining how software costs are to be recorded—when to
consider them as expenses and when to record them as assets. Use the CM2
example above to illustrate the points in your memo.
Continuing Case
33
Chapter 13
Accounting in Action: CM2
Knowing that investors and creditors keep a close watch on a company’s
liabilities in assessing liquidity and financial flexibility, Conner and Martin have
been reviewing some of CM2’s liabilities reported on its balance sheet.
Part I: Unearned Revenues
Because the company offers service contracts to all of its customers, unearned
revenue is a significant element of CM2’s current liabilities. As indicated in the
2013 forecasted financial statements (access file 4a on the website, Excel File,)
the projected amount of unearned revenue on the forecasted balance sheet is
$137,060. This amount is an increase over the amount of unearned revenue in
2012, which was $102,860.
This increase seems reasonable but you wonder whether it should be
even higher, given the increased sales expected for CM2 products. Knepp and
Lopez provide the following information about the service contracts expected to
be outstanding at the end of 2013 based on recent trends. Customers prepay
service contracts regardless of the length of the period of service.
Contract Price
Service Contract 1, dated October 1, 2013; service for six months
$42,000
Service Contract 2, dated November 1, 2013; service for one year
75,000
Service Contract 3, dated December 1, 2013; service for one year
90,000
Continuing Case
34
Instructions
(a)
Based on the information provided, determine the amount of unearned
revenue that CM2 should report on the balance sheet at the end of 2013.
Assume that the company will provide services evenly over the contract
period.
(b)
Based on your calculation in (a), prepare the journal entry to record the
correct amount of unearned revenue at the end of 2013.
(c)
Write a memo explaining to Conner and Martin your analysis and
the effect of the journal entry prepared in part (b) on the financial
statements. Discuss why your numbers are more indicative of the actual
obligation of CM2.
Part II: Contingencies
In Chapter 12, you summarized the accounting guidance on patents. Conner and
Martin tell you that, while they are confident that the patent (referred to in
Chapter 12, in the amount of $60,000) will benefit CM2 over its legal life, another
company might challenge this patent in court. If this happens, CM2 might incur
significant legal and court costs to defend the patent. They are concerned about
what how these costs would be reported in the financial statements.
Instructions
Prepare a memo to Conner and Martin to explain how to account for the
costs incurred to defend the patent. Address the following two possible outcomes
and explain what the effects would be on the financial statements: (1) CM2 wins
the lawsuit, (2) CM2 loses the lawsuit.
Continuing Case
35