Accounting for Lawyers
Professor Bradford
Fall 2002
Exam 2002
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. The following distribution will give you some idea how you did in comparison to the rest of the class:
Question 1: Range 5-7; Average = 5.70
Question 2: Range 3-9; Average = 6.70
Question 3: Range 5-9; Average = 6.80
Question 4: Range 4-8; Average = 6.35
Question 5: Range 4-9; Average = 6.70
Total (of exam, not final grades): Range 5.04-7.80; Average = 6.45
Question 1
1. Rent Expense
This transaction is accounted for properly. Kotter initially recorded the entire payment as an expense, but, at the end of the fiscal year, it deferred all but the $1,000 that should be an expense for 2002 [2 months (Oct. and Nov.) x $500/month)].
2. Bank Loan
Kotter did not properly account for this transaction. The additional $46,410 to be repaid when the note is due is interest. Treating this as an immediate loss improperly recognizes all of the interest in the current period rather than in the periods to which it is attributable. The initial entry should be:
12/1/01 Cash $100,000
Note Payable $100,000
Some of the interest on this loan (12 months) should be recognized in fiscal year 2002. Thus, an additional entry is required at the end of the year. Using a straight-line method of calculating interest (1/4 of the four-year total), the entry would be:
11/30/02 Interest Expense $11,602.50
Note Payable $11,602.50
Alternatively (and more appropriately), the effective interest rate on this loan is 10%. (From Table I, for n = 4, a conversion value of 1.46410 results from a 10% interest rate.) Using the effective interest rate method, the interest expense would be 10% of the amount borrowed:
11/30/02 Interest Expense $10,000
Note Payable $10,000
3. Purchase of Water Blasters
This is also improperly accounted for. The initial entry on 12/1/01 is correct. However, the delivery expense on 12/15/01 should be capitalized. All costs of bringing a long-lived asset to its location and condition of use should be capitalized into the cost of the asset. Thus, the correct entry is:
12/15/01 Equipment $1,000
Cash $1,000
The depreciation entry on 11/30/02 is also incorrect. First, it does not include the delivery cost as part of the cost to be depreciated. Second, it subtracts the $3,000 salvage value before calculating depreciation. The double-declining balance method uses the full cost and does not first subtract the salvage value. Third, the correct right-hand entry is to Accumulated Depreciation-Equipment, not to a reserve account:
11/30/02 Depreciation Expense $7,500
Accumulated Depreciation-Equipment $7,500
($15,000 x .25 x 2 = $7,500)
Question 2
Journal Entries
11/2 Cash 1,200
Accounts Receivable 1,200
11/7 Equipment 400
Proprietorship 400
11/10 Cash 680
Revenue 680
11/15 Allowance for Doubtful Accounts 300
Accounts Receivable 300
11/18 Salary Expense 2,000
Deferred Salary Expense 2,000
Cash 4,000
11/24 Accounts Receivable 180
Prepaid Income 740
Revenue 920
11/25 [No entry]
11/29 Secretarial Expense 600
Cash 600
11/30 Electricity Expense 130
Cash 130
11/30 Supplies Expense 700
Office Supplies 700
11/30 Phone Expense 40
Accounts Payable 40
11/30 Bad Debt Expense 400
Allowance for Doubtful Accounts 400
11/30 Depreciation Expense 590
Accumulated Depreciation: Equipment 590
11/30 Revenue 1,600
Profit and Loss 1,600
11/30 Profit and Loss 4,460
Salary Expense 2,000
Secretarial Expense 600
Electricity Expense 130
Supplies Expense 700
Phone Expense 40
Bad Debt Expense 400
Depreciation Expense 590
11/30 Proprietorship 2,860
Profit and Loss 2,860
T-Accounts
7,200 / 9,500 / 1,000
1,200 / 1,200 / 300
680 / 300 / 400
4,000 / 180 / 1,100
600 / 8,180
130
4,350
Office Supplies / Equipment / Acc. Depr.: Equipment
1,200 / 7,700 / 1,300
700 / 400 / 590
500 / 8,100 / 1,890
Deferred Salary Exp. / Accts. Payable / Prepaid Income
2,000 / 720 / 1,430
2,000 / 40 / 740
760 / 690
Proprietorship
21,150
400
2,860
18,690
Revenue / Profit and Loss / Salary Exp.
680 / 1,600 / 2,000
920 / 4,460 / 2,000
1,600 / 2,860 / 0
1,600 / 2,860
0 / 0
Secretary Exp. / Electricity Exp. / Supplies Exp.
600 / 130 / 700
600 / 130 / 700
0 / 0 / 0
Phone Exp. / Bad Debt Exp. / Depr. Exp.
40 / 400 / 590
40 / 400 / 590
0 / 0 / 0
Acme Accounting Services
Income Statement
For the Month of November 2002
Revenue / 1,600
Expenses:
Salary / $2,000
Secretary / 600
Electricity / 130
Supplies / 700
Phone / 40
Bad Debts / 400
Depreciation / 590
Total Expenses / 4,460
NET LOSS / ($2,860)
Acme Accounting Services
Balance Sheet
As of November 30, 2002
Assets
Cash / 4,350
Accounts Receivable / 8,180
Less: Allowance for Doubtful Accounts / (1,100) / 7,080
Office Supplies / 500
Equipment / 8,100
Less: Accumulated Depreciation / (1,890) / 6,210
Deferred Salary Expense / 2,000
TOTAL ASSETS / $20,140
Liabilities and Proprietorship
Liabilities
Accounts Payable / $760
Prepaid Income / 690
Total Liabilities / $1,450
Proprietorship / 18,690
TOTAL LIABILITIES
AND PROPRIETORSHIP / $20,140
Question 3
FASB has determined that research and development costs must be expensed: companies may not capitalize them. The $250,000 paid to Smart was solely for the right to Smart’s research and development. The additional $100,000 Dull spent on the process was also research and development. All of this $350,000 must be treated as an expense for 2002.
As to the remaining $50,000, Dull has a choice. FASB No. 142 repeats the rules of APB No. 17 as to internally developed intangible assets, such as this patent. The preferred alternative is to treat it as a period expense. However, companies have the option of capitalizing the cost and amortizing it over the life of the intangible. Thus, Dull may treat the entire $50,000 as an expense for 2002. Or, if it prefers, it may capitalize the $50,000, listing it on the balance sheet as the asset Patent, and amortize that cost over its 20-year expected life, producing only a small amortization expense in 2002.
Question 4
A.
To answer this question, we must use the two following formulas:
Gross Profit on Sales = Net Sales – Cost of Goods Sold
Cost of Goods Sold = Opening Inventory + Net Purchases – Closing Inventory
Net Sales. The total amount of Sales is $1,400 + $1,500 + $1,200 + $2,080 = $6,180. This is net sales because there were no sales returns or allowances.
Opening Inventory. The opening inventory was 0, since WWW just began business this year.
Net Purchases. The total amount of Purchases is $1,500 + $800 + $2,880 + $1,260 = $6,440. This is net purchases because there were no purchase returns or allowances.
Closing Inventory. To compute the closing inventory, we must first compute the average cost of the widgets purchased, since WWW uses the average cost method. The total number of widgets purchased is 100 + 50 + 180 + 70 = 400. Total purchases, as calculated above, is $6,440. Thus, the average cost is $6,440/400 = $16.10 per widget. The total number of widgets sold was 70 + 60 + 50 + 80 = 260. As shown above, WWW purchased 400, so 140 (400 – 260) remain in inventory. At the average cost of $16.10/widget, the closing inventory value is 140 x $16.10 = $2,254.
Cost of Goods Sold = 0 + $6,440 - $2,254
= $4,186
Gross Profit on Sales = $6,180 - $4,186
= $1,994
B.
To take the time value of money into account, we must convert all of these amounts into January 1, 2003 dollars by calculating the future value of each payment as of Jan. 1, 2003. Then, we can compute an actual economic profit.
Interest is compounded monthly, and the monthly interest rate is 1% (12%/12 months), so we can use the number of months as the number of periods. All of the conversion values are from Table I.
Purchases
Jan. 1 $1,500 x 1.12683 = $1,690.25
Mar. 1 $800 x 1.10462 = $883.70
Aug. 1 $2,880 x 1.05101 = $3,026.91
Nov. 1 $1,260 x 1.02010 = $1,285.33
Total = $6,886.19
The total value of the sales (in 1/1/03 dollars) is $6,886.19.
Sales
Feb. 1 $1,400 x 1.11567 = $1561.94
May 1 $1,500 x 1.08286 = $1,624.29
Sept. 1 $1,200 x 1.04060 = $1,248.72
Nov. 1 $2,080 x 1.02010 = $2,121.81
Total = $6,556.76
Average Cost = $6,886.19/400 widgets = $17.22
Closing Inventory = 140 widgets x $17.22/widget = $2,410.80
Cost of Goods Sold (1/1/03 Dollars) = 0 + $6,886.19 - $2,410.80 = $4,475.39
Gross Profit on Sales (1/1/03 Dollars) = $6,556.76 - $4,475.39 = $2,081.37
Question 5
Lawyers’ responses to audit inquiries are governed by the 1975 ABA Statement of Policy.
May the Firm Comment?
A lawyer may not provide any information absent a request from the client, Statement of Policy ¶ 1, but that clearly occurred here.
The firm may comment on this particular contingency. The contractual obligation itself falls within ¶ 5(b). Trusty as specifically identified it and requested comment. The breach-of-contract claim falls within ¶ 5(c). The claim is, as yet, unasserted, but Trusty as specifically identified it and requested comment. Moreover, nothing in the question would lead the firm to believe that the auditor has required Trusty to specify the claim without regard to the ¶ 5 standard—that there is a reasonable possibility the outcome will be unfavorable and the resulting liability would be material.
The firm must first be careful to advise Trusty about the consequences of disclosure—the possible waiver of attorney-client privilege and the possibility that any evaluation of the claim may be construed as an admission. Statement of Policy ¶ 1(a)-(d).
What Information May the Firm Provide?
General Information. Since the request is proper, the firm clearly may identify the potential claim and the position Trusty will take—probably that the insurance requirement only applies to theft insurance. The only additional information that the firm might possibly provide, under the ABA Statement of Policy, is (1) a judgment as to the possible outcome or (2) an estimate of the loss or range of loss.
Possible Outcome. The firm may provide a judgment as to outcome only if an unfavorable outcome is either “probable” or “remote.” Given what Dubyah has said, the probability of an unfavorable outcome clearly is not remote. “Probable” means A.A.’s chances of losing are “extremely doubtful” and Trusty’s chances of winning are “slight.” Dubyah says Trusty is “not likely” to win, but is that the same as slight. It’s not clear that Dubyah’s statement meets the “probable” standard. If not, the firm may not provide an evaluation of the possible outcome. If so, the firm may indicate that an unfavorable outcome is probable.
Amount of Loss. The firm may estimate the loss or range of loss only if the probability of inaccuracy is slight. Given the Pound precedent, it looks like the liquidated damages clause will be enforced; the possibility that it will not is slight. Thus, the amount of damages if Trusty loses will almost certainly be $850,000. The firm could, therefore, provide this estimate because the probability of inaccuracy is slight. The Statement of Policy says that unasserted possible claims will almost never meet the standard for estimating a loss but, given the liquidated damages clause, this unasserted claim appears to be an exception.