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 terroristsand 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.
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.
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?
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, 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.
8.On December 15, CM2 declareda dividend of $110,000, to be paid on January 15, 2013.
9.Income tax expense is $201,109.
(c)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.
Instructions
Calculate these three relationships for CM2for 2012 and the prior year,and write a short assessment ofCM2’s financial position and performance.
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.
(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 labeledProposed 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 acompany 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.
(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.
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
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 year-ends (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 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 supportsyour answer.
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 thecurrent 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 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?
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 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.