Accounting for Lawyers

Accounting for Lawyers Professor Bradford December 17, 2013 1:00 p.m. 3 Hours and 45 Minutes

GENERAL INSTRUCTIONS

1. This is a partially open book exam. You may use the Cunningham book, the Bradford book, any handouts or other text that the instructor posted on the Blackboard site or provided to you, and any materials, such as notes or outlines, written and prepared exclusively by you. During the exam, you may not use or possess any other materials, written, digital, or recorded. You may not use or possess a cell phone or any other electronic device other than the calculator provided by the instructor. You may not consult with or communicate with any other person during the exam. If you have any other books, notes, briefcases, book bags, cell phones, electronic devices, or other items, you must bring them to the front of the room now. You may not take any of these items to another designated exam room.

2. This exam has thirteen (13) pages, including the instructions. The page numbers appear on the top right-hand corner of each page. Please check to be sure that this copy has all the pages.

3. You have three hours and forty-five minutes (3:45) to complete the exam. You must turn in your answers in this room. If you finish more than five minutes early, you may turn in your answers in the Dean’s Office.

4. The exam consists of six (6) questions. The recommended time for each question is as follows:

Question 1……………………..…….. 90 Minutes Question 2………………..………….. 15 Minutes Question 3…………………..……….. 20 Minutes Question 4..………………………….. 20 Minutes Question 5…………………………… 35 Minutes Question 6…………………..……….. 15 Minutes

Each question will be weighted in accordance with its recommended time. You have an additional 30 minutes that is not allocated to any particular question. Page 2 of 15

5. Do not spend all of your time writing. Think about the issues and organize your answers before writing. Be concise. Be organized. Long, disorganized, rambling answers will be penalized, as will merely “dumping” portions of your notes or outline into your answers rather than answering the question posed.

6. Write legibly. I can’t give you credit for what I can’t read.

7. If the answer involves a calculation, show your work so I can see how you calculated the answer. If I cannot see how you calculated the answer, you will not receive full credit.

8. If you believe that additional facts are needed to answer a question, state exactly what those facts are and how they would affect your answer. If you believe that a question is ambiguous or unclear, note the ambiguity or lack of clarity and indicate how it affects your answer.

9. The questions may be answered in bluebooks or on lined notebook paper. Please write on only one side of each page. BE SURE TO WRITE YOUR EXAM IDENTIFICATION NUMBER ON EACH BLUE BOOK OR PIECE OF PAPER THAT YOU USE. If you are not using bluebooks, please staple your pages together in order. Do not put your name on any materials you turn in.

10. The Honor Code is in effect. Page 3 of 15

Question 1 (90 Minutes)

Aquapur, Inc. is a corporation that sells and repairs whole-home water purifiers, electric filters that connect to a house’s incoming water supply and remove all of the minerals, chemicals, and other impurities from the water. Aquapur is only a retailer; it does not manufacture the purifiers it sells.

Aquapur has two employees: Jack Jones, its founder and principal shareholder; and Samantha Smith, a plumber who helps install and repair the purifiers. They receive salaries of $500 per month each. Aquapur rents its small office and owns no equipment of its own.

Aquapur’s balance sheet as of Oct. 31, 2013 appears on p. 6 below.

Using the following information,

 Prepare Aquapur’s accounting journal entries for November, including any necessary closing and adjusting entries.

 Post those journal entries to t-accounts. (Don’t forget to begin by posting the beginning balances for the start of the month from the Oct. 31 balance sheet.)

 Prepare a balance sheet for Aquapur as of Nov. 30, 2013.

 Prepare an income statement for Aquapur for the month of November 2013.

Useful Information

 Revenue Accounts. Aquapur separates its revenues into two accounts:

o Sales revenue includes the price of the purifiers.

o Services revenue includes all amounts received to install and service purifiers.

 Inventory.

o Aquapur uses the periodic method of accounting for inventory and uses the average cost method to value that inventory. Page 4 of 15

o The $2,550 in inventory listed on Aquapur’s Oct. 31 balance sheet consists of four purifiers, acquired on the following dates:

. June 2013: One unit, cost $650

. September 2013: Two units, cost $600 each

. October 2013: One unit, cost $700

o At the end of November, Aquapur had five purifiers remaining in its inventory.

o Assume that the lower-of-cost-or-market rule does not apply.

 Income Taxes. Aquapur has to pay a flat 10% income tax on any income.

 Stock. Aquapur’s common stock has a par value of $1.00 per share. It is not traded on any stock exchange.

Aquapur’s November Transactions

Date Transaction

Nov. 2 Sold 100 shares of common stock to Betty Boxer for $1,200 cash.

Nov. 4 Installed a purifier at the home of Carla Customer and gave Carla a bill for $1,800, $1,500 for the purifier and $300 for installation. Carla did not pay at the time.

Nov. 5 Paid $200 owed on account to Tree Paper Co. for printed invoices Aquapur received in September.

Nov. 6 Bought 2 additional purifiers from the manufacturer, Pure Water, Inc. Paid a total of $1,400 for the 2 purifiers ($700 each).

Nov. 8 Received $100 in payment for repairs done on a customer’s purifier in October.

Nov. 9 Installed three purifiers for Ace Apartments. Ace paid a total of $5,100 cash, $4,200 for the purifiers and $900 for installation.

Nov. 10 Sent a $300 check to Pacific Water and Electric Company for Page 5 of 15

Aquapur’s past-due October utilities bill.

Nov. 11 Bought 4 additional purifiers from Pure Water, Inc. Paid a total of $2,400 cash for the 4 purifiers ($600 each).

Nov. 12 Issued 1,500 shares of common stock to Paul Property for land on which Aquapur plans to build a building. The land has an estimated fair market value of $20,000. Page 6 of 15

Nov. 13 Installed a purifier for Jerold Jones. The billed price was $1,700, $1,400 for the purifier and $300 for installation. Jerold did not pay at the time.

Nov. 14 Signed a contract to sell and install a purifier for Walter Wilson. The contract requires Walter to pay $1,400 for the purifier and another $200 for installation. Walter paid the entire $1,600 when the contract was signed, but Aquapur has not yet delivered or installed the purifier.

Nov. 15 Sent a check for $1,200 to Landlord, Inc., which owns the building Aquapur is leasing. The check covers the November and December rents of $600 per month.

Nov. 18 Received $1,900 a customer owed on account for a purifier installed in September. Of the total paid, $1,600 was for the purifier and $300 was for installation.

Nov. 21 Repaired a purifier for Hank Higgins. Higgins had already prepaid the full $200 bill for this repair in October.

Nov. 23 The Aquapur board of directors declared a cash dividend totaling $7,200 payable to the common shareholders. As of the end of November, Aquapur still had not paid the dividend to the shareholders.

Nov. 25 Carla Customer paid the $1,800 due for the purifier Aquapur installed on Nov. 4.

Nov. 27 Repaired a purifier for Frieda Frank for a price of $250. Frieda paid by check when the repair was completed.

Nov. 29 Made the required November monthly payment of $900 on the note Aquapur owes to First National Bank. $600 of the total payment is for November’s interest on the note; the remaining $300 is to repay a portion of the principal amount of the note.

Nov. 30 Paid $500 each to Jones and Smith for their November salaries.

Nov. 30 Learned that the utilities bill for November will be $375. Aquapur has not yet received or paid this bill.

Nov. 30 Aquapur aged its accounts receivable and estimated that $760 of all its accounts receivable will eventually be uncollectible. (This is the total amount estimated to be uncollectible.) Page 7 of 15

Aquapur, Inc. Balance Sheet As of October 31, 2013

Assets Cash $ 32,000 Accounts Receivable $ 5,400 Less: Allowance for Doubtful Accounts $ (270) $ 5,130 Inventory $ 2,550

TOTAL ASSETS $ 39,680

Liabilities and Shareholders' Equity Liabilities Accounts Payable $ 2,100 Utilities Expense Payable $ 300 Note Payable $ 12,000 Deferred Service Revenue $ 200 Total Liabilities $ 14,600 Shareholders' Equity Common Stock $ 2,000 Additional Paid-In Capital $ 18,580 Retained Earnings $ 4,500 Total Shareholders' Equity $ 25,080

TOTAL LIABILITIES AND SHAREHOLDER S' EQUITY $ 39,680 Page 8 of 15 Page 9 of 15

On Jan. 1, 2013, Ecuador Engines, LLC purchased an expensive precision die- casting machine to be used to manufacture small engines. Ecuador paid $350,000 for the machine. It cost Ecuador another $14,000 to transport the machine to Ecuador’s factory and $6,000 to install the machine.

The die-casting machine has an estimated life of seven years, but, since the costs to repair and maintain the machine will increase as it gets older, Ecuador plans to sell and replace the machine after five years.

Ecuador estimates that, after seven years of use, the machine would only be good for scrap metal and could probably be sold for $6,000. Ecuador estimates that if, as planned, it sells the machine at the end of five years, it would receive $45,000.

Ecuador will use the 200% declining balance method to depreciate the die- casting machine. Calculate the depreciation expense for the machine for each of the five years Ecuador expects to use it. Be sure to show your work. Page 10 of 15

Please answer both parts of this question, A and B.

A. Using the Beta Corporation balance sheets and income statements that appear on pp. 9-10 below, calculate each of the following (for fiscal year 2013). Please show all of your work, including the formula you use for each calculation.

1. Earnings per share

2. Return on equity

3. Inventory turnover ratio

4. Cash return on assets

5. Cash interest coverage ratio

Other Information You Might Need

1. As of December 1, 2012, Beta had 23,000 shares outstanding. On June 1, 2013, exactly six months into its fiscal year, Beta sold an additional 6,000 shares, giving it a total of 29,000 shares outstanding.

2. Beta’s Cash Flow from Operating Activities in 2013 was $57,600.

B. Explain the meaning of the cash interest coverage ratio, why it is important in evaluating a company, and whether a higher or lower number is better. Page 11 of 15

Beta Corporation Balance Sheet As of . . . 11/ 30/ 13 11/ 30/ 12

Assets C ash $ 247,000 $ 195,000 Accounts R eceivable (N et) 39,000 46,000 Inventory 171,000 149,000 Equipm ent (N et) 248,000 262,000 Land 58,000 58,000

TO TAL ASSE TS $ 763,000 $ 710,000

Liabilities & Shareholders' Equity Liabilities Accounts Payable $ 55,800 $ 63,200 Incom e Taxes Payable 6,200 3,800 N otes Payable 141,000 144,000 Total Liabilities 203,000 211,000 Shareholders' Equity C om m on Stock 29,000 23,000 Additional Paid-In C apital 308,000 288,000 R etained Earnings 223,000 188,000 Total Shareholders' E quity 560,000 499,000

TO TAL LIABILIT IES AN D SH AR EH O LD ER S' E Q U ITY $ 763,000 $ 710,000 Page 12 of 15

Beta Corporation Income Statement For the Fiscal Year Ending . . . 11/ 30/ 13 11/ 30/ 12

Revenues Sales R evenue $ 160,700 $ 129,750 Interest R evenue 200 50 TO TAL R EVE N U ES 160,900 129,800

Expenses C ost of G oods Sold 31,800 29,400 D epreciation 14,000 16,000 W ages and Salaries 21,000 19,000 G eneral and Adm inistrative 8,500 8,800 Interest 8,400 8,800 TO TAL EXPEN SE S 83,700 82,000

N et Incom e Before Incom e Taxes 77,200 47,800 Less: Incom e Taxes 6,200 3,800

Net Income $ 71,000 $ 44,000 Page 13 of 15

Your uncle is an attorney. He plans to retire in ten years. His current employer pays him a salary of $95,000 a year, and he expects this salary to remain the same until he retires.

He recently was offered a ten-year employment contract in a distant city. The new employer would pay him $88,000 a year for the first five years and $108,000 a year for the second five years. Your uncle estimates that the total out- of-pocket cost to move to the new city would be $12,500. Those costs are not tax deductible and will not be reimbursed by the new employer.

The new job would be exactly the same work your uncle is doing now. Except for the financial differences, the two jobs (and the two cities) are equally attractive to him.

Explain whether your uncle would be better off financially taking the new job or keeping his old job. Show your work.

In making your calculations, assume:

1. Your uncle’s discount rate is 6 percent.

2. In both jobs, your uncle will receive his entire salary at the end of each year.

3. There are no financial or tax differences between the two jobs other than those described. Page 14 of 15

You are in-house counsel for Gamma Corporation. Gamma is preparing financial statements for its fiscal year that ended on November 15, 2013.

On December 1, 2013, after the end of the fiscal year, Gamma discovered that the company’s software engineers had apparently “borrowed” another company’s patented software code and incorporated that code into one of Gamma’s most profitable software products. That Gamma software was released in January 2013. Gamma’s executives were completely unaware of this problem before December 1.

The other company has not contacted Gamma about the issue, but the use of the code is fairly obvious and the other company is a competitor of Gamma, so Gamma thinks there is a strong likelihood the other company will discover the issue before the statute of limitations on any claim runs.

It’s not certain that Gamma will be liable if the competitor sues. The law governing the use of software code is a little unclear, and there’s a chance that the pirated code was already in the public domain. However, Gamma’s outside lawyers believe there’s about a 70% likelihood Gamma would lose if the other company sues.

If Gamma loses, the amount of damages is uncertain. Depending on how the judge resolves various issues, Gamma would have to pay anywhere from $800,000 to $1.5 million. (Assume that these are material amounts for Gamma.)

Gamma’s CEO has asked you how, if at all, this matter should be reflected in Gamma’s 2013 financial statements. Discuss. Page 15 of 15

You are on the staff of U.S. Senator Froggy Fogbottom, who chairs a committee whose jurisdiction includes the accounting and auditing of public companies.

You just received the following note from the Senator:

I don’t understand why auditors are missing so much accounting fraud at public companies. Auditing should reveal those frauds. I see only two possible explanations: either the auditors are all as crooked as the companies or the auditors are all incompetent. Am I missing something?

Respond to the Senator.