Accounting for Lawyers

7

Accounting for Lawyers

Professor Bradford

Fall 2005

Exam 2005

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 or, if you didn’t use blue books, at the top of your exam answers. 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 5-9; Average = 7.23

Question 2: Range 5-8; Average = 6.00

Question 3: Range 0-8; Average = 5.08

Question 4: Range 0-7; Average = 4.77

Question 5: Range 0-8; Average = 5.08

Total (of exam, not final grades): Range 3.83-6.93; Average = 5.64

Question 1

To compute the present value of the settlement, we must split it into three parts: (1) the first $10,000 payment; (2) the other four $10,000 payments; and (3) the five $20,000 payments. After determining the present value of each part, we can add the present values to determine the present value of the entire settlement.

The present value of the first payment is simply $10,000, since it is payable immediately.

The second element is essentially an annuity of $10,000 payable at the end of each of the next four years. (An annuity payable at the beginning of year 2 is equivalent to an annuity payable at the end of year 1.) We can value this annuity using Table IV in the book. Nell can earn 5% on her investments, so that’s her discount rate. The annuity factor for a 5% discount rate and a period of four years is 3.54595. The value of this part of the settlement is thus $10,000 x 3.54595 = $35,459.50.

The final element of the settlement is a $20,000 annuity beginning at the end of year 5 (the beginning of year 6) and continuing for five years. The easiest way to calculate the present value of this annuity is to think of it as a nine-year annuity without the first four years. Thus, we can calculate the present value of a nine-year annuity and subtract the present value of a four-year annuity, and that will give us the present value of this annuity. From Table IV, the factor for a nine-year annuity (5% discount rate) is 7.10782. The factor for a four-year annuity (5% discount rate) is 3.54595. Thus, the value of this annuity will be $20,000 x (7.10782 – 3.54595) = $20,000 x 3.56187 = $71,237.40.

Adding these three present values together, the present value of this settlement is $10,000.00 + $35,459.50 + $71,237.40 = $116,696.90.

Question 2

Question 3

Buyer Corporation must record the purchased assets and liabilities at their fair market value. If the purchase price is in excess of the cumulative net fair market value of the assets and liabilities, the excess is attributed to Goodwill.

The only assets listed on Seller General Partnership’s balance sheet that need to be adjusted for fair market value are Inventory, which has a fair market value of $150,000, and Equipment, which has a fair market value of $110,000. Making these two adjustments makes the total fair market value of Seller’s assets $338,000. The net fair market value of its assets less the assumed liabilities is therefore $338,000 - $30,000 = $308,000. The total purchase price is $350,000, so Goodwill is $350,000 - $308,000 = $42,000.

The following journal entry shows the credits and debits associated with the debt incurred to make the purchase:

Cash $350,000

Note Payable $350,000.

The next journal entry shows the credits and debits associated with the actual acquisition:

Cash $65,000

Accounts Receivable $15,000

Inventory $150,000

Goodwill $42,000

Equipment $110,000

Cash $350,000

Allowance for Doubtful Accounts $2,000

Accounts Payable $30,000

Buyer’s existing assets and liabilities are not affected by the purchase. Thus, adding the assets and liabilities reflected above to Buyer’s existing balance sheet produces the post-transaction balance sheet for Buyer that appears on the following page.

Question 4

To recognize revenue, Bailey must have entered into an exchange transaction and have substantially completed the earnings process.

The contract with Potter clearly is an exchange transaction, with clearly identifiable consideration ($500,000 cash) being given for the machines. Bailey, as a 10% shareholder and director, clearly is a related party, but that does not by itself preclude revenue recognition. However, the notes to Bailey’s financial statements must disclose Potter’s connection to Bailey and describe the transaction and its effect on the financial statements.

Other than the possibility of return, the transaction appears to have been substantially completed. The machines have been delivered and, although the fine-tuning has not been done, a $2,000 expense is relatively minor in the context of a $500,000 contract. The revenue recognition rule only requires “substantial” completion, not full completion. However, under the matching principle, since the $2,000 expense relates to the contract, if the revenue is recognized in 2005, the estimated $2,000 expense must be accrued and also recognized in 2005.

The toughest issue here is the unconditional right of return. SFAS No. 48 says a seller can recognize revenue in spite of returns if several conditions are met. The only one at issue here is whether the seller can reasonably estimate future returns.

The return rate on Bailey’s machines has been pretty consistent at 2%. If this history can be applied to the sale to Potter, then the revenue can be recognized, with 2% of the purchase price taken as an estimated return expense. However, there are reasons to doubt whether the 2% historical return rate is a reasonable estimate here. First, Bailey typically sells to end users of machines, not middlemen intending to resell. Potter may be more likely to return than a typical end-user because of the possibility he will not sell the machine. Second, the timing of Potter’s purchase coupled with his related party status look very suspicious in light of the projected sales shortfall. Given the circumstances and the need to boost sales with a transaction like this, a return after the end of the year appears even more likely.

Thus, it appears the Potter transaction is not similar to prior transactions, and the 2% historical return rate may not be a reasonable estimate for this transaction. There is no other basis for estimating the likelihood Potter will return the machines, so the conditions of SFAS No. 48 for immediate recognition have not been met. Bailey should not recognize the revenue at this point. Instead, the $500,000 should be put into a deferred revenue account and all of the related expenses should also be deferred at this time.

Question 5

The response to this audit request should conform to the ABA Policy Statement Regarding Lawyers’ Responses to Auditors’ Requests for Information.