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January 24, 2011

TEACHING NOTE

CASE 1

Verona Springs Mineral Water

2 pages; introductory

Accounting cycle

Journal entries

Income statement

Balance sheet

Statement of cash flows

Synopsis

This brief case covers the accounting cycle for a start-up water bottling company. This can be either the first case in an MBA/EMBA financial accounting course, or can follow Dublin Small Animal Clinic. The two cases are similar but Dublin Small Animal Clinic is less complex. If I use both cases, I typically omit the statement of cash flows for Dublin Small Animal Clinic and include that statement for this case.

Students make simple journal entries and then prepare an income statement, balance sheet, and statement of cash flows—possibly by using the spreadsheet shown in Exhibits 1-3. The case can include a spreadsheet worksheet that summarizes journal entries into a general journal. The balances in the general journal are immediately copied into the balance sheet and income statement, and the ending and beginning balances from the balance sheet are used to immediately prepare a statement of cash flows. As a result, students can make journal entries and immediately see how financial statements change...

Objectives

This basic case is typically used as the second case in an MBA/Executive financial accounting course. It covers the first two months of operations for Verona Springs Mineral Water. The primary difference between this case and Dublin Small Animal Clinic, Inc. is that this case is slightly more complex. It includes an inventory account, debt, and a well drilling cost that is expensed instead of capitalized because of materiality. I sometimes follow this case with Holton-Central Holdings, Inc., which includes the purchase of a business including goodwill, and inventory that includes transfers between raw material, work-in-process, finished goods, and cost of goods sold.

Verona Springs can be used to introduce the following topics (same as in Dublin Small Animal Clinic):

•Accounting as the language of business

•Common business terms: capitalize, expense, revenues, assets, liabilities, and equity

•A way to record relevant business activity in a systematic, orderly manner

•A system probably in existence since at least 1300

•Balance sheet—financial position at a point in time

•Income statement—financial performance during a specific period

•Basic concepts

•Cost principle

•Going concern principle

•Matching principle

•Accrual method versus cash basis accounting

•Materiality

•Reliability

•Relevance

•Fair value

•Cost, which can be either an expense or a capital expenditure

•Basic sections of the income statement and balance sheet:

•Revenues

•Expenses

•Assets

•Liabilities

•Owners’ Equity

•Double-entry bookkeeping

•Accounting cycle

•Journal entries

•General journal

•General ledger

•Trial balance

•Financial statements

•Accounting rules

•Tax rules

This case has two objectives that are reinforced by following Dublin Small Animal Clinic with either or both Verona Springs Mineral Water and Holton-Central Holdings. One objective is to introduce students to commonly used financial reporting terms, such as those listed in the above bullets. The second objective is have students prepare an income statement, balance sheet, and statement of cash flows for a simple company, and then interpret those three statements.

Suggested use

Course Level

First-year MBA/Executive MBA financial accounting

Executive education

Function

Teaching case

Timing

I typically use this as the second class in an introductory MBA/EMBA financial accounting course

Supplemental material

Spreadsheets

Related material

Dublin Small Animal Clinic, Inc. (Chapter 1)

Holton-Central Holdings, Inc. (Chapter 1)

Suggested Questions

  1. For the two-month period March 1, 2009, to April 30, 2009, prepare: (a) journal entries, (b) an income statement, (c) a balance sheet, and (d) a statement of cash flows.
  2. Evaluate the company's performance.
  3. Is the large decline in cash a concern?
  4. How would the three financial statements change if Verona Springs bought 5,100 boxes for $5,100 ($1.00 per box) and if 2,000 boxes remained in inventory?
  5. How would the three financial statements change if, in addition to payinga total of $5,100 forboxes, Verona Springs also spent a total of $4,800 for bottles and lids (a total of $9,900 for boxes, bottle, and lids, instead of $6,300), $2,500 instead of $1,500 for labor, $1,600instead of $900 for shipping, and then shipped a total of 5,000 cases at $5.00 per case (1,000 cases for cash; 4,000 cases on credit)? Also assume negligible quantities of boxes, bottles, lids, and supplies in inventory.
  6. Identify costs that may not have been included in the case.

Teaching Outline

  1. (5-10 minutes, introduction) I usually start the case by asking someone to describe the company and to then make the first journal entry, which is the initial equity investment by Mr. Pickering and several relatives. I also ask the student to explain the terms “asset” and “equity,” and let them discuss anything else about the entry that interests them.

If I have enough board space and a screen, I will write the journal entries on the board and then enter them on the spreadsheets shown in Exhibits 1 and 2 (discussed in the following section).

  1. (30-45 minutes, complete remaining journal entries and evaluate financial statements) I then have students complete the remaining journal entries. As we cover each journal entry, I ask student to explain common terms such as asset, liability, equity, revenue, and expense. I also ask students to explain where and why each journal entry appears on a financial statement (next section), and ask about various accounting terms such as materiality and historical cost, when they are relevant to a journal entry.
  2. (10-15 minutes) After discussing the basic accounting cycle, I usually spend the remainder of the class asking students to discuss the firm’s financial performance, as reported in the income statement, and its financial condition, as reported in the balance sheet (next section).

Analysis

Spreadsheet

I use a variant of the spreadsheets shown in Exhibits 1 and 2 for this case and for two more advanced introductory accounting cycle cases, Verona Springs Mineral Water and Holton-Central Holdings. The spreadsheets use positive numbers as debits and negative numbers as credits, which is how accounting software records debits and credits.

Journal entries

Using positive numbers for debits and negative numbers for credits makes recording journal entries both simple and nearly identical to recording debits and credits. For example, debits must equal credits. By using positive and negative numbers for journal entries, the sum of the entries must always equal zero. Similarly, the normal balance in asset and expense accounts is a debit and the normal balance in liability, equity, and revenue accounts is a credit. With this method, the normal balance in asset and expense accounts is a positive number and the normal balance in liability, equity, and revenue accounts is a negative number.

In Exhibits 1 and 2, journal entries are entered on the right side of the spreadsheet. The columns numbered 1 to 8 in Exhibit 1 (1 to 11 in Exhibit 2) represent 8 different journal entries. The first column shows a journal entry to record the sale of stock: a $125,000 debit to cash and a $125,000 credit to common stock. The first cell beneath the 1 at the top of that column, shows “$ -“; it is simply the sum of all the journal entries in that column. That row shows “$ -“ for each of the 8 columns in Exhibit 1, or the 11 columns in Exhibit 2, so debits equal credits for each journal entry.

General journal and financial statements

If all the journal entries are blank, then the numbers under the fourth and fifth columns, “Account Balances, End date” and “Financial Statements, End Date”, are zero. As an entry is made, the “Account Balance,” which represents a trial balance, is simply the sum of all journal entries in that row. For the “Financial Statements” column, the number is the sum of all journal entries for that row, except the sign is switched for each liability, equity, and revenue account. Although that can be somewhat confusing for someone unfamiliar with double entry bookkeeping, it is how computers do accounting and it is effectively how bookkeepers did accounting by hand for hundreds of years.

Because students can see how a journal entry affects both the general ledger (column 4) and the financial statements (column 5) accounts as a journal entry is being made, the process is usually easier to understand than if we first make journal entries, then prepare a general journal, and finally prepare financial statements. Each time someone makes an entry, we discuss the effect on the general ledger and on the financial statements.

Sometimes we discuss the statement of cash flows, although for a very introductory class, I sometimes delete the statement of cash flow from this spreadsheet.

Some textbooks use spreadsheets where the normal balance in all accounts is a positive number. With that method, there is no need to change signs when moving from the general journal to the financial statements. However, students need to remember that: (1) some journal entries will be for two positive numbers, such as when an asset is acquired in exchange for a liability or for equity (obtain cash in exchange for common stock); (2) some journal entries will be for a positive number and a negative number, such as when an asset is acquired for another asset (pay cash to obtain inventory), and; (3) some journal entries will be for two negative numbers, such as when a liability is reduced in exchange for an asset (pay cash to reduce accounts payable).

That seems far too confusing. I use the convention that debits are positive numbers and credits are negative numbers, which is equivalent to debits always equaling credits.

Retained earnings

As journal entries begin to affect the income statement, we discuss how the income statement is included in the balance sheet as retained earnings, so that debits equal credits for the general journal and the balance sheet.

Suggested answers to questions

Question 1—journal entries

Exhibit 1 shows the first eight journal entries, which provides the answer to question 1 and the information needed to discuss question 2 for the first part of the case. Exhibit 2 shows the following three journal entries, which provides the answer to question 3 and the information needed to discuss question 4 for the second part of the case.

  1. Sale of stock.

Cash$500,000

Common stock$500,000

Discuss and define terms such as asset and equity. Discuss the trial balance and the balance sheet.

  1. Bank loan.

Cash$300,000

Notes payable$300,000

Discuss and define liabilities. Possibly discuss alternatives to “notes payable,” such as loans payable and long-term debt. Discuss the differences between current and long-term liabilities.

  1. Purchase of land.

Land$525,000

Cash$525,000

Discuss capital expenditures and land. Discuss whether land should be amortized or depreciated.

  1. Drilling of a well.

Drilling expense$1,000

Cash$1,000

Discuss expense versus capitalize. In this instance, the drilling cost has been expensed because of the materiality concept. Discuss the income statement and retained earnings. Show that the income statement accounts have been summarized, or collapsed into net income, and that net income is then added to the beginning retained earnings balance.

  1. Payment for construction of a building and purchase of purifying and bottling equipment.

Building and equipment$240,000

Cash$240,000

Introduce the concept of depreciation expense. Discuss the matching principle. Discuss the financial statements, including the statement of cash flows.

  1. Purchase of supplies and miscellaneous inventory on credit.

Supplies and miscellaneous inventory$6,300

Accounts payable$6,300

Discuss inventory. Discuss accounts payable as the normal way companies buy from each other. Mention that “payable in 30 days” isnormal in the U.S. Possibly mention that “payable in 90 or 120 days” is more common in Europe. When InBev acquired Anheuser-Busch, within two months A-B InBev announced that it would pay its creditors in 120 days instead of 30 days.

  1. Purchase of supplies and miscellaneous inventory for cash.

Supplies and miscellaneous inventory$500

Cash $500

  1. Sale of 3,000 cases of bottled water, 2,000 as credit sales and 1,000 as cash sales.

Cash$ 5,000

Accounts receivable$10,000

Revenues$15,000

  1. Paid employees.

Payroll expense$1,500

Cash$1,500

I sometimes mention that payroll costs incurred to produce a product are added to the cost of the product, along with the cost of manufacturing overhead. If I follow this case with Holton-Central Holdings, I discuss those topics in the Holton case.

  1. Pay for shipping the bottled water to supermarket chains.

Shipping expense$900

Cash $900

In the U.S. in is most common for the shipper to pay freight costs and then bill the customer for the cost of that freight. Under detailed U.S. GAAP, the shipper (in this case, Verona Springs), records payment of the shipping costs as shipping expense and shows that amount as cost of goods sold. When the shipper receives payment from its customer, the shipper records the payment as shipping revenue. Although the case does not mention whether customers must pay shipping costs, if they paid $900, Verona Springs would record $900 of shipping revenue and $900 as shipping cost of goods sold, even though those numbers total to zero.

  1. To reduce the “Supplies and miscellaneous inventory” account to its month-end balance, which is zero in this case.

Supplies expense$6,800

Supplies and miscellaneous inventory$6,800

Discuss the concept of ending inventory. Possibly mention perpetual versus periodic inventory.

  1. Record depreciation expense for one month for the $240,000 of buildings and equipment, which have a 10-year or 120-month life.

Depreciation expense$2,000

Accumulated depreciation$2,000

  1. Record interest expense and the liability for accrued interest costs.

Interest expense$3,000

Interest payable$3,000

The firm borrowed $300,000 at 6%, payable annually on the previous year’s outstanding balance. This is for a two-month period, so for simplicity, assume interest expense is 1% of $300,000, or $3,000. This distorts the income statement because the firm has only been in operation for one month. If we adjust the reported net income consider the $1,000 drilling expense and the additional $1,500 of interest expense, the firm would have earned $2,300 instead of reporting a $200 loss.

Question 2

Although the firm reported a $200 loss, this is its first month of operation. In addition, if we eliminate the $1,000 drilling expense and the additional $1,500 of interest expense, the firm would have earned $2,300 instead.

This is a startup, so it is very difficult to say much about its operating performance. However, the firm almost certainly has excess capacity. If it can increase revenues (see question 5), it may become reasonably profitable because depreciation expense and interest expense will remain constant as revenues increase.

Question 3

No. Startups need considerable cash for items such as the purchase of land, buildings, and equipment for Verona Springs, or for product development costs or research and development for many other firms.

Question 4

See Exhibit 2

Question 5

See Exhibit 3

Question 6

•Legal fees to incorporate the firm

•State, city, and county licensing and other regulatory fees

•Insurance

•Accounting fees

•Payroll taxes

•Travel and entertainment

•Advertising and marketing costs

•Water testing supplies

•Administrative wages

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Full file at

Exhibit 1

Exhibit 2

Exhibit 3

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