Accounting Case Study

University Degree Business and Administrative studies

Case Study - American Physical and Social Programs for Children

American Physical and Social Programs for Children is a program that was started one year ago by Harvey and Jane who are the sole shareholders. They have prepared a preliminary balance sheet and income statement using cash basis of accounting for their new business. All of their transactions have been presented along with the financial statements for an accountant to review and make the proper recommendations in regards to criteria for determining accounting policies.

Selection of June 30th as its fiscal year-end

The selection of when a company is going to select its fiscal year is a very interesting question. This is something that usually puzzles many people because, unlike individuals, who must file their taxes to the IRS every year within the exact same time period, companies have the benefit of deciding when their fiscal year begins and ends. Now a company must decide when their fiscal year-end will be when they first start, and they are not allowed to change this from year to year.

In most cases the main reason for a company to choose a specific fiscal year end is to properly align it with how their industry fluctuates throughout the year. The advantage to this is that a company can properly align its financial statements to avoid negative seasonal effects that may happen in their specific industry. An example of this from Investopedia stated, “A company that has to buy inventory during the summer months probably won’t want to report its earnings during this time because the inventory purchases will decrease its earnings.”

Therefore, the choice of a June 30th year end may not be the best choice for American. This business is a sports oriented school and camp that has a substantial portion of its business during the summer months and for a seasonal business such as this one is it really doesn’t make sense to have a June 30th year end. A few apparent implications of this decision are that deposits taken prior to June 30 will have to be reported as taxable income even though they won’t be earned until the following fiscal year, and for financial reporting, they are a liability at year end but for tax reporting, they are income. I feel that a September 30th year end probably would have made a little more sense for American, as they would have realized all of their revenue at that point.

Accounting Policy Decisions

In order to prepare the financial statements for American, many accounting policy decisions need to be made. There seem to be numerous aspects of the provided financial statements where potential omissions may have occurred, and multiple accounting policies that need to be addressed. It seems the most important decisions in this case are centered on Historical Cost, Revenue Recognition, proper expense matching, full disclosure and the use of proper capital asset policies.

Historical cost, revenue recognition, matching and full disclosure are the four basic principles of accounting used in recording transactions. Assets and liabilities are accounted for and reported on the basis of acquisition price, this is referred as the historical cost principle. The advantage of this principle is its reliability. Historical cost principle provides users with a stable and consistent benchmark that they can rely on to establish historical trends. The revenue recognition principle refers to revenue being recognized in the period when it was realized, realizable, and earned. The matching principle dictates that efforts, meaning expenses, be matched with accomplishment, meaning revenues, whenever it is reasonable and practicable to do so. Full disclosure principle recognizes that the nature and amount of information included in financial reports reflects a series of judgmental trade-offs. These trade-offs strive for sufficient detail to disclose matters that make a difference to users yet sufficient condensation to make the information understandable, keeping in mind costs of preparing and using. Information about financial position, income cash flows and investments can be found in one of three places: within the main body of financial statements, in the notes to those statements, or as supplementary information (Kieso, Weygandt, Warfield, 2001).

What should American do Differently?

If I had been retained as the accountant for American there are several things that could have been done differently. There are numerous omissions in the balance sheet which need to be corrected. The covenant not to compete with Fun Time Programs for $80,000 is not recorded or disclosed within the financial statements; this is an asset with a corresponding liability and should be shown on the balance sheet. The Historical cost principle has been ignored in this situation, and should be reflected. Also organizational start up costs paid to incorporate the company is eligible to be capitalized over a given period of time no less than 60 months and this also impacts the historical cost and matching principles. There doesn’t seem to be any accounts receivable or a current liability for deposits received recorded on the balance sheet, this is where the revenue recognition policies would need to come in. Depreciation appears to be calculated over a 10 year life, as most equipment is matched to revenue over either five or seven years, it’s possible that using a ten year life is effectively overstating net income and violating the matching principle. I think switching from a cash-basis to an accrual basis of accounting might make the most sense for American, they haven’t accounted for any of their $21,500 of outstanding liabilities and they can simply accrue those payments to have their financial statements properly aligned to what they should look like for year end. Also the contingent liability for the lawsuit needs to be reported including full disclosure of the circumstances, this is something that is probable to happen and is a valid liability. Once all these changes have been applied to the financial statements I suspect that company will show drastically different results, attachment at the bottom shows an updated balance sheet and income statement using the proper accounting policies.

Analyze the Criteria for Determining Accounting Policies

The process for analyzing the criteria for how to determine the proper accounting policies is something the accounting standards board, ASB is asked on a regular basis. According to the board, developing an accounting policy for a specific transaction, event or condition, an entity firstly determines whether or not a specific Standard of GRAP exists that applies to a transaction, event or condition. In the absence of a particular Standard of GRAP, management should use its judgment in developing an accounting policy that results in information that is relevant and reliable. ...

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Analyze the Criteria for Determining Accounting Policies

In making this judgement, management refers to and considers the applicability of the requirements and guidance in Standards of GRAP dealing with similar and related issues and the definitions, recognition criteria and measurement concepts for assets, liabilities, revenue and expenses as set out in the Framework for the Preparation and Presentation of Financial Statements.

Management also considers the most recent pronouncements of other standard-setting bodies and accepted public or private sector practices to the extent that these are consistent with the sources in the Standard. For example, the pronouncements of the following bodies are considered when developing appropriate accounting policies: the International Public Sector Accounting Standards Board, the International Accounting Standards Board (including the Framework for the Preparation and Presentation of Financial Statements), the Accounting Practices Board, and The South African Institute of Chartered Accountants’ Accounting Practices Committee. (Accounting Standards Board, 2008)

Case Study – Wendell Systems, Inc

Wendell Systems was incorporated and organized by ten shareholders, while two of the shareholders Mary Mahoney and Cecila Shriberg will be actively involved with the business. Wendell plans to distribute and install high-end home audio and video entertainment systems. In order to convince some high end venture capitalists to invest in their company, they are concerned about the first year’s operating results. The basis of this case will discuss deferring verses expensing costs in the first year of operations.

Organization and Start-up Costs

The distinction between organizational costs and startup costs are that organizational costs are those which relate to setting up the entity before beginning business. Startup costs are costs that would normally be operating costs except that they are incurred prior to the time when revenue would be earned. Legal and accounting fees for incorporation are organizational. Newspaper advertising and market research are startup costs.

Compare and Contrast Capitalization and Expensing

There are several pros and cons to why someone might want to expense or capitalize organizational costs. Reasons to expense organizational costs: The costs may be so relatively small that the doctrine of materiality says to expense them directly. Tax law allows expensing of the first $5,000, and a company might report following tax law. Someone in the company may be convinced that the costs or a portion thereof, have no value to the entity and therefore do not constitute an asset. For example, the cost of temporary directors is specifically listed in the IRS website under Pub 535 as a valid organizational cost. One might argue that there is no extended value on the balance sheet for that cost, and it should be expensed at the outset. (, 2009)

The other side of that would be, Reasons against expensing organization costs: One could reasonably decide not to expense organization costs because they have a benefit extended over the life of the entity. For example, the legal fees for the preparation and execution of a partnership agreement certainly have value for the finite life of a partnership. By not amortizing or expensing them, the asset would stay in the accounting records until the partnership is terminated. In that event, the partners remaining at termination would effectively receive a deduction for the costs. Using a book method for amortization is perfectly acceptable even though an accrual-basis entity might use a different method for tax reporting. Electing not to amortize costs (for tax purposes) is also an acceptable method. There could be any number of business reasons to not amortize organizational costs. One reason could be that there was no election made for tax reporting to amortize. Another reason might be that the costs are relatively large and the company doesn’t want additional expenses reported on the income statement.

Absence of Authoritative Sources of Accounting Guidance

The authoritative sources of accounting guidance are: Generally accepted accounting principles or GAAP is the financial accounting treatment rules. Other sources of accounting principles are the Financial Standards Board (FASB), The American Institute of Certified Public Accountants (AICPA) and the Securities and Exchange Commission (SEC) usually set accounting standards. The rules and the judgments regarding correct treatment of accounting information can be found in GAAP.

In the absence of guidance from any of the above accounting sources, it is acceptable to use tax law as a basis for amortizing costs provided that the amortization also makes sense in terms of accounting principles. The matching principle should be considered, and the question asked, “do the costs provide a benefit to future accounting periods.” This presumes the company is not having audited financial statements prepared and it would be appropriate, but if they are, the auditors may make certain adjustments for compliance with various accounting principles which may vary a little from tax law.

GAAP

According to an article by Jane Rohrs, “At the election of the taxpayer, start-up expenditures and organizational expenditures may be amortized over a period of not less than 60 months, beginning with the month in which the trade or business begins. Regulations require a taxpayer to file an election to amortize start-up expenditures no later than the due date for the tax year in which the trade or business begins. Further, Sec. 197 requires most acquired intangible assets (e.g., goodwill, trademarks, franchises and patents) held in connection with the conduct of a trade or business or an activity for the production of income, to be amortized over 15 years, beginning with the month in which the intangible was acquired.” (Rohrs, 2005)

The main rule of thumb is, when you launch your business and incur expenses before your business is up and running, then you have start-up costs. Start-up costs are not deductible until your business begins. Your business begins when it is first open for business - meaning it is ready to service customers. Therefore in Wendell’s case Startup costs include Newspaper and radio advertising prior to commencing operations, Training of installation technicians, accounting fees for tax consulting, market research surveys prior to commencing activities and fees paid to executive search firm to hire a marketing director all in total equaling $177,000. Organizational costs included legal fees and accounting fees for incorporation, along with promotion and commission fees paid for the sale of stock and this totaled $23,000. The total of $200,000 in which Wendell’s proposed treatment was to amortize over 60 months is in compliance with GAAP in terms of two of the four basic accounting principles of historical cost, revenue recognition, matching and full disclosure. Amounts are being recorded at cost and being amortized to match benefits to future accounting periods.

Influence on Future Investors

Future investors would be influenced by the comparative financial statements tracking the financial history of the company. Savvy investors would understand about amortizing organizational and startup costs particularly because under the principle of full disclosure, information would be provided in the footnotes to the financial statements which should fully explain the position taken. Any differences between book and tax would also be disclosed in the footnotes to the financial statements.

Capitalizing costs to be written off over future accounting periods as opposed to directly writing them off at the time the cost is incurred has much to do with the matching principle. An example: during the start-up period, the company bought 5000 glossy brochures. Instead of capitalizing them, the cost was directly expensed and the financial accounting showed a huge loss on the first day of business. Second example: on the first day of business, the company paid for their business liability insurance in full for the year. The matching principle would want the insurance expensed over 12 months.

Case Study – Octovan Construction, Inc

Octovan Construction is a small privately owned construction company where a majority of its business is from the design and construction of septic systems. Over the past several years they have steadily not been doing as well as in prior years. In reviewing several accounting policies Octovan is concerned about its financial statements. Broadmoor Country Bank has become concerned over a $600,000 demand note that it’s holding and because of this Octovan would like to investigate changing their financial statements.

Octovan’s plans for Financial Reporting

In reviewing Octovan’s plans for financial reporting as of the current year-end, I do not agree entirely with the plans for financial reporting changes, only on certain aspects. First, the reporting of $600,000 as a non-current liability is not correct. Current liabilities are those that have to be paid within one calendar year. So from that perspective 12 installments of the principal and the interest therein must be shown as a current liability. Second, the change of depreciation method and the use of longer lives of assets is not justified. This leads to a reduction in the accumulated depreciation of $250,000 and current depreciating expense by $100,000. This is clearly an attempt to show higher revenues even though the earnings are declining steadily.

The change of accounting for long term construction contracts from the time of billing to percentage of completion method for long term construction contracts is one change that I believe should be made. Long term construction contracts can be accounted for and reported under one of two methods: percentage of completion or completed contract. The purpose for the two methods is to determine the proper amount of revenue and expense which will be recognized in each of the accounting periods involved. Under the definition, a contract will not be considered for this treatment unless it involves the manufacture of unique items normally requiring more than 12 months to complete. A more descriptive term for the percent complete method is percentage-of-completion capitalized-cost method. (Erin, 2008)

For the percentage method, the end result is that the percentage of the contract that is completed within each accounting period will determine the amount of revenue and expense that will be reported. The logistics of this process involve a good estimate of the expected profit on the job times the percentage complete. These types of contracts are normally bid and in order to bid, the construction company usually prepares a detail cost estimate for the job. When the bid is accepted, the company then knows the revenue and they already have the cost estimate.
The expected profit on the job is known, but the problem arises when costs change during the contract. As the contract progresses, the profit estimate is constantly revised which then changes the amount of reportable profit in each accounting period. This is real life and this is why accounting for long term contracts is sometimes a sticky business. The second ‘real life’ issue is that contractors tend to be rather flexible about the actual percentage that the job is completed. The two soft numbers are estimated profit, and percentage complete. If you think through the process of recording revenue and expense, you will see that it is easy to manipulate reportable profit in any accounting period.

The completed contract method, on the other hand, allows revenues, costs and profits to be accumulated on the balance sheet of a company until the job is completed.  Income statement recognition only occurs after the contract is completed.  The IRS Regulations 1.460-1 provide specific guidance to clarify when a contract is considered completed, when separate contracts are to be considered as one contract, and when one contract is considered to be separate contracts.
        The preference for method would dictate that completed contract would always be used because the income tax would be assessed later than earlier, but that is not the best business view.  Percentage complete is the method which will report profits as they are earned, and is the best method from a business perspective and from an accounting perspective for the matching principle.  A company needs to make those calculations to estimate profit for reporting to stakeholders including owners, shareholders and bankers.
        Also a business needs to understand profitability on an oncoming basis in order to have the opportunity to adjust in the marketplace.  The percentage complete method makes the most sense for spreading profits over the time period in which they are earned.  Imagine a company that only has one large two-year job: using completed contract, the first year would show no revenue or expense for the job, but overhead costs would continue to accumulate.  The financial statement for year one would show a loss while year two would report all the profit earned over two years.
        The balance sheet treatment in both methods includes keeping all the amounts and accounts on the balance sheet.  Construction in progress or WIP (work in progress) is the asset account which accumulates all the costs and allocable profit.  Billings to customers can be reported as accounts receivable, but receipts from customers show as customer deposits until revenue is recognized.  The ‘deposit’ concept makes sense in that payments from customers should not be reported as revenue until earned.  WIP would normally be a current asset; customer deposits would be a current liability.  WIP is a type of inventory account.  Billings to date should not be confused with collections to date.  Billings refer to the true progress of the job assuming they are calculated based on the percentage complete.  Receipts, on the other hand are more customer-based: how fast or slow a customer pays.  There is also an issue with Retention, or retainage on larger contracts.  Customers normally withhold 10% of collections to be paid at the end of the job.  The 10% retainage may provide incentive for the builder to complete the contract quickly.

Recommendations for Financial Reporting

There were parts of Octovan’s new plan that I did disagree with I will discuss my recommendations for financial reporting below. My recommendation for the refinanced debt from Broadmoor is that 12 month’s principal payments amounting to $120,000 for the first year and the interest therein should be shown as a current liability. “Current liabilities are those debts which are due and payable within 1 year. Non-Current Liabilities are those which fall due in more than 1 Year. A long term loan payable over 5 years is both a current and non current liability. The portion payable within 1 year is current while the remaining portion payable from year 2 to 5 is non current (World Wide Web, 2009).” This is a case when the first year should be shown as current and the remaining four years can be shown as non current.

My recommendation for depreciation is that Octovan should continue using the modified accelerated cost recovery system, MACRS. If this system is used there will be no changes to the opening balance of the accumulated depreciation and there will not be any reduction in current depreciation. The Modified Accelerated Cost Recovery System (MACRS) is the current method of accelerated required by the code. (World Wide Web, 2009)

Footnotes

Below are a few different footnotes that could be used for disclosure in Octovan’s financial statements should any changes be made to their financial reporting. I choose to write footnotes based on all potential changes, even though I didn’t agree with all of them above.

1. One unsecured demand note of $600,000 held by Broadmoor County Bank has been refinanced and Octovan will now have to pay back the principal amount in 60 equal monthly instilments at an interest rate of prime plus 1 ½ percent. This debt will now be backed by collateral of motor vehicles, machinery, and equipment. This refinanced debt is now not shown as a current liability but is a part of the long-term debt.

2. From this accounting year, there is a change in the method of depreciation from the modified accelerated cost recovery system to the double declining balance method. This method will be used for the preparation of the financial accounts. The useful lives used for the calculation of depreciation will be motor vehicles 5 years, machinery and equipment 10 years, office furniture and equipment 10 years and building and leasehold improvement 35 years.

3. From this accounting year, there is a change in the method of recognizing revenue with respect to long-term construction contracts. Until this year, revenue was recognized when the customer was billed. However, starting this year revenue will be recognized using the percentage-of-completion method. It is expected that this method will help improve matching of costs and revenues.

Evaluate the Effect of Accounting Changes on Financial Reporting

In the United States, the objectives of financial reporting are defined in the Statement of Financial Accounting Concepts (SFAC) No. 1 as to provide information useful for making economic decisions (FASB, 2008). This is defined more closely as information useful to investors and creditors and other users in making rational investment, credit, and similar decisions and for predicting, comparing, and evaluating potential cash flows to them in terms of amount, timing, and related uncertainty. FASB states also that financial reporting is expected to provide information about an enterprise´s financial performance during a period and about how management of an enterprise has discharged its stewardship responsibility to owners. Thus, in layman terms, we can state that the primary objective of financial reporting is to guide all the stakeholders of the company, ie, internal as well as external stakeholders, about the progress of the company and thus assist such stakeholders in making informed decisions, such as financing or credit related decisions, investment decisions, etc. (Troberg, 1995)

A well established and administered financial reporting standard in a country helps in ensuring strong corporate governance and thus protects the interests of numerous stakeholders around the country to ascertain about the progress of companies as well as make informed decisions. The quality of financial reporting being reported in the economy is directly related to the capital markets. A high quality financial reporting standard ensures stability in the capital market of any economy by making the accounting process transparent to the shareholders and investors.
Well established and administered financial reporting standards also help in minimizing accounting related frauds and thus protect the interests of investors in the country. Further, standardized financial reporting has become a must for any economy due to increasing globalization and international trade between nations. All of this is so important regarding financial reporting; because anytime there are accounting changes it could severely effect reporting. Staying on top and giving stakeholders a clear and consistent way to view financial statements will keep major accounting changes from having to take place. (Meuller, unknown)

Exhibit 1 – Balance Sheet

Exhibit 2 – Income Statement

References

Abdolmohammadi, M. & McQuade, R. Applied Research in Financial Reporting: Text & Cases. The McGraw Hill Companies, New York, New York, 2002.

Erin. (2008). Percentage of Completion and work in Progress. Retrieved February 7, 2009 from the World Wide Web: http://accountingetc.wordpress.com/2008/09/11/percentage-of-completion/

Financial Accounting Standards Board. (2008). Facts about FASB. Retrieved February 4, 2009 from the World Wide Web:

Mueller, Gerhard G. (2009) The Role of Financial Reporting: Discussion Retrieved February 7, 2009 from the World Wide Web:

Rohrs, Jane. (2005) Organization Costs and Start up Costs amortized over 15 Years. Retrieved February 7, 2009 from the World Wide Web: http://www.allbusiness.com/accounting-reporting/expenses-expense-accounts/299887-1.html

Troberg, Pontus. (1995) Objectives of Financial Reporting and Equity Theories. Retrieved February 7, 2009 from the World Wide Web: