Question

Joan Jett and Chick Falay were unusual friends. Chick came from a background of poverty while Joan had an extremely affluent family. Indeed, the two would never have known each other except for an unusual set of events. Joan’s parents had given her a new car for her 16^th birthday. Not being used to the new vehicle, Joan misjudged a curve and wrecked the car. Chick happened to see the accident and helped Joan get out of the vehicle. Joan was unhurt but extremely distraught. She told Chick that her parents would never trust her again. When the police arrived, Chick told them that he had seen a child run in front of Joan’s car and that Joan had swerved off the road to save the child’s life. Upon hearing the story, Joan’s parents considered her a hero. The insurance company paid for a new car and Chick had made a friend for life.

Joan went to college and became a CPA in her father’s accounting firm. Chick worked for several restaurants and managed to start one of his own. The restaurant became successful and Chick turned the accounting work over to Joan’s firm. Having no formal business education, Chick had little technical knowledge of business practices.

At the beginning of 2019, Chick’s Balance Sheet included $10,000 Cash and Other Assets amounting to $380,000, liabilities consisting of a Note Payable and other items of $80,000, and Common Stock of $25,000. Joan provided Chick with accounting services for several years and was reasonably certain of the accuracy of these figures. Since Joan had always advised Chick on financial matters, Joan was also aware that during 2019, Chick had paid Cash to purchase $50,000 of Restaurant Equipment. Also during 2019, Chick had been able to repay $15,000 on the Note Payable that evidenced the restaurant’s liability to a Bank. Finally, Chick had received a $20,000 Cash Dividend from the Restaurant. Chick had made no additional Cash Contributions to the business during 2014. Even so, the records that Chick provided to Joan for 2019 indicated that the restaurant earned $200,000 in Cash Revenues and incurred $175,000 in Cash Expenses. The ending balance in the Cash account was $12,000.

After analyzing the data, Joan became convinced that Chick was not reporting everything. She confronted Chick with her suspicions and Chick admitted that he was not reporting all of the Restaurant’s Sales Revenue. He justified his behavior by saying he didn’t think the income tax system was fair and he did not want to pay any more taxes than he had to pay. Chick defended himself, “I’m only doing what everyone else does. Your dad’s biggest client, Buddy Bulbous, has been skimming a million a year off his chain of restaurants. I know because I used to work for him. Even so, you and your dad give him an Unqualified Audit Opinion every year. So why won’t you do the same thing for me? I’m supposed to be your friend and Buddy is a Dope”. Chick became so indignant, he told Joan, “Either you go along with me on this or I’ll find a new accountant and a new friend. I’ve always stood up for you and this is the thanks I get.”

Required:

1. How much Income is Chick not reporting? Show your calculation.
2. How does Chick’s failure to report Cash Revenue affect the Financial Statements?
3. Assets = Overstated or Understated? Why?
4. Liabilities = Overstated or Understated? Why?
5. Owner’s Equity = Overstated or Understated? Why?
6. Income = Overstated or Understated? Why?

Answer 1

Solution
To arrive at the answers, we need to construct the Balance sheet, and prepare Cash Book, Notes Payable account, Common stock account and Other assets account and Profit and loss account to arrive at the correct financial position.
		Joan and Chick
Balance Sheet of Mr. Chick Falay as at 1.1.2019		Cash Book
Liabilities		Assets				Debit	Credit	Balance
Notes Payable & Other Liab	$         80,000	Cash	$         10,000		Opening Balance			$         10,000
Common Stock	$         25,000	Other Assets	$      380,000		By rest Pur		$         50,000	$        (40,000)
Difference Un accounted for	$      285,000				Notes payable		$         15,000	$        (55,000)
Total	$      390,000	Total	$      390,000		Cash dividend	$         20,000		$        (35,000)
					Revenues	$      200,000		$       165,000
					Expenses		$      175,000	$        (10,000)
					Other income unreported	$        22,000		$         12,000
					Notes Payable A/c
Balance Sheet of Mr. Chick Falay as at 31.1.2019			Debit	Credit	Balance
Liabilities		Assets			By bal			$         80,000
Notes Payable & Other Liab	$         65,000	Cash	$         12,000		To payments	$         15,000		$         65,000
Common Stock	$         50,000	Other Assets	$      430,000		Closing Balance			$         65,000
Difference Un accounted for	$      327,000
Total	$      442,000	Total	$      442,000		Capital Account	Debit	Credit	Balance
					By Bal			$         25,000
					By Profit*		$         25,000	$         50,000
					Closing Balance			$         50,000
					Other Assets Account	Debit	Credit	Balance
					To Opening Balance			$       380,000
					To Purchases	$         50,000		$       430,000
					Closing Balance			$       430,000
					Profit and Loss A/c.	Debit	Credit	Balance
					By Revenues		200000	200000
					To Expenses	175000		25000
					To Profit Transferred to Common stock	25000		Nil
Solution
a. How much Income is Chick not reporting? Show your calculation.	$ 22000 income is unaccounted for as seen from cash book	Please see the Cash Book A/c. He has not reported $22000 as seen from the income and expenses recorded therein
b. How does Chick’s failure to report Cash Revenue affect the Financial Statements?	$25000 Profit	Failure to report cash revenues leads to tax evasion and the financial statements do not reflect true position. There is always a mismatch in such circumstances
c. Assets = Overstated or Understated? Why?	$285,000	Assets are overstated by $ 285000 at the beginning of the year. (Total AssetsCash10000+other assets 380000)- (Notes payable 80000+Common stock 25000). $ 285000 Borrowings or other liabilites are concealed
d. Liabilities = Overstated or Understated? Why?	$285,000	Liabilities are understated as Other borrowings to the tune of $295000 are not reported(Pl. see Balance sheet as on 1.1.2019
e. Owner’s Equity = Overstated or Understated? Why?	$25,000	As at the end of 2019 Owners equity should be $ 50000 due to the profit earned during the year. This is understated. The reason was not including it to the common stock to avoid tax payment
f. Income = Overstated or Understated? Why?	$22,000	Income is understated . Other income not included in the cash book so as to avoid taxes