Question

You have been asked to prepare the financial statements for Neema Corp., a private Canadian corporation, for the year ended 31 December 20X4. The company began operations in early 20X4. The following information is available about its business activities during the year:

a. On 2 January, Neema issued no par common shares for $300,000.

b. On 3 January, machinery was purchased for $255,000 cash. It was estimated to have a useful life of 10 years and a residual value of $40,000. Management is considering using either the straight line amortization method or the declining balance method at twice the straight line rate.

c. On 4 January, Neema purchased 20% ownership in a long term investment, ABC Co., for $45,000. During the year, ABC paid dividends of $1,750 and earned net income of $8,000. Neema can use either the cost method or the equity method of accounting for its investment in ABC.

d. Inventory purchases for the year were, in order of acquisition:

 

Neema uses a periodic inventory system. There were 25,000 units in ending inventory on 31 December. Management is considering whether to use FIFO or weighted average as the inventory accounting method.

e. Sales during the year were $1,500,000, of which 90% were on account and 10% for cash.

f. Management has estimated that approximately 1% of sales on account will be uncollectible. During the year, $1,035,000 was collected on accounts receivable. When management scrutinizes the year end outstanding accounts, it estimates that approximately 6% of the accounts will prove uncollectible.

g. Additional operating expenses for the year were $550,000.

h. On 31 December, the company paid a $5,000 cash dividend on common shares.

i. On 31 December, accounts payable pertaining to operating expenses and inventory purchases totalled $154,000.

j. The cash balance on 31 December was $102,000.

 

REQUIRED:

1. Choosing from the alternative accounting policies described above, prepare a single step income statement for the year ended 31 December 20X4 that will produce the lowest net income.

2. What ethical implications are to be considered when selecting from among alternative accounting policies?

Answer 1

Requirement 1

 

Accounting policy choices:

 

To report the lowest net income, the company must choose accounting policies that will yield the lowest revenues and the highest expenses.

 

1.    

Amortization: Double declining balance depreciation should be used. The rate will be 1/10 × 2 = 20%. For the first year, amortization will be $255,000 × 20% = $51,000.

 

2.    

Long-term investment: The equity method will report Neema’s share of ABC’s earnings. For 20X4, 20% of ABC’s earnings is $1,600. The cost method reports only dividends received from ABC, $350 (i.e., $1,750 total paid × 20%). In general, dividends received will be less than the investor’s share of earnings, and thus the cost method should be used.

 

3.    

Inventory: Assuming that the purchase data are presented in sequence from earliest to latest, prices are rising. In a period of rising prices, average cost will give a higher cost of goods sold than FIFO, and therefore the lowest net income. The periodic average cost is $745,000 ÷ 175,000 units, or $4.26. Ending inventory will be 25,000 × $4.26 = $106,500. Cost of sales is:

 

Purchases	$745,000
Ending inventory	106,500
Cost of goods sold	$638,500

 

4.    

Bad debt allowance:

a.   

Credit sales: $1,500,000 × 90% = $1,350,000

Bad debt allowance based on sales: $1,350,000 × 1% = $13,500

 

b. 

Bad debt allowance based on accounts receivable:

($1,350,000 – $1,035,000) × 6% = $18,900

 

For this year, the amount based on accounts receivable gives the higher expense, although that may not be the situation in future years. In general, however, the use of an aging schedule gives management greater estimation flexibility.

 

Using the policies described above, the single-step income statement will be as shown below:

Neema Corporation

Income Statement

Year ended 31 December 20X4

 

Sales	$ 1,500,000
Dividend income	350		$ 1,500,350
Cost of goods sold	638,500
Amortization expense	51,000
Bad debt expense	18,900
Other operating expenses	550,000		1,258,400
			$ 241,950

 

Requirement 2

 

The selection of alternative accounting policies requires the accountant to use professional judgement. There are numerous choices of accounting policy, and different choices necessarily yield different reported amounts. The accountant must carefully select accounting policies that are appropriate in the particular circumstances without misrepresenting the financial condition of the company. It is management’s responsibility to ensure the financial statements report reasonable amounts that are not misleading, a responsibility that the accountant shares. The accounting policies should present fairly and ethically the financial position of the company.