Problem 6-20 (Algo) Variable and Absorption Costing Unit Product Costs and Income Statements; Explanation of Difference in Net Operating Income [LO6-1, LO6-2, LO6-3]

High Country, Inc., produces and sells many recreational products. The company has just opened a new plant to produce a folding camp cot that will be marketed throughout the United States. The following cost and revenue data relate to May, the first month of the plant’s operation:

Management is anxious to assess the profitability of the new camp cot during the month of May.

Required:

1. Assume that the company uses absorption costing.

a. Calculate the unit product cost.

b. Prepare an income statement for May.

2. Assume that the company uses variable costing.

a. Calculate the unit product cost.

b. Prepare a contribution format income statement for May.

On July 31, 2017, Amsterdam Company engaged Minsk Tooling Company to construct a special-purpose piece of factory machinery. Construction was begun immediately and was completed on November 1, 2017. To help finance construction, on July 31 Amsterdam issued a $300,000, 3-year, 12% note payable at Netherlands National Bank, on which interest is payable each July 31. $200,000 of the proceeds of the note was paid to Minsk on July 31. The remainder of the proceeds was temporarily invested in short-term marketable securities (trading securities) at 10% until November 1. On November 1, Amsterdam made a final $100,000 payment to Minsk. Other than the note to Netherlands, Amsterdam's only outstanding liability at December 31, 2017, is a $30,000, 8%, 6-year note payable, dated January 1, 2014, on which interest is payable each December 31.

Instructions

(a)  

Calculate the interest revenue, weighted-average accumulated expenditures, avoidable interest, and total interest cost to be capitalized during 2017. (Round all computations to the nearest dollar.)

(b)  Prepare the journal entries needed on the books of Amsterdam Company at each of the following dates.

• 1.July 31, 2017.
• 2.November 1, 2017.
• 3.December 31, 2017.

Problem 6-20 Variable and Absorption Costing Unit Product Costs and Income Statements; Explanation of Difference in Net Operating Income [LO6-1, LO6-2, LO6-3]

High Country, Inc., produces and sells many recreational products. The company has just opened a new plant to produce a folding camp cot that will be marketed throughout the United States. The following cost and revenue data relate to May, the first month of the plant’s operation:

Management is anxious to assess the profitability of the new camp cot during the month of May.

Required:

1. Assume that the company uses absorption costing.

a. Determine the unit product cost.

b. Prepare an income statement for May.

2. Assume that the company uses variable costing.

a. Determine the unit product cost.

b. Prepare a contribution format income statement for May.

1-REVENUE/SALES- Based on economic conditions, she believes that the increase in sales for the current year should approximate the historical trend. (Revenues were 20x6: $11,814 20x5: $9,500, 20x4: $7,800) (Industry sales have been increasing by double digits for the last five years, competitor sales increases have ranges from 10-30% increases year over year for the last 5 years.) Using a reasonableness analytic estimate expected revenue for 2018 using the historical data provided.

2.Based on her knowledge of economic conditions, she is aware that the effective interest rate on the company's Long-term debt, less current maturity for 20X8 was approximately 11 percent. She is aware that the company pays little to no interest on the current portion of the long-term debt. Long-term debt, less current maturity is the company’s only debt, and source of interest expense. Using a reasonableness analytic estimate expected interest expense for 20X8. (Show your calculation, your answer, and if any differences noted are material or not, conclude whether you believe this account is misstated or appears reasonable.)

Managerial Epidemiology

Outbreak of Influenza in a Kentucky Nursing Home Assume that an outbreak of Influenza A occurred among 400 residents of a New York Nursing Home during December 2006 and January 2007, despite the vaccination of 375 of them between mid-October and mid-November of 2006. The residents, 70% of whom were female, had a mean age of 85 years and shared common recreational and dining areas. (Textbook Case Study 2.2) Case Questions: Base your reply upon this influenza outbreak case, research of influenza, and proposed solutions. You are to write a 2-3 page paper in APA formatting that addresses the following questions. Note: A minimum of two references should be used, which should include your textbook and the CDC, and others that support your responses in your paper. This is a paper, so your answer should not be numbered, but rather it should use titles and subtitles.

1. If 75 of the residents developed influenza-like illness (ILI), what proportion of the residents became sick?

2. Of those with ILI, 40 developed pneumonia, 25 required hospitalizations, and two died. What proportion of those with ILI developed pneumonia? What percent of those with ILI and pneumonia were hospitalized? What proportion of those with ILI died?

3. Of the 375 residents who were vaccinated, 60 developed ILI. Of the 25 residents who were not vaccinated, 20 developed ILI. What percent of vaccinated residents developed ILI? What percent of unvaccinated residents developed ILI? How many more times higher is the rate of ILI among those who were unvaccinated compared to those who were vaccinated?

4. Of the 375 vaccinated residents, 35 developed pneumonia following ILI compared to 15 residents among the 25 who were not vaccinated. What percent of vaccinated residents developed pneumonia following ILI? What percent of unvaccinated residents developed pneumonia following ILI? How many more times higher is the pneumonia following ILI among those who were unvaccinated compared to those who were vaccinated?

5. What was the vaccine efficacy for preventing LIL and pneumonia?

Your elder brother Kazim has been hired as CFO in Sohar Power Company SAOG. Sohar Power
company SAOG owns and operates the largest power generation and water desalination plant in
the Sultanate. Sohar Power is incorporated in 2004. Since then, the company has built and owns
the 585 MW electricity generation and 33 MIGD seawater desalination plant. Sohar Power has a
history of research and development in the field of power generation and water purification. It has
a long established policy for the treatment of expenditure on research and development, on which
it spends huge amount annually.
Recently, Kazim becomes aware that an investment of OMR 100,000 which was made last year
for research and development programme, has not been properly evaluated. Although in aggregate
OMR 1 million has been spent, but Kazim thinks that the criteria for the investment was not fair
and clear. The director for the research committee did not assess properly and the output of the
investment was poor. Kazim enquires Mr. Abid, the director of research committee to justify the
investment. Abid replies by saying that they will satisfy the auditors in any way.
However, the financial year end is only two months away and OMR 1 million in write-off at this
late stage in the financial year would cause Kazim and his team in difficulties. The company has
to finalize the year-end report. Kazim called the meeting of directors and discussed the issue.
During the meeting they have serious reservations on research committee. One of the directors
suggested that this amount will be considered as an asset and it will be presented on the financial
statement for this year and it would be write off in the next financial year.
a. In your opinion, what decisions will be taken by Kazim to satisfy the auditors and board of
directors of the company? How this transaction would be reflected on financial statement of Sohar
Power?
b. Abid, working on a high position in a company thinks that auditors can be satisfied in an
unethical manner. How could such an unethical behavior be a learning experience for the rest of
the employees? In your opinion, who is to be blamed for this incident in Sohar Power and why?

Your elder brother Kazim has been hired as CFO in Sohar Power Company SAOG. Sohar Power
company SAOG owns and operates the largest power generation and water desalination plant in
the Sultanate. Sohar Power is incorporated in 2004. Since then, the company has built and owns
the 585 MW electricity generation and 33 MIGD seawater desalination plant. Sohar Power has a
history of research and development in the field of power generation and water purification. It has
a long established policy for the treatment of expenditure on research and development, on which
it spends huge amount annually.
Recently, Kazim becomes aware that an investment of OMR 100,000 which was made last year
for research and development programme, has not been properly evaluated. Although in aggregate
OMR 1 million has been spent, but Kazim thinks that the criteria for the investment was not fair
and clear. The director for the research committee did not assess properly and the output of the
investment was poor. Kazim enquires Mr. Abid, the director of research committee to justify the
investment. Abid replies by saying that they will satisfy the auditors in any way.
However, the financial year end is only two months away and OMR 1 million in write-off at this
late stage in the financial year would cause Kazim and his team in difficulties. The company has
to finalize the year-end report. Kazim called the meeting of directors and discussed the issue.
During the meeting they have serious reservations on research committee. One of the directors
suggested that this amount will be considered as an asset and it will be presented on the financial
statement for this year and it would be write off in the next financial year.
a. In your opinion, what decisions will be taken by Kazim to satisfy the auditors and board of
directors of the company? How this transaction would be reflected on financial statement of Sohar
Power?
b. Abid, working on a high position in a company thinks that auditors can be satisfied in an
unethical manner. How could such an unethical behavior be a learning experience for the rest of
the employees? In your opinion, who is to be blamed for this incident in Sohar Power and why?

Case 19-7

Accounting for Contingent Payments to Employees or Selling Shareholders in a Business Combination

Company G (G), an SEC registrant, is a global financial advisory and asset management firm. Company P (P), a private company, offers advisory services for (1) mergers, acquisitions, and divestitures; (2) capital structure (including initial public offerings); (3) government advisory, including strategic, finance and capital markets related policy considerations; and (4) restructurings.

Case Facts

On September 18, 20X8, (the “Closing”), G and P executed an acquisition agreement (the “Agreement”) whereby G acquired 100 percent of the outstanding shares of P (the “Acquisition”). At the time of close, P had 10 employees that had over 200 combined years of financial and strategic advisory experience. Company P was owned as follows:

• Founder — 85 percent.

• Senior advisor — 10 percent.

• Other employees (four in total) — 5 percent.

  The purchase price was calculated using a revenue multiple that was established using market data at the midpoint and transferred in exchange for 100 percent of the outstanding shares to the Founder ÷ employees who owned 100 percent of P (collectively, the “Shareholders”) on a pro rata basis. The total purchase price comprised the following:

  • Cash = $1 million.

  • Shares = 100,000 shares in G (worth $3.3 million).

  • Delayed Consideration = 120,000 G shares, but issued to the Shareholders under the terms below (value assuming a 4-year vesting restriction = $5 million; assuming a 10-year vesting restriction = $4 million).

o Delayed consideration is held by an independent third party (Exchange Co) and on the fourth anniversary of the Closing, Exchange Co shall release the Delayed Consideration to the Shareholders, subject to the Shareholder being employed on such date.

o If a Shareholder is no longer employed on the fourth anniversary, the Delayed Consideration issued to such Shareholder will continue to be held by Exchange Co until the tenth anniversary of the Closing, at which point Exchange Co shall release the Delayed Consideration to the Shareholders.

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Case 19-7: Accounting for a Contingent Payments to Employees or
Selling Shareholders in a Business Combination Page 2

• Earnout Consideration = Up to 600,000 shares (valued at total of $20 million).

o The Earnout Consideration will be contingent upon achievement of revenue hurdles over a period beginning on September 18, 20X8, and ending on December 31, 20X2 (“Earnout Period”).

o To the extent the performance targets below are achieved, Exchange Co shall deliver the relevant Earnout Shares to the Shareholders on a pro rata basis. However, if and to the extent certain performance targets described below are not achieved, in whole or in part, no Earnout Consideration will be paid.

•  First Earnout Consideration — If revenue exceeds $10 million in the Earnout Period, the Shareholders will be entitled to 200,000 shares.

•  Second Earnout Consideration — If revenue exceeds $20 million in the Earnout Period, the Shareholders will be entitled to an additional 200,000 shares.

•  Third Earnout Consideration — If revenue exceeds $30 million in the Earnout Period, the Shareholders will be entitled to an additional 200,000 shares.

o The Shareholders are still entitled to the Earnout Consideration in the event that targets are met, but they are not employees of G at the time the Earnout Consideration is earned.

Other Key Facts

• Company P meets the definition of a business under ASC 805.

• Each employment agreement executed by G and the Shareholders contains compensation that is commensurate with the service each respective Shareholder is providing to G.

• The Shareholders have at-will employment agreements with G.

• If the Shareholders were to leave, G would be able to replace them with an existing G investment banker; therefore, the Shareholders are not integral to the future success of the acquired business.

• The fair value of P was determined to be $24 million.

• The Earnout Consideration is not being treated as compensation expense for tax purposes.

Copyright 2019 Deloitte Development LLC All Rights Reserved.

Case 19-7: Accounting for a Contingent Payments to Employees or
Selling Shareholders in a Business Combination Page 3

Required:

If there was a change to the case facts, and the Shareholders were no longer entitled to the Earnout Consideration if they were not employees of G at the time the revenue targets were met, should the Earnout Consideration to the Shareholders be accounted for as purchase consideration in exchange for the Acquisition or as compensation for postcombination services?

2. If a company uses the direct write off method of accounting for bad debts
   1. It will record bad debt expense only when an account is determined to be uncollected
   2. It will establish an estimate for the allowance for doubtful debts
   3. It will reduce the accounts receivable account at the end of the accounting period for uncollected accounts
   4. When an account is written off, total assets will stay the same.
   5. None of the above

3. Cost behaviour refers to:
   1. Manufacturing overheads
   2. Costs in a business that remain fixed when production volume increases
   3. How costs react to changes in production volume or other levels of activity
   4. Costs that stay the same per unit.
   5. Only costs that fall into the relevant range for a business.

4. What should a company do to improve its accounts receivable turnover ratio
   1. Give customers credit terms of 2/10, n/30 rather then 1/10, n/30
   2. Reduce the number of employees working in the credit department
   3. Increase its sales force
   4. Lower its selling prices
   5. None of the above

5. Which of the following effects on the accounting equation is not correct as a result of a journal entry?
   1. Decrease shareholders' equity and decrease an asset.
   2. Increase an asset and decrease an asset.
   3. Increase shareholders' equity and increase an asset.
   4. Increase an asset and decrease a liability.
   5. All of the above are not possible

6. Assume that in one accounting period liabilities increased by $8,000, assets increased by $55,000, and net profit was $29,000. The owner must therefore have:
   1. Contributed $18,000
   2. Received dividend $18,000
   3. Contributed $12,000
   4. Received dividend $12,000
   5. Cannot be calculated from the above limited information.

7. The Allowance for Bad Debts represents:
   1. Bad debt losses incurred in the current period
   2. The amount of uncollected accounts written off to date
   3. The difference between total sales made on credit and the amount collected from those credit sales
   4. The difference between the recorded value of accounts receivable and the net realisable value of accounts receivable****
   5. Fees paid to debt collection agencies

8. Two basic accounting principles determine when revenues and expenses are to be recorded under accrual basis accounting. They are:
   1. Cost and matching principles.
   2. Prudence principle.
   3. Relevance and reliability principles.
   4. Revenue recognition and matching principles.
   5. Revenue recognition and measurement principles.

9. On the last day of its financial year, Nelson Pty Ltd paid $2,150 cash for a one-year insurance policy. What is the appropriate journal entry ignoring GST, assuming the insurance policy becomes effective (starts) on the first day of the next financial year (i.e. the next day)?
   1. Unearned Insurance Revenue                 2,150

Cash 2,150

1. 2. Cash                                                     2,150

Prepaid Insurance    2,150

1. 3. Prepaid Insurance                                  2,150

Cash                                                          2,150

1. 4. Prepaid Insurance                                  2,150

Insurance Expense                                      2,150

1. 5. Cash                                                     2,150

Unearned Insurance Revenue                      2,150

10. Carin’s Corporation purchased inventory for $4,000. Due to an error in recording the journal entry for this transaction, the inventory account was debited for only $400 while accounts payable was credited for $4,000. During which phase of the accounting cycle would this error be discovered?
    1. Recording the transaction in the journal.
    2. Preparation of the financial statements.
    3. Analysis of each transaction.
    4. Preparation of the trial balance.
    5. Preparation of the consolidated analysis.

Case 5.0: Incentives in the Firm – Compensating the CEO

Let’s work through an incentive concept and problem. “Moral hazard” problems arise when someone – the “principal” – hires an agent to do something, but the agent has an incentive to do something else. For example, firm owners may want their management team to maximize profits, but maximizing profits is hard, time-consuming work that could interfere with the management team’s preference for playing golf. If top management simply receives a salary, the problem is aggravated because the managers may not be motivated to satisfy the owners, and the owners can’t easily monitor management activity to know if they’re really doing a good job. The problem is resolved in large part if the owners tie most or all of management compensation to firm profits, as income is often a pretty good motivator (although some golf nuts will still pause for a while over this one.) We can set up a scenario to explore this incentive issue further, and this problem will also help fix in our minds the difference between maximizing revenue and maximizing profit.

A small firm faces an inverse demand function of P = 100 - Q. Its total cost function is given by TC = .5Q².   (You should see right away that marginal revenue is thus MR = 100 – 2Q, and it also happens that marginal cost is just MC = Q. Both MR and MC are the first derivatives of total revenue and total cost. And a quick comment on MC: unlike some marginal cost functions we’ve seen, this one is not constant, because marginal cost is getting $1 higher with each additional unit of output.)

The Chief Executive Officer will manage the firm, choosing output and price. Currently, the CEO is negotiating an incentive-based contract with the shareholders of the company. The CEO has proposed that she get 20% of the total revenue brought in by the firm. The shareholders' representative has counter-offered that 10% of total revenue be given to the CEO. (Hint: basing compensation on revenue will motivate revenue maximization rather than profit maximization!)

1.    How much income will each plan generate for the CEO and for the shareholders, respectively? (Hint: since both plans create incentives for the CEO to maximize revenue rather than profit, you should not set MR = MC at this point. BIG hint: revenue is maximized when selling an additional unit won’t increase your revenue, or in math terms, when MR = 0.)

CEO’s proposal: she keeps 20% of TR.

Owners’ proposal: CEO keeps 10% of TR.

2.    Suppose you are asked to mediate in the negotiations. Can you propose an incentive-based compensation scheme for the CEO that both parties are likely to accept, assuming everyone would like to maximize their income?

Your proposal:

Demonstration that everyone is better off than under their own proposal and thus should accept your proposal:

3.    Now thinking even more shrewdly: what’s the maximum price you could charge for your consulting services and still leave everyone better off?