CHAPTER 3

BASIC ACCOUNTING CONCEPTS:

THE INCOME STATEMENT
Changes from Tenth Edition
The chapter has been updated. Additional topics include proforma earnings, EBITDA and SEC financial
report certification and affirmation requirements for CEOs and CFOs.
Approach
Undoubtedly, the accrual idea is the most difficult of all basic accounting matters for the student to grasp.
As a matter of fact, we sometimes say that the proper recognition of revenue and expense is the only
important accounting problem. Although this is an exaggeration, it is not far from the truth. The text and
cases in this chapter constitute only a beginning in understanding and it is to be expected that students
will understand the matter thoroughly only after they have attacked it from several different angles.
Sometimes we ask the class Suppose a company received a lawyers bill for $1,000. Explain all the
different ways in which this bill could be recorded in the accounts. The answer is that if the bill relates to
services rendered in a prior year (or accounting period) but not recorded in that time, it is nevertheless an
expense of the current year; if it represents a charge for a previous year that was recorded in that year, the
payment of the bill merely represents a decrease in a liability; if it represents a charge in the current year,
it is recorded as an expense; and if it represents a retainer for services to be rendered in the following year
it is recorded as an asset, prepaid expense.
It may be desirable to introduce a number of short questions of this type in order to hammer home the
accrual concept. It is suggested, however, that problems relating to depreciation be deferred, as this is an
intricate matter which is perhaps best left until Chapter 7.
Students should always be required to use the word revenue rather than the word income. They may
find it difficult to do this because income is still used erroneously in some published statements and in
tax forms.
Some students confuse the special meaning of consistency in accounting with the general meaning of
this term. In accounting, consistency means only that the same practice is followed this year as was
followed last year. It does not mean that, for example, the treatment of inventories is consistent with the
treatment of fixed assets.
Cases

Maynard Company (B) is a straightforward problem, although students may have some difficulty in
deducing how the amounts are to be transformed from the cash basis to the accrual basis.

Lone Pine Cafe (B) requires an income statement of the same company whose balance sheet was
prepared in Chapter 2; it is fairly straightforward.

Data Saver Inc. is the widely used case that introduces the entire accounting cycle, with some
judgmental issues.

26

Pinetree Motel provides practice in applying the accrual concept.

National Association of Accountants provides the opportunity to explore income concepts in the setting
of a nonprofit organization.
Cape Cod Novelty Shop can be used to review the basic accounting concepts and economic income
concepts such as opportunity costs and imputed costs. It has been used in the first class of the second
year Harvard Business School MBA accounting course.

Problems
Problem 3-1
Not an expense for June - not incurred.
Expense for June
Expense for June
Expense for June
Expense for June
Not an expense for June - asset acquired.
Problem 3-2
Revenues$275,000
a. Expenses

Cost of goods sold.............................................................................................................................

$164,000
Rent...................................................................................................................................................
3,300
Salaries..............................................................................................................................................
27,400
Taxes
1,375
.....................................
...........................................................................................................................................................
Other..................................................................................................................................................
50,240

Net income $28,685

27

Problem 3-3

Beginning inventory.................................................................................................................................................................
$27,000
Purchases.................................................................................................................................................................................
78,000
Available for sale.....................................................................................................................................................................
Ending inventory......................................................................................................................................................................
($31,000)
Cost of goods sold....................................................................................................................................................................
$74,000
Problem 3-4
a. (1)

Sales........................................................................................................................................................................
$85,000
Cost of goods sold...................................................................................................................................................
45,000
Gross margin...........................................................................................................................................................
$40,000

28

(2) 47 percent gross margin ($40,000 / $85,000)

(3) 11 percent profit margin (9000/85000)
The Woden Corporation had a tax rate of 40 percent ($6,000 / $15,000) on its pretax profit that
represented 17.7 percent of its sales ($15,000 / $85,000). The companys operating expenses were
82.3percent of sales ($70,000 / $85,000) and its cost of goods sold was 53 percent of sales. The
companys gross margin was 47 percent of sales ($40,000 / $85,000).
Problem 3-5
Depreciation. Each year for the next 5 years depreciation will be charged to income.
No income statement charge. Land is not depreciated.
Cost of goods sold. $3,500 charged to current years income. $3,500 charged to next years income.
Subscription expense. $36 charged to current year. $36 charged to next year. Alternatively, $72 charged
to current year on grounds $72 is immaterial.
Problem 3-6
Asset value:
October 1, 20X1
December 31, 20X1
December 31, 20X2
December 31, 20X3

$30,000
26,250
11,250
0

Expenses:
20X1 $3,750 ($1,250 x 3 months)
20X2 $15,000 ($1,250 x 12 months)
20X3 $11,250 ($1,250 x 9 months)
One months insurance charge is $1,250 ($30, 000 / 24 months)

29

Problem 3-7

QED ELECTRONICS COMPANY

Income Statement for the month of April, ----.
Sales..................................................................................................................................................
$33,400
Expenses:
Bad debts......................................................................................................................................
$ 645
Parts..............................................................................................................................................
3,700
Interest..........................................................................................................................................
880
Wages...........................................................................................................................................
10,000
Utilities.........................................................................................................................................
800
Depreciation.................................................................................................................................
2,700
Selling...........................................................................................................................................
1,900
Administrative..............................................................................................................................
4,700
______
Profit before taxes
25,325
Taxes.................................................................................................................................................
8,075
Net income........................................................................................................................................
$5,275.
Truck purchase has no income statement effect. It is an asset.
Sales are recorded as earned, not when cash is received. Bad debt provision of 5 percent related to sales
on credit ($33,400 - $20,500) must be recognized. Wages expense is recognized as incurred, not when
paid.
Marchs utility bill is an expense of March when the obligation was incurred.
Income tax provision relates to pretax income. Must be matched with related income.
Problem 3-8

First calculate sales:

Sales ($45,000 / (1 - .45)).........................................................................................................................................................
$81,818+
Beginning inventory.................................................................................................................................................................
$35,000
Purchases.................................................................................................................................................................................
$40,000
Total available..........................................................................................................................................................................
75,000
Ending inventory......................................................................................................................................................................
30,000
Cost of goods sold....................................................................................................................................................................
$45,000
Gross margin............................................................................................................................................................................
$36,818
If the gross margin percentage is 45 percent, the cost of goods sold percentage must be 55 percent.
Once sales are determined, calculate net income:
Net income ($81,818 x .1) $8,182

30

Next, prepare balance sheet:

Assets
Liabilities
Current assets
($50,000 x 1.6).........................................................................................................................................................................
$ 80,000
Current liabilities.......................................................................................
$ 50,000
Other assets
Long term debt
40,000
($218,182 - $50,000)................................................................................................................................................................
138,182
Total liabilities..........................................................................................
$ 90,000

Owners equity
Beginning balance.....................................................................................
$120,000
Plus net income.........................................................................................
8,182
Ending balance..........................................................................................
$128,182
Total liabilities
Total assets..................................................................................................................................................................
$218,182+
and owners equity....................................................................................
$218,182
+

Total assets = Total liabilities and Owners equity.

Problem 3-9
Sales LC 26,666,667 [LC 20,000,000 x (200 / 150)]
January cash LC 1,000,000 [LC 500,000 x (200 / 100)]
December cash LC 600,000
At year-end the company was more liquid in terms of nominal currency (LC 600,000 versus LC 500,000)
but in terms of the purchasing power of its cash it was worse off (LC 1,000,000 versus LC 600,000).

Cases
Case 3- 1: Maynard Company (B)
Note: This case is unchanged from the Tenth Edition.
Question 1

See below.

Question 2
This question brings out the difference between cash accounting and accrual accounting. Cash
increased by $31,677 whereas net income was $19,635. Explaining the exact difference may be too
difficult at this stage, but students should see that:
1. The bank loan, a financing transaction, increased cash by $20,865 but did not affect net income.
Cash collected on credit sales made last period ($21,798) also increased cash, but did not affect
net income this period. (The same is true of the collection of the $11,700 note receivable from
Diane Maynard, but it was offset by the payments of the $11,700 dividend to Diane Maynard, the
sole shareholder.)

31

2.

MAYNARD COMPANY
INCOME STATEMENT, JUNE
Sales ($44,420 cash sales + $26,505 credit sales)....................................................................................................................
$70,925
Less: Cost of sales *..........................................................................................................................................................
39,345
Gross Margin...........................................................................................................................................................................
31,580
Expenses
Wages($5,660+$2,202-$1,974).........................................................................................................................................
$5,888
Utilities..............................................................................................................................................................................
900
Supplies ($5,559+$1,671-$6,630)......................................................................................................................................
600
Insurance($3,150-$2,826)..................................................................................................................................................
324
Depreciation ($157,950-$156,000)+($5,928-$5,304)........................................................................................................
2,574
Miscellaneous....................................................................................................................................................................
135
10,421
Income before income tax........................................................................................................................................................
21,159
Income tax expense ($7,224 - $5,700)...............................................................................................................................
1,524
Net Income...............................................................................................................................................................................
19,635
Less: Dividends.................................................................................................................................................................
11,700
Increase in retained earnings....................................................................................................................................................
$ 7,935

*Cost of sales:
Merchandise purchased for cash........................................................................................................................................
$14,715
Merchandise purchased on credit.......................................................................................................................................
21,315
[$21,315+($8,517-$8,577)]
Inventory, June 1...............................................................................................................................................................
29,835
Total goods available during June...............................................................................................................................
65,865
Inventory, June 30
26,520
....................................................................................
...........................................................................................................................................................................................
Cost of Sales...............................................................................................................................................................
$39,345
3. The purchase of equipment ($23,400) and other assets ($408) decreased cash but did not affect
net income (at least not by this full amount) this period.
4. Credit sales made this period ($26,505) increased net income, but did not affect cash.
5. Noncash expenses such as depreciation ($2,574) and insurance ($324) decreased net income but
did not affect cash as they relate largely, if not wholly, to cash outflows made for asset
acquisition in prior periods. (Exception: such expenses on an entitys first income statement are
not related to prior period expenditures but they will be a much smaller amount than the first
accounting periods expenditures.
Question 3
(a) $14,715 is incorrect because it is the amount of cash purchases rather than the cost of sales. The
cost of cash purchases and cost of sales amounts would be equal for a period in which all
purchases were for cash, and in which the dollar amount of beginning inventory was the same as
the dollar amount of ending inventory, since Cost of Sales = Beginning Inventory + Purchases Ending Inventory.
(b) $36,030 is the sum of cash purchases ($14,715) and credit purchases ($21,315). As explained
above, purchases equal cost of sales for the period only if beginning and ending inventory
amounts are the same.

32

Case 3-2: Lone Pine Caf (B)

Note: This case is unchanged fro the Tenth Edition.
Approach
This case introduces students to preparation of an income statement based on analyzing transactions. At
this stage, students are not expected to set up accounts in the formal sense. However, in effect they do so
for those income statement items that did not coincide exactly with cash flows.
Question 1
A suggested income statement as required by Question 1 is shown below. The following notes apply
to the income statement.
1. The student needs to refer back to Lone Pine Caf (A) in order to construct the income statement
on the accrual basis. Amounts for sales on credit, purchases on credit, beginning and ending
inventory, beginning and ending prepaid operating license, and depreciation expense are to be
found there. Specifically:
a. Sales revenues = $43,480 cash sales + $870 credit sales to ski instructors = $44,350.
b. Food and beverage expense = $2,800 beginning inventory + $10,016 cash purchases + $1,583
credit purchases - $2,430 ending inventory = $11,969.
2. Since the entity is unincorporated, it is also correct (though less meaningful for evaluative
purposes) to treat the $23,150 partners salaries as owners drawings. This treatment would result
in an income of $12,296 and a decrease in equity (after drawings) of $10,854.

LONE PINE CAFE (B)

INCOME STATEMENT FOR NOVEMBER 2, 2001, THROUGH
MARCH 30, 2002
Sales...............................................................................................................................................................
$ 44,350
Expenses:
Salaries to partners....................................................................................................................................
$23,150
Part-time employee wages.........................................................................................................................
5,480
Food and beverage supplies.......................................................................................................................
l1,969
Telephone and electricity...........................................................................................................................
3,270
Rent expense.............................................................................................................................................
7,500
Depreciation
2,445
........................................................................
...................................................................................................................................................................
Operating license expense.........................................................................................................................
595
Interest.......................................................................................................................................................
540
Miscellaneous expenses.............................................................................................................................
255
Total expenses
55,204
............................................................................
.......................................................................................................................................................................
(Loss).............................................................................................................................................................
$(10,854)

33

Question 2
The income statement tells Mrs. Antoine that the partnership has suffered a $10,854 loss for the first five
months of operation. This $10,854 loss is the correct figure for evaluative purposes, not the $12,296
income before partners salaries. This assumes, of course, that nonowner salaries for the cook and table
servers would also have been $23,150, which is questionable. It would appear that Lone Pine Cafe cannot
support three partners, even at a bare level of sustenance ($23,150 was only an average of $1,543 per
partner/employee per month). Of course the three owner/employees did receive room and board, for
which no value has been imputed here.
Case 3- 3: Data Saver Inc.
Note: This classic case was updated for the Tenth Edition and otherwise remains the same for the
Eleventh Edition.
Approach
I use this case for two 80-minute sessions. On Day l, I quickly show how the balance sheet in Exhibit l
was developed and then spend the rest of the class answering Question 1. On Day 2, we develop an
income statement and (without concern for format) a cash flow statement; these are based entirely on
information from Day l in the far left (Cash) and far right (Retained Earnings) columns in the matrix
described below. I then do Question 3.
I have found it very effective in teaching this case to record the transactions on the board using a balance
sheet matrix. I put the basic equation, Assets = Liabilities + Owners Equity, at the top of the board, and
put a column heading for each balance sheet account immediately thereafter. I then record the transactions
leading up to the beginning balance sheet (Exhibit l) in rows, using parentheses if an account has
decreased. I then add the columns to get Exhibit l, then proceed to post the other transactions, again
summing the columns to get the desired ending balance sheet. With this approach, an income statement
can be prepared from the last column, Retained Earnings. This is a good way to set up the mechanics
covered in Chapter 4. At the end of Day l, I add to the Day 2 assignment preparation of a cash flow
statement, telling students not to refer to the chapter on this topic.
I give special attention to the problem of the valuation of the patent. This discussion makes the point that
the true worth of the patent does not matter; the important thing is what did the company pay for it? In
this case, the company paid stock, so the question becomes one of valuing the stock. Aspects of this
question are discussed in Note 4 under Question 2, and under Question 3. The other transactions giving
rise to the beginning balance sheet can be traced briefly.
Before class starts, I have put the beginning balance sheet on the board, as described above. We then go
through the transactions one by one, showing the effect of each on the balance sheet. I write increases and
decreases (using plus and minus signs) for each balance sheet change. I lump all the income statement
items under retained earnings so that I am working solely with the balance sheet. This procedure helps to
drive home the point that any transaction can be resolved into its effect on the balance sheet and helps lay
the groundwork for debit and credit (although I never mention, or permit students to mention, debit or
credit at this stage). After the analysis of each transaction has been concluded, I flash up Vugraphs
showing the final balance sheet and income statement. Alternatively, these can be put on the board. I try
to re-emphasize that there may legitimately be many differences in terminology and format between my
balance sheet and those that students have prepared. Also, I am never critical of students who do not
include depreciation in cost of goods sold. Not only is the product vs. period cost distinction new to them
it also happens that some manufacturing firms treat all depreciation as a period cost, even though
conceptually depreciation on plant and equipment is a product cost that should flow through inventory.

34

DATA SAVER INC.

ESTIMATED BALANCE SHEET AS OF END OF FIRST YEAR
Assets

Current assets:
Cash [11,400+336,000-106,000-650-148,000-4,000-11,000-(16,960-1,696)]
$ 62,486
Inventories...............................................................................................................................................................................
18,000
Total current assets...................................................................................................................................................................
80,486
Machinery, at cost (20,000 + 4,000).........................................................................................................................................
$24,000
Less: Accumulated depreciation..............................................................................................................................................
2,400
21,600
Patent.......................................................................................................................................................................................
56,470
Total assets
$158,556
Liabilities and Owners Equity
Taxes payable..........................................................................................................................................................................
$1,696
Capital stock
100,000
............................................................................................................
.................................................................................................................................................................................................
Retained earnings
56,860
............................................................................................................
.................................................................................................................................................................................................
Total equities............................................................................................................................................................................
$158,556

DATA SAVER INC.

ESTIMATED INCOME STATEMENT FOR FIRST YEAR OF OPERATIONS
Sales.........................................................................................................................................................................................
$336,000
Less: Cost of goods sold (per schedule below).........................................................................................................................
218,200
Gross margin............................................................................................................................................................................
117,800
Less: Selling and administrative expenses...............................................................................................................................
21,000
Operating income.....................................................................................................................................................................
96,800
Less: Other expenses:
Interest expense........................................................................................................................................................................
$ 650
Organization costs....................................................................................................................................................................
6,600
Experimental costs...................................................................................................................................................................
1,200
Amortization of patent.............................................................................................................................................................
3,530
11,980
Income before taxes.................................................................................................................................................................
84,820
Income tax expense..................................................................................................................................................................
16,960
Net income...............................................................................................................................................................................
$67,860
Comments on Questions
Question 1
(1) Cash increased $336,000
Retained earnings increased $336,000
(2) Raw materials inventory increased S106,000
Cash decreased $106,000
(3) Cash decreased $650
|Retained earnings decreased $650
(See also Note 1 below)

35

(4) Cash decreased $148,000

Retained earnings decreased $148,000 ($127,000 of this could be shown temporarily as an
increase in inventory.)
(5) Raw material inventory decreased $88,800 (the difference between $106,800 and $18,000)
Retained earnings decreased $88,800
(6) (No entry)
(7) Machinery increased $4,000
Cash decreased $4,000
(8) Experimental costs decreased $1,200
Organization costs decreased $6,600
Retained earnings decreased $7,800
(9) Machinery decreased $2,400 (at this stage, the student is not expected to handle the separate
accumulated depreciation account)
Retained earnings decreased $2,400

(10)Retained earnings decreased $11,000

Cash decreased $11,000
(11)Retained earnings decreased $3,530
Patent decreased $3,530
(See Note 4)
(12)Retained earnings decreased $16,960
Taxes payable increased $1,696
Cash decreased $15,264
Notes
1. The bank loan of $8,000 does not appear on the balance sheet since it has been paid off. It does
not appear on the income statement since it does not affect owners equity. This illustrates the
point that there may well be events occurring within the year that do not appear on the balance
sheet and income statement. Nevertheless, I encourage students to record this as three
transactions rather than just one.
2. Product costs included in cost of goods sold include only manufacturing costs, not selling and
administrative costs. This is a good opportunity to introduce the product vs. period costs
distinction. It is important at this early stage not to criticize students who immediately expensed
all production costs; they have not been formally exposed to inventory accounting, and the case
assumptions of no WIP or finished goods inventories means that all production costs incurred
(except raw material costs) will be expensed the first year.
3. The decision to charge off experimental and organizational costs in the first year is arbitrary.
Some companies would choose to write them off over a longer period of time. Probably the fact
that these costs were relatively small influenced the decision here. I point out that under todays
GAAP, capitalizing the experimental costs is questionable, since the FASB does not permit
capitalization of R&D costs.
4. The patent must be valued indirectly. Since the retired manufacturer is willing to pay par value
for the stock, in his opinion (which he backs up with his own money) the stock is worth par. We
are therefore justified in valuing the patent at the par value of the stock given for it, $60,000. It
must be recognized, however, that this is not a market valuation; it is only one persons opinion.
Presumably, however, it meets the test of an arms-length agreement. The patent should be

36

written off over its useful life. In the absence of other information, I wrote off 1/17 of its cost, or
$3,530; this is a minimum amount, since 17 years, the legal life of the patent, is its longest
possible useful life. Students should discuss, however, whether the protector is likely to remain
unique for 17 years, and hence whether the patents useful life may be much less.
5. The income taxes are an expense of the first year, even though part of the expense is not remitted
until the second year.
6. As a practical matter, the format of the statements shown here is overelaborate for the little Data
Saver Inc. The format is chosen to illustrate terminology. Practice may differ at several points.
For example, interest expense may be shown as an operating expense, or conceivably even the
write-off of intangibles may be shown as an operating expense. Accumulated depreciation is
shown separately, even though there is no logical reason for doing so based on the text material
given up to this point.
Question 3
Students tend to focus on the value of the patent. We now have evidence that the stock is worth 4/3 of par.
It seems reasonable, therefore, that the value of the patent is 4/3 of $60,000, or $80,000. The equities
section of the balance sheet would then appear as:

Capital stock, at par...................................................................................................................................................

$ 90,000
Additional paid-in capital..........................................................................................................................................
30,000
Contributed capital..............................................................................................................................................
$120,000
The asset amount for the patent would be $80,000.
However, an argument can be made that the patent should be listed at $60,000, the par value of the stock,
in which case the additional paid-in capital is only $10,000.
DATA SAVER INC.

Estimated Cost of Goods Sold

Material and supplies:

Inventory, beginning of year...............................................................................................................................
$
800
Plus: purchases.............................................................................................................................................
106,000
106,800
Less: Inventory, end of year ........................................................................................................................
18,000
Material used.............................................................................................................................................................
$ 88,800
Payroll and other cash manufacturing costs...............................................................................................................
127,000
Depreciation of machinery*......................................................................................................................................
2,400
Cost of goods sold........................................................................................................................................
$218,200
*Could be treated as a period cost although product cost treatment is preferable.
DATA SAVER INC.

Estimated Retained Earnings Reconciliation

Retained earnings at beginning of year......................................................................................................................

$
0
Add: Net income..........................................................................................................................................
67,860
Subtract: Dividends......................................................................................................................................
11,000
Retained earnings at end of year................................................................................................................................
$56,860

37

3- 4: Pinetree Motel
Note: This was updated for the Tenth Edition.
Approach
This case treats the transition from cash to accrual accounting; also, the inherent difficulties in
comparison of data with industry averages are illustrated. The case does not require a full 80 minutes of
class time, so I use the final portion of time for review.
Comments on Questions
The operating statement called for in Question I is shown below. For many termse.g., revenues,
advertising, depreciationis no difficulty in fitting Pinetrees account names with the journals standard
format; but for other items, there are problems:
1. The Kims drawings conceptually should be divided between payroll costs and
administrative/general, since the Kims apparently perform both operating and administrative
tasks.
2. Some students may treat replacement of glasses, bed linens, and towels as general expense rather
than as direct operating expense (although I feel the latter is more appropriate).
3. Some students may treat payroll taxes and insurance as a general expense; nevertheless, it
properly is part of payroll costs.
Question 2
Based on profit as a percent of sales, Pinetree Motel is only about one-third as profitable as the survey
average return on sales. The key percentage disparity is on payroll costs, which may reflect two things:
(1) the Kims tasks could be done by two employees who would work for less than $86,100 a year (which
is equivalent to saying the Kims drawings reflect both a fair salary and a distribution of entity profits); or
(2) the survey data are dominated by motels having twice as many rooms as Pinetree Motel does, thus
spreading fixed labor costs over a higher volume (e.g., a motel of 20 units and one of 40 units each needs
only one desk clerk). Of course, there is probably a lot of noise in the survey data for payroll and
administrative/general costs: owner-operators responding to the journals survey would encounter the
same problems as a student does in answering Question 1.

38

PINETREE MOTEL
OPERATING STATEMENT FOR 2001
(in industry trade journal format)

Dollars

Percentages*

Revenues:
Room rentals ($236,758- $1,660)......................................................................................................................................
$235,098
96.8
Other revenue....................................................................................................................................................................
7,703
3.2
Total Revenues............................................................................................................................................................
242,801
100.0

Operating Expenses:
Payroll costs ($86,100+$26,305+$2,894-$795-$84+$1,128+
$126).................................................................................................................................................................................
115,674
47.6
Administrative and general................................................................................................................................................

Direct operating expense ($8,800 + $1,660 + $6,820).......................................................................................................

17,280
7.1
Fees and commissions.......................................................................................................................................................

Advertising and promotion($2,335 - $600 + $996)............................................................................................................

2,731
1.1
Repairs and maintenance...................................................................................................................................................
8,980
3.7
Utilities ($12,205+$2,789+$5,611-$933-$105-$360+$840+$75+
$153).................................................................................................................................................................................
20,275
8.4
Total............................................................................................................................................................................
164,940
67.9

Fixed expenses:
Property taxes, fees ($9,870 - $1,005 + $492)...................................................................................................................
9,357
3.9
Insurance ($11,584 - $2,025 + $1,119)..............................................................................................................................
10,678
4.4
Depreciation......................................................................................................................................................................
30,280
12.5
Interest ($10,605 - $687 + $579).......................................................................................................................................
10,497
4.3
Rent...................................................................................................................................................................................

Total............................................................................................................................................................................
60,812
25.1
Profit(pretax) ...........................................................................................................................................................................
$ 17,049
7.0
*May not add exactly owing to rounding.
As a rough composition that attempts to adjust for the Kims (and probably other survey respondents)
dual roles as owners and operators, I suggest adding three accounts:

Pinetree

Average

Payroll costs.................................................................................................................................................................
47.6
22.5
Administrative/general.................................................................................................................................................

4.2
Profit
7.1
20.7
..........................................
.....................................................................................................................................................................................
Total.............................................................................................................................................................................
54.7
47.4
This tends to substantiate the hypothesis that hired employees would perform the Kims task for less than
$86,100.
Pinetrees other operating costs do not seem to be out of line compared with the survey averages. the
higher-than-average utilities may reflect a location with cold winters. Insurance and taxes are essentially

39

uncontrollable. Repairs and maintenance may be below average because the Kims personally do some of
this work, whereas other motels pay outsiders to do it.
Note that both rent and depreciation are shown in the journals survey data. This also causes comparison
problems. For Pinetree, there is no rent, but the motel buildings are depreciated, whereas for some motels
the depreciation would include only furnishings. Adding the rent and depreciation percentages may be
more meaningful than working at either one in isolation; but, of course, building depreciation is only a
very rough proxy for fair rental value.
No final conclusion on the success of their operation can be made as information on the following is
lacking:
Capital (re: the average)
Location
Pricing

Occupancy rate
Seasonality (re: Florida annual season vs. New England)
Efficiency in using their own time

Check on income calculation:

Receipts in 2001.............................................................................................................................................................
$244,461
Less: 2000 revenue collected...................................................................................................................................
1,660
Revenues in 2001...........................................................................................................................................................
$242,801
Checks written in 2001...................................................................................................................................................
196,558
Plus: 2001 expenses not paid..........................................................................................................................................
5,508
Depreciation......................................................................................................................................................
30,280
232,346
Less: 2000 expenses paid.........................................................................................................................................
6,594
Expenses in 2001...........................................................................................................................................................
225,752
Profit..............................................................................................................................................................................
$ 17,049
Case 3- 5: National Association of Accountants
Note: This case has been updated since the Tenth Edition.
Approach
This case describes a typical problem in the management of membership associations and of many other
nonprofit organizations. Each year a new governing board is elected and becomes responsible for the
operations of the organization for that year. As a general rule, the governing board should so conduct
affairs that the organization breaks even financially. If it operates at a deficit, it is eating into resources
intended for future members, as suggested in the case. If it operates at a surplus, it is not providing the
members with as much services as they are entitled to.
Thus, the difference between the concept of income described in the text for business organization and the
income concept appropriate for a nonprofit membership organization is that a business organization
should earn satisfactory net income, while the membership organization should break even. The
measurement of revenues and expenses follows the same principles in both types of organizations (at least
with respect to the transactions given in this case.)
The case is based, loosely, on experiences of the American Accounting Association, and instructors may
wish to refer to the AAA financial statements. The case relates to the general fund, which is the portion
of the financial statements that reports normal operations. The other columns in these statements can be
disregarded. (The NAA is no longer in existence.)

40

In the interest of simplicity, students are not given balance sheets. The case can be made more
complicated by assuming a beginning balance sheet, perhaps showing only cash and equity of $55,000
each. Students can then be asked to set up assets and liabilities that result from the transactions described
in the case.
Answers to Question
Various correct answers are possible. One set is given in Exhibit A and discussed below.
1. The grant relates to services to be performed in 2002, so it should not be counted as 2001
revenue. However, the $2,700 already spent must be matched against the grant in some way. This
can be done either by subtracting it from 2001 expenses and setting it up as a prepaid asset or,
more simply, by transferring $51,300 of the grant to 2002 revenue. The effect on the bottom line
is the same. The fact that the president obtained the grant is irrelevant. The principle is to
recognize the revenue in the period in which the services are performed. The legal question is
probably also irrelevant; the intention was to perform the services in 2002, and that probably
would be the governing factor. This is a debatable point, however, because it gives no credit to
the 2001 president for the fine work he or she has done in obtaining the grant.
2. The desktop publishing system is not an expense of 2001. It will be an expense of future years
and is therefore an asset on December 31, 2001. Because it was acquired so near the end of the
year, there is no need to deal with depreciation. The question can be asked about depreciation in
future years, and this raises the question of estimating the future life. Desktop publishing systems
are a hot item. They are likely to improve in performance and decrease in price fairly rapidly.
The useful life is therefore probably not more than five years. Note that although this is not an
expense of 2001, and the 2001 board has created a depreciation cost that will affect the surplus of
future boards.
3. The $32,400 of 2002 membership dues probably is not revenue of 2001. Members will receive
services in 2002 for the 2002dues. (It can be argued that early receipt of these dues avoids the
necessity of incurring expense for dues notices and follow-ups that would otherwise be needed in
2002. However, there is no feasible way of measuring this.) The fact that these members will
receive a free book is probably irrelevant. The cost of the book is a 2002 expense, and when the
associated revenue from dues is moved to 2002 they match the expense.
4. The membership directory is a real tough one. The services for the 3,000 copies were provided in
2001, but charging this as a cost in 2001, seems unfair to the 2001 board (and to boards of each
year when a new directory is published.) It can be argued that members refer to the directory for
two years, and hence the cost should be spread over both years. The 1,000 extra copies is
probably an expense of 2002, but this assumes that they will in fact be used in 2002 and are not
simply extras that eventually will be discarded. (The proportion of 1,000 extra copies to the
membership seems large.) Exhibit A takes the easy way out and assigns one-half the cost to each
year, but other solutions are equally defensible.
5. The conversion of subscription revenue from a cash basis to an accrual basis is straightforward.
The revenue in 2001 should be decreased by $2,700.
6. If the Association is likely to be reimbursed for the $10,800, it is not an expense of 2001. The
likelihood is that there will be a profit, but at this stage, one cant be sure, even though there was
a profit in 2000. It seems unlikely in any event that there would be a profit that wiped out the
whole deficit. Exhibit A removes the whole $10,800 as an expense; it becomes an account
receivable from the Annual Meeting Committee. Students who argue strongly for conservatism

41

might leave it as an expense. This transaction shows how difficult it is to arrive at the true
results, as is also the case with some of the others. The 2001 annual meeting profit, not now
known, is conceptually a revenue of 2001. (But read on.)
7. The $3,400 annual meeting profit is revenue for 2000, conceptually. However, there seems to be
no feasible way of recording this revenue in the year of the annual meeting because of the
problem of paying outstanding bills for some months after the annual meeting has taken place. It
therefore can be argued that it is appropriately left in 2001, which is done in Exhibit A. This
practice can be justified on the grounds of materiality. If eliminated from 2001, some
corresponding adjustment for an estimated profit on the 2001 annual meeting should be made.
With the adjustments made above, the 2001 results has been changed from a surplus to a deficit.
It is easy to visualize how discussions of this type can become quite heated. They can be avoided
in the future by preparing an accounting manual that describes how each of these transactions
should be handled. This illustrates the importance of the consistency concept.
Question 2
The Administrations policy says there should be a dues increase. If there were some unusual
expenses in 2001, the deficit might be tolerated, but we have no indication that there are unusual
expenses. The association had to take special steps to obtain the cash needed for the desktop
publishing system, which means there was no cash surplus to draw on. Once a deficit like this occurs,
the prudent course of action is to increase the dues.
Exhibit A
NATIONAL ASSOCIATION OF ACCOUNTANTS
ADJUSTED INCOME STATEMENT, 1995

Revenues:
As Reported
Adjustments
Adjusted
Membership dues...............................................................................................................................................................
$287,500
$-32,400
$255,100
Journal subscriptions.........................................................................................................................................................
31,000
-2,700
28,300
Publication sales................................................................................................................................................................
11,900
11,900
Foundation grant................................................................................................................................................................
54,000
-51,300
2,700
Annual meeting prof1t, 1991.............................................................................................................................................
3,400
________
3,400
Total revenue...............................................................................................................................................................
387,800
-86,400
301,400

Expenses:
Printing..............................................................................................................................................................................
92,400
-11,600
80,800
Committee meeting expenses............................................................................................................................................
49,200
49,200
Annual meeting advance....................................................................................................................................................
10,800
-10,800
0
Desktop publishing system................................................................................................................................................
27,000
-27,000
0
Administrative salaries and expenses.......................................................................................................................................
171,500
171,500
Miscellaneous..........................................................................................................................................................................
25.000
________
25,000
Total expenses.............................................................................................................................................................
375,900
$-49,400
326,500
Surplus or (deficit)...................................................................................................................................................................
$ 11,900
$-37,000
$(25,100)

42

Case 3-6: Cape Cod Novelty Shop*

Note: This is a new case for the Eleventh Edition.
This case focuses on the entity on which a report is to be made. Several separable entities can proprietor
or business owner. The profit shown in Exhibit 1 in the case is the result of this combined business
activity of all three entities, Exhibit 2 in the case presents the same statement restated on the basis that the
business operation is separable from the other entities and that the costs attributable to the business entity
are those which would be incurred if capital and labor was obtained from third parties (imputed costs).
The following questions should be addressed in the case discussion:
1. Did Mr. Stone make a profit? How much?
2. What is profit?
3. What is the objective of the Research Division?
4. Should Mr. Stone remain in the novelty business?
5. How useful is data prepared by accounting conventions? For management? Stockholders?
Potential purchasers of equity? Creditors?
1. Is Mr. Stones business profitable?
It is necessary to consider at this point both Mr. Stones own statement of profitability and that provided
by the Research Division. The Research Division has imputed opportunity costs. These are the
revenues which Mr. Stone has foregone by using his resource in his own business rather than renting his
real estate to an independent party, investing his available funds at 6% interest and working as the
manager of a firm not owned by him.
The following Exhibit TN1 shows the reconciliation of these two statements.

Copyright 1997 by the President and Fellows of Harvard College, Harvard Business School Teaching Note 5196-042.

43

Mr. Stones Revenues from

Store
Net profit as reported
Rent

Salary

Investment

Management

$10,627.98
(3,900.00)

$3,900.00

2,616.30

(2,616.30)

(10,400.00)

$10,400.00

1,125.30

(1,125.30)

Tax paid
Interest

Real Estate

(5,920.68)

___________

$5,920.68

____________

$5,851.10

$1,283.70

$5,920.68

$9,274.70

2. What is the objective of the Research Division?

The Research Division has translated Mr. Stones business results from the accounts of a proprietorship
into a set of accounts which would be comparable with those of all novelty stores, whether owned by one
person or by a corporation. Mr. Stones profit from Cape Cods operations investment in the business.
However, it should be noted that the imputation of interest on capital invested in the business is not a part
of generally accepted accounting principles. Therefore, it would be necessary for the Research Division
to also impute interest on capital invested in other businesses to keep the results comparable with that of
the Cape Cod Novelty Shop.
3. Should Mr. Stone remain tin the novelty business?
The discussion here should revolve around the various concepts of earnings which can be obtained from
the statements and their relevance to Stones continuing in business.
Mr. Stone himself appears to be using a tax concept of earnings except that he had deducted his
personal income tax payment form the net income of Cape Cod. Under the tax concept of being included.
All the income form the business after payment of expenses is proprietors taxable income (or earnings).
Under this concept of earnings, the net income on which Mr. Stone would be taxed would be.
$10,627.98
+1,125.30
$11,753.28

Income as reported
Tax added back
Taxable income

In this particular case, taxable income and the accounting earnings would be essentially the same. It
should be pointed out, however, that this is not always the case.
Mr. Stones $4,500 withdrawal appears to be adequate cash for his purposes. It is probably the measure
of his success that Mr. Stone would look to when deciding if he should remain in the novelty business.

44

An economic concept of profit would consider the total profits earned by all the activities as compared
with what might be earned, (opportunity cost). Mr. Stone is worse off through his efforts as an owner
manager than he would be as an investor, landlord, and manager for another employer.
It is then possible to discuss psychic income. Is it worth it for Mr. Stone to be his own boss? It would
appear that he might find that a $5,851.10 loss was a small price for his independence.
Question 1
In an accounting sense Stone made a profit. He did not from the point of view of economics. The
statements in Exhibit 1 of the teaching note reflect the accounting profit. Exhibit 2 of the teaching
note shows an economic profit. Businesspeople cannot afford to ignore opportunity costs, but
accounting conventions do not permit the inclusion of these items in accounting statements. The
Research Division was not bound by these conventions. Students should be asked to identify which
conventions the Research Division ignored.
Question 2
Success in business is measured by more than accounting statements. The freedom, independence, and
other psychic income items accruing to Stone must all be considered in any evaluation of his success.
Question 3
If Stone could have used his capital and time as the Research Division assumed, he might have made
more money by selling his business. However, the intangibles that neither the economic or accounting
statements measured may be more important to Stone.
Question 4
Perhaps one advantage of the Research Division statements was that they forced Stone to look at the
economic cost of his seeking freedom, etc. The accounting statements did not raise this issue. This is a
real limitation of accounting conventions.
If time permits, the discussion may be continued into such subsidiary issues as:
1. Was the Research Division correct in using book values to compute the interest charge? Should
they have used market values? Market values more closely reflect the funds tied up in the
business.
2. Would Stone be better off as a corporation? Would this make any difference to his statements? It
may help Stone to sort out his business and personal affairs better. Depending on how he set up
his employment and real estate relationship with the corporation, the transactions recorded might
be different.

45