Net Sales $1,200,000. Cost of goods sold 720,000

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1 I. Income Statement (20 Points) A. Multiple Step Income Statement (15 Points) Selected financial information for Mavericks Inc, appears below. Fill in all the blank spaces including blank subtotal names, i.e., if cost of goods sold was omitted, you would need to fill in that blank space in the first column. Please show all your work; use ( ) around numbers to be subtracted. Net Sales $1,200,000 Beginning inventory 160,000 Purchases 670,000 Purchase returns & allowances 72,000 Net purchases Freight in Cost of goods purchased 660,000 Cost of goods available for sale Ending inventory Cost of goods sold 720, ,000 1

2 B. Income Statement Classifications (5 points) Classify each of the following accounts as of (1) selling expenses, (2) administrative & general expenses, (3) other revenue, or (4) other expenses. 1. Sales salaries 2. Interest expense 3. Gain on sale of store equipment 4. Depreciation expense, office equipment 5. Freight out CLASSIFICATION 2

3 II. Inventory Valuation & Interpretation (36 points) A. Walker & Nowitzki Sneakers Inc. reported the following transactions in their inventory account for the calendar year ending December 31, The company uses the periodic inventory method. Units Cost Beginning inventory 1/01/02 1, $ 12,000 Purchases: 4/30/02 2, ,000 7/17/02 2, ,000 12/29/02 1, ,000 Cost of goods available for sale 7,000 units $154,000 Ending inventory 12/31/02 1,500 units Part A: Inventory Methods (18 points) Calculate Cost of Goods Sold in dollar amounts for each of the methods listed below: SHOW all your work in the space, below the answers. No credit will be given for amounts not supported by calculations. FIFO LIFO AVE. COST Cost of Goods Sold $ $ $. 3

4 Effects of LIFO and FIFO on Financial Analysis (9 Points) During periods of rising prices for inventory items (inflation) and assuming inventory growth, what effect does the use of LIFO rather than FIFO have on the current ratio of a company? Explain. What will be the effects on a company s reported gross profit ratio and cash flow, higher or lower, if the company uses LIFO than FIFO? You must explain why each item ( gross profit ratio and cash flow) will be higher or lower to receive any credit. Current ratio: Gross profit ratio: Cash flow Part C : Inventory Errors (9 Points) Jamison Corporation reported Net Income of $110,000 for calendar year 2002; however, ending inventory was understated by $6,000. What was the effect of the understatement of 2002 ending inventory on each of the items, below. Indicate the effect by writing either overstated, overstated or no effect, you do not need to write in dollar amounts. Cost of goods sold Net income Net income 2002 Effect 2003 Effect 4

5 III. Receivables (18 Points) A. Valuation of Accounts Receivable (12 Points) The ledger of Navarjo Corporation shows the following balances, before adjustments for bad debt expense on December 31, Navarjo reports on a calendar year basis. Accounts receivable $ 160,000 Credit sales $ 920,000 Allowance for doubtful accounts 1,300 Credit (CR) The company CEO wants to know the effect of using the percentage accounts receivable or percentage sales method to estimate bad debt expense for She asks you to prepare a schedule using the following estimates: Show all your work. 5 % of accounts receivable 1% of credit sales 1. If the company used the percentage of accounts receivable method, then bad debt expense calendar year 2002 would be: 2002 Bad debt expense: 2. If the company uses the percentage of credit sales method, then bad debt expense for 2002 would be: 2002 Bad debt expense: 5

6 B. Interpretation (6 points) The CEO wants to know why the two methods produce significantly different amounts for bad debt expense for Explain to her why the two methods should be expected to produce different numbers, i.e., what is the main objective when a company uses percentage sales, what is the main objective when a company uses percentage accounts receivable? Percentage Sales Method: Percentage Accounts Receivable Method: 6

7 IV. Multiple Choice (16 Points) 1 Which of the following gives you the best estimate of bad debt expense for income statement purposes, i.e., the income statement method. A Last in, first out B. First in, first out C. Percentage of credit sales method D. Direct write off of accounts receivable E. Percentage of accounts receivable 2. Nash Inc. sold merchandise to Dent Company on account for $220,000. Since Dent Company was new to the area, Nash Inc. insisted that Dent s CEO sign a promissory note and offered Dent the following terms. Term of Total Note Principal Interest on Note 60 days $210,000 2,800 What is the interest rate on this note? A 8% B. 9% C. 10% D. 11% E. None of the above 3. Celtics Sporting Goods reported the following components of income in its 2001 annual report. Cost of Goods Sold $ 83,500 Gross Profit $87,500 Operating Expenses $60,000 Net Income $10, Which of the following amounts are consistent with the above data? 2001 Sales 2001 Income Taxes A. $ 147,500 $ 17,500 B. $ 171,000 $ 27,500 C $ 171,000 $ 17,500 D. $ 147,500 $ 27,500 E. None of the above 7

8 4. The ledger of Navarjo Corporation, a calendar year reporting company, shows the following balances in its accounts, before adjustment for 2002 bad debt expense. Balances before adjustments at year end Accounts receivable $ 210,000 Credit sales $ 1, 200,000 Allowance for doubtful accounts 1,400 Debit (DR) Estimate for bad debt expense: 2% of credit sales Navarjo Company uses the percentage of sale method to estimate bad debt expense at the end of Which of the following amounts would the company report as the ending balance in allowance for doubtful accounts after adjusting for bad debt expense for the 2002 reporting period? A. $ 24,800 B. $ 25,400 C. $ 22,600 D. $24,000 E. None of the above 8

9 V. Essay Ethical Dilemmas (10 points) Nelson Communications Corporation uses LIFO to value its inventory; this year the CFO points out that the company will report an unusually large increase in net income for the current year. He notes that the company will be taxed at a 35% marginal tax rate this year, but that income taxes are scheduled to go down to 30% next year. He also is worried that the company will not be able to sustain the 10% return on assets rate, it will report this year. Therefore, he tells the chief accountant to recommend to the purchasing department they purchase a large amount of inventory to be delivered at year end. The CFO estimates that since prices of inventory have risen 40% during the year, the recommended year end inventory purchase will reduce income before taxes by about 15%. He also instructs the chief accountant to increase the estimate for bad debt expense for the year from 4% of accounts receivable to 10% of accounts receivable to further reduce income. A. Do the CFO s requests pose an ethical dilemma for the chief accountant. Explain how you reach your conclusions? Comment separately on each of the CFO s requests. Inventory Purchase Change in bad debt estimate B. Current investors are one stakeholder group that would be affected by the CFO s request to reduce income by overestimating bad debt expense. Discuss how current investors might be impacted by use of this procedure to understate income. 9

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11 EXTRA CREDIT Current ratio conversion (5 Points) Rustle Corporate, a leading manufacturer of recreational vehicles, reported the following in Note #1 of its annual report for the fiscal year ending October 31, Inventories: Inventories are stated at lower of cost or market. The cost of inventories ($72,380,000 and $66,289,000 at October 31, 2003 and October 31, 2002, respectively) has been determined by the last-in, first-out (LIFO) method. The excess of the current cost over LIFO cost of inventories approximates $16,730,000 and $ 14,280,000 at October 31, 2003 and October 31, The company also reported the following information for fiscal 2003: Current assets $ 112,380,000 Total assets $ 486,000,000 Current liabilities $ 82,000,000 Total liabilities $ 212,000,000 Total liabilities & equity $ 486,000,000 Net income $ 44,000,000 Calculate the current ratio for Rustle Corporation using LIFO, than recalculate the ratio, after adjusting to FIFO. You must show how you calculated the LIFO current ratio and the adjusted current ratio to receive any credit. Current ratio LIFO Adjusted to FIFO 11