Question & Answer

Ethical Decision making – inappropriate allocation of underapplied overhead82 The Australian government has contracted with alternative energy industry organisations to develop new energy technologies. These contracts are sometimes based on cost. Because these organisations are also developing technologies for non-government entities, incentives exist to shift overhead costs to the government, so that commercial operations become more competitive. Because cost allocations are private information, research provides only indirect evidence that this cost shifting occurs. The following vignette is fictional, but it illustrates potential ethical problems that arise when governments use cost-based contracts for product development.   Deep Water Hydro is an hydro-electricity energy company that focuses on innovative research and development solutions for alternative energy supply for both commercial and government agencies. Because one of its commercial contracts fell through last year, the company had fewer jobs than anticipated. Consequently, the company’s overhead costs were underapplied at the end of the year, so an adjustment was made to increase cost of goods sold (also called cost of sales).   Deep Water’s policy is to allocate production overhead as a percentage of direct labour costs for each contract. One of the government contracts completed last year was to develop a hydroelectricity generator that would supply energy from sea water entering Port Philip Bay in Melbourne. The job contract was based on cost-plus-fixed-fee for a total cost of $245 million. The hydro-electricity project was Deep Water’s only government contract last year. Commercial business completed was $105 million, so cost of goods sold (COGS) totalled $350 million.   Disagreement about underapplied overhead adjustment The government official in charge of the contract complained to the federal contract auditor that Deep Water’s underapplied overhead should not have been closed to COGS. Instead, he argued that it should have been allocated on a pro rata basis among the contracts in progress, finished goods, and COGS. The auditor asked to see the cost accounting records and financial statements for the period. Following is an analysis of the direct costs and cost allocations (in millions):   The $350 million in COGS included $245 million for the government contract. When the underapplied overhead ($100 million) was closed to COGS, the government portion of underapplied overhead was $70 million [$100 ´ ($245 ¸ $350)]. Because the contract specified that the government would pay costs plus a fixed amount, the overhead adjustment effectively increased the revenue under the contract by $70 million.   Actual direct labour costs were $150 million, and the pre-adjustment allocated overhead was $300 million. Therefore, the original allocation rate was 200 per cent ($300 ¸ $150) of direct labour cost. Total actual overhead turned out to be $400 million (the $300 million plus the $100 million underapplied). If Deep Water accountants could have perfectly estimated overhead at $400 million and direct labour cost at $150 million, they would have used 267 per cent ($400 ¸ $150) as the allocation rate.   The underapplied overhead amount was material ($100 million out of $400 million, or 25 per cent). Therefore, the government auditor decided that it should have been allocated on a pro rata basis among the three accounts that reflected work done this period: contracts in progress, finished goods, and cost of goods sold. Had this method been used, the adjustment would have been prorated as follows: The government's share of the COGS adjustment would be ($245 ¸ $350) ´ $29.4 million = $20.6 million. When the auditor compared this to the original adjustment of $70 million, she knew the government had been overcharged.   Alternative methods for allocating overapplied or underapplied overhead The auditor offered Deep Water three alternatives for allocating the overhead adjustment. Under governmental contracts, underapplied overhead could be allocated based on direct materials cost, direct labour cost, or total direct costs. If Deep Water uses direct materials, COGS is increased by $25 million, of which the government portion is $17.5 million. If direct labour cost is used, COGS is increased by $33.3 million, of which the government portion is $23.3 million. If total direct cost is used, COGS is increased by $27.3 million, of which the government portion is $20.1 million.   The government and Deep Water must now negotiate to determine the most appropriate proration method.   Required (a)     Is allocating proportionately more cost to government contracts an ethical problem for Deep Water? Why? (b)     When the government pays more than commercial customers pay for work done, does this situation pose a business problem, a social problem or both? Explain. (c)     Discuss the preferences of various stakeholders for this problem, including: ·                     Deep Water managers ·                     Deep Water shareholders ·                     Deep Water commercial customers ·                     Deep Water governmental customers ·                     Deep Water competitors ·                     Australian taxpayers (d)     Is it fair for the government to pay more for products and services than commercial customers pay? Is it fair for taxes to subsidise the overhead costs for a private business? (e)     How can an organisation monitor whether its accounting practices are ethical?             (LO2, 3 and 4)

Roquan, a single taxpayer, is an attorney and practices as a sole proprietor. This year, Roquan had net business income of $90,000 from his law practice (net of the associated for AGI self-employment tax deduction). Assume that Roquan pays $40,000 wages to his employees, has $10,000 of property (unadjusted basis of equipment he purchased last year), and has no capital gains or qualified dividends. His taxable income before the deduction for qualified business income is $100,000. a. Calculate Roquan’s deduction for qualified business income. b. Assume the same facts provided above, except Roquan’s taxable income before the deduction for qualified business income is $300,000.

The current assets and current liabilities sections of the balance sheet of Allessandro Scarlatti Company appear as follows.   The following errors in the corporation’s accounting have been discovered: 1. January 2015 cash disbursements entered as of December 2014 included payments of accounts payable in the amount of $39,000, on which a cash discount of 2% was taken. 2. The inventory included $27,000 of merchandise that had been received at December 31 but for which no purchase invoices had been received or entered. Of this amount, $12,000 had been received on consignment; the remainder was purchased f.o.b. destination, terms 2/10, n/30. 3. Sales for the first four days in January 2015 in the amount of $30,000 were entered in the sales journal as of December 31, 2014. Of these, $21,500 were sales on account and the remainder were cash sales. 4. Cash, not including cash sales, collected in January 2015 and entered as of December 31, 2014, totaled $35,324. Of this amount, $23,324 was received on account after cash discounts of 2% had been deducted; the remainder represented the proceeds of a bank loan. Instructions (a) Restate the current assets and current liabilities sections of the balance sheet in accordance with good accounting practice. (Assume that both accounts receivable and accounts payable are recorded gross.) (b) State the net effect of your adjustments on Allessandro Scarlatti Company’s retained earnings balance.

Choose two industries that you believe are very different. Identify factors used in those industries that in the short run are (i) fixed; (ii) variable.

Would it be possible for a country with a comparative disadvantage in a given product at pre-trade levels of output to obtain a comparative advantage in it by specialising in its production and exporting it?

Contrast the constructive receipt doctrine with the claim of right doctrine.

What are the mechanics whereby the central bank raises the rate of interest?

Rolanda Marshall Company, organized in 2013, has set up a single account for all intangible assets. The following summary discloses the debit entries that have been recorded during 2014. 1/2/14 Purchased patent (8-year life) $ 350,000 4/1/14 Purchase goodwill (indefi nite life) 360,000 7/1/14 Purchased franchise with 10-year life; expiration date 7/1/24 450,000 8/1/14 Payment of copyright (5-year life) 156,000 9/1/14 Research and development costs 215,000 $1,531,000 Instructions Prepare the necessary entries to clear the Intangible Assets account and to set up separate accounts for distinct types of intangibles. Make the entries as of December 31, 2014, recording any necessary amortization and reflecting all balances accurately as of that date. (Use straight-line amortization.)

Distinguish between a determinable current liability and a contingent liability. Give two examples of each type.

Compare and contrast the types of businesses that would and would not benefit from the §179 expense.

Hawkeye sold farming equipment for $55,000. It bought the equipment four years ago for $75,000, and it has since claimed a total of $42,000 in depreciation deductions against the asset. Explain how to calculate Hawkeye’s adjusted basis in the farming equipment.

Tiny and Tim each owns half of the 100 outstanding shares of Flower Corporation. This year, Flower reported taxable income of $10,000.  In addition, Flower received $20,000 of life insurance proceeds due to the death of an employee (Flower paid $900 in life insurance premiums this year). Flower had $5,000 of accumulated E&P at the beginning of the year.

Flexible budget Helium Industries manufactures glitter balloons used as party accessories. The balloons are bagged in packages of 100 and sold for $20 per pack. The company incurs fixed manufacturing overhead of $25 000 per year and the fixed overhead is applied based on packs produced. Standard costs are: material $8 per unit, direct labour $5 per unit and variable overhead $3 per unit. The marketing manager believes sales for the coming year will be somewhere between 10 000 and 15 000 packs.   Required (a) Prepare a flexible budget for sales of 10 000, 12 000 and 15 000. (Allocate fixed overhead based on the sales volume.) (b) What advantages are there for Helium Industries in using a flexible budget?

Locate the IRS Web site at www.irs.gov/ .  For every $100 the IRS collected, how much was spent on the IRS collection efforts?  What tax system criterion does this information help you to evaluate with respect to the current U.S. tax system?

In what sense is the at-risk loss limitation rule more restrictive than the tax-basis loss limitation rule?

Linda Day George Company had bonds outstanding with a maturity value of $300,000. On April 30, 2014, when these bonds had an unamortized discount of $10,000, they were called in at 104. To pay for these bonds, George had issued other bonds a month earlier bearing a lower interest rate. The newly issued bonds had a life of 10 years. The new bonds were issued at 103 (face value $300,000). Issue costs related to the new bonds were $3,000. Instructions Ignoring interest, compute the gain or loss and record this refunding transaction.

1.       : Most companies have policies that regulate employees’ personal use of work computers during work hours. Some even monitor employee e-mails and track the Web sites that have been visited. Do you consider this type of surveillance to be an invasion of privacy? What are some advantages and disadvantages of restricting employee use of the Internet and e-mail at work?

In the extractive industries, businesses may pay dividends in excess of net income. What is the maximum permissible? How can this practice be justified?

Neville Enterprises has a number of fully depreciated assets that are still being used in the main operations of the business. Because the assets are fully depreciated, the president of the company decides not to show them on the balance sheet or disclose this information in the notes. Evaluate this procedure.

As discussed in Chapter 1, the International Accounting Standards Board (IASB) develops accounting standards for many international companies. The IASB also has developed a conceptual frameworkto help guide the setting of accounting standards. While the FASB and IASB have issued converged concepts statements on the objective and qualitative characteristics, other parts of their frameworks differ. Instructions Briefly discuss the similarities and differences between the FASB and IASB conceptual frameworks as  related to elements and their definitions.

a.       Because Nikki’s 28.57% discount ($14,000 – $10,000/$14,000) is less than Shine Company’s gross profit percentage, the bargain purchase from her employer does not result in taxable income. b.     Nikki will recognize $25 of taxable income from the discounted services provided by Shine Company.  Discounts more than 20% for services are taxable. Thus, Nikki’s taxable discount is $25 ($125 Discount received – (20% x $500)=$25).

Assessing a remuneration plan Hailey’s Hair Products has two criteria upon which its reward system is based: (1) rewarding executives for performance and (2) adding to shareholder value. At present, the remuneration package for executives consists of a base salary, annual bonus and stock options. The base salary is considered critical to attract the ‘best’ people to positions with the bonus and stock options encouraging performance that leads to increases in the share price.   Base salaries are set at competitive levels to attract and retain the ‘best’ people. The bonus is payable if executives meet the annual performance targets set by the board at the beginning of the year. The stock options are not able to be exercised until five years after being granted. A recent initiative has meant that executives are able to substitute the bonus payment for stock options (but still with the five year restriction). The board’s remuneration committee is made up entirely of independent directors and makes use of outside advisors to ensure that recommendations are fair to all shareholders.   Required Evaluate the remuneration plan for executives. (LO2, 3 and 4)

At the end of the current year, Pociek Co. has prior service cost of $9,150,000. Where should the prior service cost be reported on the balance sheet?

In January of year 0, Justin paid $4,800 for an insurance policy that covers his business property for accidents and casualties. Justin is a calendar-year taxpayer who uses the cash method of accounting. What amount of the insurance premium may Justin deduct in year 0 in each of the following alternative scenarios?

How does the tax treatment of a partial liquidation differ from a stock redemption?