Question

Zachary Manufacturing Company (CMC) was started when it acquired $91,000 by issuing common stock. During the first year of operations, the company incurred specifically identifiable product costs (materials, labor, and overhead) amounting to $50,400. CMC also incurred $67,200 of engineering design and planning costs. There was a debate regarding how the design and planning costs should be classified. Advocates of Option 1 believe that the costs should be classified as general, selling, and administrative costs. Advocates of Option 2 believe it is more appropriate to classify the design and planning costs as product costs. During the year, CMC made 4,200 units of product and sold 3,500 units at a price of $35.00 each. All transactions were cash transactions. Required a-1. Prepare an income statement and balance sheet under option 1. a-2. Prepare an income statement and balance sheet under option 2. b. Identify the option that results in financial statements that are more likely to leave a favorable impression on investors and creditors. c. Assume that CMC provides an incentive bonus to the company president equal to 14 percent of net income. Compute the amount of the bonus under each of the two options. Identify the option that provides the president with the higher bonus. d. Assume a 30 percent income tax rate. Determine the amount of income tax expense under each of the two options. Identify the option that minimizes the amount of the company's income tax expense.

Answer 1

a-1.			Income statement
						$
	Sales revenue				(3500*35)	122500
	Less: Cost of goods sold				(Note:1)	42000
	Gross margin					80500
	Less: General,selling and administrative cost					67200
	Net income					13300
	Note:1
	Product cost=Materials,labor and overhead=$ 50400
	Cost per unit=Total product cost/Number of units produced=50400/4200=$ 12
	Cost of goods sold=Units sold*Cost per unit=3500*12=$ 42000
			Balance sheet
						$
		Assets
	Cash		(122500+91000-50400-67200)			95900
	Inventory				(Note:2)	8400
	Total assets					104300
		Stockholder's equity
	Common stock					91000
	Retained earnings					13300
	Total stockholder's equity					104300
	Note:2
	Inventory=Units in inventory*Cost per unit
	Units in inventory=Units produced-Units sold=4200-3500=700 units
	Inventory=700*12=$ 8400
a-2.			Income statement
						$
	Sales revenue				(3500*35)	122500
	Less: Cost of goods sold				(Note:1)	98000
	Gross margin					24500
	Less: General,selling and administrative cost					0
	Net income					24500
	Note:1
	Product cost=Materials,labor and overhead+Design ad planning cost=50400+67200=$ 117600
	Cost per unit=Total product cost/Number of units produced=117600/4200=$ 28
	Cost of goods sold=Units sold*Cost per unit=3500*28=$ 98000
			Balance sheet
						$
		Assets
	Cash		(122500+91000-50400-67200)			95900
	Inventory				(Note:2)	19600
	Total assets					115500
		Stockholder's equity
	Common stock					91000
	Retained earnings					24500
	Total stockholder's equity					115500
	Note:2
	Inventory=Units in inventory*Cost per unit
	Units in inventory=Units produced-Units sold=4200-3500=700 units
	Inventory=700*28=$ 19600
b.	Option 2 is the most favorable financial statement since it provides more net income than option 1
c.	Incentive bonus=Net income*14%
	Option 1:
	Incentive bonus=13300*14%=$ 1862
	Option 2:
	Incentive bonus=24500*14%=$ 3430
	Option 2 gives the higher bonus
d.	Income tax expense=Net income*30%
	Option 1:
	Income tax expense=13300*30%=$ 3990
	Option 2:
	Income tax expense=24500*30%=$ 7350
	Option 1 minimizes the income tax expense