Question

You have been asked to prepare the financial statements for Neema Corp. a private Canadian corporation, for the year ended December 31, 20X4. The company began operations in early 20X4. The following information is available about its business activities during the year.

a. On 2 January, Neema issued no par common shares for $300,000

b. On 3 January, machinery was purchased for $255,000 cash. It was estimated to have a useful life of 10 years and a residual value of $40,000. Management is considering using either the straight-line amortization method or the declining-balance method of twice the straight-line rate.

c. On 4 January, Neema purchased 20% ownership in a long term investment. ABC Co. for $45,000. During the year, ABC paid dividends of $1,750 and earned net income of $8,000. Neema can use either the cost method or the equity method of accounting for its investment in ABC.

Inventory purchases for the year were, in order acquisition:

Units Unit cost Total cost

50,000 $4.20 $210,000

80,000 4.25 340,000

30,000 4.30 129,000

15,000 4.40 66,000

Total 175,000 745,000

Neema uses a periodic inventory system. There were 25,000 units in ending inventory on 31 December. Management is considering whether to use FIFO or weighted average as the accounting method.

e. Sales during the year were $1,500,000, of which 90% were on account and 10% for cash

f. Management estimated that approximately 1% of sales on account will be uncollectible. During the year, 1,035,000 was collected on accounts receivable. When management scrutinizes the year end outstanding accounts, it estimates that approximately 6% of accounts will prove uncollectible.

g. Additional operating expenses for the year were 550,000

h. On 31 December, the company paid a $5,000 cash dividend on common shares

i. On 31 December, accounts payable pertaining to operating expenses and inventory purchases totalled 154,000

j. The cash balance on 31 December was $102,000

Required

1. Choosing from the alternative accounting policies described above, prepare a single-step income statement for the year ended 31 December, 20X4 that will produce the lowest net income.

2. What ethical implications are to be considered when selecting from among alternative accounting policies?

Answer 1

1.

Neema Corp. Income Statement For the year ended December 31, 20X4
Sales		$ 1,500,000
Less: Cost of Goods Sold
Beginning Inventory	0
Add: Purchases	745,000
Less: Ending Inventory ( $ 745,000 / 175,000 units * 25,000 units)	(106,429)	638,571
Gross Profit		861,429
Less: Expenses
Operating Expenses	550,000
Bad Debt Expense ( 1,500,000 x 90 % - 1,035,000 ) x 6 %	18,900	568,900
Net Operating Income		292,529

2. The users of the financial statements are entitled to a true and fair view of the operating results of the company, and its financial position. Therefore, the accounts should be prepared on a conservative basis. Therefore, profit or assets should not be overstated, and expenses, losses or liabilities should not be understated.

There is a direct correlation between profit and the cost assigned to ending inventory. Higher the value of ending inventory, higher the gross profit and vice versa. If the FIFO method was followed, the value of ending inventory would have been 15,000 x $ 4.40 + 10,000 x $ 4.30 = $ 109,000. Gross profit would have been $ 1,500,000 - $ ( 745,000 - 109,000) = $ 864,000.

Similarly, if 1 % was estimated to be uncollectible debts ( even though the management realizes that 6 % would be uncollectible), net operating income would have been overstated by another $ 15,750.

Using FIFO would also have led to overstatement of ending inventory in the balance sheet by $ ( 109,000 - 106,429) = $ 2,571.

And using 1 % for providing for bad debts would have led to overstatement of net accounts receivable by $ 15,750.