Beta Computer Equipment Company

Accounting Issues Case

Part A
On February 20, 20X4 you are well into the field work of the 12/31/20X3 audit and the following
issues have arisen during the audit of Beta Computer Equipment Company (BCE.)

1. Service revenue
2. Account receivable from officers
3. Prepaid advertising
4. Alan Almond Company receivable
5. Inventory
6. “Bring Your Daughters and Sons to Work Day” litigation

Linda Wilson the president of BCE wants you to present your position on each of these issues as she
would like your judgment as to “good GAAP” numbers. But, she has also pointed out that she
understands that GAAP often does not provide a precise answer, and in such cases, she would rather
error on the side of maintaining income rather than being “an overly pessimistic doomsayer.” The
attitude of Board of Directors members is consistent with that of Linda.

Prepare a memo that summarizes relevant professional standards (standard and paragraph should be
cited) related to each of the 6 issues and prepare any proposed journal entries. Discuss information
that would be included in any note disclosures related to each of the six items (you need not draft
formal note disclosures). Prepare entries for all misstatements you identify, regardless of the amount
involved. That is, don’t simply say no entry is needed because any amount involved would be
immaterial. Assume that the current income is $1,323,839. For purposes of preparing journal entries,
you may ignore income tax implications as any changes in taxes will be reflected later in the audit
process after any entries have been posted to the working trial balance.

Summarize the income effects (before taxes) of any entries that you propose on a schedule such as
the following (make clear over and understatements of income) :
Income Effect

1. Unearned service revenue ____________

2. Account receivable from officers ____________
3. Prepaid advertising ____________
4. Alan Almond Company receivable ____________
5. Inventory ____________
6. “Bring your Daughters and Sons to Work Day” litigation ____________

BCE Accounting Issues Case, Page 1

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 Issue 1: Service Revenue

BCE has included service revenue of $22,100 as a result of a number of one year service policies
sold late in December as an “experiment.” These service policies became effective on January 1,
20X4, or shortly thereafter.

The policies are sold at an average of $600 per year per customer; the $22,100 represents the total
cash received as of year-end (debit cash, credit service revenue). The $600 per customer amount was
arrived at by an analysis of previous service provided on a “fee for service” basis to customers. The
average cost to BCE was approximately $200 per visit, with an average of 1.7 visits per year to
customers. While the service policies allow unlimited visits for service, BCE has restricted the
number of policies available due to difficulties in calculating the costs associated with such policies.
BCE estimates that the number service calls is likely to increase to about 4 per year; the cost is
expected to decrease to around $150 per call. So, at this point, the program is projected to break
even. The aggressive pricing of the service policies is due to (1) the experimental nature of the
program and (2) a desire to maintain long-term customer loyalty for future purchases of equipment.

What entry or disclosure, if any, is necessary in this circumstance?

Issue 2: Accounts Receivable From Officers

At year-end BCE has $110,000 in accounts receivables from officers on the books. The Board of
Directors approved these loans which are in the form of “demand” notes. One of the staff assistants
asked whether there was any intent to require officers to pay back these loans. Linda Wilson and Jan
Wiggs, who each owe 1/2 of the total amount outstanding, agreed that while not much thought had
been given to it, they imagined that they might someday repay the loans. On the other hand, they
thought that the Board of Directors might forgive the loans some year in lieu of their annual bonus.

What entry or disclosure, if any, is necessary in this circumstance?

BCE Accounting Issues Case, Page 2

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 Issue 3: Prepaid Advertising

On November 1, 20X3 BCE paid $30,000 in advance for eight months of advertising on radio station
KNEWZ, a local news station. The entry was recorded with a debit to prepaid advertising and a
credit to cash. At December 31, 20X3 BCE expensed $7,500 (debit to advertising expense and credit
to prepaid advertising for 2 of the 8 months). Earlier, on December 29, 20X3 BCE received a letter
from KNEWZ indicating that the radio station was changing its format on January 1, 20X4 to
“classic heavy metal.” In brief, news is being replaced by old songs of Phish, Ozzie Osbourne, and
Metallica. It will now use the call letters KDEV.

Although BCE has no real data on this, it is management’s impression that most Ozzie Osbourne
fans buy fewer networked computer systems than news station listeners. Accordingly, management
attempted to cancel the agreement and receive a refund. Regrettably, the contract for the advertising
provides no assurances about a change in station format and BCE’s lawyers say that obtaining any
recovery in a court proceeding is doubtful. KDEV has refused any attempts at renegotiation and has
suggested that BCE might be surprised at the number of customers that might respond to the
commercials. KDEV is even willing to work with BCE to redo commercials eliminating the old ones
that used the “sappy sounding” news announcers and replacing them with commercials using their
new announcers; KDEV is willing to record these commercials for no additional cost. BCE
management still questions whether the advertising will be well placed, but does believe that there
may be a few listeners who might respond to the advertisement. BCE legal counsel suggests that it is
not worth pursuing this matter further.

What entry or disclosure, if any, is necessary in this circumstance?

Issue 4: Alan Almond Receivable

Alan Almond Company (Alan Almond) owes BCE $82,000 for a computer system installation that
was purchased in March of 20X3. Alan Almond has run into financial difficulties due to dramatic
decreases in the selling price of almonds during recent years. In August of 20X3 Linda Wilson (BCE
president) and Jan Wiggs (BCE controller) established a repayment schedule in which Alan Almond
would repay $10,000 per month (plus interest). While the first payment was made in September
(bringing the debt down from $92,000 to $82,000), no further payments have been received. (Alan
Almond has continued to make small purchases from BCE on a “cash” basis.)

Your discussion with management indicates that Alan Almond received a “going concern”
modification from its auditors for the year ended 8/30/X3 (the audit report was dated 10/22/X3). The
going concern modification arose due to a question concerning whether Alan Almond can obtain
new financing when needed, on June 30, 20X4. However, the situation is not entirely bleak for Alan
Almond’s future as layoffs of 1/3 of the company’s employees resulted in a situation in which Alan
Almond operated at break even for the year ended 8/30X3. Alan Almond has discussed filing for
bankruptcy with bankruptcy legal counsel and at this point believes it is unnecessary. But, if it
becomes necessary, counsel suggests that creditors shouldn’t expect to receive more than 50 cents on
the dollar. Management has suggested to you that 70 cents on the dollar is more likely if bankruptcy
ensues. Your analysis at the date of both the Alan Almond audited annual statements (8/30/X3) and
the interim statements (11/30/X3) indicates that if bankruptcy is declared, a recovery of 50-60 cents
on the dollar (with no amount more probable than another in that range) is likely. Yet, it’s difficult to
know what the situation will be in the future.
BCE Accounting Issues Case, Page 3
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The sales agreement for the computer system allows BCE to repossess the equipment at any time
prior to bankruptcy. But, because the equipment is used and specific to Alan Almond’s applications,
management believes that the equipment could be sold for a (net) of between $20,000 and $30,000.
Also, management points out that such an action would not be considered positively by either Alan
Almond or a number of other companies that BCE is attempting to attract as clients. Accordingly,
BCE has resisted this option and does not intend to pursue it at this time.

Your analysis of the interim statements (unaudited) reveals that Alan Almond operated at a slight
profit during the first quarter and that almond prices have increased approximately 15 percent.
However, experts disagree widely as to future almond prices as there is some concern that a
significant increase in almonds from India may enter the US market. Finally, Alan Almond’s
management, although noncommittal on details, suggests that it believes that it will be able to
continue repayments on the debt within the “next few months.” But your feeling is that it is probable
that Alan Almond will be forced to file for bankruptcy.

No allowance for this account is currently included in the allowance for doubtful accounts.

What, if any, loss reserve (and/or note disclosure) should be reflected in the financial statements?

Issue 5: Inventory

Included in BCE’s inventory (valued using the LIFO method) are the following:

• $100,000 (cost) of computers which manufacturers ceased producing in the middle of 20X3.
Although the wholesale value of these computers now is only about $60,000, the retail value (if
they could all be sold today, which they can’t be) is approximately $110,000. The selling costs of
these specific machines are considered negligible, and a normal profit margin is approximately
25% of sales price. The retail market is “thin” and it will take some time to sell the computers.
Management intends to sell all of these computers at retail and believes that the retail value of
these computers is likely to decrease at an average rate of 5 percent every quarter for the next
year; thus, on average a computer with a retail value of $1,000 on 12/31/X3 would have an
average retail value of $950 and $900 during the first two quarters of 20X4, respectively.
Management believes that the computers will be sold within the next year as follows--first
quarter 40% of inventory, second quarter 35%, third quarter 20 %, and fourth quarter 5% at
market values at the time of sale. These projections seem reasonable. It is currently February 15
and you note that sales are right on schedule and that retail prices have dropped a bit from year-
end, as projected.
• Because of discontinuance of the above computers, many suppliers of parts for these computers
have chosen to quit manufacturing the items with the result that shortages are occurring. As a
result, BCE’s $50,000 inventory of parts for these machines has increased in value and would
now cost $65,000 to replace (its retail value is $110,000). Historically, the normal profit margin
on sales of parts is 40% of sales price. Also, management has pointed out to you that computers
in inventory that don’t sell could be used for parts. But management does not anticipate the need
to do this.

BCE Accounting Issues Case, Page 4

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• Historically, BCE (and competitors) have in general separated Computers from Parts when
calculating the lower of cost or market for inventory.

Does BCE need to record an inventory writedown to reflect a lower of cost or market value? If so,
how much?

Issue 6: Bring Your Daughters and Sons to Work Day Litigation

On “Bring Your Daughters and Sons to Work Day” at Winglo Corporation not only did Sandy
Gilhaus, a Winglo employee, bring her ten year old daughter Sarah to work, but BCE also installed
Winglo’s new computer system on that day. After installation, when Sandy attempted to adjust the
monitor connected to her new computer, she inadvertently knocked the monitor off the desk and
onto the floor. The screen shattered with a piece of the glass striking Sarah’s right big toe. To make a
long story short, Sarah’s toe needed four stitches to stop the bleeding and Sandy has blamed the
installer of the system for placing the monitor in a dangerous position near the back edge of her
desk. The damages to this point have been minimal as Sandy drove Sarah to their HMO and paid the
$20 copay for an office visit. Yet, the Gilhaus family has sued BCE for the following:

Likely future plastic surgery $ 5,000

Emotional distress to Sarah 500,000
Emotional distress to Sandy 1,200,000
Total $1,705,000

BCE’s lawyers believe that this case, with the possible exception of the plastic surgery (for which
the HMO won’t pay), is frivolous. BCE has no insurance to cover this sort of liability. If this case
goes to court, BCE’s on staff attorneys will handle the case. To eliminate any possible bad prss from
this case, BCE’s lawyers suggested settling for a “nuisance value” of $10,000. Sarah’s family
rejected this offer out of hand and asked for $200,000 to settle this out of court. BCE has decided, at
least at this point, to refuse any further settlement offer.

In their lawyer’s letter to you BCE’s lawyers indicated that they believe that BCE has “just and
meritorious defense available” to fight this case. Furthermore, BCE’s legal counsel for the case
indicated that while she agrees that this case is largely frivolous, litigation involving a young child is
somewhat of a “crap shoot” and that making a definite prediction on the outcome of the case is
impossible. In the end she believes the judgment will likely be $5,000 for the plastic surgery. What
entry or disclosure, if any, is necessary in this circumstance?

BCE Accounting Issues Case, Page 5

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consent of McGraw-Hill Education.