Chapter 10, Problem 23P

a.

To determine

Prepare an income statement, a balance sheet and statement of cash flows of Company NMC for two options.

Explanation of Solution

Income statement:

The income statement is the financial statement of a company that shows all the revenues earned and expenses incurred by the company over a period of time.

Balance sheet:

Balance Sheet is one of the financial statements that summarize the assets, the liabilities, and the Shareholder’s equity of a company at a given date. It is also known as the statement of financial status of the business.

Statement of cash flows:

This statement reports all the cash transactions which are responsible for inflow and outflow of cash, and result of these transactions is reported as ending balance of cash at the end of reported period. Statement of cash flows includes the changes in cash balance due to operating, investing, and financing activities. Operating activities include cash inflows and outflows from business operations. Investing activities includes cash inflows and cash outflows from purchase and sale of land or equipment, or investments. Financing activities includes cash inflows and outflows from issuance of common stock and debt, payment of debt and dividends.

Option 1

Calculation of income statement of Company NMC is as follows:

Company NMC
Income Statement
Particulars	Amount ($)
Sales revenue (1)	$90,000
Less: Cost of goods sold (2)	22,500
Gross margin	67,500
Less: Administrative expense	24,000
Net income	43,500

Table (1)

Calculation of balance sheet of Company NMC is as follows:

Company NMC
Balance Sheet
Assets:
Cash (3)	$86,000
Finished goods inventory (4)	7,500
Total assets	$93,500
Equity:
Common stock	$50,000
Retained earnings	43,500
Total equity	$93,500

Table (2)

Calculation of statement of cash flow of Company NMC is as follows:

Statement of Cash Flows
Operating Activities
Inflow from Revenue	$90,000
Less: Outflow for Inventory (1)	(30,000)
Less: Outflow for Administrative Expenses	(24,000)
Net Outflow from Operation Activities	36,000
Investing Activities	-
Add: Financing Activities	50,000
Net Change in Cash	86,000
Beginning Cash Balance	-
Ending Cash Balance	86,000

Table (3)

Option 2

Calculation of income statement of Company NMC is as follows:

Company NMC
Income Statement
Particulars	Amount ($)
Sales revenue	$90,000
Less: Cost of goods sold (5)	40,500
Gross margin	49,500
Less: Administrative expense	0
Net income	49,500

Table (4)

Calculation of balance sheet of Company NMC is as follows:

Company NMC
Balance Sheet
Assets:
Cash (3)	$86,000
Finished goods inventory (6)	13,500
Total assets	$99,500
Equity:
Common stock	$50,000
Retained earnings	49,500
Total equity	$99,500

Table (5)

Calculation of statement of cash flow of Company NMC is as follows:

Statement of Cash Flows
Operating Activities
Inflow from Revenue	$90,000
Less: Outflow for Inventory	(54,000)
Net Outflow from Operation Activities	36,000
Investing Activities	-
Add: Financing Activities	50,000
Net Change in Cash	86,000
Beginning Cash Balance	-
Ending Cash Balance	86,000

Table (6)

Working note (1):

Calculate the sale revenue:

$\begin{array}{c}\text{Sales revenue}=\text{Number of units sold}\times \text{Price of each }\\ =3000\text{ units}\times \$30\\ =\$90,000\end{array}$

Working note (2):

1. 1. Calculate the cost per unit:

$\begin{array}{c}\text{Cost per unit}=\frac{\text{Materials}+\text{Labor}+\text{Overheads }}{\text{Total number of units produced}}\\ =\frac{\$30,000}{4,000\text{ units}}\\ =\$7.50\end{array}$

1. 2. Calculate the cost of goods sold:

$\begin{array}{c}\text{Cost of goods sold}=\text{Cost per unit}\times \text{Number of goods sold}\\ =\$7.5\times 3,000\text{ units}\\ =\$22,500\end{array}$

Working note (3):

Calculate the total cash:

$\begin{array}{c}\text{Total cash}=\text{Acquired capital}+\text{Sales revenue}-\text{Product cost}-\text{Planning cost}\\ =\$50,000+\$90,000-\$30,000-\$24,000\\ =\$140,000-54,000\\ =\$86,000\end{array}$

Working note (4):

Calculate the total finished goods:

$\begin{array}{c}\text{Finished goods}=\text{Cost per unit}\times \text{Completed goods}-\text{Number of goods sold}\\ =\$7.5\times 4,000\text{ units}-3,000\text{ units}\\ =\$7.5\times 1,000\text{ units}\\ =\$7,500\end{array}$

Working note (5):

1. 1. Calculate the cost per unit:

$\begin{array}{c}\text{Cost per unit}=\frac{\text{Materials}+\text{Labor}+\text{Overheads}+\text{Planning cost }}{\text{Total number of units produced}}\\ =\frac{\$30,000+\$24,000}{4,000\text{ units}}\\ =\frac{\$54,000}{4,000\text{ units}}\\ =\$13.50\end{array}$

1. 2. Calculate the cost of goods sold:

$\begin{array}{c}\text{Cost of goods sold}=\text{Cost per unit}\times \text{Number of goods sold}\\ =\$13.50\times 3,000\text{ units}\\ =\$40,500\end{array}$

Working note (6):

Calculate the total finished goods:

$\begin{array}{c}\text{Finished goods}=\text{Cost per unit}\times \text{Completed goods}-\text{Number of goods sold}\\ =\$13.5\times 4,000\text{ units}-3,000\text{ units}\\ =\$13.50\times 1,000\text{ units}\\ =\$13,500\end{array}$

b.

To determine

Identify the option in the financial statement that gives a favorable image to the creditors and investors.

Answer to Problem 23P

Option 2 is the financial statement that gives a favorable impression to creditors and investors with a greater net income of $6,000 than option 1’s net income.

Explanation of Solution

Income statement:

Income statement is the financial statement of a company that shows all the incomes gained and expenditures incurred by the company for a time period.

Balance sheet:

Balance sheet is one of the financial statements that summarizes the assets, the liabilities, and the shareholder’s equity of a company at a given date. It is also known as the statement of financial status of the business.

The option that gives the favorable image to the creditors and investors is as follows:

Option 2 provides the financial statement that gives a favorable image to the creditors and investors because the net income in option 2 is greater than the net income in option 1.

c.

To determine

Compute the amount of bonus under each option and recognize the option that provides a higher bonus.

Answer to Problem 23P

Option 2 provides the president with a higher bonus of $12,375.

Explanation of Solution

Income statement:

Income statement is the financial statement of a company that shows all the revenues earned and expenses incurred by the company over a period of time.

Balance sheet:

Balance sheet is one of the financial statements that summarizes the assets, the liabilities, and the shareholder’s equity of a company at a given date. It is also known as the statement of financial status of the business.

Calculation of bonus under option 1 is as follows:

$\begin{array}{c}\text{Bonus}=\text{Net income}\times 25\%\text{ on net income}\\ =\$43,500\times \frac{25}{100}\\ =\$10,875\end{array}$

Hence, the bonus received by the president under option 1 is $10,875.

Calculation of bonus under option 2 is as follows:

$\begin{array}{c}\text{Bonus}=\text{Net income}\times 25\%\text{ on net income}\\ =\$49,500\times \frac{25}{100}\\ =\$12,375\end{array}$

Hence, the bonus received by the president under option 2 is $12,375.

d.

To determine

Compute the amount of tax rate under each option and recognize which option pays less tax.

Answer to Problem 23P

Option 1 minimizes the cost of income tax expenses for the company by $15,225.

Explanation of Solution

Calculation of income tax under option 1 is as follows:

$\begin{array}{c}\text{Bonus}=\text{Net income}\times 35\%\text{ income tax rate}\\ =\$43,500\times \frac{35}{100}\\ =\$15,225\end{array}$

Hence, the income tax expense under option 1 is $15,225.

Calculation of income tax under option 2 is as follows:

$\begin{array}{c}\text{Bonus}=\text{Net income}\times 30\%\text{ income tax rate}\\ =\$49,500\times \frac{30}{100}\\ =\$17,325\end{array}$

Hence, the bonus received by the president under option 2 is $17,325.

e.

To determine

Comment on the conflict among the company’s president as determined in requirement c and the owner-based requirement d, and define an incentive compensation plan that will neglect the conflict.

Explanation of Solution

The conflicts between the owner and the president are as follows:

Option 2 provides the president with a higher bonus of $12,375. Option 1 minimizes the cost of income tax expenses for the company by $10,875. These are the two conflicts between the owner and the president.

The reasons to avoid these conflicts are as follows:

• • The bonus plans of the company can be tied up with the company’s stock price, instead of net income.
• • Market efficiency increases; as a result, the performance of the company increases, which creates a value to the company’s stock price.