Chapter 3, Problem 7ATC

a.

To determine

Prepare an income statement, balance sheet, statement of cash flow.

Explanation of Solution

Accounting event:

An accounting event is a cost-effective event that affects assets, liabilities, or stockholders’ equity of a Company.

Accounting equation:

Accounting equation is an accounting tool expressed in the form of equation, by creating a relationship between the resources or assets of a company, and claims on the resources by the creditors and the owners. Accounting equation is expressed as shown below:

$\text{Assets = Liabilities + Stockholders’ equity}$

Income statement:

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

Balance sheet:

Balance is the financial statement that reports a company’s resources (assets) and claims of creditors (liabilities) and stockholders (stockholders’ equity) over those resources. The resources of the company are assets which include money contributed by stockholders and creditors. Hence, the main elements of the balance sheet are assets, liabilities, and stockholders’ equity.

Statement of cash flows:

It is one of the financial statement that shows the cash and cash equivalents of a company for a particular period. It determines the net changes in cash through reporting the sources and uses of cash due to the operating, investing, and financing activities of a company.

Eight events of Person A are recorded as follows:

Figure (1)

Note: The unit of measure is “sheep” rather than “dollars.”

Six events if Person R is recorded as follows:

Figure (2)

Note: The unit of measure is “sheep” rather than “dollars.”

The financial statements of Person A are prepared as follows:

Figure (3)

Note: The unit of measure is “sheep” rather than “dollars.”

The financial statements of Person R are prepared as follows:

Figure (4)

Note: The unit of measure is “sheep” rather than “dollars.”

b (1)

To determine

Find out the twin having more owners’ equity at the end of the accounting period.

Explanation of Solution

Stockholders’ Equity:

Stockholders Equity refers to the right the owner possesses over the resources of the business. Common stock and the retained earnings are the components of the Stockholders Equity.

The twin having more owners’ equity at the end of the accounting period is as follows:

Equity of Person R (556) is larger compared to the Equity of Person A (384).

Note: The unit of measure is “sheep” rather than “dollars.”

b (2)

To determine

Find out the twin producing the higher net income during the accounting period.

Explanation of Solution

Net income:

Net income is the excess amount of revenue which arises after deducting all the expenses of a company. In simple terms, it is the difference between total revenue and total expenses of the company.

Twin producing the higher net income during the accounting period is as follows:

Person R (46) produced more amount of net income compared to Person A (44).

Note: The unit of measure is “sheep” rather than “dollars.”

b (3)

To determine

Find out the twin who should be designated heir based on conventional accounting and reporting standards.

Explanation of Solution

The twin designated based on conventional accounting and reporting standards is as follows:

According to conventional accounting and reporting standards Person R is assigned to the family fortune.

c.

To determine

Distinguish between the value of the land of the twins if the land is valued at market value rather than historical cost

Explanation of Solution

Distinguish between the values of the land of the twins:

• The holding of Person A is worthier than Person R as Person A purchased extra 10 acres of land and sold three acres because, there was an increase in the market value of the land. Therefore, Person A (27) has more acres of Land compared to Person R (20). It is to be noticed that this factor alone makes difference for determining which twin should be considered as legal heir.
• If the land is valued at market value, then Person A would make out a gain from the seven sheep rather than the gain recognized by Person R. Consequently, the net income of Person A is 5 sheep larger rather than two sheep smaller than Person R’ earnings. Therefore the net income will be:

Particulars	Person A	Person R
Net income	44	46
Gain on Sheep	7	0
Total	51	46

Table (1)

Note: The unit of measure is “sheep” rather than “dollars.”

d.

To determine

Ascertain whether the decision of Person A to borrow sheep increases the profitability.

Explanation of Solution

 Decision of Person A to borrow sheep is discussed below:

• The borrowing activity of Person A is considered as a profitable strategy. The herd of Person A contained 741 sheep at the end of the accounting period which includes 75 new-born sheep. Likewise, the herd of Person R contained 516 sheep at the end of the accounting period which includes 53 new-born sheep.
• The return ratio for Person A is 10.5% (1) and for person R is 10.3%(2)
• These ratios calculated can be adjusted by refining the revenue figure to account for the possibility of expected losses due to illness and predators. The denominator can be adjusted to account for timing factors.
• The approximate return of 10 % is sufficient to compare with the cost of interest of 6% (3) for Person A.

Working notes:

Calculate the return ratio of Person A:

$\begin{array}{c}\text{Return}\text{ratio}\text{of}\text{Person}\text{A}\text{=}\frac{\text{Number}\text{of}\text{new-born}\text{sheep}}{\left(\begin{array}{l}\text{Total}\text{number}\text{of}\text{sheep}\text{at}\text{the}\\ \text{end}\text{of}\text{the}\text{accounting}\text{period}\end{array}\right)}\\ \text{=}\frac{\text{75}}{\text{714}}\text{×100}\\ \text{=10}\text{.5\%}\end{array}$ (1)

Calculate the return ratio of Person R:

$\begin{array}{c}\text{Return}\text{ratio}\text{of}\text{Person}\text{A}\text{=}\frac{\text{Number}\text{of}\text{new-born}\text{sheep}}{\left(\begin{array}{l}\text{Total}\text{number}\text{of}\text{sheep}\text{at}\text{the}\\ \text{end}\text{of}\text{the}\text{accounting}\text{period}\end{array}\right)}\\ \text{=}\frac{53}{516}\text{×100}\\ \text{=10}\text{.3\%}\end{array}$ (2)

Calculate the cost of interest for Person A:

$\begin{array}{c}\text{Cost}\text{of}\text{interest}\text{for}\text{person}\text{A=}\frac{\text{Number}\text{of}\text{additional}\text{sheeps}\text{returned}}{\text{Number}\text{of}\text{sheeps}\text{borrowed}}\\ \text{=}\frac{\text{24}}{\text{400}}\text{×100}\\ \text{=6\%}\end{array}$ (3)

Note: The unit of measure is “sheep” rather than “dollars.”

e.

To determine

Ascertain whether decision of Person A to build fence is financially prudent.

Explanation of Solution

The decisions of Person A to build fence is discussed below:

• Person A has saved 7 $\text{(714}\text{×}\text{.01)}$  sheep by building fence and Person R has lost 1 % (4) of herd to predators approximately.
• The decision to build fence failed financially, since 50 sheep were given in return for the building of fence which costs around 10 sheep per useful life $\left(\text{i}\text{.e}\text{.}\text{50}\text{÷5}\right)$ and the condition is worsened even more when person A’s size of herd reduced by the repayment of the sheep that is borrowed.
• There is no possibility that the fence can provide protection against illness because the fence was built for protecting the sheep from the predators.

Working note:

Calculate the percentage of loss of herd for Person R:

$\begin{array}{c}\text{Percentage}\text{of}\text{loss}\text{of}\text{herd}\text{=}\frac{\text{Number}\text{of}\text{sheep}\text{lost}\text{to}\text{predators}}{\text{Number}\text{of}\text{sheep}\text{contained}}\\ \text{=}\frac{\text{5}}{\text{516}}\text{×100}\\ \text{=1\%}\end{array}$ (4)

Note: The unit of measure is “sheep” rather than “dollars.”

f.

To determine

Identify the reasons for loaning the sheep to Person A by a shepherd.

Explanation of Solution

The shepherd loaned the sheep to Person A because of the following reasons,

• The shepherd is no longer entitled to take care of the herd.
• And also, the shepherd is protected from risks. For instance, if the sheep die due to illness, person A have to still return the same number of sheep (424 healthy sheep) that is borrowed.

g.

To determine

Find out the twin likely to take risks to improve profitability, discuss about the financial condition of each twin and state the method for reporting risk factors in financial statements.

Explanation of Solution

The twin who is likely to take risks to improve profitability, discussion about the financial condition of each twin and the method for reporting risk factors in financial statements is as follows:

• The financial risk of Person R is lower as he has no debt that could have been aroused from the borrowing of the sheep. Person A would be bankrupt if half of the sheep die from illness since Person A will not be able to repay the 424 sheep that is borrowed.
• The person R will retain an equity base of 258 sheep $\text{(516÷2)}$, even if half of the sheep die from illness.
• By reporting the amount of liabilities in the financial statements the financial risk can be ascertained. The level of risk can also be measured by the percentage of debt-to-asset ratio. Detailed information provided by the discussion of management can be used to analyse the level of financial risk.

h.

To determine

Discuss the decision to “marry for sheep” from an ethical perspective or on the basis of the bottom-line net income figure.

Explanation of Solution

The decision to “marry for sheep” from an ethical perspective or on the basis of the bottom-line net income figure is discussed below:

Making of investment decision depend upon the ethical quality of the management. The relevance of the marriage issue is a matter of personal judgement. For the purpose of overstating profitability managers may engage in false practices. Investors have to maintain heavy integrity while making investment decisions.

i.

To determine

Prepare a report that recommends a twin designated to the family business.

Explanation of Solution

Report that recommends a twin designated to the family business is discussed below:

There is no single solution that favours person A and person R Therefore, logical consistency is the essential thing that has to be focused.