Case 1-1: Ribbons an’ Bows, Inc.
Note: This is a new case for the Twelfth Edition. Approach
This is an introductory case and it should be taught as an introductory case. There will be plenty of time in the course for the students to learn the correct form of financial statements statements and details details of accounting accounting standards. In short,the short, the instructor should be prepared to allow a variety of formats for the financial statements and tolerate some “not quite correct” accounting. The inst The instru ruct ctor or may may want want to have have stud studen ents ts disc discus usss Carm Carmen en’s ’s Marc March h 31 stateme statement, nt, but the bulk of the class should should focus on the three case case questions. questions. Any discus discussi sion on of the the March March 31 statem statement ent should should deal deal with with the the nature nature of the the vario various us accounts (i.e. prepaid rent is rent paid in advance of using the property and it is an asset because it has future economic benefits for the company, company, etc), rather than the format of the statement. statement. It is better to leave the beginning beginning of the course’s instruction instruction in financial financial statement formats to the assigned case question discussions. Comments on Information Gathered and Carmen’s Concerns
1. The three three month sales total total is the the sum of the cash cash sales ($7,400) and credit credit sales ($320). 2. Cost of of sales sales is derived derived from from the the followi following ng equation equation Beginning merchandise inventory $3,300 Plus Purchases 2,900 Equals Total available merchandise $ 6 ,2 0 0 Less Ending merchandise inventory 4,100 Equals Cost of sales $2,100 3. Rent expense is $1,800 $1,800 of $600 per per month month times times three months. Paid in cash. cash. 4. Part Part-ti -time me employ employee ee expense expensess ($1600 ($1600)) is the sum of cash cash paid paid ($151 ($1510) 0) plus amount owed ($90). 5. Suppl Supplie iess expen expense se ($80) ($80) is beginn beginning ing supplie suppliess invent inventory ory ($100) ($100) less less suppl supplie iess inventory on hand on March 31 ($20). 6. Th Thee prepai prepaid d advert advertisi ising ng ($150) ($150) was was run run by the local local paper paper on Apr April il 2. Th Thee benefit of the asset expired so the asset became an expense. 7. The commer commercial cial sewing sewing machin machinee purchase purchase led to an $1800 asset asset being being recorded recorded (a future benefit benefit). ). The asset’s asset’s benefit benefit was partly partly consumed consumed during May and June resulting in a $60 depreciation charge ($1800/ 5 years/ 12 months x 2 months – straight line depreciation.) 8. Some Some of the future future benef benefit itss of the comput computer er and rela related ted softwa software re asset asset were were consumed during during the three month period. A $250 depreciation depreciation charge must be recognized ($2000/ 2/ 12/ x 3 – straight line depreciation.) 9. Cash balance at the the end of period period lower lower than beginning balance. See Question Question 1 discussion. 10. Four month’s month’s interest interest must be recorded recorded on the cousins’ cousins’ $10,000 $10,000 loan. ($10,000 x .06 x 4/ 12). 12). Carmen has “rented” “rented” the cousins’ cousins’ money money for four months. (She forgot to include the March rent in her March 31 balance sheet.) 11. No depreciation depreciation is recorded on the cash register register loaned by the local credit-card credit-card charge processor and the furniture left by the former tenant. These “assets”
were not recognized on the financial statement because they were neither donated nor acquired in business transactions. 12. The uncle’s legal work is neither an asset nor an expense of the business. It did not result in a business transaction. 13. Carmen’s potential salary payment in July is neither an expense nor a liability as of March 31. The company does not have an obligation on March 31 to pay her any compensation. Question 1
Exhibit 1 presents the company’s initial three month income statement. It does not contain a provision for taxes, since Carmen at this early date did not know if income taxes would be due on the annual results. The principal reasons why the cash balance declined during the three month profitable operating period are: 1. The commercial sewing machine purchase reduced cash by $1,800 while the related depreciation charge only reduced income by $90. 2. Ending inventory was higher than beginning inventory and the increase was paid for with cash. That is, more inventory was bought for cash ($2,900) than the cost of goods sold ($2,100). Exhibit 2 present a cash flow analysis for the three month operating period. Question 2
Exhibit 3 presents the company’s June 30 balance sheet. Question 3
Carmen’s business is off to a good start, but it will have to do better over the rest of the year if Carmen plans to pay herself any meaningful compensations and repay the cousins’ loan at the end of the year. When discussing Question 3 some students believe that Carmen should include a consideration of an imputed compensation expense in deciding how well she has done. Students accept the non recognition of her compensation in the income statement, but believe she should recognize that personally she has incurred an opportunity cost for lost wages (at least four months x $1300). In addition, students believe Carmen’s non-recognition of any cost associated with using the abandoned counters and display equipment overstates how well she is doing from an economic point of view. These students would include some depreciation cost based on the asset’s fair value in their evaluation of how “successful” the business has been to date. Some students advocate including the free legal advice’s value ($600) in their assessment of the company’s success to date.
The instructor may challenge the class to consider why these items (free legal advice, imputed salary and depreciation) are not included in the company’s income statement.
Exhibit 1 Ribbons an’ Bows Income Statement for the Period April 1 to June 30, 2006
Sales Cost of Sales Gross Margin Employee wages Rent Office Supplies Depreciation – Computer Depreciation – Sewing Machine Interest Advertising Profit before Taxes
$7,720 (2,100) $5,620 (1,600) (1,800) (80) (250) (60) (200) (150) $1,480
Exhibit 2 Ribbons an’ Bows Analysis of Cash Flows for the Period April 1 to June 30, 2006
Beginning Cash Sales Wages Rent Merchandise Inventory Sewing Machine Ending Cash
$4,000 7,400 (1,510) (1,800) (2,900) (1,800) $3,390
Exhibit 3 Ribbons an’ Bows Balance Sheet as of June 30, 2006
Assets Cash Accounts receivable Merchandise Inventory Supplies Prepaid rent Computer (net) Sewing machine (net) Cash register deposit Total
$3,390 320 4,100 20 1,200 1,750 1,740 250 $12,770
Liabilities Wages owed Interest owed Cousins’ loan Owner’s Equity Carmen’s equity Earnings Total
$90 200 10,000 $10,290 $1,000 1,480 $2,480 $12,770
