Karate King Letter to Mr. Johnnie Petro - - Case Study Example

Accounting Cases Case Study - Karate King Letter to Mr. Johnnie Petro Dear Johnnie Re: Purchase of Karate King Club as a Going Concern Further to our telephonic conversation I reviewed the accounting statements of Karate King you mailed me. I have attached the Income Statement and the Balance Sheet of the Club as per the Generally Accepted Accounting Principles (GAAP). Sine you would like to invest your money in a going concern it is important you understand what is meant by GAAP and the underlying principles of this concept. Just for your information, accounting is not a static system but a dynamic process that incorporates the generally accepted accounting principles (GAAP) that is evolved to suit the needs of the people who read the financial statements of any business. This memo provides some basic details on the principles and concepts like business entity, monetary unit, going concern, cost principle, time period, consistency, materiality, full disclosure, objectivity, revenue recognition and matching principle, which form the basis for applying the GAAP. Business Entity Principle Under this principle, from an accounting point of view the transactions of a business entity operating in any form of organisation are considered separate and distinct from that of the personal transactions. It is necessary to maintain the personal transactions separate even if the owners work in the business entity. Monetary Unit Principle The assumption behind this principle is that the recording of the accounting transactions would be done in the primary national monetary unit. In the case of Karate King the monetary unit used is US Dollars. It is the responsibility of the accounting function to record all the inflows of sales revenue and the expense outflows in the dollar terms. Going Concern Principle In general it is assumed that a business entity will remain in operation for an indefinite period. This is the principle behind the going concern concept. The continuity of business assumes that the cost of the assets engaged in the business will be recovered over their useful life by way of profits from the business. Cost Principle This principle is closely associated with the monetary unit principle and it requires that the value of business transactions need to be recorded at the actual or equivalent cash cost. This principle is also related to stable dollar assumption. When the economy of any country suffers from continued periods of inflation or deflation comparing the revenues and earnings for different years would be meaningless if it is assumed that the dollar will have a stable value. However it would make sense to express the value of the inventories for resale as well as some items of income and some other balance sheet items in terms of current dollar value rather than on historic dollar value. Time Period Principle This principle requires that the accounting transactions be recorded and analyzed for reporting the financial status and profitability of the business operations over a specific time period of operation. Conservatism Principle This principle requires that the balance sheet items like assets should not be overstated and the value of liabilities should not be understated. Consistency Principle Under consistency principle the financial statements should be prepared applying the same accounting principles from one period to another so that the statements become comparable over different periods. Materiality Concept The materiality concept implies that all items having value which are important and material should be reported in a correct way so that the readers of the financial statements can take proper decisions. Full Disclosure Principle This principle states that any future event which is likely to have a major economic impact on the financial position of the company should be disclosed fully to the potential readers of the financial statements. Objectivity Principle This principle implies that all the accounting transactions must have some basic evidence or documentation as a support for the transaction in question. Matching Principle Based on the accrual basis of accounting, the matching principle requires that for each accounting period, it is necessary that all the sales revenue received are recognised irrespective of the fact that whether the payment is received or not. Revenue Recognition This is a basic accounting principle in which a distinction is made between the cash basis accounting and accrual basis. Under cash basis revenues of the business are accounted when cash is received irrespective of when the goods are delivered or services performed. Under accrual system revenues are accounted only when they become due or realized irrespective of the time at which cash is received. Observations on the Accounts of Karate King Coming back to the case of Karate King I have attached an income working for the next year assuming that none of the 500 new members drop out and there are no new memberships sold. You may observe that the company would be making a cash receipt of $ 120,000 for the next year. This receipt is arrived assuming that all the members pay their monthly dues without fail. Assuming that all the expenses remain the same and the advertising expense is discontinued the total cash expenses of the company would be $ 136,000. You may observe that the television advertising charges of $ 6000 pertaining to this year will not affect the cash expenses for the next year although it will affect the profits for the next year. Recommendation Based on the income statement for the next year prepared assuming that no new memberships are sold and all the existing members continue and pay without fail, the firm would be making a net loss of $ 22,000. Hence it would NOT be advisable to invest in this business unless you consider and are confident of the following: You will be able to an aggressive marketing to enroll new members at least to the extent it covers the loss and make a reasonable return. The place at which the club is currently functioning would be able to accommodate the new members The additional cost by way of wages and utilities that you're going to incur will have to be covered by the additional revenue. Conclusion Thus although the business appears to be generating cash for the first year the continuing operations are not that rosy to take up the venture unless the above points are considered. There are many instances of proper accounting treatments which will make a meaningful analysis of th accounting statements presented. Case of Camp Land Memo Addressed to Stepace Madoates Dear Mr. Madoates Re: Income Statement for the Quarter ended 31st March 2006 I reviewed the accounting information you supplied for the quarter ended 31st March 2006. I have constructed the correct income statement and attached with this memo. You may observe that the business has earned $ 22,366 for the quarter. There are some GAAP principles the accounts have not recognized. I detail those below for your information: Revenue Recognition Revenue recognition is a basic accounting principle where there should definitely be a distinction shown between the cash basis of accounting the transactions and recording them on accrual basis. Under cash basis all the revenues of the business are recorded when the business receives cash. The business does not consider when the transaction relating to the supply of goods or services is completed. But in the case of accrual system of accounting, the business account for the revenues only when they are realized or become realizable. Here the business does not consider the actual time of the receipt of cash into the business. The accounts have totally disregarded this accounting principle - as the revenue as well as expenses has been accounted as and when cash is received. The instances are: Rental Income The summer rental advance of $ 33,000 has been taken to revenue. It should be taken to Rental advance account as a balance sheet item. Because of this treatment to the transaction the revenue of the company is overstated and the liabilities representing the advance received are understated to the extent of the value of summer rental received. Till the time the advance received is refunded or adjusted against rents this item represents a liability and be shown under liability. Matching Principle "The matching principle also conforms to the timing of the recognition of sales revenue inflows and expense outflows that allow matching of sales revenue to expenses for an accounting period" (Chapter 1). In respect of the following expenses this principle has not been recognised. Expenses On the expenses side the insurance charges to the extent of $ 1,283 has not been accounted. Interest payable of $ 244 has not been considered Outstanding wages in respect of 3 days wages accrued to the extent of $ 2,160 has not been considered in the income statement. Outstanding expenses of $ 140 for insurance and $ 280 for repairs relating to the period has not been taken into account while calculating the income for the quarter. To the extent these outstanding expenses have not been taken into account, the expenses have been understated and the revenue has been overstates. As these expenses belong to the specific period for which the revenue is earned they must be charged off in the same period as these have been expended to earn the revenue. Materiality Concept "Theoretically, items that may affect the decision of a user of financial information are considered important or material, and must be reported in a correct way" (Chapter 1). By including the summer advance rental of $ 33,000 in the revenue the materiality concept has not been respected. Cost Principle Under this principle the value of business transactions should be recorded at the actual cost. By omitting to include the cost of supplies the accounts have disregarded this principle. To the extent of the value of the supplies not taken into the income statement the cost of revenue is vitiated. Conclusion As a result of the above omissions and wrong treatments given to the accounting transactions the revenue of the company has been grossly misstated to show a high figure. Because of the inclusion of the summer rental deposits in the revenue the income has been overstated to the extent of $ 33,000. Similarly the revenue has been over stated to the extent of the outstanding expenses and supplies not taken into account. Reference Chapter 1 'Basic Financial Accounting Review' Read More