Ehrlich Smith, the owner of The Shoe Box, has asked you to help him understand the proper way to account for certain accounting items as he prepares his 2011 financial statements. Smith has provided the following information and observations:
a. A three-year fire insurance policy was purchased on January 1, 2011, for $2,400. Smith believes that a part of the cost of the insurance policy should be allocated to each period those benefits from its coverage.
b. The store building was purchased for $80,000 in January 2003. Smith expected then (as he does now) that the building will be serviceable as a shoe store for 20 years from the date of purchase. In 2003, Smith estimated that he could sell the property for $6,000 at the end of its serviceable life. He feels that each period should bear some portion of the cost of this long-lived asset that is slowly being consumed.
c. The Shoe Box borrowed $20,000 on a one-year, 8 percent note that is due on September 1 next year. Smith notes that $21,600 cash will be required to repay the note at maturity. The $1,600 difference is, he feels, a cost of using the loaned funds and should be spread over the periods that benefit from the use of the loan funds.
Required:
1. Explain what Smith is trying to accomplish with the three items on p. 105. Are his objectives supported by the concepts that underlie accounting?
2. Describe how each of the three items should be reflected in the 2011 income statement and the December 31, 2011 balance sheet to accomplish Smith’s objectives.