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My doubt is on Question 3. Question 1 and 2 are done already. Should prepaid assets make difference in ROA calculation? (8 points) Some costs

My doubt is on Question 3. Question 1 and 2 are done already.

Should prepaid assets make difference in ROA calculation? (8 points)

Some costs are post paid, therefore, it creates liabilities. For example, salary is post-paid, meaning that the employees will get paid after they provide services. In class, we find that operating liabilities such as salary payable should be excluded in the denominator for ROA to be consistent with the idea.

Some costs are pre-paid. Rent (if paid in advance) and insurance come as a good example. Inventory is also pre-paid. Keep in mind, though, pre-paid doesnt always means that the company has to pay upfront. It is pre-paid because company has to pay upfront or acquire first in exchange for liabilities.

For example, lets say we have an insurance contract, which is pre-paid in nature; annual contract for $2,400. Normally, we can pay $2,400 upfront.

In the examples below, company A paid $2,400 in advance. Company B thinks the pre-paid nature is unfair, so it was able to negotiate a deal with insurance company, so that it can post-pay after each month. Thus Company B acquires same insurance, but its insurance pay schedule is following.

  • Company B gets coverage of insurance for a year starting from 5/1/2016. (same coverage as Company As insurance)
  • For the month of May, monthly insurance is $200 (2,400/12).
  • The $200 Bill for the May arrives June. On May 31, Company B should record coverage of insurance by recording insurance expense.
  • Annual contract will be voided if company B skips payment even once.

Table 1. Background information and Balance Sheet of company A and B.

Company A

Company B

# workers

8

8

Daily salary / employee

$100

100

Daily Sales revenue (all cash)

$1,100

$1,100

Beginning, 5/1/2016

Company A

Company B

Assets (all cash)

Cash

$50,000

$50,000

Equipment

60,000

60,000

Less : Accumulated depreciation

(15,000)

(15,000)

Total Assets

95,000

95,000

Liability

0

0

Note payable

60,000

60,000

Equity (common stock)

35,000

35,000

Insurance policy (all purchased insurance on 5/1, coverage starts from 5/1/2016 to 4/30/2017)

Purchase insurance 1 year ($2,400) in advance, paid cash on 5/1/2016

Annual contract started on 5/1

Structured a deal that insurance is post paid

Additional Info

  1. May 2016 has 23 working days. All the salary was paid during May 2016.
  2. Company B will pay $200 in June 2016 for the insurance provided in May 2016. Therefore, as of 5/31, the $200 is a liability (use insurance payable for this)
  3. Equipment was purchased on 5/1/2015, for $60,000 (issued debt, note payable). No salvage value and its useful life is 4 years.
  4. Note payable commands the annual interest of 3% (due 5/1/2021). Interest is payable in every year 4/30.
  5. Both companies, A and B, paid dividend of $2,000 on 5/30/2016.

Q1. (1 point) Provide journal entries for company A and B related to insurance, if any. Remember, only post paid account has designated payable account (Interest is post paid -> Interest payable. If account is prepaid, we charge to accounts payable.)

Date General Journal Debit Credit
5/1/2016 Prepaid insurance 2400
Cash 2400
(To record insurance purchased in advance)
5/31/2016 Insurance expense 200
Prepaid insurance 200
(To record expired insurance)

Company B

Date General Journal Debit Credit
5/1/2016 No entry
5/31/2016 Insurance expense 200
Insurance payable 200
(To record insurance payable)
June 2016 Insurance payable 200
Cash 200
(To record insurance paid)

Q2. (1 point) Complete the Balance Sheets right after the insurance purchase for company A and B. Explain the changed numbers (between before and after purchase of insurance)

As of 5/1/2016 (after insurance is purchased)

Company A

Company B

Assets

Cash

47,600

50,000

Equipment

60,000

60,000

Less: Accumulated Depreciation

(15,000)

(15,000)

Prepaid Insurance

$2400

0

Total Assets

$95,000

$95,000

Liabilities

Note payable

60,000

60,000

Total Liabilities

60,000

60,000

Equities (common stock)

35,000

35,000

Total Liabilities & Equities

95,000

95,000

* Fill it using the answer to Q1.

For Company A, on 5/1/2016 the cash account will decrease by $2400 for the amount paid for purchase of insurance and prepaid insurance will increase by the same amount. However, for Company B, there will be no change on 5/1/2016 since the insurance payable will be recorded on 5/31/2016 and same will be paid only in June.

Q3. (1 point) Complete the income statements for May 2016 for company A and B. Comment on net income in A and B, e.g., if they are same (or different), why? Commenting is an essential part of this question. Without comments, even the correct answer gets zero point.

Income statement for May 2016

Company A

Company B

Sales Revenue

Less: Salary Expense

Interest Expense

Depreciation Expense

Insurance Expense

Pretax Income

Less: Tax expense

Net income

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