Answer Key Legal Accounting Summer 1997 Professor Willis by Steven J. Willis All Rights Reserved

Transcription

1 Answer Key Legal Accounting Summer 1997 Professor Willis 1997 by Steven J. Willis All Rights Reserved 1

2 QUESTION ONE You have started a new law practice with a partner. You each use the accrual method of accounting and the calendar year. You have acquired and furnished your offices at a total cost of $150,000, having purchased furniture (for $10,000), books (for $10,000), and equipment (for $10,000) and an old house for $100,000 ($20,000 for the land and $80,000 for the building). You also spent $20,000 renovating the building. You purchased and paid for all the items on October 1, 1997, the date on which the renovations were complete, and the date on which you borrowed the money. You use a half-year convention for depreciation of all depreciable assets. You reasonably estimate the various personal property items each has a useful life of seven years and a salvage value equal to ten percent of its original cost and that the building has a useful life of twenty years and a salvage value of twenty percent. You each contributed $10,000 cash to the partnership, and together you borrowed $140,00 from a bank. The bank charges 9% nominal annual interest on the loan and requires monthly payments over a ten year period. The first payment is due November 1, During the final three months of 1997, the firm earned and received payment for $15,000 in legal fees. It owed and paid $6,000 in expenses (other than payments on the bank loan and depreciation). You use the double declining balance method of depreciation for the personal property and straight line for the real. Provide the journal entries for the above information and prepare a balance sheet for 12/31/97. [No explanation is necessary: just provide account names and numbers. 2

3 Entry Debit Credit Cash 20,000 My Capital Account 10,000 Partner s Capital Account 10,000 Cash 140,000 Bank Loan 140,000 Furniture 10,000 Books 10,000 Equipment 10,000 Cash 30,000 Building 80,000 Land 20,000 Cash 100,000 Building 20,000 Cash 20,000 Cash 15,000 Income from fees 15,000 Expenses 6,000 Cash 6,000 Depreciation Expense 4, Accumulated Depr. Furniture 1, Accumulated Depr. Books 1, Accumulated Depr. Equipment 1, Depreciation Expense 2,000 Accumulated Depr. Building 2,000 Interest Expense (October) 1, Bank Loan (November payment) Cash 1, Interest Expense (November) 1, Bank Loan (December Payment) Cash 1, Interest Expense (December) 1, Bank Loan (January Payment) January loan payment payable 1, Revenue & Expense Summary 15, Depreciation Expense 4, Depreciation Expense 2, Expenses 6, Interest Expense 3, Income 15, Revenue & Expense Summary 15, Retained Earnings Revenue & Expense Summary

4 Balance Sheet AS OF 12/31/97 Assets Current Assets: Liabilities Current Liabilities: cash 15, January loan payment 1, Fixed Assets: Long Term Liabilities: books 10, Bank Loan 137, equipment 10, furniture 10, acc. depr. ( 4,285.71) 25, Land 20, Building 100, acc. depr. ( 2,000.00) 98, Total Fixed Assets: 143, Total Liabilities 139, Owner s Equity Me: Contributed 10, Retained Earnings ( ) 9, Partner: Contributed 10, Retained Earnings ( ) 9, Total Equity 19, Total Assets 159, Total Liab & Equity 159,

5 QUESTION TWO Use the facts from the prior question. Your partner is having marital difficulties and fears having to pay alimony to his soon-to-be ex-wife and having to pay her an additional amount equal to one-half his interest in the law firm. He anticipates she will accept book value figures to reflect his income and assets. You may modify any assumptions, allocations, or methods of accounting or depreciation, as well as components thereof. Your modifications must be defensible, i.e., consistent with GAAP or tax accounting and reasonable. For example, you cannot assume the equipment has a useful life of 1,000 years - that would be ridiculous. You may, however, assume it has a useful life of ten or eleven years - or any other common sense, defensible period. What would you change and why? What are some of the adverse consequences that may flow from the changes you propose? In other words, argue against making the changes. Proposed Changes (list up to ten): (I include explanations here) 1. Use Tax Depreciation for all personal property. This will shorten the life from seven to probably five years and thus increase depreciation in the early years, decreasing income and book value of the assets. 2. Use Double Declining Balance method for the building. 3. Reduce the salvage to 10%. 4. Reduce the life to 18 years. This will increase the depreciation expense in the first year to $5,000, rather than $2,000. Tax depreciation would increase the life to 27.5 years and require straight line, so it would not be preferable to the original assumptions. A larger reduction in salvage and life would not be credible. Using tax depreciation for some items and traditional accounting depreciation for others might not be acceptable to the court. But, both are permissible methods in 5

6 isolation. These are not audited statements. Different depreciation methods for different classes of items is acceptable and common. 5. Elect 179 depreciation to the extent permissible. If available for the partner s (likely so since each has but $15,000 in section 179 assets), this would increase the first year depreciation expense to $30,000 and would reduce the assets to zero. This will cause an increase in income in the following year because depreciation expense would then be reduced. Of course, you could purchase more needed items and elect section 179 on them, too, in the following year. 6. Expense a portion of the building renovations, to the extent reasonable. While such substantial renovations - $20,000 - are surely capitalizable, probably some portion could be separated and expensed. Perhaps some painting or minor repairs occurred. This would reduce current income and reduce the amount of assets. Because these occurred prior to the beginning of the practice, it may not be fully credible. 7. Allocate a greater portion of the purchase price to the building and less to the land. This is a very subjective matter. The allocation, however, may have been part of the contract of purchase, which might make a re-allocation less defensible. 8. Use the cash method of accounting. This will permit the deferral of some income items and advance accrual of some 6

7 pre-paid expenses. The resulting numbers will not be as useful for business purposes. 9. Prepay some expenses for the following year, if possible. They will be deductible for tax and cash accounting purposes when paid and will not create assets, at least in reasonable amounts (subject to the Zaninovich and Grynberg cases) (not covered in this course). This will adversely affect cash flow and can lock you into contracts you might not want in the future. 10. Defer collecting some fees to the following year, if possible. This will defer taxable and cash accounting income until collection. It will reduce taxes, which will increase income. While that is more than offset by the deferred income, it may backfire. I can foresee the argument: accrue any earned and uncollected fees as income and assets (or at least as assets), but get credit only for taxes paid. I do not believe this would be fair; however, the reconciliation of tax and non-tax accounting can be quite difficult in both practice and in explanation. Hence, if you cannot explain it to the court, how can you defend it? 11. If possible, re-finance the loan at the same APR and EFF, but pay some points. This would increase apparent current interest expense (although not for tax purposes) without increasing true interest costs. 7

8 Overall: There may be some closing and paperwork costs that make this non-feasible. These proposals will reduce income and book value in the short run. This may have an adverse effect on apparent creditworthiness. It will also cause an increase in income in the future, which could have adverse tax consequences or even family law consequences at that time. E.g., if you get divorced in some future year which, because you took so many deductions now has few deductions of its own, you may end up paying more in alimony and child support than is reasonable. Thus be careful with attempts at manipulation: they can have unexpected and unintended consequences. Also, if you do too much, you risk losing credibility with the court and with opposing counsel. They may go overboard in correcting the perceived manipulations. 8