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Question: should prepaid assets make difference in roa calculation 8 points...

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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’ doesn’t 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, let’s 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 A’s 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. 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.)

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