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If Tommy's business was not going to be operating soon at another location the smart thing to do would be to end the lease so that they would no longer have to pay for the equipment. Tommy, however, has a location where he can be operating shortly so he should consider not recording lease expense on the equipment during its downtime, and distributing it to the rest of the year evenly. It would not make sense to maintain the same lease expense during which time the equipment is not generating revenue; doing so would violate the matching principle. The best way to do this is to allocate the depreciation for the equipment to later periods when the equipment will be up and running. For instance, if we had a $1000 expense each month for equipment depreciation, for the 3 months and 2 weeks the machines will be down, we would readjust the $3500 to the remaining time of our lease. If there were 10 months on the lease after that time, we could add $350 to each of the remaining months.
The situation that Tommy finds himself in is unfortunate, but yet the effects could have been reduced if he had taken a few precautions, in case of an unexpected event, occurred. The first precaution that Tommy could have taken was to produce T-shirts the whole year, not to just increase production before spring break occurs. If he had lots of extra shirts in stock for spring breakers, the week that he will not be able to produce t-shirt because of the crash would not economically affect his business as much because he will still have many shirts to sell. By waiting until the
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Second, as a small business owner, you should think about having insurance to protect yourself against events such as the one that occurred. Although, the equipment was not damaged, the building did have structural damage which if Tommy has no insurance on, will be taken as a loss. If he does have insurance, he can be reimbursed in a short time for that damage which can be put towards purchasing or renting a new space. Although Tommy, being a small business owner, may have fire and inclement weather insurance coverage, another insurance that is also used by business owners is called business interruption insurance. Business interruption insurance covers the profits you would have earned, based on your financial records, had the disaster not occurred. It also incorporates a 48 hour waiting period after the disaster occurs, which gives your company some time to recuperate. Another add-on that Tommy could get for his insurance is extra expense insurance. Extra expense insurance reimburses you for some of the money you spend to recover from the accident which helps you from having to close down the business during the time of recovery (Insurance Information Institute, paragraphs 1-6).
For the September 11 attacks, the EITF classified most of the damage not as an extraordinary event but rather to be accounted for under continuing operations. They reached this decision because they felt that terrorist attacks did not fall under the category of extraordinary events because they had happened in previous years (FASB, Pg. 5, para. 2). For this particular event, however; the accounting impact on Tommy's financial statements is that Tommy would categorize this as an extraordinary event on his company's income statement. He can make this assumption because it states clearly that it was a "combination of engine failure and unforeseen weather" and also it was clearly not a terrorist attack so it would not be characterized the same as the September 11 attacks were. It would directly lower his net income; net of taxes.
The precautions that Tommy could have taken to reduce the effects of this accident would change the accounting records for "T-shirts for Tommy". First, producing more t-shirts year round rather than increasing production right before the spring break rush would affect the financial statements. The net income for quarterly statements would change because the operating expenses would be higher for the fall and winter quarters but would be less than normal for the spring and summer quarters. On the balance sheet, your depreciation on your t-shirt making equipment could be changed depending on your depreciation method. If Tommy uses straight-line depreciation the amount per month would not be affected because the amount is the same no matter how much you actually use the equipment that month. If you used the units of production method, the depreciation would be higher during the spring and summer months for your equipment, although if Tommy decided to produce the same amount of t-shirts year round, the depreciation per month would be very close to what it was when you use the straight-line depreciation method (Petroff, para. 5).
The accounting impact on the second precaution of getting insurance for your business along with the add-ons that includes business interruption and extra expense would change the outcome of your balance sheet. Tommy would have to make adjusting entries every time you prepared your financial statements for prepaid insurance (considering it was prepaid). This would directly affect your net income, decreasing it, because it would increase your expenses with an outflow of cash in exchange for protection from events like this one in this example.
If Tommy's equipment was already idle during the plan crash due to lack of demand he would treat the situation differently. T-Shirts by Tommy is posed with a delicate situation due to the fact that idle time is something hard to account for accurately. If idle time is overvalued, then cost of goods sold will be too high, and vice versa. The first thing that Mr. Short must determine is the normal overhead rate for his equipment. At what rate are normal production hours and normal expense accounted for properly? After figuring out this number, Tommy can then move onto deciding the idle capacity of his equipment.
In determining the normal overhead rate it is important to realize that normal production is not the same thing as possible production (Vollmers). In fact, confusing the two can result in major differences in cost of goods sold and net income. Once Tommy has decided the normal capacity he can use this number to determine the cost of idle equipment. Using the normal capacity as the denominator, and cost of idle equipment as the numerator, an idle rate is determined. This idle rate should be used to determine how much to expense for the time the equipment is being transported and setup at the new location. It is important to account for this idle time because the lease on the equipment does not change if it is not being used. Therefore, the time that it is not being used, it is still being paid for. In order to report this idle time, William Palmer states in his book, Construction Accounting & Financial Management, " The easiest way to report on idle time is to account for it separately in the cost ledger as if it were a separate item of job overhead cost. The account set up is charged with the out-of-pocket costs of ownership (taxes, insurance, depreciation, and sometimes storage) for all hours " So since we would not be using the machines during the period we could transfer depreciation to job overhead cost.
The fact that the busiest time of year for Mr. Short is fast approaching should also be taken into account. Employees are working overtime, and inevitably the equipment would have been doing the same had the accident not occurred. This factor should be accounted for by inflating the normal capacity to the same level it has been in past years during the spring break season. If this accident had occurred in the winter months, it would have made sense to deflate the capacity, because the company is not operating at full capacity.
FASB. Accounting for Terriorist Attacks on September 11, 2001. 2001. United States of America. 29 Oct. 2007 .
"Insurance Information Institute." Business Insurance Information. 29 Oct. 2007 .
Keiso, Donald E. Intermediate Accounting. 12 ed. John Wiley and Sons, 2007.
Palmer, William. "Construction Accounting and Financial Management." Google Book Search. 1999. McGraw-Hill Professional. 29 Oct. 2007 .
Petroff, John. "Fixed Assets." 1991. 29 Oct. 2007 .
Statement of Federal Financial Accounting Concepts and Standards. 2007. Federal Accounting Standards Advisory Board. 29 Oct. 2007 .
Vollmers, Gloria. "Accounting for Idle Capacity." The Accounting Historians Journal. 1996. University of Mississippi. 29 Oct. 2007. .