Question

Question: Daniel Barenboim sells and erects shell houses, that is, frame structures that are completely finished on the outside but are unfinished on the inside except for flooring, partition studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy with tools and who have time to do the interior wiring, plumbing, wall completion and finishing, and other work necessary to make the shell houses liveable dwellings.Barenboim buys shell houses from a manufacturer in unassembled packages consisting of all lumber, roofing, doors, windows and similar materials necessary to complete a shell house. Upon commencing operations in a new area, Barenboim buys or leases land as a site for its local warehouse, field office, and display houses. Sample display houses are erected at a total cost of \(30,000 to \)40,000 including the cost of the unassembled packages. The chief element of cost of display houses is the unassembled packages, in as much as erection is a short, low-cost operation. Old sample models are torn down or altered into new models every 3 to 7 years. Sample display houses have little salvage value because dismantling and moving costs amount to nearly as much as the cost of an unassembled package.Instructions

1. A choice must be made between (1) expensing the costs of sample display houses in the periods in which the expenditure is made and (2) spreading the costs over more than one period. Discuss the advantages of each method.
2. Would it be preferable to amortize the cost of display houses on the basis of (1) the passage of time or (2) the number of shell houses sold? Explain.

Short answer

Answer

(a), (1) The desirable treatment of the costs of the sample display houses is expensing them for more than a period.

(2) As per the expense recognition principle, the charge of service potentials should be amortized as the advantages are obtained. Hence, the costs of sample display houses should be matched with the revenue received from the sale of the houses which is obtained over more than a year.

(b) (1) In case all the shell houses are to be sold at different prices, it would be better to assign costs based on the revenue contribution of the shell houses sold. In case all the shell houses are to be sold at a similar price, it may be right to assign the costs of the display houses based on the number of shell houses sold.

(2) Cost amortization totally on the criterion of time may be chosen when the duration of the models can be anticipated with a good deal more exactness than can the number of units that will be sold.

Step-by-step solution

Meaning of Expense Recognition Principle

The expense recognition principle is a basic accounting principle that states that business expenses and revenues are recognized and matched to one accounting period toascertain the correct profit or loss.

Explanation for statement ‘a’

1. The treatment that should be provided to the costs of the sample display houses is to charge them for more than one period. Sample display houses are treated as assets as they provide rights to future service power or financial benefits.

1. According to the principle of expense recognition, costs of service power should be amortized as assistance is provided. Hence, the costs of sample display houses should be matched with the revenue from the sale of houses which is yet to be paid for a period exceedingly more than a year. As the sample houses are left on a presentation for three to seven years. Daniel Barenboim expects to obtain benefits from the benefits obtained from the displays for at least that period.

Explanation for statement ‘b’

1. If the entire shell houses are brought to be sold at the equilibrium price, it would be just to assign the costs of the number of shell houses sold. The assignment of costs should be similar to the units-of-production method of depreciation and would ultimately lead to better matching of costs with the revenues. However, if the shell houses are sold at unequal prices, the costs should be assigned based on the contribution of revenue of the shell houses sold.
2. There is unpredictability in association with the number of homes of a specific model which will be sold as a consequence of the display sample. The benefit of the amortization method is based on the fair estimates of the number and selling prices of shell houses to be sold. Cost amortization entirely based on time may be chosen when the time of the models can be anticipated with a huge deal more exactness than can the number of units which will be sold.