Natalie's high school friend, Katy Peterson, has been operating a bakery for approximately 10 months, which she calls The Baker's Nook. Natalie and Katy usually meet once a month to catch up and discuss problems they have encountered while operating their respective businesses. Katy wishes to borrow from her bank so she can purchase a new state-of-the-art oven. She recognizes that the bank will be evaluating her financial statements.
Katy has recently negotiated a one-year contract with Coffee to Go to provide 1,500 cinnamon buns every week. Coffee to Go, upon receipt of a monthly invoice, will send Katy a cheque by the 15th of the following month.
Katy has decided that, because she has signed this contract, she is able to record as revenue in her financial statements the contracted revenue that she is about to earn over the next 12 months.
When Katy negotiated the contract with Coffee to Go, she purchased additional baking supplies to meet the increased demand for cinnamon buns. She has decided that she will not record the purchase of these supplies until the invoice is due, which is in about 30 days. She argues that the amount to be paid for the purchase of baking supplies is relatively small and the amount won't really make much of a difference to the bank when it makes its decision.
Katy assures Natalie that this is the right way to account for this revenue and the purchase of additional baking supplies. She is now sure that the bank will lend her the money that she needs to purchase this new oven. Natalie is confused and comes to you with the following questions:
1. Is Katy accounting for this revenue correctly?
2. Is Katy accounting for the purchase of the baking supplies correctly?
3. What other information will the bank be considering when deciding whether or not to extend the loan to Katy?
4. Do you think that Katy is being honest when she identifies this revenue as being earned on her income statement?
Instructions
(a) Answer Natalie's questions.
(b) How should Katy be recording this revenue? Why?
(c) How should Katy be recording the purchase of baking supplies? Why?
(d) How could Katy ensure that the bank is aware of this contractual arrangement with Coffee to Go when it reads her financial statements?