(Learning Objective 1: Evaluate quality of earnings) Mike Magid Toyota is an automobile…

 
   

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(Learning Objective 1: Evaluate quality of earnings) Mike Magid Toyota is an automobile dealership. Magid’s annual report includes Note 1—Summary of Significant Accounting Policies as follows:

Income Recognition

Sales are recognized when cash payment is received or, in the case of credit sales, which represent the majority of . . . sales, when a down payment is received and the customer enters into an installment sales contract. These installment sales contracts . . . are normally collectible over 36 to 60 months. . . .

Revenue from auto insurance policies sold to customers are recognized as income over the life of the contracts.

Bay Area Nissan, a competitor of Mike Magid Toyota, includes the following note in its Summary of Significant Accounting Policies:

Accounting Policies for Revenues

Sales are recognized when cash payment is received or, in the case of credit sales, which represent the majority of . . . sales, when the customer enters into an installment sales contract. Customer down payments are rare. Most of these installment sales contracts are normally collectible over 36 to 60 months. . . . Revenue from auto insurance policies sold to customers are recognized when the customer signs an insurance contract. Expenses are recognized over the life of the insurance contracts.

Suppose you have decided to invest in an auto dealership, and you’ve narrowed your choices to Magid and Bay Area. Which company’s earnings are of higher quality? Why? Will their accounting policies affect your investment decision? If so, how? Mention specific accounts in the financial statements that will differ between the two companies. (Challenge)