Final answer:
To record the donation of rent-free office space, consider the fair market value, which in this case is $36,900 per year, as an in-kind contribution. Do not include it in explicit costs when calculating profit, but record it for financial reporting purposes. The accounting profit is then calculated by subtracting explicit costs from revenues.
Step-by-step explanation:
When recording a business donation of rent-free office space, it is important to reflect the fair market value of the service provided. In this instance, the fair market value of the office space that would normally rent for $36,900 a year should be considered as an in-kind donation. This valuation helps in accurately accounting for the donation for both financial reporting and tax purposes.
Step 1 involves calculating the costs. Your explicit costs, which include items like office rental and law clerk's salary, amount to $85,000. However, since the office space is donated, you would not include the $36,900 as part of your explicit costs.
In Step 2, you'll adjust the explicit costs by eliminating the rent expense, which would normally be a part of such costs if you were actually paying for the office space. This allows a more accurate calculation of your accounting profit. However, for bookkeeping purposes, it is often recommended to record the value of rent-free space as both donation income and rent expense to reflect the in-kind contribution.
To determine your accounting profit, you will subtract the total explicit costs from your revenues. For example, if your revenues amount to $200,000, and your explicit costs, excluding the donated rent, are $85,000, then your accounting profit would be $200,000 - $85,000 = $115,000.
Note that Fred's potential loss of $10,000 per year is a separate consideration. It is a reflection of his personal opportunity cost, comparing the income from his own business to what he would earn at a corporate firm.