Question & Answer

Presented below are three independent situations.

Situation 1: A company offers a one-year warranty for the product that it manufactures. A history of warranty claims has been compiled, and the probable amounts of claims related to sales for a given period can be determined.

Situation 2: Subsequent to the date of a set of financial statements but prior to the issuance of the financial statements, a company enters into a contract that will probably result in a significant loss to the company. The amount of the loss can be reasonably estimated.

Situation 3: A company has adopted a policy of recording self-insurance for any possible losses resulting from injury to others by the company’s vehicles. The premium for an insurance policy for the same risk from an independent insurance company would have an annual cost of $4,000. During the period covered by the financial statements, there were no accidents involving the company’s vehicles that resulted in injury to others.

Instructions

Discuss the accrual or type of disclosure necessary (if any) and the reason(s) why such disclosure is appropriate for each of the three independent sets of facts above.

Ace Inc. produces electronic components for sale to manufacturers of radios, television sets, and digital sound systems. In connection with her examination of Ace’s financial statements for the year ended December 31, 2015, Gloria Rodd, CPA, completed field work

2 weeks ago. Ms. Rodd now is evaluating the significance of the following items prior to preparing her auditor’s report. Except as noted, none of these items have been disclosed in the financial statements or notes.

Item 1: A 10-year loan agreement, which the company entered into 3 years ago, provides that dividend payments may not exceed net income earned after taxes subsequent to the date of the agreement. The balance of retained earnings at the date of the loan agreement was $420,000. From that date through December 31, 2015, net income after taxes has totaled $570,000 and cash dividends have totaled $320,000. On the basis of these data, the staff auditor assigned to this review concluded that there was no retained earnings restriction at December 31, 2015.

Item 2: Recently Ace interrupted its policy of paying cash dividends quarterly to its stockholders. Dividends were paid regularly through 2014, discontinued for all of 2015 to finance purchase of equipment for the company’s new plant, and resumed in the first quarter of 2016. In the annual report, dividend policy is to be discussed in the president’s letter to stockholders.

Item 3: A major electronics firm has introduced a line of products that will compete directly with Ace’s primary line, now being produced in the specially designed new plant. Because of manufacturing innovations, the competitor’s line will be of comparable quality but priced 50% below Ace’s line. The competitor announced its new line during the week following completion of field work. Ms. Rodd read the announcement in the newspaper and discussed the situation by telephone with Ace executives. Ace will meet the lower prices that are high enough to cover variable manufacturing and selling expenses but will permit recovery of only a portion of fixed costs.

Item 4: The company’s new manufacturing plant building, which cost $2,400,000 and has an estimated life of 25 years, is leased from Wichita National Bank at an annual rental of $600,000. The company is obligated to pay property taxes, insurance, and maintenance. At the conclusion of its 10-year noncancelable lease, the company has the option of purchasing the property for $1. In Ace’s income statement, the rental payment is reported on a separate line.

Instructions

For each of the above items, discuss any additional disclosures in the financial statements and notes that the auditor should recommend to her client. (The cumulative effect of the four items should not be considered.)

Koch Corporation is in the process of preparing its annual financial statements for the fiscal year ended April 30, 2015. Because all of Koch’s shares are traded intrastate, the company does not have to file any reports with the Securities and Exchange Commission. The company manufactures plastic, glass, and paper containers for sale to food and drink manufacturers and distributors. Koch Corporation maintains separate control accounts for its raw materials, work in process, and finished goods inventories for each of the three types of containers. The inventories are valued at the lowerof- cost-or-market.

The company’s property, plant, and equipment are classified in the following major categories: land, office buildings, furniture and fixtures, manufacturing facilities, manufacturing equipment, and leasehold improvements. All fixed assets are carried at cost. The depreciation methods employed depend on the type of asset (its classification) and when it was acquired.

Koch Corporation plans to present the inventory and fixed asset amounts in its April 30, 2015, balance sheet as shown below.

Inventories $4,814,200

Property, plant, and equipment (net of depreciation) 6,310,000

Instructions

What information regarding inventories and property, plant, and equipment must be disclosed by Koch

Corporation in the audited financial statements issued to stockholders, either in the body or the notes, for the 2014–2015 fiscal year?

Matheny Inc. went public 3 years ago. The board of directors will be meeting shortly after the end of the year to decide on a dividend policy. In the past, growth has been financed primarily through the retention of earnings. A stock or a cash dividend has never been declared.

Presented below is a brief financial summary of Matheny Inc. operations.

($000 omitted)

2015 2014 2013 2012 2011

Sales revenue $20,000 $16,000 $14,000 $6,000 $4,000

Net income 2,400 1,400 800 700 250

Average total assets 22,000 19,000 11,500 4,200 3,000

Current assets 8,000 6,000 3,000 1,200 1,000

Working capital 3,600 3,200 1,200 500 400

Common shares:

Number of shares

 outstanding (000) 2,000 2,000 2,000 20 20

Average market price $9 $6 $4 — —

Instructions

(a) Suggest factors to be considered by the board of directors in establishing a dividend policy.

(b) Compute the return on assets, profit margin on sales, earnings per share, price-earnings ratio, and current ratio for each of the 5 years for Matheny Inc.

(c) Comment on the appropriateness of declaring a cash dividend at this time, using the ratios computed in part (b) as a major factor in your analysis.

Presented below is the comparative balance sheet for Gilmour Company.

Instructions

 (Round to two decimal places.)

(a) Prepare a comparative balance sheet of Gilmour Company showing the percent each item is of the total assets or total liabilities and stockholders’ equity.

(b) Prepare a comparative balance sheet of Gilmour Company showing the dollar change and the percent change for each item.

(c) Of what value is the additional information provided in part (a)?

(d) Of what value is the additional information provided in part (b)?

Bradburn Corporation was formed 5 years ago through a public subscription of common stock. Daniel Brown, who owns 15% of the common stock, was one of the organizers of Bradburn and is its current president. The company has been successful, but it currently is experiencing a shortage of funds. On June 10, 2014, Daniel Brown approached the Topeka National Bank, asking for a 24-month extension on two $35,000 notes, which are due on June 30, 2015, and September 30, 2015. Another note of $6,000 is due on March 31, 2016, but he expects no difficulty in paying this note on its due date. Brown explained that Bradburn’s cash flow problems are due primarily to the company’s desire to finance a $300,000 plant expansion over the next 2 fiscal years through internally generated funds. The commercial loan officer of Topeka National Bank requested the following financial reports for the last 2 fiscal years.

Instructions

(a) Compute the following items for Bradburn Corporation.

(1) Current ratio for fiscal years 2014 and 2015.

(2) Acid-test (quick) ratio for fiscal years 2014 and 2015.

(3) Inventory turnover for fiscal year 2015.

(4) Return on assets for fiscal years 2014 and 2015. (Assume total assets were $1,688,500 at 3/31/13.)

(5) Percentage change in sales, cost of goods sold, gross margin, and net income after taxes from fiscal year 2014 to 2015.

(b) Identify and explain what other financial reports and/or financial analyses might be helpful to the commercial loan officer of Topeka National Bank in evaluating Daniel Brown’s request for a time extension on Bradburn’s notes.

(c) Assume that the percentage changes experienced in fiscal year 2015 as compared with fiscal year

2014 for sales and cost of goods sold will be repeated in each of the next 2 years. Is Bradburn’s desire to finance the plant expansion from internally generated funds realistic? Discuss.

(d) Should Topeka National Bank grant the extension on Bradburn’s notes considering Daniel Brown’s statement about financing the plant expansion through internally generated funds? Discuss.

Cineplex Corporation is a diversified company that operates in five different industries: A, B, C, D, and E. The following information relating to each segment is available for 2015.

A B C D E

Sales revenue $40,000 $ 75,000 $580,000 $35,000 $55,000

Cost of goods sold 19,000 50,000 270,000 19,000 30,000

Operating expenses 10,000 40,000 235,000 12,000 18,000

Total expenses 29,000 90,000 505,000 31,000 48,000

Operating profi t (loss) $11,000 $ (15,000) $ 75,000 $ 4,000 $ 7,000

Identifi able assets $35,000 $ 80,000 $500,000 $65,000 $50,000

Sales of segments B and C included intersegment sales of $20,000 and $100,000, respectively.

Instructions

(a) Determine which of the segments are reportable based on the:

(1) Revenue test.

(2) Operating profit (loss) test.

(3) Identifiable assets test.

(b) Prepare the necessary disclosures required by GAAP.

Your firm has been engaged to examine the financial statements of Almaden Corporation for the year 2014. The bookkeeper who maintains the financial records has prepared all the unaudited financial statements for the corporation since its organization on January 2, 2009. The client provides you with the following information.

The supplementary information below is also provided.

1. On May 1, 2014, the corporation issued at 95.4, $750,000 of bonds to finance plant expansion. The long-term bond agreement provided for the annual payment of interest every May 1. The existing plant was pledged as security for the loan. Use the straight-line method for discount amortization.

2. The bookkeeper made the following mistakes.

(a) In 2012, the ending inventory was overstated by $183,000. The ending inventories for 2013 and

2014 were correctly computed.

(b) In 2014, accrued wages in the amount of $225,000 were omitted from the balance sheet, and these expenses were not charged on the income statement.

(c) In 2014, a gain of $175,000 (net of tax) on the sale of certain plant assets was credited directly to retained earnings.

3. A major competitor has introduced a line of products that will compete directly with Almaden’s primary line, now being produced in a specially designed new plant. Because of manufacturing innovations,the competitor’s line will be of comparable quality but priced 50% below Almaden’s line. The competitor announced its new line on January 14, 2015. Almaden indicates that the companywill meet the lower prices that are high enough to cover variable manufacturing and selling expenses, but permit recovery of only a portion of fixed costs.

4. You learned on January 28, 2015, prior to completion of the audit, of heavy damage because of a recent fire to one of Almaden’s two plants; the loss will not be reimbursed by insurance. The newspapers described the event in detail.

Instructions

Analyze the above information to prepare a corrected balance sheet for Almaden in accordance with proper accounting and reporting principles. Prepare a description of any notes that might need to be prepared.

The books are closed and adjustments to income are to be made through retained earnings.

Edna Millay Inc. is a manufacturer of electronic components and accessories with total assets of $20,000,000. Selected financial ratios for Millay and the industry averages for firms of similar size are presented below.

2014

Edna Millay Industry

2012 2013 2014 Average

Current ratio 2.09 2.27 2.51 2.24

Quick ratio 1.15 1.12 1.19 1.22

Inventory turnover 2.40 2.18 2.02 3.50

Net sales to stockholders’ equity 2.71 2.80 2.99 2.85

Return on common stock equity 0.14 0.15 0.17 0.11

Total liabilities to stockholders’ equity 1.41 1.37 1.44 0.95

Millay is being reviewed by several entities whose interests vary, and the company’s financial ratios are a part of the data being considered. Each of the parties listed below must recommend an action based on its evaluation of Millay’s financial position.

Archibald MacLeish Bank. The bank is processing Millay’s application for a new 5-year term note.

Archibald MacLeish has been Millay’s banker for several years but must reevaluate the company’s financial position for each major transaction.

Robert Lowell Company. Lowell is a new supplier to Millay and must decide on the appropriate credit terms to extend to the company. Robert Penn Warren. A brokerage firm specializing in the stock of electronics firms that are sold overthe- counter, Robert Penn Warren must decide if it will include Millay in a new fund being established

for sale to Robert Penn Warren’s clients. Working Capital Management Committee. This is a committee of Millay’s management personnel chaired by the chief operating officer. The committee is charged with the responsibility of periodically reviewing the company’s working capital position, comparing actual data against budgets, and recommending changes in strategy as needed.

Instructions

(a) Describe the analytical use of each of the six ratios presented on page 1535.

(b) For each of the four entities described above, identify two financial ratios, from the ratios presented on page 1535, that would be most valuable as a basis for its decision regarding Millay.

(c) Discuss what the financial ratios presented in the question reveal about Millay. Support your answer by citing specific ratio levels and trends as well as the interrelationships between these ratios.

Picasso Company is a wholesale distributor of professional equipment and supplies. The company’s sales have averaged about $900,000 annually for the 3-year period 2012–2014.

The firm’s total assets at the end of 2014 amounted to $850,000.

The president of Picasso Company has asked the controller to prepare a report that summarizes the financial aspects of the company’s operations for the past 3 years. This report will be presented to the board of directors at their next meeting.

In addition to comparative financial statements, the controller has decided to present a number of relevant financial ratios which can assist in the identification and interpretation of trends. At the request of the controller, the accounting staff has calculated the following ratios for the 3-year period 2012–2014.

2012 2013 2014

Current ratio 1.80 1.89 1.96

Acid-test (quick) ratio 1.04 0.99 0.87

Accounts receivable turnover 8.75 7.71 6.42

Inventory turnover 4.91 4.32 3.42

Debt to assets 51.0% 46.0% 41.0%

Long-term debt to assets 31.0% 27.0% 24.0%

Sales to fi xed assets (fi xed asset turnover) 1.58 1.69 1.79

Sales as a percent of 2012 sales 1.00 1.03 1.07

Gross margin percentage 36.0% 35.1% 34.6%

Net income to sales 6.9% 7.0% 7.2%

Return on assets 7.7% 7.7% 7.8%

Return on common stock equity 13.6% 13.1% 12.7%

In preparation of the report, the controller has decided first to examine the financial ratios independent of any other data to determine if the ratios themselves reveal any significant trends over the 3-year period.

Instructions

(a) The current ratio is increasing while the acid-test (quick) ratio is decreasing. Using the ratios provided, identify and explain the contributing factor(s) for this apparently divergent trend.

(b) In terms of the ratios provided, what conclusion(s) can be drawn regarding the company’s use of financial leverage during the 2012–2014 period?

(c) Using the ratios provided, what conclusion(s) can be drawn regarding the company’s net investment in plant and equipment?

As loan analyst for Utrillo Bank, you have been presented the following information.

Assets

Toulouse Co. Lautrec Co.

Cash $ 120,000 $ 320,000

Receivables 220,000 302,000

Inventories 570,000 518,000

Total current assets 910,000 1,140,000

Other assets 500,000 612,000

Total assets $1,410,000 $1,752,000

Liabilities and Stockholders’ Equity

Current liabilities $ 305,000 $ 350,000

Long-term liabilities 400,000 500,000

Capital stock and retained earnings 705,000 902,000

Total liabilities and stockholders’ equity $1,410,000 $1,752,000

Annual sales $ 930,000 $1,500,000

Rate of gross profi t on sales 30% 40%

Each of these companies has requested a loan of $50,000 for 6 months with no collateral offered.

Because your bank has reached its quota for loans of this type, only one of these requests is to be granted.

Instructions

Which of the two companies, as judged by the information given above, would you recommend as the better risk and why? Assume that the ending account balances are representative of the entire year.

Carlton Company is involved in four separate industries. The following information is available for each of the four industries. Operating Segment Total Revenue Operating Profi t (Loss) Identifi able Assets

W $ 60,000 $15,000 $167,000

X 10,000 3,000 83,000

Y 23,000 (2,000) 21,000

Z 9,000 1,000 19,000

$102,000 $17,000 $290,000

Instructions

Determine which of the operating segments are reportable based on the:

(a) Revenue test.

(b) Operating profit (loss) test.

(c) Identifiable assets test.

For each of the following subsequent (post-balance-sheet) events, indicate whether a company should (a) adjust the financial statements, (b) disclose in notes to the financial statements, or (c) neither adjust nor disclose.

______ 1. Settlement of federal tax case at a cost considerably in excess of the amount expected at year-end.

______ 2. Introduction of a new product line.

______ 3. Loss of assembly plant due to fire.

______ 4. Sale of a significant portion of the company’s assets.

______ 5. Retirement of the company president.

______ 6. Prolonged employee strike.

______ 7. Loss of a significant customer.

______ 8. Issuance of a significant number of shares of common stock.

______ 9. Material loss on a year-end receivable because of a customer’s bankruptcy.

______ 10. Hiring of a new president.

______ 11. Settlement of prior year’s litigation against the company (no loss was accrued).

______ 12. Merger with another company of comparable size.

Madrasah Corporation issued its financial statements for the year ended December 31, 2014, on March 10, 2015. The following events took place early in 2015.

(a) On January 10, 10,000 shares of $5 par value common stock were issued at $66 per share.

(b) On March 1, Madrasah determined after negotiations with the Internal Revenue Service that income taxes payable for 2014 should be $1,270,000. At December 31, 2014, income taxes payable were recorded at $1,100,000.

Instructions

Discuss how the preceding post-balance-sheet events should be reflected in the 2014 financial statements.

Heartland Company’s budgeted sales and budgeted cost of goods sold for the coming year are $144,000,000 and $99,000,000, respectively. Short-term interest rates are expected to average 10%. If Heartland can increase inventory turnover from its present level of 9 times a year to a level of 12 times per year, compute its expected cost savings for the coming year.

Answer each of the questions in the following unrelated situations.

(a) The current ratio of a company is 5:1 and its acid-test ratio is 1:1. If the inventories and prepaid items amount to $500,000, what is the amount of current liabilities?

(b) A company had an average inventory last year of $200,000 and its inventory turnover was 5. If sales volume and unit cost remain the same this year as last and inventory turnover is 8 this year, what will average inventory have to be during the current year?

(c) A company has current assets of $90,000 (of which $40,000 is inventory and prepaid items) and current liabilities of $40,000. What is the current ratio? What is the acid-test ratio? If the company borrows $15,000 cash from a bank on a 120-day loan, what will its current ratio be? What will the acid-test ratio be?

(d) A company has current assets of $600,000 and current liabilities of $240,000. The board of directors declares a cash dividend of $180,000. What is the current ratio after the declaration but before payment?

What is the current ratio after the payment of the dividend?

Identifiable assets for the seven industry segments of Foley Corporation are:

Penley $500 Cheng $200

Konami 550 Takuhi 150

KSC 250 Molina 475

Red Moon 400

Based only on the identifiable assets test, which industry segments are reportable?

Operating profits and losses for the seven industry segments of Foley Corporation are:

Penley $ 90 Cheng $ (20)

Konami (40) Takuhi 34

KSC 25 Molina 150

Red Moon 50

Based only on the operating profit (loss) test, which industry segments are reportable?

Foley Corporation has seven industry segments with total revenues as follows.

Penley $600 Cheng $225

Konami 650 Takuhi 200

KSC 250 Molina 700

Red Moon 275

Based only on the revenues test, which industry segments are reportable?

Tina Bailey, a student of intermediate accounting, was heard to remark after a class discussion on segment reporting, “All this is very confusing to me. First we are told that there is merit in presenting the consolidated results, and now we are told that it is better to show segmental results. I wish they would make up their minds.” Evaluate this comment.

Morlan Corporation is preparing its December 31, 2014, financial statements. Two events that occurred between December 31, 2014, and March 10, 2015, when the statements were issued, are described below.

1. A liability, estimated at $160,000 at December 31, 2014, was settled on February 26, 2015, at $170,000.

2. A flood loss of $80,000 occurred on March 1, 2015.

What effect do these subsequent events have on 2014 net income?

An annual report of Ford Motor Corporation states, “Net income a share is computed based upon the average number of shares of capital stock of all classes outstanding. Additional shares of common stock may be issued or delivered in the future on conversion of outstanding convertible debentures, exercise of outstanding employee stock options, and for payment of defined supplemental compensation. Had such additional shares been outstanding, net income a share would have been reduced by 10¢ in the current year and 3¢ in the previous year. . . . As a result of capital stock transactions by the company during the current year (primarily the purchase of Class A Stock from Ford Foundation), net income a share was increased by 6¢.” What information is provided by this note?

An annual report of Crestwood Industries states, “The company and its subsidiaries have longterm leases expiring on various dates after December 31, 2014. Amounts payable under such commitments, without reduction for related rental income, are expected to average approximately $5,711,000 annually for the next 3 years. Related rental income from certain subleases to others is estimated to average $3,094,000 annually for the next 3 years.” What information is provided by this note?

Presently, the profession requires that earnings per share be disclosed on the face of the income statement. What are some disadvantages of reporting ratios on the financial statements?

Explain the meaning of the following terms: (a) commonsize analysis, (b) vertical analysis, (c) horizontal analysis, and (d) percentage analysis.