The Terry Project: Adjusting the Financial Statements
Introduction
Most college courses in accounting focus on teaching the various components of the accounting system.While this is an effective way to learn and master each of the various components, it usually leaves students with only a vague notion of how those components work together.This project, as many of your know from Acct 315, will help you to consider a series of individual situations, how they should be accounted for and what each will do to the company's bottom line.Basically, this project has three goals: 1) to give you practice with at least one of the important topics we will cover in each chapter; 2) to encourage you to consider the consequences of business decisions on the financial statements; and 3) to provide you with an opportunity to work with a small group or partner to solve accounting problems.
To accomplish the first goal, I have provided you with some basic information about the financial accounts already prepared by Terry Co.For most of the chapters we cover, I will give you information about at least one transaction that Terry's accounting department has not yet recorded. It will be up to you to determine whether any adjustment needs to be made because of this new information.If so, then you will need to make the appropriate journal entries (including any tax effects).
To accomplish the second goal, each assignment will require to you create or adjust Terry's financial statements based on your adjusting entries.You will then have the opportunity to look at several commonly used financial ratios to determine what effect your changes will have on investors' opinion of Terry Co.
To accomplish the third goal, you will work with a partner (or partners, depending on the class size) of your choice. Because of the way the system is set up for grading, once you have set up your Terry teams you will have to continue with that team for the rest of the semester. Your choice of partner is due at 5:00pm on the due date given in the course schedule. If necessary, you may use the Terry Groups discussion link in BB Learn to help you find a partner.
This project will provide you with some experience in the types of activities you will be doing throughout your professional careers: making journal entries, fixing financial statements, recognizing the effects of certain decisions of the financial statements, and discussing those effects with others.In addition, the project will provide you with some perspective on how your business decisions will affect the way investors, creditors, and other outside stakeholders see your company.
Background Information
Terry Co. sells backpacks, laptop bags, briefcases, and other bags. The bags are purchased already made, then the Terry branding and finish is added. Because of several exclusive contracts and high quality products, the company has a strong following in its home state of Georgia and the surrounding area. In addition to its own brand, the company also has contracts with many colleges, firms, and local organizations to sell bags with these other groups' logos. This practice has greatly increased Terry's sales, especially since the company is usually able to use lower quality inventory to fill these orders (this leads to lower costs for the other groups without damaging Terry's reputation).
Because of its success during the past two (2) years, Terry was able to go public in January of last year. This has given the company additional capital to grow, as well as allowing the original owners to diversify some of their risk. Management's goal now is to begin marketing in the Northeast and Central regions of the country. If they are successful, they will continue on to the West Coast within a few years. Since much of their advertising is done through personal contacts and word of mouth, their growth will be slow. While that worries some of their new investors, recent economic trouble has left many investors pleased with the management team's more cautious growth.
In their rush to go public, Terry's management has forgotten one small detail. They have not created a very strong accounting department. While their auditors have been willing to help them clean up their books in the past, the managers are starting to realize that their lack of in-house accounting expertise is a problem. During the past year they engaged in several transactions and decisions that might have important repercussions on their financial statements, and they didn't know it. In an effort to start cleaning up their accounting system, they have finally hired you and your partner. Your first job will be to go through Terry's decisions for the year and clean up any mistakes that have been made, and to record any transactions that have been missed. In the future, you will be expected to give management good advice about the accounting consequences of their actions before decisions are made.
Based on recommendations from their auditor and SEC regulations, Terry uses an accrual accounting system based on U.S. GAAP. The company's fiscal year end is December 31st.Since Terry is a relatively small public company with an easy audit, the auditors don't usually arrive until about January 15th. However, you are expected to have the financial statements ready to go by January 1st so that upper management can issue an earnings announcement to the stockholders. Although an earnings announcement is known to be unaudited, investors are traditionally very harsh with companies that have a final earnings number below the initial earnings announcement. You will need to be as accurate as possible in order to avoid this type of market consequence.
Original Financial Statements
Terry has already completed a set of financial statements in good form for the current year (see below). However, they have neglected to include several key pieces of information. Throughout the semester, you will be adding and incorporating this additional information. You can get a template of these financial statements on BBLearn. Terry's tax rate is 25%.
Terry Part 1: Review of 315 Material
Goal: To review one of the key topics from Acct 315 (to help everyone get back in the swing of doing Terry!
Information:
On November 1, Terry issued a $450,000, semi-annual, 15 year, 5% bond. The market rate for similar bonds on that day was 6%.Terry uses the effective interest method to record the amortization or premiums and discounts. Terry's management has decided to report net bonds on the balance sheet, instead of reporting the bond and its premium or discount separately. No entries have yet been made for the bond.
Terry's management would like to know the effects of the new bond on the following ratios:
- Debt to Equity Ratio (Total Liabilities / Total Equity)
- Current Ratio
- ROA
Assignment:
Calculations -
1. Calculate each of the three (3) ratios before you make any adjustments.
2. Make the appropriate journal entries, if any, to account for the new bond and any accrued interest (including any necessary changes to income tax expense).
3. Make any necessary changes to the financial statements.
4. Calculate the three (3) ratios after you make any adjustments.
Critical Thinking
5. What do you think investors' reaction will be to management's decision to issue a new bond?In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with the decision to issue the new debt?Why or why not?
6. Do you think it is appropriate for management to focus on the financial statement effects when choosing how to issue a new bond (par, premium, or discount) or should they focus on the company's cash needs? Defend your answer.
Hints:
1. You might want to start with the financial statement template provided in BBLearn.
2. You should begin this problem by making the journal entry to record the issuance of the bond at its present value.
3. Next calculate the interest expense to be reported and any premium or discount to be amortized at the time of the first interest payment.
4. Multiply your interest expense and amortization numbers for the first payment by the number of months the bond has been outstanding divided by 6 (for the 6 months in each semi-annual payment period).This will give you two of the three line items you need for the interest entry on the bond this year.
5. You will need to add three line items to your Statement of Cash Flows to make it balance after recognizing the issuance of the bond and the accrued interest. One line item is the cash from the bond issue. One of the others is one of the four non-cash (4) accruals that have to be reversed in your Cash Flows from Operations section.
Terry Part 2:
Goal: To practice correcting the financial statements for different revenue recognition situations.(See Topic Guides AIO 4 &30).
Information:
Terry determined early in its history that it was more effective for them to build their own specialized production equipment than for them to share their proprietary production data with a construction company. While this process leads to a larger upfront cost for new equipment, the special production methods used by the company have earned much more than the initial extra outlay.
While the company has historically kept this production process in-house, they have recently been approached by a local university with a request to provide a set of machinery that the university can use to produce their own specialty bags. Since many members of Terry's Board of Directors (and several large shareholders) are alumni of this university, Terry's management has decided that they will go through with the sale of a three machine system to the university.
As part of the deal, Terry's management has insisted that the university also purchase a 3-year maintenance contract. This requirement will allow Terry's engineers and machinists to take care of the equipment, reducing the chance of losing their competitive advantage. The total contract price for the machines and the maintenance contract is $1,150,000.
As part of the contract, both parties have agreed that the university will have the right to return the equipment if they are not satisfied with the performance of the machines. Terry will also provide an additional refund for the maintenance contract if the company returns the equipment within the next few years.
While Terry has never sold its equipment before, machinery for making bags can be purchased from many other companies. In addition, many of those companies also provide service contracts to care for the machines they sell. Other versions of the machines typically sell for $400,000; $275,000; and $325,000.A 3-year maintenance contract sells, on average, for $250,000.
By the end of Year 2, Terry had installed the first and third machines and the university has paid $450,000.Terry's management team anticipates that the final machine will be installed in January of Year 3, and the maintenance contract will begin immediately after the final installation. The university will pay the balance of the contract once the last one is installed.
Terry's management team would like to know the effect of the sale, if any, on the following ratios:
- Profit Margin
- Current Ratio
- ROA
Assignment:
Calculations
1. Calculate each of the three (3) ratios before you make any adjustments.
2. Make the appropriate journal entries, if any, to account for the installation of the first and third machines (including any necessary changes to income tax expense) and the first payment by the university. Assume that the first machine cost Terry $100,000, the second $125,000, and the third $150,000.Terry's work building these machines has already been appropriately recorded in inventory.
3. Make any necessary changes to the financial statements.
4. Calculate the three (3) ratios after you make any adjustments.
Critical Thinking
5. What do you think investors' reaction will be to the sale of these proprietary machines to a university (if any)?In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with management's choice to enter into this agreement? Why or why not?
6. Who might be affected by the Terry's decision to give into the Board's demands and sell their proprietary machines to the university?
Hints:
1. Round your percentages to the nearest percentage point (i.e. 12.33% would be rounded to 12%).You can do this using the following Excel formula:=round(E4/E5,2).
2. Remember that Terry uses a perpetual inventory system!
3. Make sure that you include the full contract price in your journal entry, not just the amount the client has paid. The contract and the fact that you have started fulfilling the order allows you to record the balance due as A/R, but remember that you can't yet include it all as revenues!
Terry Part 3:
Goal: To practice correcting the financial statements for the Lower of Cost or Market.
Information:
Terry's internal auditor is afraid that some inventory has become obsolete. She has gathered the following information about the inventory items she is worried about:
|
Inventory Items
|
Historical Cost
|
Current
Sales Price
|
Disposal Cost
|
Replacement Value
|
|
TGIT
|
$175
|
$190
|
$25
|
$100
|
|
TT9G5
|
$225
|
$250
|
$15
|
$205
|
After talking with the Sales department, she estimates that the normal markup on TGIT would be $40 and $55 on TT9G5.They currently have 450 units of TGIT and 300 units of TT9G5 in stock.Terry's management has opted to use the direct method on any inventory write downs.
Terry's management would like to know the effect of the write down, if any, on the following ratios:
- Inventory Turnover (COGS / average total inventory)
- Current Ratio
- ROA
Assignment:
Calculations
1. Calculate each of the three (3) ratios before you make any adjustments.
2. Make the appropriate journal entries, if any, to account for the change in inventory value (including any necessary changes to income tax expense).
3. Make any necessary changes to the financial statements.
4. Calculate the three (3) ratios after you make any adjustments.
Critical Thinking
5. What do you think investors' reaction will be to the write down of inventory (if any)?In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with management's handling of inventory? Why or why not?
6. Does Terry have to make this write down (if any)? What other options does management have for dealing with this older inventory? What potential consequences (good or bad) might result from these options? Provide at least two (2) alternative options.
Terry Part 4:
Goal: To practice recognizing and reporting pension expenses.
Information:
Terry has three main classifications of employees: management, designers, and production workers. In order to retain their qualified design staff, Terry has offered them a small defined benefit pension if they remain with the company until their retirement. Terry's management team has been provided with a 401(k) (despite numerous complaints from the management team that they also deserve a pension).Since the production team traditionally turns over very quickly with little adverse effect on the company, Terry does not provide any pension or 401(k) contributions for these workers. Instead, they have provided them with opportunities to contribute into self-funded retirement plans.
At the end of year 1, the pension benefit obligation for the design team was $150,000 and the plan was fully funded (i.e. plan assets were also $150,000).They also had no balance in accumulated other comprehensive income for pensions. Because of this, the pension did not appear on Terry's Year 1 balance sheet. The pension expense for Year 2 has not yet been recognized.
On December 31st, Terry contributed $60,000 to management's 401(k) and $35,000 to the designer's pension fund. On that same day, Terry received the following information from their actuarial firm:
1. The annual service cost was $7,500.
2. The expected return on plan assets was 6% and the discount rate on the pension benefit obligation was 13%.
3. The actuarial adjustment to the obligation for the year was an increase of $3,000.
The plan's administrator reported that the plan paid out $15,000 in benefits for the year.With the $35,000 investment by the company, the ending plan balance was $181,000.
Terry's management team would like to know the effect of the pension, if any, on the following ratios:
- Profit Margin
- Debt-to-Equity
- ROE
Assignment:
Calculations
1. Calculate each of the three (3) ratios before you make any adjustments.
2. Fill out a pension worksheet for the changes to the defined benefit pension.
3. Make the appropriate journal entries, if any, to account for the pension expense (including any necessary changes to income tax expense).
4. Make any necessary changes to the financial statements. Please see the hints about the special adjustment to the Statement of Cash Flows.
5. Calculate the three (3) ratios after you make any adjustments.
Critical Thinking
6. What do you think investors' reaction will be to the adjustment for pension? In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with Terry's decisions regarding the pension? Why or why not?
7. How do you think Terry's board should respond to management's insistence that they also deserve a defined benefit pension? Write your answer in the form of a short email that the board could send to the management team.
Hints:
1. A pension worksheet similar to the one we used in class is available on BBLearn.
2. You will need to add one line to your I/S and two lines to your B/S. Please note that a net pension liability is classified as a long-term liability and a net pension asset is classified as a long-term investment. Also, companies typically combine all of their accumulated other comprehensive income accounts into just one line item.
3. The Statement of Cash Flows treatment is also a little different for pensions. Because we don't use the change in other comprehensive income accounts on the Statement of Cash Flows, you have to make a manual adjustment. If the cash contribution is different from the pension expense recognized, then we add a line called "Pension Plan Contributions."This value is calculated as Pension Expense - the cash contributed to the pension.
Terry Part 5:
Goal: To practice recognizing and reporting leases.
Information:
Terry has traditionally purchased all of its manufacturing equipment. However, in Year 2 they were unable to find a vendor willing to sell them a new $750,000 machine. After some careful negotiations, however, they were able to lease the needed equipment for 5 years. At the end of the lease Terry will have the option to purchase the equipment for $110,000, the estimated fair value at the end of the lease. They plan to exercise the option and keep the equipment.
The machine has an estimated economic life of 7 years with no salvage value. The payments on the lease will be $164,982.Terry does not know the implicit interest rate used by the vendor, but their incremental interest rate is 7%.The lease period began on June 1, Year 2.The first payment was due on that day. Subsequent payments will be made each year on May 31st.
Terry has decided to keep all of its accumulated depreciation in one account rather than create a separate account for leased assets.
Terry's management team would like to know the effect of the lease, if any, on the following ratios:
- Profit Margin
- Debt-to-Equity
- ROA
Assignment:
Calculations
1. Calculate each of the three (3) ratios before you make any adjustments.
2. Make the appropriate journal entries, if any, to account for the lease (including any necessary changes to income tax expense).
3. Make any necessary changes to the financial statements. Please see the hints about the special adjustment to the Statement of Cash Flows.
4. Calculate the three (3) ratios after you make any adjustments.
Critical Thinking
5. What do you think investors' reaction will be to the new lease? In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with Terry's decisions regarding the lease? Why or why not?
6. Management has asked the accounting department to ensure that the new lease be structured as an operating lease, even changing the contract if necessary to avoid recognizing a lease liability. Terry's controller feels that the company should get the most appropriate contract for their needs, then worry about the accounting classification. Provide two (2) arguments that the controller could use to convince the management team that her plan is the most appropriate.
Hints:
1. Don't forget to check to see how this lease should be classified by Terry. Also, remember that for capital leases the value of the lease liability and the leased asset is equal to the PV of the lease payments, not the market value of the leased item.
2. If you need to, add a new 'leased asset' account in Terry's Balance Sheet. However, Terry's management wants ALL of its accumulated depreciation to be reported in one account rather than create a separate account for leased assets.
3. Technically, a Lease Liability (if needed) should be broken into current and long-term portions on Terry's Balance Sheet. However, for the sake of simplicity, just classify the entire amount as long-term.
4. Make sure that you round all of your numbers to the nearest dollar! That's a general rule for Terry, and it is especially important with all of the PV estimates and other calculations you will need to make in this portion of the project. If necessary, use the "rounddown" for your Income Tax Expense calculation, since we have done a lot of rounding up to this point in the project that can easily throw off this calculation and make your B/S off by $1.
5. If this is a capital lease, you would need to add only one line item to your Cash Flow from Financing Activities section.
Terry Part 6:
Goal: To practice recognizing and reporting deferred taxes.
Information:
Terry's auditors have approached the management team with their concern that Terry has not been properly recording deferred taxes. In particular, they are concerned that Terry is simply recognizing 25% as the company's income tax expense. They have asked the company to make a thorough review of the company's tax liability utilizing the services of professional tax accountants.
The review revealed three book/tax differences in Terry's financial information:
1. Terry's management opened a new life insurance policy this year on the CEO. The annual premium for this new policy is $2,500/month. The policy cannot be prepaid.
2. Terry's cash receipts from the multiple deliverable approach, and not the revenue recognized, must be recognized for tax purposes.
3. Up through Year 1, Terry had no book/tax differences for amortization and depreciation. This happens when companies use the MACRS tables for determining their depreciation and amortization expenses for both GAAP and tax purposes, a common practice among small companies (like Terry). However, in Year 2, Terry decided to switch to the straight-line method for GAAP purposes. Since this is a change in estimate, it did not require any special changes to Terry's accounts, but it does create a difference for tax purposes. Under GAAP, Terry's straight line depreciation & amortization was calculated to be $213,010 for Years 2-5 and $60,317 in Year 6. For tax purposes, Terry's depreciation expense is $456,179 for Year 2, $273,707 for Year 3, and $182,471 in Year 4.
In addition, the experts feel that Terry's tax rate will increase to 30% in Year 5 due to new state laws passed and signed during Year 2.
Terry's management team would like to know the effect of the sale, if any, on the following ratios:
- Profit Margin
- Current Ratio
- ROA
Assignment:
Calculations
1. Calculate each of the three (3) ratios before you make any adjustments.
2. Make the appropriate journal entry to correctly record income tax expense for Year 2.(Please see the hints section for help with making these entries!)
3. Make any necessary changes to the financial statements.
4. Calculate the three (3) ratios after you make any adjustments.
Critical Thinking
5. What do you think investors' reaction will be to the adjustment for deferred taxes (if any)? In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with these changes? Why or why not?
6. Who might be affected by Terry's decision not to recognize deferred taxes appropriately in past years? How could this decision affect each individual or group?
Hints:
1. We calculated the revenue amounts as part of an earlier Terry problem. You'll find the numbers you need for the tax adjustment in that earlier problem. Make sure that you have made any necessary corrections to your work on that problem (based on the posted solution) before you start doing these calculations.
2. The revenue tax difference would be classified as current; the depreciation difference would be classified as long-term.
3. You should set up your tables for Step 5 just like we did in class.
4. The easiest way to create the correcting entry is to start with Step 6: Making the Journal Entry for Year 2 the same way we did in class (the entry Terry should have made).Once you have that entry, you can determine the necessary correcting entry. Start by adjusting Income Tax Expense as reported in Terry #5 (what Terry has recognized) to what it should be (as you just determined from Step 6 entry).Add in the changes to the deferred tax accounts (since Terry hasn't recognized those at all), then use Income Tax Payable as the plug figure.
5. Your ending cash balance should not change, but you will need to add one (1) new line item to make your Statement of Cash Flows balance. Remember that U.S. GAAP requires ALL of the tax effects to be included in Cash Flows from Operating Activities, but they prefer that all deferred taxes be reported as one adjustment.
Terry Part 7:
Goal: To practice recording stock options and calculating basic and diluted EPS.
Information:
On January 1st, Terry's Board of Directors awarded the team 90,000 stock options for Terry's $1 par common stock. Terry's stock price on that day was $7.50/share. The Board set the strike price of the options at $9.25/share to encourage the management team to focus on improving the company's stock price. The average stock price during Year 2 was $9.75.The options will vest in 4 years and, according to the Black Scholes Model, have a fair value of $3.10 each on the date issued. Terry's management was pleased with the decision because this is the first time that the Board has offered them options as a form of compensation, although they were disappointed that the options could only be used to purchase stock, not redeemed for their fair value.
Later in the year, on December 1st, Terry's Board voted to repurchase 25,000 shares of common stock. The stock price on the day of the purchase was $9.10/share. Neither the stock options nor the purchase of treasury stock have been recorded.
Terry's management team has also asked you to determine the correct EPS numbers for the year. Up until the issuance of the options, the company had a simple capital structure. Now, though, the company will need to present both basic and diluted EPS on its Income Statement. In addition, they would like to know the effect of the stock options and additional dividend, if any, on the following ratios:
Assignment:
Calculations
1. Calculate each of the two (2) ratios before you make any adjustments.
2. Make the appropriate journal entries to correctly record the stock options and repurchase.
3. Make the appropriate journal entry to correctly record the tax effect of the stock options. Please note that for tax purposes, equity options are treated as long-term deferred tax assets (for the future tax breaks that they will provide). In making your tax calculations, assume that Terry's management will exercise the options as soon as they can (at the beginning of Year 6).
4. Make any necessary changes to the financial statements. Please see the hints about the special adjustment to the Statement of Cash Flows.
5. Calculate the two (2) ratios after you make any adjustments. Calculate the new Basic and Diluted EPS values and report them in your Income Statement.
Critical Thinking
6. What do you think investors' reaction will be to the new compensation plan and stock repurchase? In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with Terry's decisions? Why or why not?
7. After looking back over the company's book, Terry's controller has become concerned that management purposely provided negative financial information to the market in the weeks before the strike price was set on their new options. What options are available to the controller now that she has discovered this information? Provide at least two (2) consequences for each option.
Hints:
1. Terry uses 'Executive Salaries Expense' to record all of the compensation for the management team. Do NOT create a new account for this new compensation.
2. While Terry does keep separate accounts for all of their Additional Paid-in Capital, they combine all of these amounts on the balance sheet, so you should not add a new account to the B/S for the stock option PIC.
3. You will need to change the note under the Common Stock line in the Balance Sheet to include both the Year 1 and Year 2 end of year shares outstanding.
4. Don't forget to adjust your Statement of Cash Flows for the purchase of the treasury stock.
5. As with pensions, you have to make a special adjustment in the CFO section of the Statement of Cash Flows; you can't just record the change in Additional PIC (since those are equity accounts).In this case, you can record a Stock Option Compensation line that equals the total change in Executive Salary Expense for these stock options.
6. Don't forget to calculate the weighted average common stock shares outstanding before you calculate the new basic EPS.
7. Don't forget that Terry's tax rate will change in Year 5.
Terry Part 8:
Goal: To practice making correcting entries for accounting errors.(See Topic Guides FFS3&12).
Information:
Despite all of your hard work to correct Terry's financial statements, the internal auditor recently found several additional mistakes that need to be corrected before the financial statements are closed for the period.
The following errors need to be corrected:
- During Year 1, the company neglected to record wages payable of $17,500 for its sales force. The wages were paid in full on January 10 of Year 2.
- A five year insurance contract was purchased for a production facility on August 15th, Year 2, for $30,000.At the time of the purchase, the full contract was recorded in insurance expense.
- Research and development costs of $24,000 were capitalized during Year 1. The cost was amortized using straight line depreciation over 5 years for both GAAP and tax purposes, starting in Year 1.
Terry's management would like to know the effect of these errors on the following ratios:
- Debt to Equity
- Current Ratio
- ROA
Assignment:
Calculations
1. Calculate each of the three (3) ratios before you make any adjustments.
2. Make the appropriate journal entries, if any, to correct the errors mentioned above (including any necessary changes to income tax expense).
3. Create Terry's Year 2 Statement of Retained Earnings. You do NOT need to include Year 1 in this statement.
4. Make any necessary changes to the financial statements.
5. Calculate the three (3) ratios after you make any adjustments.
Critical Thinking
6. What do you think the investors' reaction will be to these corrections? Defend your answer.
7. The CFO has asked the controller to defer these corrections until the next year. He is worried that making these corrections now will eliminate the bonuses of many company employees that had nothing to do with the accounting mistakes. He has assured her that he is not concerned with his own bonus; he just wants to be fair to those who are currently counting on the extra funds for the holidays. Provide three (3) alternatives available to the controller. Which of those three do you think she should choose? Defend your answer.
Hints:
1. Remember that Terry's books for Year 2 are still open.
2. Terry reports amortization costs in depreciation expense.
3. For tax purposes, each adjustment requires a slightly different calculation:
a. The mistake with sales force salaries would have given the company a tax break last year for the extra salaries expense. Since the company probably won't re-file for this small mistake, Terry will take the tax break in Year 2.However, you will need to change retained earnings to show that the tax benefit occurred last year.
b. Prepaying insurance on a factory doesn't cause a book/tax difference, so the change will look like those we have done in the past.
c. The assumption about GAAP and tax amortization is a simplification, but not a bad one. In reality, the patent would have to be amortized over 15 years for tax purposes (which would have made our tables a little hard to work with).So, to keep things simple, we are going to assume 5 years for both, leaving no book/tax differences to worry about. The tax issue for this mistake is similar to the first one, with one major difference. In this case you will need to update Income Tax Payable to show that Terry will take the rest of the tax break for the R&D in Year 2.The best way to determine the numbers for this entry are to first figure out how much more Terry will save in addition to the savings for the amortization already used in Years 1 and 2.Second, you will need to figure out how additional expense Terry will have to record in Year 2, since they no longer have this amortization expense as a deduction. Third, determine how much of a change needs to be made to RE, keeping in mind that the Year 2 books are still open.
4. You will need to adjust Year 1's numbers for the mistakes made during that period. Your RE balance for Year 1 should match the Retained Earnings, as adjusted line in the Statement of Retained Earnings.
5. The easiest way to adjust the financial statements for the three (3) entries is to adjust for entry 1 and make sure that everything balances before moving on to entry 2.Then make sure everything balances for entry 2 before attempting to move on to entry 3.
6. If you are using the template provided, you will not need to adjust the Statement of Cash Flows if you properly make the adjustment to the financial statements. It will adjust for the corrections automatically.
Terry Part 9:
Goal: To practice creating a Direct Method Statement of Cash Flows.
Information:
On December 30th, Terry's management completed negotiations with one of their suppliers to cover Terry's $32,000 account with shares of Terry's common stock. Rather than issue additional shares (and deal with the requirements of the SEC), Terry issued the supplier 3,250 shares of treasury stock originally purchased on December 1st.
As a relatively new public corporation, Terry still has several large investors that hold seats on its Board and have significant control over the company's decision. These investors have expressed concern with the company's new Indirect Method Statement of Cash Flows and have asked the management team to switch to a Direct Method Statement with the required Schedule to Reconcile Net Income to Cash Provided from Operations. Because of the influence of these investors, Terry's management team has no choice but to agree with their request (although, they aren't thrilled with the extra work this change will cause).They have asked you to convert the current Statement of Cash Flows into a Direct Method version. In doing so, you should show one line item for Cash Paid for Selling Expenses and one for Cash Paid for Administrative Expenses.
In addition, they would like to know the effect of their contract with the supplier, if any, on the following ratios:
- Debt-to-Equity
- Current Ratio
- ROE
Assignment:
Calculations
1. Calculate each of the three (3) ratios before you make any adjustments.
2. Make the appropriate journal entries to correctly record the payment on A/P with treasury stock.
3. Make the appropriate journal entry, if any, to correctly record the tax effect of the payment on account.
4. Make any necessary changes to the Income Statement and Balance Sheet, then create a new Direct Method Statement of Cash Flows for Terry.
5. Calculate the two (2) ratios after you make the adjustments.
Critical Thinking
6. What do you think investors' reaction will be to using stock to repay a vendor? What will be their reaction to the new Statement of Cash Flows? In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with Terry's decisions? Why or why not?
7. The CFO is concerned with the CEO's decision to issue stock to repay this debt. He feels it is inappropriate to dilute the control of their current owners by issuing stock without giving them any opportunity to retain their control (i.e. by buying up a percentage of the newly reissued shares). Provide two (2) arguments that the CFO could use to convince the CEO that they should repay the debt with cash instead of stock.
Hints:
1. Remember that Terry keeps separate accounts for all of its Additional Paid in Capital, but that it combines all of those accounts for reporting purposes. In other words, you should have a specific Add PIC account in your journal entry, but not add a new line to the Balance Sheet.
2. This carefully about the tax effects of this adjustment. Remember that in most cases taxes only change if net income changes.
3. As you start preparing the new Statement Cash Flows, keep in mind that not only will the Cash Flows from Investing and Cash Flows from Financing section stay exactly the same as they were in Terry #8, but you already have all of the necessary adjustments calculated for the Cash Flows from Operating Activities section. You just need to redo the worksheet using those same numbers.
4. Cash Paid for Selling Expenses should be the sum off the cash flows for advertising, miscellaneous selling expenses, sales for salaries, selling commissions, and shipping. Cash Paid for Administrative Expenses should be the sum of the cash flows for executive salaries, pensions, insurance, miscellaneous administrative expenses, office supplies, rent, and utilities.
5. You only need to recognize one (1) non-cash transaction, and that is the entry that you made for this Terry.
6. Note that you will NOT have to change Terry's EPS calculations, just the number of shares outstanding at the end of the year. Here's the table for Terry's weighted average number of common stock shares outstanding (notice that the result is the same as your calculation in Terry 7):
|
Date
|
Shares Outstanding
|
Adjustment for StkDiv/Splits
|
Fraction of Year
|
Total
|
|
1-Jan
|
200,000
|
1.0
|
11/12
|
183,333
|
|
1-Dec
|
175,000
|
1.0
|
1/12
|
14,583
|
|
30-Dec
|
178,250
|
1.0
|
0/12
|
0
|
|
|
|
|
197,917
|