1. Capitalizing interest on the new factory:
a. During the year, Frosty Co. paid all of the interest accrued on Bond A and Loan 1, but only $50,000 of the interest accrued on Loan 2. Using one journal entry, summarize how Frosty originally recorded the accrued interest on all three long-term debts.
b. Assuming John and Elsa are right that the new loan meets the standards for capitalizing interest, calculate avoidable interest.
c. What correcting entries would need to be made to properly record interest on Frosty Co.'s construction project if John and Elsa are right? (Hint: Assume that Frosty Co.'s income tax rate is 30 percent. Any necessary changes to taxes should be recorded to Income Tax Expense and Income Tax Payable.)
d. What correcting entries would need to be made to properly record interest on Frosty Co.'s construction project if Simon is right?
e. What would be the net effect of each of these interest adjustments on net income? What would be the net effect on EPS?
2. Recording the asset retirement obligation (ARO) on the new plant:
a. Assuming that payments will be made at the end of each year, determine the amount that Frosty Co. should recognize for the ARO.
b. Assuming Frosty Co.'s management team decides to record the ARO, what correcting entries would need to be made?
c. What would be the net effect of the ARO adjustment on the current year's net income? What would be the net effect on EPS?
3. Recording the write-down on obsolete inventory:
a. Based on the information provided in Table 2, calculate the write-down that would be necessary using the first set of assumptions.
b. Based on the information provided in Table 2, calculate the write-down that would be necessary using the second set of assumptions.
c. Assuming that Frosty Co.'s management team decided to use the first set of estimates, what correcting entries would need to be made to write down inventory? (Assume that Frosty Co. uses the direct write-off method.)
d. What correcting entries would need to be made to write down inventory if the team decided to use the second set of estimates?
e. What would be the net effect of each of these inventory adjustments on net income? What would be the net effect on EPS?
4. Recording the change from the percentage of sales to the percentage of accounts receivable method of calculating bad debt expense:
a. Calculate the amount of bad debt expense Frosty Co. would recognize using the percentage of sales method.
b. Assuming that the management team has decided to switch from the percent of accounts receivable method to the percent of sales method for estimating bad debt expense, what correcting entries would need to be made?
c. What would be the net effect of this change in method on net income? What would be the net effect on EPS?
5. Evaluating each adjustment:
a. Based on the accounting standards, can Frosty Co. capitalize the interest on the construction project? If so, how much can Frosty Co. capitalize? Explain.
b. Based on the accounting standards, does Frosty Co. need to recognize the ARO in these financial statements? Explain.
c. Based on the discussion in the case, which set of lower of cost or market assumptions do you think is the most appropriate? Explain.
d. Do you think that Frosty Co. should switch methods of calculating bad debt expense?
Explain.
6. Updating Frosty Co.'s financial statements:
a. Based on the correcting entries you made in Questions 1-4 and your answers to Question 5, make any necessary changes to Frosty Co.'s income statement (see Table 3). Your new Income Statement should include four simple footnotes summarizing how you chose to treat each of the four adjustments.
b. Based on your correcting entries and your changes to the income statement, make any necessary changes to Frosty Co.'s balance sheet (see Table 4).
c. If necessary, update Frosty Co.'s statement of cash flows (see Table 5).
7. Analyzing the consequences of your adjustments (round your ratio values to three decimal places):
a. Calculate Frosty Co.'s EPS, Current Ratio, Profit Margin, ROA, and Debt to Equity Ratio using the original financial statements.
b. Recalculate the ratios using your adjusted financial statements from Question 6.
c. Which set of financial statements do you think the management team would prefer? Which set would Frosty Co.'s investors prefer?
Defend your answers.
8 Resolving the conflict between Frosty Co.'s upper management: Simon (the controller) test that three of the issues presented in the case should be resolved immediately. Doug and Jane (the CFO and CEO) felt that the financial statements should be left alone. Using your knowledge of GAAP, Frosty Co.'s business goals, the principles of business ethics, and your answers to Questions 1-7, do the following:
a. Write one to two paragraphs defending Simon's opinion.
b. Write one to two paragraphs defending Doug and Jane's position.
c. What do you think the final decision will be? Do you agree with that decision? Why or why not?
d. Assuming that Jane insists on leaving the books as they are, what do you think Simon will do? What do you think he should do?