Problem one: (12 marks)
For about a year, Frank Poppa has been operating a sausage stand in the parking lot of a major discount retailer in a suburban area. The stand appears to be a pushcart but is actually a small trailer that is towed from home each day. Frank cleverly designed the stand to include storage compartments, napkins, and the like. What started out as a “weekend gig” to pick up 3
a few extra dollars has turned into a full-time occupation. Frank soon found that on a weekend, he could easily take in more than $1,000 from sales of a full line of fancy hot dogs and cold soft drinks.
About four months ago, Frank decided to expand to more locations. He found that large discount retailers were quite happy to provide him adequate space near the front door because customers enjoyed the convenience and the stand helped build traffic for the retailer.
Frank formed Poppas Dogs Company and negotiated contracts with several retailers to provide pushcart operations outside their stores. The contracts generally call for Poppas Dogs to pay a location fee to the retailer plus 3% of the pushcarts sales.
Frank plans to be very careful when hiring the people necessary to operate the five new pushcart locations. He is confident that he can assess good moral character and avoid hiring anyone who would take advantage of him. Frank will have to spend about $3,000 for each new pushcart and related equipment. In addition, he will have to finance an inventory of sausages, bread, condiments, and soft drinks for each location. A local bank has agreed to provide financing.
Until now, Frank has maintained an informal accounting system consisting of an envelope full of receipts and his personal account. The system has served him well enough so far, but he is finding that more and more he is getting his personal financial activities confused with those of his business. Frank is positive that the business is profitable because he seems to have more money left at the end of the month than he did when he was working full time as an auto mechanic. He has decided he needs a better accounting system and has decided to consult with a CPA he knows to see what she might recommend.
Requireda) What information does Frank’s current accounting system provide him? (4 marks)
b) What additional information should Frank want from an improved accounting system? (4 marks) 4
c) Make recommendations to Frank regarding how he can improve his accounting system. (4 marks)
Problem two: (10 Marks)
Nadia Smith is a regional sales manager for Best-Green, Inc., a producer of garden supplies. The company’s fiscal year ends on April 30. In mid-April, Nadia is contacted by the CEO of Best-Green. He indicates that the company is facing a financial problem. Two years ago, the company borrowed heavily from several banks to buy a competing company and to increase production of its primary products: insecticides and fertilizers. As a part of the loan agreement, Best-Green must maintain a working capital ratio of 1.5 to 1 and earn a net income of at least $2 per share. If the company fails to meet these requirements, as reflected in its annual financial statements, the banks can restrict future credit for the company or require early payment of its loans, potentially forcing the company into bankruptcy.
The CEO explains that this fiscal year has been a difficult one for Best-Green. Sales have slipped because of increased competition, and the rising prices of chemicals have increased the company’s production costs. The company is in danger of not meeting the loan requirements. The company could be forced to make drastic cuts or to liquidate its assets.
The CEO informs Nadia that her job could be in danger. The CEO asks her to help with the problem by dating all sales invoices that clear her office during the first half of May as though the sales had been made in April. May is a month of heavy sales volume for the company as retail stores stock up for the coming season. The CEO believes that the added sales would be sufficient to get the company past the loan problem. He explains that this procedure will be used only this one time.
By next year, the company will be in better shape because of new products it is developing. Also, he reminds Nadia that her bonus for the year will be higher because of the additional sales that will be recorded for April. He points out that the company is fundamentally in sound financial shape, and that he would hate to see its future jeopardized by a minor bookkeeping problem. He is asking for the cooperation of all of the regional sales managers. He argues that the stockholders, employees, and managers will all be better off if the sales are predated. He wants Nadia’s assurance that she will cooperate. 5
a) What effect will predating the sales have on Best-Green’s balance sheet, income statement, and statement of cash flows? Be specific about which accounts will be affected and why. (3 marks)
b) How will this practice solve the company’s problem with the banks? (2 marks)
c) What would be the appropriate behavior for the company CEO under the circumstances the company is facing? (2.5 marks)
d)f What would be the appropriate behavior for Nadia? (2.5 marks)
Problem three: (Eighteen marks)
It is late summer and General Wheels, Inc., an auto manufacturer, is facing a financial crisis. A large issue of bonds payable will mature next March, and the company must issue stock or new bonds to raise the money to retire this debt. Unfortunately, profits and cash flows have been declining over recent years. Management fears that if cash flows and profits do not improve in the current year, the company will not be able to raise the capital needed to replace the maturing bonds. Therefore, members of management have made the following proposals to improve the cash flows and profitability that will be reported in the financial statements dated this coming December 31.
1. Switch from the LIFO method to the FIFO method of valuing inventories. Management estimates that the FIFO method will result in a lower cost of goods sold but in higher income taxes for the current year. However, the additional income taxes will not actually be paid until early next year.
2. Switch from the 150 percent declining-balance method of depreciation to the straight-line method and lengthen the useful lives over which assets are depreciated. (These changes would be made only for financial reporting purposes, not for income tax purposes.) 6
3. Pressure dealers to increase their inventories—in short, to buy more cars. (The dealerships are independently owned; thus dealers are the customers to whom General Wheels sells automobiles.) Management estimates that this strategy could increase sales for the current year by 5 percent. However, any additional sales in the current year would be almost entirely offset by fewer sales in the following year.
4. Require dealers to pay for purchases more quickly. Currently, dealers must pay for purchases of autos within 60 days. Management is considering reducing this period to 30 days.
5. Borrow at current short-term interest rates (about 10 percent) and use the proceeds to pay off long-term debt bearing an interest rate of 13 percent.
6. Substitute stock dividends for the cash dividends currently paid on capital stock.
a) Prepare a schedule with four columns. The first column is to be headed “Proposals” and is to contain the paragraph numbers of the six proposals listed above. The next three columns are to be headed with the following financial statement captions: (1) “Net Income,” (2) “Net Cash Flows from Operating Activities,” and (3) “Cash.”
For each of the six proposals in the left-hand column, indicate whether you expect the proposal to “Increase,” “Decrease,” or have “No Effect” in the current year on each of the financial statement captions listed in the next three columns. (Note:Only a few months remain in the current year. Therefore, you are to determine the short-termeffects of these proposals.) (6 marks)
b) For each of the six proposals, write a shortparagraph explaining the reasoning behind your answers to part a. (12 marks)