Rachael Moulton and Bobby Lagg recently graduated from the same university. After graduation they decided not to seek jobs in established organizations but to start their own small business. They hoped this would provide more flexibility in their personal lives for a few years. Since both of them enjoyed cooking, they decided on a business selling vegetarian wraps and fruit juices from a street cart near their alma mater.
They bought a small enclosed cart for $5,000 that was set up for selling food. This cost, along with the cost for supplies to get started, a business license, and street vendor license, brought their initial expenditures to $6,500. They used $1,000 of their personal savings, and they borrowed $5,500 from Rachael’s parents. They agreed to pay interest on the outstanding loan balance each month based on an annual rate of 5 percent. They will repay the principal over the next two years as cash becomes available.
After two months in business, September and October, they had average monthly revenues of $8,200 and out-of-pocket costs of $5,100 for ingredients, paper supplies, and so on, but not interest. Bobby thinks they should repay some of the money they borrowed, but Rachael thinks they should prepare a set of forecasted financial statements for their first year in business before deciding whether or not to repay any principal on the loan. She remembers a bit about budgeting from a survey of accounting course she took and thinks the results from their first two months in business can be extended over the next 10 months to prepare the budget they need. They estimate the cart will last at least three years, after which they expect to sell it for $1,000 and move on to something else in their lives. Rachael agrees to prepare a forecasted (pro forma) income statement, balance sheet, and statement of cash flows for their first year in business, which includes the two months already passed.
Required
a. Prepare the annual pro forma financial statements that you would expect Rachael to prepare based on her comments about her expectations for the business. Assume no principal will be repaid on the loan.
b. Review the statements you prepared for the first requirement and prepare a list of reasons why Bobby and Rachael’s business results probably will not agree with their budgeted statements.