Radiohead Inc. produces electronic components for sale to manufacturers of radios, television sets, and digital sound systems. In connection with her examination of Radiohead’s financial statements for the year ended December 31, 2011, Marg Zajic, CA, completed field work two weeks ago. Ms. Zajic now is evaluating the significance of the following items prior to preparing her auditor’s report. Except as noted, none of these items has been disclosed in the financial statements or notes.
Item 1
A 10-year loan agreement that the company entered into three years ago provides that, subsequent to the date of the agreement, dividend payments may not exceed net income earned after taxes. The balance of retained earnings at the date of the loan agreement was $420,000. From that date through December 31, 2011, net income after taxes has totalled $570,000 and cash dividends have totalled $320,000. Based on these data, the staff auditor who was assigned to this review concluded that there was no retained earnings restriction at December 31, 2011.
Item 2
Recently, Radiohead interrupted its policy of paying cash dividends quarterly to its shareholders. Dividends were paid regularly through 2010, discontinued for all of 2011 to finance the purchase of equipment for the company’s new plant, and resumed in the first quarter of 2012. In the annual report, dividend policy is to be discussed in the president’s letter to shareholders.
Item 3
A major electronics firm has introduced a line of products that will compete directly with Radiohead’s primary line, which is now being produced in Radiohead’s specially designed new plant. Because of manufacturing innovations, the competitor’s line will be of similar quality but priced 50% below Radiohead’s line. The competitor announced its new line during the week following the completion of Ms. Zajic’s field work. Ms. Zajic read the announcement in the newspaper and discussed the situation by telephone with Radiohead executives. Radiohead will meet the lower prices as they are still high enough to cover variable manufacturing and selling expenses, although they will permit only partial recovery of fixed costs.
Item 4
The company’s new manufacturing plant, which cost $2.4 million and has an estimated life of 25 years, is leased from Armadillo 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 non-cancellable lease, the company has the option of purchasing the property for $1. In Radiohead’s income statement, the rental payment is reported on a separate line.
Instructions
For each of the items, discuss any additional disclosures in the financial statements and notes that the auditor should recommend to her client. The client follows IFRS. (The cumulative effect of the four items should not be considered.)