Alpha Computer Equipment Company Accounting Issues from Audit On February 16, 2019 you are well into the field work of the 12/31/2018 audit and the following issues have arisen during the audit of Alpha Computer Equipment Company (ACE.) 1. Service revenue 2. Account receivable from officers 3. Prepaid advertising 4. Wanda's Walnuts Company receivable 5. Inventory 6. "Bring Your Daughters and Sons to Work Day" litigation Linda Wilson the president of ACE wants you to present your position on each of these issues as she would like your judgment as to "good GAAP" numbers. But, she has also pointed out that she understands that GAAP often does not provide a precise answer, and in such cases, she would rather error on the side of maintaining income rather than being "an overly pessimistic doomsayer." The attitude of Board of Directors members is consistent with that of Linda. Prepare a memo that summarizes relevant professional standards (standard and paragraph should be cited) related to each of the 6 issues and prepare any proposed journal entries. Discuss information that would be included in any note disclosures related to each of the six items (you need not draft formal note disclosures). Prepare entries for all misstatements you identify, regardless of the amount involved. That is, don't simply say no entry is needed because any amount involved would be immaterial. Assume that the current income is $2,997,216. For purposes of preparing journal entries, you may ignore income tax implications as any changes in taxes will be reflected later in the audit process after any entries have been posted to the working trial balance. Summarize the income effects (before taxes) of any entries that you propose on the schedule below and include it in your memo (make clear whether each is an over and understatement of income): Income Effect 1. Service revenue 2. Account receivable from officers 3. Prepaid advertising 4. Wanda's Walnuts Company receivable 5. Inventory 6. "Bring your Daughters and Sons to Work Day" litigation Issue 1: Service Revenue ACE has included service revenue of $22,100 as a result of a number of one-year service policies sold late in December as an "experiment." These service policies became effective on January 1, 2019, or shortly thereafter. The policies are sold at an average of $600 per year per customer; the $22,100 represents the total cash received as of year-end (debit cash, credit service revenue). The $600 per customer amount was arrived at by an analysis of previous service provided on a "fee for service" basis to customers. The average cost to ACE was approximately $200 per visit, with an average of 1.7 visits per year to customers. While the service policies allow unlimited visits for service, ACE has restricted the number of policies available due to difficulties in calculating the costs associated with such policies. ACE estimates that the number service calls is likely to increase to about 4 per year; the cost is expected to decrease to around $150 per call. So, at this point, the program is projected to break even. The aggressive pricing of the service policies is due to (1) the experimental nature of the program and (2) a desire to maintain long-term customer loyalty for future purchases of equipment. Issue 2: Accounts Receivable From Officers At year-end ACE has $110,000 in accounts receivables from officers on the books. The Board of Directors approved these loans which are in the form of "demand" notes. One of the staff assistants asked whether there was any intent to require officers to pay back these loans. Linda Wilson and Jan Wiggs, who each owe 1/2 of the total amount outstanding, agreed that while not much thought had been given to it, they imagined that they might someday repay the loans. On the other hand, they thought that the Board of Directors might forgive the loans some year in lieu of their annual bonus. Issue 3: Prepaid Advertising On November 1, 2018 ACE paid $30,000 in advance for eight months of advertising on radio station KNEWZ, a local news station. The entry was recorded with a debit to prepaid advertising and a credit to cash. At December 31, 2018 ACE expensed $7,500 (debit to advertising expense and credit to prepaid advertising for 2 of the 8 months). Earlier, on December 29, 2018 ACE received a letter from KNEWZ indicating that the radio station was changing its format on January 1, 2019 to "classic heavy metal." In brief, news is being replaced by old songs of Phish, Ozzie Osbourne, and Def Leppard. It will now use the call letters KDEV. Although ACE has no real data on this, it is management's impression that most Ozzie Osbourne fans buy fewer networked computer systems than news station listeners. Accordingly, management attempted to cancel the agreement and receive a refund. Regrettably, the contract for the advertising provides no assurances about a change in station format and ACE's lawyers say that obtaining any recovery in a court proceeding is doubtful. KDEV has refused any attempts at renegotiation and has suggested that ACE might be surprised at the number of customers that might respond to the commercials. KDEV is even willing to work with ACE to redo commercials eliminating the old ones that used the "sappy sounding" news announcers and replacing them with commercials using their new announcers; KDEV is willing to record these commercials for no additional cost. ACE management still questions whether the advertising will be well placed but does believe that there may be a few listeners who might respond to the advertisement. ACE legal counsel suggests that it is not worth pursuing this matter further. Issue 4: Wanda's Walnuts Receivable Wanda's Walnuts Company (Wanda's Walnuts) owes ACE $82,000 for a computer system installation that was purchased in March of 2018. Wanda's Walnuts has run into financial difficulties due to dramatic decreases in the selling price of walnuts during recent years. In August of 2018 Linda Wilson (ACE president) and Jan Wiggs (ACE controller) established a repayment schedule in which Wanda's Walnuts would repay $10,000 per month (plus interest). While the first payment was made in September (bringing the debt down from $92,000 to $82,000), no further payments have been received. (Wanda's Walnuts has continued to make small purchases from ACE on a "cash" basis.) Your discussion with management indicates that Wanda's Walnuts received a "going concern modification from its auditors for the year ended 8/30/18 (the audit report was dated 10/22/18). The going concern modification arose due to a question concerning whether Wanda's Walnuts can obtain new financing when needed, on June 30, 2019. However, the situation is not entirely bleak for Wanda's Walnuts future as layoffs of 1/3 of the company's employees resulted in a situation in which Wanda's Walnuts operated at break even for the year ended 8/30/18. Wanda's Walnuts has discussed filing for bankruptcy with bankruptcy legal counsel and at this point believes it is unnecessary. But, if it becomes necessary, counsel suggests that creditors shouldn't expect to receive more than 50 cents on the dollar. Management has suggested to you that 70 cents on the dollar is more likely if bankruptcy ensues. Your analysis at the date of both the Wanda's Walnuts audited annual statements (8/30/18) and the interim statements (11/30/18) indicates that if bankruptcy is declared, a recovery of 50-60 cents on the dollar (with no amount more probable than another in that range) is likely. Yet, it's difficult to know what the situation will be in the future. The sales agreement for the computer system allows ACE to repossess the equipment at any time prior to bankruptcy. But, because the equipment is used and specific to Wanda's Walnuts applications, management believes that the equipment could be sold for a (net) of between $20,000 and $30,000. Also, management points out that such an action would not be considered positively by either Wanda's Walnuts or a number of other companies that ACE is attempting to attract as clients. Accordingly, ACE has resisted this option and does not intend to pursue it at this time. Your analysis of the interim statements (unaudited) reveals that Wanda's Walnuts operated at a slight profit during the first quarter and that walnut prices have increased approximately 15 percent. However, experts disagree widely as to future walnut prices as there is some concern that a significant increase in walnuts from India may enter the US market. Finally, Wanda's Walnuts management, although noncommittal on details, suggests that it believes that it will be able to continue repayments on the debt within the "next few months." But your feeling is that it is probable that Wanda's Walnuts will be forced to file for bankruptcy. No allowance for this account is currently included in the allowance for doubtful accounts. Issue 5: Inventory Included in ACE's inventory (valued using the LIFO method) are the following: $100,000 (cost) of computers which manufacturers ceased producing in the middle of 2018. Although the wholesale value of these computers now is only about $60,000, the retail value (if they could all be sold today, which they can't be) is approximately $110,000. The selling costs of these specific machines are considered negligible, and a normal profit margin is approximately 25% of sales price. The retail market is "thin" and it will take some time to sell the computers. Management intends to sell all of these computers at retail and believes that the retail value of these computers is likely to decrease at an average rate of 5 percent every quarter for the next year; thus, on average a computer with a retail value of $1,000 on 12/31/18 would have an average retail value of $950 and $900 during the first two quarters of 2019, respectively. Management believes that the computers will be sold within the next year as follows--first quarter 40% of inventory, second quarter 35%, third quarter 20 %, and fourth quarter 5% at market values at the time of sale. These projections seem reasonable. It is currently February 15 and you note that sales are right on schedule and that retail prices have dropped a bit from year- end, as projected. Because of discontinuance of the above computers, many suppliers of parts for these computers have chosen to quit manufacturing the items with the result that shortages are occurring. As a result, ACE's $50,000 inventory of parts for these machines has increased in value and would now cost $65,000 to replace (its retail value is $110,000). Historically, the normal profit margin on sales of parts is 40% of sales price. Also, management has pointed out to you that computers in inventory that don't sell could be used for parts. But management does not anticipate the need to do this. Historically, ACE (and competitors) have in general separated Computers from Parts when calculating the lower of cost or market for inventory. Issue 6: Bring Your Daughters and Sons to Work Day Litigation On "Bring Your Daughters and Sons to Work Day" at Winglo Corporation not only did Sandy Gilhaus, a Winglo employee, bring her ten-year-old daughter Sarah to work, but ACE also installed Winglo's new computer system on that day. After installation, when Sandy attempted to adjust the monitor connected to her new computer, she inadvertently knocked the monitor off the desk and onto the floor. The screen shattered with a piece of the glass striking Sarah's right big toe. To make a long story short, Sarah's toe needed four stitches to stop the bleeding and Sandy has blamed the installer of the system for placing the monitor in a dangerous position near the back edge of her desk. The damages to this point have been minimal as Sandy drove Sarah to their HMO and paid the $20 copay for an office visit. Yet, the Gilhaus family has sued ACE for the following: $ Likely future plastic surgery Emotional distress to Sarah Emotional distress to Sandy Total 5,000 500,000 1,200,000 $1,705,000 ACE's lawyers believe that this case, with the possible exception of the plastic surgery (for which the HMO won't pay), is frivolous. ACE has no insurance to cover this sort of liability. If this case goes to court, ACE's on staff attorneys will handle the case. To eliminate any possible bad press from this case, ACE's lawyers suggested settling for a "nuisance value of $10,000. Sarah's family rejected this offer out of hand and asked for $200,000 to settle this out of court. ACE has decided, at least at this point, to refuse any further settlement offer. In their lawyer's letter to you ACE's lawyers indicated that they believe that ACE has "just and meritorious defense available" to fight this case. Furthermore, ACE's legal counsel for the case indicated that while she agrees that this case is largely frivolous, litigation involving a young child is somewhat of a "crap shoot" and that making a definite prediction on the outcome of the case is impossible. In the end she believes the judgment will likely be $5,000 for the plastic surgery. Number Type* 1 2 3 4 5 6 Total Uncorrected Assets Alpha Computer Equipment Company Total Likely Misstatement December 31, 20X8 Debit (Credit) Non- Current current Liabilities 9,206,553.00 1,237,543.00 Non- Current current Revenue 6,239,932.00 2,400,000.00 Income Statement Cost of Sales Totals per financial statements Percent of unrrecorded to F.S. * Factual, Judgmental, or Projected Assume that the client does not intend to record any of the above misstatements and that 6 percent of income after taxes is considered a material misstatement. Provide the auditor's conclusion in this situation. Only consider the income effect. Selling, Gen.! Admin.,Otheri Net Income 82,000,000.00 71,000,406.00 8,002,378.00 2,997,216.00