Case 2-1 Zodiak, Inc.

You led a group of investors in purchasing Zodiak, Inc. from its founder and namesake at the beginning of 2010. You financed the $40 million acquisition of this manufacturer of quality industrial components with equal amounts of equity and debt capital. Your investment team provided the majority of owner financing, and other investors purchased stock to supplement your groups equity infusion. A $20 million, 6% loan from the First National Bank financed the remainder of the purchase.

You resigned as chief executive officer (CEO) after the firms fourth fiscal year, which ended on December 31, 2014, in order to pursue other business opportunities. You continued in your capacity as chair of Zodiaks Board of Directors (BOD). The BOD elected Johannes Skilling as CEO, effective January 1, 2015, over your objections. Mr. Skilling had a proven record of accomplishment as an executive and demonstrated strong interpersonal skill during the search process; yet, you had an uneasy feeling about him. Specifically, you felt that Skilling took too many unnecessary risks and pushed the envelope too far with overly aggressive financial reporting practices. Although Mr. Skilling was thoroughly vetted, you had off the record conversations with trusted business colleagues who echoed your concerns. None was willing, however, to speak on the record. In the end, you acquiesced to the unanimous wish of the rest of the board and ratified the hiring of Mr. Skilling as CEO effective January 1, 2015.

Financial Statements

Zodiaks financial performance during your tenure as CEO was solid, if not spectacular. Corporate profitability ostensibly soared under Skillings tutelage in 2015. The accompanying spreadsheet contains the annual income statements and statements of cash flows for the last three fiscal years, as well as the last two periods balance sheets. The financial data clearly evidence the superior results Zodiak achieved in 2015, which was the first year that Skilling served as CEO. (This problem ignores income taxes.)

Income Statements
For the Years Ended December 31 (in thousands)	2015	2014	2013
Sales revenues	$ 35,735	$ 31,906	$ 30,100
Cost of goods sold	13,579	13,608	12,840
Gross profit	22,156	18,298	17,260
Selling, general, and administrative expenses	8,270	8,427	8,025
Depreciation expense	645	640	625
Research and development expense	660	756	700
Operating income	12,581	8,475	7,910
Interest expense	2,000	1,200	1,200
Net income	$10,581	$ 7,275	$ 6,710
Balance Sheets
December 31 (in thousands)
Assets	2015	2014
Cash	$ 5,728	$ 2,123
Accounts receivable	7,047	6,282
Inventory	5,812	4,531
Other current assets	1,649	134
Current assets	20,236	13,070
Property, plant, and equipment	33,067	34,737
Total Assets	$ 53,303	$ 47,807
Liabilities
Accounts payable	$ 4,253	$ 3,402
Accrued liabilities	889	846
Current liabilities	5,142	4,248
Notes payable	30,000	20,000
Total Liabilities	35,142	24,248
Shareholders' Equity
Common stock	10,000	20,000
Retained earnings	8,161	3,559
Total shareholders' equity	18,161	23,559
Total Liabilities and Shareholders' Equity	$ 53,303	$ 47,807

The 2015 financial results presented in the spreadsheet, however, are unaudited as of this date. (The previous years financial statements received unqualified or clean audit opinions from Zodiaks external accounting firm).

Reporting Issues

One of your most trusted members of the executive team during your time as CEO was Meg Walters, the corporate controller. In early 2016, Ms. Walters expressed concern to you over a number of accounting issues. In sum, she and her internal audit staff feel that Zodiaks financial reporting was too aggressive and the firm overstated its 2015 operating performance and year-end financial position. Meg told you that she repeatedly expressed her concerns to Mr. Skilling. He assured her that Zodiaks accounting complied with generally accepted accounting principles (GAAP). At one point, Skilling stated to her that

Our financial statements conform to GAAP. Our managerial judgments about the numbers may be more optimistic than those of the previous administration, but let me assure you that they are legitimate. Moreover, they will pass muster with our new external auditors. Ive used the audit firm of Arturo Andersen at my other firms and theyve always given me a clean audit opinion. I expect that they will do the same for Zodiak

Two areas particularly concerned Ms. Walters:

The company booked revenues of approximately $2 million when it shipped product to some of its regular customers at end of 2015. Zodiak reported these sales even though the customers had not ordered the goods. Skilling stated that the sales would help the 2015 numbers. In addition, Zodiaks sales force told the recipients that they could return the goods in 2016 if they didnt want them. The firm made no provision for any returns of these sales.

Ms. Walters firmly believed that the customers would return the $2 million of goods in 2016. She knows that Zodiak could sell the goods to other customers when the customers return them. Meg further notes that Zodiaks cost of goods sold have traditionally been 42.65% of sales revenues.

Zodiak added the $1 million cost of corporate reorganization to the balance of its property, plant, and equipment account. Mr. Skilling opined that the restructuring would benefit the firm for at least the next ten years. And besides, he said, We recognized 10% of that restructuring cost as a depreciation expense in 2015. Meg believed that the total cost of reorganizing the company should be recorded as a 2016 expense because it was a necessary cost of doing business in that year.

You are very concerned about the issues that Ms. Walters presented to you. You would like to bring them to the full Boards attention. In order to do so, you charge Ms. Walters with two tasks:

Required:

Recast Zodiaks 2015 income statement and balance sheet to conform to generally accepted accounting principles.

Compose an executive summary addressing the issues in your calculations and comment on the firms 2015 financial performance and its financial position as of December 31, 2015.