Intermediate 2 Terry Part #2: Chapter 18 Goal: To practice correcting the financial statements for different revenue recognition situations. (See Topic Guides IFO 4 and 23). Information: Terry determined early in its history that it was more effective for them to build their own specialized production equipment than for them to share their proprietary production data with a construction company. While this process leads to a larger upfront cost for new equipment, the special production methods used by the company have earned much more than the initial extra outlay. While the company has historically kept this production process in-house, they have recently been approached by a local university with a request to provide a set of machinery that the university can use to produce their own specialty bags. Since many members of Terry's Board of Directors (and several large shareholders) are alumni of this university, Terry's management has decided that they will go through with the sale of a three machine system to the university. As part of the deal, Terry's management has insisted that the university also purchase a 3-year maintenance contract (which will begin as soon as the last machine is installed). This requirement will allow Terry's engineers and machinists to take care of the equipment, reducing the chance of losing their competitive advantage. The total contract price for the machines and the maintenance contract is $660,000. As part of the contract, both parties have agreed that the university will have the right to return the equipment if they are not satisfied with the performance of the machines. Terry will also provide an additional refund for the maintenance contract if the company returns the equipment within the next few years. While Terry has never sold its equipment before, machinery for making bags can be purchased from many other companies. In addition, many of those companies also provide service contracts to care for the machines they sell. Other versions of the machines typically sell for $165,000; $130,000; and $300,000. A 3-year maintenance contract sells, on average, for $72,000. By the end of Year 3, Terry had installed the first and second machines and the university has paid $293,000. Terry's management team anticipates that the final machine will be installed in January of Year 4, and the maintenance contract will begin immediately after the final installation. The university will pay the balance of the contract once the last one is installed. Terry's management would like to know the effect of the sale on the following ratios: Profit Margin Current Ratio ROA Assignment: Calculations 1. Calculate each of the three (3) ratios before you make any adjustments. 2. Make the appropriate journal entries, if any, to account for the installation of the machines (including any necessary changes to income tax expense) and the first payment by the university. Assume that the first machine cost Terry $132,000, the second $117,000, and the third $210,000. The average cost of the maintenance contract is $22,000. Terry's work building these machines has already been appropriately recorded in inventory. Please see the hints for rounding instructions for these calculations. 3. Make any necessary changes to the financial statements. 4. Calculate the three (3) ratios after you make any adjustments. Critical Thinking 5. What do you think investors' reaction will be to the sale of these proprietary machines to university (if any)? In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with management's choice to enter into this agreement? Why or why not? 6. Who might be affected by the Terry's decision to give in to the Board's demands and sell their proprietary machines to the university? Terry Co. Multi-Step Income Statement For the Year Ended December 31, Year 3 Terry Co. Terry Co. Balance Sheet Statement of Cash Flows As of 12/31/Year 3 For Year Ended 12/31/Year 3 Sales Revenue Year 2 Cash Flow from Operations Net Income Year 3 $8,100,000 $855,086 Sales Revenue Assets Less: Sales Discounts Sales Returns $89, 100 $708,750 Current Assets Adjustments: Change in A/R Change in Inventory Change in Prepaid Insurance Change in Prepaid Rent $ 730,570.00 $729,000 ($40,500) $972,000 $797,850 Cash $405,000 $688,500 ($202,500) $1,134,000 ($202,500) $162,000 $60,750 ($20,250) Net Sales Revenue $7,302,150 A/R Allowance for Bad Debts Cost of Goods Sold Inventory Prepaid Insurance Prepaid Rent Cost of Goods Sold $4.443.326 $60.750 $121.500 Amoritization of Bond Discount $289.00 $2,858,824 Gross Profit $101,250 $81,000 Depreciation & Amortization Change in A/P Change in Income Tax Payable Change in Interest Payable $243.000 $106,537 $2,227,500 Total Current Assets $2,553,070 Operating Activities Selling Expenses Advertising Expense Bad Debt Expense Miscellaneous Selling Expenses Sales Force Salaries Expense Long-term Investments Loans to other businesses $201,225 $324,000 $324,000 $4,813.00 Expansion Fund Total Long-term Investments PPE $16,200 ($12,150) $151,875 Change in Unearned Revenue Change in Wages Payable Net Cash Flow from Operations $41,420 $365,420 $41,420 $559,914 $1,415,000 $68,850 $365,420 $39,488 $111,375 $405,000 $66,319 Land $891,000 $567,000 $648,000 $1,053,000 Building Equipment Accumulated Depreciation Total PPE Selling Commissions Expense Shipping Expense $648,000 $2,268,000 Cash Flow from Investments Purchase of Land ($324,000) Purchase of Equipment Total Selling Expenses Administrative Expenses $842,907 ($1,053,000) $2,754,000 ($810,000) ($1,215,000) ($1,539,000) $1,458,000 Net Cash Flow from Investments Intangible Assets Patents, net Executive Salaries Expense Depreciation & Amortization Expense Insurance Expense $354,375 $243,000 $121,500 $121,500 $4,172,420 Cash Flow from Financing Repayment of Loans Issuance of Bonds Payable Issuance of Notes Payable Payments of Dividends ($40,500) $29,363 Total Assets $5,793,990 Miscellaneous Admin. Expenses Office Supplies Expense R&D Expense Utilities Expense Total Administrative Expenses Income from Operations $3,999 204.070 Liabilities and Stockholders' Equity $31.388 $486,000 Current Liabilities $121,500 ($200,000) $486,000 $81,000 Net Cash Flow from Financing $449,570! $60.750 Accounts Payable Income Tax Payable Interest Payable Unearned Revenue Wages Payable Current Portion of Loan Payable $592.537 $282,225 $4,813.00 $137,700 $89,100 $844,375 $1,687,282 $0.00 $121,500 $101,250 $1.171.542 Net Increase (Decrease) in Cash Cash, January 1, Year 3 Cash, December 31, Year 3 $325,570 $405.000 i $730,570 Other Gains and Losses Rent Revenue $25,313 $ (56,740.00) $40,500 $1,146,875 $40,500 Interest Expense Income from Continuing Operations before Taxes Income Tax Expense Net Income $830,250 ($31,427) Total Current Liabilities Long-term Debt Loan Payable Bond Payable, net Notes Payable Total Long-term Debt Total Liabilities $1.140.115 ($285,029) $855.086 $445,500 $204.359 $486,000 $0.00 $1,134,000 $648,000 $1,783,859 $2.930,734 EPS $2.67 $1,134,000 $1,964,250 Stockholders' Equity Common stock $320,000 ($1 par, 560,000 authorized, 320,000 outstanding) $243,000 $2,311,446 ($11,190) $2,863,256 $5,793,990 $320,000 Additional Paid-In capital Retained Earnings Accumulated OCI Total Stockholders' Equity Total Liabilities and Stockholder's Equ $243,000 $1,656,360 ($11,190) $2,208,170 $4,172,420