Need help with answering question 1 which is in regards to Capitalizing Interest...

Frosty Co. Frosty Co. is a publicly traded, medium-sized manufacturing firm that produces refrigerators, freezers, ice makers, and snow cone machines. During the past three years, the company has struggled against increasing competition, sluggish sales, and a public relations scandal surrounding the departure of the former Chief Executive Officer (CEO) and Chief Financial Officer (CFO). The new CEO, Jane Mileton, and CFO, Doug Steindart, have worked hard to improve the company's image and financial position. After several difficult years, the company now seems to be resolving its difficulties, and the management team is considering new investment opportunities. The team hopes that diversification into a line of professional ice cream makers, and perhaps a line of consumer products, will help the company continue its recent growth and effectively compete with future competitors. In order to raise the funds needed for these new investments, Frosty Co.'s Board of Directors has approved a seasoned equity offering (SEO). The discussions regarding the new investment opportunities and the equity offering have been kept quiet until a positive set of financial statements can provide strong evidence that the company has turned around, leading to an increase in the company's stock price. INTRODUCTION After a full week of carefully examining financial statements, Simon was exhausted. He had become Frosty Co.'s corporate controller only a month ago, after several years as an auditor at a public accounting firm, and was excited about the move to corporate accounting. The first few weeks had gone well, as Simon met his accounting staff and settled into his new responsibilities. Then, he had started reviewing Frosty Co.'s financial statements for the prior year to make sure they correctly followed GAAP, and to familiarize himself more with the company and industry. Unfortunately, his relative inexperience with the industry and Frosty's accounting procedures had required him to spend more time on the review than he had anticipated. He still had a few questions about the financial statements, but he needed to start preparing for the upcoming SEO. He decided that he would talk to his staff about his lingering questions tomorrow morning, just before his meeting with the CEO and CFO. The three of them were to discuss the upcoming audit and the 1 J. Porter and AAA earnings announcement and how they would impact the proposed SEO. He rubbed his tired eyes and headed home to get a little sleep. MEETING OF THE ACCOUNTING STAFF: 10:30AM Simon looked up as the divisional controllers, Elsa Pilebody and John Mortenson, came into his office. Elsa worked with Frosty Co.'s fridge and freezer division; John worked with the ice maker and snow cone machine division. So far, Simon had enjoyed working with them, especially since neither of them seemed to resent him stepping in as their new boss. They were both smiling as they came through the door, and their good-natured teasing started almost before they had finished shaking hands. ''Sorry we're a little late,'' Elsa started, ''but John had to stop for the last jelly donut.'' ''I did not!'' John said indignantly. He looked at Simon. ''It was chocolate.'' Because of his busy schedule that day, Simon got down to business instead of joining the banter as he normally would have done. ''Thanks for coming by, Elsa and John. We have several issues to discuss before I have to meet with Jane and Doug this afternoon.'' He paused for a second. ''I've spent the past week going over the financial statements. Overall, they look well done, but I need clarification on a few details. To start with, I want to discuss the construction project we began last year.'' ''That's our big project at the moment. We're building a new factory that should be done next summer,'' Elsa said. ''Construction is going well, and we've been careful to capitalize all of the expenditures.'' Simon shook his head. ''That's the problem. I think we capitalized more than we should have. More specifically, it looks like we capitalized all of the interest on our most recent bank loan.'' ''We did,'' Elsa replied. ''Since we're using all of the loan proceeds to build the new factory, we felt it was appropriate to capitalize all of the interest.'' John nodded in agreement. ''I disagree,'' said Simon. ''Here's a breakdown of the payments we made on our new building and a list of our outstanding long-term debt (see Table 1). Did we take out any of these loans specifically for the new factory?'' Elsa shook her head. ''No, we took out the new loan, Loan 2, for general expansion, then decided the most appropriate use of the funds would be for the new factory.'' 2 J. Porter and AAA Simon frowned. ''Why are we capitalizing the interest on Loan 2 if it wasn't originated specifically for the new factory?'' ''Well, if the capital from the loan is eventually used on a specific construction project, then I think we should be able to capitalize the interest on that loan as part of the historical cost of the project. Of course,'' Elsa frowned, ''maybe we are capitalizing too much. Perhaps we need to calculate avoidable interest to determine the amount of interest that should be capitalized.'' ''You are right that generally we would need to calculate avoidable interest before capitalizing any interest,'' Simon answered. ''But in this case, we don't need to do that. I believe GAAP allows interest to be capitalized only if a specific construction loan is used.'' ''Well, I still think that we should be able to capitalize at least some of the interest. But I'll do some research to make sure.'' ''You said that you had questions about other things, too?'' John asked. ''Yes,'' Simon said. ''I am curious about one other issue. This year, we introduced a new line of industrial snow cone machines.'' ''Yes, we did,'' John replied quickly. ''And we were very careful with all of the sales and expense transactions.'' ''Yes, you were, but didn't the new model replace an older version?'' ''Yes,'' John replied, and then frowned. ''The first model was replaced because of some slight design problems. It worked well, but the customers didn't 3 J. Porter and AAA like the way it looked or sounded. We shouldn't have any liability issues because of those old machines.'' ''I'm not worried about warranty or liability issues. I believe those have been properly recorded. However, we still have some of those original units in inventory, right?'' ''Only a few dozen, I believe. Is that a problem?'' ''It is since we still have those units recorded at their original historical cost. Now that we have a new model, the value of those old machines has probably dropped significantly.'' Elsa nodded. ''That's a good point. Who would buy the old version now that a newer version is available? We probably need to write down that inventory.'' John sighed. ''Okay, but to do the calculations, I'll need some data about current sales price, replacement values, and disposal costs.'' Simon handed John a table (see Table 2). ''I called the production and sales departments this morning and got everything you need.'' John studied the table for a minute. ''There are two sets of estimates here.'' Simon nodded. ''I'm afraid so. The two managers couldn't agree on the estimates. The first set comes from Todd, the sales manager. The second set comes from Nate, the line manager for the snow cone machine line. My guess is that Nate has a better feel for the production costs involved, but Todd's estimates of the current sales price are probably more accurate.'' Frowning even more, John said, ''Nate's estimates will probably require a larger write-down.'' ''Which will be a harder sell to the management team,'' Elsa said. ''They really want to report strong financial statements for the stock offering.'' 4 J. Porter and AAA ''I know, but I don't think we should base our decision on which estimates provide a smaller write-down,'' Simon cautioned. ''If we are going to write down inventory, then we need to use the most accurate estimates. However, in order to decide which set of estimates to use, I think we will need to see the results from each set. I'm sorry, John, but I need you to do the calculations twice.'' John nodded. ''Well,'' Simon said. ''Those were my questions. Do either of you have any concerns we need to discuss before I meet with Jane and Doug?'' Elsa had a pensive look on her face. ''I think we need to consider recognizing an asset retirement obligation, or ARO, for the new factory. Our lease agreement with the city states that we will clean up the land, if necessary, when we close down the factory. When we originally prepared the financial statements, we didn't have enough information to estimate the ARO, so we only disclosed the requirement in the footnotes.'' ''I saw that,'' Simon replied. ''It looked like the note was well done.'' ''Thanks. However, last week we received a letter from the city. It seems that city officials recently hired an engineer with quite a bit of experience cleaning up after factories like ours. She believes there is a 70-75 percent chance that we will have to clean up the land at the end of our lease, and she sent us a letter including her estimate of the future cost. She wanted to make sure that we were prepared to handle those costs when our lease runs out in 20 years. ''When I first got the letter, I decided that since it arrived after the close of the fiscal year, we could wait and record it this year. However, if we're going to go back and change the amount of interest capitalized on the factory, shouldn't we also record the associated ARO?'' Simon thought for a moment. ''I don't know. We did receive the information before releasing our financial statements, but there's only a 70-75 percent chance that we will actually have an obligation. Do we need to include that estimate?'' ''Do you remember how much it was?'' John asked. Elsa nodded. ''The city engineer believes it will cost $500,000 just to tear down the factory in 20 years.'' ''Well, when you consider our 12 percent internal rate of return, the ARO won't be too big,'' John said, smiling. 5 J. Porter and AAA ''You're right.'' Elsa nodded. ''That part doesn't sound too bad. However, she also estimates that we will need to spend approximately $250,000 a year for the three years after removing the plant to restore the land to its original condition.'' ''Thanks for bringing that up, Elsa,'' Simon said. ''Do you have any other concerns?'' ''Just one,'' John said, ''and it's only an idea that you might want to pitch to the management team along with these other changes. We have used the percent of accounts receivable method to calculate our Allowance for Bad Debt for several years. But we don't have to use that method.'' ''What do you mean?'' Elsa asked. ''Isn't the percent of accounts receivable method one of the best ways to calculate the Allowance?'' ''Technically, yes, it is. However, we recently hired a new credit manager who has improved our collections and tightened our credit policy for new customers. Because of these improvements, we might not have to use the percent of accounts receivable method. Instead, we could switch back to the percent of sales method that we used previously. By switching from using 12 percent of accounts receivable to 2 percent of credit sales, we would reduce our allowance for bad debts and our bad debt expense. That would offset some of these negative changes we have just discussed.'' ''What were credit sales for the year?'' Simon asked. ''About $1.25 million, and accounts receivable had an ending balance of $600,000 after we wrote off $30,000 of uncollectible accounts. We wrote off almost $50,000 the year before, so our collections really have improved. Honestly, I don't think that we'd lose information quality by switching methods. We don't really have to use any specific method for estimating bad debt expense. I think we could make a case for the more relaxed estimation method, and I think the positive effect of the change on net income might help the management team accept some of these other adjustments.'' Elsa jumped in. ''I don't see any problem with that.'' Simon frowned. ''I'm not sure I like the idea of changing methods solely to offset the negative effects of these other adjustments. But go ahead and calculate how switching methods would affect our bad debt expense. We'll meet again tomorrow morning, after I've talked with Jane and Doug about how to handle these issues.'' 6 J. Porter and AAA MEETING WITH THE CEO AND CFO: 2:00PM Jane, Frosty Co.'s CEO, shook Simon's hand as she welcomed him into her office. Doug, the CFO, was already seated. ''So, how do things look?'' Jane asked as Simon took his seat. ''Well,'' said Simon, as he handed out copies of the financial statements (see Tables 3-5). ''I think the financial statements will be ready for our audit and our earnings announcement on schedule.'' Jane frowned as she flipped through the statements. ''That's great, Simon, but how do things look?'' Simon looked confused, so Doug explained. ''I think Jane wants to know the final EPS.'' Doug glanced quickly at the financial statements, then turned to Jane and said, ''It looks like EPS will be $2.21. That's five cents higher than the analysts' $2.16 forecast.'' ''Well,'' Simon said slowly. ''Perfect!'' Jane said brightly, ignoring him. ''That's just what I wanted to hear!'' ''But . . .'' Simon tried again. 7 J. Porter and AAA 8 J. Porter and AAA 9 J. Porter and AAA ''Right,'' Doug agreed. ''Let's go ahead and announce the SEO right away.'' ''Good idea,'' Jane said, nodding. ''There's no reason to wait if we've got good news.'' ''Excuse me,'' Simon jumped in. ''But that might be a little premature.'' Jane looked at him. ''Why?'' ''Well, I do have a couple of issues I need to discuss with you.'' 10 J. Porter and AAA Doug and Jane both frowned. ''What do you mean?'' Doug asked slowly. Simon sat forward. ''I met with my team this morning, and we think there may be a few corrections that need to be made to this draft of the financial statements.'' ''I thought you said they were done,'' Jane snapped. Doug held up his hands. ''Jane, don't shoot the messenger. It's Simon's job to look through the financial statements for any problems.'' Jane took a deep breath. ''You're right.'' She sighed. ''I'm sorry, Simon. What have you found?'' Simon took a deep breath. ''First, we capitalized all of the interest on our new loan as part of our construction project. According to GAAP, we might be able to capitalize some of that interest, but certainly not all of it. Second, officials from the city where the new factory is being built have provided us with fairly accurate estimates of what we will need to spend to remove the factory and clean up the land when our lease expires. Since we haven't released the financial statements yet, we may need to record the ARO.'' Jane grimaced, but Simon pushed on. ''Third, we haven't written down any of our obsolete inventory following the introduction of the new snow cone machine line, and we know that our customers aren't going to buy the earlier model at the original price. We're still looking into how much the write-down will be, but we will need to write down some of it.'' Jane asked quietly, ''Are you finished?'' ''Those are the issues we've identified. I'm not sure what the net effect of the changes will be yet, but I'm afraid that they might drop EPS quite a bit.'' ''But . . .'' Jane said hotly. Doug jumped in. ''Look, Simon, I know you want to correctly account for all of these issues; I do too, but we need a strong set of financials this year. We're counting on that SEO to fund our new growth strategies. We need the good news now, so leave the statements as they are. We'll fix all of these issues after the offering, I promise.'' Simon said quietly, ''I think we need to make these adjustments, all of them.'' He looked at Jane's angry face. ''There is a way to reduce the drop in EPS. We could switch our method of calculating bad debt expense from the percent of accounts receivable method to the percent of credit sales method.'' 11 J. Porter and AAA Jane played with her earring while she thought. ''Would switching methods offset the other adjustments?'' Simon shook his head. ''Probably not entirely, but it will help.'' Jane shook her head. ''Simon, just leave the financial statements as they are.'' Simon started to argue, but Jane cut him off. ''Look, Simon, the decision is mine to make, and I'm telling you: don't mess with the financial statements. Leave them as they are!'' ''But the statements are wrong as they are!'' ''We don't know that,'' Doug jumped in quickly. ''All we really know is that maybe we should do something about these issues. Think about the inventory adjustment for a minute. Companies leave obsolete inventory on their books all the time, waiting for a good year to write them down. It doesn't really bother anyone. And as far as the interest capitalization, if the auditors don't catch it. . .'' ''But our numbers will be wrong!'' Jane sounded exasperated. ''You don't know that, Simon. There are so many estimates in the financial statements that you can't ever be sure if the numbers are right or wrong. Besides, we owe it to our investors to report good numbers; that's how their investments grow. Believe me, they don't want to see bad numbers. So, if the auditors happen to stumble on these issues.. . .'' She stopped for a moment, looking at Simon's face. ''If the auditors stumble on them, send them to talk to Doug or to me. We'll straighten them out.'' She smiled. ''Don't worry about this so much. Just leave things as they are, and we'll take care of you when bonuses come out. The Board's going to be thrilled to see these financial statements, and we'll be sure to tell them how much you helped us get ready for the SEO. We're always happy to reward . . . team players.'' Doug nodded. ''I think that's everything for today. Thank you for all of your hard work.'' Simon stood, picked up his papers, and headed for the door. When they had hired him, he had been excited for a new opportunity. But now, he was starting to wonder if he should have stayed in public accounting. 12 J. Porter and AAA CASE REQUIREMENTS 1. Capitalizing interest on the new factory: a. During the year, Frosty Co. paid all of the interest accrued on Bond A and Loan 1, but only $50,000 of the interest accrued on Loan 2. Using one journal entry, summarize how Frosty originally recorded the accrued interest on all three long-term debts. b. Assuming John and Elsa are right that the new loan meets the standards for capitalizing interest, calculate avoidable interest. c. What correcting entries would need to be made to properly record interest on Frosty Co.'s construction project if Simon is right? d. What would be the net effect of each of these interest adjustments on net income? What would be the net effect on EPS? 2. Recording the asset retirement obligation (ARO) on the new plant: a. Assuming that payments will be made at the end of each year, determine the amount that Frosty Co. should recognize for the ARO. b. Assuming Frosty Co.'s management team decides to record the ARO, what correcting entries would need to be made? c. What would be the net effect of the ARO adjustment on the current year's net income? What would be the net effect on EPS? 3. Recording the write-down on obsolete inventory: a. Based on the information provided in Table 2, calculate the write-down that would be necessary using the first set of assumptions. b. Based on the information provided in Table 2, calculate the write-down that would be necessary using the second set of assumptions. c. Assuming that Frosty Co.'s management team decided to use the first set of estimates, what correcting entries would need to be made to write down inventory? (Assume that Frosty Co. uses the direct write-off method.) d. What correcting entries would need to be made to write down inventory if the team decided to use the second set of estimates? e. What would be the net effect of each of these inventory adjustments on net income? What would be the net effect on EPS? 4. Recording the change from the percentage of sales to the percentage of accounts receivable method of calculating bad debt expense: a. Calculate the amount of bad debt expense Frosty Co. would recognize using the percentage of sales method. 13 J. Porter and AAA b. c. Assuming that the management team has decided to switch from the percent of accounts receivable method to the percent of sales method for estimating bad debt expense, what correcting entries would need to be made? What would be the net effect of this change in method on net income? What would be the net effect on EPS? 5. Evaluating each adjustment: a. Based on the accounting standards, can Frosty Co. capitalize the interest on the construction project? If so, how much can Frosty Co. capitalize? Explain. b. Based on the accounting standards, does Frosty Co. need to recognize the ARO in these financial statements? Explain. c. Based on the discussion in the case, which set of lower of cost or market assumptions do you think is the most appropriate? Explain. d. Do you think that Frosty Co. should switch methods of calculating bad debt expense? Explain. 6. Updating Frosty Co.'s financial statements: Based on the correcting entries you made in Questions 1-4 and your answers to Question 5, make any necessary changes to Frosty Co.'s income statement, balance sheet, and statement of cash flows. 7. Analyzing the consequences of your adjustments (round your ratio values to three decimal places): a. Calculate Frosty Co.'s EPS, Current Ratio, Profit Margin, ROA, and Debt to Equity Ratio using the original financial statements. b. Recalculate the ratios using your adjusted financial statements from Question 6. c. Which set of financial statements do you think the management team would prefer? Which set would Frosty Co.'s investors prefer? Defend your answers. 8. Resolving the conflict between Frosty Co.'s upper management: Simon (the controller) felt that three of the issues presented in the case should be resolved immediately. Doug and Jane (the CFO and CEO) felt that the financial statements should be left alone. Using your knowledge of GAAP, Frosty Co.'s business goals, the principles of business ethics, and your answers to Questions 1-7, do the following: 14 J. Porter and AAA a. b. What do you think the final decision will be? Do you agree with that decision? Why or why not? Assuming that Jane insists on leaving the books as they are, what do you think Simon will do? What do you think he should do? 15 J. Porter and AAA