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 group's 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 firm's fourth fiscal year, which ended on December 31, 2014, in order to pursue other business opportunities. You continued in your capacity as chair of Zodiak's 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

Zodiak's financial performance during your tenure as CEO was solid, if not spectacular. Corporate profitability ostensibly soared under Skilling's 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 period's 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 Zodiak's 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 Zodiak's 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 Zodiak's 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. I've used the audit firm of Arturo Andersen at my other firms and they've 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, Zodiak's sales force told the recipients that they could return the goods in 2016 if they didn't 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 Zodiak's 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 Board's attention. In order to do so, you charge Ms. Walters with two tasks:

Required:

Recast Zodiak's 2015 income statement and balance sheet to conform to generally accepted accounting principles.