(Forecasting future earnings, LO 1) You have been presented with Peverel Ltd’s

(Peverel) income statement for the year ended September 30, 2005.

In addition, you have learned the following:
© Cost of sales in 2005 includes a write-down of inventory of $295,000. The amount of the write-down is about three times larger than the amount usually written down each year to account for non-saleable inventory or inventory that will have to be sold at a deep discount.
e Sales includes $1,250,000 for a one-time-only sale to the government of a foreign country. The profit margin percentage on this sale was 60%, which is significantly higher than what Peverel normally experiences.
e Selling and administrative costs includes a $200,000 retirement bonus paid to the former CEO.
e Peverel signed a contract with its employees that goes into effect on October 1, 2005. The contract increases union employees’ wages and benefits by 5%.
Wages to employees covered by the contract represent 70% of salaries and wages expense in 2005. Wages to other employees are not expected to change during 2006.
e During 2005 Peverel won a lawsuit against a former employee for divulging confidential information to her new employer. The employee and her new employer are required to pay damages to Peverel of $1,000,000.
e Sales (excluding the one-time sale note above) are expected to grow by 8%
during 2006. Inventory costs are expected to increase by 9%, selling and administrative expenses are expected to decrease by 2%, interest expense is not expected to change, amortization expense is expected to increase by 2%, and other expenses are expected to increase by 4%.
Required:

a. Use Peverel’s 2005 income statement and the additional information to forecast an income statement for 2006.

b. Explain and interpret Peverel’s actual performance in 2005 and the performance that you forecast for 2006.

c. Discuss the difficulties that can occur with forecasting the future performance of an entity and the problems with using GAAP financial statements for forecasting.

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Sales Peverel Ltd. Income Statement For the Year Ended September 30, 2005 Cost of sales Gross margin Expenses: Salaries and wages Amortization Selling and administrative Interest Other Unusual items-lawsuit revenue Income before income taxes Income tax expense Net income $12,750,000 5,737,500 7,012,500 2,754,000 987,000 1,450,000 500,000 325,000 1,000,000 1,996,500 598,950 $ 1,397,550