Chapter 5: Graphic Apparel Company
3. GAC’s loan agreement states that it must keep a minimum current ratio of 1.0.
Part B
2. The biggest items to account for this year are the accounts receivable, bad debt expense (and allowance for bad debt), damaged goods due to the leak in the warehouse, and sales returns and allowances. Because of the new customer base that GAC has acquired, accounts receivable and bad debt expense are more important than ever. Nicki needs to make sure she is collecting every amount she can for her currently fledgling business. Also, how to account for goods that are returned for damages is important because of the amount that was damaged due to the flood.
1. The custom shirt business is having its ups and downs. While she is expanding the brand to fashions it has never seen before, she is having a hard time completing this revenue stream through cash collections. This has been the major downfall of the business so far. Nicki must find a way to collect the money she is owed, or the business will fail.
2. GAC’s new customer base has changed since Nicki took over. Since she brought her edgy and trendy taste with her, many new stores have picked up her lines while the older, more traditional stores have dropped her. This new customer base is having a hard time making their payments on time, which has been a serious issue for GAC.
3. The new graphic design is what is attracting the new customer base that is aforementioned, along with the problems.
4. The warehouse sprung a leak in the roof, staining some of the merchandise that had yet to hit stores. Nicki decided that the stains could be perceived to have an edgy quality, so she used the damaged merchandise anyways.
3. The revenue principle, according to GAAP, states that companies must recognize revenues in the accounting period in which the performance obligation is satisfied.
4. She booked the Accounts Receivable and Service Revenue when the orders were placed, not when the orders were totally fulfilled. The only times that this would be acceptable under GAAP are when the process is much more long term that shirt manufacturing (plane construction) or a good that is guaranteed to be purchased right after production (oil).
5. GAC could record revenue at the point of final sale, where the end customer has actually purchased the product. It could also recognize it at the point of delivery to the retailer, which would be the preferable method.
6. Recording revenue at the point of delivery to retailer is the best method for a t-shirt design company to record revenues, for this is when it has performed its service requirements.
7. Changing to this method would not reflect well on the income statement, for it would decrease revenues as the $10,000 in custom orders would be booked as unearned revenues. This would obviously decrease net income on the income statement.
Furthermore, it would increase liabilities and decrease equity on the balance sheet, as unearned revenues are booked as a liability. In addition, the current ratio would go down due to the increase in current liabilities.
8. GAAP requires that Accounts Receivable be reported at net realizable value.
9. GAC seems to use the direct write off method to write off their receivables and record bad debts. The only time this method is acceptable is when the amount is considered to be immaterial.
10. This method is no longer acceptable because of the size of GAC’s questionable accounts. Because of their customer base, the accounts receivable that are outstanding are more questionable than they have been in the past. A look at their days to collect receivables paints a concerning picture: the 2014 number was 48.17, while the 2013 number was 33.28. This is not a good increase and evidences poor collections and credit.
11. GAC could use the allowance method to record its bad debts. This is clearly the better option to keep good accounting practices. First, it recognizes receivables at their net realizable value, which is a better representation of the true value of the receivable.
Second, it matches revenues with expenses better than the direct write off method.
12. Nicki should definitely switch to the allowance method. By seeing receivables at their net realizable value, GAC can look at the payments and collections much more efficiently. Furthermore, the direct write off method is not used by really any sort of large, reputable company, which Nicki wants for GAC.
13. It would decrease net income because the statement now would include bad debt expense, which Nicki might not be pleased with. Furthermore, assets would decrease in the balance sheet for the allowance would take away from accounts receivable.
This change would also decrease the current ratio because the numerator (current assets) would decrease.
14. GAC reports sales returns in the month that they happen. This is only acceptable when there isn’t a large history of returns, which is not the case for Nicki and GAC.
15. Given the new customer base, circumstances have changed dramatically. Accounts receivable are now much more difficult to collect, and the style of clothes she is selling is more likely to be returned due to their edgy nature. One can see this happening within the financial statements, specifically the income statement.
16. GAAP recommends that GAC books its sales returns as a loss contingency at the beginning of the period by using reasonable estimates based on sales.
17. Yes, they should. In a business like t-shirts, returns are simply going to happen, especially when you go out on a limb and design fashionable t-shirts. Thus, while it might be tough right now, GAC should use the aforementioned method because it would provide a more truthful representation to outside users.
18. Booking them as a loss contingency with an estimate is the best method, for it is the safest way to report them. It gives a sense of normalcy to the financial statements if the same percentage is used every year, and it makes the numbers a more truthful representation.
19. This is going to decrease net income most likely, for it will be booked as a subtraction from sales to get net sales. Furthermore, it will decrease assets by decreasing accounts receivable or cash, and decrease equity by decreasing net income. This would decrease the current ratio in turn with decreasing assets.
20. GAAP requires that inventory be reported at lower of cost or market (LCM).
21. GAC reports their inventory at LCM as well, but they have been using the weighted average cost method to determine the cost of the inventory. This has been appropriate because there is not much to distinguish between the shirts.
22. Given the warehouse leak, there are now some issues with the way that they measure their inventory, and it may be time for a change. The number of days to sell inventory in 2014 is 96.16 days in 2014 compared to 40.56 days in 2013. This huge difference should be of major concern for GAC and Nicki, and she might need to reevaluate her inventory in order to better fit the needs of the customer.
23. It seems that they should mark these selling prices down lower than their cost in order to, hopefully, prevent all the returns that seem to be impending, as evidenced by the stores taking the clothes off of their clearance racks. This would be a good way to minimize their losses. The gross profit percentage is 48.32%, indicating that nearly half of the sales revenue number ends up being profit after cost of goods sold.
24. GAC should change at what price they report this, for now the market price will be lower than the cost. This is in accordance with their policy of lower of cost or market.
25. The alternative would decrease the amount that inventory is reported for, thus reducing assets on the balance sheet. Furthermore, the current ratio would go down due to the decrease in the valuation of inventory.
26. GAC is not going to be pleased with the outcome of the necessary changes that have been made. Their current ratio before the changes is 1.35. With the changes that need to be made to make the statements fair and reasonable, this ratio would fall to .96.
These changes include all of the following transactions: a booking of a $10,000 liability for unearned revenue, $3000 of allowance for doubtful accounts (which brings accounts receivable down to net realizable value), $2,000 valuation decrease on inventories due to mark downs, and $3,000 decrease in assets due to sales returns and allowances. The decrease in assets and the increase in liabilities do not bode well for the keeping of their debt covenant, which should be top of their priority list.
27. GAC would need to raise at least $2,180 more of capital to get the debt ratio back to 1, for this is the amount of difference there is between the current assets and the current liabilities.
28. Nicki should definitely reevaluate her credit policy. This is obviously a major Achilles heel for GAC. It could drive away a few potential customers, but that may not be a bad thing. GAC is in desperate need of a reliable client base so it can get back to what it does best: designing t-shirts. Nicki does not have enough time to waste trying to chase down bad debts. If they were to get more reliable payments, Nicki would be able to focus on her strong suit of fashion. Also, I would recommend Nicki, money permitting, hire someone to take care of the financial side of the company so that she
does not have to. She does not really have the necessary skill set to know what she is doing, and I think that someone with more business experience could really help Nicki propel GAC to new heights.
Chapter 6: Northwest, Delta, United, and Waste Management