Total Current Assets 46,000
Property and Equipment 92,000
Other Assets 300
Total Assets $ 138,300
Liabilities and Stockholders' Equity Current Liabilities:
Accounts Payable 36,100
Accrued Liabilities 8,680
Taxes Payable 400
Total Current Liabilities 45,180
Long-term Debt 54,000
Total Liabilities 99,180
Stockholders' Equity
Common Shares 35,000
Retained Earnings (4,080)
Total Stockholders' Equity 39,120 Total Liabilities & Stockholders' Equity $ 138,300 Figure 5.6: Change in Returns Reporting
GAC Balance Sheet with Returns Reporting Change at August
31, 2014
Inventory
Due to the unpredictable returns, the inventory balance has increased.
However, a significant event this year further affects the actual cost of inventory. A water leak damaged half of the inventory purchased for this year’s production. As Nicki’s creative idea allowed the majority of these shirts to be used in the making of the graphic design shirts, she was able to
51 minimize the loss on these shirts. However, many of these graphic design shirts were not as popular as shirts used previously. We know this by looking at the days to sell inventory in 2014 versus 2013, both of which are found in Figure 5.5. This inventory is taking much longer to sell this year than last year, and the items that aren’t sold were returned to the inventory, as mentioned before.
Right now, GAC has a deal with a discount store that allows them to sell the graphic shirts in their inventory at half their cost. If all the shirts in the graphic account are only worth half their original cost, then the difference should be a loss from inventory impairment. This allows GAC to report inventory at its lower-of-cost-or-market price in accordance with GAAP reporting. The amount to be written off would be $4,900, calculated as half the cost of the graphic shirt account. This amount would not only be an impairment loss on the income statement, but would also be a reduction to the inventory account, as shown at the top of the next page in Figure 5.7. This reduction in the current assets would result in a lower current ratio seen in Figure 5.3, and should once again be considered a concern for GAC.
Assets
Current Assets:
Cash and Cash Equivalents 4,000
Accounts Receivable 32,500
Inventory 19,600
Total Current Assets 56,100
Property and Equipment 92,000
Other Assets 300
Total Assets $ 148,400
Liabilities and Stockholders' Equity Current Liabilities:
Accounts Payable 36,100
Accrued Liabilities 8,680
Taxes Payable 400
Total Current Liabilities 45,180
Long-term Debt 54,000
Total Liabilities 99,180
Stockholders' Equity
Common Shares 35,000
Retained Earnings 14,220
Total Stockholders' Equity 49,220 Total Liabilities & Stockholders' Equity $ 148,400 Figure 5.7: Change in Inventory Reporting
GAC Balance Sheet with Inventory Reporting Change at
August 31, 2014
Analysis and Conclusion
So, the effects of the individual changes in the accounts each result in a lower current ratio than was actually reported for the year. However, as stated in the opening, GAC really needs to be aware of its actual current ratio.
If the current ratio falls below 1.0, the bank could require an external audit of GAC, which would be both timely and costly for the company. But, in order to get the best look of these changes, we must see the total effect. Therefore, we
53 begin by looking at a re-casted income statement for 2014 with all changes shown. This is found below in Figure 5.8.
Figure 5.8: Comparison to Revised Income Statement
2014 with Changes 2014 Revenue
Sales Revenue $ 170,000 $ 180,000 Sales Returns and Allowances 15,050 50 Net Sales Revenue 154,950 179,950 Cost of Goods Sold 93,000 93,000 Gross Profit 61,950 86,950 Expenses
Salaries and Wages 58,000 58,000 Selling and Administrative 20,000 20,000 Depreciation 5,000 5,000 Repairs and Maintenance 1,000 1,000 Bad Debt Expense 3,000 - Loss on Impairment of Inventory 4,900 - Interest and Other 900 900 Income before Income Taxes (30,850) 2,050 Provision for Income Taxes 400 400 Net Income $ (31,250) $ 1,650
Graphic Apparel Corporation Income Statement At
August 31
With the current reporting methods, the net income for GAC is $1,650.
However, when following GAAP principles, the company actually has a net loss of $31,250. This difference is reconciled by $7,500 sales revenue listed as unearned revenue, the $2,500 sales revenue taken off the books, the
$15,000 increase in sales allowances, the $3,000 bad debt expense that arose from the allowance, and the $4,900 loss from the impairment of inventory.
This operating loss greatly affects the retained earnings account on the balance sheet, and the balance sheet with all changes can be seen below in Figure 5.9.
Assets
Current Assets:
Cash and Cash Equivalents 4,000
Accounts Receivable 15,000
Less: Allowance for doubtful accounts 3,000 12,000
Inventory 19,600
Total Current Assets 35,600
Property and Equipment 92,000
Other Assets 300
Total Assets $ 127,900
Liabilities and Stockholders' Equity Current Liabilities:
Accounts Payable 36,100
Accrued Liabilities 8,680
Taxes Payable 400
Unearned Revenue 7,500
Total Current Liabilities 52,680
Long-term Debt 54,000
Total Liabilities 106,680
Stockholders' Equity
Common Shares 35,000
Retained Earnings (13,780)
Total Stockholders' Equity 21,220
Total Liabilities & Stockholders' Equity $ 127,900 Figure 5.9: All Changes Reported
GAC Balance Sheet with All Changes Reported at
August 31, 2014
From the original balance sheet shown in Figure 5.1 to the balance sheet reporting all changes seen above, there are significant differences.
55 Besides the addition of accounts, the current assets amount decreases by
$25,400 and the current liabilities account increases by $7,500 when all changes are implemented. This reduces the current ratio from 1.35 to 0.68, shown above in Figure 5.3. In order to meet the bank’s requirement and return to a current ratio of 1.0, GAC would need additional capital of $17,080.
This is calculated by subtracting the current assets from the current liabilities.
In light of this dramatic decrease in the current ratio, I would recommend that GAC return to the previous method for doing business.
While Nicki may want to launch a new career in fashion, the graphic design shirt business is obviously not the best choice, especially given the current location and customers. However, Nicki could still try to be creative when it comes to custom orders. Rather than making custom orders for sport teams, she could make custom orders for unique customers or even her Internet fan base using the leftover plain shirts purchased in 2014, which would allow her to further her fashion career without hurting the original business. If Nicki continues using the changes implemented this past year, GAC will more than likely declare bankruptcy, as the company will be unable to pay the interest on the new debt financing.
A further exploration of depreciation expense and potential manipulation of revenue and expenses.