You Are Working For An Elite Accounting Consulting Firm And

You Are Working For An Elite Accounting Consulting Firm And Have Been

You are working for an elite accounting consulting firm and have been hired by One-two-three Incorporated (“123 Inc.”) to assist them with a number of questions which have arisen while preparing their October 31, 2016 financial statements. 123 Inc. is a Canadian public manufacturer of high-end paper coffee cups on the cutting edge of ‘rim rolling prize’ technology. For each of the situations presented, please present the following: A. The appropriate journal entry (or entries) which should have been entered to account for the situation described. Indicate which reporting period your entries need to be recorded in (i.e., fiscal 2016 or fiscal 2017). Part marks are available for incorrect answers but only if you show your work. (80% of available marks) B. A short description of why the entry is necessary in plain language that the CEO of 123 Inc. will understand (she has an engineering background, not an accounting one). (15% of available marks) C. Describe (UP or DOWN) the impact your proposed entries (on a combined basis) will have on the following metrics for fiscal year:

• EBITDA (earnings before interest, taxes, depreciation, and amortization)
• Current ratio
• Interest coverage ratio

Paper For Above instruction

In this analysis, we address five key accounting issues faced by 123 Inc. during fiscal year 2016, providing appropriate journal entries, plain-language explanations for the CEO, and the impact on financial metrics. These cases encompass product recalls, bond issuance, machinery acquisition, bond impact on earnings per share, and investment accounting — each illustrating important principles in financial reporting.

Question 1: Product Recall

During October 2016, customer complaints led to a decision to recall a manufacturing run from September 2016. Refunds totaling $50,000 were issued in October, and the entire sale value of the run was $700,000, with anticipated additional costs of at least $100,000, and potential further costs up to $200,000.

1. A. Journal Entry

In October 2016 (fiscal 2016):

Dr. Cost of Goods Sold $50,000
Cr. Cash $50,000

This entries records the refunds issued. Additionally, for the overall recall estimate:

Dr. Recall Expense $150,000
Cr. Provision for Recall Liability $150,000

(Reflects the estimated total additional costs of $100,000 with a potential $200,000 — the conservative estimate being $150,000, half between those figures). This liability recognition aligns with the matching principle, recognizing the probable obligation in the period incurred.

1. B. Plain Language Explanation

This entry records the cash refunds already paid and estimates the total expected costs for the recall, including unknown future expenses, so the financial statements accurately reflect liabilities and expenses from the recall event.

1. C. Impact on Financial Metrics

• EBITDA: DOWN, as recall expenses reduce earnings before interest, taxes, depreciation, and amortization.
• Current Ratio: DOWN, because increase in liabilities (recall provision) reduces current assets relative to current liabilities.
• Interest Coverage Ratio: NO significant impact initially, as the recall liabilities do not involve interest expense.

Question 2: Bond Issuance and Yield Calculation

On June 1, 2016, 123 Inc. issued an 8%, 3-year bond with a face value of $800,000, quarterly interest payments of $24,000, sold at $841,031. The first interest payment occurred on September 1, 2016. The CEO wants to understand the bond’s yield, given its premium over face value.

2. A. Journal Entries for Fiscal Year 2016 and 2017

June 1, 2016 (issuance):

Dr. Cash $841,031
Cr. Bonds Payable $800,000
Cr. Premium on Bonds Payable $41,031

September 1, 2016 (interest payment):

Dr. Interest Expense $20,066
Dr. Premium on Bonds Payable $3,934
Cr. Cash $24,000

(Interest expense calculated based on the effective interest method, amortizing the premium). Future fiscal year entries continue amortizing the premium and recognizing the interest expense accordingly.

2. B. Plain Language Explanation

The bond was issued at a premium, meaning investors paid more than the bond's face value because of favorable interest rates. Over time, the premium is amortized to match the actual cost of borrowing, affecting reported interest expense and net income.

2. C. Impact on Financial Metrics

• EBITDA: No direct impact (interest and amortization are below EBITDA line).
• Current Ratio: Slightly improved (more cash received at issuance).
• Interest Coverage Ratio: Downward pressure, as amortization of premium increases reported interest expense, reducing interest coverage.

Question 3: Machinery Acquisition and Depreciation

On August 1, 2016, 123 Inc. purchased machinery costing $300,000 with a CCA rate of 45% and a salvage value of $25,000, to be used over an estimated 1.3 billion cups. The machinery was recorded with an initial entry.

3. A. Journal Entries for 2016 and 2017

August 1, 2016:

Dr. Capital Assets $300,000
Cr. Accounts Payable $300,000

For tax purposes, apply half-year rule to CCA deduction.

Fiscal 2016: CCA = 45% of $300,000 x 50% = $67,500.

Fiscal 2017: CCA = 45% of ($300,000 - $67,500) = $94,875.

Accounting depreciation is based on usage, which is not specified exactly but assumed to be linear over its useful life for illustration; actual computation would involve detailed usage data.

3. B. Plain Language Explanation

The company bought machinery to expand production, and for tax purposes, they can deduct most of the cost quickly through CCA, saving taxes. For accounting, depreciation reflects how much of the machinery's value is used up annually based on actual production.

3. C. Impact on Financial Metrics

• EBITDA: DOWN initially due to depreciation expense.
• Current Ratio: Slightly DOWN, as depreciation lowers book value, but no immediate impact on current assets/liabilities.
• Interest Coverage Ratio: Unaffected, since no interest expense involved in depreciation.

Question 4: Bonds Impact on Earnings Per Share

On May 1, Inc. issued 600 bonds at 8%, ten-year maturity, paying interest annually at face value $1,000 per bond, totaling $8,000 in annual interest. Converted at 25 shares per bond, the effect on EPS depends on potential conversion.

4. A. Calculation of EPS Impact

Net income for 2016: $2,000,000. No conversions occurred in 2016, so EPS is:

EPS = ($2,000,000) / (500,000 shares) = $4.00 per share.

If all bonds were converted, additional shares issued: 600 bonds x 25 = 15,000 shares.

Adjusted EPS if converted (assuming interest is saved):

Interest expense before tax: $480,000; after tax: $384,000.
Adjusted net income: $2,000,000 + $384,000 = $2,384,000.
New total shares: 500,000 + 15,000 = 515,000.
EPS: $2,384,000 / 515,000 ≈ $4.63.

Therefore, potential conversion increases EPS from $4.00 to approximately $4.63, indicating a dilutive effect without conversion but potentially accretive if conversion occurs.

Question 5: Investment in Alphabet Soup Inc.

On November 1, 2015, 123 Inc. purchased 125,000 shares for $2.5 million, representing 25% ownership. Dividends paid are $1.50 per share on January 15 and August 15, 2016. Net income reported: $1,040,000. Market value: $20.25 per share at October 31, 2016.

Two accounting methods are considered: the equity method and FV-OCI. The method impacts net income recognition and valuation.

5. A. Journal Entries & Method Selection

Equity Method:

Nov 1, 2015:
Dr. Investment in Subsidiary $2,500,000
Cr. Cash $2,500,000
During 2016:
Share of subsidiary’s income (25% of $1,040,000): $260,000
Dr. Investment in Subsidiary $260,000
Cr. Income from Investment $260,000
Dividends:
Jan 15, 2016:
Dr. Cash $187,500 (125,000 x $1.50)
Cr. Investment in Subsidiary $187,500
Aug 15, 2016:
Dr. Cash $187,500
Cr. Investment in Subsidiary $187,500

FV-OCI Method:

Initial investment:
Dr. Investment $2,500,000
Cr. Cash $2,500,000
At reporting date:
Adjust to fair value:
Market value ($20.25 x 125,000): $2,531,250
Difference ($2,531,250 - $2,500,000): $31,250
Dr. Investment $31,250
Cr. OCI (equity reserves) $31,250
Dividends are recognized as income: $187,500.
Net income impact:
No share of net income directly included; valuation changes appear in OCI.

5. B. Which Method Yields Higher Net Income

The equity method results in a higher net income recognition (the 25% share of $1,040,000), adding $260,000 to net income, whereas FV-OCI reflects unrealized gains or losses in OCI, which do not affect current net income directly. Therefore, the equity method produces higher net income in this scenario. This occurs because the equity method recognizes the proportionate share of net income, while FV-OCI accounts for changes in fair value that are not yet realized.

Conclusion

The decisions regarding product recalls, bond issuance, machinery depreciation, bond impact on EPS, and investment accounting profoundly influence a company's financial statements. Correct journal entries ensure accurate reporting, while understanding their impact on financial metrics guides strategic decisions. For 123 Inc., proper application of accounting principles ensures transparency, compliance, and insightful financial analysis suitable for stakeholders and management alike.

References

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• Investopedia. (2023). Bond Yield Definition. https://www.investopedia.com/terms/y/yield.asp
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