Papadopoulos
Limited (PL) sells retail merchandise in Canada. The company was incorporated
last year and is now in its second year of operations. PL is owned and operated
by the Papadopoulos family, and Iris Papadopoulos, the company president, has decided
to expand into the American marketplace. In order to do this, bank financing
will be necessary.
The
books have been kept by Iris’s daughter Tonya, who is studying accounting in
university. Financial statements had only been prepared for tax purposes in the
past. For the year ended December 31, 2011, Tonya prepared the following
statement showing cash inflows and cash outflows:
Sources
of cash:
From
shareholder loan ………………………………………………. $150,000
From
sales of merchandise ………………………………………….. 350,000
From
truck financing ……………………………………………….. 50,000
From
term deposit cashed in ……………………………………….. 100,000
From
interest income ………………………………………………. 10,000
Total
sources of cash ………………………………………………. $660,000
Uses
of cash:
For
fixed asset purchases ……………………………………………
$100,000
For
inventory purchases ……………………………………………. 250,000
Operating
expenses, including depreciation of $70,000 …………… 160,000
For
purchase of investment ………………………………………… 55,000
For
purchase of truck ………………………………………………. 50,000
For
interest on debt …………………………………………………. 30,000
Total
uses of cash …………………………………………………… $645,000
Net
increase in cash …………………………………………………
$15,000
Tonya
showed the statement to her mother, noting that the bank was sure to give them
a loan, especially since they were profitable in their second year and since
cash had increased over the year, which shows that it had been a good year.
Iris
was not convinced, however, and decided to have the statement looked at by a
“real” accountant.
Instructions
Adopt
the role of the accountant and redraft the statement, if necessary, in good
form for the bank. Discuss the company’s financial position. Consider PE GAAP
to be a constraint.
Overview
-
The bank is the main user of the financial
statements and will use them to assist in determining whether a loan will be
granted.
-
They will likely want GAAP-based financial
statements to enhance credibility and reliability. Per the case, consider ASPE
as a constraint.
-
The
financial statements prepared will be different from the statements prepared in
the past (tax basis).
-
Further, the statement prepared by Tonya
does not conform with GAAP and must therefore be converted.
Analysis and recommendations
Before any issues are dealt with, the statement must be redrafted
as follows:
Papadopoulos Ltd.
Statement of Cash
Flows
(for the
year-ended December 31, 2011)
|
Cash from operations:
|
|
|
|
Sales
|
$350,000
|
|
|
Purchases
of inventory
|
(250,000)
|
|
|
Operating
expenses (net of depreciation)
|
(90,000)
|
|
|
Interest
income
|
10,000
|
|
|
Interest
on debt
|
(30,000)
|
|
|
Cash
used in operations
|
|
$(10,000)
|
|
Cash
from investing:
|
|
|
|
Term deposit
cashed in
|
$100,000
|
|
|
Fixed asset
purchases
|
(100,000)
|
|
|
Investment
|
(55,000)
|
|
|
Truck purchase
|
(50,000)
|
|
|
Cash used in
investing
|
|
(105,000)
|
|
Cash
from financing:
|
|
|
|
Shareholder loan
|
$150,000
|
|
|
Truck
financing
|
50,000
|
|
|
Cash
from financing
|
|
200,000
|
|
Net
cash inflows
|
|
$85,000
|
-
This statement shows that operations are
not generating cash; rather, cash is required to maintain operations.
-
This will be looked upon in a negative
light by the bank, since internally generated cash from operations is what the
company should be using to repay any loan granted.
-
However, since it is only the second year
of operations, the company is profitable, and the cash required to run
operations is not that great, the bank may be somewhat flexible.
-
That the company is liquidating what
appear to be non-essential assets (term deposit) and using the money to buy
productive assets to be used to generate income will be seen in a positive
light.
-
That excess cash is being invested will
also be seen in a positive light as good management (i.e., will maximize return
on excess cash by investing).
-
The excess cash is only present, however,
due to a shareholder loan.
-
This is better than outside borrowings
since the shareholders (all family) may be more flexible if the company can not
make interest and principal repayments on time.
In conclusion, when the financial statements are redrafted, PL
will be seen in an unfavourable light by the bank primarily because it is a new
company and the cash flow from operations is negative. The only reason there is
excess cash is due to a shareholder loan. Note that the entity may use the
direct or indirect methods to present cash from operations, however, the direct
method has been used since there is insufficient info presented to prepare the
statement using the indirect method.
