Radiohead
Inc. produces electronic components for sale to manufacturers of radios,
television sets, and digital sound systems. In connection with her examination
of Radiohead’s financial statements for the year ended December 31, 2011, Marg
Zajic, CA, completed field work two weeks ago. Ms. Zajic now is evaluating the
significance of the following items prior to preparing her auditor’s report.
Except as noted, none of these items has been disclosed in the financial statements
or notes.
Item
1
A
10-year loan agreement that the company entered into three years ago provides
that, subsequent to the date of the agreement, dividend payments may not exceed
net income earned after taxes. The balance of retained earnings at the date of
the loan agreement was $420,000. From that date through December 31, 2011, net
income after taxes has totalled $570,000 and cash dividends have totalled
$320,000. Based on these data, the staff auditor who was assigned to this
review concluded that there was no retained earnings restriction at December
31, 2011.
Item
2
Recently,
Radiohead interrupted its policy of paying cash dividends quarterly to its
shareholders. Dividends were paid regularly through 2010, discontinued for all
of 2011 to finance the purchase of equipment for the company’s new plant, and
resumed in the first quarter of 2012. In the annual report, dividend policy is
to be discussed in the president’s letter to shareholders.
Item
3
A
major electronics firm has introduced a line of products that will compete
directly with Radiohead’s primary line, which is now being produced in
Radiohead’s specially designed new plant. Because of manufacturing innovations,
the competitor’s line will be of similar quality but priced 50% below
Radiohead’s line. The competitor announced its new line during the week
following the completion of Ms. Zajic’s field work. Ms. Zajic read the
announcement in the newspaper and discussed the situation by telephone with
Radiohead executives. Radiohead will meet the lower prices as they are still
high enough to cover variable manufacturing and selling expenses, although they
will permit only partial recovery of fixed costs.
Item
4
The
company’s new manufacturing plant, which cost $2.4 million and has an estimated
life of 25 years, is leased from Armadillo National Bank at an annual rental of
$600,000. The company is obligated to pay property taxes, insurance, and maintenance.
At the conclusion of its 10-year non-cancellable lease, the company has the
option of purchasing the property for $1. In Radiohead’s income statement, the
rental payment is reported on a separate line.
Instructions
For
each of the items, discuss any additional disclosures in the financial
statements and notes that the auditor should recommend to her client. The
client follows IFRS. (The cumulative effect of the four items should not be
considered.)
Item 1
The staff auditor reviewing the loan agreement
misinterpreted its requirements. Retained earnings are restricted in the amount
of $420,000, which was the balance of retained earnings at the date of the
agreement. The nature and amount of the restriction should be disclosed in the
balance sheet or a note to the financial statements.
Item 2
Unless cumulative preferred dividends are involved,
no recommendation by the auditor is required. Dividend policy is understood by
readers of financial statements to be discretionary on the part of the Board of
Directors. The company need not commit itself to a prospective dividend policy
or explain its historical policy in the financial statements, particularly
since dividend policy is to be discussed in the president’s letter. If
cumulative preferred dividends are omitted, this should be disclosed in the
notes to the financial statements.
Item 3
A competitive development of this nature normally is
considered to be the second type of subsequent event, one that provides
evidence with respect to a condition that did not exist at the date of the
balance sheet, but in some circumstances the auditor might conclude that
Radiohead’s poor competitive situation was evident at year-end. In any event,
the development should be disclosed to users of the financial statements
because the economic recoverability of the new plant is in doubt and Radiohead
may incur substantial expenditures to modify its facilities. Because the
economic effects probably cannot be determined, the usual disclosure will be in
a note to the financial statements. (Only if circumstances were such that it
was concluded that this condition did exist at year-end should the financial statements
for the year ended December 31, 2011, be adjusted for the ascertainable
economic effects of this development). Consideration should be given whether
the going concern assumption is appropriate in these circumstances.
Item 4
The lease agreement with Armadillo
National Bank meets the criteria for a capital lease because it contains a
bargain purchase option (a 25-year-life building can be purchased at the end of
10 years for $1). Additionally, unless the fair value of the building is
considerably greater than its $2,400,000 cost, the present value of the lease
payments probably exceeds 90% of the fair value of the building. The lessee,
therefore, must capitalize the leased asset and the related obligation in the
balance sheet at the appropriate discounted amount of the future rental
payments under the lease agreement. The lessee must disclose: (1) the gross
amount of the leased asset and the accumulated depreciation thereon, (2) the
future minimum lease payments as of the latest balance sheet date, in the
aggregate and for each five succeeding fiscal years and the amount of imputed
interest necessary to reduce the lease payments to present value, (3) a general
description of the lease arrangement, and (4) the existence of and the terms of
the purchase option. The income statement should contain a charge for
depreciation of the leased asset plus the interest charge.
