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ACC 113 Lecture Notes - Lecture 15: Inventory Turnover, Financial Statement, Current Liability

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School
Tunxis Community College
Department
Accounting
Course
ACC 113
Professor
Lardie

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Document Summary

The portion of non-current (long-term) debt that is due within the current year or operating cycle should be classified as a current liability. Events with uncertain outcomes: who is owed, when is it owed, and/or how much is owed. Provisions are uncertain as to timing or amount. Contingent liabilities are possible obligations that are dependent upon some future event: should be recognized if more likely than not (ifrs, should be recognized if likely (aspe) Obligations to be paid after one year or longer. Also, known as financial liabilities (a type of financial instrument: a contractual obligation to pay cash in the future. Includes long-term notes, bonds, and lease obligations. May be secured or unsecured: secured notes are also known as mortgages. Normally repayable in series of periodic payments called instalments. Instalment payments usually take one of two forms: fixed principal payments plus interest (fixed or floating interest, blended principal and interest payments.

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Related Questions

Your friend, Liz, loves to shop at Target and is now interestedin investing in the company. Tom, another friend, has told her thatTarget’s debt structure is risky with obligations of nearly 74% oftotal assets. Liz sees that debt on the balance sheet is 65% oftotal assets and is confused by Tom’s comment. Write an explanationto Liz discussing the debt structure of Target and why Tom thinksTarget is risky. Be sure to explain clearly what informationappears on financial statements, as well as what information doesnot appear directly on the financial statements. Use theinformation below in your discussion. At fiscal year-end February2, 2008, Target Corporation had the following assets andliabilities on its balance sheet (in millions): Current liabilities$11,782 Long-term debt 15,126 Other liabilities 2,345 Total assets44,560 Target reported the following information on leases in thenotes to the financial statements: Total rent expense was $165million in 2007, $158 million in 2006, and $154 million in 2005,including percentage rent expense of $5 million in 2007, 2006, and2005. Most long-term leases include one or more options to renew,with renewal terms that can extend the lease term to more than 50years. Certain leases also include options to purchase the leasedproperty. Future minimum lease payments required undernon-cancellable lease agreements existing at February 2, 2008,were: Future Minimum Lease Payments (in Millions) Operating LeasesCapital Leases 2008 $ 239 $ 12 2009 187 16 2010 173 16 2011 129 162010 123 17 After 2010 2, 843 155 Total future minimum leasepayments $3694 (a) $232 Less: Interest (b) (105) Present value ofminimum capital lease payments $127 (c) (a) Total contractual leasepayments include $1,721 million related to options to extend leaseterms that are reasonably assured of being exercised, and alsoinclude $98 million of legally binding minimum lease payments forstores that will open in 2008 or later. (b) Calculated using theinterest rate at inception of each lease. (c) Includes currentportion of $4 million.

Question 1 (40 marks)

You are the audit manager of a medium-sized firm and have just received a package from Rachel Jones, the financial controller of KidSpace Ltd., an electronic toy manufacturer. This is your firm’s first year as auditor of KidSpace Ltd. The information below was prepared for a board meeting and Rachel, the acting Chief Financial Officer, felt it might be useful to you in preparation of the forthcoming audit for the year ended 30 June 2017.

KidSpace Ltd.

Statement of Financial Position $'000s
Current assets 2017 2016 2015
Cash

1,586

1,743

830
Accounts receivable and other receivables

13,734

11,200

9,623
Inventory

16,498

11,731

7,197
Total current assets

31,818

24,674

17,650
Non-current assets
Property, plant and equipment

14,606

12,840

9,572
Long-term loan receivable

5,200

3,600

3,300
Intangible assets

1,400
Total non-current assets

21,206

16,440

12,872
Total assets

53,024

41,114

30,222
Current liabilities
Trade payables and other payables

9,012

6,288

2,021
Provisions

4,875

3821

4577
Total current liabilities

13,887

10,109

6,598
Non-current liabilities
Long-term loan

20,000

16,000

12,000
Total liabilities

33,887

26,109

18,598
Net assets

19,137

15,505

11,624
Shareholder's equity
Share capital

2,000

2,000

2,000
Retained earnings

17,137

12,505

9,624
Total shareholder's equity

19,137

14,505

11,624

KidSpace Ltd.

Income Statement $'000s
2017 2016 2015
Sales revenue

76,945

74,927

89,735
Cost of sales

51,840

51,765

63,066
Gross profit

25,105

23,162

26,669
Depreciation

5,595

4,332

2,796
Inventory obsolescence

990

1,173

670
Selling expenses

2,405

3,153

3,317
Administrative expenses

8,925

8,727

11,516
Finance costs

1,040

1,275

1,140
Total expenses

18,955

18,660

19,439
Profit before tax

6,150

4,502

7,230
Tax expense

1,518

1,621

2,386
Profit after tax

4,632

2,881

4,844
Notes:
Trade Receivables

12,034

10,655

9,300
Pre-paids

1,600

500

300
Other receivables

100

45

23
Total Trade & other receivables

13,734

11,200

9,623
Inventory
Raw Materials

6,599

5,866

3,845
WIP

4,333

2,588

1,550
Inventory held for sale

6,699

3,520

1,972

17,631

11,974

7,367
Provision for Inventory obsolescence

(1,133)

(243)

(270)
Total inventory

16,498

11,731

7,197
Ratios

2017

2016

2015
Profit ratio

7.99%

6.01%

8.06%
Return on shareholder equity

24.20%

19.86%

41.67%
Quick Ratio

0.99

1.18

1.54
Times Interest Earned

6.91

4.53

7.34
Accounts Receivable Turnover (times)

6.78

7.51

9.33
Asset Turnover

1.45

1.84

2.94
Inventory Turnover (times)

3.50

5.35

8.76

During a brief telephone call with Rachel, you made the following notes:

1. One of the conditions of the long-term loan is that the company is not to exceed a debt-to equity ratio of 2:1 at any time and they must maintain a current ratio of 2:1. The loan is reviewed each year on 31 July.
2. Provision for obsolescence of finished inventory held for sale and work-in-progress is provided for at a flat rate of 10%. The amount provided in previous years was 20%. Rachel said that the company believes it has been overly conservative in previous years and 10% is a more realistic level, given the nature of its products.
3. To combat declining sales a senior management incentive scheme based on sales and profit levels was introduced in July 2016.
4. The long-term loan receivable is from a company involved in the development and production of computer software. It is owned by one of the directors.

Required:

a) Identify and explain what the inherent risks for KidSpace Ltd. that you will need to consider. (6 marks)
b) From the information provided, perform additional preliminary analytical procedures:
i) Simple comparison (3 marks)
ii) Current ratio (1 mark)
iii) Return on assets (1 mark)
iv) Gross profit ratio (1 mark)
v) Debt-to-equity ratio. (1 mark)

c) Drawing on information from a) & b), identify and justify:

i) Three key account areas that would require special attention during the audit of the 30 June 2017 financial statements. Also, indicate if those accounts are likely to be over or understated. (12 marks)
ii) Two key assertions at risk for each of those account areas. (12 marks)

d) Identify and discuss any going concern issues to be considered at this stage?. (3 marks)

Hands-On Project 10-12

IMPROVING DECISION MAKING: USING SPREADSHEET SOFTWARE TO ANALYZEA DOT- COM BUSINESS

Software skills: Spreadsheet downloading, formatting, andformulas

Business skills: Financial statement analysis 10- 12

Pick one e- commerce company on the Internet— for example,Ashford, Buy. com, Yahoo, or Priceline. Study the Web pages thatdescribe the company and explain its purpose and structure. Use theWeb to find articles that comment on the company. Then visit theSecurities and Exchange Commission’s Web site at www. sec.gov to access the company’s 10- K ( annual report) formshowing income statements and balance sheets. Select only thesections of the 10- K form containing the desired portions offinancial statements that you need to examine, and download theminto your spreadsheet. Instructions below provide more detailedinstructions on how to download this 10- K data into a spreadsheetand information on financial statements. Create simplifiedspreadsheets of the company’s balance sheets and income statementsfor the past three years.

• Is the company a dot- com success, borderline business, orfailure? What information provides the basis of your decision? Why?When answering these questions, pay special attention to thecompany’s three- year trends in revenues, costs of sales, grossmargins, operating expenses, and net margins.

• Prepare a PowerPoint overhead presentation (with a minimum offive slides), including appropriate spreadsheets or charts, andpresent your work to your professor and classmates. An examplePowerPoint slide presentation is attached for your review in thislearning module folder in Blackboard.

As needed: Students can find material on understanding financialstatements on financial Web sites such as Ameritrade(www.ameritrade.com) or the Small Business Knowledge Basehttp://www.bizmove.com/finance/m3b2.htm.

Downloading the Data into a Spreadsheet

Use the Convert Text to Columns Wizard in your spreadsheetsoftware to arrange the 10-K data you downloaded into spreadsheetcolumns and rows. From the Excel menu, select Data and then selectthe Text to Columns option. The software brings up a Wizard toconvert the imported text into spreadsheet columns. Although youcan decide to create line breaks, it may be easiest to accept thedefault settings (Fixed Width, General format) and then adjustcolumn widths after the Wizard has arranged the data in spreadsheetcolumns.

Financial Statements

Financial statements are used to evaluate the performance of abusiness and diagnose its strengths and weaknesses. The two primaryfinancial statements are income statements and balance sheets. Theincome statement, also called an operating statement or profit andloss statement, shows the income and expenses of a firm over aperiod of time, such as a year, a quarter, or a month. Gross profitis calculated by subtracting the cost of goods sold from revenues,or sales. The gross margin is calculated by dividing gross profitby revenues (or sales). Net profit (or loss) is calculated bysubtracting all other expenses, including operating expenses andincome taxes from gross profit. Operating expenses are all businesscosts (such as expenditures for sales and marketing, general andadministrative expenditures, and depreciation) other than thoseincluded in the cost of goods sold. Net margins arecalculated by dividing net profit (or loss) by revenues (orsales).

A balance sheet provides a snapshot of a company’s financialassets and liabilities on a given date, usually the close of anaccounting period. It lists what material andintangible assets the business owns and what money the businessowes either to its creditors (liabilities) or to its owners(shareholders’ equity, also known as net worth). At any given timea business’s assets equals the sum of its liabilities plus its networth. Current assets include cash, securities, accountsreceivable, or other investments that are likely to be convertedinto cash within one year. Liabilities are outstanding obligationsof the firm. Current liabilities are debts that are due within oneyear. Long-term debt consists of liabilities that are not due untilafter a year or more. If too much debt has been used to finance thefirm’s operations, problems may arise in meeting future interestpayments and repaying outstanding loans. By examining a series ofbalance sheets, one can identify and analyze trends in thefinancial strength of a business.