REQUIREMENT 8Jerry Loos called to let you know that he had completed responses to your questions. Your listof questions and Jerry’s responses are attached. This information and additional discussionswith Jerry have provided you with insight on issues to be addressed during the audit. With alittle direction from Tom Fasbee, you also brushed up on the guidance on the application of theequity method for the PVCO investment.You and your new staff assistant, Pam Mason, generally are satisfied that the accounts andJerry’s responses are supported by the underlying facts. Jerry has agreed to adjust hisaccounts and note disclosures for all corrections proposed by Lake & Lock. No issues havecome to light during the audit, other than those revealed in your questions and the responses, inaddition to a question raised by Pam. In addition to completing work on some auditing matterssuch as confirmation letters to customers and banks, she had reviewed a number of documentsrecorded in January 20X5 for applicability to 20X4. A supplier’s invoice was found that includedthe following information about inventory in transit at year end:Invoice details:Goods were fittings for the pump and valve instruments.Aguamaint’s purchase order was dated December 21, 20X4.Goods were shipped FOB shipping point on December 29, 20X4.Goods were received by Aguamaint on January 3, 20X5, per a receiving report datedJanuary 3, 20X5.Dollar amount including the air freight totaled $27,680.Aguamaint dated the entry to book this purchase at January 5, 20X5.Pam also noted that Aguamaint’s market borrowing rate for financing vehicles and equipment atyear-end had decreased to 5.375% percent. Linda Durkee called to say that a five year life isapplicable to the new equipment for tax purposes, and that any bond discount or bond issuecost amortized during the current year is considered to be interest and is tax deductible.Finally, Pam questioned whether any new financial statement notes were needed to addressline of business or segment disclosures. Jerry had provided her copies of the following financialreports that he now routinely prepares for Nick and Ray to keep track of the two lines ofbusiness. The Company is using this information to make decisions about the company’soperations.REQUIRED:Attached are your questions and Jerry’s responses. Based on this information and the datadeveloped by Pam, prepare your suggested year end 20X4 correcting and adjusting journalentries for Aguamaint. Also create the 20X4 pension disclosure note. Your journal entries mustbe supported by descriptive explanations, calculations and authoritative sources whereappropriate.Maintenance Merchandising Corporate TotalRevenues from external customers $ 3,041,000 $ 1,242,000 $ 167,000 $ 4,450,000Interest expense 10,125 15,350 – 25,475Depreciation and amortization 76,986 34,917 – 111,902Segment pre-tax profit 1,216,636 (156,155) 5,119 1,065,601Segment assets 966,807 1,209,741 788,627 2,965,17420X4YOUR 20X4 QUESTIONS AND CLIENT RESPONSES1. Do you anticipate any significant collection problems? Your allowance for doubtful accountsto open accounts is a low ratio compared to prior years—we noted that it is just over 9% thisyear, compared to much higher levels in the past. Do you think this is a reasonable ratio?Early in the year we wrote off $46,000 of receivables. Nick, Ray, and I agree that we maylose up to $51,000 from the open accounts as of December 31, 20X4. That’s reflected inthe bad debt expense. The allowance for bad debts was just a “squeeze.”By the way, we are finding that our customers who are buying only the inventory items arequicker to pay and less likely to default so we think this ratio should be somewhat lowergoing forward.2. Were shop supplies inventoried on December 31? Did you adjust the financials to the endingcount?Shop supplies were inventoried on December 31 and their costs were computed from thelatest invoices. The account was adjusted to the count.3. Did you calculate the lower of cost or net realizable value on the pump and valve inventorythis year? We will need to verify the inventory value listed on the balance sheet at year end.Could you please provide a schedule listing the details of the inventory pricing? For each item,please provide the cost, the expected selling price, and any direct selling costs.I have the information for you—I am pretty sure I did that calculation correctly this year. Ifollowed your schedule from last year to figure it all out. There was no price drop this yearso I cannot imagine that an adjustment would be needed. We did have increased directselling costs this year since we paid our sales people a three percent commission, but webuilt that into the selling price.4. We noticed that you used air freight to bring in your pump and valve inventory this year. Doyou find that to be a cheaper way to have it shipped?It is a little more expensive, but because these instruments are so sensitive, it is thepreferred method of shipping. The dealership told us that if we used it, they would give us atwo-for-the-price-of-one deal on any replacements for items that get damaged duringshipping. In addition, as you know, PVCO is our new supplier and they have arranged tohave this equipment shipped directly to us from the manufacturer. We used air freight for allof our pump and valve instrument purchases this year and did not buy inventory from othersuppliers. Also, any inventory purchased from other suppliers in the past had been sold asof year-end.5. We noted that there was an increase in officers’ salaries. Is Aguamaint in compliance with thebank loan covenants?The Bank approved salary increases for both Mr. Ballard and Mr. Riley. No other covenantis in question as far as I know.6. Could you provide us with the market value of each of your marketable security investmentsat December 31, 20X4? We just need to verify your balance sheet numbers.Of course. Here is the 20X4 year-end broker statement:7. Do you have preliminary 20X4 financials on the PVCO investment? Also do you havefinancials at the date of acquisition? Specifically, because you have a 20% interest, we need toknow total assets and total liabilities on the purchase date and net income for the part of theyear that you owned the shares of stock. We also need to know how much they paid out individends.Financial data for PVCO are as follows:8. We also noticed that your “other salaries” increased this year. Are you paying Nick’s wifeChris to help with the bookkeeping? And, are you paying Ray’s wife for anything? We were alittle concerned with that arrangement when you explained it last year.I wondered whatever happened to that idea…no, we hired a bookkeeping assistant to helpme this year who is not related to anyone in the Company. And, thankfully, part of theincrease you are seeing is a result of my first raise after over three years of working here.9. Could you please provide us with a list all maintenance contracts and their terms? How muchis your biggest annual contract worth now?I gave the listing of maintenance contracts to your assistant, Pam Mason. We picked uptwo more advance payment contracts. These totaled $274,000, of which $78,000 wasunearned on December 31, 20X4. All other new contracts are billed monthly. Our biggest Number of MarketEquity Shares Shares Cost ValueAEP Preferred Stock 1,600 $ 214,880 $ 216,885BondsCascade Energy Bond $ 100,000 $ 100,556 May 31, 20X4 December 31, 20X4Assets $4,302,9002,402,300 $ 4,682,520Liabilities 2,670,640Net Worth $ 1,900,600 $ 2,011,880Income, 6/1/X4 to 12/31/X4 $ 129,780Dividends declared and paid, Dec 20X4 (we received 20%) 18,500Increase in net worth, last seven months of 20X4 111,280contract remains at $196,800 annually, and all previous advance pay customers renewedtheir contracts this year.10. Would you like us to reclassify the short-term portion of the finance lease payment for you?Also, it appears that we need to account for the interest portion of the lease payment. Theinterest portion of the payment should not reduce the lease payable balance as is done with theoperating lease.You are talking about the truck lease, correct? I guess I forgot that short-term portion againthis year. And, yes, please include the interest adjustment for us if you would.11. Please summarize the actuary’s reports on the pension plan. We need the service cost for20X4, and, if they have changed, we need the discount rate, the yield on plan assets, and therate of compensation increase. We also need to know if the investing strategy has changed.The actuary reported the following: Current service costInterest on the PBOInterest on plan assetsRate of compensation increase$137,6054%8%5% We have the same investment allocation as last year and the rates you asked about havenot changed. I think I have calculated the discount and return correctly this year. I followedwhat you did last year, but am still not clear on that comprehensive income aspect.12. What repairs and maintenance did you have to do?Most of that money was spent on truck repairs again. It was all just ongoing maintenance.13. Our calculations indicate that you are depreciating your new warehouse and equipmentusing the straight line method over 40 and 6 years, respectively—and with no salvage value—isthat correct?Yes, that is correct.14. Have medical benefits changed to include postretirement benefits?Medical expenses include only our health insurance policy for current employees. They donot include postretirement benefits. That would be way too expensive for us.15. We noticed that your prepaid insurance amount increased. Is this policy still a one yearpolicy?Yes, it is just for one year. They really raised our rates due to all of the additional work weare doing here and they said that the fact that we are running a late shift increases ourliability.16. We noticed that wages payable really increased this year. Can you provide us with someback up for this increase?The accrued wages are for a ten day period and are higher due to the extra employees wehired to serve our new contracts. I have the time cards if you need to see them.17. Can you tell us about your new construction project? We need the contract price and alsothe projected cost of construction. When did you begin this project, and assuming it is not yetcomplete, how much longer do you expect this project to take? We are assuming that youbooked your revenue and expenses on this project based strictly on cash received and paidout? Do you have any additional billings on this construction project outstanding at year end?Also, do you have any payables connected with this project?We started construction on this water treatment plant in late April and expect to finish itsometime this summer, weather permitting. The contract price is $250,000 and theexpected total cost is $210,000. This project has been a bit overwhelming for me in termsof accounting—between buying the warehouse and the new equipment and trying to figureout how to account for the progress on this project, I have been a little frustrated. I justdecided to book everything on the cash basis. We do have an outstanding billing amount of$12,000. We expect that to come in any day now. All of their other payments have been ontime. We do not have any payables connected with the project.18. It sounds like this is a long-term construction contract which means we can recognizerevenue while the building is in process, as long as the water treatment plant you are buildingmeets a few important criteria during construction. We need to know three things. First, does thecustomer control the completed sections of the water treatment plant as you finish them?Second, is this an asset that is customized for the customer, meaning you have no other use forthis water treatment plant as the builder? Third, will you be paid for work completed even if theCity cancels the contract?Well first of all, there is no chance that the city is going to cancel this contract. Theydesperately need this plant and they have been nothing but complimentary regarding ourwork and our progress. And, yes, they have actually started going in and installing some oftheir specialized equipment in sections that we have finished, so they are definitely incontrol. You know, if a water treatment plant isn’t customized for a certain use, I don’t knowwhat else would be.19. Nick told us about your new bond issue, but we didn’t get all the information we need. WillNick’s friend be an officer on the Board of Aguamaint? We are assuming that you are payinginterest semi-annually since you made a payment at the end of December. We are alsoassuming this is not a serial bond since there was no principal paid at year end. We see thatyou issued the bond at a discount and that the stated interest rate on the bond is 5.0% based onthe interest payment you made. Can you tell us what the effective interest rate is?I have the paperwork on that bond for you. The bond matures in five years and the marketrate is 5.3%. The semi-annual payments are interest only. Nick’s friend may join the board,but only if he converts the bond into shares of common stock. By the way, does this bondissue affect our earnings per share calculation this year? Ray was concerned about that theother day.20. We noted that you expensed the debt issue cost on the bond issue. We are pretty sure thatcost needs to be amortized over time, and that it will also affect your effective interest ratecalculation.That is another thing that was completely new to me this year. I guess I never got around toresearching that completely. Could you please do that adjustment for me?21. It appears that we need to accrue warranty expense for this year. Do you believe that the2% of cost of inventory sold is still a reasonable estimate?I guess I forgot to do that again this year. I think that 2% still seems reasonable. Once thethree year warranty is up on the items sold last year, we will have a better idea regardingthe best estimate to use.22. We noticed that you paid rent on a warehouse space. Is this a long-term lease that we needto analyze to decide if it should be recorded as an operating or a finance lease?No, that is the same warehouse that we purchased in March. We rented it for a couple ofmonths while we were waiting to take possession of the building.23. Do you know of any subsequent events or transactions that have occurred since year end20X4 that need to be disclosed?Actually, I do. I don’t exactly understand all the details, but it seems to finally be some goodnews for me in terms of compensation. First, the Company granted a nonqualified stockoption compensation plan to Nick and Ray on January 2, 20X5 that would provide themeach with 10,000 additional shares of common stock, assuming they exercise the optionssometime during 20X7. I have no idea how that works in terms of accounting. Alternatively,I was provided with a stock compensation plan that provides stock appreciation rights to besettled in cash at year-end 20X6. I am assuming that if things keep going the way theyhave been, I may get a nice chunk of cash from this deal. The only other thing that I knowof would be that they are talking about a preferred stock issue occurring sometime thisyear, but that has not yet happened.
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