Project - The Terry Project: Adjusting the Financial Statements

Background Information

Terry Co. sells backpacks, laptop bags, briefcases, and other bags. The bags are purchased already made, then the Terry branding and finish is added. Because of several exclusive contracts and high quality products, the company has a strong following in its home state of Georgia and the surrounding area. In addition to its own brand, the company also has contracts with many colleges, firms, and local organizations to sell bags with these other groups' logos. This practice has greatly increased Terry's sales, especially since the company is usually able to use lower quality inventory to fill these orders (this leads to lower costs for the other groups without damaging Terry's reputation).

Because of its success during the past two (2) years, Terry was able to go public in January of last year. This has given the company additional capital to grow, as well as allowing the original owners to diversify some of their risk. Management's goal now is to begin marketing in the Northeast and Central regions of the country. If they are successful, they will continue on to the West Coast within a few years. Since much of their advertising is done through personal contacts and word of mouth, their growth will be slow. While that worries some of their new investors, recent economic trouble has left many investors pleased with the management team's more cautious growth.

In their rush to go public, Terry's management has forgotten one small detail. They have not created a very strong accounting department. While their auditors have been willing to help them clean up their books in the past, the managers are starting to realize that their lack of in-house accounting expertise is a problem. During the past year they engaged in several transactions and decisions that might have important repercussions on their financial statements, and they didn't know it. In an effort to start cleaning up their accounting system, they have finally hired you and your partner. Your first job will be to go through Terry's decisions for the year and clean up any mistakes that have been made, and to record any transactions that have been missed. In the future, you will be expected to give management good advice about the accounting consequences of their actions before decisions are made.

Based on recommendations from their auditor and SEC regulations, Terry uses an accrual accounting system based on U.S. GAAP. The company's fiscal year end is December 31st. Since Terry is a relatively small public company with an easy audit, the auditors don't usually arrive until about January 15th. However, you are expected to have the financial statements ready to go by January 1st so that upper management can issue an earnings announcement to the stockholders. Although an earnings announcement is known to be unaudited, investors are traditionally very harsh with companies that have a final earnings number below the initial earnings announcement. You will need to be as accurate as possible in order to avoid this type of market consequence.

Original Financial Statements

Terry has already completed a set of financial statements in good form for the current year (see below). However, they have neglected to include several key pieces of information. Throughout the semester, you will be adding and incorporating this additional information. You can get a template of these financial statements on BBLearn. Terry's tax rate is 25%.

Terry Part 1:

Goal: To review one of the key topics from Acct 315 (to help everyone get back in the swing of doing Terry! (See Topic Guides RAB 4 & 7).

Information: On November 1, Terry issued a $450,000, semi-annual, 15 year, 5% bond. The market rate for similar bonds on that day was 6%. Terry uses the effective interest method to record the amortization or premiums and discounts. Terry's management has decided to report net bonds on the balance sheet, instead of reporting the bond and its premium or discount separately. No entries have yet been made for the bond.

Terry's management would like to know the effects of the new bond on the following ratios:

• Debt to Equity Ratio (Total Liabilities / Total Equity)
• Current Ratio
• ROA

Assignment:

Calculations

1. Calculate each of the three (3) ratios before you make any adjustments.

2. Make the appropriate journal entries, if any, to account for the new bond and any accrued interest (including any necessary changes to income tax expense).

3. Make any necessary changes to the financial statements.

4. Calculate the three (3) ratios after you make any adjustments.

Critical Thinking

5. What do you think investors' reaction will be to management's decision to issue a new bond? In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with the decision to issue the new debt? Why or why not?

6. Do you think it is appropriate for management to focus on the financial statement effects when choosing how to issue a new bond (par, premium, or discount) or should they focus on the company's cash needs? Defend your answer.

Hints:

1. You might want to start with the financial statement template provided in BBLearn.

2. You should begin this problem by making the journal entry to record the issuance of the bond at its present value.

3. Next calculate the interest expense to be reported and any premium or discount to be amortized at the time of the first interest payment.

4. Multiply your interest expense and amortization numbers for the first payment by the number of months the bond has been outstanding divided by 6 (for the 6 months in each semi-annual payment period). This will give you two of the three line items you need for the interest entry on the bond this year.

5. You will need to add three line items to your Statement of Cash Flows to make it balance after recognizing the issuance of the bond and the accrued interest. One line item is the cash from the bond issue. One of the others is one of the four non-cash (4) accruals that have to be reversed in your Cash Flows from Operations section.

Terry Part 2:

Goal: To practice correcting the financial statements for different revenue recognition situations. (See Topic Guides AIO 4 & 30).

Information:

Terry determined early in its history that it was more effective for them to build their own specialized production equipment than for them to share their proprietary production data with a construction company. While this process leads to a larger upfront cost for new equipment, the special production methods used by the company have earned much more than the initial extra outlay.

While the company has historically kept this production process in-house, they have recently been approached by a local university with a request to provide a set of machinery that the university can use to produce their own specialty bags. Since many members of Terry's Board of Directors (and several large shareholders) are alumni of this university, Terry's management has decided that they will go through with the sale of a three machine system to the university.

As part of the deal, Terry's management has insisted that the university also purchase a 3-year maintenance contract. This requirement will allow Terry's engineers and machinists to take care of the equipment, reducing the chance of losing their competitive advantage. The total contract price for the machines and the maintenance contract is $1,150,000.

As part of the contract, both parties have agreed that the university will have the right to return the equipment if they are not satisfied with the performance of the machines. Terry will also provide an additional refund for the maintenance contract if the company returns the equipment within the next few years.

While Terry has never sold its equipment before, machinery for making bags can be purchased from many other companies. In addition, many of those companies also provide service contracts to care for the machines they sell. Other versions of the machines typically sell for $400,000; $275,000; and $325,000. A 3-year maintenance contract sells, on average, for $250,000.

By the end of Year 2, Terry had installed the first and third machines and the university has paid $450,000. Terry's management team anticipates that the final machine will be installed in January of Year 3, and the maintenance contract will begin immediately after the final installation. The university will pay the balance of the contract once the last one is installed.

Terry's management team would like to know the effect of the sale, if any, on the following ratios:

• Profit Margin
• Current Ratio
• ROA

Assignment:

Calculations

1. Calculate each of the three (3) ratios before you make any adjustments.

2. Make the appropriate journal entries, if any, to account for the installation of the first and third machines (including any necessary changes to income tax expense) and the first payment by the university. Assume that the first machine cost Terry $100,000, the second $125,000, and the third $150,000. Terry's work building these machines has already been appropriately recorded in inventory.

3. Make any necessary changes to the financial statements.

4. Calculate the three (3) ratios after you make any adjustments.

Critical Thinking

5. What do you think investors' reaction will be to the sale of these proprietary machines to a university (if any)? In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with management's choice to enter into this agreement? Why or why not?

6. Who might be affected by the Terry's decision to give in to the Board's demands and sell their proprietary machines to the university?

Hints:

1. Round your percentages to the nearest percentage point (i.e. 12.33% would be rounded to 12%). You can do this using the following Excel formula: =round (E4/E5, 2).

2. Remember that Terry uses a perpetual inventory system!

3. Make sure that you include the full contract price in your journal entry, not just the amount the client has paid. The contract and the fact that you have started fulfilling the order allows you to record the balance due as A/R, but remember that you can't yet include it all as revenues!