Chapter 4

Exercise 4.1

Exercise 4.2

1. Aztec Artworks Ltd. Statement of Financial Postion As at December 31, 2021
   Assets
   Current assets
   Cash			$143,000
   Investments (held for trading at fair value			135,000
   Accounts receivable		$332,000
   Allowance for doubtful accounts		(12,000)	320,000
   Inventory (at lower of FIFO cost and NVR)		$960,000
   Inventory on consignment		20,000	980,000
   Prepaid expenses			30,000
   Total current assets			1,608,000
   Long-term investments:
   Investment in bonds (held to maturity at amortized cost)			200,000
   Bond sinking fund			100,000
   Land held for investment (at cost)			200,000
   			500,000
   Property, plant, equipment
   Building under construction	$220,000
   Land (at cost)	220,000	440,000
   Building (at cost)	$1,950,000
   Accumulated depreciation	(450,000)	1,500,000
   Equipment (at cost)	500,000
   Accumulated depreciation	(120,000)	380,000	2,320,000
   Intangible assets: Patents (net of accumulated amortization for $9,000)			21,000
   Total assets			$4,449,000
   Liabilities and Shareholders’ Equity
   Current liabilities
   Bank indebtedness		$18,000
   Accounts payable		370,000
   Rent payable		120,000
   Notes payable		300,000
   Other payables		35,000
   Income tax payable		80,000
   Total current liabilities			$923,000
   Long-term liabilities
   Bonds payable (20 year 5% bonds, due August 31, 2025)		800,000
   Pension obligations		210,000	1,010,000
   Total liabilities			1,933,000
   Shareholders’ equity
   Paid in capital
   Preferred, ($2, non-cumulative, participating-authorized 50,000, issued and outstanding, 20,000 shares)	$900,000
   Common (authorized, 900,000 shares; issued and outstanding 700,000 shares)	700,000
   Contributed surplus	430,000	2,030,000
   Retained earnings		326,000
   Accumulated other comprehensive income		160,000	2,516,000
   Total liabilities and shareholders’ equity			$4,449,000

   1

   Cash balance, Dec 31

   Plus bank overdraft

   Less bond sinking fund

   Adjusted cash balance, December 31

   $225,000

   18,000

   (100,000)

   $143,000

    

    

   2

   Account receivable, Dec 31

   Plus AFDA

   Plus credit balances to be separately reported

   Adjusted balance, Dec 31

   $285,000

   12,000

   35,000

   $332,000

    

    

   3

   Inventory, Dec 31

   Plus inventory on consignment

   Adjusted balance, Dec 31

   Inventory, net realizable value, Dec 31

   $960,000

   20,000

   $980,000

   985,000

    

    

   4

   Land, Dec 31

   Less land held for investment

   Adjusted land, Dec 31

   $420,000

   (200,000)

   $220,000

    

    

   5

   Balance, Dec 31

   Plus accumulated depreciation

   Adjusted balance, Dec 31

   Building

   $1,500,000

   450,000

   $1,950,000

   Equipment

   $380,000

   120,000

   $500,000

    

    

   6

   Goodwill, Dec 31

   Removed – internally generated goodwill
   cannot be recognized

   Adjust balance, Dec 31

   $190,000

   (190,000)

   $ –

    

    

   7

   Patents, Dec 31

   Accum. amortization for 3 years ($30,000 ÷ 10 × 3)

   $21,000

   $9,000

    

    

   Retained earnings = ($501,000 + $20,000 consignment inventory − $190,000 goodwill adjustment − $5,000 unrealized holding loss for trading investments) = $326,000 OR ($4,449,000 − 1,933,000 − 2,030,000 − 160,000) = $326,000

2. Liquidity ratios

   Current ratio = 1,608,000 ÷ 923,000 = 1.74

   Quick ratio = (143,000 + 135,000 + 320,000 = 598,000) ÷ 923,000 = 0.65

   Activity ratios

   Accounts receivable turnover = 3,000,000 ÷ 320,000

   = 9.38 times per year or every 38.9 days (365 ÷ 9.38)

   Days’ sales uncollected = 332,000 ÷ 3,000,000 × 365

   = 40.4 days

   Inventory turnover = (3,000,000 × 60%) ÷ 980,000

   = 1.84 times per year or every 198.4 days (365 ÷ 1.84)

   Asset turnover = 3,000,000 ÷ 4,449,000

   = 0.67 times

   Comments:

   In terms of liquidity, Aztec’s current ratio of 1.74 suggests at first glance that it can meet its short-term obligations. However, when inventory and prepaid expenses are removed, the ratio drops to .65, which is short of the general rule of 1:1 for quick ratios. This may mean that inventory levels are too high. The inventory turnover ratio below will confirm if this is the case or not.

   Activity ratios, such as the accounts receivable turnover, measure how quickly ac- counts are converted into cash. For Aztec, accounts receivable are collected every
   38.9 days on average. Looking at days’ sales uncollected, if a guideline of 30–40 days to collect is considered reasonable, then Aztec is close to the top end of the 40- day benchmark. Management would be wise to take steps to improve its receivables collections somewhat.

   Inventory turnover of every 200 days or so appears to be very low, which could mean that too much cash is being tied up in inventory or there is too much obsolete inventory that cannot be sold. A turnover ratio that is too high can signal inventory shortages that may result in lost sales. A turnover ratio for each major inventory category will help to determine if the situation is wide-spread or limited to a particular inventory category.

   Asset turnover for .67 times appears low but without industry standard ratios to use as a comparison benchmark, ratios become less meaningful.

Exercise 4.3

1. Johnson Berthgate Corp. Statement of Financial Position As at December 31, 2021
   Assets
   Current assets
   Cash			$131,000
   Investments (held for trading at fair value)			120,000
   Accounts receivable		$330,000
   Allowance for doubtful accounts		(15,000)	315,000
   Inventory (at lower of FIFO cost and NRV)			430,000
   Prepaid expenses			6,000
   Total current assets			1,002,000
   Long-term investments:
   Investments in bonds (held to maturity at amortized cost)		190,000
   Investment, FVOCI		180,000	370,000
   Property, plant, and equipment
   Land (at cost)			170,000
   Building (at cost)	$660,000
   Accumulated depreciation	(110,000)	550,000
   Equipment (at cost)	390,000
   Accumulated depreciation	(50,000)	340,000	1,060,000
   Intangible assets:
   Patents (net of accum. amort. of $80,000 on a straight-line basis)		125,000
   Franchise (net of accum. amort. of $45,000 on a straight-line basis)		115,000	240,000
   Goodwill			30,000
   Total assets			$2,702,000
   Liabilities and Shareholders’ Equity
   Current liabilities
   Accounts payable		$350,000
   Accrued liabilities		70,000
   Commissions payable		90,000
   Notes payable		60,000
   Unearned consulting fees		13,000
   Total current liabilities			583,000
   Long-term liabilities:
   Bonds payable (20-year 5% bonds, due December 31, 2025)		655,684
   Note payable (3%, 5-year, due December 31, 2024)		571,875	1,227,559
   Total liabilities			1,810,559
   Shareholders’ equity
   Paid in capital
   Preferred, ($3, non-cumulative, authorized 1200, issued and outstanding, 800 shares)	$80,000
   Common (unlimited authorized, issued and outstanding 260,000 shares)	520,000	600,000
   Retained earnings[1]		236,441
   Accumulated other comprehensive income		55,000	891,441
   Total liabilities and shareholders’ equity			$2,702,000

   Net income = (4,858,000 + 40,000 + 102,000 − 3,050,000 − 11,000 − 8,500 − 135,000 − 1,190,000 − 580,000) = $25,500

2. Debt ratio = 1,810,559 ÷ 2,702,000 = 67.01%

   Equity ratio = 891,441 ÷ 2,702,000 = 32.99%

   Nearly 70% of all assets are provided by creditors, which is significant. Digging deeper and looking at the current ratio for 1.72 (1,002,000 ÷ 583,000), it appears that the current assets will adequately cover the current liabilities. It follows that the $1.2M in long-term obligations is the true risk for this company. The company may have to re-finance the note payable when comes due in 3 more years, or sell off any assets not currently contributing to profit. Selling off long-term assets is a reasonable step provided that the assets are idle and will not be used in the foreseeable future to earn profits. This company’s debt ratio is high, so it has very little financial flexibility.

3. The credit balances in accounts receivable represent amounts owing to specific customers. IFRS requires that significant credit balances be separated and reported as a current liability.

   Current ratio without separation of the credit 1,002,000 ÷ 583,000 = 1.72

   Current ratio with separation of the credit (1,002,000 + 250,000) ÷ (583,000 + 250,000) = 1.50

   Managers may not be aware of the impact that the reporting requirement (to classify credit receivables as current liabilities) can have on the current ratio. In this case, this ratio has weakened significantly once the credit amount of $250,000 is reclassified from a current asset to a current liability. If the company had a restrictive covenant to maintain a current ratio of 1.7 times, this could spell disaster for the company in two ways. First, creditors expect a restrictive covenant ratio to be maintained at all times. If this ratio slips below that threshold, any short-term notes owing to the creditor would become payable immediately as a demand loan. This would create significant pressure to raise enough cash in a short period of time to make the single, large payment. Second, if the debt owing to that creditor also includes any long-term debt, the creditor could also force the company to reclassify the long-term balances to current liabilities, driving the current ratio even lower. This might be all that it takes to drive a marginally performing company into bankruptcy, which is a no-win for either the company or its creditors.

   The following are possible conditions or situations that would give rise to a credit balance in accounts receivable customer accounts:

   • Customers returned goods after the account was paid.
   • A customer has overpaid an account in error.
   • The company policy may be no cash refunds. Any returns would therefore be credited to the customer account to be used later for a future purchase.
   • Most of the accounting software applications apply customer prepayments (unearned revenues) as a credit balance in accounts receivable, since eventually the actual amounts when owed by the customer at the time the goods and services provided will be debited to the accounts receivable sub-ledger when the invoice is prepared.
   • On the basis of materiality, the credit balances, if insignificant, will likely remain with the existing accounts receivable as small credit balances.

Exercise 4.4

1. Hughey Ltd. Statement of Financial Position As at December 31, 2021
   Assets
   Current assets
   Cash		$250,000
   Accounts receivable	$1,015,000
   Less allowance for doubtful accounts	(55,000)	960,000
   Inventory – at lower FIFO cost and NRV		1,300,000
   Prepaid insurance		40,000
   Total current assets			$2,550,000
   Long-term investments
   Investments, FVOCI, of which investments costing $800,000 have been pledged as security for notes payable to bank			2,250,000
   Property, plant, and equipment		530,000
   Land	770,000
   Accumulated depreciation	(300,000)	470,000
   Equipment	2,500,000
   Accumulated depreciation	(1,200,000)	1,300,000	2,300,000
   Intangible assets
   Patents (net of accumulated amortization of $35,000)			25,000
   Total assets			$7,125,000
   Liabilities and Shareholders’ Equity
   Current liabilities
   7% notes payable to bank, secured by investments which cost $800,000		$600,000
   Accounts payable		900,000
   Accured liabilities		300,000
   Total current liabilities			1,800,000
   Long-term liabilities
   Bonds payable, 25-yr, 8%, due December 31, 2030 at amortized cost			1,100,000
   Total liabilities			2,900,000
   Shareholders’ equity
   Paid-in capital
   Common shares; 100,000 shares authorized, 80,000 shares issued and outstanding		2,500,000
   Retained earnings		1,330,000
   Accumulated other comprehensive income		395,000[2]	4,225,000
   Total liabilities and shareholders’ equity			$7,125,000

2. Patent annual amortization: 60,000 − 25,000 = 35,000 total amortization for the period January 1, 2015 to December 31, 2021 or 7 years amortized since its purchase. $35,000 ÷ 7 years = $5,000 per year
3. This company follows IFRS because it has classified and reported some of its investments as available for sale (OCI) which is a classification only permitted by IFRS companies. ASPE does not have this classification.

Exercise 4.5

Exercise 4.6

1. Camel Corp. Balance Sheet As at December 31, 2021
   Assets
   Current assets
   Cash		$247,600
   Accounts receivable (net)		109,040
   Total current assets		356,640
   Investment in land (at cost)		220,000
   Property, plant, and equipment
   Land	$200,000
   Building (net)	87,200
   Equipment (net)	198,000	485,200
   Total assets		$1,061,840
   Liabilities and Shareholders’ Equity
   Current liabilities
   Accounts payable		$55,200
   Current portion of long-term debt		32,000
   Total current liabilities		87,200
   Long-term liabilities
   Mortgage payable		110,200
   Total liabilities		197,400
   Shareholders’ equity
   Common shares	$470,000
   Retained earnings	394,440	864,440
   Total liabilities and shareholders’ equity		$1,061,840

   The required disclosures discussed in Chapter 3 that were missed were the AFDA, the accumulated depreciation for the building and equipment, the interest rate, securitization and due date for the mortgage payable classified as a long-term liability, and the authorized and issued common shares in the equity section.

   Calculations Worksheet:

   Adjustments
   		Dr	Cr	Dr	Cr
   Cash	$84,000	1,356,600[3]	1,193,000[4]	247,600
   Accounts receivable (net)	89,040	1,000,000	980,000	109,040
   Investments – trading	134,400		134,400	–
   Buildings (net)	340,200		225,000 28,000	87,200
   Equipment (net)	168,000	50,000	20,000	198,000
   Land	200,000	220,000		420,000
   	$1,015,640			$1,061,840
   Accounts payable	$146,000	900,000	809,200		55,200
   Mortgage payable	172,200	30,000			142,200
   Common shares	400,000		70,000		470,000
   Retained Earnings	297,440	8,000	105,000		394,440
   	$1,015,640			2,123,680	$1,061,840
   Revenues	$1,000,000	A/R	1,000,000
   Gain	2,200		2,200
   Total revenue	1,002,200
   Expenses
   Operating expenses	809,200	809,200
   Interest expenses	35,000	35,000
   Depreciation	48,000	48,000
   Loss	5,000	5,000
   	897,200
   Net income	$105,000	4,461,800	4,566,800
   			– 105,000	net income
   		4,461,800	4,461,800	to retained earnings

2. Camel Corp. Statement of Cash Flows For the Year Ended December 31, 2021
   Cash flows from operating activities
   Net income		$105,000
   Adjustments for non-cash revenue and expense items in the income statement:
   Depreciation expense	$ 48,000
   Gain on sale of investments	(2,200)
   Loss on sale of building	5,000
   Decrease in investments – trading	136,600
   Increase in accounts receivable ($109,040 − $89,040)	(20,000)
   Decrease in accounts payable ($146,000 − $55,200)	(90,800)	76,600
   Net cash from operating activities		181,600
   Cash flows from investing activities
   Proceeds from sale of building ($225,000 − $5,000)	220,000
   Purchase of land	(220,000)
   Net cash from investing activities		0
   Cash flows from financing activities
   Reduction in long-term mortgage principal	(30,000)
   Issuance of common shares	20,000
   Payment of cash dividends	(8,000)
   Net cash from financing activities		(18,000)
   Net increase in cash		163,600
   Cash at beginning of year		84,000
   Cash at end of year		$ 247,600

   Note:

   • The purchase of equipment through the issuance of $50,000 of common shares is a significant non-cash financing transaction that would be disclosed in the notes to the financial statements.
   • Cash paid interest $35,000
     Had there been cash paid income taxes, this would also be disclosed.
3. Free cash flow

   Net cash provided by operating activities

   Capital purchases – land

   Cash paid dividends

   Free cash flow

   $ 181,600

   (220,000)

   (8,000)

   $(46,400)

   An analysis of Carmel’s free cash flow indicates it is negative as shown above. Including dividends paid is optional, but it would not have made a difference in this case. What does make the difference in this case is that the capital expenditures are those needed to sustain the current level of operations. In Carmel’s case, the land was purchased for investment purposes and not to meet operational requirements. The free cash flow would more accurately be:

   Net cash provided by operating activities

   Capital purchases

   Cash paid dividends

   Free cash flow

   $ 181,600

   0

   (8,000)

   $173,600

   This makes intuitive sense and is supported by the results from one of the coverage ratios.

   The current cash debt coverage provides information about how well Carmel can cover its current liabilities from its net cash flows from operations:

   Net cash from operating activities ÷ Average current liabilities

   Carmel’s current cash debt coverage is ($181,600 ÷ ((87,200 + 176,000) × 50%) = 1.38. The company has adequate cash flows to cover its current liabilities as they come due and so overall, its financial flexibility looks positive.

   In terms of cash flow patterns, Carmel has managed to more than triple its cash balance in the year mainly from cash generated from operating activities, which is a good trend. Carmel was able to pay $8,000 in dividends, or a 1.7% return. If dividends are paid several times throughout the year, the return is more than adequate to investors. Carmel also sold off its traded investments for a profit and some idle buildings at a small loss to obtain sufficient internal funding for some land that it wants as an investment. Carmel also managed to lower its accounts payable levels by close to 60%. All this supports the assessment that Carmel’s financial flexibility looks reasonable.

4. The information reported in the statement of cash flows is useful for assessing the amount, timing, and uncertainty of future cash flows. The statement identifies the specific cash inflows and outflows from operating activities, investing activities, and financing activities. This gives stakeholders a better understanding of the liquidity and financial flexibility of the enterprise. Some stakeholders have concerns about the quality of the earnings because of the various bases that can be used to record accruals and estimates, which can vary widely and be subjective. As a result, the higher the ratio of cash provided by operating activities to net income, the more stakeholders can rely on the earnings reported.

Exercise 4.7

Disclosures:

Additional land for $37,400 was acquired in exchange for issuing additional common shares.

Exercise 4.8

Note: During the year, $160,000 in notes payable were retired by issuing common shares.

1. 1. $111,800 − $15,600 + X = $152,100; X = 55,900
   2. $27,300 − ($53,000 − $15,600)
   3. $150,000 − $111,800
   4. $133,900 − 111,800 + X = $84,500
   5. Retained earnings account: $370,200 + 24,700 − X = $374,400; Dividend declared but not paid = $20,500
      Dividends payable account: $41,600 + 20,500 − 19,500 = $42,600 cash paid dividends
2. Negative cash flows from operating activities may signal trouble ahead with regard to Egglestone’s daily operations, including profitability of operations and management of its current assets such as accounts receivable, inventory and accounts payable. All three of these increased the cash outflows over the year. In fact, net cash provided by investing activities funded the net cash used by both operating and financing activities. Specifically, proceeds from sale of equipment and land were used to fund operating and financing activities, which may be cause for concern if the assets sold were used to generate significant revenue. Shareholders did receive cash dividends, but investors may wonder if these payments will be sustainable over the long term. Consider that dividends declared was $20,500, which was quite high compared to the net income for $24,700. In addition, the dividends payable account still had a balance payable for $41,600 from prior dividend declarations not yet paid. All this adds up to increasing the pressure on the company to find enough funds to catch up with the cash payments to investors. Egglestone may not be able to sustain payment of cash dividends of this size in the long term if improvement regarding its profitability and management of receivables, payables and inventory are not implemented quickly.

Exercise 4.9

Notes:

(1) Depreciation Expense:

(2) Gain on sale of equipment:

(3) Purchase of equipment:

(4) Payment of dividends:

Exercise 4.10