ACC Assignment - Frosty Co. (2015)

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Frosty Co.

Frosty Co. is a publicly traded, medium-sized manufacturing firm that

produces refrigerators, freezers, ice makers, and snow cone machines. During the

past three years, the company has struggled against increasing competition,

sluggish sales, and a public relations scandal surrounding the departure of the

former Chief Executive Officer (CEO) and Chief Financial Officer (CFO). The new

CEO, Jane Mileton, and CFO, Doug Steindart, have worked hard to improve the

company’s image and financial position. After several difficult years, the company

now seems to be resolving its difficulties, and the management team is considering

new investment opportunities. The team hopes that diversification into a line of

professional ice cream makers, and perhaps a line of consumer products, will help

the company continue its recent growth and effectively compete with future

competitors.

In order to raise the funds needed for these new investments, Frosty Co.’s

Board of Directors has approved a seasoned equity offering (SEO). The discussions

regarding the new investment opportunities and the equity offering have been kept

quiet until a positive set of financial statements can provide strong evidence that the

company has turned around, leading to an increase in the company’s stock price.

INTRODUCTION

After a full week of carefully examining financial statements, Simon was

exhausted. He had become Frosty Co.’s corporate controller only a month ago, after

several years as an auditor at a public accounting firm, and was excited about the

move to corporate accounting. The first few weeks had gone well, as Simon met his

accounting staff and settled into his new responsibilities. Then, he had started

reviewing Frosty Co.’s financial statements for the prior year to make sure they

correctly followed GAAP, and to familiarize himself more with the company and

industry. Unfortunately, his relative inexperience with the industry and Frosty’s

accounting procedures had required him to spend more time on the review than he

had anticipated.

He still had a few questions about the financial statements, but he needed to

start preparing for the upcoming SEO. He decided that he would talk to his staff

about his lingering questions tomorrow morning, just before his meeting with the

CEO and CFO. The three of them were to discuss the upcoming audit and the

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earnings announcement and how they would impact the proposed SEO. He rubbed

his tired eyes and headed home to get a little sleep.

MEETING OF THE ACCOUNTING STAFF: 10:30AM

Simon looked up as the divisional controllers, Elsa Pilebody and John

Mortenson, came into his office. Elsa worked with Frosty Co.’s fridge and freezer

division; John worked with the ice maker and snow cone machine division. So far,

Simon had enjoyed working with them, especially since neither of them seemed to

resent him stepping in as their new boss. They were both smiling as they came

through the door, and their good-natured teasing started almost before they had

finished shaking hands.

‘‘Sorry we’re a little late,’’ Elsa started, ‘‘but John had to stop for the last

jelly donut.’’ ‘‘I did not!’’ John said indignantly. He looked at Simon. ‘‘It was

chocolate.’’

Because of his busy schedule that day, Simon got down to business instead

of joining the banter as he normally would have done. ‘‘Thanks for coming by, Elsa

and John. We have several issues to discuss before I have to meet with Jane and

Doug this afternoon.’’ He paused for a second. ‘‘I’ve spent the past week going over

the financial statements. Overall, they look well done, but I need clarification on a

few details. To start with, I want to discuss the construction project we began last

year.’’

‘‘That’s our big project at the moment. We’re building a new factory that

should be done next summer,’’ Elsa said. ‘‘Construction is going well, and we’ve

been careful to capitalize all of the expenditures.’’

Simon shook his head. ‘‘That’s the problem. I think we capitalized more

than we should have. More specifically, it looks like we capitalized all of the

interest on our most recent bank loan.’’

‘‘We did,’’ Elsa replied. ‘‘Since we’re using all of the loan proceeds to build

the new factory, we felt it was appropriate to capitalize all of the interest.’’ John

nodded in agreement.

‘‘I disagree,’’ said Simon. ‘‘Here’s a breakdown of the payments we made

on our new building and a list of our outstanding long-term debt (see Table 1). Did

we take out any of these loans specifically for the new factory?’’

Elsa shook her head. ‘‘No, we took out the new loan, Loan 2, for general

expansion, then decided the most appropriate use of the funds would be for the new

factory.’’

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Simon frowned. ‘‘Why are we capitalizing the interest on Loan 2 if it

wasn’t originated specifically for the new factory?’’

‘‘Well, if the capital from the loan is eventually used on a specific

construction project, then I think we should be able to capitalize the interest on that

loan as part of the historical cost of the project. Of course,’’ Elsa frowned, ‘‘maybe

we are capitalizing too much. Perhaps we need to calculate avoidable interest to

determine the amount of interest that should be capitalized.’’

‘‘You are right that generally we would need to calculate avoidable interest

before capitalizing any interest,’’ Simon answered. ‘‘But in this case, we don’t need

to do that. I believe GAAP allows interest to be capitalized only if a specific

construction loan is used.’’

‘‘Well, I still think that we should be able to capitalize at least some of the

interest. But I’ll do some research to make sure.’’

‘‘You said that you had questions about other things, too?’’ John asked.

‘‘Yes,’’ Simon said. ‘‘I am curious about one other issue. This year, we

introduced a new line of industrial snow cone machines.’’

‘‘Yes, we did,’’ John replied quickly. ‘‘And we were very careful with all of

the sales and expense transactions.’’

‘‘Yes, you were, but didn’t the new model replace an older version?’’

‘‘Yes,’’ John replied, and then frowned. ‘‘The first model was replaced

because of some slight design problems. It worked well, but the customers didn’t

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like the way it looked or sounded. We shouldn’t have any liability issues because of

those old machines.’’

‘‘I’m not worried about warranty or liability issues. I believe those have

been properly recorded. However, we still have some of those original units in

inventory, right?’’

‘‘Only a few dozen, I believe. Is that a problem?’’

‘‘It is since we still have those units recorded at their original historical

cost. Now that we have a new model, the value of those old machines has probably

dropped significantly.’’

Elsa nodded. ‘‘That’s a good point. Who would buy the old version now

that a newer version is available? We probably need to write down that inventory.’’

John sighed. ‘‘Okay, but to do the calculations, I’ll need some data about

current sales price, replacement values, and disposal costs.’’

Simon handed John a table (see Table 2). ‘‘I called the production and sales

departments this morning and got everything you need.’’

John studied the table for a minute. ‘‘There are two sets of estimates here.’’

Simon nodded. ‘‘I’m afraid so. The two managers couldn’t agree on the

estimates. The first set comes from Todd, the sales manager. The second set comes

from Nate, the line manager for the snow cone machine line. My guess is that Nate

has a better feel for the production costs involved, but Todd’s estimates of the

current sales price are probably more accurate.’’

Frowning even more, John said, ‘‘Nate’s estimates will probably require a

larger write-down.’’ ‘‘Which will be a harder sell to the management team,’’ Elsa

said. ‘‘They really want to report strong financial statements for the stock

offering.’’

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‘‘I know, but I don’t think we should base our decision on which estimates

provide a smaller write-down,’’ Simon cautioned. ‘‘If we are going to write down

inventory, then we need to use the most accurate estimates. However, in order to

decide which set of estimates to use, I think we will need to see the results from

each set. I’m sorry, John, but I need you to do the calculations twice.’’ John

nodded.

‘‘Well,’’ Simon said. ‘‘Those were my questions. Do either of you have

any concerns we need to discuss before I meet with Jane and Doug?’’

Elsa had a pensive look on her face. ‘‘I think we need to consider

recognizing an asset retirement obligation, or ARO, for the new factory. Our lease

agreement with the city states that we will clean up the land, if necessary, when we

close down the factory. When we originally prepared the financial statements, we

didn’t have enough information to estimate the ARO, so we only disclosed the

requirement in the footnotes.’’

‘‘I saw that,’’ Simon replied. ‘‘It looked like the note was well done.’’

‘‘Thanks. However, last week we received a letter from the city. It seems

that city officials recently hired an engineer with quite a bit of experience cleaning

up after factories like ours. She believes there is a 70–75 percent chance that we

will have to clean up the land at the end of our lease, and she sent us a letter

including her estimate of the future cost. She wanted to make sure that we were

prepared to handle those costs when our lease runs out in 20 years.

‘‘When I first got the letter, I decided that since it arrived after the close of

the fiscal year, we could wait and record it this year. However, if we’re going to go

back and change the amount of interest capitalized on the factory, shouldn’t we also

record the associated ARO?’’

Simon thought for a moment. ‘‘I don’t know. We did receive the

information before releasing our financial statements, but there’s only a 70–75

percent chance that we will actually have an obligation. Do we need to include that

estimate?’’

‘‘Do you remember how much it was?’’ John asked.

Elsa nodded. ‘‘The city engineer believes it will cost $500,000 just to tear

down the factory in 20 years.’’

‘‘Well, when you consider our 12 percent internal rate of return, the ARO

won’t be too big,’’ John said, smiling.

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‘‘You’re right.’’ Elsa nodded. ‘‘That part doesn’t sound too bad. However,

she also estimates that we will need to spend approximately $250,000 a year for the

three years after removing the plant to restore the land to its original condition.’’

‘‘Thanks for bringing that up, Elsa,’’ Simon said. ‘‘Do you have any other

concerns?’’

‘‘Just one,’’ John said, ‘‘and it’s only an idea that you might want to pitch to

the management team along with these other changes. We have used the percent of

accounts receivable method to calculate our Allowance for Bad Debt for several

years. But we don’t have to use that method.’’ ‘‘What do you mean?’’ Elsa asked.

‘‘Isn’t the percent of accounts receivable method one of the best ways to calculate

the Allowance?’’

‘‘Technically, yes, it is. However, we recently hired a new credit manager

who has improved our collections and tightened our credit policy for new

customers. Because of these improvements, we might not have to use the percent of

accounts receivable method. Instead, we could switch back to the percent of sales

method that we used previously. By switching from using 12 percent of accounts

receivable to 2 percent of credit sales, we would reduce our allowance for bad debts

and our bad debt expense. That would offset some of these negative changes we

have just discussed.’’

‘‘What were credit sales for the year?’’ Simon asked.

‘‘About $1.25 million, and accounts receivable had an ending balance of

$600,000 after we wrote off $30,000 of uncollectible accounts. We wrote off

almost $50,000 the year before, so our collections really have improved. Honestly,

I don’t think that we’d lose information quality by switching methods. We don’t

really have to use any specific method for estimating bad debt expense. I think we

could make a case for the more relaxed estimation method, and I think the positive

effect of the change on net income might help the management team accept some

of these other adjustments.’’

Elsa jumped in. ‘‘I don’t see any problem with that.’’

Simon frowned. ‘‘I’m not sure I like the idea of changing methods solely to

offset the negative effects of these other adjustments. But go ahead and calculate

how switching methods would affect our bad debt expense. We’ll meet again

tomorrow morning, after I’ve talked with Jane and Doug about how to handle these

issues.’’

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MEETING WITH THE CEO AND CFO: 2:00PM

Jane, Frosty Co.’s CEO, shook Simon’s hand as she welcomed him into her

office. Doug, the CFO, was already seated. ‘‘So, how do things look?’’ Jane asked

as Simon took his seat.

‘‘Well,’’ said Simon, as he handed out copies of the financial statements

(see Tables 3–5). ‘‘I think the financial statements will be ready for our audit and

our earnings announcement on schedule.’’

Jane frowned as she flipped through the statements. ‘‘That’s great, Simon,

but how do things look?’’

Simon looked confused, so Doug explained. ‘‘I think Jane wants to know

the final EPS.’’ Doug glanced quickly at the financial statements, then turned to

Jane and said, ‘‘It looks like EPS will be $2.21. That’s five cents higher than the

analysts’ $2.16 forecast.’’

‘‘Well,’’ Simon said slowly.

‘‘Perfect!’’ Jane said brightly, ignoring him. ‘‘That’s just what I wanted to

hear!’’ ‘‘But . . .’’ Simon tried again.

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‘‘Right,’’ Doug agreed. ‘‘Let’s go ahead and announce the SEO right

away.’’

‘‘Good idea,’’ Jane said, nodding. ‘‘There’s no reason to wait if we’ve got

good news.’’

‘‘Excuse me,’’ Simon jumped in. ‘‘But that might be a little premature.’’

Jane looked at him. ‘‘Why?’’

‘‘Well, I do have a couple of issues I need to discuss with you.’’

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Doug and Jane both frowned. ‘‘What do you mean?’’ Doug asked slowly.

Simon sat forward. ‘‘I met with my team this morning, and we think there

may be a few corrections that need to be made to this draft of the financial

statements.’’

‘‘I thought you said they were done,’’ Jane snapped.

Doug held up his hands. ‘‘Jane, don’t shoot the messenger. It’s Simon’s job

to look through the financial statements for any problems.’’

Jane took a deep breath. ‘‘You’re right.’’ She sighed. ‘‘I’m sorry, Simon.

What have you found?’’

Simon took a deep breath. ‘‘First, we capitalized all of the interest on our

new loan as part of our construction project. According to GAAP, we might be able

to capitalize some of that interest, but certainly not all of it. Second, officials from

the city where the new factory is being built have provided us with fairly accurate

estimates of what we will need to spend to remove the factory and clean up the land

when our lease expires. Since we haven’t released the financial statements yet, we

may need to record the ARO.’’ Jane grimaced, but Simon pushed on. ‘‘Third, we

haven’t written down any of our obsolete inventory following the introduction of

the new snow cone machine line, and we know that our customers aren’t going to

buy the earlier model at the original price. We’re still looking into how much the

write-down will be, but we will need to write down some of it.’’

Jane asked quietly, ‘‘Are you finished?’’

‘‘Those are the issues we’ve identified. I’m not sure what the net effect of

the changes will be yet, but I’m afraid that they might drop EPS quite a bit.’’

‘‘But . . .’’ Jane said hotly.

Doug jumped in. ‘‘Look, Simon, I know you want to correctly account for

all of these issues; I do too, but we need a strong set of financials this year. We’re

counting on that SEO to fund our new growth strategies. We need the good news

now, so leave the statements as they are. We’ll fix all of these issues after the

offering, I promise.’’

Simon said quietly, ‘‘I think we need to make these adjustments, all of

them.’’ He looked at Jane’s angry face. ‘‘There is a way to reduce the drop in EPS.

We could switch our method of calculating bad debt expense from the percent of

accounts receivable method to the percent of credit sales method.’’

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Jane played with her earring while she thought. ‘‘Would switching methods

offset the other adjustments?’’

Simon shook his head. ‘‘Probably not entirely, but it will help.’’

Jane shook her head. ‘‘Simon, just leave the financial statements as they

are.’’

Simon started to argue, but Jane cut him off. ‘‘Look, Simon, the decision is

mine to make, and I’m telling you: don’t mess with the financial statements. Leave

them as they are!’’

‘‘But the statements are wrong as they are!’’

‘‘We don’t know that,’’ Doug jumped in quickly. ‘‘All we really know is

that maybe we should do something about these issues. Think about the inventory

adjustment for a minute. Companies leave obsolete inventory on their books all the

time, waiting for a good year to write them down. It doesn’t really bother anyone.

And as far as the interest capitalization, if the auditors don’t catch it. . .’’

‘‘But our numbers will be wrong!’’

Jane sounded exasperated. ‘‘You don’t know that, Simon. There are so

many estimates in the financial statements that you can’t ever be sure if the

numbers are right or wrong. Besides, we owe it to our investors to report good

numbers; that’s how their investments grow. Believe me, they don’t want to see bad

numbers. So, if the auditors happen to stumble on these issues.. . .’’ She stopped for

a moment, looking at Simon’s face. ‘‘If the auditors stumble on them, send them to

talk to Doug or to me. We’ll straighten them out.’’ She smiled. ‘‘Don’t worry about

this so much. Just leave things as they are, and we’ll take care of you when bonuses

come out. The Board’s going to be thrilled to see these financial statements, and

we’ll be sure to tell them how much you helped us get ready for the SEO. We’re

always happy to reward . . . team players.’’ Doug nodded. ‘‘I think that’s

everything for today. Thank you for all of your hard work.’’

Simon stood, picked up his papers, and headed for the door. When they had

hired him, he had been excited for a new opportunity. But now, he was starting to

wonder if he should have stayed in public accounting.

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CASE REQUIREMENTS

1. Capitalizing interest on the new factory:

a. During the year, Frosty Co. paid all of the interest accrued on Bond A and

Loan 1, but only $50,000 of the interest accrued on Loan 2. Using one

journal entry, summarize how Frosty originally recorded the accrued

interest on all three long-term debts.

b. Assuming John and Elsa are right that the new loan meets the standards

for capitalizing interest, calculate avoidable interest.

c. What correcting entries would need to be made to properly record interest

on Frosty Co.’s construction project if Simon is right?

d. What would be the net effect of each of these interest adjustments on net

income? What would be the net effect on EPS?