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Case 4-3 The Use of Net Income and Cash Flow to Evaluate a
Company
2. One important question to be asked is whether it is possible for the company to continue to generate service revenues in succeeding years at the level attained in its first year. The ability to collect the revenues billed in 1995, but not yet collected ($230,000) should also be a concern. On the basis of the cash flows generated in the first year, the business would appear to be worth strong consideration. One major concern, however, is whether the company will be able to repay the note in 1998. It must generate sufficient cash flows over the next three years (this includes the year just concluded) to repay $1,725,000 in principal and $414,000 ($138,000 per year X 3 years) in interest. This may be very difficult to do unless more cash flow is generated from operations or the company is able to negotiate an extension of the due date for the loan. |
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| Case 4-5 Revenue Recognition and the Matching
Principle 1. If sales are recorded but the commissions associated with these sales are not recorded during the month of June, net income will be larger by the understatement of commissions expense. The failure to record advertising expense for the month of June will also result in an understatement of expense and an overstatement or increase in net income. Finally, an increase in the estimated useful life of the automobiles will result in a decrease in the amount of depreciation expense and thus an increase in net income. 2. The first suggestion, to delay recording the 4% commission expense until July, is a clear violation of the matching principle. Regardless of when the sales staff is paid commissions, it is wrong to record the revenues in June but not record the expense associated with earning that revenue, i.e. commissions, until July. Likewise, deferring the recognition of the advertising bill as an expense until July also violates the matching principle. Under the matching principle, this cost should be recognized as an expense in the period in which it provides benefits (in this case, the month of June), regardless of when cash is paid. Finally, the change in estimated useful life for the automobiles is also questionable from an accounting point of view. Companies are allowed under GAAP to change estimated useful lives of depreciable assets, but the changes must be justified on sound economic grounds. For example, changes in technology might prompt a company to decrease the estimated useful lives of its computers. The need to increase the net income for the year is certainly not an acceptable reason under GAAP to change the estimated useful lives of depreciable assets. 3. Each of the three suggestions involves a question of ethics. All three involve an attempt to consciously overstate income for the purpose of extending a loan. There is an attempt on the part of the vice-president of sales to deceive a user of the accounting information. The banker relies on the trustworthiness of the company to accurately report its income and each of the three suggestions would violate that trust. The company would not be acting in good faith if it were to report income as has been suggested. 4. To: Willie Listum, President Dewey Sellum, Vice-President of Sales From: Joe Smith, Controller Date: June 30, 1995 Subject: Proposed accounting changes I have reviewed the suggestions made by Dewey to improve the profitability of Listum and Sellum for the year ended June 30, 1995. While we are all equally anxious to be in a position to report a successful year of operations to the bank when we ask for an extension of the loan in July, I have some definite concerns relative to Dewey's suggestions that I would like to share with both of you. First, each of the suggestions for improving profits for the month of June are clear violations of generally accepted accounting principles. The recognition of June sales, but the deferral of commissions expense on these same sales until July violates the matching principle. Similarly, the deferral of advertising expense, which is directly related to the month of June, until the following fiscal year in July, is likewise at odds with the matching principle. Finally, it is not acceptable practice under accounting standards to alter the estimated useful lives of depreciable assets for the sole purpose of increasing income. We would need to be able to justify the changes on sound economic grounds. In addition to my concerns about the suggested changes from an accounting point of view, I personally believe they raise serious ethical issues. The accountant is placed in a position of trust to accurately and fairly report on the operations of a company to both its management and its outside constituency. This trust would be seriously violated if I willfully and intentionally misstates our profits to a banker who relies on our income as an important factor in making loan decisions. I am eager to meet with both of you at your earliest convenience to discuss my concerns. I am hopeful that we can resolve these issues in a manner that will be beneficial to the future of our company without compromising our high standards of ethical conduct. |
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