This is a case for my gateway course and it has a few accounting questions that I need help with
1 BANK OF GREEN VALLEY Wednesday, April 13, 2005, 9:48 a.m.: “Congratulations are in order! You remember that I told you last year that we would be submitting your opinion about ZonTech’s financial statements to a bank to get some financing for our planned addition of a production facility. Don’t you? Well, the Bank of Green Valley just notified me that the loan committee approved our three million dollars loan after analyzing this year’s audited financial statements. The committee was really impressed that while everyone else in our industry operated at a loss or just broke even, we showed a substantial profit this period,” crowed Roger Shaw, CFO of ZonTech, in a telephone call to Michael Free, an auditing manager at Victor Hines, LLP. Michael headed the audit team that issued an unqualified opinion on ZonTech’s financial statements for each of the last four years. “That’s great!” Michael responded. “The loan means that you’ll be able to complete that new circuit board production facility that you told me about, doesn’t it? That circuit board is the product your budget shows is going to increase sales revenue and cash flow next year. It’s a good thing you were able to generate a profit and get the loan. Without the new product, things looked pretty bleak.” ZonTech designs and manufactures circuit boards for low-tech applications, such as those used in major household appliances. Sales in the appliance circuit board industry had declined or been flat in the past 18 months because of people’s reluctance to buy new appliances in a poor economy. ZonTech’s new circuit board was for washers and dryers that compete with Maytag’s Neptune series. ZonTech’s customer (a major competitor of Maytag) was launching a new washer/dryer with characteristics similar to the Neptune series, but they expected the price to be about 25% below that charged by Maytag. ZonTech had developed a circuit board to meet the engineering specifications of the new product, but could only land the business if they had new production facilities. Lily Meza, an auditing staff member assigned to one of Michael’s jobs, overheard the conversation between Michael and Roger on the speakerphone while sitting in Michael’s office. “Michael, I didn’t know that the company operated at a profit this year!” exclaimed Lily. “During my fieldwork, I analyzed the monthly income statements through November, and they showed that the company operated at a loss almost every month! How did they report a substantial profit at year-end?” Michael replied, “Several years ago they made an investment in the stock of a closely held company that they thought might be a good strategic alliance. Unfortunately, that opportunity didn’t work out. Until December 2004, ZonTech had been holding the investment and hadn’t been receiving any dividends. The CFO of ZonTech actively searched for a company to buy the stock, and in December 2004, located a strategic buyer who took it off their hands at a substantial gain!” Michael continued. “ Since ZonTech frequently buys and sells stock investments, the gain is a part of their income from continuing operations.” “Oh, that’s clever!” Lily responded. “But if it were such a large transaction, why didn’t they just use the cash flow from the stock sale to finance the new manufacturing facility?” “Well,” Michael explained, “the company that ZonTech sold the stock to, GreenSel, is having their own cash flow problems right now. They couldn’t afford to give ZonTech cash, so ZonTech accepted a non- interest bearing note due in 5 years. Although ZonTech won’t see the cash for five years, since the title to the stock has passed to the new owners, it can record the gain on the sale.” Lily pondered this information for a few minutes, and then queried, “Why a non-interest bearing note? Most companies with a credit rating like GreenSel are paying about 15% on loans for transactions like this one.” 2 “ZonTech didn’t have any loans against the investment, so they aren’t incurring any interest cost on the stock or the new note. They figured that there isn’t any need to hurt GreenSel’s cash flow when ZonTech doesn’t have any interest cost on the investment,” Michael responded. “Michael, you sure know a lot about this transaction,” teased Lily. “You’d think that you had found the buyer and negotiated the deal.” “Well, I am pretty excited,” Michael responded. “ I worked with the CFO on the transaction, reviewing the entry in the general journal and its reporting in ZonTech’s income statement. I may not have arranged the deal, but I was instrumental in getting out the audited statements just in time. As you know, ZonTech really needed some serious cash infusion as soon as possible from some lender to complete a production facility for that new circuit board.” “Since I missed all the excitement while I was working on a different client, why don’t you share the details of the transaction?” demanded Lily. “Well, ZonTech was carrying the investment at $5,100,000 and sold it to GreenSel for $8,000,000. So they booked a $2,900,000 gain on the transaction,” Michael confidentially replied. Lily looked troubled and finally confided to Michael, “I’m enrolled in a CPA review course, and last week we studied long-term receivables and payables. I learned that generally accepted accounting principles (GAAP) require notes receivable due in more than one year to be carried at their present value. Wouldn’t that affect the profit you reported?” Michael looked at Lily like she was trying to put him on the spot and icily replied, “I explained that ZonTech didn’t incur any interest on this investment before the sale, so present value calculations aren’t necessary! And, yes, the income statement we audited is consistent with GAAP.” ZonTech Income Statements For the four years ended December 31, 2004 (in 000’s except per share amounts) 2004 2003 2002 2001 Net Revenues and Gains $27,500 $26,300 $25,100 $20,900 Expenses and Losses Cost of Sales 15,200 12,150 9,845 9,200 Operating Expenses 3,160 3,075 2,890 2,300 Other 4,570 3,966 3,146 2,214 Taxes 1,690 2,671 3,318 2,515 Net Income $2,880 $4,438 $5,901 $4,671 Common Shares Outstanding 3,000 3,000 3,000 3,000 3 Memo To: Rosie Cruz, Loan Delinquency Department, Bank of Green Valley. From: Harold Ricardo, Senior Lending Officer, Bank of Green Valley Date: January 17, 2008 Re: Default on ZonTech’s loan ______________________________________________ __________________________ As I mentioned to you earlier today, I am forwarding to you the ZonTech’s file. It is now in default on the three million dollar loan we extended on April 12, 2005. The total amount currently outstanding is $2,390,000. We were just informed yesterday that ZonTech has commenced bankruptcy protection under Chapter 7 of the Bankruptcy Code. As such, the prospects of a full recovery are minimal. In addition to the loan documents, I am attaching copies of all the financial statements that we obtained from ZonTech as part of the loan application, including the one for the year 2004, which we received from ZonTech’s CFO on February 2, 2005. In looking back at the financial statements that we had in our file, I was stunned by ZonTech’s dramatic and sudden collapse. When we approved the loan, the loan committee gave a lot of weight not only to the financial statements from 2004 but also to the ones from the prior three years; we were keenly impressed by the firm’s pattern of income stability during those four calendar years. I am also attaching a copy of an article I had placed in my file a number of years back. Ever since reading the article, I have had a lingering suspicion that the story in the article is about ZonTech. VALLEY TIMES December 15, 2005 Glen Oak, Green. In a surprise move yesterday, twelve staff accountants at Victor Hines, LLP left the firm and joined a competitor, Pillsbury & Skadden. In an interview with one of the twelve former auditors, it was learned that the departure followed alleged auditing irregularities practiced by senior partners at Victor Hines, LLP. “I have been really disillusioned with the level of scrutiny the senior managers and partners have been employing with regard to a number of audit engagements. In one case that I have worked on while I was an intern, my former manager signed off on an unqualified audit opinion where the client, a designer and manufacturer of home appliance circuit boards, had substantially overstated income and assets in contravention with General Accepted Accounting Principles. It is really too bad. I am really looking forward to joining this new firm. I believe it has a lot of potential,” said one of the twelve departing accountants who wished to remain 4 Required: Assume that you are Ms. Cruz, an associate in the Loan Delinquency Department at the Bank of Green Valley. Your supervisor would like to find out from you whether the Bank of Green Valley has a claim of negligence against the accounting firm of Victor Hines, LLP. You have gathered additional information from the bankruptcy courts and know about the 2004 sale of stock to GreenSel and its accounting treatment in the income statement. Read the legal cases collected by the legal assistant and attached in the Library. Assume that the applicable precedent is from the fictional jurisdiction of the state of Green provided to you in the attached library. Assume that the financial statements audited by Victor Hines for the calendar years of 2003, 2002 and 2001 were accurate. Prepare a report (see