This case requires students to evaluate financial reporting practices adopted by a small apparel company. The company’s owner/manager has recently taken the business in a new direction, and is asking for help in determining whether the company’s existing
Michelle_Michy
20190409014756gac_case2.pdf
ISSUES IN ACCOUNTING EDUCATION American Accounting Association Vol. 30, No. 1 DOI: 10.2308/iace-50762 2015 pp. 1–12
Evaluating Financial Results at Graphic Apparel Corporation (GAC):
The Impact of Accounting Policies
Fred Phillips
ABSTRACT: This case requires students to evaluate financial reporting practices adopted by a small apparel company. The company’s owner/manager has recently taken
the business in a new direction, and is asking for help in determining whether the
company’s existing financial accounting policies continue to be appropriate and how
alternative policies would affect the reported financial results. This case will require
students to apply knowledge of financial accounting and financial statement ratios to
judge the appropriateness of selected accounting policies. This case is designed for use
in introductory and intermediate financial accounting courses that aim to develop
students’ critical thinking skills.
Keywords: merchandise inventory; asset valuation; revenue recognition; current ratio; debt covenants.
INTRODUCTION
T here is nothing like being a small business owner, thought Nicki Singer as she reflected on
her first year of running the Graphic Apparel Corporation (GAC). Sure, you have to make
sacrifices, such as putting in long hours and initially getting little in financial return, but she
says the feeling of being your own boss in the apparel fashion business is worth those sacrifices.
Creativity and independence are important to Nicki, who considers herself a free spirit willing to go
against the grain and consider new perspectives when making decisions. No doubt, fresh thinking is
what first attracted Nicki to clothing and fashion, and now—in October 2014—it has led her to ask
you for financial accounting advice.
Fred Phillips is a Professor at the University of Saskatchewan.
I thank Allen Blay (associate editor), Karen Cravens, Lori Holder-Webb (editor), Doug Kalesnikoff, Brandy Mackintosh, James Smith, two anonymous reviewers, and members of the CAAA Education Committee for comments on a prior version of the case.
An earlier version of this case received first prize in the Canadian Academic Accounting Association’s (CAAA) 2013 Case Writing Competition.
Published Online: March 2014
1
Background
For as long as Nicki can remember, she has had a keen interest in fashion. While in high
school, she created a fashion blog that rated among the top 100 style sites and garnered her
invitations to fashion shows and designer sneak peeks. After high school, she enrolled in an
undergraduate program in fashion merchandising so that she could continue to pursue her dream of
creating her own fashion apparel brand. To finance her education, she worked part-time at GAC—a
local T-shirt screen printing company that made graphic T-shirts for retail stores and, to a lesser
extent, custom order shirts for sports teams and local organizations. Through this part-time job,
Nicki gained experience in clothing design, production, and sales. This hands-on experience
confirmed her interest in a fashion apparel career, and she looked forward to completing her
merchandising degree so that she could start making her own mark in the ‘‘real world.’’ The opportunity to enter the business world came sooner than Nicki had expected. A serious
illness had befallen the owner of GAC, and he was forced to stop working at the company. He had
no family, and Nicki was the employee who had the most experience at GAC, so he asked Nicki if
she would consider taking over the company. At first, she declined. She was only one year from
completing her degree and it seemed a shame to quit without finishing. But the more she thought
about running the company, the more excited she became. She had abundant energy and many
ideas for bold new designs to attract new retail customers, which could possibly make a name for
Nicki with end consumers. Also, Nicki had developed a strong relationship with GAC’s owner and
she wanted to see his business survive as his health failed. Likewise, he wanted to give Nicki a head
start in the apparel business, so he offered GAC to Nicki at a favorable price. He advised Nicki that
because GAC had virtually no debt on its balance sheet at the time, she could finance the purchase
of his shares as a leveraged management buyout; the bulk of the money to purchase the owner’s
shares would come from a loan secured by the company’s assets. After much contemplation, Nicki
decided to go for it. She took over ownership of GAC in January 2014.
GAC’s Business Activities
GAC’s business model, which had changed little over the past few years, is a simple one. In the
winter, the company purchases batches of plain white and black T-shirts from suppliers. These
shirts are received and stored in a local warehouse. Each spring, GAC produces ‘‘graphic’’ shirts using a screen-printing process whereby plastisol and water-based inks are applied to the plain
shirts to achieve desired design outcomes. These graphic shirts are sold to retail clothing stores in
early summer. At the end of summer, after T-shirt sales taper off, GAC generously offers a full
refund to retailers for any unsold graphic shirts, provided the shirts are returned by October 15 of
that year. GAC then sells these shirts to discount stores for about one-half of GAC’s original cost.
In prior years, retailers had sold almost all the graphic shirts, so GAC’s generous return policy had
little effect on GAC’s financial position. At various times throughout the year, GAC also will use its
plain white and black shirts to produce ‘‘custom’’ shirts on order from local sports teams, businesses, and community organizations. Unlike sales to retail companies, GAC requires that these
customers pay in advance and GAC does not allow returns on these custom sales.
Despite relying on a relatively stable business model, some changes have occurred since Nicki
took over GAC. One of the most obvious changes that Nicki implemented was to alter the look of
GAC’s 2014 graphic shirts. Her blogging experience had taught her that fashions change quickly in
the apparel industry. Being eager to establish a reputation for fresh new looks, Nicki created designs
for GAC’s 2014 graphic shirts that were edgier than in previous years. To her delight, Nicki caught
the attention of bloggers and fashion critics, who described her designs as ‘‘bold’’ and ‘‘inspiring.’’ However, GAC’s base of conservative retailers were not quite as enthused. They anticipated that
consumers in their target markets would be turned off by the new looks, so they cut back their
2 Phillips
Issues in Accounting Education Volume 30, No. 1, 2015
orders for the 2014 season. Nicki was disappointed by this turn of events, but, undeterred, she
sought new customers. After many store visits and aggressive marketing efforts, Nicki was able to
replace several of GAC’s reliable, longstanding customers with new start-up clothing stores that
were excited to offer bold and inspiring graphic designs to their end consumers. Although Nicki is
looking forward to working with these new retailers, she is concerned that they do not seem as well
managed as the GAC customers they replaced. These new customers complain that it is difficult for
them to comply with GAC’s sales terms of n/30. Acknowledging that she may be fighting a losing
battle, Nicki is becoming resigned to the idea of not collecting $3,000 of the August 2014 Accounts
Receivable. However, she is adamant that she will not change the stated collection period, nor will
she offer discounts for prompt payment; GAC’s terms are standard in the industry.
Throughout the spring and summer, Nicki worked tirelessly to secure more custom orders from
local sports teams and community organizations. As a sports and recreation enthusiast, Nicki had many
connections in the local community with whom she met. Her visits with these groups were initially
unsuccessful in producing orders for the current year but, by the end of summer, she had generated a
significant number of orders to be filled during the fall months. Nicki calculated that as of August 31,
2014, she had secured $10,000 of sales orders, of which $7,500 had been collected in cash. Because
$2,500 of the sales orders came from her own sports teams, Nicki made an exception to GAC’s policy
of requiring payment in advance and instead recorded them as accounts receivable. Because she plays
on these teams herself, she does not anticipate having problems collecting the balances after the shirts
are delivered. In late August, GAC started production of the $10,000 in custom shirt orders. Nicki was
encouraged by this situation because, in prior years, this was a slow period for the company. Indeed, as
of August 31, 2013, GAC had only $100 of custom orders to fill in the fall.
In addition to the challenge of maintaining sales levels, Nicki encountered other issues during
the year. For example, in May 2014, Nicki discovered that GAC’s warehouse roof was leaking.
Although the roof was easily repaired at little cost with no damage to the building itself, the leak
caused stains and other water damage in about half of the plain shirts that had been purchased for
the 2014 season. Nicki was able to remove the majority of the stains by laundering the shirts, but
some stains remained and were apparent when viewed under certain lighting. Always looking for
the positive side of problems, Nicki felt that these subtle stains presented a hidden ‘‘grittiness’’ that complemented her edgier designs, so she used the slightly imperfect shirts when producing the
2014 graphic design shirts. To date, the retail stores have returned only a few shirts and have not yet
reported any continuing issues with the imperfections. But it may be too soon to tell whether end
consumers will be so forgiving. Nicki noted that dozens of GAC shirts had been on racks in the
clearance section of a local department store in early August, but were no longer on display when
she returned in September. She hopes that retailers were successful in selling this merchandise, but
she is troubled that she saw employees removing shirts from the clearance section at one store in
late September to make room for new fall clothing that had arrived. Based on follow-up queries
with GAC’s retail customers, Nicki estimates that GAC’s total selling price for all shirts held by
retail stores at the end of August was $15,000.
A final change that occurred this year, and possibly the most significant, relates to GAC’s bank
financing. In prior years, GAC had no long-term debt, so its only external financial statement user
was the Internal Revenue Service (IRS). Because GAC’s accounting matters were straightforward,
the previous owner handled most of the accounting himself and hired a part-time accountant only to
prepare financial statements for tax purposes at the company’s August 31 year-end. After Nicki
took over, the company shifted from equity financing to debt financing. With that change, the bank
now requires GAC to submit its annual financial statements, prepared in accordance with generally
accepted accounting principles (GAAP), to the bank within 60 days of its year-end. GAC’s loan
agreement includes a covenant that requires a minimum current ratio of 1.0. At the present time, the
lender does not require an external audit of the financial statements, but that could be requested in
Evaluating Financial Results at GAC: The Impact of Accounting Policies 3
Issues in Accounting Education Volume 30, No. 1, 2015
the future if GAC violates its covenant. For now, Nicki has GAC’s part-time accountant prepare
financial statements each month and for the year ended August 31, 2014.
Your Involvement
GAC’s present accounting policies were developed years ago by the part-time accountant, in
consultation with the former owner. Nicki admits that although she recently completed an
introductory financial accounting course as part of her degree in fashion merchandising, she does
not recall many of the details of accounting. But she does remember that accounting policies and
judgments can exert a significant impact on the reported financial results. Consequently, Nicki has
asked you to look at GAC’s 2014 annual financial statements to determine whether they are likely
to be acceptable to the lender. If any aspects of the financial statements need to be changed, Nicki
would like you to explain—in language she can understand—the changes, reasons for changes, and
likely impact on GAC’s relationship with its bank. Excerpts from the most recent draft of GAC’s
year-end financial statements are presented in Exhibit 1.
EXHIBIT 1 Excerpts from GAC’s Comparative Financial Statements
Panel A: GAC’s Comparative Income Statement
(continued on next page)
4 Phillips
Issues in Accounting Education Volume 30, No. 1, 2015
EXHIBIT 1 (continued)
Panel B: GAC’s Comparative Balance Sheet
(continued on next page)
Evaluating Financial Results at GAC: The Impact of Accounting Policies 5
Issues in Accounting Education Volume 30, No. 1, 2015
EXHIBIT 1 (continued)
Panel C: GAC’s Financial Statement Notes
6 Phillips
Issues in Accounting Education Volume 30, No. 1, 2015
