IRCA for one issue and Retained Earnings statement.

AGUAMAINT, INC.

REQUIREMENT 4

You went to Aguamaint as planned on Monday, January 18. After reviewing Jerry's financials and vehicles cost schedule, you faxed him a list of your questions. Jerry called you the next morning indicating that he had the requested data ready, and you confirmed your afternoon meeting at Aguamaint’s new location. Having completed your research on the new issues for 20X2 and eaten a light lunch, you left for Aguamaint.

REQUIRED:

Your questions and Jerry's responses are summarized here. After some research, you determined that the market rate of interest on debt comparable to Aguamaint’s new note was still 6% as of year-end. You and Linda Durkee had met for lunch after your latest discussion with Jerry since you wanted to ask her about the tax treatment for bad debt expense and deferred revenue. Jerry Loos had not recorded either, but you felt that he should have. Linda stated that the IRS does not recognize bad debt expense until accounts are actually written off, and they recognize advance payments as revenue when received. She also confirmed that the tax law allows lease payments for long-term leases to be deducted for the applicable months in the current calendar year, which is no different from the treatment of short-term leases. Using this information and Jerry’s responses below, determine the adjusting and correcting journal entries needed to report Aguamaint’s financial position in accordance with U.S. GAAP. All adjusting and correcting journal entries must be documented by 1) calculations to support your analysis, 2) detailed explanations of the reason for the journal entry, and 3) authoritative sources where appropriate.

YOUR QUESTIONS AND CLIENT RESPONSES

1. Who planned the truck modification work? How was it supervised? Was it someone on payroll or do you have an invoice for this work?

The specifications were drawn by Nick Riley, which took him only about 10 hours. The actual work was supervised by Ray Ballard, who spent about 20 hours on this task. We just calculated the amounts on an average hourly rate based on their salaries.

2. We noticed shop labor on your schedule of truck additions. Was this work done by your employees, and if so, did they work only on the trucks during that month and a half period, or was there other business-related work going on in the shop at the same time? If they worked on other jobs besides the retooling of the trucks, we need to know what cost driver you used to allocate the rent and utilities. We also need to make sure the $7,200 in labor costs did not include work on jobs other than the truck modifications. Also, how many hours did they work on the trucks?

All the work on the trucks was completed by Aguamaint’s crew. They worked on the trucks and other jobs in the shop during that time, and the entire $7,200 was incurred on the retooling job. Total shop labor for the same period amounted to $17,475. That ratio was the basis of my allocation of rent and utilities. The crew worked 300 hours on the trucks.

3. How much was the total rent and utilities for the month and a half that you worked on the trucks?

Shop rent and utilities expense for the one and one-half months totaled $5,656.

4. We did not see any interest expense accrued for 20X2. Shouldn’t we expense the interest due on the note as of year-end?

I didn’t record the interest because I didn’t have to make a payment until this year.

5. Speaking of interest, we believe that you can capitalize some interest cost to the trucks since the retooling qualifies as a self-constructed asset. As long as the investment was substantial and an extended period of time was spent preparing the property for use, GAAP allows this. We think you meet this criteria, but we need to know when you purchased the various items used to modify the trucks to be able to complete our calculation.

All materials were on hand or purchased by February 1 so they would be available as needed.

6. Do you anticipate any collection problems on accounts receivable? Your ending balance has increased by over 77 percent. Is an allowance required at year-end?

We think it is all collectible. The last payment received on the $13,000 monthly contract executed on 3/1 was received at the end of October, for work done in September. Nick says we just will not renew the contract if the balance is not paid by March 1, so I am not going to worry about it until then. We are confident it will be paid. We have a $12,000 amount due from another client, but they told us the check is in the mail, so that is not a problem either. Everything else is on time.

7. We remember at the end of last year that you had not booked the supplies inventory on hand as an asset. Were these supplies inventoried at year-end this year? How were their values calculated?

Shop supplies were inventoried on December 31 and their costs were computed from the latest invoices. I made an adjusting entry for this similar to the one you had me make last year.

8. We noticed that wages payable decreased quite a bit from last year, despite having one more day in the pay period to accrue and the fact that your operations increased this year. Is there a reason for this decrease and could you make the time cards available to us?

Things went well for us this year and due to a very mild December, we ended up being ahead of schedule in completing our maintenance work for the month. As a result, we were able to close down over the holiday and give our crew several days off. Unfortunately, it was unpaid time, but they were still happy to have the break. In addition, we did not have to pay any overtime at the end of December this year. I have the time cards if you need them.

9. From our calculations, it appears that you are depreciating the original cost of the trucks over a six year period, using straight-line and with no salvage value. Is that correct? Also, we did not see any depreciation taken on the additions to the trucks. We will need to adjust for that using the same method you used for the trucks.

Yes, the trucks are depreciated over six years to the nearest full year. Salvage value is expected to be zero. I guess I was so busy getting that truck schedule done that I forgot to take the additional depreciation. Would the capitalized interest affect that depreciation amount? Can you take care of that for me please?

10. What are the requirements set out by the covenants on the bank loan?

There are a few ratios that we need to calculate. They want our current ratio to be at least 1.5 and they want our long-term liabilities to equity ratio to be under 1.2. Dividends may not be distributed unless earnings exceed five times interest. Loans may not be made either to Mr. Ballard or to Mr. Riley. Salary increases for Mr. Ballard and Mr. Riley must be approved by the bank. We are in compliance with all of those things. In fact our current ratio is about 4.7.

11. It looks like the short-term portion of the truck note needs to be reclassified. What do you think?

I didn’t reclassify the short-term principal portion due in 20X3. I didn’t think I needed it on the financial statements because I have a loan amortization schedule from the bank that helps me keep track of how the payments are allocated to principal and interest.

12. Could we get a list all maintenance contracts and their terms please? We need this information as a basis for disclosing any major customers.

Here it is…we have got some new contracts that we collect in advance now, so that has really helped us bump up our revenue.

13. We noticed that the cost of leasing trucks has decreased to $24,600 for this year. Is this because you purchased the two new trucks? We also noticed that the lease payment on your new building is $39,000, which is much higher than you paid for your location last year. We are assuming you entered into a long-term lease when you moved, so we need some additional information from you to help us determine if this is an operating or a finance lease. How long is the lease? Will you own the building when the lease ends? Can you provide us with the fair value of the building and also the interest rate used to determine the annual payments? We also need to know the useful life of the building.

We no longer lease the trucks since we purchased and retooled the new ones. That $24,600 was incurred to rent trucks at the $150/day rate until we got the new trucks retooled.

I agree that the $39,000 is a little high, but that’s the agreement that Nick and Ray negotiated. They settled on a 5.25% interest rate and a 10 year lease term. We only rent a little over half of the building, so will not own it at the end of the 10 years. I am pretty sure the building is worth well over a million dollars. It’s a relatively new building, so is not going to wear out anytime soon—certainly not within the next 50 years. We have a great location here, and the real estate prices just keep going up in this area. That is all the information I have. You can see that I recorded the lease payment correctly in the journal entries, and even allocated it between the shop and the office spaces. Why do you need all this detail? Do you want a copy of the lease?

14. We noticed the prepaid insurance balance has not changed from last year. Did you purchase any more insurance or did any of the terms of the policies change?

I forgot about adjusting that. We did not buy any more insurance and nothing has changed. That reminds me, we need to renew those policies next month.

15. Have you considered temporary differences in your income tax calculations for the year? It appears you may have a few of these.

I really don’t understand taxes very well. I just multiplied our income by our 21% tax rate. I have no idea what you mean by temporary differences. What would cause those?

16. Are there any transactions or events that have occurred since year end 20X2 that we should disclose as subsequent events this year?

As a matter of fact, yes, there is one thing. We are implementing a retirement plan for all Aguamaint employees as of January 1, 20X3. I am very happy about this since it was not something I expected to happen.