Intermediate financial accounting -11 canada(BC)

BUS 312 Project Fall 2018 Due November 26, 2018 Introduction You have been hired as the controller for Empire Tech, Inc., and are preparing for your first year- end. The fiscal year is ending this week, and you are involved in the year-end closing and preparation of the financial statements. You are excited about your new job, and you want to impress your supervisors. Empire Tech has previously relied on its accounting firm, Frank and Candid, to prepare their financial statements. The company has experienced rapid growth and has decided to hire a controller. The accounting department consists of you and a bookkeeper, Stacy Stays. Stacy is very capable at handling the day-to-day activities, but doesn’t understand some of the finer points of GAAP. The following sections summarize background information on the Company, major transactions during the past year, and current economic conditions.

Company Background A group of MBA students formed Empire Tech (the Company) after graduation in 2008. The Company designs and installs home technology applications. Although the Company has not been profitable in the past, this year it has reached a turning point as the profits from past R & D expenditures are being realized in product innovations and in increased sales. To further ensure its success, the Company has embarked on a focused effort to control costs. As the result of these efforts, the Company expects to recognize its first profit in 2018. However, the Company’s ultimate success depends on whether it will continue to be profitable over the next few years. The Company’s strength is its management, research and development, and production employees. The average employee is 35 years old, educated, and dedicated. Starting salaries are above average (although salary increases are close to average), morale is strong, and the Company has experienced little turnover. In addition to good salaries and healthcare benefits, all employees are covered by a defined benefit pension plan. The pension plan provides retirement benefits based on the employees’ pre-retirement salary levels and years of service with the firm. The Company amortizes any unrecognized prior service costs and gains/losses using the straight- line method over the average remaining service life. The future outlook for the Company has improved, but it is still uncertain. Analysts are bullish on the Company and have rated its common stock as a buy. The current market price of the Company’s common stock is $4.25 per share, and the 2017 average price was $3.65 per share. At the beginning of the current year, the Company had accumulated net operating loss carry- forwards totaling $230 thousand that will begin to expire in ten years. Based on the Company’s analysis, management determine that it was “more likely than not” all of the deferred tax asset would be realized in 2018; therefore, the deferred tax asset related to the NOL was classified on December 31, 2017 as current. Deferred tax information for January 1, 2018 is given in Exhibit 3.

Major transactions during the past year During the past year, the Company was a party to a number of major transactions that impacted the financial statements. These transactions are discussed in the following paragraphs.

Pension Plan The Company contributes to a defined benefit plan for its salaried employees. Benefits are determined based on years of service and earnings. The Company adopted SFAS no. 158 in 2013, and at the beginning of 2017 amended the plan by increasing the benefits formula, although they did not fund the increased liability of $280,000 at that time. When The Company funded the pension for the year, on December 31, Stacy prepared the following entry:

Pension expense 200,000 Cash 200,000

Pension information is given in Exhibit 2

Leases The Company entered into two lease agreements during the year:

1. A ten-year lease (Jan 2, 2018-Jan 1, 2028) for the use of a high-speed assembly line at its main production facility with General Capital. The lease requires annual payments of $30,000 beginning on January 2, 2018. The lease does not contain a bargain purchase option or transfer title at the end of the lease term, but does include a guaranteed residual value of $20 thousand. The Company estimated the useful life of the assembly line to be twelve years. The Company is unaware of General Capital’s implicit interest rate and used a 10 percent interest rate in its lease analysis. Amortization of the capitalized lease asset for financial statement and tax purposes is the same. Stacy has made the following entry to record the lease payment:

Lease expense 30,000

Cash 30,000

2. A five-year lease (April 1, 2018-March 31, 2023) for the use of a building. The lease requires annual payments of $45,000 starting on April 1, 2018. The lease does not contain a bargain purchase option or transfer title at the end of the lease term, but includes an unguaranteed residual value of $60,000 at the end of the lease. The interest rate implicit in the lease is 12%, which approximates The Company’s incremental borrowing rate. The fair value of the building on April 1, 2018 was $213,200. The expected economic life of the building is 30 years. Stacy recorded the lease payment as follows:

Lease expense 45,000 Cash 45,000

Construction Project The Company commenced construction of a new office building on January 1, 2017. The project is expected to be completed in three years. During 2018 the Company incurred construction expenditures of $360,000 on March 1; $600,000 on June 1; $1,500,000 on July 1; and $1,260,000 on December 1. To help

finance the construction, the Company borrowed $1,200,000 at 12% on January 1, 2017, using the constructed asset as collateral for the loan. In addition, The Company had the following borrowings:

Long-term note: $600,000 at 10% (borrowed on 12/31/16) Bonds payable $3,000,000 at 11% (issued at a discount of $169,517 on 12/31/2013 to

effect 12% interest) Mortgage payable $3,200,000 at 6% (borrowed on Jan 1, 2018)

Operational Assets The Company, upon reviewing expenses for gasoline, decided their service calls to customers could be handled with a van, rather the truck they had been using. They located a van and exchanged their truck for the van, and received $6,000 cash in the exchange. At the time of the exchange, after updating depreciation expense, the truck was on the balance sheet at its original cost of $55,000, with $12,000 of accumulated depreciation. Kelley Blue Book estimate for the value of the truck on the date of the exchange was $48,000. Stacy recorded the exchange, which occurred on Oct 31, as follows:

Van 37,000 Cash 6,000 Accum depr-truck 12,000 Truck 55,000

Also, on May 1, The Company purchased land, a building and equipment from a bankrupt firm, paying $330,000. In order to determine the values of the assets, the company hired an appraiser, and paid her $6,000. The appraised values were as follows:

Building $175,000 Land 75,000 Equipment 150,000

The purchase was recorded as follows:

Miscellaneous expense 6,000 Building 175,000 Land 75,000 Equipment 150,000

Cash 336,000 Gain 70,000

Stacy has not recorded depreciation expense on the assets acquired through either transaction.

Other transactions: At the beginning of 2018, The Company had 539,000 shares of common stock outstanding. An additional 38,500 shares were issued on January 1, 2018.

Required

1. Review the preliminary financial statements and supporting data for Empire Tech. Prepare the journal

entries and update the preliminary statements (round all percentages two decimal places). 2. Submit the completed financial statements, including comparative Balance Sheets for 2017 and 2018; an

Income Statement for 2018; and a Statement of Cash Flows for 2018. Include journal entries used in adjusting the preliminary statements, and provide all schedules used in calculations. Prepare the appropriate disclosures and footnotes based upon information provided in the case. In some instances you will not have enough information to provide full disclosure.

Summary of Selected Accounting Policies Judgments and Estimates—significant judgments and estimates are made in the preparation of the financial statements. These judgments and estimates include those related to asset valuation, accrued expenses, expected interest rates, and employee service lives, among others. Some of the more critical judgments and estimates are discussed in the following accounting policies. Investments—Passive investments are classified upon acquisition as held-to-maturity, FV-OCI, or FV-NI. The Company makes fair value adjustments as required and reviews initial classifications based on available information.

Property, Plant, and Equipment—Property, plant, and equipment are stated at cost and are depreciated over their estimated useful lives of 5 years for vehicles, 10 years for equipment, and 30 years for buildings, using the straight-line method of depreciation, with zero residual value. Capital leases are amortized using the straight-line method.

Impairments—The Company reviews its noncurrent assets and goodwill and performs annual impairment tests. No impairment losses were identified for 2018.

Taxes—Deferred taxes are provided for temporary differences between financial and tax reporting. The Company has accumulated substantial net operating loss carry-forwards in previous years and utilized the maximum net operating loss carry-forwards in the current year as allowed by law. The Company also records a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. Should the Company determine that it would (not) be able to realize more (less) of the deferred tax assets in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination is made.

Exhibit 1: Preliminary Financial Statements

Empire Tech, Inc. Comparative Balance Sheets at December 31, 2018 and 2017 12/31/2018 12/31/2017 Assets Cash $72,000 $114,000 Accounts receivable $22,642 $35,073 Prepaid expenses $13,000 $11,000 Deferred tax asset $65,700 $65,700 Investments $65,000 $65,000 Land $200,000 $125,000 Equipment $250,000 $100,000 less accumulated

depreciation ($30,000) ($20,000)

Vehicles $37,000 $55,000 less accumulated

depreciation $0 ($10,000)

Buildings $535,000 $360,000 less accumulated

depreciation ($132,000) ($120,000)

Construction in progress $6,265,000 $2,545,000 Patents $50,000 $55,000 $7,413,342 $3,380,773 Total Assets Liabilities Accounts payable $83,469 $75,000 Salaries payable $18,000 $11,000 Noncurrent deferred tax

liability $56,100 $56,100

Accrued pension liability $10,000 $10,000 Note payable-long term, 6

yr, 10% $600,000 $600,000

Mortgage payable, 6% $3,200,000 $0 10 year, 11% bonds

payable $3,000,000 $3,000,000

Discount of bonds ($123,358) ($136,927) Construction loan, 12% $1,200,000 $1,200,000 Total Liabilities $8,044,211 $4,815,173 Shareholder's Equity Common stock, no par $1,734,000 $1,348,900 OCI-Prior service cost ($30,000) ($30,000) Retained earnings ($2,334,869) ($2,753,300) Total Liabilities and Shareholder's equity $7,413,342 $3,380,773

Empire Tech, Inc. Income Statement for the year ended December 31,

2018

Service revenue $2,087,000 Investment revenue 11,000 Gain 70,000 Total Revenues $2,168,000 Salaries expense $475,000 Operating expense 203,000 Depreciation expense 24,000 Research and Dev. expense 82,000 Pension expense 200,000 Patent amortization 5,000 Lease expense 75,000 Interest expense 679,569 Miscellaneous expense 6,000 Total Expenses $1,749,569 Income before tax $418,431

Exhibit 3 Deferred Tax information

(in thousands) At December 31, 2017 item book value

tax book value

gaap difference rate def tax classification

Loss Carry Forward 230,000 30% 69,000 CDTA Fixed assets 243,000 365,000 (122,000) 30% (36,600) NCDTL CIP-int cap 2,500,000 2,545,000 (45,000) 30% (13,500) NCDTL Pension 0 20,000 (20,000) 30% (6,000) NCDTL Prepaid expenses 0 11,000 (11,000) 30% (3,300) CDTL Totals CDTA 65,700 NCDTL (56,100) 2018 amounts: Book value of Fixed assets for tax purpose

$470,000

Tax rate in future periods 30%

Exhibit 2 Pension information

Balances, January 1, 2018 Memo information

Pension Benefit Obligation $840,000 Fair value of plan assets $830,000

Balances, January 1, 2018 Balance sheet information

Accrued pension liability

$10,000

Other comprehensive Income-Prior Service Cost $30,000

Pension expense information For the year ended December 31, 2018

Service cost

$160,000

Interest rate 6% Expected return on plan assets 6.2% Actual return on plan assets 5.5% Average remaining service life 10 years Contributions $200,000