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Frosty Co. is a publicly traded, medium-sized manufacturing firm thatproduces refrigerators, freezers, ice makers, and snow cone machines. During thepast three years, the company has struggled against increasing competition,sluggish sales, and a public relations scandal surrounding the departure of theformer Chief Executive Officer (CEO) and Chief Financial Officer (CFO). The newCEO, Jane Mileton, and CFO, Doug Steindart, have worked hard to improve thecompany’s image and financial position. After several difficult years, the companynow seems to be resolving its difficulties, and the management team is consideringnew investment opportunities. The team hopes that diversification into a line ofprofessional ice cream makers, and perhaps a line of consumer products, will helpthe company continue its recent growth and effectively compete with futurecompetitors.In order to raise the funds needed for these new investments, Frosty Co.’sBoard of Directors has approved a seasoned equity offering (SEO). The discussionsregarding the new investment opportunities and the equity offering have been keptquiet until a positive set of financial statements can provide strong evidence that thecompany has turned around, leading to an increase in the company’s stock price.INTRODUCTIONAfter a full week of carefully examining financial statements, Simon wasexhausted. He had become Frosty Co.’s corporate controller only a month ago, afterseveral years as an auditor at a public accounting firm, and was excited about themove to corporate accounting. The first few weeks had gone well, as Simon met hisaccounting staff and settled into his new responsibilities. Then, he had startedreviewing Frosty Co.’s financial statements for the prior year to make sure theycorrectly followed GAAP, and to familiarize himself more with the company andindustry. Unfortunately, his relative inexperience with the industry and Frosty’saccounting procedures had required him to spend more time on the review than hehad anticipated.He still had a few questions about the financial statements, but he needed tostart preparing for the upcoming SEO. He decided that he would talk to his staffabout his lingering questions tomorrow morning, just before his meeting with theCEO and CFO. The three of them were to discuss the upcoming audit and the 2© J. Porter and AAAearnings announcement and how they would impact the proposed SEO. He rubbedhis tired eyes and headed home to get a little sleep.MEETING OF THE ACCOUNTING STAFF: 10:30AMSimon looked up as the divisional controllers, Elsa Pilebody and JohnMortenson, came into his office. Elsa worked with Frosty Co.’s fridge and freezerdivision; John worked with the ice maker and snow cone machine division. So far,Simon had enjoyed working with them, especially since neither of them seemed toresent him stepping in as their new boss. They were both smiling as they camethrough the door, and their good-natured teasing started almost before they hadfinished shaking hands.‘‘Sorry we’re a little late,’’ Elsa started, ‘‘but John had to stop for the lastjelly donut.’’ ‘‘I did not!’’ John said indignantly. He looked at Simon. ‘‘It waschocolate.’’Because of his busy schedule that day, Simon got down to business insteadof joining the banter as he normally would have done. ‘‘Thanks for coming by, Elsaand John. We have several issues to discuss before I have to meet with Jane andDoug this afternoon.’’ He paused for a second. ‘‘I’ve spent the past week going overthe financial statements. Overall, they look well done, but I need clarification on afew details. To start with, I want to discuss the construction project we began lastyear.’’‘‘That’s our big project at the moment. We’re building a new factory thatshould be done next summer,’’ Elsa said. ‘‘Construction is going well, and we’vebeen careful to capitalize all of the expenditures.’’Simon shook his head. ‘‘That’s the problem. I think we capitalized morethan we should have. More specifically, it looks like we capitalized all of theinterest on our most recent bank loan.’’‘‘We did,’’ Elsa replied. ‘‘Since we’re using all of the loan proceeds to buildthe new factory, we felt it was appropriate to capitalize all of the interest.’’ Johnnodded in agreement.‘‘I disagree,’’ said Simon. ‘‘Here’s a breakdown of the payments we madeon our new building and a list of our outstanding long-term debt (see Table 1). Didwe take out any of these loans specifically for the new factory?’’Elsa shook her head. ‘‘No, we took out the new loan, Loan 2, for generalexpansion, then decided the most appropriate use of the funds would be for the newfactory.’’Simon frowned. ‘‘Why are we capitalizing the interest on Loan 2 if itwasn’t originated specifically for the new factory?’’‘‘Well, if the capital from the loan is eventually used on a specificconstruction project, then I think we should be able to capitalize the interest on thatloan as part of the historical cost of the project. Of course,’’ Elsa frowned, ‘‘maybewe are capitalizing too much. Perhaps we need to calculate avoidable interest todetermine the amount of interest that should be capitalized.’’‘‘You are right that generally we would need to calculate avoidable interestbefore capitalizing any interest,’’ Simon answered. ‘‘But in this case, we don’t needto do that. I believe GAAP allows interest to be capitalized only if a specificconstruction loan is used.’’‘‘Well, I still think that we should be able to capitalize at least some of theinterest. But I’ll do some research to make sure.’’‘‘You said that you had questions about other things, too?’’ John asked.‘‘Yes,’’ Simon said. ‘‘I am curious about one other issue. This year, weintroduced a new line of industrial snow cone machines.’’‘‘Yes, we did,’’ John replied quickly. ‘‘And we were very careful with all ofthe sales and expense transactions.’’‘‘Yes, you were, but didn’t the new model replace an older version?’’‘‘Yes,’’ John replied, and then frowned. ‘‘The first model was replacedbecause of some slight design problems. It worked well, but the customers didn’t like the way it looked or sounded. We shouldn’t have any liability issues because ofthose old machines.’’‘‘I’m not worried about warranty or liability issues. I believe those havebeen properly recorded. However, we still have some of those original units ininventory, right?’’‘‘Only a few dozen, I believe. Is that a problem?’’‘‘It is since we still have those units recorded at their original historicalcost. Now that we have a new model, the value of those old machines has probablydropped significantly.’’Elsa nodded. ‘‘That’s a good point. Who would buy the old version nowthat a newer version is available? We probably need to write down that inventory.’’John sighed. ‘‘Okay, but to do the calculations, I’ll need some data aboutcurrent sales price, replacement values, and disposal costs.’’Simon handed John a table (see Table 2). ‘‘I called the production and salesdepartments this morning and got everything you need.’’John studied the table for a minute. ‘‘There are two sets of estimates here.’’Simon nodded. ‘‘I’m afraid so. The two managers couldn’t agree on theestimates. The first set comes from Todd, the sales manager. The second set comesfrom Nate, the line manager for the snow cone machine line. My guess is that Natehas a better feel for the production costs involved, but Todd’s estimates of thecurrent sales price are probably more accurate.’’Frowning even more, John said, ‘‘Nate’s estimates will probably require alarger write-down.’’ ‘‘Which will be a harder sell to the management team,’’ Elsasaid. ‘‘They really want to report strong financial statements for the stockoffering.’’‘‘I know, but I don’t think we should base our decision on which estimatesprovide a smaller write-down,’’ Simon cautioned. ‘‘If we are going to write downinventory, then we need to use the most accurate estimates. However, in order todecide which set of estimates to use, I think we will need to see the results fromeach set. I’m sorry, John, but I need you to do the calculations twice.’’ Johnnodded.‘‘Well,’’ Simon said. ‘‘Those were my questions. Do either of you haveany concerns we need to discuss before I meet with Jane and Doug?’’Elsa had a pensive look on her face. ‘‘I think we need to considerrecognizing an asset retirement obligation, or ARO, for the new factory. Our leaseagreement with the city states that we will clean up the land, if necessary, when weclose down the factory. When we originally prepared the financial statements, wedidn’t have enough information to estimate the ARO, so we only disclosed therequirement in the footnotes.’’‘‘I saw that,’’ Simon replied. ‘‘It looked like the note was well done.’’‘‘Thanks. However, last week we received a letter from the city. It seemsthat city officials recently hired an engineer with quite a bit of experience cleaningup after factories like ours. She believes there is a 70–75 percent chance that wewill have to clean up the land at the end of our lease, and she sent us a letterincluding her estimate of the future cost. She wanted to make sure that we wereprepared to handle those costs when our lease runs out in 20 years.‘‘When I first got the letter, I decided that since it arrived after the close ofthe fiscal year, we could wait and record it this year. However, if we’re going to goback and change the amount of interest capitalized on the factory, shouldn’t we alsorecord the associated ARO?’’Simon thought for a moment. ‘‘I don’t know. We did receive theinformation before releasing our financial statements, but there’s only a 70–75percent chance that we will actually have an obligation. Do we need to include thatestimate?’’‘‘Do you remember how much it was?’’ John asked.Elsa nodded. ‘‘The city engineer believes it will cost $500,000 just to teardown the factory in 20 years.’’‘‘Well, when you consider our 12 percent internal rate of return, the AROwon’t be too big,’’ John said, smiling.‘‘You’re right.’’ Elsa nodded. ‘‘That part doesn’t sound too bad. However,she also estimates that we will need to spend approximately $250,000 a year for thethree years after removing the plant to restore the land to its original condition.’’‘‘Thanks for bringing that up, Elsa,’’ Simon said. ‘‘Do you have any otherconcerns?’’‘‘Just one,’’ John said, ‘‘and it’s only an idea that you might want to pitch tothe management team along with these other changes. We have used the percent ofaccounts receivable method to calculate our Allowance for Bad Debt for severalyears. But we don’t have to use that method.’’ ‘‘What do you mean?’’ Elsa asked.‘‘Isn’t the percent of accounts receivable method one of the best ways to calculatethe Allowance?’’‘‘Technically, yes, it is. However, we recently hired a new credit managerwho has improved our collections and tightened our credit policy for newcustomers. Because of these improvements, we might not have to use the percent ofaccounts receivable method. Instead, we could switch back to the percent of salesmethod that we used previously. By switching from using 12 percent of accountsreceivable to 2 percent of credit sales, we would reduce our allowance for bad debtsand our bad debt expense. That would offset some of these negative changes wehave just discussed.’’‘‘What were credit sales for the year?’’ Simon asked.‘‘About $1.25 million, and accounts receivable had an ending balance of$600,000 after we wrote off $30,000 of uncollectible accounts. We wrote offalmost $50,000 the year before, so our collections really have improved. Honestly,I don’t think that we’d lose information quality by switching methods. We don’treally have to use any specific method for estimating bad debt expense. I think wecould make a case for the more relaxed estimation method, and I think the positiveeffect of the change on net income might help the management team accept someof these other adjustments.’’Elsa jumped in. ‘‘I don’t see any problem with that.’’Simon frowned. ‘‘I’m not sure I like the idea of changing methods solely tooffset the negative effects of these other adjustments. But go ahead and calculatehow switching methods would affect our bad debt expense. We’ll meet againtomorrow morning, after I’ve talked with Jane and Doug about how to handle theseissues.’’MEETING WITH THE CEO AND CFO: 2:00PMJane, Frosty Co.’s CEO, shook Simon’s hand as she welcomed him into heroffice. Doug, the CFO, was already seated. ‘‘So, how do things look?’’ Jane askedas Simon took his seat.‘‘Well,’’ said Simon, as he handed out copies of the financial statements(see Tables 3–5). ‘‘I think the financial statements will be ready for our audit andour earnings announcement on schedule.’’Jane frowned as she flipped through the statements. ‘‘That’s great, Simon,but how do things look?’’Simon looked confused, so Doug explained. ‘‘I think Jane wants to knowthe final EPS.’’ Doug glanced quickly at the financial statements, then turned toJane and said, ‘‘It looks like EPS will be $2.21. That’s five cents higher than theanalysts’ $2.16 forecast.’’‘‘Well,’’ Simon said slowly.‘‘Perfect!’’ Jane said brightly, ignoring him. ‘‘That’s just what I wanted tohear!’’ ‘‘But . . .’’ Simon tried again.‘‘Right,’’ Doug agreed. ‘‘Let’s go ahead and announce the SEO rightaway.’’‘‘Good idea,’’ Jane said, nodding. ‘‘There’s no reason to wait if we’ve gotgood news.’’‘‘Excuse me,’’ Simon jumped in. ‘‘But that might be a little premature.’’Jane looked at him. ‘‘Why?’’‘‘Well, I do have a couple of issues I need to discuss with you.’’Doug and Jane both frowned. ‘‘What do you mean?’’ Doug asked slowly.Simon sat forward. ‘‘I met with my team this morning, and we think theremay be a few corrections that need to be made to this draft of the financialstatements.’’‘‘I thought you said they were done,’’ Jane snapped.Doug held up his hands. ‘‘Jane, don’t shoot the messenger. It’s Simon’s jobto look through the financial statements for any problems.’’Jane took a deep breath. ‘‘You’re right.’’ She sighed. ‘‘I’m sorry, Simon.What have you found?’’Simon took a deep breath. ‘‘First, we capitalized all of the interest on ournew loan as part of our construction project. According to GAAP, we might be ableto capitalize some of that interest, but certainly not all of it. Second, officials fromthe city where the new factory is being built have provided us with fairly accurateestimates of what we will need to spend to remove the factory and clean up the landwhen our lease expires. Since we haven’t released the financial statements yet, wemay need to record the ARO.’’ Jane grimaced, but Simon pushed on. ‘‘Third, wehaven’t written down any of our obsolete inventory following the introduction ofthe new snow cone machine line, and we know that our customers aren’t going tobuy the earlier model at the original price. We’re still looking into how much thewrite-down will be, but we will need to write down some of it.’’Jane asked quietly, ‘‘Are you finished?’’‘‘Those are the issues we’ve identified. I’m not sure what the net effect ofthe changes will be yet, but I’m afraid that they might drop EPS quite a bit.’’‘‘But . . .’’ Jane said hotly.Doug jumped in. ‘‘Look, Simon, I know you want to correctly account forall of these issues; I do too, but we need a strong set of financials this year. We’recounting on that SEO to fund our new growth strategies. We need the good newsnow, so leave the statements as they are. We’ll fix all of these issues after theoffering, I promise.’’Simon said quietly, ‘‘I think we need to make these adjustments, all ofthem.’’ He looked at Jane’s angry face. ‘‘There is a way to reduce the drop in EPS.We could switch our method of calculating bad debt expense from the percent ofaccounts receivable method to the percent of credit sales method.’’12© J. Porter and AAAJane played with her earring while she thought. ‘‘Would switching methodsoffset the other adjustments?’’Simon shook his head. ‘‘Probably not entirely, but it will help.’’Jane shook her head. ‘‘Simon, just leave the financial statements as theyare.’’Simon started to argue, but Jane cut him off. ‘‘Look, Simon, the decision ismine to make, and I’m telling you: don’t mess with the financial statements. Leavethem as they are!’’‘‘But the statements are wrong as they are!’’‘‘We don’t know that,’’ Doug jumped in quickly. ‘‘All we really know isthat maybe we should do something about these issues. Think about the inventoryadjustment for a minute. Companies leave obsolete inventory on their books all thetime, waiting for a good year to write them down. It doesn’t really bother anyone.And as far as the interest capitalization, if the auditors don’t catch it. . .’’‘‘But our numbers will be wrong!’’Jane sounded exasperated. ‘‘You don’t know that, Simon. There are somany estimates in the financial statements that you can’t ever be sure if thenumbers are right or wrong. Besides, we owe it to our investors to report goodnumbers; that’s how their investments grow. Believe me, they don’t want to see badnumbers. So, if the auditors happen to stumble on these issues.. . .’’ She stopped fora moment, looking at Simon’s face. ‘‘If the auditors stumble on them, send them totalk to Doug or to me. We’ll straighten them out.’’ She smiled. ‘‘Don’t worry aboutthis so much. Just leave things as they are, and we’ll take care of you when bonusescome out. The Board’s going to be thrilled to see these financial statements, andwe’ll be sure to tell them how much you helped us get ready for the SEO. We’realways happy to reward . . . team players.’’ Doug nodded. ‘‘I think that’severything for today. Thank you for all of your hard work.’’Simon stood, picked up his papers, and headed for the door. When they hadhired him, he had been excited for a new opportunity. But now, he was starting towonder if he should have stayed in public accounting.13CASE REQUIREMENTS1. Capitalizing interest on the new factory:a. During the year, Frosty Co. paid all of the interest accrued on Bond A andLoan 1, but only $50,000 of the interest accrued on Loan 2. Using onejournal entry, summarize how Frosty originally recorded the accruedinterest on all three long-term debts.b. Assuming John and Elsa are right that the new loan meets the standardsfor capitalizing interest, calculate avoidable interest.c. What correcting entries would need to be made to properly record intereston Frosty Co.’s construction project if Simon is right?d. What would be the net effect of each of these interest adjustments on netincome? What would be the net effect on EPS?