Question

Mr. Bestall, CFO of the Best Finance Inc., was satisfied with its income statement report. He decided to have a meeting with the analysts following the Best Finance Inc. before filing its financial statements with the SEC. The following conversation was in the meeting. CFO: The year ended on September 30 should be our most profitable in history and as a consequence, the board of directors has just awarded the officers generous bonuses. Analysts: I thought profits were down this year in the industry, mainly because of the pandemic COVID 19. Your latest interim report showed losses too. CFO: Well, they were down, but ten days before closing the accounting period we closed a deal that will give us a substantial increase for the year. Analysts: Oh, what was it? CFO: Well, you remember a few years ago our former president bought stock in Jubilee Enterprises because he had an inorganic growth plan. For six years, we have not been able to sell this stock, which cost us $3,000,000 and has not paid any dividends at all. We sold this stock to Rich & Rich Inc. for $4,000,000. So we had a gain of $700,000 ($1,000,000 before tax) which increased our net income for the year to $4,000,000. Last year's net income was $3,700,000. As far as I know, we will be the only company in the industry to register an increase in net income this year. That should help the market value of the stock! Analysts: When do you expect to receive the $4,000,000 in cash? CFO: They give us a $4,000,000 zero-interest bearing note with payments of $400,000 per year for the next ten years. The first payment is due on September 30 next year. Rich & Rich Inc. is an excellent company. They are a little tight for cash because of their rapid growth. Analysts: Why is the note zero-interest bearing? CFO: Because that's what everybody agreed to. Since we don't have any interest-bearing debt, the funds invested in the note do not cost us anything and besides, we were not getting any dividends on the Jubilee Enterprises stock.

Do you agree with the way the CFO has accounted for the transaction?

Explain your reasoning.

Answer 1

Calculation of Net income of stock:

Particulars    Amount ($)

Sale Price 4,000,000

(-) Cost   (3,000,000)

Profit 1,000,000

(-) Tax (300,000)

Net Profit 700,000

The company is getting a profit of $ 1,000,000 but is not realising it in cash. The company receives zero-interest bearing note for $ 4,000,000 for which the company receives $ 400,000 per year for the next ten years.

Even the consideration of CFO that the company earned income more than the previous year is not fair since the company is not realising the proceeds immediately.

Even there is a little tight for cash in the company the move of CFO will leave the same tight position for cash if they accept the zero-interest bearing note.

If the company accepts interest bearing note if any, it will receive cash at respective intervals and the little tight for cost will get reduce to some extent.

Considering the time value of money and tight cash position of the company I will not agree the move taken by CFO. The company should consider possible alternatives and considering the time value of money it should realise the same in cash since there is little tight for cash for the company.