Question

FIN 610 - Practice Questions - Week 1

You have recently been hired by the Treasury department of the firm QLogic. The Controller of QLogic showed you the most recent draft financial statements (Balance Sheet, Income Statement, and Statement of Cash Flows). He admitted that major transactions had not been entered. Your task is to correct the financial statements. Apparently, the following three events were missed when preparing the financial statements:

1) An accident at a plant caused damage to machinery that was not currently in use and which was not repaired. However, the book value of Property, Plant, and Equipment (PP&E) decreased by $7 million as a result.

2) QLogic sold inventory for $5.2 million cash. The inventory had a book value of $3 million.

3) QLogic used Cash of $8 million to pay off a part of its Long Term Debt.

There are no taxes.

Question: The following items may change but other items do not change when you correct the financial statements. You should explain by what amount the following items change or do they remain unchanged?

1) Accounts Payable, Accounts Receivable, PP&E, Assets (sum of the left side of the B/S), Liabilities and Owners' Equity (sum of the right side of the B/S), Retained Earnings, Net Income, and Cash Flows from Operations.

2) PP&E, Cash (item on the left side of the B/S), Inventory, Assets (sum of the left side of the B/S), Liabilities and Owners' Equity (sum of the right side of the B/S), Retained Earnings, Net Income, Cash Flows from Operations, Cash Flows from Investing Activities, and Net Sales.

3) PP&E, Cash (item on the left side of the B/S), Assets (sum of the left side of the B/S), Liabilities and Owners' Equity (sum of the right side of the B/S), Retained Earnings, Long Term Debt, Net Income, Cash Flows from Operations, Cash Flows from Financing Activities, and Net Sales.

Additional information:

Sometimes students ask whether they have to prepare (or even need) the entire financial statements, and the answer is no. You just have to find the changes to the financial statements due to individual transactions.

For example, suppose you have the completed financial statements ready and then a colleague comes and says “There was a transaction I forgot to tell you about. There were ten units of our product in inventory priced at $1,000 that we sold for $1,200 cash. The cost of transporting the product to the customer was $50 (borne by us), but we haven’t paid the transportation company as yet.”

So how would the above change the financial statements.

1) In the left side of the Balance Sheet, you would have Cash increase by $1,200 and Inventory go down by $1,000. So total Assets would increase by $200.

2) The entire transaction created a net profit of $1,200 - $1,000 - $50 = $150. So in the Income Statement you would have Net Income increase by $150. This would imply that in the Balance Sheet you would have an increase of $150 in Retained Earnings.

3) In the Cash Flows statement “Cash Flows from Operations” would increase by $1,200. The net increase in cash would also by $1,200 (as the transportation company hasn’t been paid yet). So in the Balance Sheet you would have an increase of $1,200 in Cash.

4) Come back to the Balance Sheet, on the right side you would have an increase in Retained Earnings of $150. However, as the left side has increased by $200, there must be something else that happens to the right side to restore balance. The last item to change would be Accounts Payable, which would increase by $50 (money owed to transportation company).

As you can see from the above example, you don’t need the entire financial statements to calculate changes due to individual transactions.

Answer 1

1) An accident at a plant caused damage to machinery that was not currently in use and which was not repaired. However, the book value of Property, Plant, and Equipment (PP&E) decreased by $7 million as a result.

Journal Entry
Loss on Damage...................... (Dr) 7 Million .... _{Will reduce Net Income > Retained Earning >Stockholder Equity}
Property, Plant, and Equipment ................ (Cr) 7 Million.... _{Will reduce PPE > Assets}

Accounts Payable - No Effect
Accounts Receivable - No Effect
PP&E - Reduced by 7 Million
Assets - Reduced by 7 Million
Liabilities and Owners' Equity - Reduced by 7 Million
Retained Earnings - Reduced by 7 Million
Net Income - Reduced by 7 Million
Cash Flows from Operations - No Effect

2) QLogic sold inventory for $5.2 million cash. The inventory had a book value of $3 million.

Journal Entry
Cash..........(Dr) 5.2 Million .... _{Will increase Cash > Asset}
Sales .............(Cr)5.2 Million.... _{Will increase Net Income > Retained Earning > Stockholder Equity}

COGS.......... (Dr) 3 Million... _{Will decrease Net Income > Retained Earnings > Stockholder Equity}
Inventory...........(Cr) 3 Million...._{Will decrease Inventory > Asset}

PP&E - No Impact
Cash - Will Increase by 5.2 Million
Inventory - Will Decrease by 3.0 Million
Assets - Will Increase by 5.2 -3.0 = 2.2 Million
Liabilities and Owners' Equity - Will Increase by 5.2 -3.0 = 2.2 Million
Retained Earnings - Will Increase by 5.2 -3.0 = 2.2 Million
Net Income - Will Increase by 5.2 -3.0 = 2.2 Million
Cash Flows from Operations - Will Increase by 5.2 Million
Cash Flows from Investing Activities - No Impact
Net Sales - Will Increase by 5.2 Million

3) QLogic used Cash of $8 million to pay off a part of its Long Term Debt.

Journal Entry
Long Term Debt...... (Dr) 8 Million ... _{Will Decrease Long Term Debt > Liabilities}
Cash...........................(Cr) 8 Million .... _{Will Decrease Cash > Asset}

PP&E - No Impact
Cash - Will Reduce by 8 Million
Assets - Will Reduce by 8 Million
Liabilities and Owners' Equity - Will Reduce by 8 Million
Retained Earnings - No Impact
Long Term Debt - Will Reduce by 8 Million
Net Income - No Impact
Cash Flows from Operations - No Impact
Cash Flows from Financing Activities - Will Reduce by 8 Million
Net Sales - No Impact