Question

Lancaster Electronics produces electronic components for sale to manufacturers of radios, television sets, and phonographic systems. In connection with his examination of Lancaster’s nan- cial statements for the year ended December 31, 2017, Don Olds, CPA, completed fieldwork two weeks ago. Mr. Olds is now evaluating the signi cance of the following items before preparing his auditor’s report. Except as noted, none of these items has been disclosed in the financial statements or footnotes.

1-Recently, Lancaster interrupted its policy of paying cash dividends quarterly to its stockholders. Dividends were paid regularly through 2015, discontinued for all of 2016 to nance equipment for the company’s new plant, and resumed in the rst quarter of 2017. In the annual report, dividend policy is to be discussed in the president’s letter to stockholders.

2-A 10?year loan agreement, which the company entered into three years ago, provides that dividend payments may not exceed net income earned after taxes subsequent to the date of the agreement. The balance of retained earnings at the date of the loan agreement was $298,000. From that date through

December 31, 2017, net income after taxes has totaled $360,000, and cash dividends have totaled $130,000. Based on these data, the staff auditor assigned to this review concluded that there was no retained earnings restriction at December 31, 2017.

3-The company’s new manufacturing plant building, which cost $600,000 and has an estimated life of 25 years, is leased from the Sixth National Bank at an annual rental of $100,000. The company is obligated to pay property taxes, insurance, and maintenance. At the conclusion of its 10?year noncancelable lease, the company has the option of purchasing the property for $1. In Lancaster’s income statement, the rental payment is reported on a separate line.

4-A major electronics arm has introduced a line of products that will compete directly with Lancaster’s primary line, which is now being produced in the specially designed new plant. Because of manufacturing innovations, a competi- tor’s line will be of comparable quality but priced 50 percent below Lancaster’s line. The competitor announced its new line during the week following completion of fieldwork.

Mr. Olds read the announcement in the newspaper and discussed the situation by telephone with Lancaster executives. Lancaster will meet the lower prices with prices that are high enough to cover variable manufacturing and selling expenses but will permit recovery of only a portion of fixed costs.

Required:

For each of the preceding items, discuss any additional disclosures in the fnancial statements and footnotes that the auditor should recommend to his client. (The cumulative effect of the four items should not be considered.)

Answer 1

ITEM-1

a. Unless cumulative preferred dividends are involved, no recommendations by the CPA are required. Common stock dividend policy is understood by readers of financial statements to be discretionary on the part of the board of directors. Here Company need not commit for prospective common stock dividend policy or explain its historical policy in the financial statements, particularly since dividend policy is to be discussed in the president’s letter. If cumulative preferred dividends are omitted, this should he disclosed in the financial statements or a footnote.

b. If Lancaster does not disclose this event as the auditor recommends, the financial statements are misleading. Mr. Olds should take exception to the adequacy of disclosure and depending upon the degree of materiality, he may express an adverse opinion. A Subject to” opinion or disclaimer of opinion (neither of which is proper under the given assumption) might be justified if the development was adequately disclosed and the economic effects could not be determined.

The occurrence of this event after the completion of field work does not affect the need for disclosure. The auditor generally is responsible for inquiry as to subsequent events only to the end of field work and dates his report accordingly, but he has the responsibility to evaluate subsequent information if it comes to his attention. statements unless an omission of cumulative preferred dividends is not properly disclosed.

ITEM-2

a. The staff auditor reviewing the loan agreement misinterpreted its requirement. Retained earnings are restricted in the amount of $298,000, which was the balance of retained earnings at the date of the agreement. The nature and amount of the restriction should be disclosed in the balance sheet or in a footnote to the financial statements.

b. Assuming Lancaster does not make the recommended disclosure, the nature of an amount of the restriction should be disclosed in the auditor’s report, and the opinion should be appropriately qualified.

ITEM-3

a. The lease agreement with the Sixth National Bank meets the criteria for an installment purchase of property: (1) it is noncancellable; (2) the company may purchase the property at the expiration date at a nominal price, substantially less than probable fair value: property taxes, insurance and maintenance.

Accordingly, Mr. Olds should recommend that the property and the related obligation be stated in the balance sheet at the appropriate discounted amount of future payments under the lease agreement. The income statement should include annual financing charges applicable to the unpaid obligation and amortization of the cost of the property based upon its useful life. Additional footnote disclosure may be required.

b. If Lancaster does not capitalize the installment purchase as recommended, Mr. Olds should explain the circumstances in his report and qualify his opinion as to conformity with generally accepted accounting principles (or express an adverse opinion, if the amounts involved are so material that in his judgment a qualified opinion is not justified).

ITEM-4

a. A competitive development of this nature normally is considered to be the second type of subsequent event, one that provides evidence with respect to a condition which did not exist on date of balance sheet, but in some of the circumstances auditor might conclude that Lancaster’s poor competitive situation was evident at year-end. In any event, this development should be disclosed to users of the financial statements because the economic recoverability of the new plant is in doubt and Lancaster may incur substantial expenditures to modify its facilities.Because the economic effects probably cannot be determined, the usual disclosure will be in a footnote to the financial statements. If the present recoverable value of the plant can be determined, Lancaster should consider disclosure of the Company’s revised financial position in a pro forma balance sheet, assuming that this event is concluded to be evidence of a condition that did not exist at year-end. (Only if circumstances were such that it was concluded that this condition did exist at year-end should financial statements for the year ended December 31, 2011 be adjusted for the ascertainable economic effects of this.Because the economic effects probably cannot be determined, the usual disclosure will be in a footnote to the financial statements. If the present recoverable value of the plant can be determined, Lancaster should consider disclosure of the Company’s revised financial position in a pro forma balance sheet, assuming that this event is concluded to be evidence of a condition that did not exist at year-end. (Only if circumstances were such that it was concluded that this condition did exist at year-end should financial statements for the year ended December 31, 2011 be adjusted for the ascertainable economic effects of this.