Question

The following information was reported by GAP Inc. in its 2005 annual report: 2001 7387 (153) 2005 Total Assets $10048 Working Capital 2004 10713 4156 2003 10283 2972 2002 8096 1018 4062 Note: An within bracket indicates a negative figure. Instructions 1. By what percentage did total assets increase from 2001 to 2005? What was the average increase for each year? 3. Comment on the change in the Gap's liquidity position. 4. What could be the possible reasons for the change in Gap's liquidity position? 5. Would you be concerned about the liquidity position of the company? Why? 6. What additional information do you need to evaluate Gap's liquidity position more accurately 7. Recommend some actions to Gap to ensure better liquidity position. In the wake of financial scandals that are still making an impression, the Canadian Securities Administration introduced requirements in 2005 for management to evaluate the reliability of a company's accounting system and controls. This includes a review of year-end procedures, including the procedures that are used to record adjustment entries 8. Explain with examples how an adjustment entry be used to overstate net income figure PL

Answer 1

(1): % of increase of assets from 2001 to 2005 = (10048-7387)/7387*100 = 36.02%

Average increase for each year = CAGR = (10048/7387)^(1/4) – 1 = 7.99%

(3): Gap’s liquidity position can be gauged from its working capital. Working capital = current assets – current liabilities. We can see that the company’s working capital has been increasing every year and this indicates that the company’s current assets are increasing much faster than its current liabilities. This indicates an increasing liquidity position for the company and higher current assets means that the company can easily pay of its current liabilities.

(4): The possible reasons for change in Gap’s liquidity position can be either increase in the company’s current assets on a year-on-year basis or a decline in the company’s current liabilities on a year-on-year basis. Both of these reasons will lead to current assets to outgrow the current liabilities and hence improve its liquidity position.

(5): No, I will not be concerned with the liquidity position of the company as the working capital has been increasing every year. It was negative in the year 2001 and this meant that its current liabilities were more than its current assets. This was a cause of concern. However with passing years the level of working capital has only increased, indicating a healthy liquidity position.

(6): To evaluate the company’s liquidity position more accurately we will need information with regards to amounts of current assets and current liabilities. This will enable the computation of current ratio and quick ratio for Gap.

(7): To ensure better liquidity position Gap can look at maintain a healthy current ratio and ensuring that its current assets and current liabilities stand at optimal levels. In no year it should allow its current liabilities to exceed its current assets, rather it should strive to ensure that its current assets are twice the level of its current liabilities.

(8): Adjusting entries are made to convert a company’s record to accrual basis of accounting. Take the example of a case in which a company received rent on December 1, 2018 for 3 months. The monthly rent is $1000 and the company received $3000 on December 1, 2018. The amount of 3000-1000 = $2,000 pertains to the months of January and February of 2019 and hence an adjustment entry should be made to record $1000 as rent revenue and $2000 as rent earned in advance. If no adjusting entry is made then the entire $3000 will be recorded as 2018’s rent revenue and this will increase the company’s net income for 2018.