Question

Soon after beginning the year-end audit work on March 10 at Cullumber Company, the auditor has the following conversation with the controller. CONTROLLER: The year ended March 31 should be our most profitable in history and, as a consequence, the board of directors has just awarded the officers generous bonuses. AUDITOR: I thought profits were down this year in the industry, according to your latest interim report. CONTROLLER: Well, they were down, but 10 days ago we closed a deal that will give us a substantial increase for the year. AUDITOR: Oh, what was it? CONTROLLER: Well, you remember a few years ago our former president bought stock in Henderson Enterprises because he had those grandiose ideas about becoming a conglomerate. For 6 years we have not been able to sell this stock, which cost us $3,190,000 and has not paid a nickel in dividends. Thursday we sold this stock to Bimini Inc. for $4,240,000. So, we will have a gain of $735,000 ($1,050,000 pretax) which will increase our net income for the year to $4,100,000, compared with last year’s $3,930,000. As far as I know, we’ll 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! AUDITOR: Do you expect to receive the $4,100,000 in cash by March 31, your fiscal year-end? CONTROLLER: No. Although Bimini Inc. is an excellent company, they are a little tight for cash because of their rapid growth. Consequently, they are going to give us a $4,240,000 zero-interest-bearing note with payments of $424,000 per year for the next 10 years. The first payment is due on March 31 of next year. AUDITOR: Why is the note zero-interest-bearing? CONTROLLER: 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 Henderson Enterprises stock. Do you agree with the way the controller has accounted for the transaction? If not, how should the transaction be accounted for? (If you agree with the way the controller has accounted for the transaction, select "No Entry" for the account titles and enter 0 for the amounts. Credit account titles are automatically indented when the amount is entered. Do not indent manually.)

Answer 1

The above Question mainly relates to ( Accounting for Zero Interest Bearing Note)

Couple of important sentence involved in this Question :

1. Controller said “he year 31^st March should be most profitable year “ – this is not correct report , We noticed that in the current year Company has done one ( ONE OFF) nature of Income from sale of “ Sale of Stock and expected gain post tax $ 735000 ( as mentioned in the Question)

The above transaction income is One Off in nature and Controller should exclude the same while doing past trend analysis of Profit .

After exclude the above amount , please see below analysis :

31st march Profit ($) Post Tax	ONE OFF adjustment($)-Post Tax	31st march Profit ( Derived)($) –Post Tax	LY Profit ($) –Post tax	Variance ($)
41,00,000	7,35,000	33,65,000	39,30,000	-5,65,000	Reduction in Profit

There fore I am not agree with Controller Explanation .

2. Other challenges – Cash flow Challenge . Bimni Company presently having tight cash flow . Instead of releasing cash , company is giving Zero Interest Note amount to $ 4,240,000. Company needs to pay $424000 in coming 10 Years.

Instead of Cash collection , another Liability will park in Cullumber Company book and they have to show into this as on 31^st March . Only good part there is no Interest amount included other wise it will create more problem at bottom line

Present Status to derive gain from this transaction :

	Amnt-$
Sale Value	42,40,000
Cost	31,90,000
Gain on sale -Pre Tax	10,50,000
Gain on sale - Post Tax	7,35,000
Tax rate	70%

With help of NPV ( Derived present value of future cash flow ) * discount factor . In the Question , discount factor amount not yet mentioned , on assumption , we considered general 6% as discount factor ( purely on assumption basis –market growth rate On Avg basis)

Company will going to pay $ 424000 in period of 10 years . We need to derived present value of 10 years period

Formula of PV - Cash flow /(1+r)t

Cash Flow - represents net cash inflow and outflow . r- Discount factor ( in this example 6%) T - time ( period - Year 1 ,2 etc .

PV = Cash flow * (1/1+r)^1, Year 2 discount factor = 1/(Year 1 discount factor )

	Payment ($)	Discount Factor	PV($)
year1	4,24,000	0.943	4,00,000
year2	4,24,000	0.890	3,77,358
year3	4,24,000	0.840	3,55,999
year4	4,24,000	0.792	3,35,848
year5	4,24,000	0.747	3,16,837
year6	4,24,000	0.705	2,98,903
year7	4,24,000	0.665	2,81,984
year8	4,24,000	0.627	2,66,023
year9	4,24,000	0.592	2,50,965
year10	4,24,000	0.558	2,36,759
Sum	42,40,000		31,20,677

On the basis of above analysis , we noticed that present value of $42,40,000 would be $ 31.20,677

Let put the above number as below

	Amnt-$
Sale Value	31,20,677
Cost	31,90,000
Gain on sale -Pre Tax	-69,323

( net basis Company is losing money) . Auditor needs to highlight this matter and update in their Audit report ,