Paper details Please answer questions (with explanation) BANK OF BUSINESS SOLUTIONS “Congratulations are in order! You remember that I told you last year that we would be submitting your opinion about MicroDex’ financial statements to a bank to get some financing to our planned addition of a production facility. Don’t you? Well, the Bank of Business Solutions just notified me that the loan committee approved our three million-dollar loan after analyzing this year’s audited financial statements. The committee was really impressed that while everyone else in our industry operated at a loss or just broke even, we showed a substantial profit this period,” crowed Kevin Clark, CFO of MicroDex, in a telephone call to Daniel Riley, an auditing manager at Peter Nelson, LLP. Daniel headed the audit team that issued an unqualified opinion on MicroDex’ financial statements for each of the last four years. “That’s great!” Daniel responded. “The loan means that you’ll be able to complete that new circuit board production facility that you told me about, doesn’t it? That circuit board is the product your budget shows is going to increase sales revenue and cash flow next year. It’s a good thing you were able to generate a profit and get the loan. Without the new product, things looked pretty bleak.” MicroDex designs and manufacturers circuit boards for low-tech applications, such as those used in major household appliances. Sales in the appliance circuit board industry had declined or been flat in the past 18 months because of people’s reluctance to buy new appliances in a poor economy. MicroDex’s new circuit board was for washers and dryers that compete with Maytag’s Neptune series. MicroDex’s customer (a major competitor of Maytag) was launching a new washer/dryer with characteristics similar to the Neptune series, but they expected the price to be about 25% below that charged by Maytag. MicroDex had developed a circuit board to meet the engineering specifications of the new product, but could only land the business if they had new production facilities. Sylvia Lopez, an auditing staff member assigned to one of Daniel’s jobs, overheard the conversation between Daniel and Kevin on the speakerphone while sitting in Daniel’s office. “Daniel, I didn’t know that the company operated at a profit this year!” exclaimed Sylvia. “During my field work, I analyzed the monthly income statements through November, and they showed that the company operated at a loss almost every month! How did they report a substantial profit at year end?” Daniel replied, “Several years ago they made an investment in the stock of a closely held company that they thought might be a good strategic alliance. Unfortunately, that opportunity didn’t work out. Until December 2004, MicroDex had been holding the investment and hadn’t been receiving any dividends. The CFO of MicroDex actively searched for a company to buy the stock, and in December 2004, located a strategic buyer who took it off their hands at a substantial gain!” Daniel continued. “ Since MicroDex frequently buys and sells stock investments, the gain is a part of their income from continuing operations.” “Oh, that’s clever!” Sylvia responded. “But if it were such a large transaction, why didn’t they just use the cash flow from the stock sale to finance the new manufacturing facility?” “Well,” Daniel explained, “the company that MicroDex sold the stock to, Greenco, is having their own cash flow problems right now. They couldn’t afford to give MicroDex cash, so MicroDex accepted a non-interest bearing note due in 5 years. Although MicroDex won’t see the cash for five years, since the title to the stock has passed to the new owners, it can record the gain on the sale.” Sylvia pondered this information for a few minutes, and then queried, “Why a non-interest bearing note? Most companies with a credit rating like Greenco are paying about 15% on loans for transactions like this one.” Copyright Dr. Rafi Efrat and Dr. Janice Bell, 2009 “MicroDex didn’t have any loans against the investment, so they aren’t incurring any interest cost on the stock or the new note. They figured that there isn’t any need to hurt Greenco’s cash flow when MicroDex doesn’t have any interest cost on the investment,” Daniel responded.
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