Intermediate Accounting II
Running head: Milestone II Management Brief
It is always good to see a business experience growth each year, and even more exiting when the business makes a decision to expand due to the continued success of the initial location. Therefore, in this analysis brief we will be discussing the both the pro forma balance sheet and income statement, as well any implications that of current liabilities, revenue recognition, and inventory costing. Additionally, it will be discussed if there were any potential issues that was found in preparing the financial statements that could impact the expansion of business by the addition of a second location. We are going to primarily focus on the financial statements that were generated from Peyton Approved during the 2015 – 2018 time period.
The first item to be discussed is the creation of the pro forma statements themselves. Using these financial statements, it can be analyzed to make the final decision about expanding the current business to a second location, when a business is considering making this expansion, there are several other expenses that need to be taken into consideration in addition to the current expenses for the current location. Additional expenses such as additional inventory, cost of acquiring new employees, purchase and maintenance of new equipment, and the cost of leasing the additional space for the second location. The use of pro forma balance sheet statements is not regulated or made by by the GAAP (Generally Accepted Accounting Principles), as they are only a tool to help predict the potential possibility of what could happen based on the current financial data, therefore, it is also critical that the information given about the pro forma balance sheet is a not a financial fact, only projections when showing this to potential investors of the organization. The pro forma income statement shows a positive project for the additional location, however that income is still projected to be 42.2% lower than the net income that it is receiving at the location it currently occupies. However, in the bigger picture, it is my recommendation to continue with the expansion, as they still be operating with making a profit at the additional location, and the overall bottom line of the organization would still be increased by the expansion.
However, there are also some issues that do need to be discussed which include inventory costing, contingent liabilities, and revenue recognition. The first issue that we will address is the use of the LIFO (last in, first out) system that is currently in place. While, this inventory system considers the most recently made products to be the first products that are sold, it does create a lot of waste. Changing the system over to a FIFO (first in, first out) would create less waste and also generate higher revenue due to the decreased waste and decreased inventory cost (Kenton, 2018). Additionally, it does need to be kept in mind that the when you change the system of how inventory is managed, then the amount of inventory dollars is going to change on the statements as well.
Kenton (2018) defines contingent liability as “potential liability that may occur depending on the outcome of an uncertain event.” One way to think about this would be consider what would happen if the organization was in a lawsuit or produced products that the organization had decided would come with a warranty, which from a financial statement point of view should be recorded on a balance sheet. An example would be the organization got hit with legal fees in the amount of one million dollars, which the accountant would then record as a debit of one million dollars and would place a one-million-dollar credit in accrued expense. These are contingent because there is no way to predict if the organization is going to have them, however, it is a good idea to have an estimated amount and make sure that amount is included on the financial statements of the organization.
The third issue that needs to be addressed is revenue recognition. CFI Education, Inc (2019) “revenue recognition is an accounting principal that outlines the specific conditions under which revenue is recognized.” Additionally, it is stated CFI Education, Inc (2019) “there are five principals that are used for recognizing revenue; identification of client contact, identification of obligations in client contract, determination of the price of transaction, allocate the transaction price according to the performance obligations in the client contract, and recognize the revenue when the performance obligations are met. These five principals are established by the FASB (Financial Accounting Standard Board) which also sets the standards for the United States General Accepted Accounting Principles.” Being able to predict revenue recognition is not a task that can be done easily, therefore the best way to handle these projections is to use the prior’s year’s financial statements.
Regarding the pro forma statements, when those statements are being prepared to be presented to stockholders, management, and investors, it is best to make sure that they are being prepared the same way each time in order to ensure that the information being presented in those reports is accurate. Due to the fact, that different organizations use different ways to have these documents prepared, it could be helpful if a brief description of how the financial document was prepared was made available to the person who is reading the document and analyzing the data that is contained in the report. Additionally, the other expenses like depreciation, interest and taxes, one-time expenses, amortization, losses from affiliates, and restructuring cost are all items that are typically not seem on these pro forma statements. Simply due to these items not being considered to being a true expense of the organization, that is why that are not being listed as an expense of the organization, nor can they be considered to show earning potential of the organization.
Based on the given information and looking at both the pro forma income statement and balance sheet, expanding to the second location would be a good idea for Peyton Approved. Although, based on the information, there will be a decrease in the net income for the first year of the organization being in the new location, it will ultimately bring in additionally revenue and increase the bottom-line profit of the organization. Therefore, based on the bigger picture and looking at the financial health of the organization overall, yes this would be a good move for the organization, and would recommend the expansion.
CFI Education Inc. (2019). Revenue Recognition – Principles, Criteria for Recognizing Revenues. Retrieved April 1, 2022, from https://corporatefinanceinstitute.com/resources/knowledge/accounting/revenue-recognition/
Kenton, W. (2018, December 13). Contingent Liability. Retrieved April 1, 2022, from https://www.investopedia.com/terms/c/contingentliability.asp
Kenton, W. (2018, December 13). Last In, First Out – LIFO. Retrieved April 1, 2022, from https://www.investopedia.com/terms/l/lifo.asp