REQUIREMENT 7
It was a pretty autumn day in late October 20X4. Tom Fasbee had just returned from vacation. He was getting caught up on the many matters that no one else had handled while he was gone. Near the middle of a stack of messages, he found a note from Nick Riley. Nick requested an appointment with Tom and you. Tom arranged a meeting with Nick, Ray, Jerry, and you for 2:00 P.M. the next day at Aguamaint.
Once the meeting began, Nick reminded Tom of a pickleball engagement and then got down to business. First, Nick noted that maintenance work and merchandise sales were going like “gangbusters.” To meet demand, Aguamaint now was running two crews at night and had also begun selling inventory parts separate from the maintenance work.
Tom asked what steps had been taken to expand their customer base. Ray replied that Aguamaint had acquired a 20 percent interest in the small dealership, PVCO, which carried their line of pumps and valves. Ray also had been appointed a member of PVCO’s board. This new investment would give Aguamaint the opportunity to observe and learn the equipment supply business firsthand. If things went well, Aguamaint would later consider acquiring the remaining interest in the dealership.
Ray indicated that Aguamaint had paid more than book value for the stock because PVCO owned an important patent that had been developed internally that was not included in their financial statements. The patent has a remaining life of 4 years. You also learned later from Linda Durkee that the equity method of accounting was not allowed for tax purposes. For tax purposes, such investments were recorded at cost, and the only income reported came from dividends. Linda Durkee also revealed that when equity ownership equals 20 percent or more, the dividends received deduction is 65 percent rather than 50 percent.
Nick then stated that because they had the expertise in-house, the Company had decided to take on the construction of a water treatment plant for a small town nearby. As it happened, a warehouse had come up for sale just a block away from the shop, and although it was larger than what they needed to house the inventory items, the extra space was perfect for setting up the facility needed to support construction projects. The warehouse was purchased on March 15, 20X4. All equipment needed to move and store the inventory and to perform the work related to the construction of the water treatment plant was purchased and put into use on the same date.
The financing for these investments was provided in part by a local investor who had been Nick’s college roommate and was a trusted friend. He has been so impressed by the growth and potential of Aguamaint, that he was eager to negotiate a convertible bond, with the idea of becoming an owner in the future if the company continued on its current path. The bond was set up with the same covenants that the Bank had required on the note, and also required that the annual financial statements would be audited instead of reviewed as in the first three years. The bond was set up to convert to 3,400 shares of common stock any time after two years of the five-year term.
Jerry hoped that Lake & Lock would accept the engagement and that you would conduct the audit. Although the thought of one more time crossed your mind, the engagement was accepted. In parting, you asked Jerry to furnish 20X4 financial statements in early January. Because of the large increase in the pump and valve inventory levels, you also requested that Lake & Lock be involved with the year-end physical inventory. This prompted Jerry to ask whether expanding the line of merchandise and doing construction would put Aguamaint in two or three lines of business and whether this would impact the financial statements.
You observed the physical inventory in late December and found that the construction job was well underway. On January 16, 20X5, Jerry sent you copies of the financial statements and related schedules, and a pre-audit meeting was scheduled for January 19.
REQUIRED:
The journal entries and financial statements prepared by Jerry Loos are attached. Review these data and prepare a list of additional information needed from Jerry. Be as specific as possible and phrase your requests in the form of questions as they normally would be asked of a client. You should also be prepared to explain your reasons for asking specific questions. Once again, Jerry has asked you to prepare the statement of cash flows, statement of changes in stockholders’ equity, financial statement notes, and earnings per share disclosures once the audit is complete. He also reminded you that the Bank wants comparative statements and requires the fair value of all financial instruments and information on major customers be disclosed.
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