The Company Lalo Company headquartered in Vaduz is a

company #4131
The Company Lalo Company, headquartered in Vaduz, is a company listed in Amsterdam,
Paris and Zurich. It is the third largest small home appliance manufacturer in Europe. The
company was founded in 1955 by Patrick O’Share, a self-made millionaire, whose family
emigrated from Ireland during the 1930s. Despite Lalo being a public company, the O’Share
family still holds a significant interest in the company through the ownership of 20 percent of the
outstanding voting shares. The remainder of the shares is actively traded and the stock
ownership is diversified. Patrick O’Share, now 70 years old, serves in the largely honorary
position of Chairman of the Board. His eldest daughter, Minnie Mize (her married name), 45, is
the current President and Chief Executive Officer.The company has a 31 December fiscal year-
end. Today is 10 January X2 and the books for year X1 are about to be physically closed (as of
31 December X1). All normal and recurring transactions have been recorded in the accounts
and a preliminary balance sheet and income statement have been prepared (see Exhibits 1 and
2).Eric Faithful, Vice President of Finance, has organized a meeting to discuss several issues
concerning seven year-end adjustments and closing entries. All parties interested in the year-
end adjusting entries have been invited to attend. The meeting will include, among others, Eric
Faithful, Minnie Mize (CEO), Max E. Mumm (Vice President for Investor Relations), Celia Vee
(Vice President for Sales) and Gunther Somday (Vice President for Production).Key
playersAfter graduating from a French Graduate School of Business, Eric Faithful, after a tough
exam, qualified as a Certified Public Accountant. He worked as an Audit Supervisor for a ‘Big
Four’ accounting firm in Frankfurt before joining Lalo two years ago. In his opinion, compliance
with the letter and spirit of generally accepted accounting principles is essential. He is opposed
to any form of manipulation of the accounts. He often declares: ‘Our mission is to give a clear
and truthful view of the financial position and results of operations of the company’.Minnie Mize
is the daughter of the founder of the Company. She progressed through the ranks from being a
salesperson to her current position as President and CEO. She is a firm believer, especially in
the difficult economy that affects the globe at this time, in reinvesting profits and generating
enough operating cash flows to support growth without having to depend too much on external
financing. Her philosophy is that the accounting experts should ‘use conservative accounting
methods and take advantage of all legal loopholes to minimize reported and taxable income and
avoid unnecessary drains on the cash flow of the company. A better future for all comes from
our ability to generate and reinvest as large a cash flow as possible’.After five years in the
Investor Relations Department of a large North American conglomerate, Max E. Mumm
assumed the position of Vice President for Investor Relations at Lalo approximately 12 months
ago. He has been critical of what he sometimes refers to as the ‘lack of vision of the family’. He
believes that presenting the company in the most favorable light, and maintaining effective
communications with financial analysts and the investment community, are key to the
Company’s success. ‘If we are to continue expanding in the face of increased international
competition and the consolidation trend in the industry in this depressed economic environment,
we are going to need to obtain additional equity capital. We must keep the loyalty of our
shareholders and attract new ones. It is essential for a growing business like ours to earn a high
return on equity in order to lower our cost of capital’. Minutes of the meeting Item on the
agenda: Seven adjusting entries still need to be finalized and this is the major objective of the
meeting.1. Depreciation Eric Faithful: ‘Last 1 July, we purchased a new sheet metal press for
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one million CU. The cost of the press was added to property, plant and equipment, but no
decision has been made yet about its useful life or depreciation. Gunther, what do you think of
the useful lifeof this press?’Gunther Somday (VP-Production): ‘Technically the useful life of the
press should be between five and ten years. Although I do not want to interfere with your
accounting discussion, I know we have to choose between a straight-line and an accelerated
method of depreciation.’Minnie Mize: ‘This is a no-brainer, let’s choose the accelerated
method and let’s do it over the shortest acceptable life, i.e., five years here. The machine will
become obsolete in a few years and I’d rather depreciate it to the maximum before we have to
scrap or replace it, or at least, as soon as we have benefited from all the production that we’re
going to get from the machine. Eric, I believe we should multiply the straight-line amount by two
to get the accelerated amount, is that right?’Eric Faithful: ‘Yes, it would be two, if we use
double declining balance depreciation. That would give a depreciation rate equal to twice as
much as straight-line. This rate would be applied to the remaining balance, until you have to
switch back to straight-line when the amount of depreciation expense is lower than the straight-
line amount calculated over the remaining years. Of course, whatever method of depreciation
we choose, we must start depreciating as of 1 July X1.’Max E. Mumm: ‘I don’t agree with that
approach. This machine, when we bought it, had a life expectancy of at least ten years. With
our projected sales demand we can use the machine’s capacity for at least ten years to come.
And, on top of that, I hear it’s a good machine with a technology that will not become obsolete
that soon. Based on these facts, I feel the straight-line ethod is the one that is most appropriate.
In addition, analysts tell me that straight-line depreciation is the method that is most commonly
used by our competitors. Furthermore, if we choose to depreciate the machine over ten years,
we will show a better bottom line. If the machine were to become obsolete, we could just
expense the remaining un-depreciated book value at that point in time. Why penalize ourselves
now in the eyes of shareholders?’Eric Faithful: ‘I don’t necessarily agree with either of you.
Our accounting methods should reflect as well as possible the actual position of the company.
Gunther says that given the new products in the pipeline, he expects to use the machine at
least for the next eight years, but beyond that he is not sure we’ll still use this technology. I
would therefore suggest we take the eightyear time frame into consideration in our decision
about depreciation. As for the method of depreciation, the accelerated method seems to me to
be the most appropriate because the market indicates that the resale value of the machine falls
off dramatically after the first year of operation. I second Minnie’s motion in favor of the double-
declining balance method.’2. Allowance for doubtful accounts Eric Faithful: ‘A 200,000 CU
invoice for a sale of microwaves that we made last 15 May to Worldapart is still outstanding and
the receivable is still unpaid. The sales people estimate that, in all probability, we will not collect
more than 10 percent to 40 percent of the face value of the receivable. Their best educated
guess is that we will collect about 30 percent.’ Minnie Mize: ‘How about creating a provision for
90 percent of that receivable? It is conservative since, at worst, we’ll collect only 10 percent,
and it is easy to defend if we are criticized.’Max E. Mumm: ‘Why not constitute a 60 percent
valuation allowance? The financial analysts will not be happy if we signal that we might have
collection problems that could signal lower future earnings numbers. If they feel we do not
manage our receivables well, their opinion might lead the banks to raise our cost of capital at
the worst time. Let’s work hard on making sure we do collect those 40 percent of that
receivable instead of giving up so easily.’3. Contingent liabilities Eric Faithful: ‘We are also
involved in a lawsuit brought against us by Fairprice for patent infringement. They are asking for
damages of 200,000 CU. I really see no merit in the suit and we will definitely not settle out of
court. I don’t know which way the judge will go. I estimate we have a fifty-fifty chance of losing
the case. I would suggest recording a liability for half the amount they are seeking.’Minnie Mize:
‘Absolutely not. Let’s plan for the worst. What happens if our lawyers blow it? We should
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provide for the worst case: the full amount. We can reverse the accrual later if our lawyers get
us off the hook.’Max E. Mumm: ‘I think that this is another unneeded accrual. The more you
accrue, the less earnings you report. Let’s face it, this is an era of global capital markets. You
may not like it, but the view that the analysts have about the company can make or break us. In
any case the amount of damages Fairprice is seeking is ridiculously high. In a lawsuit you know
that you always ask for five if you want to get one. If we make any provision, we would be
admitting that we would be willing to pay that amount. So, I don’t see any need to make any
accrual here at this time.’4. Revenue recognition Celia Vee (VP-Sales): ‘We may have a
problem with determining the exact X1 sales revenue. We shipped a truckload of mini-ovens to
Pricelead’s warehouse on 28 December. I understand our bookkeeper did not have time to
record that invoice until 2January X2, and I am not sure whether the truck got to their
warehouse before that date. We are talking here about an invoice for 500,000 CU; it is no small
change. The question is whether to record the sale in X1 or postpone its recognition into
X2.’Max E. Mumm: ‘Since we shipped the goods in December X1, it seems logical to consider
it as an X1 sale.’Minnie Mize: ‘But, wait a minute, the invoice was recorded and mailed in X2
and the goods may have been delivered in X2. The preliminary income figures I received show
that the operating income for X1 will be great. Wouldn’t it be better to shift the revenue into X2?
Why make X1 even better? In addition, it would be good for the sales force to know they are
starting the year X2 with a little plus, don’t you think Celia? Competition is getting harder every
day and we all know they have an uphill battle in front of them. Let’s give them a push and
record that sale in X2.’Eric Faithful: ‘Sorry to rain on your parade, but I think Celia forgot to tell
you that our shipments are always made FOB Shipping Point, i.e., when the goods leave our
warehouse they no longer are our responsibility.’5. Accrued warranty expense Eric Faithful:
‘Because of our quality control systems, we have relatively low warranty claims. However, we
still need to record a liability for our potential warranty claims. Ramon Psikotic, in the Sales
department, has estimated that given the sales volume in X1, the warranty provision expense
for X1 should be about 100,000 CU.’Minnie Mize: ‘Yes, but Ramon Psikotic based his
calculations on the actual cost of warranty service in X0. The repair department thinks that the
cost of servicing our products under warranty is going to increase in the years to come. I believe
the total amount of the provision for warranty should be increased to 120,000 CU. We can
always adjust the figure downwards later if the real figures end up being less than
anticipated.’Max E. Mumm: ‘Personally, I’ve reviewed Ramon’s calculations and I think he
was pessimistic. My opinion is that the accrual for warranty costs should only be 80,000 CU.
That’s the number I would go with.’6. Deferred revenue Eric Faithful: ‘On 1 November, we
received a 300,000 CU cash payment for the rent on the warehouse that we leased to Ready-
Sol, our European distributor. This represents the rent for three months, i.e., through the end of
January X2. We recorded the full payment as rent revenue in the year X1.’Max E. Mumm: ‘I
agree. Since the cash is in, it ought to be recorded as revenue in X1.’Minnie Mize: ‘Sorry, Max,
I don’t agree! One month of that rent relates to January and therefore only two-thirds of the rent
payment should be recognized as revenue for X1.’7. Deferred expenses Eric Faithful: ‘On 1
September, we paid 90,000 CU for our annual liability insurance premium. We recorded the
payment as insurance expense (external expense). The period of coverage extends from 1
September X1, to 31 August X2.’Minnie Mize: ‘What matters is when the payment took place.
Keep it fully in X1 expenses.’Max E. Mumm: ‘Wait a minute, here! Since we had no liability
claim in X1, the period during which we will receive the benefits from that premium can only be
for X2. It would seem more logical to recognize the expense as belonging to X2.’Required1
What are the bases for the arguments of each of the three protagonists? What relevant
principle(s) support or infirm their position?2 Prepare the three sets of financial statements
(balance sheet as of 31 December X1, plus income statement for year X1) reflecting strictly the
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 points of view of each of the three protagonists on the seven points evoked during the meeting
(assume for this question that each protagonist is legitimate in his or her position).3 Prepare
three sets of financial statements (one per protagonist) as of 31 December X1 (balance sheet
and income statement) that reflect the correct application of the accounting principles described
in the chapter while respecting the position of the person to the largest extent (for example,
nothing in the chapter indicates that one asset life expectancy is more appropriate than another,
for each case you will use the depreciable life horizon preferred by each individual). Arguments
advanced, and positions taken, should be backed-up with references to the relevant accounting
principles whenever possible. Exhibits 1 and 2 present the preliminary balance sheet and
income statement established by the accountant Exhibit 1 Preliminary balance sheet before
yearend adjustments (horizontal, increasing format)Exhibit 2 Preliminary income statement for
X1 before year-end adjustments (format by nature)Exhibit 3 Preliminary balance sheet before
year-end adjustments (vertical, decreasing format)Exhibit 4 Preliminary income statement for X1
before year-end adjustments (format by function)before any of the seven year-end adjusting
entries. Exhibits 3 and 4 present the financial statements using a different format (see this
concept in Chapters 2 and 5): vertical, decreasing for the balance sheet and by function for the
income statement. Use either Exhibits 1 and 2 or Exhibits 3 and 4 in your answers to the
questions above. => Calculations should ignore the impact of both income tax and value added
tax.=> The only adjustments that need to be made to the balance sheet and income statement
are those relating to the seven issues that were discussed above. View Solution:
The Company Lalo Company headquartered in Vaduz is a company

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