Lancaster Electronics produces electronic components for sale to manufacturers of radios, television sets, and phonographic systems. In connection with his examination of Lancaster’s financial statements for the year ended December 31, 2014, Don Olds, CPA, completed fieldwork two weeks ago. Mr. Olds is now evaluating the significance of the following items before preparing his auditor’s report. Except as noted, none of these items has been disclosed in the financial statements or footnotes.
1. Recently, Lancaster interrupted its policy of paying cash dividends quarterly to its stockholders. Dividends were paid regularly through 2012, discontinued for all of 2013 to finance equipment for the company’s new plant, and resumed in the first quarter of 2014. In the annual report, dividend policy is to be discussed in the president’s letter to stockholders.
2. A 10- year loan agreement, which the company entered into three years ago, provides that dividend payments may not exceed net income earned after taxes subsequent to the date of the agreement. The balance of retained earnings at the date of the loan agreement was $ 298,000. From that date through December 31, 2014, net income after taxes has totaled $ 360,000, and cash dividends have totaled $ 130,000. Based on these data, the staff auditor assigned to this review concluded that there was no retained earnings restriction at December 31, 2014.
3. The company’s new manufacturing plant building, which cost $ 600,000 and has an estimated life of 25 years, is leased from the Sixth National Bank at an annual rental of $ 100,000. The company is obligated to pay property taxes, insurance, and maintenance. At the conclusion of its 10- year noncancelable lease, the company has the option of purchasing the property for $ 1. In Lancaster’s income statement, the rental payment is reported on a separate line.
4. A major electronics firm has introduced a line of products that will compete directly with Lancaster’s primary line, which is now being produced in the specially designed new plant. Because of manufacturing innovations, a competitor’s line will be of comparable quality but priced 50 percent below Lancaster’s line. The competitor announced its new line during the week following completion of fieldwork. Mr. Olds read the announcement in the newspaper and discussed the situation by telephone with Lancaster execu-tives. Lancaster will meet the lower prices with prices that are high enough to cover variable manufacturing and selling expenses but will permit recovery of only a portion of fixed costs.

For each of the preceding items, discuss any additional disclosures in the financial statements and footnotes that the auditor should recommend to his client. (The cumulative effect of the four items should not be considered.)

  • CreatedDecember 17, 2014
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