Preparing and using pro forma statements Nancy Pinedo and Justin Johnson recently graduated from the same university. After graduation they decided not to seek jobs at established organizations but, rather, to start their own small business hoping they could have more flexibility in their personal lives for a few years. Nancy’s family has operated Mexican restaurants and taco-trucks for the past two generations, and Nancy noticed there were no taco-truck services in the town where their university was located. To reduce the amount they would need for an initial investment, they decided to start a business operating a taco-cart rather than a taco-truck, from which they would cook and serve traditional Mexican styled street food. They bought a used taco-cart for $15,000. This cost, along with the cost for supplies to get started, a business license, and street vendor license brought their initial expenditures to $20,000.

Five-thousand dollars came from personal savings they had accumulated by working part time during college, and they borrowed $15,000 from Nancy’s parents. They agreed to pay interest on the outstanding loan balance each month based on an annual rate of 6 percent. They will repay the principal over the next few years as cash becomes available. They were able to rent space in a parking lot near the campus they had attended, believing that the students would welcome their food as an alternative to the typical fast food that was currently available. After two months in business, September and October, they had average monthly revenues of $20,000 and out of pocket costs of $16,000 for rent, ingredients, paper supplies, and so on, but not interest. Justin thinks they should repay some of the money they borrowed, but Nancy thinks they should prepare a set of forecasted financial statements for their first year in business before deciding whether or not to repay any principal on the loan. She remembers a bit about budgeting from a survey of accounting course she took and thinks the results from their first two months in business can be extended over the next 10 months to prepare the budget they need. They estimate the cart will last at least five years, after which they expect to sell it for $5,000 and move on to something else in their lives. Nancy agrees to prepare a forecasted (pro forma) income statement, balance sheet, and statement of cash flows for their first year in business, which includes the two months already passed.

Required

a. Prepare the annual pro forma financial statements that you would expect Nancy to prepare based on her comments about her expectations for the business. Assume no principal will be repaid on the loan.

b. Review the statements you prepared for the first requirement and prepare a list of reasons why actual results for Justin and Nancy’s business probably will not match their budgeted statements.