Executive Summary. The one page executive summary is properly balanced, stated the correct purpose of the report with very brief facts (10%), and properly discussed the type and the results of the conducted analyses that are necessary to address the purpose of the report (80%). A correct conclusion or a recommendation is provided based on the discussed analyses (10%).

Executive Summary. The one page executive summary is properly balanced, stated the correct purpose of the report with very brief facts (10%), and properly discussed the type and the results of the conducted analyses that are necessary to address the purpose of the report (80%). A correct conclusion or a recommendation is provided based on the discussed analyses (10%).

 

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BANK OF GREEN VALLEY Wednesday, April 13, 2005, 9:48 a.m.: “Congratulations are in order! You remember that I told you last year that we would be submitting your opinion about ZonTech’s financial statements to a bank to get some financing for our planned addition of a production facility. Don’t you? Well, the Bank of Green Valley just notified me that the loan committee approved our three million dollars loan after analyzing this year’s audited financial statements. The committee was really impressed that while everyone else in our industry operated at a loss or just broke even, we showed a substantial profit this period,” crowed Roger Shaw, CFO of ZonTech, in a telephone call to Michael Free, an auditing manager at Victor Hines, LLP. Michael headed the audit team that issued an unqualified opinion on ZonTech’s financial statements for each of the last four years. “That’s great!” Michael responded. “The loan means that you’ll be able to complete that new circuit board production facility that you told me about, doesn’t it? That circuit board is the product your budget shows is going to increase sales revenue and cash flow next year. It’s a good thing you were able to generate a profit and get the loan. Without the new product, things looked pretty bleak.” ZonTech designs and manufacturers circuit boards for low-tech applications, such as those used in major household appliances. Sales in the appliance circuit board industry had declined or been flat in the past 18 months because of people’s reluctance to buy new appliances in a poor economy. ZonTech’s new circuit board was for washers and dryers that compete with Maytag’s Neptune series. ZonTech’s customer (a major competitor of Maytag) was launching a new washer/dryer with characteristics similar to the Neptune series, but they expected the price to be about 25% below that charged by Maytag. ZonTech had developed a circuit board to meet the engineering specifications of the new product, but could only land the business if they had new production facilities. Lily Meza, an auditing staff member assigned to one of Michael’s jobs, overheard the conversation between Michael and Roger on the speakerphone while sitting in Michael’s office. “Michael, I didn’t know that the company operated at a profit this year!” exclaimed Lily. “During my fieldwork, I analyzed the monthly income statements through November, and they showed that the company operated at a loss almost every month! How did they report a substantial profit at year-end?” Michael replied, “Several years ago they made an investment in the stock of a closely held company that they thought might be a good strategic alliance. Unfortunately, that opportunity didn’t work out. Until December 2004, ZonTech had been holding the investment and hadn’t been receiving any dividends. The CFO of ZonTech actively searched for a company to buy the stock, and in December 2004, located a strategic buyer who took it off their hands at a substantial gain!” Michael continued. “ Since ZonTech frequently buys and sells stock investments, the gain is a part of their income from continuing operations.” “Oh, that’s clever!” Lily responded. “But if it were such a large transaction, why didn’t they just use the cash flow from the stock sale to finance the new manufacturing facility?” “Well,” Michael explained, “the company that ZonTech sold the stock to, GreenSel, is having their own cash flow problems right now. They couldn’t afford to give ZonTech cash, so ZonTech accepted a noninterest bearing note due in 5 years. Although ZonTech won’t see the cash for five years, since the title to the stock has passed to the new owners, it can record the gain on the sale.” Lily pondered this information for a few minutes, and then queried, “Why a non-interest bearing note? Most companies with a credit rating like GreenSel are paying about 15% on loans for transactions like this one.” 1 “ZonTech didn’t have any loans against the investment, so they aren’t incurring any interest cost on the stock or the new note. They figured that there isn’t any need to hurt GreenSel’s cash flow when ZonTech doesn’t have any interest cost on the investment,” Michael responded. “Michael, you sure know a lot about this transaction,” teased Lily. “You’d think that you had found the buyer and negotiated the deal.” “Well, I am pretty excited,” Michael responded. “ I worked with the CFO on the transaction, reviewing the entry in the general journal and its reporting in ZonTech’s income statement. I may not have arranged the deal, but I was instrumental in getting out the audited statements just in time. As you know, ZonTech really needed some serious cash infusion as soon as possible from some lender to complete a production facility for that new circuit board.” “Since I missed all the excitement while I was working on a different client, why don’t you share the details of the transaction?” demanded Lily. “Well, ZonTech was carrying the investment at $5,100,000 and sold it to GreenSel for $8,000,000. So they booked a $2,900,000 gain on the transaction,” Michael confidentially replied. Lily looked troubled and finally confided to Michael, “I’m enrolled in a CPA review course, and last week we studied long-term receivables and payables. I learned that generally accepted accounting principles (GAAP) require notes receivable due in more than one year to be carried at their present value. Wouldn’t that affect the profit you reported?” Michael looked at Lily like she was trying to put him on the spot and icily replied, “I explained that ZonTech didn’t incur any interest on this investment before the sale, so present value calculations aren’t necessary! And, yes, the income statement we audited is consistent with GAAP.” ZonTech Income Statements For the four years ended December 31, 2004 (in 000’s except per share amounts) Net Revenues and Gains Expenses and Losses Cost of Sales Operating Expenses Other Taxes Net Income Common Shares Outstanding 2004 $27,500 2003 $26,300 2002 $25,100 2001 $20,900 15,200 3,160 4,570 1,690 $2,880 3,000 12,150 3,075 3,966 2,671 $4,438 3,000 9,845 2,890 3,146 3,318 $5,901 3,000 9,200 2,300 2,214 2,515 $4,671 3,000 2 Memo To: Rosie Cruz, Loan Delinquency Department, Bank of Green Valley. From: Harold Ricardo, Senior Lending Officer, Bank of Green Valley Date: January 17, 2008 Re: Default on ZonTech’s loan ______________________________________________ __________________________ As I mentioned to you earlier today, I am forwarding to you the ZonTech’s file. It is now in default on the three million dollar loan we extended on April 12, 2005. The total amount currently outstanding is $2,390,000. We were just informed yesterday that ZonTech has commenced bankruptcy protection under Chapter 7 of the Bankruptcy Code. As such, the prospects of a full recovery are minimal. In addition to the loan documents, I am attaching copies of all the financial statements that we obtained from ZonTech as part of the loan application, including the one for the year 2004, which we received from ZonTech’s CFO on February 2, 2005. In looking back at the financial statements that we had in our file, I was stunned by ZonTech’s dramatic and sudden collapse. When we approved the loan, the loan committee gave a lot of weight not only to the financial statements from 2004 but also to the ones from the prior three years; we were keenly impressed by the firm’s pattern of income stability during those four calendar years. I am also attaching a copy of an article I had placed in my file a number of years back. Ever since reading the article, I have had a lingering suspicion that the story in the article is about ZonTech. VALLEY TIMES December 15, 2005 overstated income and assets in contravention with General Accepted Accounting Principles. It is really too bad. I am really looking forward to joining this new firm. I believe it has a lot of potential,” said one of the twelve departing accountants who wished to remain Glen Oak, Green. In a surprise move yesterday, twelve staff accountants at Victor Hines, LLP left the firm and joined a competitor, Pillsbury & Skadden. In an interview with one of the twelve former auditors, it was learned that the departure followed alleged auditing irregularities practiced by senior partners at Victor Hines, LLP. “I have been really disillusioned with the level of scrutiny the senior managers and partners have been employing with regard to a number of audit engagements. In one case that I have worked on while I was an intern, my former manager signed off on an unqualified audit opinion where the client, a designer and manufacturer of home appliance circuit boards, had substantially 3 Required: Assume that you are Ms. Cruz, an associate in the Loan Delinquency Department at the Bank of Green Valley. Your supervisor would like to find out from you whether the Bank of Green Valley has a claim of negligence against the accounting firm of Victor Hines, LLP. You have gathered additional information from the bankruptcy courts and know about the 2004 sale of stock to GreenSel and its accounting treatment in the income statement. Read the legal cases collected by the legal assistant and attached in the Library. Assume that the applicable precedent is from the fictional jurisdiction of the state of Green provided to you in the attached library. Assume that the financial statements audited by Victor Hines for the calendar years of 2003, 2002 and 2001 were accurate. Prepare a report (see guidelines on the class website) for your supervisor. You may want to review section 53.01 of the AICPA Code of Professional Ethics. (You can visit the AICPA website at http://www.aicpa.org/about/code/index.htm.) In preparing your answers you may also wish to review the following Lower Division Core concepts, described in the Lower Division Core section of the Bus. 302L website: financial accounting concepts 4, 7, and 9, and business law concept 2. 4 BANK OF GREEN VALLEY LIBRARY© 1. APB Opinion 21 2. AICPA Code of Professional Conduct, Section 53 – Article II: The Public Interest 3. Bily v. Peat Young & Company 4. Manhattan Federal v. Coopers Gibson © Copyright Dr. Rafi Efrat and Dr. Janice Bell, 2007 5 APB Opinion 21, (portions bolded to direct reader) 12. Note exchanged for property, goods, or service. When a note is exchanged for property, goods, or service in a bargained transaction entered into at arm’s length, there should be a general presumption that the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation to the supplier for the use of the related funds. That presumption, however, must not permit the form of the transaction to prevail over its economic substance and thus would not apply if (1) interest is not stated, or (2) the stated interest rate is unreasonable (paragraphs 13 and 14) or (3) the stated face amount of the note is materially different from the current cash sales price for the same or similar items or from the market value of the note at the date of the transaction. In these circumstances, the note, the sales price, and the cost of the property, goods, or service exchanged for the note should be recorded at the fair value of the property, goods, or services or at an amount that reasonably approximates the market value of the note, whichever is the more clearly determinable. That amount may or may not be the same as its face amount, and any resulting discount or premium should be accounted for as an element of interest over the life of the note (paragraph 15). In the absence of established exchange prices for the related property, goods, or service or evidence of the market value of the note (paragraph 9), the present value of a note that stipulates either no interest or a rate of interest that is clearly unreasonable should be determined by discounting all future payments on the notes using an imputed rate of interest as described in paragraphs 13 and 14. This determination should be made at the time the note is issued, assumed, or acquired; any subsequent changes in prevailing interest rates should be ignored. 13. Determining an appropriate interest rate. The variety of transactions encountered precludes any specific interest rate from being applicable in all circumstances. However, some general guides may be stated. The choice of a rate may be affected by the credit standing of the issuer, restrictive covenants, the collateral, payment and other terms pertaining to the debt, and, if appropriate, the tax consequences to the buyer and seller. The prevailing rates for similar instruments of issuers with similar credit ratings will normally help determine the appropriate interest rate for determining the present value of a specific note at its date of issuance. In any event, the rate used for valuation purposes will normally be at least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction. The objective is to approximate the rate which would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount of the purchase which bears the prevailing rate of interest to maturity. 14. The selection of a rate may be affected by many considerations. For instance, where applicable, the choice of a rate may be influenced by (a) an approximation of the prevailing market rates for the source of credit that would provide a market for sale or assignment of the note; (b) the prime or higher rate for notes which are discounted with banks, giving due weight to the credit standing of the maker; (c) published market rates for similar quality bonds; (d) current rates for debentures with substantially identical terms and risks that are traded in open markets; and (e) the current rate charged by investors for first or second mortgage loans on similar property.i7 1 APB21, Footnote 7–A theory has been advanced which states that no imputation of interest is necessary if the stated interest rate on a note receivable exceeds the interest cost on the borrowed funds used to finance such notes. The Board considers this theory unacceptable for reasons discussed in this Opinion. Copyright 2000 Financial Accounting Standards Board (source of GAAP) 6 AICPA Code of Professional Conduct Section 53 – Article II: The Public Interest Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism. .01 A distinguishing mark of a profession is acceptance of its responsibility to the public. The accounting profession’s public consists of clients, credit grantors, governments, employers, investors, the business and financial community, and others who rely on the objectivity and integrity of certified public accountants to maintain the orderly functioning of commerce. This reliance imposes a public interest responsibility on certified public accountants. The public interest is defined as the collective well-being of the community of people and institutions the profession serves. .02 In discharging their professional responsibilities, members may encounter conflicting pressures from among each of those groups. In resolving those conflicts, members should act with integrity, guided by the precept that when members fulfill their responsibility to the public, clients’ and employers’ interests are best served. .03 Those who rely on certified public accountants expect them to discharge their responsibilities with integrity, objectivity, due professional care, and a genuine interest in serving the public. They are expected to provide quality services, enter into fee arrangements, and offer a range of services—all in a manner that demonstrates a level of professionalism consistent with these Principles of the Code of Professional Conduct. .04 All who accept membership in the American Institute of Certified Public Accountants commit themselves to honor the public trust. In return for the faith that the public reposes in them, members should seek continually to demonstrate their dedication to professional excellence. ©2000 AICPA 7 CURTIS W. BILY, et al Plaintiffs and Respondents, v. PEAT YOUNG & COMPANY, Defendant and Appellant. Plaintiffs, in this case, were investors in the Company. They include individuals as well as pension and venture capital investment funds. Several plaintiffs purchased warrants from the Company as part of the warrant transaction. Others purchased the common stock of the Company during early 1983. No. YU56823 SUPREME COURT OF GREEN The Company retained defendant Peat Young & Company (“Peat Young”), one of the then-“Big Eight” public accounting firms, to perform audits and issue audit reports on its 1981 and 1982 financial statements. In its role as auditor, Peat Young’s responsibility was to review the annual financial statements prepared by the Company’s in-house accounting department, examine the books and records of the Company, and issue an audit opinion on the financial statements. August 27, 1991, Decided COUNSEL: Marie L. Fiala, for Defendant and Appellant. Thomas G. Redmon & Matthew W. Powell on behalf of Defendant and Appellant. OPINIONBY: WOODS, C. J. Peat Young issued unqualified or “clean” audit opinions on the Company’s 1981 and 1982 financial statements. OPINION: I. Summary of Facts Each opinion appeared on Peat Young’s letterhead, was addressed to the Company, and stated in essence: (1) Peat Young had performed an examination of the accompanying financial statements in accordance with the accounting profession’s “Generally Accepted Auditing Standards” (GAAS); (2) the statements had been prepared in accordance with “Generally Accepted Accounting Principles” (GAAP); and (3) the statements “present[ed] fairly” the Company’s financial position. The 1981 financial statement showed a net operating loss of approximately $1 million on sales of $6 million. The 1982 financial statements included a ” Consolidated Statement of Operations” which revealed a modest net operating profit of $69,000 on sales of more than $68 million. This litigation emanates from the meteoric rise and equally rapid demise of Norne Computer Corporation (the “Company”). Founded in 1980 by entrepreneur Adam Osborne, the Company manufactured the first portable personal computer for the mass market. Shipments began in 1981. By fall 1982, sales of the Company’s sole product, the Osborne I computer, had reached $ 10 million per month, making the Company one of the fastest growing enterprises in the history of American business. In late 1982, the Company began planning for an early 1983 initial public offering of its stock, engaging three investment banking firms as underwriters. At the suggestion of the underwriters, the offering was postponed for several months, in part because of uncertainties caused by the Company’s employment of a new chief executive officer and its plans to introduce a new computer to replace the Osborne I. In order to obtain “bridge” financing needed to meet the Company’s capital requirements until the offering, the Company issued warrants to Investors in exchange for direct loans or letters of credit to secure bank loans to the Company (the “warrant transaction”). The warrants entitled their holders to purchase blocks of the Company’s stock at favorable prices that were expected to yield a sizable profit if and when the public offering took place. Peat Young’s audit opinion on the 1982 financial statements was issued on February 11, 1983. The Peat Young partner in …
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