Graves Manufacturing, Inc.*
John Graves, Darryl Hamblin, and James Gaugher were the sole
shareholders of Graves Manufacturing, Inc., a fabricator of special
purpose equipment, and held 80%, 15%, and 5% respectively of the
outstanding voting common stock. John Graves was the President, Darryl
Hamblin the Vice President, and James Gaugher the Chief Financial
Officer of Graves Manufacturing.
John Graves was desirous of effecting a business combination between
Graves Manufacturing and another company in order to step up the book
values of Graves’s assets to market value. He also wanted the
combination to be with a public company in order to make other
acquisitions easier, to possibly make a public offering in the future, and to
provide himself, Hamblin and Gaugher with an investment that would be
much more liquid than Graves Manufacturing common stock.
Thus, early in 2010, John Graves entered into discussions about a
possible business combination with Lawrence Hammer, the controlling
shareholder of Hammer Tool, Inc., an inactive public company. Hammer
Tool used to be a manufacturer of industrial machinery until it ceased
operations in 2006. At the time that it entered into discussions with John
Graves, Hammer Tool’s only assets were cash and marketable securities
totaling approximately $600,000.
After several months of negotiations an agreement was entered wherein
the shareholders of Graves Manufacturing would be issued 80% of the
outstanding common stock of Hammer Tool, Inc., in exchange for 100% of
the outstanding common stock of Graves. After the business combination
Graves became a wholly owned subsidiary of Hammer Tool, and John
Graves, now a 64% shareholder in Hammer Tool, became President and
Chairman of the Board of Directors. Darryl Hamblin and James Gaugher,
now 12% and 4% shareholders in Hammer Tool, also became officers and
board members of the company. Three other individuals associated with
Graves Manufacturing were named to the nine-member board of directors
of Hammer Tool.
In preparing consolidated financial statements for the year-ended
December 31, 2010, John Graves and James Gaugher increased the
carrying value of Graves Manufacturing’s fixed assets from $3,898,200 to
an appraised value of $6,690,700. Depreciation in the financial
statements was based on the $3,898,200 carrying value of the assets with
a useful life of twenty years for machinery and equipment. Prior to 2010
the useful life of Graves’s machinery and equipment had been eight years,
which was always considered reasonable.
The 2010 consolidated balance sheet also presented as a current asset a
$210,000 receivable that had no allowance for uncollectible amounts. The
receivable resulted from a 2010 transaction in which Graves
Manufacturing sold obsolete inventory previously written down to a zero
basis. The sale was to Marshall Manufacturing Company, which was
controlled by John Graves. Marshall’s financial statements for the yearended September 30, 2010, reported an operating loss of $806,129 on
sales of $4,021,290 and a deficit stockholders’ equity of $1,233,541. The
2010 auditor’s opinion on Marshall was qualified as to whether Marshall
could continue to operate as a going concern.
The only disclosure in the consolidated statements prepared by Graves
and Gaugher pertaining to the machinery and equipment indicated that
they were being depreciated by the straight-line method over 20 years.
There was no disclosure in regard to the receivable from Marshall.
The 2010 consolidated financial statements prepared by Graves and
Gaugher received an unqualified opinion from the accounting firm of
Wilson, Teeter and Company, CPAs.
Required:
1) Discuss whether or not you agree with how John Graves and James
Gaugher prepared the 2010 consolidated financial statements. State
your reasons for you position, and give your proposed accounting
treatment if you disagree.
2) If you indicated any proposed changes in question 1, discuss the
impact such changes would have on the consolidated balance sheet and
income statement.
*
Adapted from Cases in Financial Accounting by Ralph J. McQuade