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SOLUTION NOTES / AEROFLEX, INC.

Barry M Frohlinger, Inc. copyright 1981 - 2018 all rights reserved www.learnfrombarry.com

AEROFLEX, INC.

Barry M Frohlinger

SOLUTION NOTES



A2 June 30, 2015 June 30, 2014 Current assets 45,617,000 44,264,000 Current liabilities 19,745,000 18,964,000 (Net) working capital 25,872,000 25,300,000 Net increase in working capital during 2015 = $572,000 The change in working capital during 2015 of $572,000 was reflected1 in the

following increases and decreases: Increase (decrease) Decrease in cash ( 61,000) Increase in invested cash (current) 69,000 Decrease in accounts receivable, net (1,493,000) Decrease in income tax refund receivable ( 926,000) Increase in inventories 3,403,000 Increase in deferred income taxes 172,000 Increase in prepaid exp. & other 189,000 Decrease in long-term debt (current) 12,000 Increase in accounts payable (1,125,000) Decrease in accrued expenses & other 403,000 Increase in income taxes payable ( 71,000) Total change in working capital 572,000

[Working Capital is calculated as Current Assets - Current Liabilites]. [Observe that the calculation of Working Capital can be done as Current Assets - Current

Liabilities OR [Long Term Liabilities and Owner's Equity less Non Current Assets]

1 Working capital is capital financing current assets. It will be reflected in current assets net of current liabilities but the source is the capital of the firm. Working Capital Requirement is also a critical calculation.

Current Assets

Non Current Assets

Current Liabilites

Long Term Liabilities and Owners Equity



A3 The 2015 net income is reflected in two ways in Aeroflex’s 2015 balance sheet:

• the net income itself (i.e., revenues less expenses) is included in accumulated deficit (i.e., retained earnings) [see consolidated statement of stockholders' equity]

• the other side of the journal entry is reflected in changes in every asset & liability account (except invested cash & long-term debt) (e.g., the sales amount increases accounts receivable and then when collected, cash)

The 2014 net loss is reflected in the same way as the 2015 net income (except that the

effect in 2014 is to increase the accumulated deficit- accumulated deficit is negative retained earnings).

A4 Almost. Aeroflex’s statement of cash flows reflects all transactions except that it

excludes non-cash investing and non-cash financing activities. [However, these must be footnoted, so there is ample disclosure. Remember, that in the operating section, interest paid [cash outflow] and income taxes paid [cash outflow] are also footnote disclosures].



A5 by delayed payments for operating payables & accruals $17,091,000 by cash borrowing from lenders $28,916,000a by stockholders (both by investment & retained profits) $35,040,000 total $81,047,000 a long-term debt (current & noncurrent) including Senior Subordinated Convertible Debentures (assumed that all "Other long-term liabilities" are operating payables) A6 The most significant was operations which generated net cash flows of 8,729,000 (the

gross cash inflows & gross outflows were much larger). Capital expenditures were 2,931,000 Debt of 5,719,000 was repaid2. [not required] Minor cash flow items were: Treasury stock was purchased for 438,000 Stock options were exercised for cash received of 305,000. Cash was decreased by 61,000. These last three amounts are minor as they represent less than 10% of the net cash

flow from operations. A7 Because it is "shown" as a "use" in line 1. The amounts on line 1 [“use”-debit] and on

line 4 [“source”-credit] net to zero which is the real cash effect of depreciation3. Remember that depreciation and amortization expenses are on the income statement and therefore are included in line 1 of the statement of cash flow.

A8 Line 13 is usually the first cash amount. [T-accounts with journal entries can be used

to demonstrate that lines 1 to 12 each include non-cash amounts]. A9 Net income based on accrual accounting provides the best possible accounting

measure of profitability because (i) revenues are recognized when performance occurs and (ii) costs are matched with revenues.

Neither of these reasons is true for cash from operating activities which provides a

broader view of a company by including not only profitability, but also the management of accounts receivable, inventories and operating payables.

2 Although the current portion of long term debt [principal] due during 2015 is a much better analytic number versus the actual amount which the firm paid during the year. 3 We put the words "source" and "use" in quotes because this is common language, but these items are not really sources nor uses of cash.



A10a Unqualified. A10b No. The report says that the examination was done “on a test basis” to “obtain

reasonable assurance”. [As an analyst, make sure you check both the auditors report on the accounting and

the auditors report on internal controls]. A11 Aeroflex shows none. Comment: Extraordinary items are rare. “Gain (loss) from early retirement of long-term debt” was an

extraordinary item until 2010, but now is above the line. Restructuring charges are not extraordinary as they are neither unusual nor infrequent.



A12 [2014 and 2013 included for comparison]4

2015 2014 2013 Net Sales 100.0 100.0 100.0 Cost of Sales 66.9 68.7 66.9 Gross Profit 33.1 31.3 33.1 Selling, General & Administrative Costs 22.8 20.6* 22.2 Special Charge 0 31.2 0 Restructuring Charge . 0 . 0 . 2.3 Operating Income (Loss) 10.3 -20.5 8.6 2015 2014 2013 Net Sales 100.0 100.0 100.0 Cost of Sales 66.9 68.7 66.9 Gross Profit 33.1 31.3 33.1 Selling, General & Administrative Costs 22.8 20.6* 22.2 Operating Income (Loss) 10.3 9.7 10.9 Other Income (Expense)

Life Insurance Proceeds 0 0 2.8 Interest Expense -3.1* -2.6 -2.1 Other Income (including int. & div.) 0.1 1.4 1.1 Total Other Income (Expense) -3.0 -1.2 1.8 Income (Loss) From Continuing Operations Before Income Taxes

7.3

-21.7

10.4

Provision For Income Taxes 2.6 1.7 1.2 Income (Loss) From Continuing Operations

4.7

-23.4

9.2*

Income From Discontinued Operations . 0 . 0 0.7 Net Income (Loss) 4.7 -23.4 9.9 * rounded up or down by 0.1 to balance

4 For common-sizing an income statement, it is relevant to common-size only to the operating income subtotal. The amounts after this subtotal, are not directly tied to the revenue of the business. Also, the special charge and the restructuring charge are normally removed before common-sizing the income statement.



A13 The analyst can easily see the changes in the relationship of expenses to sales for several years. [The common-size income statements are especially useful when the sales levels change significantly as in 2015.]

Since the relationship of expenses to sales is very complex, and not always a causal

relationship, the common-size income statements help an analyst to raise questions rather than providing answers. For example, why was cost of sales so much greater in 2014 than in the other two years? [Note, the primary weakness in the common size numbers is that we do not see the growth in revenues, which is a very important analytical amount].

A14 Increase in profitability from 2014 to 2015 was due to:

-Net sales increased substantially by 26.8%, and... -Cost of sales decreased significantly from 68.7% of sales to 66.9% of sales; -but, Selling, general & administrative expenses increased significantly from 20.6% of

sales to 22.8% of sales. -Also, interest expense increased from 2.6% of sales to 3.1% of sales which was

compounded by a decrease in other income from 1.4% of sales to 0.1% of sales. These basic percentage changes can then be further explained by using the information in

Note 16 (Business Segments) and Quarterly Data (following Note 17) plus the Management's Discussion and Analysis.

A15a Yes. A15b Same as “Operating Income (Loss)” in the Income Statement but excluding “Special

Charge” and “Restructuring Charge”. [see fiscal year 2014 as there were no “special” or” restructuring” charges in 2015].

A15c No -- Although we frequently talk about “Aeroflex” as if it were one business, we

must be aware that Aeroflex is more complex. In 2015 when total revenues increased by approximately 27%, Microelectronics revenues increased by 71%, Electronics revenues decreased by 7% and Isolator Products revenues increased by 12%. [As another illustration, total inventories could be unchanged while the inventories in one segment could have dropped below normal operating requirements and inventories in another segment could have increased to an excessive level.]



A15d

Sales 2015 2014 2013 Microelectronics 48,462 28,414 24,250 Electronics 28,144 30,109 31,357 Isolator Products 17,693 15,844 15,506 Operating Profit Microelectronics 6,644 3,282 2,075 Electronics 2,762 4,830 6,028 Isolator Products 2,844 2,150 2,377 OPM Microelectronics 13.7% 11.6% 8.6% Electronics 9.8% 16.0% 19.2% Isolator Products 16.1% 13.6% 15.3%

A16a Aeroflex’s sales appear to be seasonal [However, management states that the business

is not seasonal]. For both 2015 & 2014, the fourth quarter exceeds the preceding quarters during the same year and the first quarter of 2015 is less than the fourth quarter of 2014. [Note: later we will determine that 2014 has been affected by an acquisition in the fourth quarter.]

1 2 3 4 TOTAL 2015 19,061 22,914 22,937 29,387 94,299

Common size 20% 24% 24% 31% 2014 13,149 15,195 15,956 30,067 74,367

Common size 18% 20% 21% 40% Pro forma revenue 7,388 7,388 6,157 20,933 20,537 22,583 22,113 30,067 95,300 Common size 22% 24% 23% 32%

A16b Look for seasonal pattern within each year for at least two years.



A17 (000's omitted) (i) (ii) (iii) Rate of return Current ratio Leverage ratio on total assets Current assets Total liabilities Operating Profit Current liab. Tot. Lia. + equity Total yearend assets a. +110 = + none = - +110 = + b none +110 +110 b. +500 = + none = - none = - none +500 +500 c. +120 = - a +120 = + b none = - +120 +120 +120 a because reported ratio is more than 100% b because reported ratio is less than 100% Note: ratios in the question were calculated as follows: Current ratio: 45,617 = 2.3 to 1 19,745 Leverage ratio: 46,007 = 57% 81,047 Rate of return on assets = Operating Profit = 9,736 = 12.0% Year end assets 81,047 Not required [aftertax return on assets]: Rate of return Net income+interest on assets = -tax saving on int. = 4,420+2,974-1,011* = 6,383 = 7.9% Ave. total assets [81,047 + 81,169]/2 81,108 * tax saving of 34% of 2,974 A18, A19 and A20 For class discussion



A21 Entries in June. a. Increase Inventories (raw materials) 27,500 Increase Accounts payable 27,500 b. Increase Inventories (work in process) 30,000 Increase Accrued expenses (Liab.) 30,000 c. Increase Prepaid expenses 8,000 Reduce Cash 8,000 d. no entry in June. [see footnote 1; revenue recognition] A22 The variables* identified by Aeroflex are: Net sales: Volume Price (implied, but not stated) Cost of sales: Cost as a percentage of sales (also, given as “profit margin”) Selling, General & Administrative expenses: Cost as a percentage of sales Interest expense: Level of borrowing Interest rate (implied, but not stated) Other income (mainly interest & dividend income): Level of cash invested Interest rate (implied, but not stated) Provision for income taxes: Statutory rate *All comparisons are affected by the late fiscal 2014 acquisition of MIC.



A23a Potential cash provided by operating activities is generally larger than net income. Potential cash provided by operating activities is net income [but changed to exclude some items that are included in net income]. Net income includes all operating activities plus some investing activities and some financing activities. The investing activities and financing activities are removed [in the financial community, the term "added back to net income" is used, although we are not adding it, but removing it.] to leave only operating activities remaining. For Aeroflex, depreciation is the only item that needs to be removed ["added back"] in 2015. [Remember that the depreciation expense is in net income [line 1] not the line which is the adjustment (line 4)].

A23b Potential cash provided by operating activities is measured on an accrual basis.

Adjustments are made for the changes in operating assets and operating liabilities to convert to actual cash flows of $8,729,000 during 2015. [Notice that Aeroflex has several significant changes in operating assets and liabilities.]

A24 “Reclassifications” means that an amount has been moved from one line to another

line in the statement with no change in the bottom line. A25 For class discussion



B1 Accounts receivable (on the balance sheet) represents the uncollected net sales at yearend.

B2 The portion of the gross accounts receivable of 22,260,000 (21,843,000 + 417,000) which

Aeroflex estimates will be uncollectible. B3 The provision for doubtful accounts exceeded write-offs for identified uncollectible

customers as reflected in the following T-account: Begin Allowance 354,000 Plus Bad Debt Expense 72,000 Less Net Write Offs 9,000 Closing Balance 417,000 [1] Fiscal 2015 provision for doubtful accounts (per Form 10-K) [2] Write-off of identified uncollectible customers (often this is a plug to

balance, but in this case it is explicitly stated in Schedule II) B4 AR Gross 23,690,000 Plus Revenue 94,299,000 [1] Less Net Write offs 9,000 [3] Less Closing Balance 22,260,000 Equals Collections 95,270,000 [4] [1] Net sales (per income statement) [2] Provision for doubtful accounts (bad debt exp.) (per Form 10-K) [3] Write-off of identified uncollectible customers (Schedule II) [4] Collections (plug)



B5 AR Net 23,336,000 Plus Revenue 94,299,000 [1] Less Bad Debt Expense 72,000 [3] Less Closing Balance 21,843,000 Equals Collections 95,270,000 [4] B6 Reported Changed Accounts receivable 22,260,000 22,269,000 Less allowance for doubtful account 417,000 426,000 Net 21,843,000 21,843,000 The “changed” amounts assume that no entry was made for the 9,000 write-off of

identified doubtful customers (i.e., receivables was not reduced and the allowance was not reduced).



B7a 2015 2014 Receivable turnover ratio 4.2 times 3.5 times Average number of days receivables outstanding 87 days 104 days Calculations: [000's omitted] 2015 Net sales = 94,299 = 4.2 times [365/4.2 = 87 days] Average Net A/R [21,843+23,336]/2 2014 Net sales = 74,367 = 3.5 times [365/3.5 = 104 days] Average Net A/R [23,336+18,898]/2 Comment: most analysts use 360 days rather than 365 days. B7b Average receivables have increased by 7% during 2015 while sales have increased by

27%; as a result, the average collection period is faster in 2015. B7c The numerator and denominator of a ratio must be comparable for the ratio to be

valid. Because of the acquisition of MIC, the 2014 ratio is distorted. The numerator includes MIC for approximately one quarter. The denominator includes MIC for one of the two years.

Comment: The 2014 ratio could be improved by making the numerator and denominator comparable;

we will discuss this later. B8 Line 8 of the cash statement is not a use of cash. Line 8 is an adjustment to convert

from line 1 (an accrual amount) to line 13 (a cash amount). Line 1 includes: (i) 2014 net sales even though they were not all collected in cash

and (ii) bad debt expense of which did not affect cash. Comment: This can be illustrated using numbers with 2015 included for comparison. You need to

know that Aeroflex actually shows the adjustment for the increase (decrease) in accounts receivable on two lines—the amount of bad debt expense has been removed in line no. 7.

2015 2014 Line 1 includes net sales 94,299,000 74,367,000 Line 1 includes bad debt expense (72,000) 55,000 Line 7 includes the removal of bad debt expense 72,000 (55,000) Line 8 Increase (decrease) in accounts receivable 1,421,000 (2,220,000) Line 13 includes cash collections of 95,720,000 72,147,000 Notice that the bad debt provision in 2014 is negative; i.e., a credit to the income statement. Also, notice that if one prepares a T-account for receivables for the year 2014, an amount will be

missing for the receivables acquired in the business acquisition. Later we will determine that the accounts receivable acquired was 2,163,000.



B9 Aeroflex has a master or general ledger account that reflects the total changes in accounts receivable for all customers and is the basis for the balance sheet amount.

In addition, Aeroflex must maintain a separate account for each customer. B10 --percentage-of-sales method --aging-of-accounts receivable method B11 Changes to tighten credit policies (e.g., shorten terms, reject more credit applications)

would have resulted in fewer uncollectible accounts and, therefore, a lower bad debt expense. But sales would also have been reduced and, thereby, earnings reduced. Bad debts are acceptable so long as the revenues collected from credit sales exceed the sum of both selling costs and the cost of sales on credit.

B12 Yes. Current assets include accounts receivable that are expected to be collected

within the current operating cycle, or one year, whichever is longer. B13 The account receivable would be replaced by a note receivable. Either the caption

would be changed to “Notes and Accounts Receivable” or the note receivable would be shown on a separate line. The interest will not be recorded until time passes.

B14 Increase Receivables 625 Increase Other income - interest earned 625 [PxRxT: 75,000 x .10 x 1/12 = 625] B15 Backlog is not recorded in the financial statements. It is assumed that the benefits

(assets) to be generated by the executory contracts exceed the obligations (liabilities) to be incurred. When this assumption is not true, a company must record an anticipated loss on the contract.



B16 For manufacturing contracts: revenue is recognized upon shipments or billings. For certain engineering and support services contracts: revenue is recognized as costs are incurred (i.e., percentage-of- completion method).

Comment: Related production costs must be matched as cost of sales at the time revenue is

recognized. Aeroflex uses two methods: • percentage-of-completion method in which revenues and costs are recognized as performance

occurs (these contracts in process are recorded as receivables, not as inventories) • completed contract method in which revenues and costs are recognized at time of shipment (these

contracts in process are recorded as inventories) B17 [000's omitted] Alternative (i) (ii) Balance sheet Cash +1000 +1000 Accounts receivable -- -1000 Short-term debt +1000 -- Income statement No effect Statement of cash flows line 8 - Decrease in receivables -- 1000 line 13 -- 1000 line 21a- (new line) Proceeds from s-t borrowing 1000 -- line 27 - Increase in cash 1000 1000



B18a P = F x Factor [10%; 1 yr.] P = 45,000 x 0.90909 P = 40,909 P = sales price = $40,909

Note: The "list" price is not relevant; Aeroflex is receiving $45,000 total, including both the sales price and interest.

B18b (i) $64,794 Calculation: P = F x Factor [9%; 4-yr. series] P = 20,000 x 3.2397 P = 64,794 (ii) $15,206 [80,000 - 64,794] (iii) $485.96 [PxRxT: 64,794 x 9% x 1/12] (iv) $64,794 [The interest will not be added to assets until it is earned.] [note: the entire principal amount is shown as a current receivable because Aeroflex incurs installment receivables due beyond one year as part of its operating activities] B18c P = F x Factor [8%; 2-yr. series] P = [10,000 x 1.0] + [10,000 x 1.7833] P = 10,000 + 17,833 P = 27,833 Note: The factor for an amount due immediately is 1.0. It is not necessary to write

this factor and the above equation could be shortened to P = 10,000 + [10,000 x 1.7833].



B18d P = F x Factor [?%; 1 yr.] 100,000 = 109,000 x Factor Factor = 100,000/109,000 = 0.91743 Search the 1 year tables for a Factor of 0.91743 ==> 9% Note: The arithmetic step-by-step is: given 100,000 = 109,000 x Factor divide both sides of 100,000/109,000 = [109,000 x Factor]/109,000 equation by 109,000 then 100,000/109,000 = Factor reverse equation Factor = 100,000/109,000 = 0.91743 B18e P = F x Factor [?%; 3-yr series] 200,000 = 77,600 x Factor Factor = 200,000/77,600 = 2.5773 Search 3-year series tables for a Factor of 2.5773 ==> 8%

Note: If you used $232,800 as the value for "F", you have forgotten that the note is for a series of three payments of $77,600, not one payment of $232,800

B18f P = F x Factor [9%; 2-yr. series] 400,000 = F x 1.7591 400,000/1.7591 = [F x 1.7591]/1.7591 F = 400,000/1.7591 = 227,389



C1 Inventories is the cost of goods (raw materials, work in process and finished products) on hand at a specific date. Cost of sales is the cost of goods sold during the period. The relationship between inventories and cost of sales is shown in the T-account below in which inventories are the balances. The T-account was constructed “in words” first; then the dollar amounts were added.

C2 Beginning Inventory 16,916,000 Plus Production 66,512,000 Less CGS 63,109,000 Closing Balance 20,319,000 C3 All costs of production are added to inventories. The components would be raw

materials, direct labor and overhead. Some examples of overhead would be depreciation of production facilities, utilities used for production, insurance on production plant & equipment, payroll tax costs for factory employees, etc.

C4 Depreciation of $2,915,000 is one of the costs of production and is included in the

$66,512,000 addition to the T-account above. The entry is: Increase Inventory Increase Accumulated Depreciation C5 The increase in inventories on line 9 of the cash statement is not shown as a use of

cash. Rather, line 9 is an adjustment to convert the accrual amount on line 1 (cost of sales) into a cash outflow for line 13.

Line 1 includes cost of sales (63,109,000) Line 9 Increase in inventories (3,403,000) Subtotal (66,512,000) The sub total represents the amount of additions to inventories (see T-account above).

The adjustments for payables & accruals in line 11 are also needed to get to the cash amount.



C6 Inventories are physical goods (raw materials, work in process and finished goods). A dollar value is assigned to these goods for presentation in Aeroflex’s balance sheet (based on cost flow assumptions and the application of the lower-of-cost-or-market basis).

C7 Per Note 1, inventories are recorded at the lower of cost (first-in, first-out) or market. C8 2015 Cost of sales = 63,109,000 = 3.4 times Ave. inventories [16,916,000+20,319,000] /2 365/3.4 = 107 days [or you can use 360 days] C9 Yes. Contracts in process recorded on the percentage-of-completion method are

shown as receivables, not as inventories. Therefore, the reported inventory turnover ratio is overstated [the reported days of inventory is too small] because this work in progress is excluded.

C10 No. This information is not disclosed, but probably is based on a perpetual system. C11 Buried in cost of sales. C12 Product costs appear in the income statement as cost of sales after flowing through

the inventory account as production costs. Period costs (i.e., period expenses) are all of the other expenses and are usually reflected as expenses when incurred or based on the passage of time.

C13 For class discussion.



C14 Inventories [gross] Reserve for Obsolescence

Beg 21,176,000 4,260,000 Beg

[2] 66,512,000 63,009,000 [1] [4] 305,000 100,000 [3] 305,000 [4] End 24,374,000 4,055,000

End

[1] Transfer to cost of sales (per income state, excluding 100,000) [2] Additions to inventories (plug to balance inventories account) [3] Provision for inventory obsolescence (included in cost of sales) (per Schedule II) [4] Write-offs of inventory (per Schedule II)

Inventories [net] Beg 16,916,000 [2] 66,512,000 63,109,000 [1] End 20,319,000

[note that the Cost of Sales (63,109) in the net Inventory account is the sum of Cost of Sales

in Gross Inventory account and the provision in the reserve account]. C15a Total inventory cost is the sum of the costs for all items of inventory. For each item

of inventory, the quantity is multiplied by the unit cost of the item. The unit cost is calculated as the average of the cost for the beginning inventory plus the cost of inventory added during the period. [The period can be of any length chosen by the company -- many companies choose one year.]

C15b Inventories (raw materials) 10,000 Accounts payable 10,000 [to record raw materials received on June 27] It is important that Aeroflex have a good “cut-off” on June 30 so that the accounting

records will agree with the physical reality. The raw materials were received on June 27 and will be included in the quantities of physical goods on hand at June 30. The fact that the invoice was not received until July is irrelevant since Aeroflex became liable for payment on June 27.



C15c [The amount of each overstatement or understatement is $10,000.] (1) No effect --on Inventories, June 30, 2015 [because inventories are determined by

a physical count, not by the records] (2) No effect --on Inventories, June 30, 2016 [see (1) above] (3) Understate--Cost of sales, 2015 [because the 2015 additions to inventories are

understated, the plug for transfer to cost of sales will also be understated--this can be illustrated by T- accounts]

(4) Overstate --Cost of sales, 2016 [opposite of (3) above] (5) Overstate --Net income, 2015 [if Cost of sales is understated, net income will be

overstated] (6) Understate--Net income, 2016 [if Cost of sales is overstated, net income will be

understated] (7) Understate--Accounts payable, June 30, 2015 [because purchase of raw materials

received on June 27 was not recorded] (8) No effect --Accounts payable, June 30, 2016 [because purchase of raw materials

has now been recorded] (9) No effect --Retained earnings, June 30, 2016 [because Retained earnings is

cumulative, the overstatement of 2015 net income and the understatement of 2016 net income combine to zero net effect on retained earnings]

C15d Net realizable value is selling price of the inventory less the estimated costs necessary

to make the item ready for sale and to sell it. The product should be carried in the inventories account at its new value of $25

thousand. The journal entry needed at June 30, 2015 to reduce the value from cost to market would be:

Cost of sales 170,000 Inventories 170,000 [reduce inventories to market which is lower than cost] C15e Effect of inventory on earnings 2016 2015 (1) Lower-of-cost-or-market -0- (170,000)a (2) Cost (170,000)b -0- a anticipated loss b sales (25,000) less cost (195,000) C15f The lower-of-cost-or-market accounting shows expense sooner than the cost accounting --

but the total expense over a period of years is identical for the two methods. [Lower-of-cost- or-market does always show an equal or smaller balance sheet amount.]



D1 D2 The accounting matches warranty expense with associated revenues. Because

Aeroflex recognizes the expense, it creates the liability. In this case, neither the amount nor the due date of the liability is definite, but they are reasonably certain. Generally accepted accounting principles require the accrual when the company can reasonably estimate the amount.

D3 The liability must be recognized when both (i) the outcome is probable and

(ii) the amount of payment can be reasonably estimated. D4 A delay in the payment of payables causes lines 11 and 27 to be larger positive

amounts (and increases line 13).



D5a The following are the amounts for the Defined Benefits plan:

Plan Assets 9,621 Plan Obligations 5,795 Over/Underfunded Status 3,826 [overfunded] Pension cost 182 [income]

D5b [1] For the ESOP, the entries are: 6-30-05 Selling, General & Admin. Expense 263,000 Accrued expenses (liability) 263,000 [accrue employee benefit] 6-30-05 Accrued expenses (liability) 263,000 Cash 263,000 [record payment of employee benefit] D5b [2] 6-30-05 Selling, General & Admin. Expense 263,000 Accrued expenses (liability) 263,000 [accrue employee benefit] 7-01-05 Accrued expenses (liability) 263,000 Cash 263,000 [record payment of employee benefit]



D6a Year Ended June 30,

----------------------------------------------------------------- 2015 2014 2013 ----------------------------------------------------------------- Current: Federal $ 1,752,000 $ 1,166,000 $ 307,000 State and local 693,000 569,000 454,000 U.S. Territory - - 102,000 ----------------------------------------------------------------- 2,445,000 1,735,000 863,000 ----------------------------------------------------------------- Deferred: Federal 404,000 (776,000) 43,000 State and local (414,000) 201,000 (54,000) U.S. Territory - 114,000 (2,000) ----------------------------------------------------------------- (10,000) (461,000) (13,000) ----------------------------------------------------------------- $ 2,435,000 $ 1,274,000 $ 850,000 =================================================================

Provision for income taxes (expense) 2,435,000 Income taxes payable 2,445,000 Deferred income taxes on the balance sheet 10,000

--or—

Provision for income taxes (expense) 2,445,000 Income taxes payable 2,445,000 [record current income tax expense] [comment: could be two entries] D6b Deferred income taxes on the balance sheet 10,000 Provision for income taxes (expense) 10,000 [record deferred income tax expense] D6c Income taxes payable 281,000 Additional paid-in capital 281,000 [record income taxes benefit of stock options] D6d Income taxes payable 1,468,000 Cash 1,468,000 [record income taxes paid per Note 12] D6e Cash 1,117,000 Income tax refund receivable 1,117,000 [record income tax refunds per Note 12]



Supplemental (000’s omitted) The income tax T-accounts for 2015 would be as follows.

Deferred tax assets on B.S.- net Income tax refund receivable Beg 1,699 Beg Beg 926 [b] 10 [?] 191 1,117 [e] End 1,709 End End 0

Income taxes payable (CL) Provision for taxes (expense)

1,770 Beg Beg 0 [c] 281 2,445 [a] [a] 2,445 10 [b] [d] 1,468 [?] 625 1,841 End End 2,435

Beg & End balances are per the balance sheet and income statement. The two beginning and

two ending balances for deferred taxes are the asset and liability balances; these could be shown as a net debit.

[a], [b], [c], [d], [e] are per the journal entries above. [?] There is a large unexplained debit to the income taxes payable account and refund

receivable account.



D7 2015 2014 2013 Expected tax 2,331 = 34% (5,490) = 34% 2,529 = 34% Pretax income from 6,855 (16,146) 7,437 continuing operations D8 Note 12 (second table) provides a reconciliation of “Tax at statutory rate” (of 34%) to

the actual income tax expense of 1,274,000. There are five reasons listed for 2014. D9 2014 Loss from continuing operations before tax $(16,146,000) (100.0)% Tax at statutory rate $(5,490,000) (34.0)% Non-deductible special charge 7,888,000 48.9 Utilization of net operating loss carryforwards (1,437,000) (8.9) State, local & U.S. Territory income tax 376,000 2.3 Officers’ life insurance premiums 21,000 0.1 Other, net (84,000) (0.5) Actual income tax expense $1,274,000 7.9% Comment: The tax benefit of net operating loss carryforwards must be anticipated and set up as a

deferred tax asset—Aeroflex did this in earlier years. This results in proper matching of income tax costs and benefits and no “differences” would show in the reconciliation table. However, Aeroflex believed that it was more likely than not that some of these benefits would not be realized and they set up valuation allowances. In fact some of these benefits were realized in 2014 (and 2013). So, with hindsight, we know that Aeroflex made a poor estimate. The result was to omit these benefits from earlier years where they belong and to include them in 2014 (and 2013) where they do not belong. As a consequence, these out of place benefits show up as a difference in the reconciliation table (debits in the earlier years and credits in 2014 and 2013). [Remember that a poor estimate must be corrected in the year discovered without restatement of prior years.]



D10a Footnotes to the Quarterly Data frequently disclose aftertax amounts for gains & losses where the pretax amount is disclosed elsewhere. The difference between the two amounts is the tax. Here, the 437,000 net of tax gain on sale of securities can be compared to the pretax gain of 533,000 disclosed on line 5 of the cash statement to calculate the tax of 96,000.

D10b The second table of Note 12 discloses significant differences between the expected

(statutory) tax and the actual tax for a specific item. One would expect the special charge of 23,200,000 to have a 34% tax benefit of 7,888,000. However, Note 12 indicates that the special charge is non-deductible for tax reporting and that the actual tax benefit is 7,888,000 less than expected—i.e., expected benefit of (7,888,000) less difference of 7,888,000 equals actual tax benefit of zero.

D10c Statutory rate is very useful unless there is disclosure to show a different rate, the

analyst must assume that the statutory tax rate applies (which ignores state & local taxes as generally small and undisclosed).

Effective rate (average rate) is useless because the analyst needs the rate for a single item at a time, not the average for all items in the income statement.

D11a Provision for income taxes (expense) 1,735,000 Income taxes payable 1,735,000 [record current income tax expense] D11b Deferred income taxes (on balance sheet) 461,000 Provision for income taxes (expense) 461,000 [record deferred income tax expense] [You can combine the entries for D11a and D11b into the following entry: Provision for income taxes (expense) 1,274,000 Income taxes payable 1,735,000 Deferred income taxes on the balance sheet 461,000 D11c Income taxes payable 63,000 Additional paid-in capital 63,000 [record income taxes benefit of stock options] D11d Income taxes payable 588,000 Cash 588,000 [record income taxes paid] D11e Cash 268,000 Income tax refund receivable 268,000 [record income tax refunds]



D12 As soon as the tax claim was (i) probable and (ii) could be reasonably estimated, Aeroflex would make the following entry:

Provision for income tax (expense) 200,000 Accrued income tax payable 200,000 When paid: Accrued income tax payable 200,000 Cash 200,000 Comment: GAAP does not allow a company to restate prior years for changes in estimates. Note that

the 200,000 would show up in the second table of Note 12. D13 These allowances reduce the deferred tax asset to expected realizable value (similar to

allowance for doubtful accounts). For Aeroflex, some of the deferred tax asset (probably some of the four lines of unrealized loss carryforwards) is not expected to be realized.

D14 Current 1,735,000 ===> based on income per tax return Deferred (461,000) ===> difference Total 1,274,000 ===> based on book income Therefore, income per tax return exceeded income per books D15 Deferred tax amount for receivables at 34% (given) 148,000 Pretax difference re accounts receivable (148,000/.34) 435,000 Because the deferred tax amount is shown on the books as an asset, the pretax

difference must be a negative asset on the books—i.e., accounts receivable are lower on the books than on the tax return by about 435,000. Most likely the 417,000 for doubtful accounts on the books has not been allowed for tax reporting purposes. That is, bad debts are deducted for tax reporting later when the uncollectible account is identified and written off.

Comment: Indeed, the direct write-off method must be used for reporting bad debts on the tax return.

In general, while the accountant accrues estimates of losses, the tax reporting waits for the event to occur.

Comment: One could perform a similar analysis with inventories: Deferred tax amount for inventories at 34% (given) 1,676,000 Pretax difference re inventories (1,676,000/.34) 4,929,000 The reserve for inventory obsolescence set up on the balance sheet would not be allowed for tax return

reporting and would explain 4,055,000 of the pretax difference.



D16 Aeroflex shows its deferred income tax as: 2015 2014 Current asset net debit 2,043,000 1,871,000 Noncurrent liability net credit 334,000 172,000 Comment: For balance sheet reporting, all deferred taxes are first split into (i) current (working capital) and (ii) noncurrent. Then, debit and credit amounts are netted and a net

amount is shown each for: • current assets & current liabilities • noncurrent assets & noncurrent liabilities

For future reference, remember that companies give enough disclosure in the tax footnote to relate to

the total deferred tax in the balance sheet; but very few companies give the added footnote disclosure to shown the split between current and noncurrent.

[Be careful not to confuse the “current” (i.e., working capital) portion of deferred taxes with accrued

income taxes currently payable (also called “current” taxes).]



E1a All of the costs would be capitalized as the cost of the machine of $95,000. E1b All of the costs would be capitalized as the cost of the building of $650,000. [note: interest cost for self-constructed assets must be capitalized during construction;

per GAAP.] E2 Maintenance & repairs should be expensed as incurred by Aeroflex -- these costs do

not extend the estimated service life or otherwise increase productive capacity. Betterments should be capitalized as Property, Plant & Equipment (PPE) by

Aeroflex -- these costs do extend the estimated service life of the asset or do increase productive capacity.

E3 Fixed assets (plant & equipment) are depreciated on a straight-line basis over the

estimated useful lives. [Leasehold improvements are amortized over the life of the lease or the estimated life of the asset, whichever is shorter.]

E4 It appears that accelerated depreciation methods are used for tax purposes because

Note 12 shows deferred tax liabilities caused by differences in methods used for the financial statements and those used for income tax reporting for “Property, plant and equipment”.

E5 Accelerated depreciation method depreciates the asset faster but shows less

depreciation in the later years. For example, for an asset with a cost of $100,000, depreciation expense could be:

Accelerated Straight line Year l 33,333 20,000 Year 2 26,667 20,000 Year 3 20,000 20,000 Year 4 13,333 20,000 Year 5 6,667 20,000 [Accelerated depreciation does always show a smaller book value of an asset on

the balance sheet.] E6 The total fixed asset cost to be depreciated must continually increase (because of

inflation, expansion or replacement of labor with machines).



E7 Amortization of Intangibles 1,021,000 [given in the footnotes] Depreciation of PPE 3,301,000 [PLUG] Total DA 4,322,000 E8 The cost of fixed assets is shown as follows:

(i) income statement: depreciation expense as an operating cost reflecting use of fixed assets.

(ii) cash statement: purchases of fixed assets shown as an investing activity.

The two presentations are not comparable!



The Three PPE Accounts, and the Three Identifiable Intangible and Goodwill

accounts are:

PPE gross Acc Dep PPE net [2] c 37228 22374 a a 14854 h 2931 436 i i 439 3301 g h 2931 3301 i 3 c 39723 25236 b b 14487

Intangible Gross Acc Amortization Intangible Net [1]

c 9223 516 a a 8707 0 1021 f 1021 f c 9223 1537 b b 7686

Goodwill Gross Acc Amortization Goodwill Net [1] c 12140 2086 a a 10054 d 162 0 e 162 0 e c 12302 2086 b b 10216

Dep reciation 3301 [plug after “e” and “f” are calculated Amortization 1021 [given in the notes] DA from SCF 4322 A opening balance NET B closing balance NET C Opening/closing balance Gross D SCF and note page 24 E No amortization of goodwill F Amortization G Plug H SCF Cap X I Plug [small, or may be due to rounding, NOTE That the net dr to the Net PPE account does not make sense]



E9 Aeroflex only mentions three types of intangible assets although it must have others

(e.g., trade marks) for which costs are expensed as incurred [not capitalized].

Intangible Assets Acquired in Connection with the Purchase of Businesses (Intangible assets are recorded at cost, less accumulated amortization. The company’s identified intangible assets are being amortized on a straight-line basis over periods ranging from 3 to 10 years except for certain costs allocated to existing technology and customer relationships which are amortized over 13 to 15 years, the estimated remaining lives of the intangibles at the time they were acquired by the Company).

Cost in Excess of Fair Value of Net assets of Businesses Acquired (Goodwill) is

capitalized and not amortized but tested for impairment. Research & development costs are expensed as incurred (per Note 1) E10 No, because Generally Accepted Accounting Principles [GAAP] require that

research & development costs be expensed as incurred. E11 An extreme example easily demonstrates that the immediate expensing of research &

development costs results in more expense in some years but less expense in other years. Assume that 500,000 is spent in year 1 on research & development of a product which generates revenues equally in years 2 through 6. No other research & development costs are incurred. Immediate expensing of these costs results in 500,000 greater expense in year 1 but then results in no expense in years 2 through 6 rather than the 100,000 of expense that would have occurred if the costs had been capitalized and amortized. [Immediate expensing of research & development does always show a smaller balance sheet amount.]

Obviously, an even more extreme illustration is Aeroflex’s purchase of in-process

research and development in 2014 for 23,200,000 that was immediately expensed as required by GAAP. This R&D will benefit 2015 (maybe) and future years without a corresponding R&D expense.



E12a (i) PPE -- Machinery & equipment 200,000 (ii) 2015 depreciation expense --

[because no revenues are generated until next year; then the tools will be amortized over their useful life of 4 years]

E12b (i) No asset will be shown [because research & development costs must be

expensed when incurred] (ii) 2015 research & development expense 347,000 Under Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, certain internal-use software costs historically expensed are now capitalized once specific criteria are met and these costs are amortized on a straight-line basis over a three-year period.

E13 Aeroflex’s research & development expense is small in relation to sales but represents

a significant impact on net earnings. It is not possible to evaluate the level of expense without additional information about the nature of the research & development and more industry information. For trend comparison, research expenditures were down significantly in 2014. Management should be asked to explain the reasons for this decrease.

Comment: R&D is required by GAAP to be expensed immediately. If a major effort is being devoted

to developing something with future benefit, GAAP may result in an understatement of current earnings (and an offsetting overstatement of future earnings). If a company cuts back on R&D the result will be to increase current year’s earnings. As an example, a company in a liquidity squeeze may be forced to cut back essential R&D efforts even though the long-run effects may be to reduce future earnings; the immediate effect is to boost current earnings.



E14 The rate of return on assets is the left side of the following: [000's omitted] Rate of Profit margin ratio Total assets return = (before interest exp. X turnover ratio on assets & related tax effects) 2015 2015 operating profit operating profit X Revenue Average total assets Revenues Ave. total assets 9,736 = 9,736 X __94,299 . [81,047 + 81,169]/2 94,299 [81,047 + 81,169]/2 9,736 = 9,736 X 94,299 81,108 94,299 81,108 11.99 % = 10.32 % X 1.16 The ROA calculation is done many ways: it can be done pretax or after tax and pre interest

and after interest; this calculation is an pre tax, pre interest calculation from core operations.

E15 Aeroflex’s rate of return on assets ratio is the result of many variables. The

disaggregation allows the analyst to concentrate on a portion of the variables in each of the two disaggregated parts.

E16 Rate of return on assets should be compared to the cost of financing the assets. If the

rate of return is calculated pretax, the cost of financing should be pretax.



E17 Capital expenditures are at current cost and should be compared to depreciation. Capital expenditures are only about 90% of depreciation (at current cost). This indicates that either:

(i) 2015 capital expenditures are below the quantity needed for replacement, (ii) depreciation is being recorded too quickly or (iii) the firm had significant capital spending in prior years or expects to make

capital spending in future years or (iv) the firm has made acquisitions and is using the target firm’s fixed assets (v) some combination of (i), (ii), (iii) and (iv). [Note: this situation also occurred in 2014.]

E18a A Company must writedown long-lived assets when a group of operating assets have

declined in market value such that expected future cash flows (not discounted) from the assets will be less than the book value of the assets.

E18b If a writedown is required, the assets are written down to the market value of the

assets. If the market value is unknown, the assets are written down to the discounted expected future cash flows for the assets.

E18c No. Extraordinary items are rare and must be both (i) unusual and (ii) infrequent. A

loss of value for operating assets would not meet these requirements. E18d Deferred. The anticipated loss could not be taken as a deduction in the tax return

until the future events occur. E19 The entire ten-year effect of the acquisition and use of the machine would be reflected

as follows in the cash statement: Line no. 1 in net income (depreciation expense) (10,000) Line no. 4 adjustment to remove depreciation exp. 10,000 Line no. 13 Cash provided by operating activities -0- Line no. 16 Investing activities-Capital expenditures (10,000) Line no. 27 Increase (decrease) in cash (10,000) Line no. 1 contains the effect of the cash expenditure; however, this effect is removed

on line no. 4. The actual cash expenditure is shown on line no. 16 as an investing activity. All cash inflows generated from the use of the machine are shown in operating activities.



E20a Other expense (in income state)a 20,000 PPE, net b 20,000 a Aeroflex has no line for other expense unless it has been netted with other income b Credit either (i) PPE-Machinery or (ii) Accumulated depreciation. E20b Balance sheet Property, plant & equipment, net -20,000 credit Accumulated deficit +20,000 debit Income statement Other expense (or S,G&A) +20,000 debit Net income -20,000 debit Statement of cash flows line 1 - net income (20,000) debit line 7 - other net 20,000 credit line 13 – Net cash provided by operating activities -- line 26 - increase in cash -- E20c Net income before interest = -20,000 ==> decrease Total assets -20,000 [decrease because reported denominator > reported numerator and because reported ratio is less than 100%] E21a Restructuring charge 1,669,000 Accumulated depreciation 597,000 Accrued expenses & other CL 1,072,000 [to record restructuring charge] Accrued expenses & other CL 972,000 Cash 972,000 [to record payment of accrued restructuring expenses] E21b Line 1 includes restructuring charge (1,669,000) Line 4 includes depreciation 597,000 Line 11 includes an increase in accrual of 100,000 Line 13 includes cash payment of ( 972,000) Line 27 includes decrease in cash of ( 972,000)



E22 The 55,000 of interest cost would be capitalized in PPE instead of being a period expense.

(i) direct entry: Interest expense 2,974,000 Property, plant & equipment 155,000 Other accrued liab. (interest) 3,129,000 or (ii) take to expense, then correct: Interest expense 3,129,000 Other accrued liab. (interest) 3,129,000 Property, plant & equipment 155,000 Interest expense 155,000 The additional 155,000 of PPE cost will result in additional depreciation expense of

7,750 for each of the next 20 years. E23 Aeroflex would make no new entries specifically for the change in estimate. Its

normal entry for depreciation expense would be for a different amount. [The remaining undepreciated cost at the beginning of 2015 would be spread over the new estimated useful lives.]

E24 Capital expenditures Depreciation and amortization expense



E25a Project Project A Project B selected (i) Net accounting profit $ 30,000 $ 40,000 B (ii) Payback 2 1/3 yrs. 3 3/4 yrs. A (iii) Present value (note) $ 104,239 $ 97,598 A (note) P.V. factor Project A Project B . year @ 12% Cash flow PV Cash flow PV . 1 0.89286 50,000 44,643 20,000 17,857 2 0.79719 40,000 31,888 20,000 15,944 3 0.71178 30,000 21,353 30,000 21,353 4 0.63552 10,000 6,355 40,000 25,421 5 0.56743 -0- -0- 30,000 17,023 Totals 104,239 97,598 the NPV of each investment is: Project A Project B (i) Investment $ 100,000 $ 100,000 (ii) PV of cash inflows $ 104,239 $ 97,598 (iii) NPV $ 4.239 $ ( 2,402) E25b The (i) accounting profit method ignores the time value of money (i.e., ignores

interest cost). The (ii) payback method ignores cash inflows after the payback period. [For illustration, Project B would clearly be preferable if its cash inflows were $15 in year 5, but the fifth year would be ignored for payback calculations.]



E26a Investment in subsidiary 37,843,000 [a] Cash 36,769,000 [b] Common stock 30,000 [c] Additional paid-in capital 1,044,000 [c] [to record purchase of 100% of common stock of MIC] [a] per footnote 2 [b] plug to balance [The footnote says cash of approximately 36,000,000 but the total purchase price is given as 37,843,000 that indicates cash paid was 36,769,000. The cash statement does not help because the amount is shown net of cash acquired.] [c] per statement of stockholders’ equity A second journal entry was required. Special charge (income statement) 23,200,000 Investment in subsidiary 23,200,000 [to record write-off of in-process research & development] E26b Various tangible assets & liabilities 6,190,000 Intangible Assets Acquired in Connection with the Purchases of Businesses 8,453,000 Accumulated deficit (via Special Charge) 23,200,000 Cash 36,769,000 Common stock 30,000 Additional paid-in capital 1,044,000 [to show effect on consolidated balance sheet of acquisition of MIC] E26c Aeroflex says that it borrowed $27 million that is reflected in the 2014 cash

statement. The remaining $9 million was a takedown of cash on hand. There was no buildup of cash during 2014, so the cash was accumulated in prior years. The 3 million buildup of cash during 2013 was due to the discontinued operations. The remaining cash was accumulated in years before 2013—most likely by the sale of Huxley in fiscal 2012 and the subordinated borrowing in June 2012 (per Note 10).

E26d The increase in receivables caused by the purchase of another business must be

shown as an investing activity on line #14.



E26e Accounts receivable, net

Beg 18,898,000 [1] 2,218,000 subtotal 21,116,000 [2] 74,367,000 } [3] 55,000 }=> must equal 2,220,000 72,202,000 [4] } End 23,336,000

Ending balance per B/S; beginning balance given in question. [1] Acquired receivables; plug to equal subtotal determined as follows: Ending balance 23,336,000 Less increase in A/R per line 8 of SCF ( 2,220,000) =Beg. balance (after including acquisition) 21,116,000 [2] Net sales (per income statement) [3] Provision for doubtful accounts (negative bad debt exp.) (per Form 10-K) [4] Collections equal plug to balance Comment: to summarize, receivables increased by 2,218,000 from acquisition of another company and by 2,220,000 from normal operations. E26f MIC was acquired just before the end of the third quarter of fiscal 2014. That quarter

includes Aeroflex plus a few days of MIC. The two prior quarters include only Aeroflex and the subsequent five quarters include MIC fully. There is not pro forma disclosure to provide comparability for the quarterly information.

E26g No difference. The purpose of the consolidated balance sheet is to present two

companies as if they were one company. E27a Pro Forma [000's omitted]* Year ended June 30, 2015 2014 2013 2012 2011 Net sales 94,299 90,097 95,300 N/A N/A Income from cont. oper. 4,420 (19,392) 6,729 N/A N/A *includes acquired company (MIC) from July 1, 2012 N/A = not available E27b The pro forma income statement puts Aeroflex and MIC together as if the acquisition

had occurred at the beginning of fiscal 2013. The two main adjustments would be to include (i) amortization of the intangible assets and goodwill acquired and (ii) interest expense on the $36 million paid—less related tax benefits.



E28 2015 2014 Goodwill (Cost in Excess…) 162,000 63,000 Cash 162,000 63,000 [to record contingent consideration for business acquisition] E29a All of Huxley’s revenues and expenses (including income taxes) have been removed

from the body of the income statement and shown net on one line at the bottom of the income statement. The “operating revenues” are included in the discontinued operations at the bottom of the income statement.

E29b Cash 5,550,000 given Discontinued operations—loss on disposal 2,911,000 [a] Various assets and liabilities 8,461,000 [b] [to record sale of Huxley’s operating assets] [a] pretax: 1,921,000/(1-.34) [b] plug to balance Accrued income tax payable 990,000 Discontinued operations—loss on disposal 990,000 [to record tax on sale of Huxley’s assets] E29c If Aeroflex had not segregated the discontinued operations in the income statement, then

fiscal 2012 & 2011 would include the discontinued operations in each line of the income statement and would not be comparable to years 2013 to 2015.



F1 Yes.

Long-term Debt (cur+noncur)a 24,596,000 Beg [2] 5,719,000 58,000 [1] 18,935,000 End

a Excludes Senior Subordinated Convertible Debentures of 9,981 which did not change during 2015 [1] Net borrowings under debt agreement (per line 21 of cash statement) [2] Debt repayments (per line 22 of cash statement) F2 [000's omitted]

Common stock, par value Additional paid-in capital 1,238 Beg 57,820 Beg 28 [2] 281* [1] 9* [2] 1,266 End 58,110 End

Accumulated deficit Treasury shares, at cost Beg 28,004 Beg 582 4,420 [4] [3] 438 268 [2] End 23,584 End 752

* [the APIC account shows 290 as the credit, this is the amount that you want to put into this T-Account; I

disaggregated the 290 into 9 and 281 from information in the Statement of Cash Flow] [1] Accrued income taxes payable (CL) 281 Additional paid-in capital 281 [tax benefit of stock options] [2] Cash5 305 Common stock 28 Additional paid-in capital 9 Treasury stock 268 [stock issued upon exercise of options] [3] Treasury stock 438 Cash1 438 [purchase of treasury stock] [4] Various assets & liabilities 4,420 Accumulated deficit 4,420 [all revenues & expenses per I/S]

5 Agrees with cash statement.



F3 [000's omitted] a. LTD (nc) = 14,688 + 9,981 = 24,669 = 41% LTD (nc) + SE 14,688+9,981+35,040 59,709 b. LTD (c+nc) + STD = 28,916 + 0 = 28,916 = 45% LTD(c+nc)+STD+SE 28,916 + 0 + 35,040 63,956 c. Total Liabilities = 46,007 = 46,007 = 57% Tot. Liab. + SE 46,007 + 35,040 81,047 d. Earnings from cont. operations before interest & income tax = 6,855 + 2,974 = 9,829 = 3.3 times Interest expense 2,974 2,974 F4 Long-term debt (current) 5.2% Accounts payable 6.3 Accrued expenses and other 10.6 Income taxes payable 2.3 Total current liabilities 24.4 Long-term debt (noncurrent) 18.1 Deferred income taxes 0.4 Other long-term liabilities 1.6 Sr. Sub. Convertible Debentures 12.3 Stockholders' equity 43.2 Total 100.0%



F5 2015 Net income - Preferred dividends = 4,420,000 - 0 = $0.34 Average # of common shares outstanding 13,057,000 F6 2015 Net income - preferred div. = 4,420,000 - 0 = 13.5% Average common stockholders' equity [35,040,000 + 30,472,000]/2 F7 [000's omitted]

Tangible Book Equity Calculation 2015 2014 Book Equity 35,040 30,472 Intangible 7,686 8,707 Goodwill 10,216 10,054 Tangible Book Equity 17,138 11,711

a1. Total liabilities = 46,007 = 46,007 = 72.9% Total liabilities+share. equity 46,007 + 17,138 63,145 less intangibles a2. 2015 Net income - preferred div. = 4,420 - 0 = 30.7% Average tangible common stock. equity [17,138+11,711]/2

b. The use of tangible stockholders' equity (instead of reported stockholders' equity) makes some ratios appear better (e.g., return on stockholders' equity) and some ratios appear worse (e.g., leverage ratios or debt-equity ratio).

F8 None. In a few rare cases, companies are required to restate prior years' income

statements (e.g., material corrections of prior errors and certain changes in accounting methods).



F9 Cash 9,184,000 [a] Other assets (debt issuance costs) 816,000 [c] Sr. Sub. Convertible Debentures (LTD) 10,000,000 [b] [to record issuance of LTD] Other assets (debt issuance costs) 131,000 [c] Additional paid-in capital 131,000 [d] [to record issuance of warrants] Sr. Sub. Convertible Debentures 19,000 Common stock 0 [e] Additional paid-in capital 19,000 [d] [to record conversion of debentures in 2014]

[a] per 2012 cash statement [b] per Note 10 [c] plug (but items [c] + [d] total 947,000 which agrees with Note 9) [d] per 2012 statement of stockholders' equity [e] 3,000 shares at 0.10 par value equals 300 (lost in rounding to thousands)



F10 a. & b. [a.] [b.] as debt as equity Long-term debt ratio at 7/1/2015 41.3% 24.6% Fiscal 2016 net income 4,625,941 5,120,000 Fiscal 2016 earnings per share 0.37 0.36 Fiscal 2016 cash provided by operating act. 9,005,941 9,500,000 Fiscal 2016 cash used for financing act. (3,000,000) (3,000,000) Calculations: LTD ratio [a.]: 14,688,000 + 9,981,000 = 41.3% 14,688,000+9,981,000+35,040,000 LTD ratio [b.]: 14,688,000 = 24.6% 14,688,000+35,040,000+9,981,000 Net income [a.]: 5,120,000 less interest [7½% of 9,981,000 = 748,575] plus tax saving [34% of 748,575 = 254,516] equals 4,625,941 Net income [b.]: same as given in question EPS [a.]: 4,625,941/12,489,000 = 0.37 EPS [b.]: 5,120,000/(12,489,000 + 1,774,400) = 0.36 [new shares = 9,981,000/5.625 = 1,774,400] Cash from operating act. [a.]: 9,500,000 less interest (748,575) plus tax saving (254,516) = 9,005,941 Cash from operating act. [b.]: same as given in question Cash used for financing act. [a.] & [b.]: same as given in question F10c The conversion of debt into equity improved reported net income because the "cost of

equity" is not included in the income statement. However, EPS reflects the added equity and shows a decrease. From a lender's viewpoint, the issuance of equity has improved earnings and has also improved cash flow (because no dividends are paid). From a stockholder's viewpoint, the issuance of equity has reduced earnings (EPS) available to each share of ownership.

[Note: this discussion merely compares debt to equity financing and does not

consider the benefit derived from the increased investment in the business.]



F11a Term loan 11,500,000 [*] Revolving line 5,650,000 [plug] Total 17,150,000 [per Note 9] * Term loan at March 15, 2014 16,000,000 Less five quarterly payments of 900,000 4,500,000 Balance at June 30, 2015 could be estimated 11,500,000 But, Management discussion [page 13] states that the outstanding balance is $9,041,000 on

the term loan and $8,109,000 on the revolving line. So Term loan 9,041,000 Revolving line 8,109,000 Total 17,150,000 F11b Aeroflex has a written agreement from the banks to renew the revolving line until

March 31, 2017 (which is more than one year). F12a The Board of Directors can vote to pay a cash dividend if: {sufficient cash is available; {there are no legal constraints imposed by the government; and {there are no legal constraints imposed by lenders' covenants Aeroflex did not have sufficient cash on hand at yearend 2015 to pay the dividend.

The Directors would need to know how sufficient cash would be generated by early fiscal 2016.

There is no evidence of a legal constraint imposed by the government. However, the

existence of an “accumulated deficit” would cause one to examine the government laws carefully.

Note 9 indicates that there are numerous lenders' covenants including a prohibition of

the payment of cash dividends. F12b A distinction is made between “creditors” and “owners” in the balance sheet, income

statement and cash statement and probably is logical. However, this distinction can cause difficulties for the analyst because of Aeroflex’s ability to shift between financing by creditors or owners. The analyst should be careful not to unduly emphasize “net income” and “cash provided by operating activities” while excluding dividends (especially for trend analysis when the capital structure changes).



F13 Alternative (i) looks better when only the income statement is considered. But alternative (ii) shows a higher return on equity investment because half of the capital has been obtained by debt with interest cost deductible for tax purposes and because the return in excess of the fixed interest cost is available to Aeroflex.

(i) (ii) Sales 1,000,000 1,000,000 Cost of sales 700,000 700,000 Sell. & Adm. 150,000 150,000 Interest exp. -0- 50,000 Sub-total 150,000 100,000 Income tax exp. 51,000 34,000 Net income 99,000 66,000 Return on equity* 9.9% 13.2% *99,000/1,000,000 = 9.9%; 66,000/500,000 = 13.2% F14a P = F x Factor [r=8%; n=10 yr. series] P = 476,900 x 6.7101 P = 3,200,000 (with rounding difference of 47) [could also set P=3,200,000 and solve for the "Factor"; then search the present value

tables for 10-year series to locate the interest rate.] F14b PPE -- Machinery 3,200,000 Long-term debt 3,200,000 [record capital lease] F14c The current portion of the long-term debt at the beginning of the lease is 220,900. Interest $ 256,000 8% of 3,200,000 Principal 220,900 plug Total payment 476,900 given



F14d Long-term debt [current] 220,900 Interest payable* 256,000 Cash 476,900 *interest expense & interest payable would have been accrued during the year. F14e Interest of 256,000 (see “c” above) Depreciation of 320,000 (using straight-line method--3,200,000/10 = 320,000) F14f (i) capital lease will show greater expense in first year [$320,000 + $256,000 vs. $476,900] (ii) the two methods will show the same total expense for the 10-year lease period. F14g The transaction in “b” above is a non-cash transaction. It would not be included in

Aeroflex’s statement of cash flows but would be disclosed in a footnote to the statement.

F15 When the leases were originally recorded, the two amounts were the same—

2,392,000. The capitalized lease obligation has been reduced by principal payments. [Note also that there is some undisclosed amount of accumulated depreciation & amortization subtracted from the asset.]

F16 The long-term debt has a fixed interest rate. As the market rate of interest for

Aeroflex changes, the fair value of the principal changes inversely. This change in value is not recorded by the accountant but must be disclosed in the footnotes.



F17a Cash 31,293,000 Common stock (2,597,000 @ 0.10) 259,700 Additional paid-in capital 31,033,300 [issuance of common stock Long-term debt 9,639,000 Cash 9,639,000 [repayment of long-term debt] Senior Subordinated Conv. Debentures 9,981,000 Common stock (9,981,000/5.625) @ 0.10 177,440 Additional paid-in capital 9,803,560 [conversion of debt into stock] Additional paid-in capital 599,000 Other assets 599,000 [write-off deferred bond issuance costs] F17b Balance sheet:

• very significant change in capital structure long-term debt decreased by 19,620,000 stockholders’ equity increased by 40,675,000

• very significant increase in cash of 21,654,000 Income Statement:

• remove interest on Sr. Sub. Conv. Debt (7½% of 9,981,000) 748,575 • remove interest on bank loan (approx. 8½% of 9,639,000) 819,315 • no added cost because new stockholders’ equity has no related expense

F18 For class discussion. F19 For class discussion

end of solution notes

end

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