Professional Portfolio

Michele Jones

I am presenting this professional portfolio to demonstrate the knowledge that I have

gained in my studies at Southern New Hampshire University and my various assignments with

S.N.H.U., LLC. I have been very fortunate to have excellent leadership through my professors

and fellow classmates. This portfolio will show that I have mastered many aspects of the

accounting field and I still have room to grow. I will present three artifacts that I have completed

through my work in this capstone.

The first artifact I am presenting is the preparation and presentation of financial

statements for Chester, Inc. I have also presented the ratio, horizontal and vertical analysis based

on Chester Inc.’s financial data. This information will show how well Chester is performing in

comparison its competitors, Under Armour, Inc. and Columbia Sportswear Company. All

financial statements were prepared in compliance with GAAP from the trial balance provided by

the company. Ratio analysis was performed on various areas and I presented an evaluation of the

results. Chester is considering an investment in the global market and requested an analysis of

the impact of IFRS standards on the financial statements if this occurred. The horizontal and

vertical analyses were evaluated to determine if there were any outlying variances that needed

further investigation and changes that could be made to improve performance.

The second artifact I am presenting is a sample audit program for Newham Company. A

business risk analysis was performed in relation to its competitors, fraud risk and compliance

with PCAOB standards. A sample audit program was created to assist Newham in determining

how efficiently they are operating, where they could make improvements and assist management

in determining the reasons for deviations in the processes. The program would help the company

initiates changes in their operations and provide a higher level of service to its employees and

customers. Recommendations were made concerning Sarbanes-Oxley requirements and where

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the company was weak in these areas. My report indicated what sampling methods were

appropriate for the company and how they could experience success in the performance of the

external audit.

The third artifact shows my knowledge of the tax field through the preparation of two tax

memos. Ms. Emma Shire requested that I prepare her personal income tax return and provide

advice on personal and business tax issues. I have provided the completed income tax return and

provided her recommendations on how she could reduce her tax liability on a personal level. A

tax memo was provided to her with tax advice on the possible conversion of her partnership to a

corporation and how she may be able to reduce her tax liability. The second memo was prepared

for Clifford Company concerning the property distribution of machinery. The company

requested tax advice on which machines should be distributed to shareholders and the tax

implications that would occur.

The capstone and this MS Accounting program have introduced the true ethics of this

profession and have helped me develop the necessary tools to perform at the highest standards.

Through the guidance of seasoned accounting professionals, I will be able to build on this

knowledge and develop fair and consistent opinions on many areas of the field. This program

and the capstone have introduced me to new accounting standards, various methods on financial

statement analysis, and income tax research tools along with many other techniques. I have taken

these new tools and applied them all to the three artifacts in this portfolio. This capstone has

shown that I have grown professionally over the course of several years and this knowledge will

assist me with my future pursuit of my certification. I faced several issues with the statement of

cash flows in the first artifact and I was able to review the numbers provided in the trial balance

and correct the statements for Chester, Inc. I also had an incorrect entry on Ms. Shire’s tax return

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and I was able to review my calculations and correct the itemized deductions. This capstone has

been very beneficial to my professional and personal growth in many ways. I am very happy

with the path I have taken and look forward to furthering my experiences and applying all of my

educational knowledge to all of my future endeavors.

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Table of Contents

Artifact One……………………………….. 6

Artifact Two………………………………. 23

Artifact Three……………………………... 32

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Analysis of Chester Inc.

Chester Inc. has consistently made a reasonable profit over the last several years. There

are some indications that the business could be improved in certain areas and that investigations

should be conducted on various issues. These concerns will be addressed below. There is also the

possible advancement into the global market. The impact of IFRS guidelines will also be

addressed below.

As illustrated on the horizontal analysis of the balance sheet and income statement

located in the appendix, there are several variances that raise concerns.

The 205% increase in accounts receivable between 2013 and 2014 does not

match the 14% decrease in net sales for the same two years. This is a possible

indication that receivables are not being collected in a reasonable amount of

time or that credit is being issued to customers that are not creditworthy. A

revision of the credit policy should be done. The 14% decrease in 2015 was in

relation to paid accounts.

The 222% increase in inventory between 2013 and 2014 also does not match

the 14% decrease in sales. This is an indication that inventory is being ordered

in excessive amounts or that there is a large amount of obsolete inventory on

hand. This would be an indicator to creditors that the company may not be

able to pay its outstanding payables if this condition continues. The 13%

decrease in 2015 was in relation to a slight increase in sales. However, the

increase in sales does not account for the large decrease in inventory. This

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occurrence should be investigated to determine if there is theft loss in the sale

or processing of inventory.

There was 205% increase in prepaid insurance. This variance should be

investigated as to why there was such a large increase. If this increase is

attributed to a new insurance policy that covers a number of years it should be

disclosed in the financial statements. If this is a one-time occurrence, it should

be determined why there was such a large increase in one year.

The 165% increase in property, plant, and equipment in 2014 was attributed to

the purchase of new equipment in 2014. The 14% decrease in 2015 was

attributed to the increase in the accumulated depreciation account.

The 213% increase in investments is attributed to the investment income

received.

The 100% decrease in other non-current assets was attributed to the sale of

land in 2014.

There were several large increases in current liabilities ranging from 288% to

1654% in 2014. Many of the larger variances occurred in the payroll tax

accounts and may be attributed to an increase in employees. The 288%

increase in accounts payable is partially attributed to the increase in the

inventory account. The 88% increase in taxes payable in 2015 should be

investigated as well to determine what type of taxes increased this much and

why the company is paying them.

The introduction of and subsequent 21% increase in interest payable may have

been attributed to the increase in the line of credit debt and the current

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portions due on long-term debt. A more thorough investigation should be

conducted to determine what interest has accrued on.

A 298% increase in the amount of the line credit may indicate that the

company was having difficulty paying their debt in 2014. A thorough

investigation should be conducted to determine the reason and to find

alternative ways to gain capital.

The 154% increase in dividends payable was attributed was due to the large

amount that was distributed in 2014. This was in line with 306% increase in

net income in 2014.

The 310% increase in the retained earnings account was in relation to the net

income that was earned in 2014. The 69% decrease in 2015 was attributed to

61% decrease in net income and the relative large dividend that was declared

in 2015.

The 192% increase in 2014 and the 14% decrease in 2015 in assets, liabilities,

and equity are attributable to all of the explanations above.

Net sales decreased by 14% in 2014. This variance should be investigated for

inaccuracy in billing or an excessive amount of sales returns.

The 11% increase in cost of goods sold in 2015 should be investigated to

determine if there were lags in production, excessive scrap amounts, or an

increase in production costs.

Due to the decrease in sales for 2014 there was a 21% decrease in the gross

profit for 2014. The 12% decrease in gross profit in 2015 was due to the

increase in cost of goods sold.

8

The company experienced a 48% decrease in 2014 and 28% increase in 2015

in selling expenses. The decrease in 2014 was attributed to the large decrease

in R&D expenses. This may have been the result of a new product going to

market or the elimination of a research project. The 28% increase in 2015 was

the result of a large increase in R&D and bad debt expenses. The increased

R&D expense would indicate that a new product was being developed and

tested. The increase in bad debt expense should be investigated to determine if

credit policies need to be changed.

The 15% decrease in administrative expenses in 2014 was a result of a large

decrease in phone, rent, and administrative wage expenses.

The 438% increase in other revenue and gains was in relation to a large

increase in investment income.

The 87% decrease in other expenses and losses in 2014 was in relation to the

large legal settlement that was accounted for in 2013.

The 377% increase in income taxes in 2014 was due to the increase in income.

The 49% decrease in 2015 was due to the decrease in income.

The 306% increase in net income was mainly due to the increase in

investment income, decrease in expenses and a decrease in other expenses and

losses.

The 61% decrease in net income in 2015 was mainly due to the increase in

cost of goods sold and the increase in selling expenses.

9

In regards to the potential expansion into the global market, there are factors to consider

in the valuation of certain accounts and the presentation of the financial statements. The key

areas of the financial statements that are affected by this will be as follows:

A statement of financial position must be presented with classification of

current and non-current assets and liabilities under IFRS. This is not required

under U. S. GAAP. Under IFRS, an unclassified statement based on the order

of liquidity is acceptable only if reliable and more relevant information is

provided. Under U.S. GAAP, there are no restrictions on when this statement

can be presented.

Under IFRS, when the functional currency of the entity becomes

hyperinflationary, price-level adjustments are made retrospectively. Under

U.S. GAAP, price-level adjustments are made prospectively.

If any inventories are measured at market, they must be changed to lower of

cost or net realizable value under IFRS.

If the cost of inventory is determined by using last-in, first-out (LIFO) under

U.S. GAAP, the cost method must be changed to first-in, first-out (FIFO) or

weighted-average. LIFO is prohibited under IFRS.

All inventory having a similar nature and use must have the same cost formula

applied.

When inventory is written down, net realizable value is used when less than

cost under IFRS. Under GAAP, inventory is written down to market if less

than cost.

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The reversal of write-downs in inventory is allowed in IFRS. Under GAAP,

reversals are not permitted unless they are related to changes in exchange

rates.

Property, plant and equipment can be revalued at fair value under IFRS. All

items that are in the same class are revalued together and on regular basis.

Property, plant and equipment are valued at historical cost under GAAP.

If the functional currency of a foreign operation is hyperinflationary, a current

purchasing power adjustment is made before translation and is based on the

closing rate at the end of the period. U.S. GAAP requires that the financial

statements are remeasured as if the parent’s reporting currency were its

functional currency.

The statement of cash flows is presented slightly different under IFRS. Bank

overdrafts are sometimes included in the cash and cash equivalents amount.

Under GAAP, bank overdrafts are presented under financing activities.

Interest and dividends paid can be classified as operating or financing

activities. Interest and dividends received can be classified as operating or

investing activities. Under GAAP, interest received and paid is classified as

operating activities, dividends received is classified as operating, and

dividends paid are classified as financing.

Income taxes can be classified as financing or investing activities if they can

be specifically identified with an activity. Under GAAP, income taxes are

classified as operating activities.

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Under IFRS, comparative information is required for the preceding period and

additional information and periods may be presented. US GAAP does not

require comparative information.

A statement of financial position is presented when there has been a change in

accounting policy, error correction, or the reclassification of items under

IFRS. US GAAP does not require the presentation of a statement of financial

position in any circumstances.

As you can see there are many differences between U.S. GAAP and IFRS. It would be

wise to thoroughly review your operations and determine how these variations will affect your

profit. It would be most profitable to enter the global market in a country that has a stable

economy and their exchange rate is fairly close to yours. With the large market for sports apparel

and accessories, it would most likely be profitable to enter the global market.

Doupnik, Timothy. International Accounting. 3rd ed. McGraw-Hill. 2012.

Kieso, Donald. Intermediate Accounting.14 ed. John Wiley & Sons, Inc. 2012.

KPMG. IFRS Compared to US GAAP: An Overview. 2012. http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/IFRS-GAAP-comparisons/Documents/IFRS-compared-to-US-GAAP-2012.pdf

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Ratio Analysis

2015 2014 2013LiquidityCurrent ratio 2.27 2.30 3.71Quick ratio 0.56 0.59 0.94Days Sales Outstanding 64.96 81.20 22.88

ProfitabilityProfit margin on sales 1.81% 8.56% 3.26%

Payout ratio172.99

% 68.70%109.81

%Return on assets 7.55% 16.54% 11.88%

SolvencyDebt to equity 4.16 3.69 1.12Debt to assets 0.81 0.79 0.53Interest coverage ratio 6.60 12.11 30.87

Chester Inc. had substantially high liquidity ratios. The liquidity ratios represent the

amount of assets that are quickly convertible into cash in the event the company dissolves and

the debt of the company can be satisfied. The current ratio represents all of the current assets that

can be converted to cash within a reasonable amount of time. The quick ratio disregards fixed

assets and inventory because these assets may not be easily converted to cash. The day’s sales

outstanding measures how often they are collecting on their accounts receivable accounts. If the

ratio is represented by a high number, the company may not be sufficiently collecting their

receivable or extending excessive amounts of credit. Chester Inc. was above the industry

standard of 2.34 for the current ratio in 2013 but recovered in 2014 and 2015 with a much lower

ratio that was in line with the standards. Their competitors, Columbia and Under Armour,

experienced varied ratios from 2.65 to 4.15. The industry standard for the quick ratio is 1.00 and

Chester had a normal ratio in 2013 indicating that they had sufficient liquid assets to cover

liabilities. If the ratio falls below 1.0 this could indicate liquidity problems. In 2014 and 2015,

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the quick ratio decreased to a dangerously low level. Columbia and Under Armour remained at a

quick ratio rate that was well above the 1.0 standard. The day’s outstanding ratio was below the

industry standard of 40 in 2013 and increased substantially in 2014 and 2015. This could be an

indication that credit was extended to unreliable customers or that the accounts receivable

department was not sufficiently collecting payments on a regular basis. Its competitor, Under

Armour, remained below the industry standard in both 2013 and 2014; however, Columbia was

above the industry norm with 66.48 and 59.84 days sales outstanding in 2013 and 2014,

respectively.

The profit margin measures how much net income was part of the net sales. Chester had a

very low profit margin in 2013 compared to the industry standard of 7.1%. In 2014, they had an

above average profit margin and in 2015 this figure dropped below the average. The large

fluctuations could be a result of excessive expenses in 2013 and 2015 or it could indicate that net

sales were not sufficient to cover the expenses. Chester’s competitors experienced profit margin

slightly below the industry norm but were consistent in their margin. The payout ratio shows

how much of the net income is paid out in cash dividends to stockholders. In 2013 and 2015,

Chester paid out dividends that were in excess of their net income. These two years far exceed

the industry standard of approximately 47%. The dividend payout in 2014 was far more realistic

and was sufficiently covered by the net income for that year. This may indicate that the company

is more interested in providing their stockholders with a return on their investment but this could

be detrimental in the future if the funds could have aided the company in expanding its business.

Both of its competitors had below average payout ratios indicating that they were retaining their

earnings for future development. In the case of Under Armour, they have not paid out cash

dividends in the last two years. The return on asset ratio shows how well the company is utilizing

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its assets to create a profit. Chester demonstrated a lower than average return in 2013 and 2015 in

comparison to the industry standard of approximately 16%. This was a result of reduced income

or large increases in total assets. This could be an indication that the company is carrying too

many assets or is experiencing an excessive amount of expenses that is reducing net income. The

16.5% return in 2014 was on target for optimal use of available assets. Both of its competitors

experienced below average results in both 2013 and 2014.

The solvency ratios indicate how well the company can protect its long-term creditors

and its investors. The debt to equity ratio indicates when the business is financing its assets

through debt rather than equity. Chester has a much higher debt to equity ratio than the industry

standard of 0.8 in 2014 and 2015 with a more stable ratio in 2013. This is an indication that they

rely on outside financing for operating activities and less on investors. This would result in

higher interest expenses and lower net income. Its competitors experienced lower ratios which

indicate that they rely more heavily on equity than debt to finance operations. The debt to asset

ratio measures how much of the assets are financed by debt in comparison to equity. This ratio is

important to long-term creditors and shareholders and will indicate how solvent the company is

in paying interest expense and still realizing a reasonable profit. The debt to asset ratio in the

apparel industry should be approximately 0.2. Chester has experienced higher than usual debt

ratio in all three years and the ratio has increased every year. This indicates that the company’s

assets are more heavily financed through debt rather than equity. This could eventually pose a

problem in satisfying maturing debt. Under Armour maintained an average debt to assets ratio

while Columbia was slightly higher than the industry norm. The interest coverage ratio indicates

how well the company can pay its interest expenses on outstanding debt. The industry standard is

5.8. Chester had above average ratios for all three years. Typically, the ratio should average 1.5

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and a ratio lower than this would indicate that the company may be having difficulty making

interest payments on outstanding debt. It appears that Chester should have no problem paying

their interest payments with its high debt financing. Both competitors are well above the industry

norm and have no indications that interest payments are a problem.

Apparel manufacturing - quarterly update 2/9/2015. (2015). Austin: Hoover's Inc. Retrieved from http://ezproxy.snhu.edu/login?url=http://search.proquest.com/docview/1652798307?accountid=3783

http://www.bizstats.com/corporation-industry-financials/manufacturing-31/apparel-manufacturing-315/apparel-accessories-and-other-apparel-315990/show?asset_class_id=7&submit=Apply

Columbia Sportswear Company. 2014 Annual Report.http://www.shareholder.com/visitors/dynamicdoc/document.cfm?documentid=3156&companyid=COLM&page=1&pin=&language=EN&resizethree=yes&scale=100&zid=b4abdcae

Under Armour. 2014 Annual Report.http://files.shareholder.com/downloads/UARM/506859626x0x816471/3BEBC664-8584-4F22-AC0B-844CB2949814/UA_2014_Annual_Report.PDF

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2015 2014 2013

Current AssetsCash and Cash Equivalents 4,451,964$ 4,339,579$ 4,056,327$ Accounts Receivable (net) 47,299,976 57,709,400 18,935,104 Inventory (net) 55,432,255 63,715,368 19,766,507 Prepaid Insurance 2,667,722 2,830,474 929,143 Prepaid Rent - - 250,000 Office Supplies 9,182 9,565 9,259 Investments 2,070,736 2,238,634 715,864

Total current assets 111,931,835$ 130,843,020$ 44,662,203$ Property, plant, and equipment (net) 2,863,557 3,345,711 1,262,654 Other non-current assets - - 67,301

Total assets 114,795,392$ 134,188,731$ 45,992,157$

Current LiabilitiesTaxes Payable 6,011,540$ 3,205,440$ -$ Accounts Payable 13,850,648 22,488,866 5,791,398 Wages Payable 198,384 264,513 36,838 FICA Employee Withholding 7,089 9,452 1,648 Medicare Withholding 9,589 12,785 730 Federal Payroll Taxes Payable 99,192 132,256 7,541 State Payroll Taxes Payable 46,291 61,720 3,519 FICA Employer Withholding 7,089 9,452 1,648 Medicare Employer Withholding 9,589 12,785 730 Current portion of long-term debt 12,084,720 13,440,000 - Interest payable 568,429 470,311 - Bonuses payable 459,000 504,000 - Dividend payable 15,000,000 15,250,000 6,000,000 Line of credit 44,177,211 49,731,360 12,500,000

Total Liabilities 92,528,772$ 105,592,941$ 24,344,053$

10,131,250 10,131,250 10,131,250 Paid-in Capital 9,278,750 9,278,750 9,278,750 Retained Earnings 2,856,620 9,185,791 2,238,105

Total equity 22,266,620$ 28,595,791$ 21,648,105$ Total liabilities and equity 114,795,392$ 134,188,731$ 45,992,157$

Common stock, $1.22 par value, issued and outstanding, 8,275,000 shares

Stockholders' Equity

Chester Inc.Consolidated Balance Sheet

ASSETS

December 31,

LIABILITIES AND EQUITY

December 31, 2015

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2015 2014 2013Net Sales 265,766,109$ 259,406,820$ 302,094,169$ Cost of goods sold 179,103,248 161,029,981 176,961,527 Gross profit 86,662,862 98,376,838 125,132,642 Selling expenses 40,217,839 31,527,867 60,888,999 Administrative expenses 27,685,580 26,007,696 30,483,568 Income from operations 18,759,443 40,841,276 33,760,075 Income from investment 1,138,905 1,227,199 - Interest income 142,168 147,707 255,379 Interest expense (2,842,147) (3,373,056) (1,093,750) Loss on legal settlement - - (23,965,000) Income before income tax 17,198,369 38,843,126 8,956,704 Income tax expense - federal (7,269,540) (14,142,240) (2,956,250) Income tax expense - state (1,258,000) (2,503,200) (536,250) Net income 8,670,829$ 22,197,686$ 5,464,204$

Earnings per common share 1.05$ 2.68$ 0.66$

Year Ended December 31,

Chester Inc.Consolidated Statements of Operations

December 31, 2015

Balance, January 1, 2013 2,773,901$ Net Income 5,464,204 Cash dividends (6,000,000) Balance, December 31, 2013 2,238,105$ Net Income 22,197,686 Cash dividends (15,250,000) Balance, December 31, 2014 9,185,791$ Net Income 8,670,829 Cash dividends (15,000,000) Balance, December 31, 2015 2,856,620$

Chester Inc.Statement of Retained Earnings

December 31, 2015

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2015 2014Cash flows from operating activities

Net Income 8,670,829$ 22,197,686$

617,155 581,012 Change in current assets 19,023,570 (85,897,565) Change in current liabilities (13,064,169) 81,248,888

Net cash used by operating activities 15,247,385 18,130,021

Cash flows from investing activities

Sale of land - 142,299 Purchase of equipment - (2,739,067) Purchase of storage building (135,000) -

Net cash used by investing activities (135,000) (2,596,769)

Cash flows from financing activitiesPayment of cash dividend (15,000,000) (15,250,000)

Net cash provided by financing activities (15,000,000) (15,250,000)

Net increase (decrease) in cash 112,385 283,252 Cash at beginning of year 4,339,579 4,056,327 Cash at end of year 4,451,964$ 4,339,579$

Depreciation Expense

December 31, 2015

Chester Inc.Statement of Cash Flows

Adjustments to reconcile net income to net cash provided by operating activities:

Year Ended December 31,

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2015 2014/2015 Change % Change 2014 2013/2014 Change % Change 2013Net Cash 4,451,964$ 112,385$ 3% 4,339,579$ 283,252$ 7% 4,056,327$ Accounts Receivable (net) 47,299,976 (10,409,424) -18% 57,709,400 38,774,297 205% 18,935,104 Inventory (net) 55,432,255 (8,283,113) -13% 63,715,368 43,948,861 222% 19,766,507 Prepaid Insurance 2,667,722 (162,752) -6% 2,830,474 1,901,331 205% 929,143 Prepaid Rent - - #DIV/0! 0 (250,000) -100% 250,000 Office Supplies 9,182 (383) -4% 9,565 306 3% 9,259 Property, plant, and equipment (net) 2,863,557 (482,155) -14% 3,345,711 2,083,058 291% 715,864 Investments 2,070,736 (167,898) -7% 2,238,634 1,522,770 121% 1,262,654

Other Noncurrent Assets - - #DIV/0! 0 (67,301) -100% 67,301 Total assets 114,795,392$ (19,393,340)$ -14% 134,188,731$ 88,196,574$ 192% 45,992,157$

Taxes Payable 6,011,540 2,806,100 88% 3,205,440$ 3,205,440$ #DIV/0! -$ Accounts Payable 13,850,648 (8,638,219) -38% 22,488,866 16,697,468 288% 5,791,398 Wages Payable 198,384 (66,128) -25% 264,513 227,675 618% 36,838

FICA Employee Withholding 7,089 (2,363) -25% 9,452 7,804 473% 1,648 Medicare Withholding 9,589 (3,196) -25% 12,785 12,055 1651% 730 Federal Payroll Taxes Payable 99,192 (33,064) -25% 132,256 124,715 1654% 7,541 State Payroll Taxes Payable 46,291 (15,429) -25% 61,720 58,200 1654% 3,519 FICA Employer Withholding 7,089 (2,363) -25% 9,452 7,804 473% 1,648

9,589 (3,196) -25% 12,785 12,055 1651% 730 Line of Credit 44,177,211 (5,554,149) -11% 49,731,360 37,231,360 #DIV/0! - Current Portion Long-term debt 12,084,720 (1,355,280) -10% 13,440,000 13,440,000 #DIV/0! - Interest Payable 568,429 98,118 21% 470,311 470,311 #DIV/0! - Bonuses Payable 459,000 (45,000) -9% 504,000 504,000 8% 6,000,000 Dividends Payable 15,000,000 (250,000) -2% 15,250,000 9,250,000 74% 12,500,000 Common Stock 10,131,250 - 0% 10,131,250 - 0% 10,131,250 Paid-in Capital 9,278,750 - 0% 9,278,750 - 0% 9,278,750 Retained Earnings 2,856,620 (6,329,171) -69% 9,185,791 6,947,686 310% 2,238,105

Total Liabilities and Equity 114,795,392$ (19,393,339)$ -14% 134,188,731$ 88,196,574$ 192% 45,992,157$

Medicare Employer Withholding

Chester Inc.Horizontal Analysis of Balance Sheet

December 31, 2015

2015 2014/2015 Change % Change 2014 2013/2014 Change % Change 2013Net Sales 265,766,109$ (6,359,289) -2% 259,406,820$ (42,687,349)$ -14% 302,094,169$ Cost of Goods Sold 179,103,248 (18,073,266) -11% 161,029,981 (15,931,546) -9% 176,961,527 Gross Profit 86,662,862$ 11,713,977 12% 98,376,838$ (26,755,804)$ -21% 125,132,642$ Expenses:

Selling expenses 40,217,839 (8,689,972) -28% 31,527,867 (29,361,132) -48% 60,888,999 Administrative expenses 27,685,580 (1,677,884) -6% 26,007,696 (4,475,872) -15% 30,483,568

67,903,419$ (10,367,856) -18% 57,535,562$ (33,837,005)$ -37% 91,372,567$ Other Revenues and Gains 1,281,073 93,833 7% 1,374,906 1,119,528 438% 255,379 Other Expenses and Losses 2,842,147 530,909 16% 3,373,056 (21,685,694) -87% 25,058,750 Income before taxes 17,198,369$ 21,644,757 56% 38,843,126$ 29,886,422$ 334% 8,956,704$ Income taxes 8,527,540 8,117,900 49% 16,645,440 13,152,940 377% 3,492,500 Net Income 8,670,829$ 13,526,857 61% 22,197,686$ 16,733,482$ 306% 5,464,204$

December 31, 2015

Chester Inc.Horizontal Analysis of Income Statement

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Net Cash 4,451,964$ 3.9% 4,339,579$ 3% 4,056,327$ 8.8%Accounts Receivable (net) 47,299,976 41.2% 57,709,400 43% 18,935,104 41%Inventory (net) 55,432,255 48.3% 63,715,368 47% 19,766,507 43%Prepaid Insurance 2,667,722 2.3% 2,830,474 2% 929,143 2%Prepaid Rent - 0.0% - 0% 250,000 1%Office Supplies 9,182 0.01% 9,565 0.01% 9,259 0.02%Land 131,040 0.1% 131,040 0.1% 146,250 0.3%Buildings and Land Improvements 833,775 0.7% 698,775 1% 779,882 2%Equipment (net) 1,898,741 1.7% 2,515,897 2% 336,521 1%Investments 2,070,736 1.8% 2,238,634 2% 715,864 2%Other Noncurrent Assets - 0.0% - 0% 67,301 0.1%

Total assets 114,795,391$ 100.0% 134,188,731$ 100% 45,992,157$ 100%

Taxes Payable 6,011,540 5.2% 3,205,440 2% - 0.0%Accounts Payable 13,850,648 12.1% 22,488,866 17% 5,791,398 12.6%Wages Payable 198,384 0.2% 264,513 0.2% 36,838 0.1%FICA Employee Withholding 7,089 0.01% 9,452 0.01% 1,648 0.004%Medicare Withholding 9,589 0.01% 12,785 0.01% 730 0.002%Federal Payroll Taxes Payable 99,192 0.1% 132,256 0.1% 7,541 0.02%State Payroll Taxes Payable 46,290 0.04% 61,720 0.05% 3,519 0.01%FICA Employer Withholding 7,089 0.01% 9,452 0.01% 1,648 0.004%Medicare Employer Withholding 9,589 0.01% 12,785 0.01% 730 0.002%Line of Credit 44,177,211 38.5% 49,731,360 37% 12,500,000 27.2%Current Portion Long-term debt 12,084,720 10.5% 13,440,000 10% - 0.0%Interest Payable 568,429 0.5% 470,311 0.4% - 0.0%Bonuses Payable 459,000 0.4% 504,000 0.4% - 0.0%Dividends Payable 15,000,000 13.1% 15,250,000 11% 6,000,000 13.0%Common Stock 10,131,250 8.8% 10,131,250 8% 10,131,250 22.0%Paid-in Capital 9,278,750 8.1% 9,278,750 7% 9,278,750 20.2%Retained Earnings 2,856,620 2.5% 9,185,791 7% 2,238,105 4.9%

Total Liabilities and Equity 114,795,391$ 100.0% 134,188,731$ 100% 45,992,157$ 100%

2015 2014 2013

Chester Inc.Vertical Analysis of Balance Sheet

December 31, 2015

21

Net Sales 265,766,109$ 100% 259,406,820$ 100% 302,094,169$ 100%Cost of Goods Sold 179,103,248 67% 161,029,981 62% 176,961,527 59%Gross Profit 86,662,862$ 33% 98,376,838$ 38% 125,132,642$ 41%Expenses:Selling expenses 40,217,839 15% 31,527,867 12% 60,888,999 20%Administrative expenses 27,685,580 10% 26,007,696 10% 30,483,568 10%

67,903,419$ 26% 57,535,562$ 22% 91,372,567$ 30%

Other Revenues and Gains 1,281,073 0.5% 1,374,906 1% 255,379 0.1%Other Expenses and Losses 2,842,147 1% 3,373,056 1% 25,058,750 8%Income before taxes 17,198,369$ 6% 38,843,126$ 15% 8,956,704$ 3%Income taxes 8,527,540 3% 16,645,440 6% 3,492,500 1%Net Income 8,670,829$ 3% 22,197,686$ 9% 5,464,204$ 2%

2015 2014 2013

Chester Inc.Vertical Analysis of Income Statement

December 31, 2015

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Auditor’s Recommendations

The personal products industry is highly competitive and has a narrow profit margin. For

this reason, any company in this industry must be able to manage their costs effectively and

maintain a large market share. There is a large occurrence of product failure in this industry and

considerable research and development must be conducted to introduce new products. With the

customer interaction there is also a higher chance of product liability and recalls for harmful or

misused products. There is a large legal expense to protect the company from large and excessive

lawsuits. In the case of Newham, the company was involved in a false advertisement campaign

that will have financial ramifications. There has also been questionable bonus payments issued to

upper management. A recommendation is made to establish a compensation committee that

reviews bonus payments for executives.

Risk can occur in various components of the business. An assessment of operational,

compliance, internal audit, financial statement, fraud, credit risk, and customer risk should be

conducted at various levels of the organization. The financial statement risk assessment

considers the characteristics of the financial reporting elements and the effectiveness of internal

controls. The fraud risk assessment involves the evaluation of key areas that are susceptible to

fraud and is performed in conjunction with the requirements of the Sarbanes-Oxley act. The

optimal management of risk is achieved through prevention and protection. A company can

educate employees, thoroughly investigate discrepancies, provide resources for reports of risk,

and financial protection through insurance coverage. The business risks that should be

considered are monetary loss, lost discounts, increased warehousing space, vendor changes,

regulatory compliance changes, or loss of shareholder confidence. Every business must be able

to adapt to any risks that may arise and this is no different for Newham.

23

There are several red flags that were detected in the audit risk assessment of Newham. In

sales and accounts receivable, there is the chance of vendor/employee collusion with the initial

test of controls that found 42 sample items with no credit approval. There could have also been

false invoices prepared to inflate sales. This could be the reason for the missing shipping

documentation on 25 samples. Although the total of the customer account balances are

reconciled with the general ledger at the end of the month, this does not detect whether the

payments were posted to the correct account. Employee embezzlement could also occur when

refunds and credit memos are presented to the controller.

The cash management function has shown several flaws. The payroll register and the

payroll bank account should not be retained by the controller. This shows a lack of internal

control and may invite other employees to fabricate fictitious employees and the controller does

not take action to verify actual employees. There is no evidence that there are access restrictions

on the company bank accounts. This could be a clear invitation for employee embezzlement.

There is also opportunity to falsify reconciliations when the bank statements are mailed to one

person. The internal auditors may be influenced by the controller when the reconciliations are

reviewed. The internal auditors may feel that pressure from the controller to agree with the

reconciliations which would produce false reports.

The cash receipts and accounts receivable processing has several flaws as well. The

receipt of payments by the office secretary could introduce the possibility of theft. The posting of

payments to the accounts could be inaccurate and allow employees to improperly credit the

wrong account. It could also allow employees to commit collusion with customers and divert

payments to their accounts. Incorrect or inaccurate resolutions could occur in the case of

customer disputes. A customer service employee could be influenced by a customer to resolve an

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issue hastily or to the benefit of the customer. Employee/customer collusion could also occur in

this situation. The cash disbursement process could be impacted by fraudulent disbursement

requests.

The Sarbanes-Oxley act was established to protect investors from companies that took

part in fraudulent financial reporting. There are many concerns with Newham and its compliance

with this act. There are many functions within the accounts receivable function that lack internal

controls and there were substantial inconsistencies found in the test of controls. Section 404 of

the act specifically states that management must attest to adequate internal controls and

procedures to ensure fair financial reporting within the company. The external auditor must

indicate if there were any material weaknesses that were attributed to internal controls. Newham

has shown that they lack certain internal controls and are not in compliance with the SOX act.

With the large change in accounts receivable between 2014 and 2015 and the large

amount of deviations in test of controls, it is my primary recommendation to increase the sample

size to 300 sales transactions. This should consist of 25 transactions from each month. The

overall audit of Newham’s internal controls and management’s assessment to these controls is in

line with AS No. 5 of the PCAOB standards. With the selection of the sample size, I have

devised an audit plan in accordance with AS No. 9 of the PCAOB standards. The audit should

verify that each invoice is part of the processed batch and a matching computer-generated listing.

Verification that the invoice is part of the daily accounts postings report should be performed.

The auditor should also verify that the monthly summary entries match the postings to the

general ledger. There seems to be a lack of internal controls for the cash disbursement process.

The audit should sample 5 percent of the cash refunds and credit memos and verify the

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authorization. The examination of these transactions is performed to identify audit risk in

conjunction with AS No. 8 of the PCAOB standards.

The process of bank statement reconciliation lacks important internal controls. The

auditor should request copies of account statements for two months out of the year from the

bank. A comparison of withdrawals and deposits recorded by the bank should be made to the

company records, cash receipt journal listing and cash disbursement listing. It should be verified

that internal audits are completed on a regular basis on bank account reconciliations. It should

also be verified that sample transactions were correctly paid with appropriate documentation

such as a check copy or electronic transfer memo. Sample transactions should appear on the

duplicate deposit slips and remittance advices. These actions should be verified by the auditor.

To verify the customer balance statement process, pull the statements of the sample transactions

and verify that the balance and any transactions are reported correctly. The auditors should also

review the disputes and discrepancies that are handled by the customer service team. The audit

should consist of 5 percent of the cash disbursements to verify the controller’s signature and

documentation that should be available to substantiate the reason for the disbursement. The

evaluation and validation of these results should constitute an opinion on the fairness of the

financial statements in conjunction with AS No. 14 of the PCAOB standards.

All of these recommendations rely on the preparation and success of the external audit.

To facilitate a successful external audit, Newham must conduct internal audits on a regular basis

and report results to their audit committee. In light of the deviations in the control test, there

should be every effort made to retain all documentation for all transactions. There should also be

a record of all disputes and discrepancies that are handled by Newham. The internal and external

auditors should have early and frequent communication to avoid duplicate work. To enhance the

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audit quality, there must be open communication between the audit committee, external auditors

and internal auditors. Proper training of the internal auditors on what audit evidence the external

auditors may need is essential to the success of this audit. The audit committee can facilitate

communication between the internal and external auditors and act as an intermediary in the

management of expectations between both. The cooperation of Newham’s audit committee and

its internal auditors will impact the success of this audit.

A Practical Guide to Risk Assessment. PriceWaterhouseCoopers. http://www.pwc.com/en_US/us/issues/enterprise-risk-management/assets/risk_assessment_guide.pdf

Davis, Marc. Identifying and Managing Business Risks. Investopedia. Accessed August 4, 2015. http://www.investopedia.com/articles/financial-theory/09/risk-management-business.asp

Public Company Accounting Oversight Board. Accessed August 12, 2015. http://pcaobus.org/Standards/Auditing/Pages/default.aspx

Tysiac, Ken. How Audit and Audit Committees Can Work Together. Journal of Accountancy. March 10, 2015. Accessed August 14, 2015. http://www.journalofaccountancy.com/news/2015/mar/how-audit-and-audit-committees-can-work-together-201511930.html

U. S. Securities and Exchange Commission. Accessed August 8, 2015. https://www.sec.gov/about/laws/soa2002.pdf

Venture Choice. Business Risk Analysis. Accessed August 4, 2015. www.venturechoice.com/articles/business_risk.html

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Newham CorporationAUDIT PROGRAM

Scope of the Audit

The overall objective of this audit is to determine the reliability of company information

and its financial statements. The sales, cash receipt, cash disbursement, and invoicing processes

will be reviewed to determine their accuracy and the existence of satisfactory internal controls.

This will include the verification of authorization on applicable transactions, the determination

that separation of duties is being observed. The existence of and adherence to sound business

practices and procedures will be reviewed for compliance.

1. Sales and Accounts Receivable: Sales invoices are prepared on a daily basis with a

computer-generated invoice number. The accounts receivable clerk does not have the

authorization to override this process. Measures are taken to verify that the first invoice

number of the day is consistent with the last invoice number from the prior business day.

Inconsistencies are investigated and resolved in a sufficient manner. The quantity, price,

and other sales terms are compared on the items shipped and items billed. The daily sales

invoice batch report is reconciled to the accounts posting report by the accounting

department manager.

2. General Ledger: The ending balances of customer account balances are reconciled

with the control account by the accounting department supervisor. All monthly summary

entries are approved by the accounting department supervisor.

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3. Cash Management: All cash refunds and credit memos are approved by the

controller. Bank statements are mailed to the controller’s office. Bank deposits, the cash

receipt journal listing, and the cash disbursement listing are reconciled to the bank

accounts. The payroll account is reconciled to the payroll register. The assistant controller

performs the bank account reconciliation. Bank reconciliations are occasionally reviewed

by the internal auditors.

4. Cash Receipts and Accounts Receivable Processing: The office secretary receives

the cash receipts. A cash receipt listing and daily deposit are prepared and a copy is sent

to the controller. A copy of the listing and the remittance advice are sent to accounts

receivable for posting. Statements are mailed to accounts receivable customers on a

monthly basis. Disputes are investigated and resolved.

5. Cash Disbursements: Checks are signed by the controller. It will be determined if

sufficient documentation and proper authorization occurred for all cash disbursements.

Audits Steps Completed by

Planning and Administration SectionConduct pre-audit interview with Newham and document the discussion. (AS No. 14)Hold an audit planning meeting with Internal Audit and document the discussion. The time period being audited, audit objectives and testing being performed should be discussed with upper management.A meeting should be scheduled with key personnel about the audit objectives and the type of information being collected.

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Determine if there are any process flowcharts available.

FieldworkSales and Accounts ReceivableConduct a walkthrough of the sales and accounts receivable process and verify that procedures exist. (AS No. 5)Pull 300 sample invoices (25 per month) for testing. (AS No. 9)Verify that each sample invoice is part of a processed batch and computer generated listing.Verify that each sample invoice is part of the daily accounts posting report.Verify that the monthly summary entries match the general ledger posting from four selected months.Verify that the items shipped matches the items billed on the invoice (i.e. description/item number, quantity, price).Verify that the invoice is applied to the customer’s account.Verify that discrepancies are recorded with resolutions.General LedgerCompare sales batches to entries in general ledger control account.Verify that credit approval was obtained.

Check computation on sample invoices.

Determine if shipping documentation is found that matches invoice.Sample 5% of the cash refunds and credit memos for appropriate approval. (AS No. 8)Cash Management Obtain copies of bank statements from the bank for March and October.Choose 10 transactions per month and compare to deposit slip and journal entries.Review the internal reconciliations for these

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statements and verification that the internal audit department reviewed them.

Cash Receipts and Accounts Receivable ProcessingCompare daily cash receipts listing for 10 random days to remittance advices and posted entries.Verify that the posting date is the same as the remittance date on the 10 selected dates.Send verification letters to 10 accounts receivable customers to confirm legitimate accounts.Verify that customer disputes and resolutions are recorded.Cash DisbursementsPull a 5% sample of all cash disbursements.

Verify proper authorization is obtained and supporting documentation is retained on cash disbursements. (AS No. 14)

Communicate ResultsShare testing results with appropriate Newham personnel.Submit a findings summary so an action plan and target date can be developed. (AS No. 14)

Close Out and Submit ReportSubmit draft report for review.

Complete an exit interview with upper management to discuss findings.Discuss action plans and target dates for addressing the issues.Make necessary changes to the report and submit for approval.Issue final report after review is complete. (AS No. 14)

http://www.peruvirtual.net/finreporting/SelectionofAuditprograms/Revenue%20Receivables%20Audit%20Program.pdf

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https://view.officeapps.live.com/op/view.aspx?src=http%3A%2F%2Fauditknowledge.com%2Foperational%2FFIN%2520-%2520Audit%2520Program%2520Template.doc

Memorandum-to-the-File

Date: May 1, 2023From: Michele Jones, S.N.H.U., LLCRe: Emma Shire

Facts

Ms. Shire has questions and concerns about her personal income taxes, as well as other taxes as

they relate to her role in a partnership with Marlene Anderson. Ms. Shire is questioning what

actions she can take throughout the year to 1) effectively reduce her personal tax liability, 2)

effectively reduce her partnership tax liability, and 3) the tax consequences of changing the

partnership to a corporation.

Issues

Ms. Shire has provided tax information and requested that her 2014 income tax return be

prepared. She would like to know the tax ramifications of actions that could be taken in reference

to her personal income taxes.

Law

Sec. 21(a)(1) provides that in the case of an individual who maintains a household which

includes as a member one or more qualifying individuals, there shall be allowed as a credit

against the tax imposed by this chapter for the taxable year an amount equal to the applicable

percentage of the employment-related expenses paid by such individual during the taxable year.

Sec. 21(a)(2) provides that the term “applicable percentage” means 35 percent reduced (but not

below 20 percent) by 1 percentage point for each $2,000 (or fraction thereof) by which the

taxpayer’s adjusted gross income for the taxable year exceeds $15,000. Sec. 21(b)(1)(A) defines

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“qualifying individual” as a dependent of the taxpayer who is under the age of 13 and with

respect to whom the taxpayer is entitled to a deduction under section 151(c). Sec. 21(c)(2)

provides that the amount of the employment-related expenses incurred during any taxable year

which may be taken into account under subsection (a) shall not exceed $6,000 if there are 2 or

more qualifying individuals with respect to the taxpayer for such taxable year. Sec. 21(e)(3)

states an individual legally separated from his spouse under a decree of divorce shall not be

considered as married.

Sec. 103(a) provides that gross income does not include interest on any state or local bonds. Sec.

103(c) defines a state or local bond as an obligation of a state or political subdivision and a state

is defined as any possession of the United States including the District of Columbia.

Sec. 170(b)(1)(B) provides that there is an allowable deduction of no greater than 50% of the

taxpayer’s AGI for charitable contributions. Per Sec. 170(b)(1)(B)(ii), the excess of 50 percent of

the taxpayer’s contribution base will be carried forward up to five successive years.

Sec. 219(a) provides that an individual is allowed as a deduction of an amount equal to the

qualified retirement contributions of the individual for the taxable year. Sec. 219(b)(5) dictates

that the deductible amount is $5,000 for taxable years after 2008 and a cost-of-living adjustment

of $500 has increased the deductible amount to $5,500 in 2014.

Sec. 162(a)(2) provides that there shall be allowed as a deduction all the ordinary and necessary

expenses paid or incurred during the taxable year in carrying on any trade or business including

traveling expenses, such as meals and lodging, while away from home in the pursuit of a trade or

business.

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Sec. 179(a) provides that a taxpayer may elect to treat the cost of any section 179 property as an

expense which is not chargeable to a capital account. Any cost so treated shall be allowed as a

deduction for the taxable year in which the section 179 property is placed in service. Per Sec.

179(b)(1), the aggregate cost which may be taken into account under subsection (a) for any

taxable year shall not exceed $25,000. Sec. 179 property is defined as tangible property,

computer software, section 1245 property, and property acquired for use in the active conduct of

a trade or business.

Sec. 301.7701-3(g)(1)(i) provides that, if an eligible entity classified as a partnership elects under

Sec. 301.7701-3(c)(1)(i) to be classified as an association, the following is deemed to occur: the

partnership contributes all its assets and liabilities to the association in exchange for stock in the

association, and immediately thereafter, the partnership liquidates, distributing the stock of the

association to its partners.

Sec 351(a) provides that no gain or loss shall be recognized if property is transferred to a

corporation by one or more persons solely in exchange for stocks in such corporation and

immediately after the exchange such person or persons are in control.

Analysis

Issue 1: Both of Ms. Shire’s children are under the age of 13 and are considered qualifying

individual under Sec. 21. If she must place the children in child care while working at Clifford,

she is eligible to use the child care credit. She can claim up to $6,000 for both children and her

credit is based on her adjusted gross income. Based on her adjusted gross income she could

receive up to $1,200 in child care credit. Interest on state and local bonds is tax free per Sec. 103.

34

This benefit could reduce the amount of interest that she claims as income. Ms. Shire has weekly

charitable contributions to qualifying institutions. Sec. 170 allows up to 50% of adjusted gross

income to be deducted and any excess to be carry forward up to 5 years after. Each individual

contribution cannot exceed $250 and must be given to a qualifying organization. This would

provide an itemized deduction of up to $46,990. In addition, Ms. Shire could take advantage of

the IRA deduction. Based on the criteria, a 100% deduction can be taken on up to $5,500 of

contributions made by her per Sec. 219

Issue 2: As a partner, Ms. Shire could claim any business expenses that she personally incurred

for the operation of the boutique. This amount cannot exceed the amount of net income of

$23,580 that is included on her Schedule K-1. Ms. Shire has the opportunity to use the Section

179 deduction on any eligible property that is not applied to a capital account. This amount

cannot exceed $25,000 in a taxable year and is included on the Schedule E.

Issue 3: The partnership has the option to incorporate under Sec. 301-7701. This must be

accomplished by transferring all assets and liabilities of the partnership to the new corporation in

exchange for stock in the corporation. The partnership will then be liquidated and each partner

will receive equal shares of stock in the corporation. The transfer of assets and liabilities for an

equal amount of stock will create no gain or loss for the partners. If there is excess funds that are

distributed to the partners, these amounts will be taxable as a gain on the sale of capital assets.

Conclusion

There are several areas where Emma Shire could reduce her tax liability on a personal and

professional level. If she incurs child care expenses for her two children and has proper

substantiation, she could benefit from a reduction in taxes due. Emma could purchase municipal

35

bonds and avoid the taxable interest that is included in her gross income. This would lower her

adjusted gross income and also lower the limitation amounts on some itemized deductions. The

amount of charitable contributions could be increased substantially to increase itemized

deductions and reduce tax liability. She should be cautioned to not make an individual

contribution of more than $250 and that the recipient is a qualified organization. Ms. Shire is still

at a young age where an IRA could benefit her at retirement. She should consider opening an

account and making annual contributions. An annual contribution of up to $5,500 is fully

deductible from gross income. This would also lower her adjusted gross income and lower some

of the ceiling limitations on itemized deductions offering her more opportunities to use other

deductions such as medical expenses and other miscellaneous deductions.

There are several areas where Emma could also reduce her tax liability in relation to her

partnership. She should consider expenses that she incurs to promote and operate her business

that are not reimbursed by the business. This could include traveling expenses such as meals and

lodging. She should be careful to not include extravagant or excessive expenses that could be

excluded from this benefit. Another option is the inclusion of Sec. 179 expenses on Schedule E.

This inclusion would reduce the amount of business income and effectively reduce her gross

income. She must be careful to not include expenses that have already been accounted for in the

taxable income reported on Schedule K-1. These expenses cannot be charged to the capital

accounts of the partnership.

The tax consequences of changing the partnership to a corporation are favorable for Emma and

Marlene. If all assets and liabilities of the partnership are exchanged for equal amounts of stock

in the corporation, the partners will not experience a gain or loss on the change. There will be no

36

tax liability associated with the conversion. Other tax benefits of incorporating would be the

elimination of recognizing business income on their personal tax returns and incurring additional

tax liability. If they incorporate, they will only incur a tax liability if the corporations issues

dividends. If dividends are issued, the tax rate will be lower for Emma because the recognition of

partner income puts her in a higher tax bracket. Also, when partnership income is recognized,

this is regardless of whether any distributions were made during the taxable year.

Fitzpatrick J.D., Diana. How Partnership Are Taxed. Accessed 8/21/2015. http://www.nolo.com/legal-encyclopedia/how-partnerships-are-taxed-29710.html

Internal Revenue Code. www.fourmilab.ch/ustax.html

Kunz, Marnie. 5 Major Differences Between a Corporation and a Partnership. Accessed 8/21/2015. http://smallbusiness.chron.com/5-major-differences-between-corporation-partnership-18830.html

Lamaute, D. (1991, 10). Defensive tax planning. Black Enterprise, 22, 84. Retrieved from http://ezproxy.snhu.edu/login?url=http://search.proquest.com/docview/217874267?accountid=3783

Laurence, Beth. How Corporation Are Taxed. Accessed 8/24/2015. http://www.nolo.com/legal-encyclopedia/how-corporations-are-taxed-30157.html

Rev. Rul. 2004-59. Internal Revenue Service. Accessed 8/21/2015. www.irs.gov/irb/2004-24_IRB/ar12.html

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Memorandum-to-the-File

49

Date: May 1, 2023From: Michele JonesRe: Clifford Co.

Facts

Emma Shire is a human resource manager at Clifford Company in College Park, MD. The

company would like to make a property distribution (dividend) of the three machines that it uses

in its business. It no longer needs two of these machines. All three machines have a fair market

value of $20,000 each. The basis of each machine is as follows: Machine A, $27,000; Machine

B, $20,000; and Machine C, $12,000. The corporation has asked for your advice.

Issues

Ms. Shire is questioning Clifford’s tax preparation in regards to a property distribution to

shareholders. Clifford Co. is asking for recommendations on which two machines should be

distributed to the shareholders.

Law

Sec. 317(a) defines property as money, securities, and any other property.

Sec. 301(b)(3) states that fair market value shall be determined as of the date of the distribution.

Sec. 301(c)(1) states that the portion of the distribution which is a dividend shall be included in

gross income. Sec. 301(c)(2) states that the portion of the distribution which is not a dividend

shall be applied against and reduce the adjusted basis of stock. Sec. 301(c)(3)(A) provides that a

portion of the distribution which is not a dividend, to the extent that it exceeds the adjusted basis

of the stock, shall be treated as a gain from the sale or exchange of property. Sec. 301(d) states

the basis of property received in a distribution to which subsection (a) applies shall be the fair

market value of such property.

50

Sec. 311(a)(2) states that no gain or loss shall be recognized to a corporation on the distribution

with respect to its stock of property except as provided in subsection (b). Sec. 311(b)(1)(B) states

that if the fair market value of such property exceeds its adjusted basis (in the hands of the

distributing corporation), then gain shall be recognized to the distributing corporation as if such

property were sold to distribute at its fair market value.

Analysis

Issue 1: Emma will experience a dividend distribution if appreciated property is distributed to the

shareholders. If there is no gain or loss recognized, there will be no tax implications for Emma. If

the company distributes depreciated property, there will also be no tax implications for Emma.

Emma’s basis in the property that is distributed is equal to the fair market value of the distributed

machine - $20,000.

Issue 2: The company will not recognize a loss on the distribution of depreciated property. If the

company distributes appreciated property, the company is taxed on the recognized gain governed

by Sec. 311(b). Machine A would be distributed at loss of $7,000; however, no loss would be

recognized by Clifford per Sec. 311. Machine B would be distributed with no gain or loss. This

distribution would be recognized as a reduction in the equipment account with no other

implications to the company or its shareholders. Machine C would be distributed at a gain of

$8,000. This gain would be passed through to the shareholders as a capital gain and Clifford

would be required to recognize a gain as if the machine were sold for cash.

51

Conclusion

The tax preparation by Clifford is dependent upon which machine is distributed to the

shareholders. All three scenarios will result in different outcomes. If Machine A is distributed, no

loss will be reported on the company’s financial statements. Machine B is indifferent because the

property will be distributed at its basis. If Machine C is distributed, the company must recognize

a gain of $8,000. This will increase the tax liability for Clifford and reduce net income. The gain

will also be distributed to the shareholders and there are no deductions allowed for dividends

issued. It is my recommendation that Clifford distribute Machine A and B. With the distribution

of Machines A and B, there will be no tax implications for Emma. Machine C should not be

distributed to the shareholders. The company should sell the machine outright and pay the taxes

on the realized gain. In most cases, the corporate tax rate is lower than a shareholder’s tax rate in

the recognition of capital gains. Also, the portion of the gain that remains after taxes would be

reinvested within the company.

Internal Revenue Code. www.fourmilab.ch/ustax

Property Dividends. 2007. Howells Business Consulting & CPA Firm, LLC. Accessed 8/24/2015. http://www.rhowellsconsulting.com/propertydividends.htm

Property vs. Cash Distributions from your Corporation. Accessed 8/24/2015. http://www.chochan.com/doc/taxletters/Property-vs-cash-distribution-from-Corporation.pdf

Publication 542 (03/2012), Corporations. Accessed 8/24/2015. http://www.irs.gov/publications/p542/ar02.html#en_US_2011_publink1000257895

Tax Consequences of Distributions from C Corporations. Accessed 8/24/2015. http://jer.co/distributions-c-corporations/

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