Question

(Disclosures Required in Various Situations) Ace Inc. produces electronic components for sale to manufacturers of radios, television sets, and digital sound systems. In connection with her examination of Ace’s financial statements for the year ended December 31, 2018, Gloria Rodd, CPA, completed field work 2 weeks ago. Ms. Rodd now is evaluating the significance of the following items prior to preparing her auditor’s report. Except as noted, none of these items have been disclosed in the financial statements or notes.

Item 1: A 10-year loan agreement, which the company entered into 3 years ago, provides that dividend payments may not exceed net income earned after taxes subsequent to the date of the agreement. The balance of retained earnings at the date of the loan agreement was \(420,000. From that date through December 31, 2018, net income after taxes has totaled \)570,000 and cash dividends have totaled $320,000. On the basis of these data, the staff auditor assigned to this review concluded that there was no retained earnings restriction at December 31, 2018.

Instructions

For each of the above items, discuss any additional disclosures in the financial statements and notes that the auditor should recommend to her client. (The cumulative effect of the four items should not be considered.)

Short answer

Retained earnings are restricted to the amount of $420,000.

Step-by-step solution

Meaning of Financial Statements

Financial statements are reports generated by a company's management to demonstrate the company's financial performanceand position at a certain moment in time. A balance sheet, income statements, statement of owner's equity, and statement of cash flows are usually included in a general-purpose collection of financial statements.

Additional disclosure in the financial statements

The provisions of the loan agreement were misinterpreted by the employee auditor evaluating it. Retained profit is limited to the amount of $420,000, which was the remainder of retained earnings at the time of settlement. The nature and amount of the limit should be mentioned in the balance sheet or financial statement note.