AEROFLEX DISCUSSION QUESTIONS...A12. Prepare income statements for Aeroflex for 2015 (one year) where each amount is shown as a percentage of “Net sales”. [This is called a common-size

AEROFLEX, INC.

Barry M Frohlinger, Inc. copyright 1981 - 2018 all rights reserved Page 1

Barry M Frohlinger

AEROFLEX DISCUSSION QUESTIONS

AEROFLEX, INC.


FINANCIAL STATEMENTS

• You have received the Aeroflex, Inc. 2015 annual report INSTRUCTIONS [read before each major topic]

1. Notice that the fiscal year end is June 30. 2. Ignore income taxes unless the question asks you to consider them. The statutory federal income tax rate for all years for Aeroflex is 34% (because net income is too small to be taxed at 35%). 3. The amounts and account titles in your answers should be specific to the Aeroflex

financial statements. 4. A page of definitions of common financial ratios is attached at the end of this

document.

DISCUSSION QUESTIONS A. NATURE & PURPOSE OF FINANCIAL STATEMENTS [see Instructions above] A1. Read the company information included at the beginning of Aeroflex, Inc's annual

report. Then, scan Aeroflex's 2015 financial statements with attachments. Notice the principle financial statements and their formats, the headings for the footnotes, the Independent Auditors' Report, and Management's Discussion and Analysis.

AEROFLEX, INC.


A2. Calculate Aeroflex's (net) working capital at yearend 2014 and at yearend 2015 and list the increases or decreases in the components of working capital during 2015. [ a common calculation of working capital is total current assets – total current liabilities].

A3. How is the fiscal year 2015 net income of $4,420,000 per the income statement

reflected in Aeroflex's June 30, 2015 balance sheet?1 Also, how is the fiscal year 2014 net loss of $(17,420,000) reflected in Aeroflex's

2014 balance sheet? A4. Aeroflex recorded many transactions during 2015 that caused the changes in its

balance sheet accounts from yearend 2014 to yearend 2015. Does Aeroflex give us any summary of these 2015 changes?

A5. Aeroflex has $81,047,000 of assets at yearend 2015. Show how these assets have

been financed using the following groupings2:

by delayed payments for operating payables & accruals $ by cash borrowing from lenders $ by stockholders (both by investment & retained profits) $_________ total $81,047,000

A6. Based on the information in the 2015 statement of cash flows, describe the most

significant cash flow occurrences for Aeroflex during 2015. A7. Why is depreciation and amortization shown as a “source” of cash ($4,322,000 for

2015) in Aeroflex's statement of cash flows? A8. For Aeroflex's 2015 statement of cash flows, which is the first line reporting a flow of

cash?

1 Remember that all income statement items are found in TWO places in the balance sheet 2 Insert equity first, as this is the easiest to find, then debt.

AEROFLEX, INC.


A9. Which amount gives a better portrayal of Aeroflex's true 2015 profitability: (i) net income of $4,420,000 or (ii) net cash provided by operating activities of

$8,729,000? A 10. Read the following:

Excuses Vary for Dallas-Area Firms Seeking Extensions for Annual Statements

During 2015, in the Dallas area, several companies were late in filing their annual financial statements, Form 10K, with the U.S. Securities and Exchange Commission. Eighteen of the area's 240 largest publicly traded companies asked the SEC for an extension for the filing of their 2014 annual reports. The late filing should make lenders and investors a little uncomfortable. This is typically not a good sign. If they are requesting extensions, there ought to be a darn good reason why. The deadline is not a surprise for corporations. All public companies are required to file a quarterly financial statement, called a Form 10Q, 40 days after the close of the quarter, and [and large corporates] an annual report 60 days after the end of the year. That means the 2014 10K for companies with a year ending Dec. 31 should have been filed with the SEC by March 1, 2015. Companies that couldn't meet that deadline could ask the SEC for an extension. Some companies are late because of financial entanglements with creditors; others report they just didn't have enough accounting help to get the reports out in time; and some companies say they just don't like the wording of a paragraph. Sometimes the auditors want to restate some numbers, or there might have been an acquisition that just got approved or fell through. The late-filing request by Dallas-based Silverleaf Resorts Inc., which owns and operates 22 time- share resorts, was typical in that it cited ongoing negotiations with lenders as the main reason for the delay. Silverleaf reported that it was negotiating with one of its principal lenders to extend additional credit. The money is needed to "sustain normal sales and marketing operations," according to an SEC filing. The "uncertainties associated with the company's proposed downsizing ... (are) expected to delay its earnings release," the company said.

10. Aeroflex's financial statements include an Independent Auditors' Report. a. Is the Report (i) an unqualified opinion or (ii) a qualified opinion? b. Did the auditors check all of Aeroflex's transactions to be certain that they were

recorded correctly?

AEROFLEX, INC.


Read the following:

Ernst & Young LLP collected $2.6 million from HealthSouth Corp. for conducting janitorial inspections of the health-services company's facilities and advised it to classify the payments as "audit-related fees," leading HealthSouth to make inaccurate public disclosures about Ernst & Young's fees for nonaudit services.

The brainchild of former HealthSouth Chairman and Chief Executive Richard Scrushy, the inspections were part of a program HealthSouth called "Pristine Audits." Despite the name, these reviews had nothing to do with Ernst's audits of the company's financial statements. Rather, the primary purpose of the inspections was to check the cleanliness and physical appearance of HealthSouth's approximately 1,800 surgical and rehabilitation facilities.

Under the program, Ernst made unannounced visits to each facility once a year, using dozens of junior-level accountants who were trained for the inspections at HealthSouth's headquarters. The accountants carried out the reviews armed with a 50-point checklist designed by Mr. Scrushy. The checklist included seeing if magazines in waiting rooms were orderly, the toilets and ceilings were free of stains, and the trash receptacles all had liners. HealthSouth paid Ernst more money to inspect its facilities than it did to audit its books.

An Ernst spokesman, Donald Howarth, says: "E&Y believes that HealthSouth's fees were properly classified." He declined to comment when asked how the pristine audits were related to HealthSouth's financial-statement audits. HealthSouth's new management team takes a different view. "HealthSouth relied on Ernst & Young to classify the audit- and nonaudit-related fee information," says Andrew Brimmer, a HealthSouth spokesman. "We do not consider the pristine audit work to be related to the financial audit."

The wording of the disclosures came amid widespread investor criticism over hefty fees auditing firms receive from corporate clients for nonaudit services. Since the SEC began requiring auditor-fee disclosures, audit fees at large companies typically have been about one-third the size of the fees paid to auditors for other services. The disclosures have prompted many investors to complain that accountants might not be impartial and independent in audits with so much other business at stake.

Many companies, encouraged by their auditors, have tried to allay such concerns by voluntarily disclosing how much of their fees for "other" services are "audit-related." The SEC's rules didn't envision this practice or define the term "audit-related." But it would be considered improper for a proxy to use the term "audit-related" in a false and misleading way. More-common examples of audit-related services include pension-plan audits and consultations on accounting rules. "Pristine audits" previously had been unheard of, according to accounting-industry executives.

HealthSouth's proxy, filed with the SEC, said the company paid Ernst $1.03 million to audit its financial statements and $2.65 million of "all other fees." The proxy said the other fees included $2.58 million of "audit-related fees," and $66,107 of "nonaudit-related fees."

AEROFLEX, INC.


The proxy did not describe in any detail the audit-related or nonaudit-related services for which Ernst was paid. A HealthSouth spokesman, says the audit-related-fee figure included about $1.3 million for the pristine audits.

Mr. Scrushy was fired by HealthSouth's board, as was Ernst, shortly after the first of 11 former HealthSouth executives pleaded guilty to felony charges over an accounting fraud that overstated profits by $2.5 billion. In a civil complaint, the SEC has accused Mr. Scrushy of participating in the fraud. Upon firing Ernst, HealthSouth discontinued the pristine audits.

The government's fraud complaints against former HealthSouth executives haven't cited the pristine audits. But the program illustrates how Ernst had become an instrument of HealthSouth's marketing machine when it was supposed to be acting as the company's financial watchdog. Mr. Scrushy touted the company's nearly perfect pristine-audit scores at public appearances. Ernst says its auditors had been unaware of HealthSouth's accounting deceptions.

Describing the pristine audits at an investor conference, Mr. Scrushy said: "We believe one of the reasons that we have done so well has to do with the fact that we do audit all of our facilities, 100%, annually. And we use an outside audit firm, our auditors, Ernst & Young. They visit all our facilities, 100%."

On its Web site, HealthSouth said the pristine audit, "administered independently by Ernst & Young LLP ... ensures that all of our patients enjoy a truly pristine experience during their time at HealthSouth. The average score was 98 percent, with more than half of our facilities scoring a perfect 100 percent."

Thomas Sjoblom, an attorney for Mr. Scrushy, says the pristine audits were aimed at providing better care for HealthSouth patients. "The intent was not to use Ernst & Young as part of its marketing program," Mr. Sjoblom says.

"E&Y arguing that checking the cleanliness of a facility is 'audit related' goes well beyond the pale of sanity and common sense," said Lynn Turner, the SEC's chief accountant from 1998 until 2011. Walter Schuetze, another former SEC chief accountant, says Ernst should stop insisting that HealthSouth properly characterized the firm's fees.

"Calling that audit-related is false and misleading," Mr. Schuetze says. "Not only does it fly in the face of facts. It suggests that Ernst & Young was covering up the facts .... When Ernst & Young deliberately misclassifies something that is clearly on its face wrong, that undermines everything Ernst & Young says and does."

AEROFLEX, INC.


A11. A gain or loss must be both (i) unusual in nature and (ii) infrequent in occurrence in

order for it to be segregated at the bottom of the income statement as an extraordinary item (shown net of income taxes). What extraordinary1 items does Aeroflex show?

A12. Prepare income statements for Aeroflex for 2015 (one year) where each amount is

shown as a percentage of “Net sales”. [This is called a common-size statement or vertical analysis.]

A13. Explain why a common-size income statement would be useful to a financial analyst. A14. What explains Aeroflex's increase in pretax profitability from continuing operations

from 2014 to 2015? [Ignore income taxes.] A15. Aeroflex's Note 16 shows information by Business Segment.

a. Does each of the tables agree with a balance sheet or income statement or cash statement amount?

b. What is the definition of “operating profit”? c. Is it appropriate to say that all of Aeroflex's businesses grew by approximately

27% in 2015 (as reflected by net sales)? d. Calculate the operating profit margin, by each of the three segments, for 2014 and

2015.

1 Until 2002, material gains and losses from the early retirement of debt were specifically required to be classified as extraordinary items. SFAS 145 rescinded this requirement. Since 2002, SFAF 141 requires that negative goodwill be recorded as an extraordinary item.

AEROFLEX, INC.


A16. Aeroflex presents its “Quarterly Financial Data” following Note 17. a. Do Aeroflex's sales appear to be seasonal? b. How did you distinguish between seasonal fluctuations (occurring annually) and

cyclical fluctuations (related to general economic conditions)? A17. Indicate the immediate effects [ +, -, none, for increase, decrease, no effect] of each of

the independent transactions below on Aeroflex's 2015: (i) current ratio of 2.3 to 1.0; [use the calculation of current assets/current liabilities] (ii) leverage ratio of 57%; [leverage ratio in this question is defined as (total

liabilities/[total liabilities plus equity]) (iii) pretax rate of return on total assets at yearend of 12.0% [defined as (operating profit)/total assets] [Suggestions: Determine the effect of the journal entry on the numerator and on the

denominator. Ignore income tax consequences.]

a. Inventory costing $320,000 is sold on account for $430,000. b. Common stock is issued for $500,000. c. Inventories are purchased on account for $120,000.

A18. Aeroflex's “Management's Discussion and Analysis” contains a section titled

“Results of Operations”. List any questions that you have about the discussion, analysis and terminology.

A19. Aeroflex shows the following information:

Market value per share (June 30, 2015) $ 5.13 Book value per share (calculated) 2.81 Stockholders' equity = 35,040,000 Common shares outstanding at yearend* 12,489,000 *12,658,000 issued less 169,000 in treasury

What circumstances might explain the large difference between these two amounts? [Note: At August 29, 2015 the market value per share was $8.38.]

AEROFLEX, INC.


A20. What is Aeroflex's liquidation value at yearend 2015?

[First read the following from March 26, 2015]:

NEW YORK -- Children's book publisher and marketer Scholastic Corporation conditionally won an auction to purchase the inventory of failed Internet retailer eToys Inc. Scholastic was the highest of more than 30 bidders for the Los Angeles toy retailer's inventory. Scholastic bid 30 cents on the dollar, or about $10 million, for the inventory, which includes toys, books, videos, software and other children's products, with a book value of $35 million.

[Then read the following from December 2015]:

Last year, Gary Brooks probably could have sold the knitting machines of the bankrupt company he is liquidating for $12,000 to $15,000 each. This year, the chairman of Allomet Partners, a Manhattan turnaround firm, thinks he'll be lucky to get $8,000. That drastic drop in price is a signal of deep trouble for asset-based lenders. As the recession shrinks the value of everything from heavy machinery to electronic goods, lenders that used those assets to protect their loans may lose millions of dollars if their borrowers go belly-up. "We sent emergency notices to our clients for some time saying the world is ending," says Morris Hodkin, president of Daley-Hodkin, a Melville, L.I.-based appraisal and liquidation company that works with most asset-based lenders in New York. "I have been in the business for 30 years, but I have never seen conditions that are so bad across all sectors of manufacturing." But the pain is likely to spread as the economy worsens and the market is flooded with the assets of companies that are going out of business. Oddly enough, asset-based lenders are supposed to do well during bad times. Typically, they make loans to companies with weak financial statements, including startups and those close to bankruptcy. During 2014, when the economy turned sour, outstanding loans grew by $48.9 billion to nearly $342.7 billion. The firms that stepped up their lending then didn't anticipate the rapid and unprecedented decline in the value of assets that accompanied the deepening recession. Economists say the drop is so dramatic because it comes on the heels of such a long expansion. Asset-based lenders' aggressive lending practices and loose credit policies, adopted during the boom times, are exacerbating the problems now.

AEROFLEX, INC.


New York lenders facing the downturn include asset-based lending departments of large banks, such as Foothill Capital, which is owned by Wells Fargo, and Congress Financial, which is owned by First Union. GE Capital, which is owned by General Electric, is one of the biggest lenders. While their lending practices vary and some are affected more than others, none is completely immune because of the variety of assets that are showing signs of stress. Machinery and equipment, which are typically the most illiquid assets, are the first to be affected in a downturn. But other assets, such as real estate and inventory, are declining in value as well. For instance, an inventory of women's stockings that would have been valued at $6 to $10 per dozen five years ago, now, it will go for no more than $1 per dozen.

Miles Stuchin, the president of Access Capital in Manhattan, says his asset-based lending firm makes loans to many service companies, including information technology businesses and advertising and media companies that don't have many hard assets. In those cases, Access Capital ties its loans to companies' accounts receivable. But with some of those customers beginning to hurt, those assets are also under pressure. The asset-based lenders are very concerned about collateral values. Foothill Capital typically makes loans in the plastics industry for 70% of the value of plastic injection molding equipment. But recently, the value of those machines has dropped by 30%. Companies that are seeking loans and own a large number of those machines stand to lose millions of dollars in financing as a result.

AEROFLEX, INC.


A21. Aeroflex must have a good, clean cutoff of transactions at June 30 each year. What

journal entries, if any, would Aeroflex make by June 30 for each of the following transactions? a. On July 10 received invoice for $27,500 for raw materials received on June 24. b. On July 3 paid factory payroll of $30,000 for work performed during June. c. On June 26 paid $8,000 for office rent for July. d. During June received written sales orders for $13,400 that were shipped to

customers on July 7. A22. Read the section of Aeroflex's Management's Discussion and Analysis titled “Results

of Operations--Fiscal 2015 compared to fiscal 2014”. Then list the variables for each line of the income statement that Aeroflex identifies to explain the increase in net income. Do not include dollar amounts. For example, one of the variables identified for net sales is “Volume” (increase or decrease).

A23. Aeroflex’s potential cash provided by operating activities for 2015 is $8,742,000

(calculated as the total of line nos. 1, 4 & 5 on the cash statement). a. Explain why potential cash provided by operating activities of $8,742,000 greatly

exceeds net income of $4,420,000.

b. Explain why actual cash provided by operating activities of $8,729,000 is less than potential cash provided by operating activities of $8,742,000.

A24. The last sentence of Note 1 says that “reclassifications” have been made to 2014 and 2013 financial statements. What does this mean?

AEROFLEX, INC.


A25. Would an increase in the (net) working capital be desirable for Aeroflex? Copy the column headings listed below on to a wide sheet of paper. List some typical

actions that Aeroflex might have taken to increase each current asset or decrease each current liability (one account at a time). Then identify the related consequence (i.e., to keep the balance sheet in balance). Next, determine the effect that the action (and related consequence) would have on the (net) working capital (“+” for increase, “-“ for decrease, “NE” for no effect). Finally, decide whether the action would be (i) desirable or (ii) not desirable for Aeroflex, and why.

Suggestion: Ignore income tax consequences for each action except when specifically

considering the income tax accounts in the balance sheet. Action to Effect on Desirable or increase CA work. cap. not desirable or decrease CL Related consequences +, -, NE and why . Illustration to increase receivables:

Extend credit Less cash on hand NE not desirable-cash terms for earns interest income receivables but receive. do not

Illustration to increase long-term debt:

Borrow long-term Reduce current portion +WC may be desirable if cash and prepay debt of debt is needed long-term and currently due interest rate is acceptable

AEROFLEX, INC.


B. OPERATING CASH INFLOWS / REVENUES / RECEIVABLES [Reread instructions]

B1. What is the relationship between (i) accounts receivable of $21,843,000 and (ii) net sales of $94,299,000? B2. The balance sheet shows “less allowance for doubtful accounts” of $417,000 related

to receivables. What does the $417,000 represent? B3. What caused the increase during 2015 in the allowance for doubtful accounts (from

$354,000 to $417,000)? See Schedule II. B4. Calculate the amount of cash that Aeroflex collected during 2015 from its customers. B5. Redo the preceding question using one account for receivables, net of the allowance. B6. What effect did the write off of specific accounts (i.e., not the provision for bad debts

expense) have on net receivables at yearend 2015? [Suggestion: show that if no specific accounts had been written off during 2015, the net accounts receivable would not have changed.]

B7. Consider Aeroflex’s receivable turnover ratio.

a. Calculate the 2015 & 2014 receivable turnover ratios and then express them in days. You need to know that the net accounts receivable balance at yearend 2013 was $18,898,000.

b. Does the decrease in receivables indicate that the average collection period is faster in 2015?

c. Explain why the 2014 (last year) ratio is not a valid calculation. See Note 2.

AEROFLEX, INC.


B8. Explain in words why the 2014 (last year) statement of cash flows shows the increase in accounts receivable of $2,220,000 as a use of cash even though the receivable account involves no cash outflows.

B9. Describe the type of records that Aeroflex would maintain for accounts receivable. B10. Identify & describe the two basic methods that Aeroflex could have used to calculate

the allowance for doubtful accounts. B11. List two or three management policies that Aeroflex could have changed at the

beginning of 2015 that would have resulted in a smaller bad debt expense for 2015. Would these changes (and the resulting lower bad debt expense) have resulted in a higher or lower 2015 income from continuing operations before income taxes?

B12. If Aeroflex normally accepts notes receivable collectible in monthly installments due

for 24 months, can it include the entire note receivable amount in current assets? B13. Assuming that the following transaction had occurred on June 30, 2015 (yearend),

describe how Aeroflex's 2015 balance sheet would have been different. A customer whose account receivable balance totaled 75,000 signed a 90-day, 10% note for $75,000 in full payment of its balance. B14. What entry will Aeroflex make on July 31, 2015 to record the interest earned (after

one month) on the note receivable described in the preceding question? All interest is collected at the maturity of the note.

B15. The Letter to Shareholders (last paragraph) mentions backlog. How is the

June 30, 2015 backlog of $53.3 million shown in Aeroflex's financial statements?

AEROFLEX, INC.


B16. Note 1 describes the accounting for “Revenue and Cost Recognition on Contracts”. When does Aeroflex recognize revenue? [Is revenue recognized as production progresses or only upon completion of the contract?]

Then read the following, from Bausch and Lomb [10-K], 2012:

Revenue Recognition and Related Provisions and Allowances The Company recognizes revenue when realized or realizable and earned, which is when the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred; the sale price is fixed and determinable; and collectibility is reasonably assured. The Company has established programs that, under specified conditions, enable customers to return product. The Company establishes liabilities for estimated returns and allowances at the time revenues are recognized. In addition, accruals for customer discounts, rebates and estimated costs of warranties are recorded when revenues are recognized.

Revenues from equipment under operating leases are recognized over the lease term.

Service revenues are derived primarily from service contracts on equipment sold to customers and are recognized over the term of the contracts while costs are recognized as incurred. The Company maintains provisions for uncollectible accounts for estimated losses resulting from the inability of its customers to remit payments. The Company continuously monitors collections and payments from its customers and maintains a provision for estimated credit losses based upon its historical experience and any specific customer collection issues that have been identified. For the sale of multiple-element arrangements whereby equipment is combined with services, including maintenance and training, and other elements such as supplies, the Company allocates to and recognizes revenues from the various elements based on verifiable objective evidence of fair value.

Amounts billed to customers in sale transactions related to shipping and handling are classified as revenue.

Net sales reflects reductions in gross revenues attributable to customer incentive programs offered including cash discounts, promotional and advertising allowances, volume discounts, contractual pricing allowances, rebates and specifically established customer product return programs.

AEROFLEX, INC.


B17. Aeroflex could finance $1 million of its receivables in either of the following ways:

(i) borrow $1 million in short-term bank loans by pledging the receivables to the bank as collateral (receivables are not sold); or

(ii) sell the receivables by factoring1 them, with recourse, to a financial institution for

$1 million (the recourse is only a contingent liability). What effect would each of these two alternatives have on Aeroflex's balance sheet,

income statement and statement of cash flows? Be specific and use line numbers for the statement of cash flows. There are no income tax consequences.

B18. Assume that Aeroflex made each of the following transactions on April 1, 2015.

Answer the questions using present value tables first, and then use a programmed calculator if you desire. [Compare your solutions to the solution notes after completing each transaction.]

a. Aeroflex sold merchandise with a list price of $50,000. Typically, Aeroflex gives

a discount off the list price (the list price less discount represents the “normal” sales price). The customer gave Aeroflex a non-interest-bearing note for $45,000 due one year after date of sale. The customer normally borrows at 10% for this type of note. What is the real sales price for this transaction (i.e., what is the principal amount)?

b. Aeroflex sold merchandise with a list price of $80,000. A customer whose

borrowing rate is 9% gave Aeroflex a non-interest bearing note for four equal annual payments of $20,000 each (a total of $80,000).

(i) What is the real sales price? (ii) What is the total interest income to be recognized? (iii) How much interest income will be recognized during the first month? (iv) What amount will be shown as a current asset (note receivable) at the date of

sale?

1 The factoring arrangement is similar to securitization. Assume in this case, the securitization passes the tests of FAS 166 and the receivables are removed from the balance sheet.

AEROFLEX, INC.


B18. continued c. Aeroflex sold merchandise with a list price of $30,000. The customer whose

borrowing rate is 8%, made a down payment of $10,000 and gave a non-interest bearing note to Aeroflex for $20,000 due in two annual installments of $10,000 each with the first installment due one year after the sales date. What is the real sales price?

d. Aeroflex sold merchandise with a normal sales price of $100,000 and received a

non-interest bearing note receivable for $109,000 due one year after date of sale. What is the apparent borrowing rate of the customer for this type of contract (i.e., what is the interest rate implied in the contract)?

e. Aeroflex sold merchandise with a normal sales price of $200,000 and received a

non-interest bearing note receivable for $232,800 due in equal annual installments of $77,600 at the end of each of the next three years. What is the interest rate implied in the contract?

f. Aeroflex has some old merchandise with a list price of $500,000. A discount

wholesaler has offered to take these goods “off Aeroflex's hands” if payment can be made in two equal installments (at the end of each of the first two years after sale). Aeroflex estimates that the prospective customer's borrowing rate is 9%. Aeroflex would be happy to sell the old merchandise for $400,000 in cash. What installment payments should Aeroflex ask from the customer?

[Suggestion: use the formula -- P = F times FACTOR and calculate “F”; evaluate your answer for reasonableness].

AEROFLEX, INC.


C. OPERATING CASH OUTFLOWS / COST OF SALES / INVENTORIES [Reread instructions] C1. What is the relationship between (i) total inventories (on the balance sheet) and (ii) cost of sales? C2. Calculate the amount of additions to inventories during 2015. C3. Describe the “additions to inventories” calculated in the preceding question. What

would be some of the components of these additions? C4. Assume that Aeroflex's 2015 depreciation provision related to production was

$2,915,000. Explain how this depreciation is included in your figures for the preceding question.

C5. Explain why the 2015 statement of cash flows shows the increase in inventories of

$3,403,000 as a use of cash even though the inventories account has no journal entries that involve cash.

C6. What is the nature of Aeroflex's inventories at yearend 2015? [I.e., the balance sheet shows $20,319,000, but this is not money.] C7. Describe the valuation basis used for Aeroflex's inventories. C8. Calculate Aeroflex's 2015 inventory turnover ratio and give the number of days.

AEROFLEX, INC.


C9 Does Aeroflex’s use of the percentage of completion method for some contracts (see Note 1) affect the usefulness of the inventory turnover ratio that you calculated?

C10. Can you determine whether Aeroflex uses a (i) periodic or (ii) perpetual inventory

system to determine the quantities of inventories on hand? C11. Aeroflex, like most manufacturing firms, has “shrinkage” of inventories. Where is the

cost of shrinkage shown in the income statement? C12. What is the distinction between a “product” cost and a “period” cost? C13. Some businesses are considered to be “high fixed production cost” businesses. Does

Aeroflex appear to be one? Identify an industry group that has a much higher percentage of fixed cost.

C14. Redo your inventories T-account for 2015 using two accounts—one for gross

inventories and the second for the “Reserve for inventory obsolescence” which Aeroflex has netted with gross inventories on the balance sheet. See Schedule II for the amounts.

AEROFLEX, INC.


C15. Assume that Aeroflex has a plant that uses the lower of FIFO cost or market method (periodic inventory system) for inventories. a. The quantity of inventories is determined by a physical count at June 30, 2015.

Explain concisely how Aeroflex determines the cost (dollar amounts) for these inventories.

b. The plant receives a $10,000 invoice on July 10, 2015 for raw materials received

in the plant on June 27 (before yearend). What journal entry should be made before the books are closed for June 30, 2015?

c. Assume that the preceding entry was not made until July 10 and that this error was

never discovered. Indicate the effect [overstate, understate, no effect] on each of the following amounts. (1) Inventories, June 30, 2015 (2) Inventories, June 30, 2016 (3) Cost of sales, 2015 (4) Cost of sales, 2016 (5) Net income, 2015 (6) Net income, 2016 (7) Accounts payable, June 30, 2015 (8) Accounts payable, June 30, 2016 (9) Retained earnings, June 30, 2016

d. Illustrate how the plant would account for a product which has a total FIFO cost of $195,000 but is obsolete at June 30, 2015 and has a market value (net realizable value) of only $25,000. [the product is not yet sold, but has salvage or scrap value of $25,000].

e. Assume that the obsolete inventory in the preceding entry is sold for $25,000 in

fiscal 2016. Compare the effects of this inventory and its sale on fiscal 2015 & 2016 earnings: • if accounted for by lower-of-cost-or-market • if accounted for at cost

f. It is commonly believed that the lower-of-cost-or-market accounting is more conservative than the cost method and shows more cost of sales expense in each year. Comment based on your work in the preceding question.

AEROFLEX, INC.


D. OPERATING CASH OUTFLOWS / VARIOUS EXPENSES / OPERATING PAYABLES [INCLUDING INCOME TAXES1] [Reread instructions2]

D1. Assume that Aeroflex provides an accrued warranty expense liability that is included

in “Accrued expenses” on the balance sheet. The balances in the account are $927,000 for 2015 and $876,000 for 2014. Warranty expense is $823,000 for 2015 and $782,000 for 2014. Explain the changes during 2015 in the Accrued warranty expenses account.

D2. Why does Aeroflex show accrued warranty expenses of $927,000 as a liability at

yearend 2015? Who are the creditors? What are their claims against Aeroflex at yearend 2015?

D3. Aeroflex's Note 15b describes a lawsuit. What conditions are necessary before this

contingent liability would be recorded on the balance sheet? D4. If Aeroflex delays the payment of some accounts payable, how is this shown in the

2015 statement of cash flows?

1 In 1954, the nation's tax code, regulations and related material fit onto 14,000 pages in nine thick volumes issued by CCH Inc., a Riverwoods, Ill., publisher then known as Commerce Clearing House. By 1974, the company's standard tax publication had grown to 19,500 pages in 12 volumes. This year, it is 45,662 pages in 25 volumes. The intent of our training regarding tax is not to learn the code, but to understand what the footnote is telling us.

2 Upon exercise of a nonqualified stock option by an employee, the company receives a tax deduction (and the employee reports taxable income) for the difference between the exercise price and the quoted market price of the stock. Assuming that the company has sufficient taxable income in the year the option is exercised, the deduction reduces the income taxes that the company will pay to the federal government (that is, the deduction ultimately reduces the cash outflow for federal income taxes). The income tax benefit (reduction of a cash outflow) from the exercise of employee stock options must be included in the statement of cash flows.

AEROFLEX, INC.


D5. Note 14 describes employee benefit plans.

a. Find the following amounts at Year end 2015 for the defined benefit [DB] pension plans:

Plan Assets _________________ Plan Obligations _________________ Over/Underfunded Status _________________ Pension cost _________________

b. Prepare entries to record the 2015 ESOP Plan expense and payment of $263,000: 1. assuming the employer contribution was paid on June 30, 2015 (last day of

fiscal year) 2. assuming the employer contribution was paid on July 1, 2015 (first day of

next fiscal year)

AEROFLEX, INC.


Read the following regarding off balance sheet liabilities for Dow:

Dow stock plunged because of jitters about asbestos lawsuits. The company it had $230 million in asbestos liability, but that insurance covered all but $10 million of that. "We don't consider that to be material," reports the company.

Many analysts and investors disagree. They want to know how many claims are pending against Dow. What has been the average cost of resolving claims? What are Dow's reserves and amount of insurance coverage? Without that information, they say they have no way of verifying Dow's estimate of the problem.

Dow's taciturn approach to its asbestos exposure comes at a time when companies are under growing pressure to fully disclose their financial risks. In contrast, Halliburton Co. and 3M are among the companies that have bent over backward recently to discuss their respective exposures to asbestos-related litigation.

Numerous analysts want Dow to be just as forthright about the company's exposure. Dow has said it intends to more aggressively litigate asbestos lawsuits. But analysts worry that strategy leaves the company open to stiff verdicts. SEC rules say companies must disclose all material information, but the definition of material is fuzzy. The Supreme Court has defined it as anything the average investor would need to know to make an informed decision about an investment.

Some companies say they need to disclose only those things that have a direct impact on their finances. One rule of thumb is to disclose anything that affects more than 5% of net income. Others disclose issues that would affect at least 5% of assets or revenue. But some securities law experts argue that anything affecting a company's stock also should be considered material. Asbestos litigation has been particularly hard for investors to understand. Many companies have claimed the issue wasn't a serious burden right up to the time they sought bankruptcy-law protection. Three major companies that sold asbestos-containing products -- W.R. Grace, USG Corp. and Owens Corning -- have filed Chapter 11 bankruptcies, and investors are understandably skeptical. In addressing the issues, Dow and Halliburton couldn't be further apart. Attention focused on Dow, when its Union Carbide subsidiary settled a suit for an undisclosed amount just as jury selection was getting under way. Dow's stock price fell to $27 from $36 in a week, and later dipped to $24. Its financial reveal little more. The company hasn't mentioned asbestos litigation in either its own financial reports or those of its Union Carbide unit, which files separate reports. Dow directed inquiring investors to three and a half lines in Carbide's quarterly financial filing, where Carbide says it had recorded "nonenvironmental litigation accruals of $175 million," with $146 million paid by insurance. It estimated an additional $58 million, after insurance, of liability from future litigation. But Dow wouldn't say how much of those figures were asbestos-related. By contrast, Halliburton spends more than four pages of its financial filings giving the history and background of its asbestos litigation, breaking down the claims against its different entities, outlining its

AEROFLEX, INC.


strategy and its estimated liabilities. Since the first asbestos lawsuit was filed against Halliburton in 1976, asbestos litigation has cost the company a total of five cents a share, which wouldn't be considered material. Worried about attracting more lawyers looking for deep pockets, Halliburton hadn't revealed the amount of its insurance coverage. But after its stock price fell nearly 50% after its fourth asbestos jury verdict for $30 million, the company held a special investor conference call to review its litigation and disclose more than $2 billion in insurance covering about 45% of its claims, in addition to "significant insurance" for the remaining liability.

D6. Prepare entries to record Aeroflex's 2015 income tax transactions. [Combine the federal + state + foreign taxes for each journal entry.]

a. Accrue current income taxes b. Accrue deferred income taxes The accountant uses one balance sheet account for all deferred income taxes called “Deferred

income taxes on the balance sheet” to record the entry. Later, when the accountant prepares the balance sheet, this one account must be split between (i) current (i.e., working capital) and (ii) noncurrent in a manner similar to the one long-term debt account.

c. Accrue the $281,0001 income tax benefit from stock option plans. [This is a

reduction of accrued income taxes payable and increases the additional paid-in capital account (because the tax benefit relates to stockholder transactions, not to the income statement).] [Note: we will consider stock options in more depth as part of financing activities.]

d. Cash payments of income taxes (see last paragraph of Note 12). e. Cash refunds of income taxes (see last paragraph of Note 12). f. Complete the following three T-Accounts

a. tax payable b. deferred tax [combine all deferred tax into one account] c. income tax refund receivable d. tax expense

AEROFLEX, INC.


D7. The second table in Note 12 shows that expected taxes at the statutory rate are

$2,331,000, $(5,490,000) and $2,529,000. Demonstrate that the expected statutory rate for Aeroflex is 34% (which is below the typical 35% corporate rate because Aeroflex has small earnings).

D8. What were the main reasons why Aeroflex's actual income tax expense for 2014 (last

year) was more or less than the 34% statutory rate for Aeroflex? D9. Note 12 contains a table that reconciles the statutory rate for Aeroflex (34.0%) to the

actual tax expense using dollar amounts. Convert these dollar amounts into percentages of pretax income for the 2014 (last year) amounts. Be careful in the use of brackets.

D10. A financial analyst may want to adjust Aeroflex’s reported income statements to

segregate nonrecurring gains and losses as net aftertax amounts at the bottom of the income statement. Explain how each of the following would help the analyst to determine the amount of income tax related to the nonrecurring gain or loss. a. Footnote 2 to the “Quarterly Financial Data” (also footnote 2 to the “Selected

Financial Data” for five years). [Suggestion: also, see line no. 5 of SCF for pretax amount.]

b. The second table of Note 12 (especially the $7,888,000). c. The (i) statutory rate and (ii) actual tax rate that you just calculated from the

second table of Note 12. [The actual tax rate is also called the “effective” tax rate and the “average” tax rate.]

AEROFLEX, INC.


D11. Prepare entries to record Aeroflex's 2014 (last year) income tax transactions. [Combine the federal + state + foreign taxes for each journal entry.] a. Accrue current income taxes b. Accrue deferred income taxes [make one combined net entry to “Deferred income

taxes on balance sheet” because the split between deferred assets and deferred liabilities is not disclosed]

c. Accrue the $63,000 income tax benefit from stock option plans. [This is a reduction of

accrued income taxes payable and increases the additional paid-in capital account (because the tax benefit relates to stockholder transactions, not to the income statement).] [Note: we will consider stock options in more depth as part of financing activities.]

d. Cash payments of income taxes. e. Cash refunds of income taxes.

D12. Aeroflex is undergoing audits of prior years by the taxing authorities. Assume that

the authorities successfully claimed an additional income tax for 2012 of $200,000 that Aeroflex paid during fiscal 2015. How would this have been recorded?

D13. Aeroflex discloses “Valuation allowances” of $(3,569,000) and $(3,884,000) in the list of

deferred tax assets in the last table of Note 12. What might these allowances represent? D14. For this question, consider only temporary differences--ignore permanent differences.

Was book income before taxes larger or smaller than taxable income for 2014 [last year]?

D15. Convert the deferred tax for “Accounts receivable” of $148,000 for 2015 (per third

table of Note 12) into a pretax amount and, if possible, explain what the pretax amount represents.

D16. The third table in Note 12 shows total deferred income taxes of $1,709,000 at yearend

2015. Aeroflex provides unusually good disclosure because it shows the split between current assets and noncurrent assets in the footnote that enables the reader to relate the footnote amounts to the balance sheet. Find Aeroflex’s deferred income taxes in the balance sheet for both years.

AEROFLEX, INC.


E. INVESTING ACTIVITIES [reread Instructions] E1. Which of the following costs would be “capitalized” by Aeroflex as a fixed asset

(amounts in thousands): a. a machine: invoice price of $91,000; freight cost of $3,000; installation cost of

$1,000. b. a self-constructed manufacturing plant (building): construction materials

purchased of $200,000; labor of $285,000; depreciation on equipment used in construction of $27,000; overhead costs of $115,000; interest during construction on debt borrowed for construction of $23,000.

E2. Explain the distinction between “maintenance & repairs” and “betterments” and how

each should be accounted for by Aeroflex.

AEROFLEX, INC.


Read the following regarding Capital Spending:

Pathmark Woos Disaffected Shoppers; Spruces Up Stores, Retools Marketing Pathmark supermarkets have something of an image problem. Pathmark executives concede the 143-store chain holds a reputation in certain communities for low food prices but also for outdated stores -- and not always in that order. But those days could be over. Pathmark is working to reverse years of neglect with a plan to spend $150 million to revamp 35 stores and open nine new ones. Rounding out the comeback strategy: a new advertising campaign, price-cutting measures and an expanded ethnic marketing effort. An ill-fated leveraged buyout in the 1980s led to years of floundering that ended with Pathmark filing for Chapter 11 bankruptcy-court protection. Meanwhile, competitors opened on Pathmark turf sprawling new supermarkets featuring florists, gourmet bakeries and even banks. Moreover, archrival ShopRite, a 192-store cooperative has underpriced Pathmark with extensive coupon promotions and deals with wholesalers. Pathmark wasn't always the also-ran. When the company expanded into tough neighborhoods in the late 1960s and 1970s, its stores brought a gleaming vision of suburbia to the gritty inner-city streets. Then came a hostile takeover bid in 1987 from Dart Group, a food retailer in Landover, Md., since bought by Richfood Holdings. Fearing Dart would break up the company, Pathmark thwarted the takeover by buying back its 42.6 million shares outstanding for $47 each. Pathmark retained its independence, but its debt load soared to $2 billion from $50 million. According to Harvey Gutman, Pathmark's senior vice president for retail development, money for store maintenance dried up as the chain paid interest totaling $3 million a week. Executives responded by, among other measures, slashing capital spending to only 1.5% of annual sales. As a result, paint peeled, light bulbs burned out and shopping-cart wheels jammed. Since appearance is tied closely to a supermarket's success, analysts say chains usually devote about 4% of annual sales to upkeep, and the $150 million Pathmark plans to spend on improvements this year represents just that.

AEROFLEX, INC.


E3. Identify Aeroflex's depreciation method (for fixed assets) used for financial statement reporting.

E4. Does Aeroflex use the same or different depreciation methods for tax return

reporting? E5. It is commonly believed that an accelerated depreciation method is conservative and

shows more depreciation expense in each year than does the straight-line method. Create a simple illustration to show that accelerated depreciation (use sum-of-the-years'-digits method) depreciates the asset faster that the straight-line method but results in more depreciation in the early years and less depreciation in the later years.

E6. What factors would be necessary before Aeroflex could continually show more

depreciation expense every year for its accelerated depreciation method as compared to the straight-line method?

E7. Aeroflex’s 2015 cash statement shows depreciation and amortization of $4,322,000.

How much depreciation and how much amortization is included in this amount?

AEROFLEX, INC.


E8. How is the cost of fixed assets reflected in (i) the income statement and (ii) the statement of cash flows? Are the two presentations consistent?

a. Reconcile the following nine Accounts a. PPE gross, the accumulated depreciation and PPE net Accounts and b. the intangible gross, the accumulated amortization and intangible net

Accounts and c. the goodwill gross, the accumulated amortization and goodwill net

Accounts. E9. What types of intangible assets does Aeroflex have and how is the cost of each

amortized? [Include research & development costs in your discussion.] E10. Could Aeroflex have capitalized its research & development costs and amortized the

costs over the estimated useful life? E11. It is commonly believed that the immediate expensing of research & development

costs (as compared to capitalizing and amortizing the costs) is conservative and results in more expense and less net income in each year. Demonstrate that immediate expensing of research & development costs results in more expense in some years and less expense in other years.

E12. For each of the following independent situations, identify the (i) specific asset and

dollar amount to be shown on the yearend balance sheet and (ii) the amount of 2015 expense. [Dollar amounts are in thousands and were paid in cash; straight-line depreciation & amortization is used.] a. In midyear fiscal 2015 Aeroflex paid $200,000 for specialized machine tools

necessary to produce a new product. The tools last for 6 years, on average, but the new product is expected to be produced for only 4 years beginning in early fiscal 2016.

b. Aeroflex operates a large laboratory that has, over the years, found marketable

ideas and products worth tens of millions of dollars. On average, the successful products have a life of 8 years. Expenditures for the laboratory personnel were $347,000 expended evenly throughout 2015.

E13. Aeroflex shows the amount of research & development costs in Note 1. Comment on

the amount of this expense for the last 3 years.

AEROFLEX, INC.


E14. Calculate Aeroflex's 2015 pre-tax rate of return on assets [unleveraged profit] then disaggregate this ratio into (i) profit margin (before interest) and (ii) total assets turnover. Round to two decimal places.

Operating Profit = Operating Profit X Net sales Ave. total assets Net sales Ave. total assets E15. How does the disaggregated ratio in the preceding question aid a financial analyst in

developing a better understanding of Aeroflex's performance? E16. Is Aeroflex's rate of return (calculated above) high, adequate or low? E17. Comment on the level of Aeroflex's 2015 capital expenditures based on the following

2015 amounts: Capital expenditures (per statement of cash flows) 2,931,000 Depreciation (historical cost ) 3,301,0001 Depreciation (based on current replacement cost ) 3,301,0002 1 calculated as depreciation of $4,322,000 per line 4 of the cash statement less amortization of $1,021,000 2 not disclosed in Aeroflex's financial statements but assumed equal to depreciation charge

AEROFLEX, INC.


E18. Aeroflex has already adopted FAS 121, the accounting for the impairment of long-

lived assets.

a. Under what circumstances would Aeroflex be required to writedown the carrying value of its intangibles and goodwill?

b. What new value would be used if long-lived assets were written down? c. If a loss were recorded, could it be shown at the bottom of the income statement as

an extraordinary item? d. Would the tax benefit recorded for the loss be (i) current or (ii) deferred? e. Read the following about FASB 143, Accounting for Asset Retirement

Obligations [ARO]. The standard requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. When the liability is initially recorded, the entity capitalizes a cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss upon settlement. What journal entry is recorded by the firm when it recognizes the ARO? What entries are made over time regarding the asset and the obligation? What entry is made when the liability is settled?

E19. Aeroflex purchases a machine (e.g., for $10,000), depreciates it evenly over ten

years and retires it with no gain or loss. Compress the ten years into one cash statement and explain all aspects of the cash statement presentation for this machine.

E20. Aeroflex's Note 1 describes its accounting for fixed assets.

a. What journal entry would Aeroflex make if one of its machines (which cost $95,000 and has accumulated depreciation of $73,000) was determined to be obsolete, with a salvage value of $2,000?

b. What effect would this have on Aeroflex's balance sheet, income statement and

statement of cash flows? [Identify specific lines and ignore income tax consequences.]

c. What effect [+, - or none] would this have on Aeroflex's rate of return on yearend

assets ratio (during a profitable year)?

AEROFLEX, INC.


E21. Note 3 describes the restructuring charge.

a. What entry did Aeroflex make to record the restructuring charge and related payments during 2013? Ignore income tax consequences. You may assume the following: • the non-cash costs were for the abandonment of leasehold improvements and

the write-down of excess equipment and were made to accumulated depreciation.

• the remaining costs were accruals for severance, lease terminations and other related costs and all but $100,000 were paid before yearend 2013.

b. How is the payment reflected in the 2013 cash statement? Show all effects.

E22. Aeroflex capitalizes interest paid during the construction period for its buildings. Assume that total interest cost is $3,129,000 of which $155,000 was capitalized during the construction of a manufacturing plant with a useful life of 20 years. Describe the accounting for this interest and indicate when and where it will be reflected in Aeroflex's income statement.

E23. Assume that at the beginning of fiscal 2015 Aeroflex changes its estimate of the

useful lives of its fixed assets (depreciated on a straight-line basis) to reduce the useful lives by two years. Describe in words without figures how Aeroflex would handle the bookkeeping in 2015 for this change in accounting estimate.

E24. See Aeroflex's Note 16 re information by business segment. What information is

given about fixed assets?

AEROFLEX, INC.


E25. Aeroflex has the opportunity to invest $100,000 in only one of two projects. The expected net cash inflows from the two projects are:

Year Project A Project B 1 $ 50,000 $ 20,000 2 40,000 20,000 3 30,000 30,000 4 10,000 40,000 5 0 30,000 The three methods which Aeroflex can use to chose a project are:

(i) Accounting profit -- Select the project with the largest net cash inflows (after subtracting $100,000 investment). [Projects that do not cover the investment are never chosen.]

(ii) Payback -- Select the project with the shortest number of years to recover the

initial investment. [Projects that do not pay back in 4 years are never chosen.] (iii) Present value -- Same as (i) but all cash flows are converted to present value at

12%. [Projects for which the present value of future cash inflows does not cover the investment are never chosen.]

a. Which project, if any, would Aeroflex choose using each of the three selection

methods? b. What are major weaknesses of the first two selection methods?

AEROFLEX, INC.


E26. Note 2 describes the purchase of 100% of the stock of MIC Technology Corp. a. What entry(s) did the parent (Aeroflex, Inc.) make to record the purchase of 100%

of the stock of MIC? Also, show the required write-off of in-process R&D (which has no related tax benefit). Assume that the borrowing from the bank has already been recorded.

b. Show the effect of the purchase of MIC on the individual accounts of the

consolidated balance sheet at the date of acquisition, including the write-off of in-process R&D.

c. Where did Aeroflex get the cash needed for the MIC acquisition? d. Explain how the purchase of receivables (one portion of your entry for the

purchase of MIC) was shown in Aeroflex's cash statement. e. Prepare a T-account for accounts receivable, net for 2014 (last year). After the

beginning balance, include acquired receivables (unknown) and a subtotal. The remaining amounts are the normal operations and can be determined using line no. 8 of the cash statement. Schedule II discloses the bad debt provision as a negative $55,000. The prior annual report discloses the yearend 2013 accounts receivable, net as $18,898,000.

f. How does the acquisition of MIC affect the comparability of the Quarterly

Financial Data? g. How would the consolidated balance sheet have been different if Aeroflex, Inc.

had purchased the assets and assumed the liabilities of MIC (instead of purchasing the stock)? [No change in dollar amounts.]

AEROFLEX, INC.


E27. Aeroflex had an acquisition of another business--MIC was acquired on March 19, 2014 (see Note 2).

a. Prepare a 3-year summary of (i) net sales and (ii) income from continuing

operations showing pro forma results on a comparable basis including MIC for all years. At the time of the acquisition, Aeroflex disclosed the following pro forma results for fiscal 2014 & 2013:

2014 2013 Pro forma net sales $90,097,000 $95,300,000 Pro forma income (loss) from continuing oper. (19,392,000) 6,729,000

b. The pro forma income for 2013 consists of the following: Aeroflex’s reported earnings $A MIC’s reported earnings $B Pro forma adjustments $C . =Pro forma earnings $6,729,000 The amounts for $A, $B and $C are not disclosed. But, describe, in words, the

main pro forma adjustments for $C.

E28. Aeroflex acquired the operating assets of Lintek in January 2013 (per Note 2) for

$537,000. Additional amounts were paid during fiscal 2014 & 2015. What journal entries were made to record these additional payments?

AEROFLEX, INC.


E29. Aeroflex had discontinuations of businesses. See Note 4 and the “Selected Financial Data” for prior years. A prior annual report gave more footnote disclosure of the amounts shown in the prior years’ income statements.

[Excerpts from prior year’s Note] In November 2011, the Company sold substantially all of the net operating assets of its wholly-

owned subsidiary, Huxley Envelope Corp., for $5,550,000, including a $700,000 five year subordinated secured note. The income from discontinued operations is as follows: Year ended June 30, 2013 2012 Operating Revenue: Huxley $ -- $4,868,000 T-CAS -- 2,195,000 $ -- $7,063,000 Income (loss) from operations (net of taxes): Huxley $ -- $ (187,000) Estimated gain (loss) on disposition (net of tax): Huxley $ 240,000 $(1,921,000) T-CAS 222,000 2,295,000 462,000 374,000 Income from discontinued operations $ 462,000 $ 187,000

a. Explain where the “Operating revenues” amount of $7,063,000 was included in the 2012 income statement (which we do not have).

b. What journal entry did Aeroflex make in November 2011 to record the sale of

Huxley’s net operating assets? You may assume the tax rate was 34%. c. Many companies are unable to separate discontinued businesses in the income

statement. What difficulties would have been caused for an analyst if Aeroflex had been unable to segregate its discontinued operations and had not been able to provide the disclosure in Note 4?

AEROFLEX, INC.


F. FINANCING ACTIVITIES [reread Instructions] F1. Does the 2015 statement of cash flows explanation for debt changes completely

explain the 2015 long-term debt changes in the balance sheet (combine working capital plus non-working capital portions)?

F2. Explain the changes during 2015 in each Stockholders' Equity account. Remember

that additional paid-in capital includes $281,000 of income tax benefit from stock options.

F3. For 2015 calculate the following ratios for Aeroflex:

a. long-term debt ratio [long-term debt/long-term debt + stock. equity] b. same as “a” above but combine long-term debt (current) + long-term debt

(noncurrent) + short-term debt c. leverage ratio [total liabilities/total liab. + stock. equity] d. times interest charges earned [income before interest & taxes/interest expense]

F4. Prepare the right-side of Aeroflex's 2015 balance sheet (Liabilities & Stockholders'

Equity) where amounts are shown as percentages of the total ($81,047,000). [This is called a common-size statement.]

F5. Calculate Aeroflex's primary 2015 earnings per share. [see bottom of income

statement for average number of common shares outstanding.] F6. Calculate Aeroflex's 2015 rate of return on stockholders' equity. F7. Many financial analysts prefer to calculate ratios using tangible shareholders' equity

[which is total shareholders' equity less intangible assets]. a. Recalculate the following two ratios using tangible stockholders' equity.

• 2015 leverage ratio • 2015 return on shareholders' investment

b. Is the use of tangible stockholders' equity (instead of reported stockholders' equity) conservative?

AEROFLEX, INC.


F8. Describe the types of gains & losses that Aeroflex can take directly to retained earnings and by-pass all income statements.

F9. What entry(s) were made to record the issuance of $10,000,000 Senior Subordinated

Convertible Debentures (including the debt issuance costs of $947,000)? Also, show the journal entry to record the subsequent conversion of $19,000 of these

debentures.

The 2012 cash statement shows net proceeds from debentures offering of $9,184,000 and the 2012 statement of stockholders’ equity shows additional paid-in capital of $131,000 for warrants issued to the placement agent.

F10. Aeroflex has issued convertible debentures (see Note 10). The following questions

provide an opportunity to compare the impact on the financial statements of debt versus equity financing. Ignore deferred debt discount costs.

The following projected figures for next year do not include any amounts for the

convertible debt, either as debt or converted to equity. To answer the questions, you must include any appropriate amounts for the convertible debt and its effects (for example, interest). Long-term debt ratio at beginning of fiscal 2016 without convertible debentures [14,688,000/14,688,000+35,040,000) 29.5% Fiscal 2016 net income (after 34% income tax) 5,120,000 Fiscal 2016 earnings per share (12,489,000 shares outstanding) 0.41 Fiscal 2016 net cash provided by operating activities 9,500,000 Fiscal 2016 net cash used by financing activities (3,000,000)

a. Redo the five amounts listed above assuming that debentures are debt and are not

converted into common stock. List any assumptions. b. Redo the five amounts listed above assuming that all debentures are converted

into common stock (at $5.625 per share) on the first day of fiscal 2016. List any assumptions.

c. Did the conversion of debt into equity improve or reduce reported earnings?

AEROFLEX, INC.


F11. Aeroflex has a line of revolving credit plus a term loan from two banks. a. Estimate the amount at yearend 2015 for the (i) revolver and (ii) term loan. b. Explain why a revolving credit line is shown as a long-term liability (rather than

short term).

F12. Concerning Aeroflex's dividends: a. Could Aeroflex's Board of Directors have chosen to declare and pay a $0.10 cash

dividend to its common stockholders at yearend 2015 payable in early fiscal 2016? [Note: this question is intended to focus on what balance sheet or income statement conditions limit the dividends declared and paid].

b. Is it logical for Aeroflex to show interest paid as an operating activity but to show dividends paid (when it has dividends) as a financing activity in its cash statement?

F13. Assume that Aeroflex plans to form a subsidiary on the first day of fiscal 2016. First

year sales are estimated at $1,000,000 with cost of sales of 70% of sales and selling & administrative expenses of $150,000. All income is taxed at 34%. Aeroflex can either (i) invest $1,000,000 for 100% of the common stock or

(ii) invest $500,000 for 100% of the common stock and have the sub borrow $500,000 at 10% interest. The sub will pay no dividends in the first year.

Prepare an income statement for each alternative and explain which one “looks

better”. F14. Aeroflex entered into a major lease in December 1994 for certain machinery at an

annual lease of $476,900 for 10 years1. The principal (present value) amount of the lease was $3,200,000 and the implicit interest rate was 8%. a. Present a calculation to show that the implicit interest rate for the lease was 8%. b. IF Aeroflex had recorded this lease as a capital lease, what journal entry would

have been made? c. What portion of the principal would have been shown as a current liability at

December 1994 when the lease began? d. What journal entry would have been made in December 1995 to record the first

$476,900 lease payment? e. What expenses would be shown for the first year of this capital lease? f. Which method (operating lease or capital lease) will show greater expenses (i) in the first year of the lease and (ii) for the entire 10-year lease period? g. How would the transaction in “b” above be shown in Aeroflex's statement of cash

flows?

1 At the end of 2012, off Balance Sheet Operating leases totaled $1.252 trillion and on Balance Sheet Capital leases totaled $45 billion.

AEROFLEX, INC.


F15. Aeroflex discloses the following for 2015: Assets recorded under capital leases (Note 7) $2,392,000 Capitalized lease obligations (Note 9) 1,536,000 Why are these two amounts different? F16. The last sentence of Note 10 states that the Senior Subordinated Convertible

Debentures carried at $9,981,000 have a fair value of $10,430,000. How is this possible?

F17. You need the following two footnotes from Aeroflex’s Third Quarter Report for

this question. Aeroflex had major transactions in the first nine months of fiscal 2016 which are disclosed in Note 2 (Common stock offering) and Note 9 (Conversion of 7½% debentures) of Aeroflex’s Third Quarter Report.

2. Common Stock Offering --------------------- In March 2016, the Company sold 2,597,000 shares of its Common Stock in a public offering for $31,293,000, net of an underwriting discount of $1,973,000 and issuance costs of $488,000. Of these net proceeds, $9,639,000 was used to repay bank indebtedness. The balance of the net proceeds, which is included in cash and cash equivalents, will be used for general corporate purposes, including working capital, capital expenditures, facilities expansion and potential acquisitions. 9. Conversion of 7-1/2% Debentures ------------------------------- On September 8, 2015, the Company called for the redemption of all of its outstanding 7-1/2% Senior Subordinated Convertible Debentures ($9,981,000) at 104-1/2% of the principal amount. As of October 2015, all of the principal amount outstanding was converted into Common Stock at $5-5/8 per share. In connection with the conversions, $599,000 of deferred bond issuance costs were charged to additional paid-in capital.

a. Prepare journal entries for all transactions listed in these two notes. b. List the few key points about the impact of these transactions on the (i) balance

sheet and (ii) income statement.

AEROFLEX, INC.


F18. Review Aeroflex’s computation of two EPS amounts for the first nine months of

fiscal 2016 using the new accounting rules. List any questions. [See Note 3]. F19. The following table has been prepared to show the impact of Aeroflex’s leverage. Be certain that you understand the source or calculation for each amount.

Earnings -Aftertax Accruing to 2015 On amount cost of (detracting Yearend Supplied supplier from) return Category of Supplier Amount @7.876% financing on common Operating payables 17,091 1,346 1,346 External borrowing 28,916 2,277 -1,963 314 Stockholders' equity 35,040 2,760 . 2,760 Total 81,047 6,383 -1,963 4,420 2015 amount is from balance sheet Rate of return on assets is 6,383/81,047 or 7.876%. Each amount in the first column is multiplied by 7.876% to show earnings amount in second column Supplier financing is interest 2,974 less tax saving 1,011 Rate of return on equity is 4,420/35,040 or 12.6%

a. Explain why the return to common stockholders’ of 12.6% exceeded Aeroflex’s

return on assets of 7.876%. b. Did the use of external borrowing during 2015 improve the return to shareholders

during 2015? end of discussion questions

AEROFLEX, INC.


Throughout financial analysis, various ratios are used. Although you do not need to memorize the ratios, you should understand the calculation of each ratio. DEFINITIONS:

BOOK VALUE1 Amounts reported in financial statements as adjusted by the analyst MV Market value of common shares outstanding times closing stock price TOTAL FUNDED DEBT Short-term debt plus long-term debt (including current portion) NET DEBT Total Debt - Cash & Cash Equivalents - Marketable Securities AMV MV + Total Debt + Minority Interests + Preferred Stock - Cash P/E Price (closing price of common stock) divided by net earnings per share NET INTEREST Interest expense less Interest Income EBIT Earnings2 Before Net Interest and Taxes EBITDA Earnings3 Before Net Interest, Taxes, Depreciation and Amortization MARGIN Means income statement amount3 related to total revenues CAPEX Capital Expenditures RETURN Earnings from continuing operations3 [specified as either pretax or net (aftertax)] CAPITALIZATION3 Total Debt + Minority Interests + Preferred + Common Equity LTM Latest Twelve Months COMMON GLOSSARY:

Net Income, also called "reported earnings" Operating Earnings, which is adjusted net income and also called Core Earnings and sometimes

called Pro Forma Earnings or Adjusted Earnings Special Charges, any expense that the firm wants to highlight and is shown above the line Asset Impairments, an expense to lower the cost of an asset Goodwill Impairment, same as an asset impairment but related only to one asset Writedown, similar to an asset impairment Restructuring Reserve, an expense for a future cash outflow, like firings

1All ratio amounts are at book value except for MV. 2 Earnings amount is before nonrecurring items. 3All amounts are at book value unless specified that common equity is at market value.

AEROFLEX, INC.


VALUATION RATIOS: P/E MV/B(ook) V(alue) AMV/REVENUES AMV/EBIT AMV/EBITDA OPERATING RATIOS1: NET DEBT/[NET DEBT + EQUITY] (at book values) TOTAL DEBT/EBITDA EBITDA/NET [or gross] INTEREST [EBITDA-CAPEX]/NET INTEREST S,G&A/REVENUES CAPEX/REVENUES REVENUES/EMPLOYEES (Yearend or average) PRETAX RETURN ON EQUITY (Yearend common equity or average) EBIT/TOTAL ASSETS (Yearend or average) GROSS MARGIN [Gross Margin/Revenues] EBIT MARGIN [EBIT/Revenues] PRETAX MARGIN [Pretax Earnings/Revenues] NET MARGIN [Net Earnings/Revenues] EBITDA MARGIN [EBITDA/Revenues] Other: Growth Rate [the % change in revenue]

1Also, growth rates will be calculated for Revenues, Gross Margin, EBIT, Pretax income, Net income, EPS, EBITDA, Total Assets and Stockholders' Equity--[Year 2 minus Year 1]/Year 1.

end

Documents

AEROFLEX DISCUSSION QUESTIONS...A12. Prepare income statements for Aeroflex for 2015 (one year) where each amount is shown as a percentage of “Net sales”. [This is called a common-size