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CHAPTER 24
Full Disclosure in Financial Reporting
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics Questions
Brief Exercises Exercises Problems
Concepts for Analysis
- The disclosure principle; type of disclosure.
- Role of notes that accompany financial statements.
- Subsequent events. 6 3 1, 2 1 4, 12
- Segment reporting; diversified firms.
- Discussion and analysis. 12, 13
- Interim reporting. 16, 17, 18, 19
- Audit opinions and fraudulent reporting.
- Earnings forecasts. 14, 15 10
*9. Interpretation of ratios. 22, 23, 24 4, 5, 6 5
*10. Impact of transactions on ratios. 8 4, 5, 6 3 13
*11. Liquidity ratios. 8 4, 5, 6 3, 5
*12. Profitability ratios. 28 4, 5, 6 3, 5
*13. Coverage ratios. 4, 5, 6
*14. Activity ratios. 25, 26 8, 9 4, 5, 6 3
*15. Comprehensive ratio problems. 4, 5, 6 3, 5
*16. Percentage analysis. 24, 27 3, 4
*This material is dealt with in an Appendix to the chapter.
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Learning Objectives Questions
Brief Exercises Exercises Problems
Concepts for Analysis
- Review the full disclosure principle and describe how it is implemented.
- Discuss the disclosure requirements for related party transactions, post-balance- sheet events, major business segments, and interim reporting.
- Identify the major disclosures in the auditor’s report and understand management’s responsibilities for the financial statements.
- Identify reporting issues related to financial forecasts and fraudulent financial reporting.
*5. Understand the approach to financial statement analysis.
*6. Identify major analytic ratios and describe their calculation.
*7. Explain the limitations of ratio analysis.
*8. Describe techniques of comparative analysis.
*9. Describe techniques of percentage analysis.
ANSWERS TO QUESTIONS
- As indicated in the text, the major advantages are: (1) additional information pertinent to specific financial statements can be explained in qualitative terms, or supplementary data of a quantitative nature can be provided to expand on the information in the financial statements, and (2) restrictions on basic contractual agreements can be explained. The types of items normally found in footnotes are: (1) disclosure of accounting methods used, (2) disclosure of contingent assets and liabilities, (3) examination of creditor claims, (4) claims of equity holders, and (5) executory commitments.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The full disclosure principle in accounting calls for reporting in financial statements any financial facts significant enough to influence the judgment of an informed reader. Disclosure has increased because of the complexity of the business environment, the necessity for timely information, and the desire for more information on the enterprise for control and monitoring purposes.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The benefit of reconciling the effective tax rate and the federal statutory rate is that an investor can determine the actual taxes paid by the enterprise. Such a determination is particularly important if the enterprise has substantial fluctuations in its effective tax rate caused by unusual or infrequent transactions. In some cases, companies only have income in a given period because of a favorable tax treatment that is not sustainable. Such information should be extremely useful to a financial statement reader.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- (a) The increased likelihood that the company will suffer a costly strike requires no disclosure in the financial statements. The possibility of a strike is an inherent risk of many businesses. It, along with the risks of war, recession, etc., is in the category of general news.
(b) A note should provide a description of the unusual and infrequent loss in order that the financial statement user has some understanding of the nature of this item.
(c) Contingent assets which may materially affect a company’s financial position must be disclosed when the surrounding circumstances indicate that, in all likelihood, a valid asset will materialize. In most situations, an asset would not be recognized until the court settlement had occurred.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Transactions between related parties are disclosed to ensure that the users of the financial state- ments understand the basic nature of some of the transactions. Because it is often difficult to separate the economic substance from the legal form in related party transactions, disclosure is used extensively in this area. Purchase of a substantial block of the company’s common stock by Holland, coupled with the use of a Holland affiliate to act as food broker, suggests that disclosure is needed.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- “Subsequent events” are of two types:
(1) Those which affect the financial statements directly and should be recognized therein through appropriate adjustments. (2) Those which do not affect the financial statements directly and require no adjustment of the account balances but whose effects may be significant enough to be disclosed with appropriate figures or estimates shown.
(a) Probably adjust the financial statements directly. (b) Disclosure. (c) Disclosure. (d) Disclosure.
Questions Chapter 24 (Continued)
(e) Neither adjustment nor disclosure necessary. (f) Neither adjustment nor disclosure necessary. (g) Probably adjust the financial statements directly. (h) Neither adjustment nor disclosure necessary.
LO: 2, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Diversified companies are enterprises whose activities are segmented into unrelated industries. The accounting problems related to diversified companies are: (1) the problem of defining a segment for financial reporting purposes, (2) the difficulty of allocating common or joint costs to various segments, and (3) the problem of evaluating segment results when a great deal of transfer pricing is involved.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- After the company decides on the segments for possible disclosure, a quantitative test is made to determine whether the segment is significant enough to warrant actual disclosure. A segment is identified as a reportable segment if it satisfies one or more of the following tests.
(a) Its revenue (including both sales to unaffiliated customers and intersegment sales or transfers) is 10% or more of the combined revenue (sales to unaffiliated customers and intersegment sales or transfers) of all the enterprise’s industry segments. (b) The absolute amount of its operating profit or operating loss is 10% or more of the greater, in absolute amount, of
- the combined operating profit of all industry segments that did not incur an operating loss, or
- the combined operating loss of all industry segments that did incur an operating loss. (c) Its identifiable assets are 10% or more of the combined identifiable assets of all segments.
In applying these tests, two additional factors must be considered. First, segment data must explain a significant portion of the company’s business. Specifically, the segmented results must equal or exceed 75% of the combined sales to unaffiliated customers for the entire enterprise. This test prevents a company from providing limited information on only a few segments and lumping all the rest into one category.
Second, the profession recognized that reporting too many segments may overwhelm users with detailed information. Although the FASB did not issue any specific guidelines regarding how many segments are too many, this point is generally considered reached when a company has 10 or more reportable segments.
LO: 2, Bloom: K, Difficulty: Simple, Time: 7-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- GAAP requires that a company report:
(a) General information about its operating segments. (b) Segment profit and loss and related information. (c) Segment assets. (d) Reconciliations (reconciliations of total revenues, income before income taxes, and total assets). (e) Information about products and services and geographic areas. (f) Major customers.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- An operating segment is a component of an enterprise:
(a) That engages in business activities from which it earns revenues and incurs expenses. (b) Whose operating results are regularly reviewed by the company’s chief operating decision maker to assess segment performance and allocate resources to the segment. (c) For which discrete financial information is available that is generated by or based on the internal financial reporting system.
Questions Chapter 24 (Continued)
- The accounting problems related to the presentation of interim data are as follows:
(a) The difficulty of allocating costs, such as income taxes, pensions, etc., to the proper quarter. (b) The problem of LIFO inventory valuation. (c) Presentation of EPS figures. (d) Problems of fixed cost allocation.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The problem when a LIFO base is used for quarterly reporting is that the LIFO base might be reduced in a given quarter, but for the year, this base is not reduced. If the inventory base will be replaced before the year ends, then a purchase reserve (equalization account) should be set up to reflect a higher cost of sales and to achieve a more realistic interim statement for net income.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- One suggestion has been to normalize the fixed nonmanufacturing costs on the basis of predicted sales. The problem with this method is that future sales are unknown and hence a great deal of subjectivity is involved. Another approach is to charge as a period charge those costs that are impossible to allocate to any one period. Under this approach, reported results for a quarter would only indicate the contribution toward fixed costs and profits, which is essentially a contribution margin approach. To alleviate the problem of seasonality, the profession recommends companies subject to material seasonal variations disclose the seasonal nature of their business and consider supplementing their annual reports with information for 12-month periods ended at the interim dates for the current and preceding years.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The CPA expresses a “clean” or unqualified opinion when the client’s financial statements present fairly the client’s financial position and results of operations on the basis of an examination made in accordance with generally accepted auditing standards, and the statements are in conformity with generally accepted accounting principles and include all informative disclosures necessary to make the statements not misleading. The CPA expresses a qualified opinion when he/she must take exception to the presentation of one or more components of the financial statements but the exception or exceptions are not serious enough to negate his/her expression of an opinion or to express an “adverse” opinion.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Fraudulent financial reporting is intentional or reckless conduct, whether by act or omission, that results in materially misleading financial statements. Fraudulent financial reporting can involve many factors and take many forms. It may entail gross and deliberate distortion of corporate records, such as inventory count tags, or falsified transactions, such as fictitious sales or orders. It may entail the misapplication of accounting principles. Company employees at any level may be involved, from top to middle management to lower-level personnel. If the conduct is intentional, or so reckless that it is the legal equivalent of intentional conduct, and results in fraudulent financial statements, it comes within the operating definition of the term fraudulent financial reporting.
Fraudulent financial reporting differs from other causes of materially misleading financial statements, such as unintentional errors. Fraudulent financial reporting is distinguished from other corporate improprieties, such as employee embezzlements, violations of environmental or product safety regulations, and tax fraud, which do not necessarily cause financial statements to be materially inaccurate.
Questions Chapter 24 (Continued)
Fraudulent financial reporting usually occurs as the result of certain environmental, institutional, or individual forces and opportunities. These forces and opportunities add pressures and incentives that encourage individuals and companies to engage in fraudulent financial reporting and are present to some degree in all companies. If the right combustible mixture of forces and opportunities is present, fraudulent financial reporting may occur.
A frequent incentive for fraudulent financial reporting that improves the company’s financial appear- ance is the desire to obtain a higher price from a stock or debt offering or to meet the expectations of investors. Another incentive may be the desire to postpone dealing with financial difficulties and thus avoid, for example, violating a restrictive debt covenant. Other times the incentive is personal gain: additional compensation, promotion, or escape from penalty for poor performance.
Situational pressures on the company or an individual manager also may lead to fraudulent financial reporting. Examples of these situational pressures include:
Sudden decreases in revenue or market share. A single company or an entire industry can experience these decreases.
Unrealistic budget pressures, particularly for short-term results. These pressures may occur when a company arbitrarily determines profit objectives and budgets without taking actual conditions into account.
Financial pressure resulting from bonus plans that depend on short-term economic performance. This pressure is particularly acute when the bonus is a significant component of the individual’s total compensation.
Opportunities for fraudulent financial reporting are present when the fraud is easier to commit and when detection is less likely. Frequently these opportunities arise from:
The absence of a board of directors or audit committee that vigilantly oversees the financial reporting process.
Weak or nonexistent internal accounting controls. This situation can occur, for example, when a company’s revenue system is overloaded from a rapid expansion of sales, an acquisition of a new division, or the entry into a new, unfamiliar line of business.
Unusual or complex transactions. Examples include the consolidation of two companies, the divestiture or closing of a specific operation, and agreements to buy or sell government securi- ties under a repurchase agreement.
Accounting estimates requiring significant subjective judgment by company management. Examples include allowance for loan losses and the yearly provision for warranty expense.
LO: 4, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*22. It has been said that “everything is relative,” and this is certainly true of financial statement data. The chief significance of financial statement data is not so much in the absolute amounts presented but in their relative significance; that is, in the conclusions reached after comparing each item with similar items and after association with related data. Financial statements present measures of quantity (this is not to exclude the qualitative aspects of things that dollar quantities reflect), but whether any amount is adequate or not in view of the company’s needs, or whether it represents an amount out of proportion to the company’s other amounts, or whether it represents an improvement over previous years cannot be determined from the absolute amount alone.
LO: 5, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 24 (Continued)
*28. Some believe that the FASB should not be involved in developing standards related to the presentation of ratios. A basic concern expressed by this group is: how far should the FASB go? That is, where does financial reporting end and financial analysis begin? Furthermore, we know so little concerning which ratios are used and in what combinations that attempting to require disclosure of certain ratios in this area would not be helpful. One reason for the profession’s reluctance to mandate disclosures of ratios on the financial statements is that research regarding the use and usefulness of summary indicators is still limited.
LO: 7, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 24-
The reader should recognize that the firm has an annual obligation for lease
payments of approximately $5,711,000 for the next three years. In certain
situations, this information is very important in determining: (1) the ability of
the firm to use additional lease financing, and (2) the nature of maturing
commitments and the amount of cash expenditures involved. Off-balance-
sheet financing is common and the investor should be cognizant that the
company has a commitment even though it is not reflected in the liability
section of the balance sheet. The rental income from the subleases also
provides useful information concerning the company’s ability to generate
revenues in the near future.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
BRIEF EXERCISE 24-
The reader should recognize that there are dilutive securities outstanding
which may have an effect on earnings per share. In addition, the purchase
of treasury stock enabled the company to increase its earnings per share.
The important point concerning this note is that information is provided
about potential dilution related to some dilutive securities outstanding.
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
BRIEF EXERCISE 24-
Net income will decrease by $10,000 ($160,000 – $170,000) as a result of the
adjustment of the liability. The settlement of the liability is the type of sub-
sequent event which provides additional evidence about conditions that
existed at the balance sheet date. The flood loss ($80,000) is an event that
provides evidence about conditions that did not exist at the balance sheet
date but are subsequent to that date and does not require adjustment of
the financial statements.
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*BRIEF EXERCISE 24-
(a) X + $500,000 = 5X
$500,000 = 4X
$125,000 = Current liabilities
(b) Cost of goods sold last year = $200,000 X 5 = $1,000,
$1,000,000 ÷ 8 = $125,000 = Average inventory in current year
(c) $ 90,000 ÷ $40,000 = Current ratio of 2.25:
$ 50,000 ÷ $40,000 = Acid-test ratio of 1.25:
$105,000 ÷ $55,000 = Current ratio of 1.91:
$ 65,000 ÷ $55,000 = Acid-test ratio of 1.18:
(d) $600,000 ÷ $420,000 = 1.43:1 after declaration, but before payment
After payment, $420,000 ÷ $240,000 = 1.75:
LO: 6, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*BRIEF EXERCISE 24-
Cost of Goods Sold
= Inventory Turnover
Average Inventory
Average Inventory
Average inventory (current) therefore equals $11,000,000 ($99,000,000 ÷ 9).
Average Inventory
Average inventory (new) equals $8,250,000 ($99,000,000 ÷ 12).
$2,750,000 X 10% = $275,000 cost savings.
LO: 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
SOLUTIONS TO EXERCISES
EXERCISE 24-1 (10–15 minutes)
(a) The issuance of common stock is an example of a subsequent event
which provides evidence about conditions that did not exist at the
balance sheet date but arose subsequent to that date. Therefore, no
adjustment to the financial statements is recorded. However, this event
should be disclosed either in a note, a supplemental schedule, or even
pro forma financial data.
(b) The changed estimate of income taxes payable is an example of a
subsequent event which provides additional evidence about conditions
that existed at the balance sheet date. The income tax liability existed at
December 31, 2017, but the amount was not certain. This event affects
the estimate previously made and should result in an adjustment of the
financial statements. The correct amount ($1,270,000) would have been
recorded at December 31 if it had been available. Therefore, Madrasah
should increase income tax expense in the 2017 income statement by
$170,000 ($1,270,000 – $1,100,000). In the balance sheet, income taxes
payable should be increased and retained earnings decreased by
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
EXERCISE 24-2 (10–15 minutes)
1. (a) 4. (b) 7. (c) 10. (c)
2. (c) 5. (c) 8. (b) 11. (a)
3. (b) 6. (c) 9. (a) 12. (b)
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*EXERCISE 24-5 (20–30 minutes)
(a) The acid-test ratio is the current ratio with the subtraction of inventory
and prepaid expenses (generally insignificant relative to inventory) from
current assets. Any divergence in trend between these two ratios
would therefore be dependent upon the inventory account. Inventory
turnover has declined sharply in the three-year period, from 4.91 to
3.42. During the same period, sales to fixed assets have increased and
total sales have increased 7 percent. The decline in the inventory
turnover is therefore not due to a decline in sales. The apparent cause
is that investment in inventory has increased at a faster rate than
sales, and this has accounted for the divergence between the acid-test
and current ratios.
(b) Financial leverage has definitely declined during the three-year period.
This is shown by the steady drop in the long-term debt to assets ratio,
and the debt to assets ratio. Apparently the decline of debt as a
percentage of this firm’s capital structure is accounted for by a
reduction in the long-term portion of the firm’s indebtedness. This
reduction of leverage accounts for the decrease in the return on
common stock equity ratio. This conclusion is reinforced by the fact
that net income to sales and return on total assets have both
increased.
(c) The company’s net investment in plant and equipment has decreased
during the three-year period 2015–2017. This conclusion is reached by
using the sales-to-fixed-assets (fixed asset turnover) and sales-as-a-
percent-of-2015-sales ratios.
Because sales have grown each year, the sales-to-fixed-assets could
be expected to increase unless fixed assets grew at a faster rate. The
sales-to-fixed-assets ratio increased at a faster rate than the 3 percent
annual growth in sales; therefore, net investment in plant and equipment
must have declined.
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*EXERCISE 24-6 (30–40 minutes)
(a) The current ratio measures overall short-term liquidity and is an indicator
of the short-term debt-paying ability of the firm.
The quick ratio also is a measure of short-term liquidity. However, it is
a measure of more immediate liquidity than the current ratio and is an
indicator of a firm’s ability to pay all of its immediate debts from cash
or near-cash assets. The quick ratio is also an indicator of the degree
of inventories in its current assets when compared to the current ratio.
Inventory turnover is an indicator of the number of times a firm sells
its average inventory level during the year. A low inventory turnover
may indicate excessive inventory accumulation or obsolete inventory.
Net sales to stockholders’ equity is an activity ratio that measures the
number of times the stockholders’ equity was turned over in sales
volume. This ratio could also be referred to as a net asset turnover ratio
that measures net asset management. Thus, it is a measure of
operational efficiency. This ratio is similar to asset turnover.
Return on common stockholders’ equity is a profitability ratio. It
measures the return on stockholders’ investment and is used to
evaluate the company’s success in generating income for the benefit
of its stockholders (i.e., management effectiveness).
Total liabilities to stockholders’ equity compares the amount of resources
provided by creditors to the resources provided by stockholders. Thus,
it measures the extent of leverage in the company’s financial structure
and is used to evaluate or judge the degree of financial risk. This ratio
is similar to the debt to assets ratio.
(b) The two ratios that each of the four entities would specifically use to
examine Edna Millay Inc. are as follows:
Archibald MacLeish Bank might employ the current or quick ratio and
the total liabilities to equity ratio.
Robert Lowell Company might employ either the current or quick ratios
in conjunction with either the inventory turnover or total liabilities to
equity ratio.
Robert Penn Warren might employ net sales to stockholders’ equity and
return on common stock equity.
TIME AND PURPOSE OF PROBLEMS
Problem 24-1 (Time 40–50 minutes) Purpose—to provide the student with various post-balance-sheet or subsequent events to evaluate and to prepare the proper disclosures for each item, if necessary.
Problem 24-2 (Time 24–30 minutes) Purpose—to provide the student with an understanding of the rules for segment reporting. The student must determine which of five segments are subject to segment reporting rules and describe the required disclosures.
*Problem 24-3 (Time 35–45 minutes) Purpose—to provide the student with an understanding of certain key ratios. In addition, the student is asked to identify and explain what other financial reports or financial analysis might be employed. Also, the student is to determine whether the company can finance the plant expansion internally and whether an extension on the note should be made.
*Problem 24-4 (Time 40–60 minutes) Purpose—to provide the student with an understanding of the conceptual merits in the presentation of financial statements by both horizontal analysis and vertical analysis. The student is required to prepare a comparative balance sheet for the given financial information under each of the two approaches. The student is then asked to discuss the merits of each of the presentations.
*Problem 24-5 (Time 40–50 minutes) Purpose—to provide the student with a situation in which ratio analysis is used in a decision concerning payment of dividends.
SOLUTIONS TO PROBLEMS
PROBLEM 24-
ALMADEN CORPORATION
Balance Sheet
December 31, 2017
Assets
Current assets
Cash ($571,000 – $300,000)..... $ 271,
Accounts receivable
Less allowance for
doubtful accounts ......... 30,000 480,
Notes receivable ...................... 162,
Inventories (LIFO) .................... 645,
Prepaid expenses .................... 62,
Total current assets .... $1,620,
Long-term investments
Investments in land ................. 185,
Cash surrender value of
life insurance policy ............. 84,
Cash restricted for plant
expansion ............................. 300,000 569,
Property, plant, and equipment
Plant and equipment
(pledged as collateral
for bonds)
Less accumulated
depreciation ................... 1,430,000 4,130,
Land ......................................... 446,200 4,576,
Intangible assets
Goodwill, at cost...................... 252,
Total assets ................. $7,018,