F/S, Cash Flow, Dividend Calc
Compliance with Current
and D:E Ratios and audited F/S
AAR’s bank loan agreement requires the company provide audited financial statements
in accordance with IFRS and maintain a current ratio of at least 2:1 and a debt-to-equity
ratio no greater than 3:1. The company has requested assistance in preparing the
financial statements in accordance with the bank covenants as well as a statement of
cash flows. The owner also wants advice on issuing a dividend and recommended
controls to increase profitability.
To: Greg Clark
Re: Financial accounting assistance
This report has been prepared to analyze and recommend accounting policies. Although
Antique Automotive Restoration is a private company not normally bound by GAAP, they
are preparing their financial statements in accordance with IFRS to uphold a bank loan
Issue: Currently the cash approach is being used to account for warranty expenses.
However, this is not GAAP because the costs associated with honoring the warranty are
material. Should the warranty obligation be recognized in the financial statements and,
if so, how should it be measured?
Implication: Recognizing income earned from the sale of goods and the sale of
warranty separately would have a negative effect on the debt-to-equity and current
Under the expense approach, the following journal entry is needed to accrue for the
outstanding warranty obligations.
Under the revenue approach, the revenue attributable to the warranty is recognized
separately from from the revenue from the product.
The journal entry to record the sale of the cars would be:
Unearned Warranty Revenue
The journal entry to remeasure the unearned warranty revenue account at December 31
Unearned Warranty Revenue
Recommendation: Since there was no information given to indicate that any costs were
incurred to honor the warranty in the current year, there were no adjustments necessary
for actual warranty costs incurred. The revenue approach is recommended under IFRS
as it accurately allocates revenue attributable to the warranty and allows it to be earned
over the life of the commitment as the warranty obligation is fulfilled.
Issue: Should the possibility that the accounts receivable will not be collected be
recognized as liability in the financial statements? If not should it be disclosed in the
Implication: If the accounts payable is recognized as a liability under allowance for
doubtful accounts, then it will negatively affect the debt to equity ratio as well as the
Alternatives: There are no alternatives. As the vehicle was only delivered recently and
the fact that Greg has been in contact with the customer and the customer intends to
pay, the amount should remain in accounts receivable for the current year.
Recommendation: As there are no alternatives, Greg should keep the full amount in
accounts receivable. Greg should also disclose the fact that this amount might be
received at a later date than was previously expected. If payment is not received within
the time agreed upon, AAR should move the amount or an amount figured out at a later
date to allowance for doubtful accounts. If Greg decides that the whole amount or a
significant portion of it is going to be unclaimed, then Greg should repossess the vehicle
and put it back into inventory.
Issue: Should the lease be presented in the financial statements as a capital asset or
an expense? If it is considered an asset should the associated amortization and interest
expense be recognized? If yes then how do we measure it?
Implication: If the lease is capitalized it will have a negative effect on the current and
debt-to-equity ratios due to the increase in the asset obligation liability and amortization
Alternatives: Antique Automotive Restoration is currently accounting for the lease as an
expense using the minimum lease payments. The lease should be capitalized as an
asset and valued using the present value of the minimum lease payments.
Minimum lease payments = 2500*12*10 = 300,000
PV of minimum lease payments = 216572
The journal entry to record the lease should have been:
Capital Lease- Land & Building
Obligation under Capital Lease
Recommendation: As there are no alternatives, the lease should be valued at the
present value of the minimum payments; which is $216,572, and amortized over the
lease term of 10 years. The current years amortization expense is $21,657. The
payments should be allocated between the obligation and interest expense accounts.
Deferred Tax Liability
Issue: For tax purposes, depreciation and amortization cannot be claimed as deductions
from income. Instead the CCA of capital assets must be determined. The temporary
difference between these two gives rise to potential tax benefits or liabilities in future
years. Should the future tax implications be recognized in the current year and how
should they be measured?
Implication: Recognizing a deferred tax liability from temporary differences would have a
negative effect on the debt-to-equity ratio
Machinery and equipment
The journal entries to record the deferred tax liability caused by the temporary difference
in CCA and amortization amounts in the current year would be:
Deferred income tax expense
Deferred income tax liability
Recommendation: Since there are no other alternatives under IFRS for the recognition
of temporary differences the deferred tax liability must be recognized in the current year
and measured by the difference between the amortization and CCA amounts so that the
future tax implications that arise from the current years amortization are recorded in the
Issue: How should the amount of the repossessed vehicle be measured in the inventory
Implication:If the inventory amount is measured based on the cost of the vehicle, then
the inventory amount will be overstated and will have a negative affect on the current
ratio when it is corrected.
Alternative: The inventory amount for the repossessed vehicle should be measured at
the lower of cost and net realizable value. Although the initial cost as well as the resale
value is $35,000, the net realizable value of $ 30,000 (the difference between original
cost and cost incurred to make ready for resale) must be used as it is the lower of the
two. The reduction in inventory would be recognized as a loss on the income statement.
Recommendation: Since there are no alternatives, the repossessed vehicle should be
valued in inventory at its net realizable value which will have an adverse effect on both
the current and debt-to-equity ratios.
The following financial statements include only those accounts that were altered.
Since the both of the ratios do not meet the requirements set by the bank the company
will be unable to pay out a dividend. This is primarily due to the capitalization of the
lease which was not initially recognized in the financial statements. The result of the
recognition of the lease obligation as a liability had a large negative impact on both
ratios. In addition, the company should require payment before releasing goods to the
customer and consider a down payment for custom orders.
As At December 31 2013
Capital Assets – Lease
Less: Accumulated Depreciation
Liabilities and Shareholder’s Equity
Accounts Payable and Accruals $8,455
Income Taxes Payable
Unearned Warranty Revenue
Differed Income Tax Liability
Long-Term Bank Loan
Cost of Sales
For The Year Ended December 31, 2013
Advertising and Promotion
Legal and Accounting
Office and General Expenses
Repairs and Maintenance
Wages and Benefits
Retained Earnings – Opening Balance
Retained Earnings – Closing Balance
Statement of Cash Flows
Year ended December 31, 2013
Cash flows from operating activities
Adjustments: Increase in A/R
Increase in inventory
Increase in prepaid expenses
Increase in A/P and accruals
Increase in income taxes payable 10,201
Unearned warranty revenue
Deferred tax liability
Net cash used in operating activities
Cash flows from investing activities
Total cash flows from investing activities
Cash flows from financing activities
Long-term bank loan
Issuance of common shares
Total cash flows from financing activities
Net increase in cash
Cash at beginning of period