Antique Automotive Restoration
Content
Users
Owner (Greg Clark)
Bank
CRA
Objectives
F/S, Cash Flow, Dividend Calc
Compliance with Current
and D:E Ratios and audited F/S
Tax determination
Constraints
IFRS
IFRS
ITA
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
From: CMA
Re: Financial accounting assistance
Introduction
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
covenant.
Warranty Obligation
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
ratios.
Alternatives:
1)
Expense approach
Under the expense approach, the following journal entry is needed to accrue for the
outstanding warranty obligations.
Warranty Expense
$ 6,000
1
Warranty Liability
$ 6,000
($1,250*.6*8)
2)
Revenue approach
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:
Cash
$ 320,000
Sales Revenue
$ 310,000
Unearned Warranty Revenue
$ 10,000
The journal entry to remeasure the unearned warranty revenue account at December 31
would be:
Unearned Warranty Revenue
$ 100
Warranty Revenue
$ 100
(10,000*.01)
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.
Accounts Receivable
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
notes?
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
current ratio.
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
2
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.
Lease
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
expense.
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
$ 216,572
Obligation under Capital Lease
$ 216,572
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?
3
Implication: Recognizing a deferred tax liability from temporary differences would have a
negative effect on the debt-to-equity ratio
Alternatives:
1) Class
Machinery and equipment
Leasehold improvements
Office equipment
Vehicles
Total
Amortization
$15,500
1,000
3,125
3,125
CCA
$37,500
1,000
2,500
3,750
Difference
($22,000)
0
625
(625)
($22,000)
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
$ 3,630
Deferred income tax liability
$ 3,630
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
correct period.
Inventory
Issue: How should the amount of the repossessed vehicle be measured in the inventory
account?
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.
4
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.
Ratio Calculations
Debt-to-equity= 3.53
Current=0.74
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.
BALANCE SHEET
As At December 31 2013
Unaudited
Assets
Current
Inventory
Other
$95,775
82,224
5
Revised
$90,775
82,224
177,999
172,999
Capital Assets
287,250
Capital Assets – Lease
Less: Accumulated Depreciation
$465,249
Liabilities and Shareholder’s Equity
Current
Accounts Payable and Accruals $8,455
Income Taxes Payable
17,334
Unearned Warranty Revenue
0
Lease Obligation
0
Differed Income Tax Liability
0
25,789
287,250
216,572
(21,657)
$655,164
Long-Term Bank Loan
277,240
277,240
Common Shares
Retained Earnings
74,500
87,721
162,220
$465,249
74,500
69,992
144,492
$655,165
6
$8,455
10,201
9,900
201,246
3,630
233,432
Sales
Warranty Revenue
Cost of Sales
Gross Profit
INCOME STATEMENT
For The Year Ended December 31, 2013
Unaudited
320,000
0
128,000
192,000
Expenses
Advertising and Promotion
Amortization
Bad Debt
Insurance
Interest
Legal and Accounting
Lease Expense
Office and General Expenses
Repairs and Maintenance
Utilities
Wages and Benefits
Revised
310,000
100
(128,000)
182,100
2,000
22,750
0
1,500
16,920
2,500
30,000
2,775
750
11,000
22,500
112,695
2,000
44,407
0
1,500
31,595
2,500
0
2,775
750
11,000
22,500
119,027
Operating Income
Other Service Income
Loss Due to Decline in Inventory – NRV
Income Before Taxes
Provision for Income Tax – Current
Provision for Income Tax – Deferred
Net Income
79,305
25,750
0
105,055
17,334
0
87,721
63,073
25,750
(5,000)
83,823
(10,201)
(3,630)
69,992
Retained Earnings – Opening Balance
Net Income
Dividends
Retained Earnings – Closing Balance
0
87,721
0
87,721
7
69,992
69,992
Statement of Cash Flows
Year ended December 31, 2013
Cash flows from operating activities
Net Income
Adjustments: Increase in A/R
$(45,000)
Increase in inventory
(90,775)
Increase in prepaid expenses
(1,775)
Amortization expense
44,407
Increase in A/P and accruals
8,455
Increase in income taxes payable 10,201
Unearned warranty revenue
9,900
Lease obligation
201,246
Accumulated amortization
(44,407)
Deferred tax liability
3,630
$ 69,992
95,882
$ 165,874
Net cash used in operating activities
Cash flows from investing activities
Capital assets
Capital assets-lease
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
$ (287,250)
(194,915)
$ (482,165)
$ 277,240
74,500
$ 351,740
$ 35,449
8
Owner (Greg Clark)
Bank
CRA
Objectives
F/S, Cash Flow, Dividend Calc
Compliance with Current
and D:E Ratios and audited F/S
Tax determination
Constraints
IFRS
IFRS
ITA
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
From: CMA
Re: Financial accounting assistance
Introduction
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
covenant.
Warranty Obligation
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
ratios.
Alternatives:
1)
Expense approach
Under the expense approach, the following journal entry is needed to accrue for the
outstanding warranty obligations.
Warranty Expense
$ 6,000
1
Warranty Liability
$ 6,000
($1,250*.6*8)
2)
Revenue approach
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:
Cash
$ 320,000
Sales Revenue
$ 310,000
Unearned Warranty Revenue
$ 10,000
The journal entry to remeasure the unearned warranty revenue account at December 31
would be:
Unearned Warranty Revenue
$ 100
Warranty Revenue
$ 100
(10,000*.01)
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.
Accounts Receivable
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
notes?
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
current ratio.
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
2
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.
Lease
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
expense.
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
$ 216,572
Obligation under Capital Lease
$ 216,572
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?
3
Implication: Recognizing a deferred tax liability from temporary differences would have a
negative effect on the debt-to-equity ratio
Alternatives:
1) Class
Machinery and equipment
Leasehold improvements
Office equipment
Vehicles
Total
Amortization
$15,500
1,000
3,125
3,125
CCA
$37,500
1,000
2,500
3,750
Difference
($22,000)
0
625
(625)
($22,000)
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
$ 3,630
Deferred income tax liability
$ 3,630
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
correct period.
Inventory
Issue: How should the amount of the repossessed vehicle be measured in the inventory
account?
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.
4
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.
Ratio Calculations
Debt-to-equity= 3.53
Current=0.74
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.
BALANCE SHEET
As At December 31 2013
Unaudited
Assets
Current
Inventory
Other
$95,775
82,224
5
Revised
$90,775
82,224
177,999
172,999
Capital Assets
287,250
Capital Assets – Lease
Less: Accumulated Depreciation
$465,249
Liabilities and Shareholder’s Equity
Current
Accounts Payable and Accruals $8,455
Income Taxes Payable
17,334
Unearned Warranty Revenue
0
Lease Obligation
0
Differed Income Tax Liability
0
25,789
287,250
216,572
(21,657)
$655,164
Long-Term Bank Loan
277,240
277,240
Common Shares
Retained Earnings
74,500
87,721
162,220
$465,249
74,500
69,992
144,492
$655,165
6
$8,455
10,201
9,900
201,246
3,630
233,432
Sales
Warranty Revenue
Cost of Sales
Gross Profit
INCOME STATEMENT
For The Year Ended December 31, 2013
Unaudited
320,000
0
128,000
192,000
Expenses
Advertising and Promotion
Amortization
Bad Debt
Insurance
Interest
Legal and Accounting
Lease Expense
Office and General Expenses
Repairs and Maintenance
Utilities
Wages and Benefits
Revised
310,000
100
(128,000)
182,100
2,000
22,750
0
1,500
16,920
2,500
30,000
2,775
750
11,000
22,500
112,695
2,000
44,407
0
1,500
31,595
2,500
0
2,775
750
11,000
22,500
119,027
Operating Income
Other Service Income
Loss Due to Decline in Inventory – NRV
Income Before Taxes
Provision for Income Tax – Current
Provision for Income Tax – Deferred
Net Income
79,305
25,750
0
105,055
17,334
0
87,721
63,073
25,750
(5,000)
83,823
(10,201)
(3,630)
69,992
Retained Earnings – Opening Balance
Net Income
Dividends
Retained Earnings – Closing Balance
0
87,721
0
87,721
7
69,992
69,992
Statement of Cash Flows
Year ended December 31, 2013
Cash flows from operating activities
Net Income
Adjustments: Increase in A/R
$(45,000)
Increase in inventory
(90,775)
Increase in prepaid expenses
(1,775)
Amortization expense
44,407
Increase in A/P and accruals
8,455
Increase in income taxes payable 10,201
Unearned warranty revenue
9,900
Lease obligation
201,246
Accumulated amortization
(44,407)
Deferred tax liability
3,630
$ 69,992
95,882
$ 165,874
Net cash used in operating activities
Cash flows from investing activities
Capital assets
Capital assets-lease
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
$ (287,250)
(194,915)
$ (482,165)
$ 277,240
74,500
$ 351,740
$ 35,449
8
