Baker
Company Limited (BCL) was founded in 2009 and its first year of operations
turned out to be a good one, as start-up years-go, since the company not only
broke even but actually showed a very small profit. Just as the company was
getting established in the market, however, a full-fledged recession hit in
2010 and had devastating effects.
Demand
for BCL's products in retail markets declined as consumers tightened their
purse strings. Through tight cost controls, however, BCL managed to hold its
own and still recorded a small profit in 2010.
While
the recession finally petered out by the end of 2011, BCL did end up feeling
its effects, as the company was unable to remain profitable and suffered large
operating losses that year. In fact, the losses were significantly greater than
the profits that were reported in the previous two years. Despite this change,
BCL management was not overly alarmed by the losses and had the following
comments to make:
The
losses were expected given the widespread recession. Since the bulk of our
sales are in retail markets, and with unemployment levels being at record
highs, it is not surprising that consumer demand has fallen off. If BCL is
compared with the industry, you will see that we did much better than our
competitors, some of whom went bankrupt.
Keep
in mind that we are a relatively new company and managed to record a profit in
two out of our first three years. We attribute this to our strong management
team and our ability as a streamlined company to react to the recession with
cost control measures and an aggressive, yet flexible sales staff.
We
see ourselves positioned for a new growth spurt given that the economy seems to
have recovered and a lot of "dead wood" (i.e., competition) has been
cleared out. As a matter of fact, in that regard, the recession will have a
positive impact on our short- to mid-term growth potential.
BCL
is on the verge of introducing two new products that will revolutionize the
industry and assure us a solid earnings base for the future. These products
will be introduced in 2012 and we have already lined up sufficient buyers such
that we predict we will at least break even in terms of net income in 2012.
This is a very conservative forecast.
Although
the effects of the recession were lessening, unemployment was still high in
early 2012 and consumer spending had not increased significantly. Some
economists were predicting that it would take two or three years for consumer
confidence and spending to pick up to pre-recession levels.
Instructions
Adopt
the role of the company's auditor and determine whether BCL should recognize
the benefits of the losses suffered in the 2011 financial statements. Assume
BCL is a private company.
Overview
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Assume that GAAP is a constraint since the
financial statements are being audited. As a private company, the company could
use ASPE or IFRS .
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The role is that of company auditor and,
therefore, the auditor would ensure transparency.
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Management has high expectations of the
company’s ability to turn around and continue to grow—and may be biased to show
this.
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Users include shareholders/investors who
will want transparent statements. Given loss situation—they will be looking to
decide whether to divest or not.
Analysis and Recommendations
Issue: The issue is whether the benefit from the losses should be
recognized in the current financial statements.
To the extent that taxes were paid in previous years, the losses
would first be carried back to recover these taxes and a partial benefit could
be recognized.
The real issue is whether there is sufficient certainty to
recognize the benefits that might be realized if the losses are carried
forward. The benefits may be recognized if it is more likely than not that the
benefits will be realized (under ASPE) or probable (under IFRS ). This
ultimately depends on the existence of sufficient taxable income in the carry
forward period to be able to utilize the loss and shelter future taxable
income. Note that under ASPE, the entity has a choice to use the taxes payable
method or future income taxes method.
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Recognize benefit of losses
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Do not
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On the one hand, management has big
plans to expand into new markets with new products. Two new products are
scheduled to be introduced and there are sufficient customers lined up to
purchase the products, such that the company is predicting at least a break
even situation using conservative estimates.
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The fact that the company did not suffer
pre-recession losses in its first two years is a signal that they must be
doing something right. With respect to the economists, it might be argued
that no one can really predict the future. Management has better insight into
its own company and customers and, therefore, might be in a better position
to predict the future.
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The fact that numerous competitors have
gone under will hopefully open up new markets and help increase market share.
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In addition, this option would not be
allowable under the taxes payable method (ASPE).
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Forming a conclusion that the benefits
are likely to be realized is difficult when certain unfavourable evidence
exists.
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In this case, unfavourable evidence
would include the fact that there is a history of marginal profits only (and,
of course, the loss) and the fact that this company is still in its formative
years. It is not unusual for companies to sustain losses in the start-up
period.
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Furthermore, it might be argued that the
current state of the economy is unsettled. Unemployment is still high and
consumer spending has still not increased significantly. The fact that economists
are predicting that it might take two to three more years for consumer
spending to recover results in more uncertainty.
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In addition, if using the taxes payable
method (ASPE), would only recognize taxes receivables based on current and/or
refilled tax returns. Therefore no tax assets would be recorded in advance.
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In conclusion, although management might be able to make a strong
case for profitability, it is still a projection at best and, given that the
economy still appears to be slow, it might be more conservative not to
recognize the benefit. This is in keeping with the role of auditor. The
unrecognized benefits and expiry dates would be note disclosed.
