Cringle
Inc. (CI) has just had a planning meeting with its auditors. There were several
concerns that had been raised during the meeting regarding the draft financial
statements for the December 31, 2011 year end. CI is a public company whose
shares list on the TSX. It has recently gone through a major expansion and, as
a result, there are several financial reporting decisions that need to be made
for the upcoming year-end financial statements. The expansion has been financed
in the short term with a line of credit from the bank; however, the company
plans to raise capital in the equity markets in the new year. It is hoped that
the expansion will increase profitability, although it is too early to tell. Just
before year end, the company purchased a number of investments as follows:
•
20% of the common shares of KL. CI was able to appoint one member to KL's board
of directors (which has four members in total). CI is unsure as to whether it
will hold on to this investment for the longer term or sell it if the share
price increases. The company has currently set a benchmark that if the share
price increases by more than 25%, it will liquidate the investment. KL has been
profitable over the past few years and the share price is on an upward trend.
The original reason for entering into this transaction was to create a
strategic alliance with KL that will help ensure a steady supply of
high-quality raw materials from KL to CI.
•
Corporate bonds. These bonds are five-year bonds that bear interest at 5%
(which is in excess of market interest rates). As a result, the company paid a
premium for the bonds. The bonds are convertible to common shares of the
company. It is CI's intent to hold on to these bonds to maturity, although if
there were an unforeseen cash crunch, it might have to cash them in earlier.
The
company completed a significant sale to a new U.S. customer on credit on
December 31, 2011. Under the terms of the agreement, CI will provide services
to the customer over a one-year period. The sales agreement includes a non
refundable upfront fee for a significant amount, which the company has
recognized as revenue. As part of the deal, CI will provide access to
significant proprietary information (which it has already done) and then
provide ongoing analysis and monitoring functions as a service to the customer.
It is not specified in the contract whether the rights to the proprietary
information are transferable but CI is taking the position that they are. The
proprietary information is of no value as a separate item if not transferable.
During the year, CI renewed service contracts for some of its other major
customers under similar deals.
The
receivable for this large sale is in U.S. dollars. Half of this has been hedged
using a forward contract to sell U.S.
dollars
at a fixed rate. The other half is hedged through a natural hedge since the
company has some U.S. dollar payables.
The
auditor has asked that the company prepare some notes analyzing the need for
hedge accounting for this transaction and explaining the risks associated with
the sales transaction and hedge transactions.
This
has been a bad year for the company due to one-time charges on a lawsuit
settlement, and currently the draft statements are showing a loss. The
company's tax accountants have determined that the company will also have a
loss for tax purposes.
Instructions
Assume
the role of the controller and analyze the financial reporting issues.
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Role –
controller – potential bias towards making company look better since looking
for new capital and to potentially refinance loan.
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Bank and
potential investors are key users who will be relying on statements to make
decisions – need transparency.
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Public company
since shares trade on TSX – IFRS
is a constraint.
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For
investments, company must decide whether to follow IFRS
9 (early adopt) or IAS 39.
Analysis and recommendations
Issue: Investment in
common shares
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Equity method
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At fair value with
gains and losses through income or OCI
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20% -
borderline for significant influence.
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Representation
on Board (1/4) may allow influence.
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Original
intent was for strategic purposes.
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20%
inconclusive.
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No longer
being held for strategic purposes – i.e. intent to sell/trade is share prices
rise above certain point.
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If FVOCI –
revalue to fair value and gains/losses to OCI (if following
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If FVTPL
(HFT) – revalue to fair value and gains/losses to net income.
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Option to
treat as either (FVTPL and/or FVOCI) under IAS 39 or
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Recommendations:
Could select any of
the options however, given the intent to sell if the shares reach a certain
price, consider measuring at fair value with gains/losses through income
(easier). This option is available under IFRS
9 and IAS 39.
Issue: Investment in
bonds
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Amortized cost
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Fair value (with
gains/losses booked to income)
|
|
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Under IAS 39
- Intent to hold to maturity expressed and ability to hold given new
potential influx of cash (raising capital).
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Amortized
cost – amortize premium as an adjustment to interest cost.
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Under IAS 39
– may have to segregate the conversion option and value at fair value
(embedded derivative). NB. This is generally beyond the scope of the text.
|
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Under
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In addition,
since these are debt instruments, the option to value at FVOCI is not
available under
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Under IAS 39
if classified as HTM (amortized cost) and sell prior to maturity, it may
invoke tainting provisions (if significant). If this is the case, would no
longer be able to value this and other debt securities at amortized costs.
Therefore do not measure at amortized cost upfront and avoid risk of
tainting.
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More
transparent to value at FVTPL since business model seems to indicate the
investments are incidental to main business.
|
Recommendations:
To value at fair value with gains/losses
through income.
Issue: Revenue
recognition – Non-refundable fees
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Recognize upfront
fee
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Do not
|
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Multiple
element arrangement?
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Proprietary
info considered separable unit – transferable per company and therefore must
have standalone value.
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Objective and
reliable evidence of undelivered item since issued renewal contracts to
others this year.
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Persuasive
evidence of contract – since deal is done and likely documented.
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Measurable
since no material uncertainties.
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Delivery of
proprietary info already occurred.
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Would have to
bifurcate.
|
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Proprietary
info may not be transferable separately and therefore considered an integral
part of the whole transaction (has no value otherwise if not transferrable).
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Recognize
over time – straight line unless other pattern.
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May use
percentage of completion method.
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Recommendations:
To recognize entire
contract amount over time as more reflective of the bundled nature of the
transaction.
Hedging
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Hedge accounting –
discussion of theory as requested by client
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No hedge
accounting
|
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Meant to ensure that gains/losses from
hedged items offset gains/losses from hedging items in income in same period.
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Must use if
do not already do so.
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Modifies
normal accounting.
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Must ID
hedging relationship between hedged and hedging item
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Must ensure
effective.
|
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Optional.
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Costs and
complexity are significant.
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No need to
use hedge accounting since gains and losses of hedged (US AR) and hedging items (forward
contract) already essentially offset (forward contract recognized, valued at
fair value and gains/losses to net income already. US AR revalued to spot
rate with gains and losses to net income).
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Natural hedge
does not require special accounting since US AP also revalued to spot rate
with gains/losses to income.
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Recommendations:
There is no need to
use hedge accounting. Risk that counterparties will fail to complete
transaction – forward contract – would mean still exposed to risk.
Issue: Recognize
benefit of LCF
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Yes
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No
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Due to a one
time loss.
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Otherwise
expected to be profitable.
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- Not sure if
company will be profitable next year.
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