Earthcom
Inc. (EI) is in the telecommunications industry. The company builds and
maintains telecommunication lines that are buried in the ground. The company is
a public company and has been having some bad luck. One of its main underground
telecommunications lines was cut by accident and the company cannot determine
the exact location of the problem. As a result, many of the company's customers
have lost service. Because EI did not have a backup plan, it is uncertain about
how long it will take to restore service. The affected customers are not happy
and are threatening to sue.
In
order to try to calm them down, EI has managed to purchase some capacity from a
competitor. Unfortunately, the cost of the service is much higher than the
revenues from EI's customers. EI is also currently spending quite a bit on
consulting fees (on lawyers and damage control consultants).
In
addition, EI is spending a significant amount of money trying to track down the
problem with its line, and although it has had no luck so far the company
recently announced that it was confident that services would be restored
imminently. As a result of the work being done, EI feels that it will be in a
better position to restore service if this ever hap pens again.
The
company has been upgrading many of its very old telecommunications lines that
were beginning to degrade due to age. It has capitalized these amounts and they
are therefore showing up as investing activities on the cash flow statement.
The company's auditors have questioned this as they feel that the amounts
should be expensed.
As
a result of all this, EI's share price has plummeted, making its stock options
worthless. Management has historically been remunerated solely based on these
stock options, however. The company's CFO meanwhile has just announced that he
is leaving and is demanding severance pay for what he is calling constructive
dismissal. He feels that because the stock options are worthless, he is working
for free-which he cannot afford to do-and that the company has effectively
fired him.
Instructions
Adopt
the role of the company controller and discuss the financial reporting issues.
Overview
-
Public company and therefore IFRS is a constraint
-
Shares are declining in value due to the loss of one
of the company’s major assets , therefore the pressure to make things look more
positive (potential for bias).
-
Loss of CFO under adversarial conditions — auditors
will have to be more cautious when doing the audit.
-
High risk for auditors who–will have to ensure
assets/income are not overstated.
-
As controller (since CFO has left) it is better to be
safe and provide transparency during this time of crisis. Conservatism would be the safest route
especially since the share price has already plummeted.
Analysis and recommendations
Issue: Impairment of telecommunications lines
|
Leave as is
|
Recognize impairment
|
|
-
Company is in the process of doing a substantial
amount of work to recover the services.
-
Once this is done – the asset would retain its
value.
-
No reason to think that they will not be able to
find the problem.
-
Note disclosure would suffice.
|
-
Severance of line represents an event that reduces
the potential future benefits of the asset.
-
Cannot provide services to customers and therefore
not able to generate future benefits.
-
Customers have currently lost service.
-
Company uncertain as to how long (if at all) it will
take to restore service as do not have backup plan.
-
They stand to lose customers over this – many
customers threatening to sue.
-
The company is already restoring other lines using
better and newer technology and so these older lines will likely be obsolete
and receive less and less use as time goes on.
|
Recommendations: It is too early to tell if the asset
is indeed impaired. Full and prominent note disclosure should suffice at this
point. Care should be taken at the next quarter with this valuation since by
then the company will have a better idea as to the feasibility of restoring
service.
Issue: How to treat
the amounts spent on lawyers and consultants regarding severed line.
|
Capitalize costs
|
Expense
|
|
- Without these expenditures, significant
goodwill will be lost.
- Many customers may also leave the company—
this is an opportunity to show how the company deals with a crisis.
|
- Expenditures do not add any future value.
- Really just maintaining reputation.
- Internally generated goodwill may not be
capitalized.
|
Recommendations:
More conservative to expense as these costs are really to maintain the status
quo and do damage control.
Issue: How to account
for expenditures to track down the problem
|
Capitalize costs
|
Expense
|
|
- May argue that
work done is an enhancement – this will allow them to deal with any problems
in a much more expedient way in the future.
|
- Really being spent just to restore service.
- Is not a betterment, i.e., it will not
necessarily make the service better or more enhanced.
|
Recommendations:
certain costs may add value and may be capitalized – i.e. if they are gathering
data that will help with problems in future. Those costs that are being spent
just to restore capacity to prior level are maintenance and must be expensed.
Issue: How to
present the funds spent on upgrading old telecommunications lines
|
Capitalize/treat
as investing activity
|
Expense/treat as
operating activity
|
|
- Must be able to argue that these
expenditures are an enhancement or benefit, that they will increase the life
of the lines or enhance the service potential.
- This sounds like it is a major upgrade and
given fast paced technology it could be argued that this is an enhancement.
|
- All significant assets such as these
degrade over time and need to be maintained.
- This is merely part of the ordinary ongoing
activities of the company to maintain the service potential of its assets.
|
Recommendation: May
be able to argue that these are significant upgrades due to changes in
technology and therefore capitalization is acceptable.
Issue: Lawsuit
|
Accrue
|
Do not
|
|
- Company will want to settle quickly to
minimize uncertainty in marketplace especially since the company at present does
not have a leader.
- May want to accrue a reasonable amount for
settlement so that it can hire a new CEO and move forward to deal with the
crisis.
|
- Too early to be able to assess probability
and measurement.
|
Recommendation: Too
early to tell on this one. Do not recognize. There is no lawsuit. The news will
likely already be in the marketplace via newspapers, etc. The company can best
deal with this by putting a new CFO in place (not really a financial reporting
issue).
