Sunlight
Equipment Manufacturers (SEM) makes barbecue equipment. The company has
historically been very profitable; however, in the last year and a half, things
have taken a turn for the worse due to higher consumer interest rates and a
slowdown in the economy. On its 2011 draft year-end statements, the company is
currently showing a break-even position before any final year-end adjustments.
The company had fired its CEO, Sam Lazano, at the beginning of the year and a
turnaround specialist was hired—Theo Lundstrom. Theo has a reputation of being
able to come into companies that are suffering and make them profitable within
two years. Theo has agreed with SEM’s board of directors that he will be paid a
$1-million bonus if the company has a combined two-year profit of $5 million by
the end of 2013. Among other things, Theo instituted a more aggressive sales
policy for its customers, who are mainly retailers, as well as a new
remuneration policy for sales staff. Theo attributed the company’s poor
performance to untrained sales staff whose remuneration and bonus scheme was
not properly aligned to maximize sales. Under the new remuneration policy, sales
staff is paid salary as well as a bonus, which is a percent of gross sales as
at year end. The sales staff has responded well and sales have increased by
20%.
The
new sales policy is as follows:
•
Cash down payment of 20% with remaining payment for shipment once the barbecues
are sold by the customer to a third party.
•
If the customers order double their normal order, no down payment is required.
•
The barbecues may be stored on the premises of SEM. Many customers have taken
the company up on this offer in order to double the size of their purchase.
•
Any unsold barbecues are allowed to be returned after year end.
Under
the new policy, sales have increased dramatically, with many customers taking
advantage of the new terms. As at year end, legal title to all barbecues has
passed to the customers. Only customers with excellent credit history have been
allowed to purchase under the new policy. The company has accrued bonuses for
almost all its sales staff.
The
increased profits from these sales have been offset by the accrual of $500,000
of Theo’s bonus. He is very confident that he will be able to turn the company
around and so has accrued part of his bonus. He has also decided to change several
accounting policies, including the following:
•
Depreciation on machinery switched to straight-line from
double-declining-balance. Note that the equipment is about 2 years old with an
estimated life of 10 years. Theo felt that the double-declining-balance method
was arbitrary and noted that several of their competitors used the
straight-line method. Machinery is most useful when new since it requires less
downtime for fixing.
Another
problem that Theo had identified was in inventory management. Theo was
convinced that inventory was being stolen and/or “lost” due to poor tracking.
The company had therefore hired a company, Software Limited, to install a new
inventory tracking system during the year. Midway through the year, Software
Limited had gone bankrupt and was not able to finish the installation. The
installation was a customized job and as at year end, the system was not
functioning yet. SEM has not been able to find a company to replace Software
Limited. To date, $2 million has been spent on the new system. Theo had
capitalized the costs and noted he was confident that he would be able to find
a company that could successfully complete the installation.
Instructions
Adopt
the role of the company’s auditors and discuss the financial reporting issues
for the 2011 year end. The company is a private company but would like the
statements to be prepared in accordance with IFRS.
Overview
·
There
may be a reporting bias since new manager may opt to make numbers look better
to earn his bonus (NI is a key number since bonus is based on this). A bias may
also exist since Theo will want to pay his sales staff a bonus, which is based
on sales. The slowdown in the economy may also put pressure on the financial
statements— the company may want to make the numbers look better.
·
Assume
IFRS since the company is being audited (role –—auditor). Although it is a
private company, the company has the choice to prepare the statements according
to IFRS or ASPE. They have elected to use IFRS.
·
Users of
the financial statements will want transparency to assess how the company is
faring in the economic downturn and also to assess how Theo is performing.
·
As
auditor you must be aware of these pressures on financial reporting.
Analysis and recommendations
Issue: Revenue recognition
Due to the
aggressive sales policy, sales are up 20%, however, this figure might be
inflated.
|
Recognize revenues
|
Defer recognition
|
|
-
20% cash down
payment will help ensure collectibility. Note also that only customers with
excellent credit history have been allowed to purchase under the new policy.
-
Legal title
to the BBQs has passed.
-
Persuasive
evidence of an arrangement since legal title has passed.
|
-
Only 20% cash
down and in many cases (if customers’ orders double) – no down payment.
Therefore collectibility an issue. Customers may have ordered double just to
avoid the down payment but may not be able to sell.
-
Measurability
is also an issue since the customer does not have to pay until he resells to
a third party— is this real sale or like consignment? Economic substance over
legal form. SEM still has the risks and rewards of ownership thus if the
consignment is not sold by the customer, the inventory reverts to them.
-
Possession
remains with SEM – BBQs stored on premises— have not even shipped them— bill
and hold arrangement— may be evidence that risks and rewards rest with SEM.
|
Recommendation: Defer recognition – more conservative.
Issue: New inventory system
The company has
purchased a new inventory tracking system however it is incomplete and
therefore does it have value?
|
Capitalize
|
Expense
|
|
-
The new
system has/will have future benefit since it will help track inventory. In
the past, this has been a source of lost profits.
-
SEM owns the
new system and will be able to use it once it is complete.
-
Theo is
confident that he will be able to find another software company to complete.
|
-
The software
company SL has gone bankrupt and therefore may not be able to finish the software
– thus there is no future benefit and this is a sunk cost.
-
Without the
project being completed, SEM has no access to potential future benefits.
-
Care should
be taken since Theo may not want to admit failure, since it will also affect
his bonus and the perception about how he is performing in terms of turning
the company around.
-
Presentation
of loss on Income Statement – discuss.
|
Recommendation: Expense since significant uncertainty as to
future benefit.
Issue: Bonus
|
Accrue bonus for
Theo and sales staff
|
Do not accrue
|
|
-
The payment
for Theo is likely as he has a reputation as a turnaround specialist and has
put new policies in place to turn the company around: new sales
policies/remuneration and new inventory tracking system.
-
It is
measurable since it is defined – all the company has to do is achieve the
combined two year profit of $5,000,000 – has been profitable in the past.
-
More
conservative to accrue.
|
-
Currently
breakeven situation— may not achieve profitability— future uncertain.
-
Appears to
have created income by overly aggressive sales policies and changes in
accounting policies. Note that the software acquisition is a large loss.
-
This is a
condition involving uncertainty that will only be resolved when the company
hits the 2 year profit target.
|
Recommendation: Do
not accrue due to overstated net income – which should be restated.
Issue: Accounting policy change
-
Must be
skeptical. SEM may have changed just to make net Income higher.
-
Just because
competitors use straight-line, it does not justify SEM changing its accounting
policy. The accounting policy can only change if results are reliable and more
relevant information is given/provided.
-
The fact that
the machinery is most productive when new would support the double declining
balance method.
-
Straight line
would be arbitrary and unjustifiable.
Conclusion: should not change
