Face to Face #3 - Solutions PDF

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Summary

F2F solutions 3...

Description

Alexander Electr onics Ltd.

In this case, the student plays the role of an advisor to a prospective buyer of a home electronics business. The prospective buyer has concerns about the accounting for certain transactions in the

financial statements and he would like a report evaluating the appropriateness of the treatments used for purposes of determining the price he should pay . The role of the fnancial statements in seting the price is vague, so the analysis should include a discussion of how fnancial statements should be used for purposes of seting the selling price.

Role:

• Advisor to Mr. Evans, who is a prospective buyer of Alexander Electronics Ltd.

Key facts:

Mr. Evans has concerns about the accounting for certain transactions in the fnancial statements. He would like a report evaluating the appropriateness of the treatments used in AEL’s 2017 income statements to help him determine the price he should pay. • Ryan Evan is seriously considering buying the business he has worked for as a marketing manager. • It’s not clear how the fnancial statements will be used in pricing AEL, however, the seller has an incentive to make the fnancial statements “look beter” to increase the price he’ll receive for his business.

Constraints:

• None specified. Using accounting standards to provide structure for

Objectives:

• Evans would like to see financial statements that are representative of what

Issues:

• Terms of reference

seting accounting standards. he can expect if he buys AEL.

We’re not given any guidance on how the fnancial statements will be used to set the price.  The statements should be prepared in a way that best reflects the performance of AEL on a going-forward basis. Mr. Evans will want an idea of how AEL will perform if he buys the business. That means non- recurring items should be clearly identified.  The statements should also reflect the actual economic activity of the company. This will probably be helped by applying IFRS or ASPE as appropriate. • Revenue recognition—Sale of Zordef of the Deep 

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AEL collected payment in advance from buyers of a new video game. Buyers received vouchers they would redeem for the game when it came in, in the next fscal year. AEL recognized the revenue when the

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customer signed-up and paid. The revenue recognition criteria for goods require performance: risk and rewards must have transferred and no continuing management involvement with the sold item. Usually this corresponds with delivery. Delivery hasn’t occurred at the time of payment so clearly the risks and rewards haven’t transferred to the buyer, since the buyer doesn’t have the game.  The other criteria are met at the time of payment.  This treatment results in an overstatement of revenue and net income for 2017, which could result on Mr. Evans paying too much for AEL, depending on how the price is set. • Revenue recognition—service contracts 

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Revenue recognition for services requires that the entity is able to estimate the percentage of completion of the service, there is a reasonable expectation of cash collection, and revenue and costs are reasonably estimable.  Recognizing revenue when customers sign-up and pay for their contracts because at that time the percentage of the contract that has been performed is zero. At best, revenue should be recognized over the term of the contract. Since this is a new product, there are potential problems with estimating the costs that will be incurred, which could mean delaying recognition until the end of the contract. This service is being offered on electronic equipment so there could be a lot of costs. The amount of revenue is also uncertain because customers can cancel after the first year—so recognizing revenue at payment is not appropriate, since the amount of revenue is not really known. This is further compounded because this is the frst year of the arrangement, so there is no history to predict cancellations.  The most conservative approach would be to recognize revenue at the end of contract term because of the uncertainty about costs. At a minimum, the revenue should be recognized month-to-month with the passage of time.  The method used by AEL overstates net income for 2017. • Owners’ compensation An owner is entitled to be compensated however he wants, so this is not really an accounting issue.  The impact of this change is to increase net income in 2017. This could be an atempt by the existing owner to overstate income to get a larger price for his business. It also makes net incomes from previous years not comparable with 2017 because of the different approach to owner compensation. The treatment of owner compensation should be consistent from period to period if multiple years’ financial statements will be used to set the price. One way or another, the owner has to receive a reasonable return for his investment and his work, particularly if he is

managing the business. It’s fne not to include the owner’s compensation in the income statement but if a multiple is used it should be a smaller multiple than if the wage is included. • Advertising campaign  

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AEL has capitalized the cost of the advertising and is amortizing it over 12 months. This treatment means that the advertising is being classifed as an asset so the cost isn’t fully expensed in 2017, which increases net income, compared with expensing. The diffculty with advertising is that it’s difficult to estimate the timing and amount of any future beneft, so while there is definitely an expectation that there will be a future benefit (otherwise the advertising wouldn’t be done), expenditures on advertising don’t meet the recognition criteria. The other criteria are met. The past transaction is the payment of the cost of the adverting. AEL clearly controls the message and timing of the advertising and will be the benefciary of any positive efect. • Sale of land The land sale is a one-time gain that has no impact on Mr. Evans future operation of the business. It should not affect the price.  The gain should be recognized in 2017, the year it was sold.

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