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Memo To: Asha Patel From: CPA Subject: Accounting questions Barbor sofa order Issue 1 The issue is whether Modern can recognize revenue on the undelivered sofas at year end. We need to consider the guidance in ASPE 3400 Revenue to determine when revenue should be recognized. Handbook and analysis Per ASPE 3400.04-.05, the recognition of revenue depends on whether all the following criteria are met: 1) Performance has been achieved — in other words, the risks and rewards of ownership have transferred to the buyer.  This criterion is not met. The delivery was not completed until January 2, which is subsequent to year end. Modern had not transferred the risks and rewards of ownership of the sofas by year end. Revenue can be recognized in advance of delivery if a bill and hold arrangement exists, as per 3400.09(a); however, this is not applicable here because the delayed delivery is not at the request of the buyer. 2) Consideration is reasonably measured.  This criterion is met. The sales order provides evidence of the measurability of the consideration. 3) Reasonable assurance exists that consideration will be received (collectability).  This criterion is met. There was an agreement in place, and Barbor is a longtime customer of Modern’s. This provides reasonable assurance that Modern will receive the consideration. As well, some of the consideration was received before year end in the form of a $9,000 deposit. Recommendation Based on the analysis of the revenue recognition criteria, Modern should not recognize revenue on this transaction in its December 31 financial statements. Accounts receivable and revenue on the sale must be reversed. In addition, the deposit should be recorded as a liability (deferred revenue) because Modern had an obligation at year end to provide Barbor with the sofas. Finally, because this inventory was owned by Modern at December 31, we need to adjust the inventory balance to include these sofas. This adjustment will reduce net income and increase liabilities, which in turn worsens the debt-to-equity ratio. This will also negatively affect the valuation of Lisa’s shares based on net income.

Lumber inventory Issue 2 The issue with the lumber inventory is whether it should be recorded as inventory at year end. We need to consider the guidance in ASPE 3031 Inventories to determine when the inventory should be recorded. We may also use basic accrual accounting rules in ASPE 1000 Financial Statement Concepts. Handbook and analysis The asset is in the form of materials to be consumed in the production process and therefore meets the definition of inventories as per ASPE 3031.07. The order of lumber was received FOB destination, meaning that ownership of the lumber transferred to Modern when the items were received at the Modern plant on December 31. The fact that the items were received after the inventory count does not change the fact that ownership of the inventory had transferred to Modern, in accordance with the shipping terms, prior to year end. Recommendation Based on the analysis above at year end, Modern owned the goods, and they were ready and available to be consumed in the production process. As a result, an adjustment is required to include this amount in inventory and accrue for the related payable. This adjustment will have no impact on net income and therefore will not affect the valuation of Lisa’s shares based on net income. This adjustment will increase accounts payable, which will negatively impact the debt-to-equity ratio. Saw repair Issue The issue is whether to record the saw repair as a repair expense or to capitalize it as a betterment to the saw. We need to consider the guidance in ASPE 3061 Property, Plant and Equipment to determine which costs are considered a betterment to capital assets. Handbook and analysis Per ASPE 3061.14, costs incurred to enhance the service potential of capital assets are considered betterments. Examples of enhancements of service potential include:    

The previously assessed physical output or service capacity is increased. Associated operating costs are lowered. The life or useful life is extended. The quality of output is improved.

The repair resulted in an increase in the service capacity and a 10% reduction in production time, which has increased the physical output of the saw. In addition, the

repair resulted in a 5% to 10% reduction in waste, which has lowered the associated operating costs. This suggests that the repair is a betterment. Recommendation Based on the analysis above, these costs represent betterments to the underlying saw, and the repair costs should be included in the cost of the asset. As a result of the capitalization of these costs, we must record amortization expense of $1,150 on the addition. The net adjustment will increase net income, which supports Lisa’s desire to present a strong set of financial statements to the bank, as the debt-to-equity ratio will improve. As well, a valuation based on net income will be positively impacted by this adjustment. National retail chain agreement Issue 3 The issue with the signing bonus is when to record it — in full at the time it was received or over the life of the contract. Handbook and analysis To determine the appropriate treatment, we need to look to ASPE 3400 Revenue for the criteria for revenue recognition: 1) Performance has been achieved — in other words, the risks and rewards of ownership have transferred to the buyer.  This criterion is not met. The agreement specifies that the bonus will be paid up front, because Modern agreed to provide all the furniture required in the agreement. The furniture will begin to be sold in March. As such, performance has not yet been achieved, since the products have not been delivered to the customer and because the title and benefits of ownership of the furniture have not been transferred to the customer. 2) Consideration is reasonably measured  This criterion is met. The performance bonus is $75,000. 3) Collection is reasonably assured  The $75,000 has already been collected, so measurement of the consideration is certain. Recommendation Based on the analysis above, the bonus should be recognized as deferred revenue now, with revenue recognized over the three-year life of the sales agreement. This is consistent with the fact that the bonus was paid up front. It should be recognized in the period in which the products are delivered and considered sold to the customer, representing the period in which the risks and rewards are transferred.

While this alternative is not consistent with Lisa’s desire to record the bonus as revenue now, it adheres to accounting standards. This will reduce net income and increase liabilities, which has a negative impact on the valuation of the company and the debt-toequity ratio. Impact on bank covenant Modern is required to adhere to a maximum debt-to-equity ratio of 1.10. After adjusting for the items above, the debt-to-equity ratio is 1.10 (Exhibit I). Therefore, the company is in compliance, but only barely so. This analysis did not consider the tax impact of the adjustments. Because the adjustments decrease net income overall, the tax impact of the adjustments will be favourable for the debt-to-equity ratio. The situation is serious given that the bank could call the loan if the ratio worsens. Modern would not have the means to pay off the full amount of the loan, given its current cash balance is low. Modern should implement plans to improve its working capital and debt management. In addition, Modern should identify ways to improve its debt-to-equity ratio to ensure it is in compliance with the bank’s covenant, such as selling any redundant assets and using the proceeds to reduce accounts payable. Strategies should be communicated to the bank proactively because attempts to improve the cash flow position will be seen positively by the bank....