As an external auditor of Terry Timber Inc.(TT), my objective is to analyze the observations made by you and give recommendations, which will help attain the goals of the company and objectives of all the users, regarding the proper treatment of these matters for financial statements ending December 31, 2009.
The primary users of TT’s financial reports and their respective objectives are John Taylor – maximizing profits; respecting the bank covenants that includes improving the current ratio; upholding the integrity of financial reporting to regain confidence of shareholders and the bank, the Bank- ensuring compliance with covenants; ability to pay back loans ; sound financial reporting, shareholders- maximizing income and return on investment; relying on accurate financial results to measure the performance and growth of the company and success of management, etc., union- maximizing profits to increase gain sharing; evaluating the growth of company to measure job security. The secondary users of TT’s financial statements are Future Investors – maximizing income and accurate financial reporting, CRAand other regulators- to verify if the company adheres to income tax act.
There are various constraints in preparing the financial statements for TT i.e. GAAP- TT is a publicly traded company, it must follow the GAAP accounting rules, Toronto Stock Exchange act-TT is publicly traded on Toronto Stock exchange and hence should adhere to Toronto stock exchange act, Covenants set by bank-SinceTT has been close to breaching its bank covenants, particularly the minimum current ratio-it should emphasize meeting the bank covenants and improving the current ratio, Lawsuit -The recent lawsuit is a constraint in this year’s financial statements as all the stakeholders will pay close attention to this year’s financial statements. Finally, the union negotiations are a constraint because the profits reported this year will impact future negotiations with TT.
TT has two lawsuits filed against it – Lawsuit filed by a shareholder and wrongful dismissal claim filed by David Mcdonald. There are three options to account for these contingency losses: – it can be accrued, disclosed in financial statements or ignored for financial reporting purposes. As per GAAP, a contingency should be evaluated on measurability, materiality and likelihood of the occurrence. In the case of the lawsuit filed by the shareholder, the likelihood of the outcome and the claim amount are unknown. In the case of wrongful dismissal claim filed by David Mcdonald, the likelihood of the outcome is not determinable although the claim amount is known. Therefore, GAAP being a constraint, I recommend disclosing both these lawsuits in the notes to financial statements. There is no need to accrue the claim amount in shareholder lawsuit case.
Valuation:
Conservatism concept of GAAP requires that measurement in financial statements should be made to ensure that the assets, revenue and income are not overstated. Under this GAAP principle:-
- Land (which is a capital asset) should be reported at its current book value and not at the market value.
- Timber holdings Similarly, inventory (in this case, Timber) is valued at the lower of its historical cost and market value. Although the historical costs of land and timber are negatively affecting the current ratio, values cannot be appreciated to the present market values.
Government Regulations and Strike :
According to GAAP, any losses or gains due to event, which is not expected to occur frequently, not a typical of the entity’s business and not primarily the result of the management decision can be categorized as Extraordinary item (EOI), but the one which do not meet definition of EOI but not expected to occur frequently or not considered part of the normal business activity is categorised as Unusual item. These events are classified separately (according to Sec-1520 of CICA handbook) in the income statement. Therefore, these losses can be excluded from the cost of sales, preventing TT from distorting the gross profit margin for 2006-07.
Revenue Recognition : There are number of alternatives to account the revenue generated from the sale of furniture to Aussy company. At the signing of Contract (does not meet GAAP, too aggressive, although amount of revenue and cost can be measured but performance not occurred and full payment is not collected, estimate for bad debt required), at time of shipment (does not meet GAAP, although amount of revenue and cost can be measured but rights and risks of ownership not transferred to the customer and full payment is not collected, estimate for bad debt required), at receipt of shipment (does not meet GAAP, although amount of revenue and cost can be measured and ownership is transferred but full payment is not collected, estimate for bad debt required and it is difficult to know accurate time of receipt of shipment), or after 30 days of receipt of consignment (meets GAAP, amount of revenue and cost is known, ownership transferred and payment is received and if not then estimation of bad debt will be more reliable but it is too conservative). As the contract is non cancellable, I would recommend the policy of gradual recognition (% completion) i.e. recognize total revenue minus the additional revenue charged because of a special coating, at the time of shipment of furniture and balance revenue from the additional amount charged because of a special coating, at the time of shipment of the premium coating. However, estimate for bad debt and ownership transfer cost will be required and it can be done through the past experience of the company. This will help to recognize cash received upfront, thus increasing its current ratio. Although, the current ratio using this methodology will be less as compare to the total revenue recognition at the time of shipment, it addresses the GAAP rules more appropriately than the former. Also, missing delivery deadline can cause severe penalty to TT, which seems to be very much material. Therefore, I would recommend including the Note in the FS about the consignment agreement and appraising the Aussy Company about the progress of the manufacturing of the premium coating and if possible, negotiate the delivery clause of the contract.
Consignment Inventory : As per the accounting principles, consignment inventory should be included in the inventory account of the owning entity and not in the inventory account of the selling entity, even though owning entity does not have the physical custody of the inventory. Further, revenue on the sale of the consignment inventory can only be recognised when the inventory is sold by the selling entity to a customer. Therefore, TT has to include this as the component of inventory ($800,000) not of sales ($1,200,000), which will affect the current ratio negatively.