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From : External Auditor, Terry Timber Inc.
Subject : Advice on accounting policies of stated matters of Terry Timber Inc. (TT)
Dear Mr. Taylor
Enclosed is the report you requested regarding the adequate accounting policies for the stated matters for financial statements of TT. My objective, as an external auditor for TT, is to come up with reasonable and justifiable treatments for the accounting matters that result in meeting the goals of the company and objectives of all users.
The Financial Statements (FS) of TT have primarily four users with different objectives, Shareholders – to evaluate the performance and growth of the company, to increase return on their investment, and to ensure accurate reporting. Bank - to determine, if company complies with covenants, to ensure repayment of their loan and accurate reporting, Union - to evaluate ongoing and future gains of the company and to see maximum profits, and Mr. Taylor, president of TT (preparer of FS) - to maximize profits, to evaluate growth of the company, to meet bank covenants, to minimize taxes and to ensure accurate financial reporting. There are other users as well like CRA/Auditors - to ensure accurate reporting by TT, Court (if requested during trails) – to see if FS reports are fairly stated or not.
TT is a publicly traded company listed on Toronto Stock Exchange therefore it is constraint by GAAP and has to meet the requirements of the securities laws of Ontario and the rules of the stock exchange. TT is also constraint by covenants set by its Bank, and has to be extra careful about the Current Ratio.
Also, union is expecting a significant gain-sharing plan therefore incomes reported in this year financial report will play crucial role in the negotiations. Further this time; auditors will be extra careful during audits because of the lawsuit filed by the shareholders, therefore, scrutiny will be high. Following are the issues that need to be addressed, while complying with the Financial reporting constraints.
Court Cases : TT has two potential court cases against it, first, by Shareholders and second by Mr. MacDonald, ex-president of TT. According to GAAP, if likelihood of the event happening is known, damage is material and measurable then accrue the cost and disclose in financial notes but if any one of the three components are not known than disclose it in Financial Notes. In Mac Donald’s Case - even though damage is known and is very much material, likelihood of happening is not known.
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Land and Timber Valuation : Conservatism is a fundamental GAAP concept that serves to ensure that assets, revenues and net income should not be overstated. Therefore, under GAAP, capital assets (in this case, Land) is always reported at the historical cost and GAAP accounting is not intended to capture the changes in the market values. 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.
Two Events (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.
Inventory Valuation Method – The furniture division of TT is using LIFO method for valuation of inventory for lumber that was purchased in bulk in late 2007, when there was depression in the prices of lumber predicting that its price will rise in near future. GAAP identifies four inventory valuation methods - LIFO, FIFO, average cost and specific identification. In predicting the future cash flow and evaluating the company performance, FIFO based inventory value is more useful than alternatives because it gives a more current indication. Also, when inventory prices are rising, FIFO gives the lowest cost of sale and the highest inventory value, whereas LIFO gives the highest cost of sales and the lowest inventory value. Average cost gives between these two. Therefore, as indicated that price of lumber is expected to rise, I would recommend to use FIFO as the inventory valuation method because with FIFO, the reported amount of ending inventory is always higher as compare to other alternatives resulting in higher current ratio. Moreover, according to Income Tax Act, LIFO cannot be used in Canada.
Allowance of Account Receivable : Normally, management can change the percentages for allowances based on the historical information about the proportions of the receivables that are not corrected in recent past. But in order to convert old receivables into current receivables by revising the invoice date is not legal. Therefore, I would recommend using the same percentages, which were consistent over last few years, for un-collectable accounts receivable and not revising the date on the invoice, even though this will hurt the current ratio and decrease the income.
Based on the above-mentioned context, I have made recommendations that are supportable in term of GAAP, fairness and accrual accounting. Any change in the context and assumption, would seek reconsideration of the analysis conducted on the financial reporting of TT. I hope this will provide you sufficient information about the accurate accounting treatments of the stated matters. If necessary, I would be glad to provide any further information you might need.