IAF640 Midterm

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Seneca College *

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IAF640

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Accounting

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Apr 3, 2024

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Case Study J&C CO. J&C Co. (J&C) is a manufacturer of women’s outerwear. Most of J&C’s merchandise in manufactured in Canada. Although production costs are higher in Canada, the company finds that the high quality of the clothes allows it to remain profitable. J&C was founded in 2006 by John Hogan and Christine Murker. Each shareholder owns 50 percent of the shares of the company. In late 2019, John and Christine had a major disagreement on the direction of the company, and they have not spoken since. John is no longer involved in the day-to-day operations of the company and any input he provides is done through his lawyer. In April 2020, John and Christine agreed (through their lawyers) that Christine would buy John’s shares at fair market value, where fair market value would equal three times net income for the year ended December 31, 2020, with the financial statements prepared in accordance with Accounting Standards for Private Enterprises (ASPE) consistently applied. You are John’s long-time accountant and financial advisor. On February 15, 2021, John storms into your office in a rage. He has just received the 2020 financial statements from Christine, and they showed that net income was $142,000, well below the average reported in recent years. John blasts that this is “a complete and utter rip-off” because he’s not going to get nearly enough for his shares, and he isn’t going to stand for it. You tell John to calm down and he gives you the financial statements to examine. John points out a number of issues he is concerned about, and you tell him you will analyze them and prepare a report explaining any problems with the accounting treatments used and the impact on the agreement. The issues are described in Exhibit A, which follows. Required: Prepare the report for John Hogan. (100 marks) EXHIBIT A: Issues Identified on Your Review of J&C’s 2020 Financial Statements 1. In November 2020, J&C received an order from an outerwear distributor in Chile. The goods were produced and shipped on December 15. This is the first time J&C has shipped to this distributor and the first time it has shipped outside of North America. J&C’s credit department received a report from a credit rating agency in Chile that indicated the customer had a credit rating of “good.” The goods shipped are standard models that have been modified to meet the tastes of the Chilean market. These designs have always been popular in the North American market. The customer isn’t allowed to return any of the goods, but J&C has agreed to provide a rebate of 30 percent of the price the customer paid for any goods that it is unable to sell. J&C has not recognized the revenue as of December 31, 2020, because it’s waiting until the goods are sold by the Chilean distributor. 2. In 2016, J&C took advantage of an opportunity to buy large supply fasteners (buttons and zippers) from a supplier that was going out of business. At the time, John and Christine estimated that the supply of

fasteners purchased would last about four years. Since then, styles and technology have changed so that the items purchased in 2016 can only be used on lower-quality items and/or on the less-stylish garments J&C makes. Christine now thinks that this supply of fasteners can be used, but that it will take much longer than originally thought. Christine has been trying to sell the fasteners but has only managed to dispose of about 30 percent of the remaining amount. For accounting purposes, Christine has written off the remaining unsold inventory in the year ended December 31, 2020. 3. In late January 2021 one of the J&C Co’s customers filed for bankruptcy, which J&C had suspected might occur because the customer was already four months behind on payments. Christine thinks it’s very unlikely that it will collect any of the $55,000 owed by the customer. Christen has written off the amount. 4. J&C has provided a guarantee on $40,000 of debt for a related company, Thunder Bay Clothing (TBC) a couple of years ago. TBC has been experiencing financial difficulties, and there is a 10% chance that it may be insolvent within the next six months. TBC is currently working with its bank to refinance its debt and avoid bankruptcy. J&C accrued the entire amount in the financial statements of 2020. Your Answer Reporting To: John Hogan, Founder, J&C Co. From:, Accountant Reporting: Analyzing the identified issues from J&C's 2020 financial statement in accordance with ASPE GAAP constraint: This report will coincide with ASPE as the company is private and the financial statements are prepared in accordance with ASPE. Users Description John Hogan Co-Founder of J&C who is trying to withdraw from company by selling all shar Christine Murker Co-Founder of J&C who is trying to buy all shares of the company and may ha manipulated the Financial statements to reduce share price CRA For income tax purposes Introduction: John Hogan and Christine Murker opened a women's clothing company and everything was going well until they had a disagreement and John Hogan was excluded from all operations. John Hogan now wants to sell all his shares at fair market value to leave the company. To receive the shares at a better price, Christine Murker may have altered the treatment of the above transactions in favor of lowering Net Income which in turn would lower share prices. John Hogan has hired me to review these transactions and show the recommended treatment for them. Issues Issue 1: Revenue Recognition for sale to Chilean Distributor Measurable: Yes, Clothing was shipped off to the Chilean distributor at an agreed price

Collectable: Yes, the Chilean distributor has a good credit score according to a Chilean credit agency Performance Attained: Yes, J&C has shipped off the product, have been received by the distributor and there is no refund policy, only a rebate for unsold items of 30% Inference: Christine Murker did not recognize the revenue from the Chilean Distributor as she is waiting for the goods to be sold but within ASPE standards, the revenue should be recognized as all three criteria are met. Recommendations Alternative 1. Do not recognize the revenue  This is the chosen method on the Financial statements  As the Chilean Distributor has not yet paid, there is no revenue to be recognized Alternative 2. Recognize the full revenue  As outlined in ASPE standards, for revenue to be recognized there are three conditions that need to be met. As shown above all three conditions have been met and therefore the revenue should be recognized  There is a no return policy which means the Chilean distributor cannot back out of the deal and must pay  It is shown they have a good credit score which represents their ability to pay Alternative 3. Recognize 70% of the revenue  As stated, 30% of the price of merchandise unsold can be rebated.  As there is no estimate on how much will be unsold, 70% of all revenue can be recognized first with the rest being recognized after the Chilean distributor has paid and shown the amount they could not sell It is recommended to go with alternative 3, as it is not too conservative nor aggressive in how it affects the net income of the year. Alternative 1 (currently elected) is too conservative and does not reflect the proper standings of the company. Alternative 2 is too aggressive and does not take into account the possible returns and therefore may overstate and inflate the net income of the year. Therefore alternative 3 is the best option and would increase net income Issue 2: Unsold fasteners write-off Inference: Christine has written off the fasteners from inventory as they are not selling as fast as projected. By doing so, net income is decreased while there may be better treatment for this transaction Recommendations Alternative 1: Write off the fasteners  Chosen by the company  Increases expenses which in turn reduces net income  The fasteners are out dated and are no longer selling as fast as projected nor at the foreseen volume  Write-off now to prevent changes to future years Alternative 2: Keep the fasteners  Keep the fasteners in inventory  There is no expiration date of the fasteners  May come back into trend in the future  Although the fasteners are not selling as foreseen, they are sitting in inventory and have no affect on the company Recommendation There is no need to write off the fasteners as they do not expire and may sold or used in the future. It is recommended to elect alternative 2. This would increase net income Issue 3: Customer Bankruptcy

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Measurable: Yes Collectable: Unlikely Performance Attained: Yes Inference: Customer has filed for bankruptcy in January 2021 and has not paid in 4 months to the company. Christine has written off this amount which reduces net income by $55,000. Recommendations Alternative 1. Write off the amount owed  This is elected by the company  Uses future knowledge of bankruptcy  As the buyer has not paid in 4 months, it is highly unlikely to be collected and should be written off Alternative 2. Do not write off the amount  Though at the time of the year end statements the buyer has not paid, there is still a chance it can be collected  Under ASPE, since performance, and measurability have been fulfilled and collectability, though unlikely has a value the revenue should still be recognized until further notice Alternative 3. Allocate to 60% to bad debts  As the buyer has not paid for 4 months up to the company year end, it was likely the company would not receive the full amount  As it was highly unlikely to be receivable, a fair percentage such as 60% of receivables should be moved to bad debts first and if required, the remaining can be allocated with new information. Recommendation Alternative 1 which is to write off the full amount in the fiscal year is not recommended as it takes into account information that happened past this fiscal year end. Till the year end the customer only did not pay for 4 months and hadn't yet filed for bankruptcy. Alternative 2 is a little too aggressive as the customer has not paid in 4 months already and therefore there is likelihood of not receiving the funds. The recommendation is alternative 3 as the information during the year showed the customer is yet to pay but they still may pay. Amounts should only be moved into bad debt as time goes on and therefore only a percentage of the amount should be moved. Choosing alternative 3 would increase net income Issue 4: Guaranteed debt for related company facing financial difficulties Inference: Thunder Bay Clothing is facing possible insolvency and therefore J&C is prepared to take over the debt. Christine has elected to recognize the full amount of the debt even though TBC has yet to file for bankruptcy. There is also a low possibility to which they do file and therefore there may be a better alternative in treatment. Recommendations Alternative 1: Take over all debt  Chosen by company  Reduces net income by larger amount as all responsibility is taken over Alternative 2: Do not prepare for any debt  Under ASPE, the probability of this happening is highly unlikely at 10% and all companies face financial difficulties of sort at some time  Since the probability is so low, there is no need to take action over the debt as of yet and so no amount needs to be set aside for the debt. Alternative 3: Prepare for 10% of debt  Set aside $4,000 as a prorated amount in comparison to the likeliness of insolvency will keep J&C prepared for anything, if it were to happen  This is a good step to maintain cash flow and for preparation

Recommendation The recommended alternative is #3 as it acknowledges the financial difficulties and is taking responsibility for the debt at a proration of the probability. Alternative #1 is unfair treatment as it is shown to be unlikely for the company to become insolvent. Alternative #2 is negligent and unprepared for any insolvency or financial help required. Choosing alternative 3 would increase net income. Overall Bias in Report Overall, it is shown the originally elected treatment of these transactions yield negative impact on net income. Its is shown that the ASPE was not followed in treatment of some of these transactions. Overall Changes to Net Income Issue 1: Alternative 3: Recognizing 70% of revenue DR: AR CR: Reven Increase in Net In Issue 2: Alternative 3: Keep fasteners in inventory DR: Inventory CR: Increase net incom Issue 3: Alternative 3: 60% to bad debt DR: Bad Debt CR: Increase net incom Issue 4: Alternative 3: 10% set aside for possible financial debt DR: Loan Account Increase net incom Original Net Income: $142,000 Issue 1: Amount Unknown Issue 2: Amount Unknown Issue 3: $33,000 Issue 4: $36,000 New Net Income: $211,000 The new net income would be at least $211,000 for the year. This does not take into the account the amounts from the Chilean Distributor and fasteners as they were not included in the transactions. By electing the recommended alternatives per issues, J&C would conservatively increase their net income by at least $69,000. This shows there may have been mistreatment in transactions before