Question

ABC Limited (ABC) is a private company producing lunch packages. It mainly sells products to supermarkets and grocery stores. ABC has a loan from a local bank, which is secured by its accounts receivable and inventory. The loan is not to exceed 70% of accounts receivable and 40% of inventory as at the accounting year end (December 31, 2016). ABC uses perpetual inventory system. ABC must provide the bank with the reviewed financial statements within 60 days of its year end. It is now in early January 2017, you are a CPA from a local accounting firm and will conduct a review of the ABC’s financial statements. You received a memo from the ABC’s management including the following accounting issues:

1. Super Software Co. (SSC), an ABC’s neighbour, is a software development company with high growth in recent years. On August 15, 2016, SSC signed a contract with ABC that SSC’s employees can pick up a lunch package every working day for one year beginning on September 1, 2016 for a yearly fee of $120,000, with 50% payable upfront. The fee is non-refundable, non-cancellable, and not dependent on the number of lunch packages picked up. When the contract was signed, ABC credited revenue for $120,000 and debited both cash and accounts receivable for $60,000 each.

2. During November 2016, ABC paid $10,000 to purchase frozen chicken meat from Fresh Meat Butcher (FMB), a small meat supplier in financial difficulty. ABC has not begun to use the FMB’s frozen chicken meat in producing lunch packages so far. In December 2016, there was an allegation that FMB’s chicken meat could be polluted in the production process. The Canadian Food Inspection Agency is now investigating this allegation, and the outcome is uncertain.

3. In December 2016, ABC just began to sell frozen lunch packages. To promote this new product, ABC signed contracts with stores, which specify that the actual number of packages sold to stores depends on the number of packages bought by consumers before the expiry date of packages. ABC has delivered 10,000 frozen lunch packages to stores by the end of 2016, with a price of $3.50 per package. ABC’s suggested retail price of this lunch package is $6.00 per package.

4. In October 2016, ABC launched a loyalty program. According to the program, consumers can earn one point for buying an ordinary lunch package (excluding frozen lunch packages), and can redeem 20 points for an ordinary lunch package in stores. ABC first uses packages purchased by stores for the redemption and then deducts them from its sales. On December 31, 2016, stores reported that they had sold 50,000 ordinary lunch packages to consumers at $7 per package since the beginning of the loyalty program, and that consumers had redeemed 6,000 points. Ordinary lunch packages are sold to stores at $4.00 per package. The cost of ordinary lunch packages is $1.80 per package.

Required

You are asked to provide a report to the ABC’s management to analyze these accounting issues and their implications for the bank loan.

(Please do not give me an answer that already exists !!)

Answer 1

1..Entry that was passed in ABC's books :
		Debit	Credit
Sep.1,2016	Cash	60000
	Acs. Rec.	60000
	Revenue		120000
	Cost of Revenue
	Inventory

1.the fee is non-refundable, non-cancellable, and not dependent on the number of lunch packages picked up

2. The balance $ 60000 is contracted to be received at the end of 1 year only, ie. Aug.31, 2017

So, the balance standing against Accounts receivables is coorect as far as the loan balance is to be measured at a maximum of 70% *this balance.

But as ABC follows perpetual inventory system of book-keeping , it would have charged the entireyear's cost of revenue ,to inventory--which means , the inventory level would have gone down & in all probability will affect the 40% benchmark for inventory-loan measurement.

So, as the bank loan is measured against receivables & inventory balances, only obligations that are performed for the period corresponding to Sep.1 & dec. 31, 2016 can be recorded against revenues & cost of revenues booked accordingly.

The proper entry will be
		Debit	Credit
Sep.1,2016	Cash	60000
	Acs. Rec.	60000
	Unearned		120000
	Unearned	40000
	Revenues		40000
	(120000/12*4mths.)
	Cost of Revenue
	Inventory
	(for 4 mths' Cost)

2. The goods that have been taken into ABC's inventory is subject to the verdict from Canadian Food Inspection Agency

& the loan is subject to the 40% threshold of this value of inventory

The quantum of uncertainty about the level of bank loan is (10000*40%*100%) or (10000*40%*0),ie.   Either $ 4000 or $ 0

ie. The disallowance by bank for the loan may be a maximum of (4000+0)*50%= $ 2000---in the event of CFIA's verdict going against FMB.

3.Again, accounts receivables balance depends on the amount owed by the stores &

inventory balance depends on the cost of revenue booked under the perpetual system followed by the company

---both of which will have implications on the quantum of bank loan permissible.

4…As far as ABC is concerned :			Cost to ABC
Acs. Receivables	50000*4=	200000	50000*1.80=	90000
Less: Redemptions	6000/20*4=	1200	6000/20*1.80=	540
		198800		90540

On a/c of loyalty redemptios--Bank loan will be reduced by
Receivables----1200*70%=		840
Inventory----540*40%=				216

Redemptions are free & will not fetch any additional sale value , but are used a promotional exercise to boost the on-going sales.

They are reduced from sales revenues like rebates& discounts , but the product have a cost to ABC.

So, they reduce the receivables but add to cost of sales & also reduce inventory.

Thus , the balances in receivables & inventory,get affected after the loyalty redemptions

& will leave their effect on the quantum of bank loans permissible.