Question

Jack Construction Supplies Ltd.

Jack Construction Supplies Ltd. (Jack) is a retail and commercial building supply dealer. Until recently, Jack was part of a national chain of stores, but the chain decided to sell off stores that weren’t in its core business. Several local investors purchased Jack. The purchasers believe that Jack will be successful, but that it wasn’t well managed by the chain. The new investors paid $1,000,000 in cash for Jack. Jack will also pay 25% of net income before unusual or non-recurring items that Jack earns in excess of $500,000 for each of the next three years (including fiscal 2019), as reported in Jack’s general purpose financial statements.

It’s now late January 2020. Jack has just provided its financial statements for the fiscal year ended December 31, 2019 to the national chain as required by the agreement of purchase and sale. The CFO of the company that sold Jack has asked you to examine the financial statements, discuss any issues with Jack’s new management, and identify any problems that might affect net income end the amount the national chain is due as part of the agreement. In your review, you identified the following issues:

1. Jack reported net income before unusual or non-recurring items of $510,000 for the year ended December 31, 2019.
2. Jack’s business with most customers is transacted in cash or on credit cards. Jack offers credit terms to builders and contractors, allowing them up to 90 days to pay. The revenue on these sales is recognized at the time of the exchange. Jack has also given extended credit terms to a number of struggling home builders in its community. The builder began construction of new homes, but sales have been slower than expected. Jack has agreed to accept payment each time a builder sells one of its homes. To date, none of these builders have defaulted on any amounts they owe. Jack recognizes these sales on collection of cash from a builder. As of the end of December 31, 2019, these builders owe $275,000. The costs associated with these sales are $150,000. These costs were expensed as incurred.
3. During 2019, Jack’s management discovered that certain assets purchased several years ago hadn’t been depreciated. The amount of depreciation that should have been expensed to date on these assets, $175,000, was fully expensed in 2019.
4. In mid-2015, Jack obtained an exclusive dealership for a line of high-quality kitchen cabinets. The dealership rights were for an initial five-year period, with five-year renewals possible at the option of the manufacturer. At the time of signing the initial agreement, Jack was assured that a renewal was virtually certain. Jack spent $210,000 to set up displays to promote the line. These costs were capitalized and are being amortized over 10 years. In December 2019, Jack learned that the exclusive dealership arrangement will not be renewed because it’s no longer part of the national chain. Jack won’t be able to sell the products beyond April 2020. Jack wrote off the unamortized portion of the costs in 2019.
5. Jack purchased some heavy equipment for use in the lumberyard at an auction for $225,000. The equipment was fairly old and in poor condition and required $125,000 to get it in working condition. Jack’s management believes the equipment will be usable for at least 10 years. Jack capitalized the purchase price of the equipment and expensed the $125,000 as a repair cost.
6. In May 2019, Jack opened a large plumbing department. Because management had little expertise in plumbing but wanted to provide for customers’ plumbing needs, it contracted with SEH Plumbing Ltd. (SEH) to own and operate the plumbing department. SEH paid Jack a $200,000 non-refundable fee on July 15, 2019 and will pay 5 percent of net sales (sales after returns and bad debts) per year. SEH is getting the plumbing department ready for business. The contract between SEH and Jack is for 10 years. Jack capitalized the $200,000 fee as a long-term deposit and will recognize it as revenue over the term of the contract on a straight-line basis.

REQUIRED: Prepare a report to your CFO on your findings and recommendations regarding Jack.

Answer 1

Report to CFO in Findings and Recommendations of Jack Constructions Ltd for the Year ended 31.12.2019.

1 . Finding : Amount received from Investors $10,00,000 and Agree to Pay 25% before unusual or Non recurring items

Recommendations : Amount should be paid to investors after Unusal or Non recurring items and After taxes , because if it had been paid before Unusual items it would lead to understatement of Profit and incorrect calculations for income tax payable , So it is recommended to Pay to investors after Unusal items or Non recurring items.

2. Finding : Reveunue Recognition and Credit term allowed to Debtors .

  Recommendations : Revenue should be recognised as and when sale is made and not when actual cash received from debtors , as it would lead to Deviation from Accrual concept & Double entry booking system and underatatement of Sales.

It is not good for the company to allow credit term for some builders more credit period ,as it would lead to Blocking of working capital requirements , if it is not possible to allow less credit period company should charge interest for excess credit period allowed to certain debtors.

3. Finding : Depreciation on Assets that purchased Several years ago.

  Recommendations : Only current depreciation should be charged to Profit & loss a/c not the entire amount of $1,75,000 , if it would have charged entire amount it would lead to Understatement of Profit and deviation from matching concept .

4. Finding : Written off Unamortized cost in 2019

  Recommendations : Jack was correct in writting entire unamortized amount as it wont be able to sell further .

5. Finding : Capitalization of Cost of Equipment only $2,25,000

  Recommendations : Cost of Purchase $2,25,000 and Cost of repair $1,25,000 both should be capitalised as wouldnot possible to use the equipment without repair.

6. Finding : Deposit of $2,00,000 from SEH and Revenue recognition of Non refundable deposit.

  Recommendations : Jack was correct in recognizing the Deposit as revenue, as it is Non refundale deposit and it would have been a different scenario if it is refundable deposit.