Question

Question: What are the auditing implications to the Cash and Accounts Receivable accounts in the situation described below?

White, CPA audits LJM Supply. There is an issue as to the proper treatment of $60 million in capitalized costs related to the construction of a partially complete processing plant. This issue impacts the company's financial statements.

Six years ago, LJM started construction of the processing plant, with the original estimated cost of $37 million and completion expected within four years. Cost overruns have been huge with construction delayed by associated litigation. At this time, the project is only 59% complete, and construction is at a standstill, as LJM seeks more funding. If the processing plant gets finished, some of the costs may be recouped through state granted surcharges. Since it is the state, there is no assurance that the surcharges will be allowed or that they will cover all the costs associated with the construction of the plant. If the project was abandoned now, $0 of the construction costs would be recovered. The write-off would amount to 68% of LJM's shareholder's equity. It is likely, though, that the company would survive, even with the write-off.

The management at LJM is committed to completing the processing plant. Management has received authorization from the shareholders to issue $40 million in bonds and additional shares of common stock to provide funds for the project's completion. If LJM takes on this additional debt without making the processing plant operational, it is likely that company would have to file bankruptcy. LJM's management and shareholders are willing to roll-the-dice and take the risk with the new plant.

Answer 1

Solution:-

Facts of the case in short

LJM Supply has a processing plant currently of $60 million which is 59% complete. This construction of the plant was started 6 years ago with the estimated cost of $37 million and completion of the plant was expected to be completed in 4years time. Because of many reasons the cost increased and the time of completion also went beyond 4years. If the plant is abandoned now then $0 million will be recovered and 68% would be written off from equity. If it is continued then the management has to take additional debt of $40 million which can lead to its bankruptcy.

Auditing Implications to the Cash and Accounts Receivables can be:-

If processing plant is not made operational after taking the debt then the company will lead to bankruptcy which can ultimately lead to the dissolution of the company and hence the closing of the company. If there is cash crunch, then the company will not be able to meet all its expenses. If the company is bankrupt, then it will not be able to complete its plant subsequently which will lead to the loss of its sales of the products which will be made from the plant and thus the whole accounts receivable will be affected as the company will not be able to maintain its debtors if it is not able to give them credit. Also, the ratios of the company will be adversly affected, especially the current ratio, quick ratio, interest coverage ratio etc. since these ratio involves the movement of debtors and creditors ie. accounts receivable. The cash flow from Operating, Investing and financing activities will all have negative value. Also, bankruptcy will spoil the reputation of the company leading to no investors for the company. Even if the shareholders have agreed to take the risk, they are expecting a return of that plant. If no return on plant is received, then even they will loose trust on the company. The companies financial statements will be adversly affected and if no returns are filed by the company then the ROC can file the company as defunct company. Also, one more aspect, taking of debt or bond will increase the interest liability of the company because of which the financial leverage ratio of the company will be adversly affected and more debt will accumulate with the company at the time of bankruptcy to be paid before the shareholders or creditors of the company.

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Note- It has been answered as per my knowledge, but there can be different views for the same