Question

Earthcom Inc. is in the telecommunications industry. The company builds and maintains telecommunication lines that are buried in the ground. The company is a public company and has been having some bad luck. One of its main underground telecommunications lines was cut by accident and the company cannot determine the exact location of the problem. As a result, many of the company’s customers have lost service. Because Earthcom did not have a backup plan, it is uncertain about how long it will take to restore service. The affected customers are not happy and are threatening to sue. In order to try to calm them down, Earthcom has managed to purchase some capacity from a competitor. Unfortunately, the cost of the service is much higher than the revenues from Earthcom’s customers. Earthcom is also currently spending quite a bit on consulting fees (on lawyers and damage control consultants).

In addition, Earthcom is spending a significant amount of money trying to track down the problem with its line, and although it has had no luck so far, the company recently announced that it was confident that services would be restored imminently. As a result of the work done, Earthcom feels that it will be in a better position to restore service if this ever happens again.

The company has been upgrading many of its very old telecommunications lines that were beginning to degrade due to age. It has capitalized these amounts and they are therefore showing up as investing activities on the cash flow statement. The company’s auditors have questioned this as they feel that the amounts should be expensed. As a result of all this, Earthcom’s share price has plummeted, making its stock options worthless. Management has historically been remunerated solely based on these stock options, however. The company’s CFO meanwhile has just announced that he is leaving and is demanding severance pay for what he is calling constructive dismissal. He feels that because the stock options are worthless, he is working for free – which he cannot afford to do – and that the company has effectively fired him.

Adopt the role of the company controller and discuss the financial reporting issues.

Answer 1

Issue:- Financial Reporting Issue of the company

Facts of the Case:- Upgradation of the telecommunication line and reduction in stock prices

Analysis of Case:- The recent cut in the telecommunication line has made the customer of Earthcom Inc. furious and with the dissatisfaction of customer, Earthcom Inc. decided to upgrade its old telecommunication line so that they can restore their services in future if a cut in lines happens again.

Now Upgradation of lines which if reflects the nature of repairs to the company should be shown as Cash flow from operations activity rather than Cash flow from investing activity, which is also the viewpoint of Auditors. Cash flow from investing activity includes Purchase & Sale of Long term Property Plant & equipment and this upgradation does not fall under this activity, it is in the nature of repairs to the asset which is part of operating activities, Therefore, the capitalization of this upgradation is not correct by the company. As a result of the difference in the method of accounting, the share price has suffered a lot.

The nature of capital expenditure can be decided by reading Management Discussion & Analyse(MD&A). This MD&A provides great insight into company future prospects. Therefore the method of accounting of capital expenditure varies from company to company

Conclusion:- So in this case, Earthcom Inc Management should adopt best practices and should conduct a discussion with experts regarding falling stock prices of the company which is only in the end eroding shareholder's wealth.