Question

James North and Leanne South have operated a small gardening centre and landscaping business for the past 10 years. Their business is incorporated as a private corporation. Since there is no market price for their shares, their shareholder agreement states that in the event a shareholder decides to buy or sell their shares the amount will be based on four times shareholders’ equity. The company has a December 31 year-end.

For the past year, Leanne has been managing all operations and making all accounting policy decisions, as James decided he wanted a career change and went back to school. Last week they met for coffee, and James mentioned he wanted to invoke the shareholders’ agreement. He felt it unfair that Leanne was doing all the work but not getting all the profits. He has no intention of returning to the business; he loves school and is in fact contemplating setting up his own advertising agency. Besides, he said, on a personal note he needs the money to pay back his school loans and set himself up in his new career.

Leanne has been happy with being able to make all the decisions and wants to buy James out rather than get a new partner. She has negotiated with their bank to obtain a loan with a personal guarantee to make the buyout. She is a little nervous, however, about the risk of having a lot of debt.

You have been the accountant for the business since they started. You know both the owners well. This morning you had your usual year-end meeting with the bookkeeper to go over anything new so you can start to prepare their financial statements. The following are notes from your meeting:

1. During the year, a significant amount of inventory of garden gnomes and animal statues were written off. They had been sitting in the gardening centre for the past two years with only a few being sold each year. The bookkeeper said that Leanne thought it was time to write off their bad decision in investing in that inventory.

2. The business has never offered a warranty to go along with their trees and shrubs. All their competitors offer a one-year money-back guarantee. If a shrub or tree dies within a year of purchase, the money is refunded. Leanne decided in the fall it was time to implement a similar policy. The bookkeeper was told by Leanne to recognize warranty expense and set up an estimated liability based on their past history that approximately 5% from the sales of all trees and shrubs this year would need to be replaced based on her best guess.

3. Another decision made this year by Leanne was to finally invest in some new computer equipment in the gardening centre. A new computer system was installed that keeps track of all sales in the stores, on-line ordering, inventory values, and all sorts of information Leanne feels will be very useful for future decisions on the direction the business should take. The other assets in the business all use straight-line depreciation. Leanne feels that since computer equipment can get obsolete very quickly it would be more appropriate to use declining balance, and proposes a 40% rate with full depreciation in year 1.

You have a meeting with Leanne at the end of the week to discuss the new accounting policies she has proposed.

James was invited to the meeting but he has a class on that date that he cannot miss.

Required:

Prepare briefing notes for your discussion with Leanne. Consider if the proposed policy is appropriate, consider valid alternatives, and provide a recommendation for each policy.

Answer 1

Notes for Discussion With Leanne:

There is a conflict of interest between the objectives of Leanne and James due to the shareholder agreement. Leanne will have a motivation to decrease shareholders’ equity since this will reduce the amount that she will be required to pay to buy out James. James will be interested in increasing shareholders’ equity to increase the amount he will receive. It must be clarified who I am working for since I may have a conflict of interest since I know both parties.  

It is important that all accounting policies are ‘fair’ to both sides. What is considered ‘fair’? Fair could be consistent accounting policies with the past since that would be the expectation of James that the accounting policies would be the same. Fair could be if the economic events change the accounting policy would change. Fair could be both sides split the difference. In the future it is important that the shareholders agreement is more specific. Due to the choices allowed within GAAP a policy could be selected that would be more beneficial to one of the parties. It is assumed since this is a small private company that they are using ASPE. There is no indication that they would be using IFRS. 

Inventory

Leanne wants to write off the inventory value for the garden gnomes and statues and this will decrease the amount of her payment to James. According to ASPE inventory would be valued at the lower of cost and net realizable value. Even though this inventory has been sitting in the gardening centre there is still a few being sold each year. This indicates there is still some value and they should not be written off to zero. It should be determined what the net realizable value of this inventory is to determine the amount of the write off. If it is all written off and then sold at a later date this would not be fair to James since Leanne would get the benefit if these are sold at a later date. The purchase of this inventory would have been a decision made by both James and Leanne so if it was a bad decision they should both bear the impact of this decision.

Warranty

According to ASPE the accounting policy is appropriate and a warranty expense should be included for the guarantee. The impact is that this would decrease shareholders equity and the amount of the payment to James. This is a new policy that did not exist until this year. The estimate of 5% was only based on sales from the fall. Since it is a new policy that was made by Leanne on her own it may be appropriate that the impact of this is excluded from the calculation of the shareholders equity. At a minimum the estimate should be reviewed to determine if it is reasonable. 

Computer Equipment

ASPE is flexible in the method used to depreciate assets. The declining balance method using 40% would write off the value of the computers in approximately two years. This is very fast especially for a small company than is likely to use a computer for a longer period of time that a large company due to limited resources. Just because it will become obsolete quickly does not mean the business will not continue to use the computer. The impact of this is this would reduce the payment to James. If we look at consistency with other assets it would be appropriate to use the straight line method. Since again since this was a decision made only be Leanne maybe it should be excluded from the calculation or maybe they policy should be consistent with their other assets.