Question

Paint Inc. (PI) has been operating as a family owned private company for the past 30 years. It started as a company manufacturing paint for sale in its own retail stores in Ontario. PI is known as a manufacturer of high quality paint. Since then it has expanded with stores across Canada and recently started a decorating business. It has no desire to go public at this point in time and wants to keep accounting costs as low as possible.

With the recent real estate boom and new housing, the company has been very profitable for the past few years. PI has a loan with Canadian Bank. The bank requires audited financial statements and has a maximum debt to equity ratio.

You have recently been hired as an accounting consultant to assist PI’s board of directors. You have been asked to develop appropriate accounting policies for events that have occurred during 20X5. The board has asked that you explain fully your analysis for your recommendations. PI has a 31 December year end.

1. Individuals can purchase paint in the store or order on line. If they order on line they must pay by credit card. Contractors and real estate developers can purchase paint directly at the warehouse in bulk and receive a 15% to 25% discount depending on the quantity they purchase. They also have 30 days in which to pay. The paint provides a three month money back guarantee.

2. In the summer of 20X5, to encourage use of their new decorating services, PI offered customers a special deal. With the purchase of $200 of paint they received one hour of consulting advice from the decorator for free. Normally, the fee for the decorating service is $75 an hour. This deal was very popular with many customers purchasing additional services from the decorator beyond the one hour for free.

3. On 1 April 20X5, PI announced it was going to sell one of its older manufacturing facilities including all of the equipment. This facility will be replaced in a new location with a brand new, fully computerized, state of the art facility. The new facility will be operational in the spring of 20X6. Until that time PI will continue to manufacture in the existing facility. The facility has been listed at a reasonable price. The carrying amount of the facility and equipment is $1,000,000 with a fair value of $850,000. The land has a carrying amount of $200,000 and a fair value of $1,200,000.

4. In 20X5, PI traded a piece of excess land they owned for a potential new store for some manufacturing equipment for the new facility. The land had a carrying amount of $80,000, but three real estate appraisals estimated the fair value to be $500,000. The equipment was specially manufactured for PI and is unique.

5. In 20X5, PI sold a large quantity of paint to a board member who owns a new housing development. The paint was sold to the director for cash and the director was given a 25% discount and 30 days to pay.

6. In February 20X6, PI was informed that one of its building contractors went bankrupt and will not be able to pay an outstanding receivable of $80,000. This receivable was not considered in determining their allowance for bad debts for 20X5.

 

Required:

Prepare the report.

Answer 1

To: Board of Directors

From: Accounting Advisor

 

PI has been in business for over 30 years. The bank requires audited financial statements therefore they would prefer to see GAAP based financial statements. Since they have no desire to go public and they wish to keep costs low therefore ASPE would be appropriate.

 

The bank would be an important user since they provide the financing. They would be interested in future cash flows to see if you can repay the loan as well as checking compliance with the covenant. You, the Board and management would be interested in profitability and performance evaluation.

 

Revenue Recognition

Individuals that purchase paint in the store would be straightforward. When customers go into the store they pick up the paint and pay. The only complication is the three month money back guarantee. Since PI has been in business for 30 years the returns would be predictable. PI would estimate returns from their past history for their guarantee. An allowance would be set up for these returns.

 

For paint ordered on-line revenue would not be recognized until the paint has been delivered to the customers when you have performance. There is no cash collection risk since payments are made when the paint is ordered on-line. Similar to above an allowance would be set up for returns.

 

Contractors and real estate developers have 30 days to pay. Revenue would be recognized on delivery of the paint when there is performance net of any discount. Since PI has been in business for over 30 years an estimate would be made for an allowance for bad debts based on past history. Similar to above an allowance would be set up for returns.

 

Special Deal

The special deal is a multiple deliverable. The customer pays one price for the paint and free consulting. The consulting would have stand alone value since consulting services can be purchased separately. The $200 should be split between the portion related to the paint and the portion related to the consulting based on their relative fair values.

 

Paint                200 = 72.7% x 200 = 145.4

Consulting       _75 = 27.3% x 200 = 54.6

Total                275

 

The portion related to the purchase of the paint would be recognized when the paint is purchased assuming they take the paint home with them and do not have it delivered. The portion related to the consulting services would be recognized when the consulting services are provided or the time limit passes in which they are eligible for the consulting.

 

Sale of Facility

In April, PI announced they were going to sell a facility. It must be determined if the sale meets the criteria for held for sale asset. In looking at criteria for a held for sale asset a Board decision was made to sell the facility. It is listed at a reasonable price. However, the facility cannot be sold at the balance sheet date since they cannot move until the new facility is ready next year. Since the fair value of the facility and equipment is below the carrying amount it should be determined if there is a need for a writedown due to impairment.

 

Non-monetary Transaction

It must be determined if there is commercial substance. There would be a change in the cash flows before and after the transaction since PI would not have cash flows associated with the land e.g. property taxes which would be different than the cash flows related to the equipment. Therefore, the transaction should be measured at the fair value of what is given up, unless the fair value of what is received is more reliable. The value of the land was estimated as $500,000 for three real estate appraisals. The equipment was specially manufactured and is unique therefore it would be difficult to determine the fair value. The equipment should be valued at the fair value of the land $500,000. This results in a gain of $420,000.

 

Related Party Transaction

The sale of the paint from PI to a Board member is a related party transaction. The sale of the paint is in the normal course of business. The discount of 25% and 30 days to pay is similar to what PI provides to contractors which would be their normal terms and conditions therefore the transaction should be recorded at the exchange amount.

 

Subsequent Event

The customer went bankrupt after the year-end but before the financial statements were issued therefore it is a subsequent event. The accounts receivable was existing at the balance sheet date therefore the balance for accounts receivable should be adjusted and the receivable of $80,000 should be written off.