Question

Manufacturing Inc. (MI) is a public company that sells construction equipment to builders of primarily homes, office buildings, and highways. MI has been in operation for over 30 years. Up until this year the company has had profits with the real estate boom and large amounts of government funding for highway construction. With the recent economic downturn MI has had to go to its bank for increased financing. The bank has imposed a minimum current ratio as well as a minimum balance that must be maintained in one of its accounts. You have been recently hired as an accounting policy analyst to assist MI with its accounting policies. You have just finished meeting with Nancy who is the majority shareholder as well as CEO. Nancy had a lot of questions for you! You are trying to get a handle on what Nancy wants you to do and feeling a little overwhelmed at the moment. The following are comments made by Nancy at that meeting.
“This economic downturn has hit us really hard. We have had profits for a number of years and never worried about having enough cash on hand. Cash is critical in our business where the manufacturing of this specialized equipment can take a long period of time. In addition, our customers are really struggling to be able to invest in new machinery and pay their bills.
“I am very excited that you are able to join us and help out with a number of new situations that have arisen due to the economic downturn and possible solutions I have to solve our current cash crisis. Our bank has been very supportive but they are a little nervous about the economic downturn. I am not sure what, if anything, I need to do in the financial statements and notes about their recent covenant and restrictions. In addition, we have a number of bank accounts with our bank. Our line of credit has been in an overdraft position for over a year now. But we also have positive balances in our other accounts. All of these accounts are currently in cash and cash equivalents on our balance sheet. Is that okay?
“Some of our purchases for our manufacturing purchases are from the U.S. and we are required to pay in U.S. dollars. This has never been an issue for us before since the Canadian and U.S. dollar have been at par. As you know, with the recent economic downturn the Canadian dollar has been dropping in value and is currently at an all time low and may continue to drop. What is the appropriate accounting for this drop in value and what impact will this have on our financial statements?
“Some customers who have been buying from us are having difficulty paying and are currently overdue. I know they will pay eventually and I want to help them out. What I have done is make their life a little easier by changing their accounts receivable to a note. This note allows them a two year period to pay with an interest rate of 4% even though the current market rate is 8%. I have just taken the $500,000 of accounts receivable and reclassified them as a note receivable since I am sure they will pay. Is this okay?
“To get some extra cash I was considering selling some of my high quality receivables to a financial institution. I have $5,000,000 in these receivables. The financial institution will provide me with $4,800,000 in cash if I agree to make any payments that default. What would be the impact of this on my financial statements?
“One last thing: our head office was purchased a long time ago when real estate values were low. Currently, the carrying amount of that building is $520,000 but recent appraisals say it is worth $2 million. So I was thinking I could sell the building then immediately lease it back for its remaining useful life. What do you think of this idea? This could give me some much needed cash and an immediate gain of $1.48 million on my financial statements. “Sorry; I have to run to another meeting. Can you draft up a report on your preliminary ideas to all of my concerns? Thanks, and again we are so glad that you have become part of our team.”

 

Required:

Prepare the requested report for Nancy.

Answer 1

To:        Nancy

From:    Accounting Policy Analyst

 

Overview

 

Manufacturing Incorporated (MI) is a public company therefore must follow IFRS. In addition, the bank requires a minimum current ratio and a minimum cash balance. You, Nancy are the key shareholder and I am sure are concerned about the recent downturn in the economy and the impact this has on MI. You have mentioned your concern about ensuring there is adequate cash on hand. I have addressed your specific concerns below.

 

Issues

 

1.      Covenants

2.      Cash and cash equivalents

3.      Purchases in U.S. dollars

4.      Note receivable

5.      Sale of receivables

6.      Sale leaseback

 

1. Covenants

 

You must have note disclosure of your covenants and restrictions. These will not have any impact on your financial statements.

 

2. Cash and cash equivalents

 

Cash and cash equivalents are your items that can readily be converted to cash. Your line of credit has been in an overdraft position for a year. Normally, this would be shown as a separate line item as a current liability. Since you have positive balances in a number of other accounts with the same bank you are allowed to net those balances and show one amount. Assuming overall you have a positive balance you would show a positive amount for cash and cash equivalents. Therefore, your current accounting is appropriate.

 

3. Purchases in U.S. dollars

 

The payables in U.S. dollars must be translated to Canadian dollars at the current exchange rate at the reporting date. Since, the Canadian dollar has been dropping this will create a foreign exchange loss which will be included in net income. It might be worthwhile to consider hedging this risk to protect yourself from exchange fluctuations in the future.

 

4. Note receivable

 

It is not appropriate to just transfer the amount of the accounts receivable to the same amount as a note receivable. Since, the note is over a two year period it must be discounted using the market rate of 8%. The amount of the note receivable will be 

 

Note $500,000 (2 years, 8%) = $428,870 plus interest $20,000 (2 years, 8%) = $35,665 for a total of $464,535. This assumes that the interest payments are made at the end of each year. The note would be separated into the current portion of interest receivable due this year of $20,000 from the noncurrent portion. The accounts receivable of $500,000 would have all been classified as current and will now be noncurrent. This will have a negative impact on the current ratio.

 

5. Sale of receivables

 

It must be determined if the sale of the receivables to the bank is treated as a sale or a loan from an accounting perspective. The transfer of the receivables is with recourse since MI agrees to make any payments for defaults. This would increase cash by $4,800,000 but this would be treated as a loan. The receivables would stay on the financial statements at $5 million and the $4.8 million would be shown as a loan. The difference of $200,000 would be recognized as interest expense. 

 

6. Sale leaseback

 

The sale leaseback usually will have a higher cost of financing than other types of borrowings. Yes you would receive cash for your building but the gain could not be recognized immediately. It would be recognized over the remaining life of the building.