Question

Study Case – 1

Snow Spray Corp. (SSC) recently filed for bankruptcy protection. The company manufactures downhill skis and reports under ASPE. With the increased popularity of such alternative winter sports as snowboarding and tubing, sales of skis are sagging. The company has decided to start a new line of products that focuses on the growing industry surrounding snowboarding and tubing. At present however, the company needs interim financing to pay suppliers and its payroll. It also needs a significant amount of cash so that it can reposition itself in the marketplace. Management is planning to go to the bank with draft financial statements to discuss additional financing. The company’s year end is December 31, 2019 and it is now January 15, 2020. Current interest rate for loans are 5%, but because it is in Bankruptcy protection SSC feels that it will likely have to pay at least 15% on any loan. There is concern that the bank will turn the company down.

At a recent management meeting, the company decided to convert its ski manufacturing facilities into snowboard manufacturing facilities. It will no longer produce skis. Management is unsure if the company will be able to recover the cost of the ski inventory. Although the conversion will result in significant expenditure, the company feels that this is justified if SSC wants to remain a viable business. The shift in strategic positioning will not result in any layoffs. As most employee will work in the retrofitted plant. The remaining employees will be trained in the new business.

The conversion to snowboard manufacturing facilities would not require selling ski manufacturing machines, as these machines can be used to produce snowboards. The company estimates the results and cash flows from its operations of selling skis to be a $20 million loss.

On December 15, 2019, the company entered into an agreement with Cashco Ltd. To sell its entire inventory in ski building to Cashco. Under the terms of the deal, Cashco paid $10 million cash for the inventory (its regular selling price at the time). The cost to SSC of this inventory was $6 million and so a profit of $4 million was booked pre-tax. In a separate deal, SSC agreed to buy back the inventory in January for $10,125,000.

Before filling for bankruptcy protection, the company was able to buy a large shipment of snow tubes wholesale for a bargain price of $7 million from a supplier that was in financial trouble. The value of the inventory is approximately $10 million. The inventory was sitting in the SSC manufacturing facility taking up a lot of space. Because the manufacturing facility was being renovated, SSC reached an agreement with its leading competitors, Alpine Gear Ltd. According to the contract, AGL agreed to purchase the snow tubes from SSC for $8 million, and SSC shipped the inventory to December 31 to arrive on January 5. The inventory was shipped f.o.b shipping point. SSC normally reimburses its customers if the inventory is damaged in transit. SSC has attentive verbal agreement that it will repurchase the snow tubes that AGL does not sell by the time the renovation are complete (in approximately six months). The buyback price will include an additional amount that will cover storage and insurance costs.

Instructions:

Adopt the role of Rachel Glover – the company controller – and discuss the financial reporting issues related to the preparation of the financial statements for the year ended December 31, 2019.

Answer 1

Answer :

Overview

- The company is in bankruptcy proceedings and needs cash to effect a change in strategy. The bank is therefore the key user and will look to assess the ability of the company to repay loans. The higher the perceived risk, the higher the interest rate that will be charged.
- Management will therefore want to present the company in the best light as there is a concern that the loan will be turned down. Note that management will want to ensure transparency as well.
- The overall reporting objective, given the role, will be more aggressive while still being within ASPE and transparent.

Analysis and Recommendations

Sale of bindings to Cashco Ltd.

Recognize revenue as sale

No sale/financing

Profits of $4 million material (material since 5% of $20 million loss = $1 million). Legal title and possession (control) have passed to Cashco and therefore the performance obligation has been satisfied. Transaction is measurable and cash is already collected - $10 million. Persuasive evidence of contract = agreement. Other

Economic substance is that this is a loan – the company is short of cash and this is an alternate means of unlocking the cash that is tied up in the inventory. No profit should be recognized. Since the company has agreed to buy back the inventory in January, they have an obligation which cannot be avoided. Thus this represents a liability. The inventory appears to have little value since management is unsure as to how much they can resell it for and so the $6 million cost should be written down. This is a material loss and will make the company look even worse. Other

Even though it is tempting to record the transaction as a sale and therefore make the company look better, the economic substance is that this is a financing transaction.

Sale of Snow Tubes to AGL

Recognize as a sale

No sale/financing transaction

Since the goods are shipped FOB shipping point in December, a sale has occurred. Legal title and possession (control) has therefore passed and the performance obligation has been settled. Persuasive evidence of contract – agreement exists. The $1 million profit is material (since it equals the $1 million threshold noted earlier). There is a bona fide reason for selling the inventory – i.e. need the space as well as the cash generated. It is not clear in the case what the buyback price is. If it is (future) market price, then this is a separate deal. Other

Even though the goods were shipped FOB shipping point, the company still retains the risk of loss since they reimburse the customer if there is damage. Since SSC will take back any unsold merchandise – they still have the risk of loss on the goods. If this is estimable – may make a case to recognize the sale as well as an allowance for returns. The fact that the company will end up paying storage and insurance costs is further evidence that they have retained the risks of loss. This also supports the fact that the transaction is like a parking transaction only. Although it is not clear in the case, if the buyback price reflects the original transaction price, then this supports the fact that the transaction is a financing transaction. Other

In conclusion, this appears to be a bona fide sale transaction and should be recorded as such. The only issue is how, if at all, to record the potential obligation for buyback. If it is measurable, it could accrue any potential liability for items not sold by AGL. Detailed disclosures should be provided.

Disposition of ski business

Present as discontinued operations	Loss/costs part of continuing operations
Ski business separate and distinct from snow tubing. Cash flows and records separate – ($20 million loss) Will no longer be involved in selling skis. Want to show this as separate from new business since bank interested in ability to generate profits and cash flows in future. Other.	Retaining facilities and people (will be retrained) and therefore will have continuing involvement in the assets and related cash flows. This is not a separate division or subsidiary but really represents the whole income statement – it is therefore not really a component therefore. Other.

In conclusion, this is not really a disposition of a division but rather the transitioning of the whole business. Therefore, it should not be shown as discontinued operations.

Minor issue —costs to refurbish the machinery. This may be capitalized since will have future benefit.

If ur satisfied with Answer , please upvote.