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06-02-2019

Product code Accounts-PH332

ADMS 3595 – Group Project 2018 Fall - Due Date : November 25, 2018

Kodak Equipment Manufacturers (KEM) makes barbecue equipment. KEM is a family owned and operated business started by Jack Kodak 15 years ago and is now succeeded by his 2 sons, Alan and Mike. Under the terms of the shareholder’s agreement, either party may buy the other out at a price of 10 times of the current net income.

The company has historically been very profitable; however, in the last year and a half, things have taken a turn for the worse due to higher consumer interest rates and a slowdown in the economy. On its 2018 draft year-end statements, the company is currently showing a break-even position before any final year-end adjustments. Alan and Mike fired its CEO, Tony Munden, at the beginning of the year and a turnaround specialist was hired—Mary Lundstrom. Mary has a reputation of being able to come into companies that are suffering and make them profitable within two years. Mary has agreed with KEM's board of directors that she will be paid a $1-million bonus if the company has a combined two-year profit of $5 million by the end of 2018. Mary also has to make sure that the company’s debt to equity ratio will not be worsened as the bank has warned KEM that their current debt to equity ratio is marginal.

Among other things, Mary instituted a more aggressive sales policy for KEM's customers, who are mainly retailers, as well as a new remuneration policy for sales staff. Mary attributed the company's poor performance to untrained sales staff whose remuneration and bonus scheme was not properly aligned to maximize sales. Under the new remuneration policy, sales staff is paid salary as well as a bonus, which is a percent of gross sales as at year end. The sales staff has responded well and sales have increased by 20%.

The new sales policy is as follows:

§ Cash down payment of 20% with remaining payment for shipment once the barbecues are sold by the customer to a third party.

§ If the customers double their normal order, no down payment is required.

§ The barbecues may be stored on the premises of KEM. Many customers have taken the company up on this offer in order to double the size of their purchase.

§ Any unsold barbecues are allowed to be returned after year end.

 

Under the new policy, sales have increased dramatically, with many customers taking advantage of the new terms. As at year end, legal title to all barbecues has passed to the customers. Only customers with excellent credit history have been allowed to purchase under the new policy. The company has accrued bonuses for almost all its sales staff.

The increased profits from these sales have been offset by the accrual of $500,000 of Mary's bonus. She is very confident that she will be able to turn the company around and so has accrued part of her bonus. She has also decided to change several accounting policies, including the following:

Depreciation on machinery switched to straight-line from double-declining-balance. Note that the equipment is about 2 years old with an estimated life of 10 years. Mary felt that the double-declining-balance method was arbitrary and noted that several of their competitors used the straight-line method. Machinery is most useful when new since it requires less downtime for fixing.

ADMS 3595 – Group Project 2018 Fall - Due Date : November 25, 2018

Another problem that Mary had identified was in inventory management. Mary was convinced that inventory was being stolen and/or “lost” due to poor tracking. KEM had therefore hired a company, Software Limited, to install a new inventory tracking system during the year. Midway through the year, Software Limited had gone bankrupt and was not able to finish the installation. The installation was a customized job and as at year end, the system was not functioning yet. KEM has not been able to find a company to replace Software Limited. To date, $2 million has been spent on the new system. Mary had capitalized the costs and noted she was confident that she would be able to find a company that could successfully complete the installation.

The machinery that makes the barbeque equipment has been in use for 20 years and is due for replacement. KEM has the option of buying the machine or leasing it. Currently, KEM is leaning toward leasing the machine since it is expensive to buy and funds would have to be borrowed from the bank. After much negotiation with the leasing company, the following terms were agreed upon and written into the lease agreement.

§ Anchor Limited would manufacture and lease to KEM a unique machine for making the barbeque equipment.

§ The lease would be for a period of 12 years.

§ The lease payments of $150,000 would be paid at the end of each year.

§ KEM would have the option to purchase the machine for $850,000 at the end of the lease term, which is equal to the expected fair market value at that time; otherwise, the machine would be returned to the lessor.

§ KEM also has the option to lease the machine for another eight years at $150,000 per year.

§ The rate that is implicit in the lease is 9%.

 

The new machine is expected to last 20 years. Since it is a unique machine, The lessor has no other use for it if KEM does not either purchase it at the end of the lease or renew the lease. If KEM had purchased the asset, it would have cost $1.9 million. Although it was purposefully omitted from the written lease agreement, there was an understanding that KEM would either renew the lease or exercise the purchase option.

KEM has a policy of refunding purchases by dissatisfied customers, as long as it is within two years from the date of purchase. This refund policy is not documented, but KEM has made a practice of doing so in the past. During the year, KEM’s sales totalled $35 million. From experience, the company has determined the following probabilities for returns: there is a 25% probability that returns will represent 6% of total sales, 55% probability that they will represent 4% of total sales, and 20% probability that they will represent 2% of total sales. During the year, there were returns on current year's sales of $1.1 million, on which refunds were made.

KEM is being sued by a former employee. The non-manager employee contends that not enough severance was paid when he was let go in June 2018. The ex-employee's lawyers are asking for a severance payment of two weeks' pay for each year worked, which in this case was 25 years. KEM agreed to pay the employee severance of $30,000 when he was asked to leave the company. This $30,000 has already been accrued in the accounting records. The case is still being disputed and will go to arbitration early in March 2019. KEM's lawyers believe that the probabilities of settlements for additional amounts (over and above the $30,000) are as follows: 25% probability of settling at $20,000, 60% probability of settling at $28,000, and 15% probability of settling at $30,000.

ADMS 3595 – Group Project 2018 Fall - Due Date : November 25, 2018

In order to conserve cash and retain 2 key employees, Mary suggested KEM should issue some shares to these employees. KEM has set aside 10% of the total shares outstanding in order to remunerate these 2 employees. Under the terms of this agreement, these employees may convert their shares to cash at the end of 2018. KEM plans to have a valuation done of the company at the end of 2018 and 10% of the value will be attributable to these employee' shares. The valuation will be based on the average income from 2017 and 2018.

During 2018, KEM implemented a new customer loyalty program that grants “points” to companies based on the amount they spend. The points have no expiry date and can be redeemed against future purchases in the store. The company has already determined that the fair value of each point is $ 0.50. During the year, 700,000 points were awarded to these companies, of which 80,000 were subsequently redeemed for purchases in the stores. The company anticipates that 90% of the points will be redeemed at some point in time.

KEM pays on average three weeks’ vacation pay, even though KEM’s legal obligation is only for two weeks. This vacation pay accumulates and can be carried over for up to one year. However, if the employee leaves before the vacation is taken, then they are only legally entitled to the two-week rate. At the end of 2018, there were 10 non-manager employees who had only taken one week of their annual entitlement during 2018. There is a probability of 15% that one of these employees will leave before the full vacation accrual is taken.

By the end of 2018, Mike had decided that he wanted Alan to buy out his shares. The last few years of operations had been so stressful for him that he had developed several health problems.

Required:

Adopt the role of the company's auditors and discuss the financial reporting issues for the 2018 year end. The company is a private company but would like the statements to be prepared in accordance with IFRS. If applicable, include the journal entries to explain the accounting implication.

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Change in the Depreciation Method As per IAS 16 and IAS 8 any kind of change in depreciation method is treated prospectively not retrospectively. Basically, this is change in the accounting estimate not the accounting policy. Also change in the accounting estimate does not necessarily mean rectification of prior period mistake. Therefore, any change in the depreciation method won’t result in change in the accounting of the firm retrospectively. Though this change in method will result in the change of calculation of the depreciation. The written down value of the machinery at the beginning of the third year will be depreciated over a period of 8 years. This would result in decrease in the depreciation expenses and increase in the overall income of the company. Therefore, company should keep in mind when comparing the two years results. Also, the company would be required to make disclosure stating the change in method with the reasons and its impact on the income statement.

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