To: Shania Mendez (Old Time Furniture Ltd.)
Subject: Accounting Issues addressed as per ASPE guidelines (Task#1), and Audit Impact due to accounting issues (Task# 2)
Issue: Design Contracts
OTF creates contracts for clients which creates the special furniture items. customers are charged a non-refundable fee of $1500 to design customizable plan. The issue is, if the customer proceeds with the project, the full credit amount is applied, whereas the credit should only apply until the service has been performed.OTF pays the designer about $40/hr to prepare the design and it takes about 10 hours to complete averagely. If a customer decides not to use the work, they can pay $500 to purchase a copy of the design where as 75% customer proceeds with the designs then 15% proceed with the later date and half of them decide to pay $500 fee to obtain a copy.
Analysis: Under ASPE 3400.04: Revenue from sales and service transactions shall be recognized when the requirements as to performance are satisfied, provided that at the time of performance ultimate collection is reasonably assured.
Criteria NOT MET: There is reasonable doubt if the customer proceed with the design now or later date or if they choose just to obtain a copy collection is not reasonably assured
Under ASPE 3400.05: In a transaction involving the sale of goods, performance shall be regarded as having been achieved when the following conditions have been fulfilled:
(a) The seller of the goods has transferred to the buyer the significant risks and rewards of ownership, in that all significant acts have been completed and the seller retains no continuing managerial involvement.
This condition has not been met, Furniture must be transferred to the customers in order for this condition to be met, and however customers are already credited even before the ownership of furniture has been transferred.
(b) Reasonable assurance exists regarding the measurement of the consideration that will be derived from the sale of goods
Criteria NOT MET: As customer can proceed with the project now or later date so
it is not assured
As per ASPE 3400.16: Revenue from service transactions and long-term contracts is usually recognized as the service or contract activity is performed, using either the percentage of completion method or the completed contract method.
Criteria NOT MET: In this case customer are charged in advance before the service has been provided and measurement can’t be determined before the credit applied to the customer account.
As per ASPE 3400.06: In the case of rendering of services and long-term contracts, performance shall be determined using either the percentage of completion method or the completed contract method, whichever relates the revenue to the work accomplished.
Criteria NOT MET: As there is no way we can find that service has been performed
before the customer account is credit $1500, so criteria is not met.
As per analysis mentioned above on the basis of revenue recognition, All the payments need to be reversed to unearned revenue because these services have not been performed yet and the furniture are not delivered to the customers. This adjustment will increase the liabilities and decrease the net income and significantly affect the equity.
Issue: Land-Non-Monetary Transaction.
OTF made a plan to build a new distribution centre and was interested in a piece of land held by a customer. Listed price of land was $200,000. OTF made a deal to the customer to trade furniture for land. Furniture retail price was $185,000. The issue is whether the recorded transaction is measured for carrying value or market value.
Analysis: Under 3831.06 Non-Monetary Transaction: An entity shall measure an asset exchanged or transferred in a non-monetary transaction at the more reliably measurable of the fair value of the asset given up and the fair value of the asset received, unless:
The transaction lacks commercial substance;
Criteria NOT MET: As the transaction has a commercial substance, If OTF has sold the furniture for $185000, assuming the customer would have purchased the furniture from OTF. OTF would have paid $200,000 for the piece of land. This exclusion from measurement at Fair Value has not been met.
The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange;
Criteria NOT MET: As Land and Furniture are two different merchandises. This exclusion from measurement at Fair Value has not been met.
Neither the fair value of the asset received nor the fair value of the asset given up is reliably measurable;
Criteria NOT MET: As the Land has fair value of $200,000 and Furniture has a fair value of $185,000 both merchandises Fair Value can be measured. So due to that reason this exclusion from measurement at Fair Value has not been met.
The transaction is a non-monetary non-reciprocal transfer to owners: This transaction is not a non-reciprocal transaction.
Criteria NOT MET: As deal has been made between these two parties as Land and Furniture are being exchanged. This exclusion from measurement at Fair Value has not been met.
As per analysis mentioned above, my suggestion is that this transaction needs to be reported at the fair value of the assets given or received Since both the values appears to be reliable as per my consideration so therefore this transaction needs to be measured at the fair value of the assets received $185,000 rather than land was reported in the financial statement at $200,000.
Impact: The total impact of this transaction on OTF Financial Statement would be assets will decrease by $15,000 and revenue and income would decrease by $15,000 which will affect the impact on profitability.
Issue: Leased Facility
As OTF leased a facility to carry out their business operations for spray painting. The building belongs to private developer, LAW Properties who has signed an agreement between two parties on January 1. OTF would like to purchase the property, but the LAW is not willing to sell the property. The Fair Market value of the building is $1,200,000. The issue is lease payments were expensed without analysing if it qualifies for finance or operating lease. So now its important to decide before payments could actually be expensed.
Analysis: As per 3065.06 Leases: As per lessee point of view a lease would normally transfers substantially and all the benefits and risks of ownership to the lessee when, at the inception of the lease, one or more of the following conditions are present:
There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term.
Criteria NOT MET: As OTF will not obtain an ownership of the property at the end of the lease because LAW Properties Inc. intentions are clear that they don’t want to sell the property at all. So, criteria not met.
The lease term is of such a duration that the lessee will receive substantially all of the economic benefits expected to be derived from the use of the leased property over its life span.
Criteria NOT MET: As useful life of property is 35 years, and lease terms is 15 years, then economic benefit from a leased property should be 75% or more of economic life of the leased property. In this case it is coming as 42% so criteria not met.
The lessor is assured of recovering the investment in the leased property and of earning a return on the investment as a result of the lease agreement. This condition exists if the present value, at the beginning of the lease term, of the minimum lease payments, excluding any portion thereof relating to executory costs, is equal to substantially all (usually 90 percent or more) of the fair value of the leased property,
Criteria MET: As it has been classified as finance lease and the reason for classified as finance lease is because the present value of lease payment is greater than 90% of the Fair Market Value of the building.
N=15, I/Y=5%, PMT=$98000, FV=$500,000 Therefore PV= $1,308,575 greater than $1,080,000. So FMV= $1,200,000 x 90%= $1,080,000.
As per consideration the rent payments were expensed on the financial statement previously. So, test was performed to determine if the lease is an operating or finance lease but the test did meet the criteria for a finance lease. Therefore, instead payments are entered as rent expense these payments must be recorded a lease liability.
Impact: It will increase the liability as expense was previously increased therefore, now expenses will be decreased resulting in an increase in the net income and overall profitability.
Audit Impact: Design Contract
As sales increased significantly in the past years due to the implementation of the new program: “Fees for designing the specialty furniture items”. There is reason to determine that revenues are recorded impulsively. Customers are charged a non-refundable flat fee of $1500 to prepare a design plan without service has been provided and the full amount of fee is credited to customer’s account by showing increase in revenue.
Assertion: Occurrence and Cut off.
Risk: As OTF management is recording the revenue before the customer proceeds were received from their projects and even before the delivery of the furniture was made to customers so sales might be overstated
Audit Procedure: Sampling and Tracing:
A sample of client contracts needs to be reviewed to determine the actual number of clients who proceed with the design plans to match number of contract and also to determine the dollar value from Accounts Receivable Control Account which also verifies credit amounts. They should also trace back those sales invoices with the shipping documents to determine whether an actual sale has been recorded from furniture delivered in the correct period.
OTF policy for recognizing the revenue will increases net income, and it will also have considerable increase in management bonuses too.
Audit Impact: Non-Monetary Transaction- Land
Sales would have increased considerably, when this transaction; exchange for land and furniture had taken place. The revenue amount has been incorrectly reported on the financial statement as Land was reported at $200,000 so did the revenue, instead of $185000.
Assertion: Occurrence and Accuracy.
Risk: As per inaccurate accounting knowledge Sales may overstated on the financial statement
Audit Procedure: Sampling and Inspection
A sample from the inventory list should be selected and for each selected sample inspect the recent sales invoice and recent purchase invoice then compare the per unit net book value of the items to determine whether items are lower than NRV or items have been recorded at their appropriate value.
If the inventory will be overstated then revenue recognition will also increase which will increase an overall net income, which also increase management bonuses.
Audit Impact: Leased Facility
As lease payments were recognized as an expense so expenses are overstated, they need to be realized as an obligation. As there is now a reasonable ground to determine that expenses were recorded incorrectly.
Assertion: Completeness and Valuation.
Risk: Due to inaccurate reporting there could be unrecorded balance in the lease obligation
Audit Procedure: First obtain the copy of the lease contract from the customer made by LAW Properties. Read the contractual obligations to determine if the Lease is Finance or Operating Lease then match the outcome from the contractual obligation onto the financial statement to determine the way lease payments are recorded.
By reporting lease payment as an expense will understate the net income, and resulting decrease in the equity, which decreases profitability in general.
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