Brave Maven Inc. (BMI) operates in challenging economic times. It currently manufactures trucks and equipment used for construction as well as off-road automobiles and automotive parts. During the year, net losses from offroad automobiles and parts totalled $1 million (net of tax). Future losses are expected to increase by an additional $1 million. BMI's management team is contemplating selling off this unprofitable business segment. In December, BMI's board of directors authorized a sale transaction.
Management would also like to expand the production of trucks and construction equipment. BMI's lenders are not willing to provide additional financing, so BMI will need to explore equity financing. Management is preparing the necessary documentation for an initial public offering.
The carrying value of the facility and equipment used to manufacture the automobiles and parts is $2 million. Two years ago, some modifications were made to the equipment. The equipment is now specialized for use by BMI, which would have to spend $500,000 to disassemble the previous modifications in order to sell the equipment. By year end, management had already hired a contractor to begin disassembling the equipment.
BMI has been in sale negotiations with one of its automotive parts suppliers interested in expanding its own automotive parts business. Negotiations are expected to continue, but the two companies are not able to agree on a price.
The supplier has indicated it would only be willing to pay up to 90% of the asking price as it would have to make its own modifications to the equipment first. The purchase would only go ahead if BMI completed the disassembly of the equipment's existing modifications and the supplier's engineer subsequently inspected and approved the equipment.
Management feels that 90% of the asking price is just under what it would be willing to sell the assets at.
BMI is also in a dispute with one of its suppliers of truck parts. In order to get a discounted price, BMI had to commit to purchasing $500,000 of spare parts each year for three years. BMI recently upgraded its safety standards and consequently made modifications to its construction trucks in the current year. As a result, management did not accept delivery of the spare parts for the current year. There is a provision in the contract that stipulates an annual penalty of $250,000 for failure to take delivery. One more year remains in the contract. BMI's lawyers are reviewing the contract.
They have suggested that BMI may qualify for exemption from the penalty for not taking delivery because its refusal resulted from a cllange in the safety specification for the part and not because of a change in sales demand. The supplier is willing to modify its spare parts to conform with BMI’s new safety standard.
Just before year end, management purchased an additional building. BMI plans to use 50% of the building and move the current sales team to the new location. It does not plan to use the other 50% as part of its current operations.
BMI's real estate agent looked at the property and believes the part of the building that BMI will not occupy can be sold and leased separately. Management does not want BMI to use fair value as its basis for measurement because it is concerned that changes in fair value will create too much volatility in the income statement. This may lower the price that BMI shares sell at in the future public offering.
It is now two months after year end. Assume the role of BMI's auditor and discuss the financial reporting issues.