Carlisle Carpet Corporation (CCC) is a manufacturer of broadloom carpeting, located in Winnipeg, Manitoba. The company enjoys a good reputation for its product, but unfortunately has not been very profitable in recent years owing to increasing imports of cheaper carpeting. To combat this threat, CCC has invested substantial sums of money in new equipment to improve efficiency. Although efficiency picked up as a result, the improvement seemed only to keep the profit picture from getting any worse, rather than to actually increase net income. It is unclear whether CCC will recover its investment in the new equipment and therefore it recorded an impairment of value at the end of the prior fiscal year. CCC is a private Canadian corporation, with 60% of the shares held by Professors Pension Plan (PPP). The other 40% is held by the original founders of CCC, now retired. Three months ago, PPP sold its 60% interest in CCC to Upper Lip Enterprises Ltd., a publicly owned British carpet manufacturer. Upper Lip planned to integrate CCC into its own operations, so that CCC would both (1) manufacture certain types of carpet sold through Upper Lip’s distributors and (2) be the North American distributor of Upper Lip’s British-made carpets.
Last week, the financial vice- president of Upper Lip sent a letter to David Blase, the controller of CCC, in which he detailed certain changes in accounting policy that CCC should institute to make its reporting practices consistent with those of Upper Lip, for purposes of consolidation and divisional performance appraisal. Included in the letter were the following:
1. Inventories, both raw materials and finished goods, should be valued on the average- cost basis rather than on the FIFO basis previously used by CCC.
2. Carpeting sold to Upper Lip and its other subsidiaries should be billed at standard cost plus 10%, rather than at full list price less 15%, as is now the case. In effect, the gross margin on the intercompany transfers would be reduced from 35% of cost to 10% of cost. Carpet purchased by CCC from the Upper Lip group of companies would also be invoiced to CCC at cost plus 10%.
3. CCC should restore the equipment write- down before the end of the current fiscal year, since the takeover of CCC by Upper Lip will enhance the value of the equipment.
4. Depreciation on the new equipment should be increased from 8% per year (straight- line) to 12.5% per year. Standard costs would be adjusted to reflect the higher rate. The financial vice- president, in his letter to David, has asked for a report to specifically identify and describe any problems in implementing the suggested changes in accounting, and provide solutions to any problems that exist.
Assume that you are David Blase. Draft the report for the vice-president on the suggested changes to the accounting policies.