Cringle Inc. (CI) has just had a planning meeting with its auditors. There were several concerns that had been raised during the meeting regarding the draft financial statements for the December 31, 2011 year end. CI is a public company whose shares list on the TSX. It has recently gone through a major expansion and, as a result, there are several financial reporting decisions that need to be made for the upcoming year-end financial statements. The expansion has been financed in the short term with a line of credit from the bank; however, the company plans to raise capital in the equity markets in the new year. It is hoped that the expansion will increase profitability, although it is too early to tell. Just before year end, the company purchased a number of investments as follows:
• 20% of the common shares of KL. CI was able to appoint one member to KL's board of directors (which has four members in total). CI is unsure as to whether it will hold on to this investment for the longer term or sell it if the share price increases. The company has currently set a benchmark that if the share price increases by more than 25%, it will liquidate the investment. KL has been profitable over the past few years and the share price is on an upward trend. The original reason for entering into this transaction was to create a strategic alliance with KL that will help ensure a steady supply of high-quality raw materials from KL to CI.
• Corporate bonds. These bonds are five-year bonds that bear interest at 5% (which is in excess of market interest rates). As a result, the company paid a premium for the bonds. The bonds are convertible to common shares of the company. It is CI's intent to hold on to these bonds to maturity, although if there were an unforeseen cash crunch, it might have to cash them in earlier.
The company completed a significant sale to a new U.S. customer on credit on December 31, 2011. Under the terms of the agreement, CI will provide services to the customer over a one-year period. The sales agreement includes a non refundable upfront fee for a significant amount, which the company has recognized as revenue. As part of the deal, CI will provide access to significant proprietary information (which it has already done) and then provide ongoing analysis and monitoring functions as a service to the customer. It is not specified in the contract whether the rights to the proprietary information are transferable but CI is taking the position that they are. The proprietary information is of no value as a separate item if not transferable. During the year, CI renewed service contracts for some of its other major customers under similar deals.
The receivable for this large sale is in U.S. dollars. Half of this has been hedged using a forward contract to sell U.S.
dollars at a fixed rate. The other half is hedged through a natural hedge since the company has some U.S. dollar payables.
The auditor has asked that the company prepare some notes analyzing the need for hedge accounting for this transaction and explaining the risks associated with the sales transaction and hedge transactions.
This has been a bad year for the company due to one-time charges on a lawsuit settlement, and currently the draft statements are showing a loss. The company's tax accountants have determined that the company will also have a loss for tax purposes.
Instructions
Assume the role of the controller and analyze the financial reporting issues.