Earthcom Inc. (EI) is in the telecommunications industry. The company builds and maintains telecommunication lines that are buried in the ground. The company is a public company and has been having some bad luck. One of its main underground telecommunications lines was cut by accident and the company cannot determine the exact location of the problem. As a result, many of the company's customers have lost service. Because EI did not have a backup plan, it is uncertain about how long it will take to restore service. The affected customers are not happy and are threatening to sue.
In order to try to calm them down, EI has managed to purchase some capacity from a competitor. Unfortunately, the cost of the service is much higher than the revenues from EI's customers. EI is also currently spending quite a bit on consulting fees (on lawyers and damage control consultants).
In addition, EI is spending a significant amount of money trying to track down the problem with its line, and although it has had no luck so far the company recently announced that it was confident that services would be restored imminently. As a result of the work being done, EI feels that it will be in a better position to restore service if this ever hap pens again.
The company has been upgrading many of its very old telecommunications lines that were beginning to degrade due to age. It has capitalized these amounts and they are therefore showing up as investing activities on the cash flow statement. The company's auditors have questioned this as they feel that the amounts should be expensed.
As a result of all this, EI's share price has plummeted, making its stock options worthless. Management has historically been remunerated solely based on these stock options, however. The company's CFO meanwhile has just announced that he is leaving and is demanding severance pay for what he is calling constructive dismissal. He feels that because the stock options are worthless, he is working for free-which he cannot afford to do-and that the company has effectively fired him.
Instructions
Adopt the role of the company controller and discuss the financial reporting issues.