Siegfried Air Control Ltd. (SAC) manufactures and installs air conditioning and ventilation systems, mainly for businesses but also for home use. The company was founded 18 years ago by a group of five professional engineers, who had previously worked for a multinational air conditioning company based in Germany. The five engineers are the only shareholders. Additional financing is provided through bank loans and a bank line of credit. The line of credit is limited to 70% of SAC’s accounts and notes receivable plus 50% of the book value of inventory. Over the years, SAC developed a sophisticated air conditioning system that could be installed in older buildings without the need for extensive reconstruction. The AirRing System, as it was called, was very popular for old residences and commercial buildings. AirRing evolved through several designs over the years. In 20X4, due to severe energy shortages, SAC developed a new energy- efficient model (Sigmund) that reduced energy con­- sumption by 40% and also substituted a new type of refrigerant that was safe for the envi-ronment, unlike refrigerants in prior years that caused damage to the ozone layer if they leaked into the atmosphere. The only difficulty with Sigmund was that both the condenser and the air- handler (the fan unit that circulates the air) were appreciably larger than the older, less efficient, models. The larger size meant that customers that had to replace their old air conditioning units would need to provide larger spaces for both units— not always an easy task in older buildings. SAC began manufacturing, selling, and installing Sigmund in 20X5. Most of the components were subcontracted to other manufacturers in the region and in Europe. Subcon-tractors were intentionally scattered so that the exact design of the new system would not be immediately obvious to competitors. Of course, SAC knew that other companies would successfully copy its design through reverse engineering. Therefore, SAC set a high price on the new systems at the beginning to recover the development costs before similar systems became available from other manufacturers. The total cost to manufacture Sigmund was $ 10,000 for a medium- sized unit suitable for homes. Commercial systems were custom- designed to specifications and could run up to a million dollars to manufacture and install. It is now the end of 20X5. The VP, Finance, who is one of the founding engineers and shareholders, is pondering the proper presentation of some transactions and events. Because it is a private company, SAC has never been audited. Nevertheless, SAC’s shareholders want the company’s financial statements prepared on the basis of GAAP so that the bank does not ask any awkward questions and perhaps force an expensive audit in future years.
You, Theresa Tie, have been hired as an accounting expert to advise the company on the proper treatment of the following matters:
1. The company has been charging all direct manufacturing costs to inventory— raw materials, direct labour, and the full cost (including taxes, foreign exchange gains and losses, and shipping costs) of subcontracted components. All other costs are charged to expense in the year incurred.
2. Accounts payable includes several million dollars worth of unpaid subcomponent costs that were invoiced to SAC in euros. On advice from the bank, SAC hedged the euro commitment when the company signed the subcontracting agreement and established the euro price of the subcontracted components. Due to the strength of the Canadian dollar (compared with the euro), the Canadian dollar value of the accounts payable has decreased by $ 156,000.
3. Historically, SAC has incurred very little cost in honouring its warranties on its equipment and installations. These costs have been charged to expense when incurred. Call-backs for service on newly installed Sigmunds have been largely the result of their having been installed in small spaces with inadequate ventilation, which has caused the overall cost of honouring warranties on Sigmund to be higher than usual in the short run.
4. SAC has an inventory of older units (the Erda model) that are about to become obsolete in Ontario due to pending new regulations on energy and refrigerant. Some customers are hurrying to purchase the Erdas in advance of the effective date of the new regulations. Unsold units can be shipped into the United States and sold through another company but would have to be discounted by at least 50% below Erda’s usual selling price, which is about 10% below the recorded inventory cost. SAC would have to pay shipping costs to get the units to the United States.
5. In October 20X6, SAC signed a contract to retrofit an old factory building that is being converted into condominiums. The contract price is $ 1,200,000; SAC’s estimated cost is $ 1,000,000. By the end of the year, SAC had spent $ 600,000 on the project, including the $ 250,000 cost of the compression and air- handling equipment that had not yet been installed. Just before the end of the year, the SAC project supervisor advised SAC that due to more difficult conversion problems than expected, an additional $ 150,000 would probably have to be spent. The project supervisor estimated that about 40% of the physical work had been finished.

Prepare a memorandum to the VP, Finance, in which you identify and analyze alternative accounting treatments for these five issues. Recommend which treatments SAC should adopt.

  • CreatedFebruary 17, 2015
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