Pablo Ltd. (PL) reproduces fine works of art as posters. The company was started 10 years ago with used equipment. Demand for the posters increased recently when PL began to glue the posters onto a wood backing and laminate them. The old equipment has become very expensive to maintain and keeps breaking down, disrupting production. Pietro Pablo, the owner, has decided to go to the bank for a loan to buy new equipment. In preliminary talks with the bank, the manager indicated that financial statements are needed from PL for the year ended December 31, 2011.
While the statements have now been drafted, Pietro is not happy with the net income figure, which is lower than he had expected. Pietro calls you, his accounting manager, and asks if the net income has been correctly calculated. He points to the large payroll expense, which has increased over the last year. You note that the main cause of the increase is that pension expense increased for the following two reasons:
1. The employee pension plan was renegotiated at the beginning of the year and a key change was to increase the amount of pension benefits for each employee for each hour worked. The plan is a defined benefit plan and the amendment provided for retroactive application, so that most of the employees, who were older, would benefit from the plan. The increase in the pension obligation arising from this amendment is being amortized to net income over 14 years, beginning with 2011.
2. The actuary has recently prepared a new actuarial valuation of the pension obligation. In doing so, she suggested that the interest rate used for discounting be changed to reflect recent reductions in interest rates. Short-term interest rates have declined but many economists predict that the mid- to long-term rates will remain more stable at the higher rate. The reduction in the interest rate for discounting has resulted in an increase in the pension obligation. The increase is also being amortized to net income over 14 years, beginning in 2011.
Pietro asks you to determine whether there is any flexibility in applying PE GAAP. The company is a private company.
Instructions
Discuss the financial reporting issues.