Its December 31, 2020, and youre sitting at your desk looking out the window watching the snowflakes

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Question:

It’s December 31, 2020, and you’re sitting at your desk looking out the window watching the snowflakes fall. Your friends have the day off and have just left to go skiing. You are required to stay at work as the report that you are preparing for the most influential partner in your accounting firm is due tomorrow.

Your firm is doing some special work for Tammy Bai and her company Tammy’s Toy Shop (TTS). Tammy has been approached by Eduardo Santiago, sole shareholder of Santiago Enterprises, with a proposal that would have TTS purchasing 45% of the outstanding shares of Santiago Enterprises (SE). Eduardo has told Tammy that the injection of funds (the cash received by SE when TTS purchases the shares) will be used to create leading-edge toys for children and young adults.

Tammy would like to ensure that the information provided by Eduardo to her is accurate as she doesn’t want her own retirement income to melt away due to a bad investment, nor does she want to spend too much. Tammy has given your partner all the information that she has with respect to SE. Your partner has delegated this task to you and is providing you with very specific instructions on how to write the report to her.

Tammy is interested in SE and states that it looks like a good investment. She noted that the financial statements are showing a large profit and Tammy is interested in a steady stream of income to help her ease into semi-retirement in the summer months. Still, she does not fully trust Eduardo, so she has asked your firm to look at the information about SE (Exhibit I) and let her know of any discrepancies that you may find. Note that SE has never been audited before.

Your partner has asked that your report begin with an overview that addresses TTS’s investment objectives and then discusses Eduardo and SE. This overview should include a discussion of the users of the information, their objectives, and the reporting implications. You should ensure you make specific reference to the conceptual framework where applicable. Tammy has asked for some clarification of some accounting terms she found in the excerpts (Exhibit I). Within the report to your partner, prepare notes to help Tammy understand these terms. Your discussion should include detailed calculations of accounting issues when asked to do so or deemed appropriate. You should split your discussion between those issues affecting the investment in SE and those specific to TTS.

Both companies are private companies. TTS is interested in going public in the future and Tammy has asked you for some IFRS explanations regarding her own financial information, so read Exhibit I carefully.

Exhibit I

Information About Santiago Enterprises

SE has been around for a number of years. In the past 10 years, SE has had reduced profits, which Eduardo has attributed to a decline in retail purchases by consumers.
The past two years have shown resurgence within SE and record profits have been recorded. According to Eduardo, this turnaround is due to the increased marketing to kids and teenagers through various social media websites. Santiago’s unadjusted net income for the year ended December 26, 2020, was $1,340,000.
During 2020, SE purchased a group of assets for $1.1 million. The assets included land with an appraised value of $800,000, equipment with an appraised value of $150,000, and a building with an appraised value of $600,000. SE recorded this transaction by debiting land for $800,000, equipment for $100,000, and building for $200,000. The equipment is being depreciated over seven years and the building over 20 years.
SE owns 19% of the outstanding shares of Acme Toys and Games Inc. (ATG). SE is a major customer of ATG as it purchases many of its toy components from them. SE has three members on ATG’s board, with another seven members from other organizations. During the year ended December 28, 2020 (you have ATG’s financial statements), ATG incurred a loss of $322,000 and paid dividends of $110,000. SE has recorded dividend revenue of $8,500.
TTS is contemplating going public around 2020 and would like an example of what the impact would be on the financial statements. Disregarding any other information for the moment, Tammy provides you with a scenario where she has a $500,000 bond payable and equity investments with a cost of $340,000 and a year-end market value of $380,000. She would like to know how these would be recorded and presented under IFRS.
No dividends have been paid on the SE shares in the last 50 years.
During the year, SE decided to exchange a computer tablet-manufacturing machine that had cost $822,000 and had accumulated depreciation of $420,000 with another tablet-making machine with another company. This machine had a cost of $960,000 and had accumulated depreciation of $444,000. The fair value of SE’s machine was $480,000 at the time. SE has recorded a gain of $78,000. The exchange was done because Eduardo preferred the fact that the acquired machine allowed you to work from both the right and the left side.
In January 2020, SE changed its estimated percentage of bad debts from 4% of sales to 3% of sales. A note from the controller of SE states that “although historically we have found that our bad debts are running at approximately 4.5% of sales, we feel that our increased profits this year will result in our customers wanting to pay us back on a timely basis.”
Sales this year amounted to $20,200,300.
Due to the decline in popularity of the DVD players, SE has stopped making its top-of-the-line supercharged DVD player in fire engine red. The DVD-making machine is currently on the books at a cost of $550,000 and has accumulated depreciation totaling $200,000. The fair value of the machine is estimated at $50,000. SE has not made any entry this year regarding this machine.
On December 1, 2020, SE signed a contract with DIY Depot to supply it with toys for the next five years beginning January 2021. Under the terms of the contract, SE would produce and deliver toys to DIY Depot and DIY Depot would pay SE a fixed amount of $1 million for the five-year contract. SE requested that DIY Depot pay 50% of this amount upfront to help defray the costs of producing the toys. SE has recorded this $500,000 as revenues in 2020.
Tammy is somewhat confused about the difference between depreciation and valuation. She would like you to explain this to her. She is also unsure of how you go about choosing the number of years to depreciate. She wonders if it is prescribed somewhere.
TTS has depreciable assets on its books with a cost of $5.4 million and a fair value of $8.8 million. TTS has heard that under IFRS you may be able to value your depreciable assets at fair value instead of maintaining them at cost. Tammy would like you to explain to her, using the above information, how her statements would look if she were to follow IFRS.
In addition to the investment in SE, TTS is considering investing in Madison Manufacturing (MM). TTS is contemplating purchasing 30% of MM, which would result in a purchase price of $450,000 cash for the investment. Currently, MM is reporting assets of $4,550,000 and liabilities of $3,300,000. Asset values reflect fair market values, except for capital assets, which have a net book value of $630,000 and a fair market value of $825,000, and inventory, which has a fair value that is $20,000 less than book value. The capital assets have a remaining useful life of six years.
- Madison is actively traded with a fairly consistent 2020 share price of $14.
- Tammy would like to know how this would be recorded by her company assuming she maintains her current ASPE reporting framework.

Accounting Analysis Approach

Introduction: Establish the landscape of the case

· Who are the main users of the case? Consider any key internal and external users of the financial information.

· What are the user objectives? What do the users really care about? For example a bank is a typical user and they care most about receiving the scheduled interest payments.

· What is your role in the case? This should be reasonably clear in the case but may be overlooked if not.

· What GAAP is appropriate in the case? Determine whether ASPE or IFRS is used or perhaps both need to be applied to the case.

· Is there a Big Picture item in the case? For example there may be a debt covenant imposed by the bank for financing. This covenant will likely be based on maintaining a certain financial ratio, such as current ratio or debt-to-equity ratio. As you identify issues in the case and recommend adjustments, this ratio will also require adjustment that could either better or worsen the ratio. Other common big picture items could be fraud, business acquisition/valuation, bonus payments, etc.

Analysis: Accounting Issues

Identify EACH accounting issue in the case using the following format:

ISSUE #1 - …..

· State the accounting issue and how it is currently being accounted for.

· Identify any possible alternative ways to account for the issue such as to capital or expense.

· Discuss the appropriate GAAP criteria that should be applied such as the definition of a capital asset. Try to provide a balanced analysis if alternatives do exist. For example, do not only provide facts to support capitalization, try to also discuss points that support the expensing option.

· Apply case facts to the noted GAAP criteria. This will support the criteria and ultimately provide the support needed for a recommendation.

· Recommend how the issue should be accounted for.

· Quantify the financial statement impact of each adjustment to correct or account for the issue. If numbers are not provided simply discuss the general financial statement impact.

Conclusions and Big Picture Issue

· Based on the big picture issue noted in Step 1, discuss, and quantify the overall impact (if possible) of the adjustments required from the accounting issues.

· What does this mean for the company? For example, if there is a restrictive covenant and after the suggested adjustments it appears to be in breach, then the underlying bank debt would be repayable immediately!