Capilano Forest Company Ltd. (CFCL) has been owned and managed by an experienced forester, Don Strom, for 20 years. The company has performed well in the past few years, but the industry is cyclical. In the interior of British Columbia, CFCL manufactures lumber of all grades from raw logs. A small lumberyard and sales office is located in Vancouver.
Your firm has been re-appointed auditor for CFCL. You, CA, the senior on this engagement, have been going over some issues with the recently hired controller of the company, Everett Green. CFCL had been searching for a controller for several months. Green agreed to accept the position with the condition that his compensation includes a bonus based on net income. Strom finally agreed to this form of remuneration, despite initial resistance.
A large Japanese lumber importer has recently expressed an interest in purchasing CFCL. Therefore, Green proposes to make changes to CFCL’s accounting policies, which he believes will maximize the value of the company.
During the year CFCL was granted, by the Ministry of Forests, the right to log a large area of standing timber on Crown land. Although CFCL does not own the land, it does have the right to log all the timber on it, not to exceed an allowable annual limit. This right was granted to the company at no initial cost. However, a fee is paid to the Ministry based on the number of logs removed from the forest. Shortly after CFCL received this right, the Ministry announced that all holders of logging rights over Crown land are responsible for reforesting the lands at their own expense; the ruling applies to all rights granted in the past five years. After eight months of logging, CFCL has still not carried out any reforestation. The controller is proposing that CFCL record receipt of this right at fair market value. In addition, he would like to include in the financial statements the fair market value of rights received from the Ministry two years ago. These rights do not currently appear on the company’s balance sheet.
CFCL recently purchased the right to log the standing timber on a mine site. As part of the purchase contract, CFCL agreed that it would cease logging in five years, when mining would commence. Although CFCL would probably be unable to log all the timber in this period, the five-year rights were considered to be worth considerably more than the purchase price. Since logging operations began, however, it has become apparent that many of the trees are infested with insects, and are therefore worthless. Green does not think that this presents a valuation problem for financial reporting. “These rotten trees are part of the cost of the good ones, and will be expensed as the good trees are sold. The purchase price will be allocated to all the good trees on the mine site.”
With respect to the costing of trees on land that CFCL owns, Green contends that these trees really have no cost. "We paid for the land which produces the trees. The trees themselves do not have any cost. If anything, replanting and pesticide expenses are the only costs we have. The situation is similar to owning land on which we have a building and machinery producing widgets. When we sell the widgets, we don’t expense the land, do we?”
Last year the company acquired a large tract of land and timber along the Pacific Coast for $2.9 million. This year, 20% of this tract, along the shoreline, was sold to a resort developer. CFCL has assigned a cost of $25,000 to this parcel. At the date of original purchase, CFCL considered this parcel to be worthless from a logging standpoint. The rest of this land is abundant in timber. CFCL paid a premium for the land, with its rich soil and moist, coastal climate ideal for tree growth. Lately, however, the company has been having problems logging the area. Environmentalists have vowed that no one will be allowed to destroy its natural beauty. Roadways have been blocked on several occasions by these protesters. In addition, they have campaigned aggressively against the company and its products. In response, CFCL has spent large amounts on public relations, advertising, and legal costs in order to obtain injunctions. These amounts, as well as the estimated costs of idle time related to the protests, will be capitalized as goodwill.
Green intends to include in goodwill costs relating to forest fires which are rampant in areas surrounding CFCL’s land. Although none of CFCL’s timber has been damaged by the blaze, the company did pay for resources to help control the disaster. As the controller explained, "It was in our best interests to help combat the fires because they were headed towards our timber." The fires are continuing, and CFCL has promised an additional $300,000 in aid.
CFCL has gained a reputation amongst Japanese companies as a good source of clear pine. CFCL can sell the Japanese as much pine as it can cut. Orders currently out-standing will take the company at least six months to fill. Linder the terms of the contracts, the purchase price, denominated in yen, may be increased or decreased by a maximum of 5%, depending on the grade as determined by inspection at a Japanese harbour. The company would like to record the revenue on these contracts as soon as the lumber is cut.
The company sells wood chips as a by-product of its sawmill operations. It entered into a three-year contract with a large pulp mill, Remul Ltd., under which Remul can purchase all the chips produced by CFCL. CFCL would have plenty of willing customers, given the current market demand, for any chips that Remul did not take. CFCL transports the chips by truck and rail car. The truck drivers have been on strike for the past two weeks. Green does not see this strike lasting much longer, and he would, therefore, like to recognize the revenue on the chips as they are produced.
The partner on this engagement has asked you to prepare a memo discussing the accounting alternatives of the issues raised with the controller.
Required:
Prepare the requested memo.