Finishing International Enterprises (FIE), a private company based in Vancouver, is Canada’s largest dealer of heavy equipment, such as tractors, grapple skidders, and backhoes. The company sells, rents, finances, and provides customer support for all of the heavy equipment it finances. FIE is owned by Tony Finishing, who provides the strategic vision, while all of the accounting functions are the responsibility of Chen Yi, the controller. Tony has determined that FIE will be expanding into the United States next year. FIE has been able to reduce its debt load over the years but still relies heavily on its creditors for continued support and growth. The bank has never asked for an audit before, but recently, Tony met with the bank to make some routine changes to the banking agreement. He was told the company would have to provide audited statements for the year ended December 31, 2011, given its expansion into the United States. The bank has also stipulated that FIE must maintain a total debt-to-equity ratio of no more than 1 to 1 (i.e., for every $1 in equity, there should be no more than $1 in debt), where debt is defined as all liabilities, including payables and accruals. Lento & Partners LLP (L&P) has been FIE’s accountants for many years. It is now January 2012, and you are the senior accountant at L&P who has been responsible for FIE’s year end in the past. Tony has asked you to come in before year end to help Chen establish accounting policies to ensure that FIE is in compliance with GAAP. You meet with Tony and Chen and note the following:
1. During the year, FIE sold 2,000 small tractors for $2,600 each, including a one-year warranty. Maintenance on each machine during the warranty period averages $380. During the year, actual warranty costs incurred were $180,000. FIE is currently using the cash basis to record the warranty expense.
2. On October 1, 2011, the provincial environment ministry identified FIE as a potentially responsible party in a chemical spill in its Hamilton warehouse. Management, along with legal counsel, has concluded that it is likely that they will be responsible for damages, and a reasonable range of these damages is $500,000 to $750,000. FIE’s insurance policy of $1 million has a deductible clause of $250,000. Management has yet to record this transaction in the books.
3. The company purchased a new piece of machinery on January 1, 2011. The purchase was financed though an interest-free five-year loan, whereby it is required to pay back $500,000 in each year. Management recorded the asset and liability at $2.5 million in the books. Management was excited about this promotion as the interest rate normally charged on a similar loan would have been 9%. FIE uses the straight-line method to amortize the asset, which has a seven-year useful life.
4. On January 1, 2010, FIE constructed a warehouse on property it leased for a five-year period. FIE will be required to remove the warehouse and restore the property to its original condition at the end of the lease term. Inflation- adjusted costs of removing the warehouse and restoring the property are estimated to be $200,000. In 2010, management recorded a liability for $200,000 in the books. No additional entries have been made.
5. On January 1, 2011, FIE issued 30,000 redeemable and retractable preferred shares at a value of $10 per share. The shares are redeemable by FIE at any time after January 2015. The shares are retractable for $10 per share at any time up to January 2015, after which the retractable feature expires. The preferred shares require the payment of a manda- tory dividend of $2 per share during the retraction period, after which the dividends become non-cumulative and non-mandatory (i.e., paid at the discretion of the board). FIE’s balance sheet reveals that the corporation has $1.6 million in debt and $2,850,000 in equity. Tony stated that since equity is greater than debt by $1,250,000, he is planning on paying a large $800,000 dividend on his common shares, which “will still allow the debt-to-equity ratio covenant (1:1) to be maintained.” FIE’s credit-adjusted risk-free rate is 8%.
Instructions
Provide a report to Tony and Chen outlining your recommendation on accounting policies and other important issues.