Alpha Classic Car Restorations

John Wallace is an automotive enthusiast. He has over 25 years of experience as a mechanic for the dealership of a large car manufacturer in Oakville. John also gained experience doing minor body work and painting.

Recently, John decided to retire from the car dealership and pursue his interest of restoring classic American muscle cars. Accordingly, John started Alpha Classic Cars Restoration (ACCR). John leased an industrial building and converted it into a repair and body shop. The building's land has a small parking lot that is used to showcase the restored vehicles that are for sale.

Generally, John selects the classic muscle cars that ACCR will restore and then places them for sale to the general public in the lot. John also posts his vehicles to various Internet sales sites, frequents car shows, and uses the classifieds of local newspapers to market his inventory. ACCR also takes custom jobs, whereby an individual can request the car to be restored.

ACCR has a December 31, 2020, year end, and just completed its first year of operations. John had a friend help him compile financial statements for the year end (draft financial statements can be found inExhibit I). ACCR's bank requires the preparation of annual audited financial statements in accordance with IFRS (details of the loan agreement can be found inExhibit II), and the auditors are scheduled to commence year-end work on January 18.

Exhibit I

Draft Financial Statements

Statement of Financial Position

As at December 31 (unaudited)

2020

Assets

Current

Cash

$35,449

Accounts receivable

45,000

Inventory

95,775

Prepaid insurance

1,775

177,999

Capital assets

287,250

$465,249

Liabilities and shareholders' equity

Current

Accounts payable and accruals

$8,455

Income taxes payable

17,334

25,789

Long-term bank loan

277,240

Common shares

74,500

Retained earnings

87,721

162,220

$465,249

Income Statement

For the year ended December 31 (unaudited)

2020

Sales

$ 320,000

Cost of sales

128,000

Gross profit

192,000

Expenses

Advertising and promotion

2,000

Bad debt

0

Depreciation

22,750

Insurance

1,500

Interest

16,920

Legal and accounting

2,500

Lease expense

30,000

Office and general expenses

2,775

Repairs and maintenance

750

Utilities

11,000

Wages and benefits

22,500

112,695

Operating income

79,305

Other service income

25,750

Income before taxes

105,055

Provision for income taxes (16.5%)

17,334

Net income

87,721

Opening balanceretained earnings

0

Net income

87,721

Dividends

0

Closing balanceretained earnings

$ 87,721

Exhibit II

Bank Loan Agreement

The Bank of Toronto has provided a $300,000 loan to help finance working capital and capital assets. The following are the terms and conditions of the loan.

• Security:The bank secures its loan with a first claim against inventory and accounts receivable.
• Repayment:The loan is to be repaid over a 10-year period, with blended monthly payments.
• Interest rate:The rate of interest is 6%, effective annual rate (EAR).
• Covenants:ACCR must comply with the following covenants:
• The current ratio must not be below 2:1.
• The debt to equity ratio must not exceed 3:1. Debt is defined as both current and long-term liabilities.

A violation of either covenant will result in the loan becoming payable upon demand.

• Financial statements:Audited financial statements are to be presented no later than 60 days after year end. Financial statements can be prepared with ASPE.

Realizing that ACCR needs accounting assistance, John has hired you, CPA, as a consultant on December 24, 2020. Your first task is to review the draft financial statements and provide any recommendations to comply with IFRS. In addition, John required some assistance preparing a statement of cash flow. John has provided you with a file for review, which outlines all of the significant transactions that have taken place during the year (Exhibit III).

Exhibit III

Notes of Significant Transactions

During the first year of operations, ACCR made the following sales:

1. 1972 Chevy Camaro, Z28

$45,000

2. 1978 Chevy Corvette Coupe, 25^thAnniversary

$33,000

3. 1969 Pontiac GTO

$38,000

4. 1967 Ford Shelby Mustang

$55,000

5. 1974 Dodge Dart

$33,000

6. 1970 Buick GSX

$40,000

7. 1970 Chevelle 454 SS

$37,000

8. 1970 Plymouth Hemi

$39,000

ACCR is so confident in its workmanship that it offers a 10-year bumper-to-bumper warranty with all car sales. The warranty covers all defects and breakdowns that are not directly related to regular wear and tear. John is unsure of how much the warranty will cost to service, but is confident that his vehicles will stand the test of time. Based on his experience, John estimates the probability of a vehicle making a warranty claim during the 10 years of coverage are as follows:

Year 1

2

3

4

5

6

7

8

9

10

1%

2%

2%

5%

5%

10%

12%

15%

18%

20%

The average retail value per claim is $1,250. The average cost of parts and service at ACCR is about 60% of that of a dealership.

• ACCR sold the 1972 Chevy Camaro to a wealthy telecom CEO during the year. Shortly after delivery of the vehicle, John found out that the CEO resigned from the company due to various accounting irregularities and restatements. John has been in contact with the customer and knows that he is happy with the car, and fully intends to pay once things settle down.
• ACCR entered into a lease agreement on January 1 for the land and building that is used as the repair and body shop. ACCR is required to make monthly payments of $2,500, commencing January 31, for a 10-year period (at which point, John expects to be fully retired and live off of his pension). The following additional information is available regarding the lease:
• The rate implicit in the lease is 7%.
• The building and land have fair values of $170,000 and $56,667, respectively.
• The building has a useful life of approximately 13 years.
• The lease payments were set to provide the lessor with a return of 60% related to the building and 40% related to the land.
• There is no bargain purchase option, or renewal option, at the end of the lease.
• The capital asset breakdown is as follows:

Capital Assets

Cost

Accumulated Depreciation

Net Book Value

Machinery and equipment

$250,000

$15,500

$234,500

Leasehold improvements

10,000

1,000

9,000

Office equipment

25,000

3,125

21,875

Vehicles

25,000

3,125

21,875

$310,000

$22,750

$287,250

The leasehold improvements include changes to the building and land (e.g., paving). The machinery and equipment is expected to have a residual value of $95,000 after their 10-year useful life. Both the office equipment and vehicle are expected to have useful lives of eight years, with no residual values.

• The income taxes presented in the financial statements are based on the pre-tax income times the tax rate of 16.5%. No adjustments have been made to calculate taxes in accordance with the Income Tax Act even though the deferred taxes method has been adopted. The following are the CCA rates relevant to the capital assets of ACCR:

1. Machinery and equipment: 30%
2. Leasehold improvements: 10 years, straight-line
3. Office equipment: 20%
4. Vehicles: 30%

• The inventory balance includes a 1971 Corvette Coupe. The car was a custom order for a doctor. Due to financial problems, the doctor was unable to purchase the vehicle, at which point ACCR repossessed the vehicle. The vehicle is included in inventory at its cost of $35,000. The vehicle will require minor moderations, costing up to $5,000, to make it ready for resale at a price of $35,000.

Aside from the year-end statements, John would also like to know whether he will be able to pay any dividends in the current year. He has drawn a minimal salary, and is hoping to supplement his income by paying a $35,000 dividend with the current cash balance.

Finally, John has asked you to provide some advice regarding the additional controls or procedures that could be implemented to improve the day-to-day operations of the company.

Required.

Assuming everything else is correct in the case and that the case is following ASPE not IFRS, how would you deal with the lease.