Case Study and Assignment #3 Hawkeye Motors

You will be the audit manager on the annual audit of Hawkeye Motors. This is your firms first year as Hawkeye's auditor, and your team is planning the audit.

Hawkeye builds and sells upscale motorcycles. They have been around for about 15 years, and after a good many rough years, they have developed into a financially sound company. Their bikes are very well regarded for style, speed, and efficiency. They sell for about $25,000.

Hawkeye used to have a relationship with Wells Fargo Bank where Wells provided financing for Hawkeye's customers. In fact, Hawkeye even had Wells loan documents and credit applications on hand at its showrooms, and a customer/buyer would fill-out the documents when they agreed to puchase a bike. All Wells did was approve credit and disburse funds! This worked well until Wells got greedy and started asking for a $250 credit application fee, which effectively made Wells more expensive than other financing sources. Hawkeye felt that this was hurting their sales so they discontinued the relationship with Wells.

Hawkeye now provides financing themselves through a wholly owned subsidiary called Hawkeye Financial Services (HFC). {Note: HFC is wholly owned so they are included in Hawkeye Motors consolidated financial statements. Consolidation is not an issue here.}

First Issue:

You have a first-year senior on the job who has never worked on an engagement where there exists a captive finance company. He's been looking at the cash flow statement and related footnotes, and he thinks there is a big problem.

In Hawkeye's consolidated cash flow statement, they count as cash from operations the proceeds of sales of motorcycles that customers bought with money borrowed from HFC. For example, if a customer buys a $25,000 bike on December 29^th with first payment due a month later, Hawkeye will show a $25,000 cash outflow in the investing section and $25,000 cash inflow in the operating section of the December 31^st cash flow statement. (Note: The cash outflow in the investing section is netted with amounts received from customers paying-off loan principal.)

However, the company makes no secret of this accounting treatment. Last year's 10-K contains a footnote telling the reader that operating cash flow includes intracompany cash received from sale of motorcycles by Hawkeye to customers who receive financing from HFC. It also discloses exactly how much of this intracompany cash is included in operating cash, which by the way is over half of total operating cash.

Your senior makes argues that this accounting overstates operating cash, which investors look at very, very closely.

Second Issue:

Hawkeye has $5 million of debt on its balance sheet that matures over the next three to eight years. This money was borrowed when interest rates were higher and also when Hawkeye's financial position wasn't as strong as it is now. Therefore, the interest on this debt is about 250 basis points higher than what Hawkeye would have to pay if they were to borrow the money today.

Hawkeye wants to pay-off (retire) the "old" debt now on its books, and then borrow money at today's favorable interest rates. In other words, they want to refinance this debt. Because interest rates are lower, they would incur a loss by retiring the old debt, which they realize. However, the prospect of lower interest payments in the future more than compensates for the loss they would take now. In fact, Hawkeye has already "run the numbers", and it would cost them about $5.75 million to retire the debt today.

They also know that this loss would be reported on the income statement net-of-tax as an extraordinary item. They like that a lot, but they are concerned how it will be reported on the cash flow statement. Specifically, they have asked you if it will be reported in the operating section. That they don't like, because they know investors pay close attention to operating cash flow.

{Something else that may or may not be important: the reason for the debt in the first place was to fund HFC so it could carry-out its lending activities. HFC is actually the debtor, though Hawkeye Motors guaranteed the debt. The debt is carried on HFC books, but of course it is included on Hawkeye's consolidated balance sheet.}

Required:

1. Construct an example of a memo-to-file that documents the proper cash flow statement treatment of sales financed by Hawkeye Financial.

2. Construct an example of a letter to Hawkeye addressed to the CFO (with a 'cc' to the permanent audit file) that addresses the proper treatment of the refinancing loss on the cash flow statement. (If you need a combined state/federal tax rate use 40%.)

Please note: you are required to reference appropriate accounting guidance and to document all work in a professional and appropriate format.