Custom Auto Parts

Today is November 1, 2020. You, CPA, have just been hired by Custom Auto Parts (CAP) as an accountant to provide financial expertise during its current expansion. CAP was founded in 1995 by Jerome Blackman (sole shareholder), and CAP has remained a private corporation ever since. From its humble beginnings, CAP has grown substantially. CAP's operations focus on the production of both standard and unique car parts. CAP always strives to use modern technology to produce quality car parts. When CAP commenced, it produced car parts for Canadian automotive companies that were seeking to outsource their production. Soon after, as word spread on the quality of its parts, CAP's products were being sought after by companies outside of Canada. In addition, CAP began selling its to individuals who were looking for unique car parts to restore older cars.

As a car buff, you are very excited about the position as it allows you to apply your accounting knowledge in an industry that interests you. On your first day, you met with CAP's CFO, Robert Ryder. Robert begins by explaining how excited he is that you have joined CAP's team and he looks forward to the expertise that you will bring to CAP's accounting department.

Robert continues by explaining that as CAP has grown, so has its on external financing. Just this year, CAP had purchased additional equipment to handle its recent growth. CAP has had a long-standing relationship with its bank. However, given the recent credit crisis, the bank has changed its policies on all loans. Robert has provided you with a copy of CAP's statement of financial position (see Exhibit I) as at October 31, 2020, which is CAP's fiscal year-end date.

Exhibit I ( CAP's FINANCIAL POSITION)

Custom Auto Parts

Statement of Financial Position

as at October 31

Assets

Current assets 2020 2019

Cash $ 35,000 $ 20,000

Accounts receivable 13,000 10,000

Inventory 20,000 12,000

Prepaids 3,000 3,000

Total current assets 71,000 45,000

Property, plant, and equipment (net) 2,800,000 2,200,000

Total assets 2,871,000 2,245,000

Liabilities

Current liabilities

Accounts payable 25,000 20,000

Notes payable 13,000 25,000

Current portion of long-term debt 150,000 50,000

188,000 95,000

Long-term debt 1,800,000 1,450,000

Total liabilities 1,988,000 1,545,000

Shareholders's equity

Share capital 100 100

Preferred shares 100,000 100,000

Retained earnings 782,900 599,900

Total equity 883,000 700,000

Total liabilities and shareholders equity $2,871,000 $2,245,000

Debt equity 2.67 2.21

After the meeting, Robert asks you to analyze the new accounting issues surrounding CAP and to provide recommendations on their resolution. He concludes by reminding you that the bank is eager to see the year-end financial statements. As you make your way back to your desk, you begin by reviewing a file outlining important transactions undertaken by CAP. You note the following issues:

1.On November 1, 2019 (the beginning of the fiscal year), CAP acquired a of its equipment through a lease agreement with Lessor Corp. The lease contract has the following terms and conditions:

CAP agrees to lease equipment from Lessor Corp. with a fair market value of $900,000

The term of the lease is for seven years, with annual rental payments of $145,000 due at the beginning of each year. CAP knows the implicit interest rate on the lease agreement is 5%. CAP knows that it could borrow at an incremental rate of 6%.

There is no residual value.

CAP will cover the executory costs associated with the lease. The executor costs will be approximately $10,000 per annum and are included as part of the $145,000 rental payment.

The lease offers a bargain purchase option to purchase the equipment for $50,000 at the end of the seventh year. At the end of year seven, the fair market value of the asset is expected to be $70,000.

The first payment was made on November 1, 2019, with annual payments thereafter. You remember from auditing a client in the past that equipment such as this usually has an economic life of nine years. CAP has classified this lease as an operating lease. You remember from your discussion with Robert that he was unsure of the benefits of leasing versus buying an asset. This information is for Robert for any future capital budgeting decisions.

2.After reviewing the statement of financial position, you notice that there are preferred shares valued at $100,000, which equals a total of 1,000 shares outstanding. The preferred shares are redeemable and have a 5% annual dividend. The dividend will double every three years up to a maximum 20% dividend yield. The preferred shares convertible into common shares if CAP does not pay the specified dividend on the preferred shares.

3.The file also contained a letter from CAP's lawyer (Stonechild, Pilla, and Partners). The letter from the lawyers explained a current lawsuit undertaken against CAP. Apparently, a customer had asked for 50,000 parts to be produced and delivered no later than July 15, 2020. However, due to major downtime in July, CAP could not produce the parts as scheduled. In turn, the customer was late in delivering its vehicles to its distributors and had to pay a penalty equivalent of $600,000. This customer is now suing CAP for retribution for these costs. The letter goes on to state that retribution will be inevitable; however, it is believed that a settlement between $350,000 to $550,000 can be reached.

4.On November 1, 2019, an additional $500,000 of long-term loan was taken out to help finance the purchase of certain manufacturing equipment for $600,000. (Note: the additional $100,000 was paid for with cash.) Given this new loan and CAP's revised debt load, CAP must now maintain a maximum debt to equity ratio of 3:1 and its financial statements must comply with ASPE. If CAP breaches the covenant, the bank has the ability to call for the loan in full.

The manufacturing equipment that was purchased during the year will be depreciated over 10 years. It is classified as class 39 and has a CCA rate of 25%. CAP is taxed at the highest rate of 45%, and the half-year rule applies. Robert explained that CAP has not taken any consideration for potential tax consequences on the equipment purchase. (Note: for simplicity, assume that all other future tax considerations have been properly addressed.)

After reviewing this information, you realize that you have much to contemplate as to how these issues should dealt with.

Required

Provide a report to Robert outlining your recommendation on the accounting issues and note other important issues.