I have attached the case. Please help me answer the questions.

CAS 1 - INDIVIDUEL : FROSTY CO. Date d'chance : 27 juin 2017, 21 h Valeur : 20 % L'objectif de ce cas est de vous amener dvelopper votre jugement professionnel et votre pense critique face une problmatique comptable fondamentale : la comptabilisation de dpenses - qui est souvent la source de manipulation des rsultats. Dans ce cas, vous devez faire une analyse critique des principes et mthodes comptables adopts par l'entreprise pour la prparation de ses tats financiers. En identifiant les problmes comptables vous devez les rattacher aux principes et mthodes comptables en consultant les sources premires des normes comptables : les IFRS. Vous devez aussi, le cas chant, analyser les diffrentes options en faisant ressortir les avantages et inconvnients de chaque mthode. Ce cas vous permet galement de dvelopper votre sens de recherche et votre communication crite. Travail faire Rdigez un rapport, en vous rfrant au Manuel de CPA Canada. Le temps requis pour prparer votre rapport est estim entre 10 et 15 heures. Directives Le rapport doit tre remis par la date d'chance, mais il peut tre envoy avant cette date. Le rapport doit tre envoy par courriel mon intention. Une page titre est requise et chaque page du rapport doit tre numrote. Bonne recherche ! BACKGROUND INFORMATION Frosty Co. is a publicly traded, medium-sized manufacturing firm that produces refrigerators, freezers, ice makers, and snow cone machines. During the past three years, the company has struggled against increasing competition, sluggish sales, and a public relations scandal surrounding the departure of the former Chief Executive Ofcer (CEO) and Chief Financial Officer (CFO). The new CEO, Jane Mileton, and CFO, Doug Steindart, have worked hard to improve the company's image and financial position. After several difficult years, the company now seems to be resolving its difficulties, and the management team is considering new investment opportunities. The team hopes that diversification into a line of professional ice cream makers, and perhaps a line of consumer products, will help the company continue its recent growth and effectively compete with future competitors. In order to raise the funds needed for these new investments, Frosty Co.'s Board of Directors has approved a seasoned equity offering (SEO). The discussions regarding the new investment opportunities and the equity offering have been kept quiet until a positive set of financial statements 1 2 can provide strong evidence that the company has turned around, leading to an increase in the company's stock price. INTRODUCTION After a full week of carefully examining financial statements, Simon was exhausted. He had become Frosty Co.'s corporate controller only a month ago, after several years as an auditor at a public accounting firm, and was excited about the move to corporate accounting. The first few weeks had gone well, as Simon met his accounting staff and settled into his new responsibilities. Then, he had started reviewing Frosty Co.'s financial statements for the prior year to make sure they correctly followed IFRS, and to familiarize himself more with the company and industry. Unfortunately, his relative inexperience with the industry and Frosty's accounting procedures had required him to spend more time on the review than he had anticipated. He still had a few questions about the financial statements, but he needed to start preparing for the upcoming SEO. He decided that he would talk to his staff about his lingering questions tomorrow morning, just before his meeting with the CEO and CFO. The three of them were to discuss the upcoming audit and the earnings announcement and how they would impact the proposed SEO. He rubbed his tired eyes and headed home to get a little sleep. MEETING OF THE ACCOUNTING STAFF: 10:30AM Simon looked up as the divisional controllers, Elsa Pilebody and John Mortenson, came into his office. Elsa worked with Frosty Co.'s fridge and freezer division; John worked with the ice maker and snow cone machine division. So far, Simon had enjoyed working with them, especially since neither of them seemed to resent him stepping in as their new boss. They were both smiling as they came through the door, and their good-natured teasing started almost before they had finished shaking hands. ''Sorry we're a little late,'' Elsa started, ''but John had to stop for the last jelly donut.'' ''I did not!'' John said indignantly. He looked at Simon. ''It was chocolate.'' Because of his busy schedule that day, Simon got down to business instead of joining the banter as he normally would have done. ''Thanks for coming by, Elsa and John. We have several issues to discuss before I have to meet with Jane and Doug this afternoon.'' He paused for a second. ''I've spent the past week going over the financial statements. Overall, they look well done, but I need clarification on a few details. To start with, I want to discuss the construction project we began last year.'' ''That's our big project at the moment. We're building a new factory that should be done next summer,'' Elsa said. ''Construction is going well, and we've been careful to capitalize all of the expenditures.'' Simon shook his head. ''That's the problem. I think we capitalized more than we should have. More specifically, it looks like we capitalized all of the interest on our most recent bank loan.'' ''We did,'' Elsa replied. ''Since we're using all of the loan proceeds to build the new factory, we felt it was appropriate to capitalize all of the interest.'' John nodded in agreement. ''I disagree,'' said Simon. ''Here's a breakdown of the payments we made on our new building and a list of our outstanding long-term debt (see Table 1). Did we take out any of these loans specifically for the new factory?'' Elsa shook her head. ''No, we took out the new loan, Loan 2, for general expansion, then decided the most appropriate use of the funds would be for the new factory.'' Simon frowned. ''Why are we capitalizing the interest on Loan 2 if it wasn't originated specifically for the new factory?'' 3 TABLE 1 Avoidable Interest Information Panel A: Construction Payments on the New Factory Payment Date Amount Feb. 15 Apr. 1 Jun. 30 Oct. 1 Nov. 15 $90,000 $125,000 $200,000 $300,000 $585,000 Panel B: Long-Term Debt Information Type of Debt Bond A Loan 1 Loan 2 Amount Interest Rate $678,500 $650,000 $1,000,000 7.1% 6.0% 7.0% ''Well, if the capital from the loan is eventually used on a specific construction project, then I think we should be able to capitalize the interest on that loan as part of the historical cost of the project. Of course,'' Elsa frowned, ''maybe we are capitalizing too much. Perhaps we need to calculate avoidable interest to determine the amount of interest that should be capitalized.'' ''You are right that generally we would need to calculate avoidable interest before capitalizing any interest,'' Simon answered. ''But in this case, we don't need to do that. I believe IFRS allows interest to be capitalized only if a specific construction loan is used.'' ''Well, I still think that we should be able to capitalize at least some of the interest. But I'll do some research to make sure.'' ''You said that you had questions about other things, too?'' John asked. ''Yes,'' Simon said. ''I am curious about one other issue. This year, we introduced a new line of industrial snow cone machines.'' ''Yes, we did,'' John replied quickly. ''And we were very careful with all of the sales and expense transactions.'' ''Yes, you were, but didn't the new model replace an older version?'' ''Yes,'' John replied, and then frowned. ''The first model was replaced because of some slight design problems. It worked well, but the customers didn't like the way it looked or sounded. We shouldn't have any liability issues because of those old machines.'' ''I'm not worried about warranty or liability issues. I believe those have been properly recorded. However, we still have some of those original units in inventory, right?'' ''Only a few dozen, I believe. Is that a problem?'' ''It is since we still have those units recorded at their original historical cost. Now that we have a new model, the value of those old machines has probably dropped significantly.'' Elsa nodded. ''That's a good point. Who would buy the old version now that a newer version is available? We probably need to write down that inventory.'' John sighed. ''Okay, but to do the calculations, I'll need some data about current sales price, replacement values, and disposal costs.'' Simon handed John a table (see Table 2). ''I called the production and sales departments this morning and got everything you need.'' 4 TABLE 2 Inventory Information (Snow Cone Machine WQ-567) Current Sales Price Historical Cost Replacement Cost Disposal Cost Typical Markup Units in Inventory Estimate 1 Estimate 2 $750 $850 $700 $65 $200 62 $600 $850 $500 $70 $175 62 John studied the table for a minute. ''There are two sets of estimates here.'' Simon nodded. ''I'm afraid so. The two managers couldn't agree on the estimates. The first set comes from Todd, the sales manager. The second set comes from Nate, the line manager for the snow cone machine line. My guess is that Nate has a better feel for the production costs involved, but Todd's estimates of the current sales price are probably more accurate.'' Frowning even more, John said, ''Nate's estimates will probably require a larger write-down.'' ''Which will be a harder sell to the management team,'' Elsa said. ''They really want to report strong financial statements for the stock offering.'' ''I know, but I don't think we should base our decision on which estimates provide a smaller write-down,'' Simon cautioned. ''If we are going to write down inventory, then we need to use the most accurate estimates. However, in order to decide which set of estimates to use, I think we will need to see the results from each set. I'm sorry, John, but I need you to do the calculations twice.'' John nodded. ''Well,'' Simon said. ''Those were my questions. Do either of you have any concerns we need to discuss before I meet with Jane and Doug?'' Elsa had a pensive look on her face. ''I think we need to consider recognizing an asset retirement obligation, or ARO, for the new factory. Our lease agreement with the city states that we will clean up the land, if necessary, when we close down the factory. When we originally prepared the financial statements, we didn't have enough information to estimate the ARO, so we only disclosed the requirement in the footnotes.'' ''I saw that,'' Simon replied. ''It looked like the note was well done.'' ''Thanks. However, last week we received a letter from the city. It seems that city officials recently hired an engineer with quite a bit of experience cleaning up after factories like ours. She believes there is a 70-75 percent chance that we will have to clean up the land at the end of our lease, and she sent us a letter including her estimate of the future cost. She wanted to make sure that we were prepared to handle those costs when our lease runs out in 20 years. ''When I first got the letter, I decided that since it arrived after the close of the fiscal year, we could wait and record it this year. However, if we're going to go back and change the amount of interest capitalized on the factory, shouldn't we also record the associated ARO?'' Simon thought for a moment. ''I don't know. We did receive the information before releasing our financial statements, but there's only a 70-75 percent chance that we will actually have an obligation. Do we need to include that estimate?'' ''Do you remember how much it was?'' John asked. Elsa nodded. ''The city engineer believes it will cost $500,000 just to tear down the factory in 20 years.'' 5 ''Well, when you consider our 12 percent internal rate of return, the ARO won't be too big,'' John said, smiling. ''You're right.'' Elsa nodded. ''That part doesn't sound too bad. However, she also estimates that we will need to spend approximately $250,000 a year for the three years after removing the plant to restore the land to its original condition.'' ''Thanks for bringing that up, Elsa,'' Simon said. ''Do you have any other concerns?'' ''Just one,'' John said, ''and it's only an idea that you might want to pitch to the management team along with these other changes. We have used the percent of accounts receivable method to calculate our Allowance for Bad Debt for several years. But we don't have to use that method.'' ''What do you mean?'' Elsa asked. ''Isn't the percent of accounts receivable method one of the best ways to calculate the Allowance?'' ''Technically, yes, it is. However, we recently hired a new credit manager who has improved our collections and tightened our credit policy for new customers. Because of these improvements, we might not have to use the percent of accounts receivable method. Instead, we could switch back to the percent of sales method that we used previously. By switching from using 12 percent of accounts receivable to 2 percent of credit sales, we would reduce our allowance for bad debts and our bad debt expense. That would offset some of these negative changes we have just discussed.'' ''What were credit sales for the year?'' Simon asked. ''About $1.25 million, and accounts receivable had an ending balance of $600,000 after we wrote off $30,000 of uncollectible accounts. We wrote off almost $50,000 the year before, so our collections really have improved. Honestly, I don't think that we'd lose information quality by switching methods. We don't really have to use any specific method for estimating bad debt expense. I think we could make a case for the more relaxed estimation method, and I think the positive effect of the change on net income might help the management team accept some of these other adjustments.'' Elsa jumped in. ''I don't see any problem with that.'' Simon frowned. ''I'm not sure I like the idea of changing methods solely to offset the negative effects of these other adjustments. But go ahead and calculate how switching methods would affect our bad debt expense. We'll meet again tomorrow morning, after I've talked with Jane and Doug about how to handle these issues.'' MEETING WITH THE CEO AND CFO: 2:00PM Jane, Frosty Co.'s CEO, shook Simon's hand as she welcomed him into her office. Doug, the CFO, was already seated. ''So, how do things look?'' Jane asked as Simon took his seat. ''Well,'' said Simon, as he handed out copies of the financial statements (see Tables 3-5).1 ''I think the financial statements will be ready for our audit and our earnings announcement on schedule.'' Jane frowned as she flipped through the statements. ''That's great, Simon, but how do things look?'' Simon looked confused, so Doug explained. ''I think Jane wants to know the final EPS.'' Doug glanced quickly at the financial statements, then turned to Jane and said, ''It looks like EPS will be $2.21. That's five cents higher than the analysts' $2.16 forecast.'' ''Well,'' Simon said slowly. ''Perfect!'' Jane said brightly, ignoring him. ''That's just what I wanted to hear!'' ''But . . .'' Simon tried again. 6 TABLE 3 Statement of Profit or Loss Frosty Co. Statement of Profit or Loss For the Year Ended December 31, Year 2 Revenue Sales Revenue Less: Sales Discounts Sales Returns and Allowances Net Sales Revenue Cost of Goods Sold Inventory, Dec. 31, Year 1 Purchases Less: Purchase Discounts Purchase Returns Purchase Allowances Net Purchases Freight In $4,452,300 $44,523 $25,000 $69,523 $4,382,777 $495,600 $1,850,000 $37,000 $92,500 $18,500 $1,702,000 $61,500 Cost of Merchandise Available for Sale Less: Inventory, Dec. 31, Year 2 $1,763,500 $2,259,100 $775,000 Cost of Goods Sold $1,484,100 Gross Profit Operating Activities Advertising Expense Bad Debt Expense Depreciation Expense Insurance Expense Miscellaneous Expense Supplies Expense Utilities Expense Wages Expense Warranty Expense $2,898,677 $445,230 $62,000 $782,500 $92,000 $97,205 $52,450 $97,800 $355,000 $39,950 Total Operating Expenses Income from Operations Other Income and Expenses Rent Revenue Interest Expense Loss on Sale of Machinery $2,024,135 $874,542 $70,000 ($87,174) ($67,500) ($84,674) Income before Income Taxes Income Tax Expense (30%) $789,868 ($236,960) Net Income (Loss) for Year 2 $552,908 Basic Earnings per share (EPS) (250,000 shares outstanding) $2.21 7 TABLE 4 Statement of Financial Position Frosty Co. Statement of Financial Position As of December 31, Year 1, and December 31, Year 2 Assets Current Assets Cash Accounts Receivable (Allowance for Doubtful Accounts) Inventory Prepaid Advertising Prepaid Insurance Total Current Assets Year 2 Year 1 $85,050 $600,000 ($72,000) $775,000 $90,000 $25,000 $75,000 $350,000 ($40,000) $495,600 $105,000 $45,000 $1,503,050 $1,030,600 $1,250,000 $8,870,000 $11,000,000 ($7,582,500) $1,250,000 $7,500,000 $10,500,000 ($6,800,000) Total PPE Intangible Assets Goodwill $13,537,500 $12,450,000 $3,250,000 $3,250,000 Total Assets $18,290,550 $16,730,600 $433,659 $186,390 $60,000 $77,193 $325,000 $750,000 $57,500 $40,000 $52,000 $255,000 $1,082,242 $1,154,500 $1,650,000 $678,500 $650,000 $678,500 $2,328,500 $1,328,500 $3,410,742 $2,483,000 $5,104,300 $125,000 ($11,000) $9,661,508 $5,000,000 $50,000 ($11,000) $9,208,600 PPE Land Building Machinery (Accum Depr) Liabilities and Stockholder's Equity Current Liabilities Accounts Payable Income Tax Payable Interest Payable Other Payables Unearned Sales Revenue Total Current Liabilities Long-Term Debt Loans Payable Bonds Payable Total Long-Term Liabilities Total Liabilities Stockholders' Equity Share Premium Share Capital Treasury Stock ($11 par; 1,000 shares) Retained Earnings Total Equity $14,879,808 $14,247,600 Total Liabilities and Equity $18,290,550 $16,730,600 8 TABLE 5 Statement of Cash Flows Frosty Co. Statement of Cash Flows For the Year Ended December 31, Year 2 Cash Flows from Operating Activities Net Income Adjustments to Accrual-Basis Net Income Increase in Accounts Receivable, net Increase in Unearned Revenue Increase in Inventory Decrease in Accounts Payable Decrease in Prepaid Advertising Depreciation Decrease in Prepaid Insurance Increase in Interest Payable Increase in Other Payables Loss on Sale Increase in Income Tax Payable Net Cash Flows from Operating Activities Cash Flows from Investing Activities Sale of Machinery Purchase of Machinery Construction of Building Net Cash Flows from Investing Activities Cash Flows from Financing Activities Cash from Sale of Stock Cash from New Loan Cash Paid as Dividends Net Cash Flows from Financing Activities $552,908 ($218,000) $70,000 ($279,400) ($316,341) $15,000 $782,500 $20,000 $20,000 $25,193 $67,500 $128,890 $315,342 $868,250 $477,500 ($1,065,000) ($1,350,000) ($1,937,500) $179,300 $1,000,000 ($100,000) $1,079,300 Net Increase in Cash and Cash Equivalents Cash and Cash Equivalents at Beginning of Period $10,050 $75,000 Cash and Cash Equivalents at End of Period $85,050 ''Right,'' Doug agreed. ''Let's go ahead and announce the SEO right away.'' ''Good idea,'' Jane said, nodding. ''There's no reason to wait if we've got good news.'' ''Excuse me,'' Simon jumped in. ''But that might be a little premature.'' Jane looked at him. ''Why?'' ''Well, I do have a couple of issues I need to discuss with you.'' Doug and Jane both frowned. ''What do you mean?'' Doug asked slowly. Simon sat forward. ''I met with my team this morning, and we think there may be a few corrections that need to be made to this draft of the financial statements.'' ''I thought you said they were done,'' Jane snapped. Doug held up his hands. ''Jane, don't shoot the messenger. It's Simon's job to look through the financial statements for any problems.'' 9 Jane took a deep breath. ''You're right.'' She sighed. ''I'm sorry, Simon. What have you found?'' Simon took a deep breath. ''First, we capitalized all of the interest on our new loan as part of our construction project. According to IFRS, we might be able to capitalize some of that interest, but certainly not all of it. Second, officials from the city where the new factory is being built have provided us with fairly accurate estimates of what we will need to spend to remove the factory and clean up the land when our lease expires. Since we haven't released the financial statements yet, we may need to record the ARO.'' Jane grimaced, but Simon pushed on. ''Third, we haven't written down any of our obsolete inventory following the introduction of the new snow cone machine line, and we know that our customers aren't going to buy the earlier model at the original price. We're still looking into how much the write-down will be, but we will need to write down some of it.'' Jane asked quietly, ''Are you finished?'' ''Those are the issues we've identified. I'm not sure what the net effect of the changes will be yet, but I'm afraid that they might drop EPS quite a bit.'' ''But . . .'' Jane said hotly. Doug jumped in. ''Look, Simon, I know you want to correctly account for all of these issues; I do too, but we need a strong set of financials this year. We're counting on that SEO to fund our new growth strategies. We need the good news now, so leave the statements as they are. We'll fix all of these issues after the offering, I promise.'' Simon said quietly, ''I think we need to make these adjustments, all of them.'' He looked at Jane's angry face. ''There is a way to reduce the drop in EPS. We could switch our method of calculating bad debt expense from the percent of accounts receivable method to the percent of credit sales method.'' Jane played with her earring while she thought. ''Would switching methods offset the other adjustments?'' Simon shook his head. ''Probably not entirely, but it will help.'' Jane shook her head. ''Simon, just leave the financial statements as they are.'' Simon started to argue, but Jane cut him off. ''Look, Simon, the decision is mine to make, and I'm telling you: don't mess with the financial statements. Leave them as they are!'' ''But the statements are wrong as they are!'' ''We don't know that,'' Doug jumped in quickly. ''All we really know is that maybe we should do something about these issues. Think about the inventory adjustment for a minute. Companies leave obsolete inventory on their books all the time, waiting for a good year to write them down. It doesn't really bother anyone. And as far as the interest capitalization, if the auditors don't catch it . . .'' ''But our numbers will be wrong!'' Jane sounded exasperated. ''You don't know that, Simon. There are so many estimates in the financial statements that you can't ever be sure if the numbers are right or wrong. Besides, we owe it to our investors to report good numbers; that's how their investments grow. Believe me, they don't want to see bad numbers. So, if the auditors happen to stumble on these issues.. . .'' She stopped for a moment, looking at Simon's face. ''If the auditors stumble on them, send them to talk to Doug or to me. We'll straighten them out.'' She smiled. ''Don't worry about this so much. Just leave things as they are, and we'll take care of you when bonuses come out. The Board's going to be thrilled to see these financial statements, and we'll be sure to tell them how much you helped us get ready for the SEO. We're always happy to reward . . . team players.'' Doug nodded. ''I think that's everything for today. Thank you for all of your hard work.'' Simon stood, picked up his papers, and headed for the door. When they had hired him, he had been excited for a new opportunity. But now, he was starting to wonder if he should have stayed in public accounting. 10 CASE REQUIREMENTS 1. Capitalizing interest on the new factory: a. During the year, Frosty Co. paid all of the interest accrued on Bond A and Loan 1, but only $50,000 of the interest accrued on Loan 2. Using one journal entry, summarize how Frosty originally recorded the accrued interest on all three long-term debts. b. Assuming John and Elsa are right that the new loan meets the standards for capitalizing interest, calculate avoidable interest expense. c. What correcting entries would need to be made to properly record interest on Frosty Co.'s construction project if John and Elsa are right? (Hint: Assume that Frosty Co.'s income tax rate is 30 percent. Any necessary changes to taxes should be recorded to Income Tax Expense and Income Tax Payable.) d. What correcting entries would need to be made to properly record interest on Frosty Co.'s construction project if Simon is right? e. What would be the net effect of each of these interest adjustments on net income? What would be the net effect on EPS? 2. Recording the asset retirement obligation (ARO) on the new plant: a. Assuming that payments will be made at the end of each year, determine the amount that Frosty Co. should recognize for the ARO. b. Assuming Frosty Co.'s management team decides to record the ARO, what correcting entries would need to be made? c. What would be the net effect of the ARO adjustment on the current year's net income? What would be the net effect on EPS? 3. Recording the write-down on obsolete inventory: a. Based on the information provided in Table 2, calculate the write-down that would be necessary using the first set of assumptions. b. Based on the information provided in Table 2, calculate the write-down that would be necessary using the second set of assumptions. c. Assuming that Frosty Co.'s management team decided to use the first set of estimates, what correcting entries would need to be made to write down inventory? (Assume that Frosty Co. uses the direct write-off method.) d. What correcting entries would need to be made to write down inventory if the team decided to use the second set of estimates? e. What would be the net effect of each of these inventory adjustments on net income? What would be the net effect on EPS? 4. Recording the change from the percentage of sales to the percentage of accounts receivable method of calculating bad debt expense: a. Calculate the amount of bad debt expense Frosty Co. would recognize using the percentage of sales method. b. Assuming that the management team has decided to switch from the percent of accounts receivable method to the percent of sales method for estimating bad debt expense, what correcting entries would need to be made? c. What would be the net effect of this change in method on net income? What would be the net effect on EPS? 5. Evaluating each adjustment: a. Based on the accounting standards, can Frosty Co. capitalize the interest on the construction project? If so, how much can Frosty Co. capitalize? Explain. b. Based on the accounting standards, does Frosty Co. need to recognize the ARO in these financial statements? Explain. 11 c. Based on the discussion in the case, which set of lower of cost or market assumptions for inventory do you think is the most appropriate? Explain. d. Do you think that Frosty Co. should switch methods of calculating bad debt expense? Explain. 6. Updating Frosty Co.'s financial statements: a. Based on the correcting entries you made in Questions 1-4 and your answers to Question 5, make any necessary changes to Frosty Co.'s statement of profit or loss (see Table 3). Your new statement of profit or loss should include four simple footnotes summarizing how you chose to treat each of the four adjustments. b. Based on your correcting entries and your changes to the statement of profit or loss, make any necessary changes to Frosty Co.'s statement of financial position (see Table 4). c. If necessary, update Frosty Co.'s statement of cash flows (see Table 5). 7. Analyzing the consequences of your adjustments (round your ratio values to three decimal places): a. Calculate Frosty Co.'s EPS, Current Ratio, Profit Margin, ROA, and Debt to Equity Ratio using the original financial statements. b. Recalculate the ratios using your adjusted financial statements from Question 6. c. Which set of financial statements do you think the management team would prefer? Which set would Frosty Co.'s investors prefer? Defend your answers