Marathon Petroleum Inc. commenced operations on January 2, 2018, and has a year-end of December 31. It operates an oil refinery located on the Seaway and a chain of 36 gasoline stations in eastern Canada. It is privately owned and reports under IFRS. The refinery supplies gasoline and home heating oil retailers as well as all the gasoline stations it owns. Most of the capital came from a single bond issue due January 2, 2028, (10-year, $200 million face value, 6% coupon, issued to yield 8%) on which interest is paid semi-annually, and through shares issued to the owners ($40 million). A 7% note payable for $40 million to a bank was also issued in 2018, due in May 2020. Retained earnings was $15 million as at December 31, 2018, and no dividends were paid in 2018.
You work for a mid-sized CPA firm in Toronto and have been asked by a partner to look into the accounting by Marathon’s accounting team. The controller, Tom Tesarski, CPA, is concerned about the loan covenants included on the debt issue and whether the financial results for the 2019 fiscal year will fall short of their requirements. Specifically, it requires that, beginning with the fiscal year ended December 31, 2019, the following loan covenants need to be met:

The long-term debt-to-equity ratio must not exceed 4:1.

Times interest earned must exceed 2 times.

The draft 2019 earnings are an improvement over last year’s: net income after tax was $16 million with $4 million of dividends having been declared and paid.
The following may impact the financial position and 2019 earnings:

Tom mentions that, to simplify matters, he accounted for the bond interest using the straight 6% rate on the $200 million principal amount in 2019. The financial statements for 2018 were audited by your firm and the bond accounting to the end of that year was in accordance with IFRS.

The refinery has a 30-year life starting in 2018. It was expected then that site restoration would cost $75 million and a separate property, plant, and equipment account for this ARO (asset retirement obligation) was set up. A 6% discount rate was used to value the related ARO. At the beginning of 2019, an external geo-technical evaluation showed that the eventual cost will be $90 million. Tom recorded the same amounts for 2019 as for 2018 for interest on the ARO and depreciation, and otherwise did not update any accounting for the ARO in 2019 nor did he include the impact if any from the ARO revaluation.

In December 2019, Marathon obtained an extension on $20 million of the 7% note payable to the bank with a new maturity date in 2021. A contractual arrangement was also made with one of the shareholders to purchase an additional $20 million in shares in April 2020, with the funds being used to pay the remaining $20 million of the 7% bank note in May 2020.

Starting in February 2019, Marathon offered customers the option of buying a prepaid card for gasoline. The cards are loaded with “gasoline dollars” and offer a discount to encourage their popularity and to “lock in” future sales. For $100, a customer can obtain $115 in gas from one of Marathon’s gasoline stations. Tom mentions that he has considered the cash received on sale of the cards as unearned revenue, and then has recognized the revenue as the cards were used to purchase gasoline. The notes made by the audit partner in your 2019 audit file state the proper accounting would be: “When a card is sold, a liability for $115 is recognized; then when the card is used, the retail value of gasoline is credited to revenue. The $15 discount is included in promotion expense.”

Up to December 31, 2019, cards with a retail value (exchangeable for gasoline) of $12 million have been issued and gasoline with a retail value of $6.5 million has been paid for using the cards. It is expected that the remaining amount will be redeemed equally over the next two years to the end of December 2021.

Required

You are a CPA working for a medium-sized CPA firm in Toronto and have been asked by your senior to draft a report to respond to Tom Tesarski’s concerns.