Part B: Scenario (35 marks 63 minutes) Answer these questions in the Part B tab in Securexam. Modern Furnaces Ltd. (MFL) is a Canadian manufacturer of furnaces and air conditioning units. Jacob is the president and chief executive officer. Over the years, MFL has struggled in the face of increased competition from overseas competitors. The owners believe that three years from now, MFL will be poised to be a major player in the North American heating and cooling markets. Jacob points out that the company's financial performance seems to be improving, given the smaller loss in the most recent fiscal year and the increasing revenues after two years of falling sales. MFL uses ASPE. Your firm has been MFL's auditor for several years. It is now January 20X9. This is the first year you are an audit junior in the audit team. Yesterday, you and Nicole Cusano, the senior auditor for the audit, visited MFL and met with key personnel to discuss the forthcoming audit engagement. You obtained the information in the attached appendixes (Appendix II can be found in the Excel file). Required: Draft a memo to Nicole that includes the following: Identify and discuss alternatives for measuring the warranty liability. Recommend the amount of the liability to record, and draft an adjusting journal entry. For now, assume that the entire liability should be treated as current. Develop some valid audit procedures to obtain evidence about the valuation assertion for the warranty liability. Draft the appropriate journal entry to expense the remaining balance of product development costs, since they no longer meet the criteria for capitalization. Restate the financial statements for the journal entries that you drafted. Calculate the ratios relating to the debt covenant before and after the adjustments, and discuss your findings. Discuss how MFL should account for its new lease arrangements. Appendix I: Notes from discussions with key personnel 1. In early fiscal 20X8, the company increased its debt load significantly by borrowing $300,000 from Colo Investors Ltd. An excerpt from the loan agreement follows: Modern Furnaces Ltd. (the borrower) covenants that: a. A current ratio of 1.2 or higher will be maintained, and b. The debt-to-equity ratio will not exceed 2.0:1. Debt is defined as all liabilities of the company. 2. In 20X3, MFL introduced a new model of gas furnace that was popular with consumers because its reduced gas consumption resulted in lower heating bills. The furnace design has remained virtually unchanged since it was introduced. The furnaces are sold with 10-year warranties on parts and labour. Historically, claims have been minimal. In 20X8, several warranty claims were made against MFL. Routine random inspections by gas company employees revealed cracked heat exchangers, which could leak gases that might cause health and safety problems when mixed with warm air in a home. Thirty claims were made, and MFL paid for repairs. The cost of repairing each furnace was $150, which was expensed by MFL. Other than dealing with the warranty claims, no further actions were taken by MFL to see if there were cracked heat exchangers in other installations of this gas furnace model. Jacob Kovacs believes that the furnaces were damaged because of poor installation by contractors. He does not expect that more than 40 or 50 additional units will need to be repaired. The 30 already repaired furnaces were manufactured in 20X6 and 20X7. Over 10,000 units of this model have been sold over the past five years. Later, in a discussion with Maya Goto, the chief engineer, you learn that she had examined the heat exchanger used in the gas furnace model in question and saw no evidence of a design flaw. However, she expressed concern that the problem might be due to heavy use of the furnace. She noted that the 30 problems were reported in Northern Canada, where the demands on the equipment are considerable. Between 1,500 and 2,000 furnaces were installed in homes in those locations. You asked Maya if she had examined other installations of this gas furnace in other northern locations to see if they had similar problems. She told you that she had made a recommendation to Jacob for MFL to do a random audit of 50 installations in northern locations to see if this was a possible connection. However, Jacob said that would be unwise, since it might raise concerns among customers about the safety and reliability of MFL products. It might also increase warranty repair costs for the current year. 3. MFL began working on a new technology for heating office buildings in early 20X7. Market studies completed in late 20X7 confirmed strong consumer interest in the technology, and the product development costs were properly capitalized at that time. According to management, the project is nearing the end of development, and it is now only a matter of time before it is successfully brought to market. However, Jacob does not think that it will be possible to bring the project to market in the coming fiscal year without additional financing. 4. Starting in February 20X9, MFL will begin offering customers the option of paying a monthly fee for the use of a furnace. At the end of a certain number of years, the customer can purchase the unit for a nominal amount or ask for a replacement furnace and continue with the monthly payments. MFL will perform all maintenance at no cost until a customer purchases the unit. Jacob has asked for advice on how to account for these new lease arrangements. For Appendix II, see the Excel file. Part C: Scenario (35 marks 63 minutes) Answer these questions in the Part C tab in Securexam. It is June 1, 20X9, and you have just met with your friends Richard and Nancy Nickerson. Richard is a nurse at a local hospital and Nancy is a substitute teacher. They are trying to decide whether to proceed with a new business venture and would like your input. Futura Shoes Franchises Ltd. approached the Nickersons to open a women's shoe store and gave them a draft franchise agreement (Appendix I). The Nickersons see this as an opportunity to satisfy Nancy's interest in managing her own business and increase her income. The Nickersons met with two other franchisees to gain some further insight and have provided you with notes on their meetings, as well as other information (Appendix II). Futura also provided earnings projections (Appendix III see the Excel file), but the Nickersons are concerned about whether these projections are reasonable and what level of sales will be required to break even. Nancy has been earning $20,000 a year from part-time teaching. She is concerned that she will not be able to replace her earnings with income from the franchise. She also questions whether they have enough funds to make the initial investment required. The Nickersons have no prior business experience and have engaged a lawyer to review the draft franchise agreement before they sign it, if they decide to proceed. However, the Nickersons would like to know if you have any concerns about the "Accounting" clause so they can discuss them with the lawyer. Richard will be doing the bookkeeping in his spare time and plans to set up an accounting system using Excel. A major concern for him is how to select appropriate tools to monitor performance and safeguard assets. The Nickersons are nervous about the fact that they will have to leave the store in the hands of a salesperson from time to time. Required: Write a report for the Nickersons addressing their concerns. Appendix I: Draft franchise agreement Extracts from draft franchise agreement between Futura Shoes Franchises Ltd. and Richard and Nancy Nickerson 1. Parties Futura Shoes Franchises Ltd., the franchisor, and a company to be incorporated by Richard and Nancy Nickerson, the franchisee. 2. Premises To be leased by the franchisor to the franchisee. The base rent is $50,000 per year. In addition, 2% of total sales must be added to the rent when sales volume is higher than $400,000. 3. Initial Franchise Fee $60,000 payable to the franchisor upon signing the contract. 4. Initial Investment An amount of $150,000 is to be paid by the franchisee to the franchisor by September 1, 20X9, for initial inventory ($110,000) and leasehold improvements ($40,000). 5. Royalty (continuing franchise fee) The franchisee is to pay a monthly royalty of 5% of gross sales plus 10% of the store's operating profit before franchise royalties. 6. Accounting The franchisee is responsible for organizing and maintaining an accounting system and for providing financial information on which the lease and royalty payments will be based. Certified financial statements must be provided to the franchisor no later than two weeks after year end. 7. Advertising The franchisee agrees to spend approximately 1% of sales on local advertising. Appendix II: Other information The franchisor (Futura) has signed a five-year lease, renewable at its option. The store is located just outside Middleville in a large new mall scheduled to open on September 1, 20X9. Leasehold improvements, payable by the franchisee, will cost $40,000. During the first year, the franchise contract requires Futura to give the Nickersons advice on purchasing (for example, recommended styles and sizes) and inventory levels. The franchisee must sell only women's shoes and related products. Except for the initial inventory, which requires an investment of $110,000, purchases do not have to be made from Futura. Shoe purchases average $32 per pair and retail for $64. The representative gave the Nickersons a five-year earnings projection for a typical Futura franchise (Appendix III see the Excel file). The Nickersons thought that the earnings projections were reasonable, but they were unable to estimate how many pairs of shoes would have to be sold to break even or make up for Nancy's income from her current job. Futura has already established 12 franchises. The Nickersons visited two franchisees located in shopping malls serving markets comparable in size to Middleville. Both were very positive about their businesses, although they said that they had taken longer to build up sales than the Futura projections had indicated. One of the franchisees told them that sales in his first year were under $300,000 but were now, in his third year, over $700,000. The other franchisee had sales of $300,000 in the first year, but had not yet achieved $600,000 in his fourth year. Both were enthusiastic about the purchasing/inventory advice provided by the franchisor. Their monthly inventory peak is seldom below $130,000. The Nickersons will pay the initial franchise fee of $60,000 when they sign the contract. They will still have $50,000 of savings available outside their RRSPs; however, they think that they might require even more financing. They discussed the franchise contract with their bank manager, who told them that there should be no problem in lending them the funds they would require. The Nickersons have an excellent credit rating. They own a home that was originally purchased with a mortgage of $240,000. The remaining mortgage on their home is $120,000. For Appendix III, see the Excel file