Question

Should Peterson Accounting have relied on the income statement and footnote information provided by Ms. Riveras accountant? Why or why not?

179 CARSON'S INN In 1982, Sophia Ivy obtained her bachelor's degree in Business Administration from California State University, Chino, specializing in the hospitality industry. After working for fifteen years as a manager at the Hilton Hotel in Redwood, Green, Ms. Ivy decided to go on her own and acquire an existing hotel located in Laguna in the state of Green and convert it to a bed and breakfast inn. After locating a suitable hotel, known as Carson's Inn, Ms. Ivy conducted an in-depth study of the market and decided that the hotel possessed an immense potential if it were to become a bed and breakfast inn. She contacted the listing agent of the hotel, Gibson Miller, and obtained preliminary data on the property, including financial statements of the hotel for the past three years. The hotel was listed for sale for $4.5 million. After conducting her own due diligence, Ms. Ivy, Alison Rivera, the hotel owner, and Mr. Miller met on January 5, 2005 and had a preliminary discussion on the purchase and sale of the hotel. Following the meeting, Ms. Rivera called Ms. Ivy and offered her the property for $4.3 million, excluding the furniture. The sale was to conclude following a 45-day escrow. On January 6, 2005, Ms. Ivy faxed Ms. Rivera a letter stating the following: Thank you for offering to sell me the hotel you own, Carson's Inn, located at 3020 Main Avenue, Laguna, Green. I am excited to accept your offer to sell the hotel for $4.3 million, excluding the furniture. However, since it would take me some time to arrange financing, i would like to close escrow within 60 days. I look forward to working with you on this deal. Sincerely, Signed Isi Sophia Ivy The same day, Ms. Ivy contacted a number of lenders to secure financing for the deal. Most lenders that she contacted turned her down due to her poor credit record and lack of business ownership experience. However, on January 30, 2005, she managed to obtain a financing commitment from one lender. It was a sixty-day firm commercial loan commitment from Interstate Bank. The loan commitment required that Interstate Bank would obtain a first priority lien on the hotel property, as well as on an unrelated undeveloped parcel of land that Ms. Ivy owned in Lagoon Beach, Green. Ms. Ivy had acquired the land in Lagoon Beach in 1984 and had managed to pay off the mortgage on that property on November 1, 2004. However, the lender on the Lagoon Beach property, Bank of Land, had failed to remove the lien it had on that property despite the language in the deed of trust requiring it to promptly record a reconveyance of its lien on the property upon payment in full of the underlying loan. For the next sixty days following her faxed response, Ms. Ivy vigorously attempted to get Bank of Land to remove its lien on the Lagoon Beach property, but to no avail. She specifically mentioned to a number of officers at the bank that she would need Bank of Land to reconvey the lien on her Lagoon Beach property as soon as possible so that she could pledge the property as collateral for a new loan she was in the process of obtaining to finance a hotel acquisition. Despite repeated assurances from various officers at Bank of Land, no one at Bank of Land initiated and In most states, lenders typically use the deed of trust as the mechanism for holding a security interest in real property. In a deed of trust transaction, the borrower deeds to the trustee the property that is to be put up as security for the mortgage obtained from the lender. The trust agreement usually gives the trustee the right to foreclose or sell the property if the debtor fails to make a required payment on the debt. However, under the typical "reconveyance clause" in a deed of trust, upon full repayment of the debt, the lender must request the trustee to promptly reconvey the property and release any liens on it too. 1 followed up on the processing of the reconveyance request. The failure resulted due to the various internal turnovers in Bank of Land. To further her chances of obtaining a loan from the Interstate Bank (and to try and persuade them to lend the money without a lien on the vacant land,) Ms. Ivy contracted for an appraisal report from an independent company. Ms. Ivy hired Peterson Accounting to prepare an appraisal using techniques that banks generally employ to determine the loan value of small hotels. Unfortunately, that valuation did not result in enough loan value to justify the hotel property as the sole collateral on the loan. Hence, to obtain the loan from Interstate Bank, she still needed clear title to the vacant land. On March 28, 2005, following the sixtieth day, Interstate Bank informed Ms. Ivy that its previous loan commitment of sixty days had expired. Ms. Ivy desperately attempted to obtain alternative financing, but was unable to locate another loan. Hoping to get extra time, Ms. Ivy contacted Ms. Rivera and Mr. Miller and asked for a thirty days extension for the consummation of the deal. Mr. Miller then informed Ms. Ivy that Ms. Rivera had already entered into a sale agreement with another buyer and hence the property was no longer available for sale. Not giving up on her dream of owning a bed and breakfast Inn, Ms. Ivy located another hotel, similarly situated, that was virtually identical to the one she pursued previously. Later in 2005, Ms. Ivy acquired it for $4.7 million, excluding the furniture. Ms. Ivy is now seeking a recovery for her damages of lost opportunity to acquire the first Laguna hotel. She is suing her former mortgage lender, Bank of Land, for negligent failure to promptly remove the lien on her Lagoon Beach property. Required Your company, is handling Ms. Ivy's lawsuit. Your team has been charged with writing a report for your company. Use the report writing guide from the course website. In answering this case, please review financial accounting LDC concepts 6 (valuation), 5 (cash flow analysis) and 7 time value of money); statistics concept 5; and business law concepts 1, 2, and 10. CARSON'S INN INCOME STATEMENT For the years ended December 31, 2004 2003 2002 Rental Revenue Other Revenues (note 1) Total Revenues $892,513 212,432 $1,104,945 $796,500 183,195 $979,695 $759,656 171,923 $931,579 Cost of Revenue (note 2) Gross Profit Marketing General and Administrative (note 3) Operating Income 441,978 $662,967 110,495 287,286 $265,187 411,472 $568,223 97,970 254,721 $215,533 419,211 $512,368 93,158 242,211 $177,000 Notes to Income Statement Note 1: Other Revenues Other revenues consist of charges to guests for charges for other goods and services. Note 2: Cost of Revenue Cost of revenue includes all payroll related costs of employees; depreciation on the property, improvements, and furniture; linen service charges; utilities; and bed taxes. Depreciation in cost of revenue 2004 2003 2002 Building (40 year life, Straight line) $50,000 $50,000 $50,000 Property Improvements (various) 72,000 68,500 65,000 Furniture (5 year life, Straight line) 88,000 82,000 82,000 Note 3: General and Administrative Expenses General and administrative expenses do not include a salary for S. Rivera, the owner of the hotel, since this is a sole proprietorship and not a corporation. Ms. Rivera took drawings of $75,000 in 2004; $72,000 in 2003; and $70,000 in 2002 in addition to the expenses listed above. These amounts approximate what a manager would be paid. General and administrative expenses also include depreciation on equipment of $22,000 in 2004; $23,000 in 2003, and $27,000 in 2002. 179 CARSON'S INN In 1982, Sophia Ivy obtained her bachelor's degree in Business Administration from California State University, Chino, specializing in the hospitality industry. After working for fifteen years as a manager at the Hilton Hotel in Redwood, Green, Ms. Ivy decided to go on her own and acquire an existing hotel located in Laguna in the state of Green and convert it to a bed and breakfast inn. After locating a suitable hotel, known as Carson's Inn, Ms. Ivy conducted an in-depth study of the market and decided that the hotel possessed an immense potential if it were to become a bed and breakfast inn. She contacted the listing agent of the hotel, Gibson Miller, and obtained preliminary data on the property, including financial statements of the hotel for the past three years. The hotel was listed for sale for $4.5 million. After conducting her own due diligence, Ms. Ivy, Alison Rivera, the hotel owner, and Mr. Miller met on January 5, 2005 and had a preliminary discussion on the purchase and sale of the hotel. Following the meeting, Ms. Rivera called Ms. Ivy and offered her the property for $4.3 million, excluding the furniture. The sale was to conclude following a 45-day escrow. On January 6, 2005, Ms. Ivy faxed Ms. Rivera a letter stating the following: Thank you for offering to sell me the hotel you own, Carson's Inn, located at 3020 Main Avenue, Laguna, Green. I am excited to accept your offer to sell the hotel for $4.3 million, excluding the furniture. However, since it would take me some time to arrange financing, i would like to close escrow within 60 days. I look forward to working with you on this deal. Sincerely, Signed Isi Sophia Ivy The same day, Ms. Ivy contacted a number of lenders to secure financing for the deal. Most lenders that she contacted turned her down due to her poor credit record and lack of business ownership experience. However, on January 30, 2005, she managed to obtain a financing commitment from one lender. It was a sixty-day firm commercial loan commitment from Interstate Bank. The loan commitment required that Interstate Bank would obtain a first priority lien on the hotel property, as well as on an unrelated undeveloped parcel of land that Ms. Ivy owned in Lagoon Beach, Green. Ms. Ivy had acquired the land in Lagoon Beach in 1984 and had managed to pay off the mortgage on that property on November 1, 2004. However, the lender on the Lagoon Beach property, Bank of Land, had failed to remove the lien it had on that property despite the language in the deed of trust requiring it to promptly record a reconveyance of its lien on the property upon payment in full of the underlying loan. For the next sixty days following her faxed response, Ms. Ivy vigorously attempted to get Bank of Land to remove its lien on the Lagoon Beach property, but to no avail. She specifically mentioned to a number of officers at the bank that she would need Bank of Land to reconvey the lien on her Lagoon Beach property as soon as possible so that she could pledge the property as collateral for a new loan she was in the process of obtaining to finance a hotel acquisition. Despite repeated assurances from various officers at Bank of Land, no one at Bank of Land initiated and In most states, lenders typically use the deed of trust as the mechanism for holding a security interest in real property. In a deed of trust transaction, the borrower deeds to the trustee the property that is to be put up as security for the mortgage obtained from the lender. The trust agreement usually gives the trustee the right to foreclose or sell the property if the debtor fails to make a required payment on the debt. However, under the typical "reconveyance clause" in a deed of trust, upon full repayment of the debt, the lender must request the trustee to promptly reconvey the property and release any liens on it too. 1 followed up on the processing of the reconveyance request. The failure resulted due to the various internal turnovers in Bank of Land. To further her chances of obtaining a loan from the Interstate Bank (and to try and persuade them to lend the money without a lien on the vacant land,) Ms. Ivy contracted for an appraisal report from an independent company. Ms. Ivy hired Peterson Accounting to prepare an appraisal using techniques that banks generally employ to determine the loan value of small hotels. Unfortunately, that valuation did not result in enough loan value to justify the hotel property as the sole collateral on the loan. Hence, to obtain the loan from Interstate Bank, she still needed clear title to the vacant land. On March 28, 2005, following the sixtieth day, Interstate Bank informed Ms. Ivy that its previous loan commitment of sixty days had expired. Ms. Ivy desperately attempted to obtain alternative financing, but was unable to locate another loan. Hoping to get extra time, Ms. Ivy contacted Ms. Rivera and Mr. Miller and asked for a thirty days extension for the consummation of the deal. Mr. Miller then informed Ms. Ivy that Ms. Rivera had already entered into a sale agreement with another buyer and hence the property was no longer available for sale. Not giving up on her dream of owning a bed and breakfast Inn, Ms. Ivy located another hotel, similarly situated, that was virtually identical to the one she pursued previously. Later in 2005, Ms. Ivy acquired it for $4.7 million, excluding the furniture. Ms. Ivy is now seeking a recovery for her damages of lost opportunity to acquire the first Laguna hotel. She is suing her former mortgage lender, Bank of Land, for negligent failure to promptly remove the lien on her Lagoon Beach property. Required Your company, is handling Ms. Ivy's lawsuit. Your team has been charged with writing a report for your company. Use the report writing guide from the course website. In answering this case, please review financial accounting LDC concepts 6 (valuation), 5 (cash flow analysis) and 7 time value of money); statistics concept 5; and business law concepts 1, 2, and 10. CARSON'S INN INCOME STATEMENT For the years ended December 31, 2004 2003 2002 Rental Revenue Other Revenues (note 1) Total Revenues $892,513 212,432 $1,104,945 $796,500 183,195 $979,695 $759,656 171,923 $931,579 Cost of Revenue (note 2) Gross Profit Marketing General and Administrative (note 3) Operating Income 441,978 $662,967 110,495 287,286 $265,187 411,472 $568,223 97,970 254,721 $215,533 419,211 $512,368 93,158 242,211 $177,000 Notes to Income Statement Note 1: Other Revenues Other revenues consist of charges to guests for charges for other goods and services. Note 2: Cost of Revenue Cost of revenue includes all payroll related costs of employees; depreciation on the property, improvements, and furniture; linen service charges; utilities; and bed taxes. Depreciation in cost of revenue 2004 2003 2002 Building (40 year life, Straight line) $50,000 $50,000 $50,000 Property Improvements (various) 72,000 68,500 65,000 Furniture (5 year life, Straight line) 88,000 82,000 82,000 Note 3: General and Administrative Expenses General and administrative expenses do not include a salary for S. Rivera, the owner of the hotel, since this is a sole proprietorship and not a corporation. Ms. Rivera took drawings of $75,000 in 2004; $72,000 in 2003; and $70,000 in 2002 in addition to the expenses listed above. These amounts approximate what a manager would be paid. General and administrative expenses also include depreciation on equipment of $22,000 in 2004; $23,000 in 2003, and $27,000 in 2002