^ WITH THE SCENARIO IN QUESTION 3 SPECIFICALLY (allowance for bad debt)

Question: Big Lots Stores Limited (Big Lots) is a chain of retail stores across Canada. Big Lots sells a wide range of kitchen and hardware items, cleaning supplies and seasonal items that it obtains from major manufacturers and wholesalers. Big Lots' strategy has long been to deliver value and help shoppers save time by offering everyday products with low prices and good value in convenient neighborhood location. The company is wholly owned by Sanjay and Priyanka Chowdry, who founded it many years ago. In recent years, the Chowdrys have not been involved in managing the company but have hired professional managers. The Chowdrys currently live in Bermuda and rely on the cash flow generated by Big Lots to live on. A year ago, the Chowdrys hired Joseph Wan as the chief executive officer of the company to help turn the company around after a number of unprofitable years. At the time Joseph was hired, the Chowdrys were worried that Big Lots would go bankrupt and they would lose their main source of income. Joseph was well known as an excellent manager, and the Chowdrys were prepared to pay for someone who could reverse the current financial status of their business. The Chowdrys agreed to pay Joseph a salary plus a bonus of 25 percent of net income (in accordance with ASPE) in each year of a three-year contract. Big Lots' tax rate is 40%. In his first year with Big Lots, Joseph made significant improvements in the strategic direction of the business. In addition to adding online shopping and corporate clients, Big Lots new business strategy is to provide customers with a consistent value add shopping experience, offering a broad assortment of national brand-named merchandise, consumables and seasonal items. Products are available in individual or multiple units at low, fixed price points. This allowed Big Lots to compete with large retail chain stores. Joseph estimated that the bonus this year could reach to $45,000. After hiring Joseph, the Chowdrys feel confident about the viability of Big Lots. Joseph has just presented the financial statement for the current year to the Chowdrys for their approval. The Chowdrys are pleased about Big Lots' profitability, but they are concerned about some accounting treatments that appear to have contributed to the significant increase in net income. Here are the items noted below: 3. To attract more customers, Joseph has begun offering credit to specific Corporate customers. At the end of the year, the accounts receivable balance reached $150,000. He has not, however, recorded an allowance for bad debt for the period. He believes there is no need to estimate bad debt expense since he only provides credit to customers that have a long standing relationship with Big Lots and has gone through an extensive credit review and pass with flying colours. The industry averages 10% of ending accounts receivable as an appropriate allowance for doubtful account for this type of industry. You are a CPA who is also a good friend to the Chowdrys. The Chowdrys have come to you for advice on the above accounting issues. They are concerned that Joseph's accounting choices will result in him receiving a bonus that does not reflect his actual performance as CEO and unreasonably reduce the amount of money that the Chowdrys receive from Big Lots. Lastly, the Chowdrys has asked you to suggest three key ratios that should be included in Joseph's performance evaluation. They don't want you to provide the calculation but rather an explanation to why these three should be part of Joseph's bonus calculation. Required: Prepare a report for the Chowdrys providing them with the advice they seek. Please try to follow the format as shown here and in the example (Identity issue, analyze the nature of the issue and implication, provide multiple alternative, finally provide recommendations: Note: Please make every effort to apply the case analysis framework discussed in class. Here are a few suggestions to keep in mind: Please use the following framework: - You need to provide an analysis of users and their strategic objectives. - In analyzing the issues in the case, follow the case analysis approach discussed in class namely the "I/A/A/R" approach to case writing. I= Identify the Issue; A= Analyze why it's an issue; A= Alternatives, if any; and R= Recommendation. - In your recommendation, ensure you clearly indicate your recommendation, discuss the impact of your recommendation to users' needs and objectives and calculate the financial impact, if any. - In the role of the CPA advisor, students must assess each financial reporting issue, recalculate the net income, and estimate the revised bonus payable (if any). Here is an example of a good description of a user and user needs (not related to the case) is included below: Bank of Northern Ontario (BNO) The BNO will use ESL's financial statements to monitor ESL performance and its cash flows as well as any other terms, covenants, or conditions included in the line of credit agreement. Here is a suggested example (not related to the case) in how to apply the I/A/A/R approach to case analysis: Analysis of the Financial Accounting Issues Initial Franchise Fee Revenue Recognition - Regular Rate Fees Issue: When should the revenue be recognized for the initial franchise fee of $225,000. Analyze the Nature of the Issue and Implication: The recognition of revenue will impact the revenue and net earnings reported in the Ontario and Quebec regions, and therefore, impact Jason's bonus. Alternatives: Alternative I-Recognize 100% of revenue when the franchise agreement is signed - This would be more appropriate for a franchisor with a long history of creating successful franchises. Given that ESL is new in the Ontario and Quebec market, this alternative may be too aggressive. Alternative 2 - Recognize 100% of revenue when the franchise commences operations - Once the operations have commenced, ESL will no longer incur significant costs and there will be less uncertainty about the collectability of future payments. Therefore, it may be appropriate to record revenue once the franchise commences operations. Alternative 3 - Recognize 100% of revenue one-year after the franchise commences operations - Given that ESL is new to the Ontario and Quebec markets, there is some uncertainty about the collectability of the $150,000 payment as there is no past history to suggest how likely a franchisee is to go bankrupt. Therefore, it may be most appropriate to recognize revenue after one year of operations. However, deferring the initial payments may be too conservative. Alternative 4 - Recognize $75,000 when the operations commence and $150,000 one year after - This alternative is based on the rational that the first two payments can be recognized as revenue when received, which will help offset the initial costs incurred to establish the new franchise; however, the remaining payment is deferred until one year after operations commenced given the uncertainty surrounding its collectability. Recommendation - Alternative 2 would be appropriate if ESL had a long, established track record of developing successful franchises or if an analysis of the historical collections of franchises have panned out (i.e., you were able to determine the likelihood of collecting the remaining $150,000 based on similar historical transactions); however, given the lack of historical information, I would recommend alternative 4 as the most appropriate revenue recognition policy for the initial franchise fee. - Alternative 2 would be appropriate if ESL had a long, established track record of developing successful franchises or if an analysis of the historical collections of franchises have panned out (i.e., you were able to determine the likelihood of collecting the remaining $150,000 based on similar historical transactions); however, given the lack of historical information, I would recommend alternative 4 as the most appropriate revenue recognition policy for the initial franchise fee. - It appears that Jason has recorded the initial franchise fee revenue based on alternative one (Ontario 6$225,000=$1,350,000; Quebec 6$225,000=$1,350,000). - Five of the seven locations in Ontario are open, and six of the eight locations in Quebec are open. However, one in Ontario and two in Quebec signed the special, promotional agreement (discussed below). Therefore, there are six locations in Ontario and six in Quebec that have signed the normal agreement. - Therefore, a total initial franchise fee revenue of $900,000(12$75,000 [$50,000+$25,000] should be recognized. The final payment revenue of $150,000 per franchise should be recognized after their first year of operations. - This will result in an adjustment to the revenue and operating income of $1,800,000($2,700,000$900,000)