You have just been appointed financial controller at ABC Company, a manufacturer of specialized equipment used by various manufacturers of consumer products on their own production lines. Your immediate supervisor, the vice-president finance, has indicated that he will be retiring in six months and that you could be in line for his position if you do a good job managing the preparation of the year-end financial statements. He has provided you with the following comments for your consideration during the preparation of these statements:

a. The company is currently being sued for breach-of-contract by one of our largest customers. This case has been ongoing for two years and will likely reach a conclusion next year. Our lawyers have now estimated that it is likely we will lose, and that the award will probably be in the range of $250,000 to $300,000. We have disclosed this previously in our notes, but have not accrued anything. Use the same treatment this year, as the case is not yet completed.

b. We have changed our inventory costing method this year from weighted-average to FIFO. This has resulted in an increase in net income of $115,000. The new method should be identified in the accounting policy note.

c. There are $50,000 worth of customer prepayments included in the Accounts Receivable sub-ledger. The customers have paid these amounts to guarantee their priority in our production cycle, but no work has yet been done on their special orders. We will just net these prepayments against the Accounts Receivable balance and report a single amount on the balance sheet.

d. This year we hired a director of research and development. He has not yet produced any viable products or processes, but he was a top performer at his previous company. We have capitalized the cost of his salary and benefits, as we are confident he will soon be producing a breakthrough product for us.

e. Our bank has put us on warning that our current ratio and debt-to-equity ratio are close to violation of the covenant conditions in our loan agreement. Violations will likely result in an increase in the interest rate the bank charges us. Keep this in mind as you prepare the year-end adjustments.

Required: 

i. Comment on the accounting treatments proposed by the vice-president finance, supporting your discussion with relevant components from the conceptual framework of accounting.

ii. Discuss the impact of item (e) on your work in preparing the year-end financial statements.