Sunlight Equipment Manufacturers (SEM) makes barbecue equipment. The company has historically been very profitable; however, in the last year and a half, things have taken a turn for the worse due to higher consumer interest rates and a slowdown in the economy. On its 2011 draft year-end statements, the company is currently showing a break-even position before any final year-end adjustments. The company had fired its CEO, Sam Lazano, at the beginning of the year and a turnaround specialist was hired—Theo Lundstrom. Theo has a reputation of being able to come into companies that are suffering and make them profitable within two years. Theo has agreed with SEM’s board of directors that he will be paid a $1-million bonus if the company has a combined two-year profit of $5 million by the end of 2013. Among other things, Theo instituted a more aggressive sales policy for its customers, who are mainly retailers, as well as a new remuneration policy for sales staff. Theo attributed the company’s poor performance to untrained sales staff whose remuneration and bonus scheme was not properly aligned to maximize sales. Under the new remuneration policy, sales staff is paid salary as well as a bonus, which is a percent of gross sales as at year end. The sales staff has responded well and sales have increased by 20%.
The new sales policy is as follows:
• Cash down payment of 20% with remaining payment for shipment once the barbecues are sold by the customer to a third party.
• If the customers order double their normal order, no down payment is required.
• The barbecues may be stored on the premises of SEM. Many customers have taken the company up on this offer in order to double the size of their purchase.
• Any unsold barbecues are allowed to be returned after year end.
Under the new policy, sales have increased dramatically, with many customers taking advantage of the new terms. As at year end, legal title to all barbecues has passed to the customers. Only customers with excellent credit history have been allowed to purchase under the new policy. The company has accrued bonuses for almost all its sales staff.
The increased profits from these sales have been offset by the accrual of $500,000 of Theo’s bonus. He is very confident that he will be able to turn the company around and so has accrued part of his bonus. He has also decided to change several accounting policies, including the following:
• Depreciation on machinery switched to straight-line from double-declining-balance. Note that the equipment is about 2 years old with an estimated life of 10 years. Theo felt that the double-declining-balance method was arbitrary and noted that several of their competitors used the straight-line method. Machinery is most useful when new since it requires less downtime for fixing.
Another problem that Theo had identified was in inventory management. Theo was convinced that inventory was being stolen and/or “lost” due to poor tracking. The company had therefore hired a company, Software Limited, to install a new inventory tracking system during the year. Midway through the year, Software Limited had gone bankrupt and was not able to finish the installation. The installation was a customized job and as at year end, the system was not functioning yet. SEM has not been able to find a company to replace Software Limited. To date, $2 million has been spent on the new system. Theo had capitalized the costs and noted he was confident that he would be able to find a company that could successfully complete the installation.
Instructions
Adopt the role of the company’s auditors and discuss the financial reporting issues for the 2011 year end. The company is a private company but would like the statements to be prepared in accordance with IFRS.