Accounting Issues

Subject: Accounting Issues addressed as per ASPE guidelines (Task#1), and Audit Impact due to accounting issues (Task# 2) Issue: Design Contracts OTF creates contracts for clients that include a fee to design the special furniture items. A design process is the creation of customized designs plan for which customers are charged a nonrefundable fee of $1500. If a customer proceeds with the project full amount is credited to their account towards a final invoice. OTF pays the designer about $40/hr to prepare the design, the average plan takes about 10 hours to complete. OTF retains the design plan if a customer decides not to use the work they can pay $500 to purchase a copy of the design. • Out of which, 75% customer proceeds with the designs. • Out of which 15% proceed with the later date. • Out of which half pay $500 fee to obtain a copy. The issue when the customer proceeds with the project, the full credit amount is applied, whereas the credit should only applied when the performance has been satisfied. Hand Book Analysis: As per ASPE 3400.04: Revenue from sales and service transactions shall be recognized when the requirements as to performance are satisfied, provided that at the time of performance ultimate collection is reasonably assured. This condition has not been met, there is a reasonable doubt if customers will even proceed with the design either; at earlier stage or later stage, some customers will not even continue with the design. Collection is not reasonable assured. As per ASPE 3400.05 In a transaction involving the sale of goods, performance shall be regarded as having been achieved when the following conditions have been fulfilled: (a)The seller of the goods has transferred to the buyer the significant risks and rewards of ownership, in that all significant acts have been completed and the seller retains no continuing managerial involvement. This condition has not been met, Furniture must be transferred to the customers in order for this condition to be met, and however customers are already credited even before the ownership of furniture has been transferred. (b) Reasonable assurance exists regarding the measurement of the consideration that will be derived from the sale of goods This condition has not been met, since customers can either proceeds with the project either at earlier or later stage there is no assurance provided to OTF. As per ASPE 3400.16: Revenue from service transactions and long-term contracts is usually recognized as the service or contract activity is performed, using either the percentage of completion method or the completed contract method. This condition has also not been met, customers are charged even before the service is performed by the OTF, measurement of completion is usually not determined even before the credit has been applied to customer’s account. As per ASPE 3400.06: In the case of rendering of services and long-term contracts, performance shall be determined using either the percentage of completion method or the completed contract method, whichever relates the revenue to the work accomplished. This condition has not been met, there is no mechanism to measure if performance has been completed even before the customer’s accounts are credited with $1500 on their invoices. Recommendation: Based on the analysis of revenue recognition criteria, OTF should stop recognizing the revenues of $1500 on customer’s accounts. These payments received from the customer needs to be reversed to unearned revenue because they have an obligation to provide customers with furniture since the furniture are not delivered to the customers we need to adjust this revenue. This adjustment will increase the liabilities portion and decrease the net income and significantly affect the equity. Issue: Non-Monetary Transaction. OTF made a plan to build a new distribution centre and was interested in a piece of land held by a customer. The land listed price was $200,000, a deal was struck to trade furniture for land. Retails price for furniture was $185,000. The issue is whether, is it possible for OTF to reliably determine if this transaction can be measured at either Carrying Value or Fair Value of the assets given up or received. Hand Book Analysis: As per 3831.06 Non-Monetary Transaction: An entity shall measure an asset exchanged or transferred in a non-monetary transaction at the more reliably measurable of the fair value of the asset given up and the fair value of the asset received, unless: (a) The transaction lacks commercial substance; This transaction has a commercial substance, had this transaction not taken place the OTF would has sold the furniture for $185000, assuming the customer would have purchased the furniture from OTF. OTF would have paid $200,000 for the piece of land. This exclusion from measurement at Fair Value has not been met. (b) The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange; Land and Furniture are two different commodities. This exclusion from measurement at Fair Value has not been met. (c) Neither the fair value of the asset received nor the fair value of the asset given up is reliably measurable; Land has fair market value of $200,000 and Furniture has a fair market value of $185,000 both commodities Fair Value can be measured. This exclusion from measurement at Fair Value has not been met. (d) The transaction is a non-monetary non-reciprocal transfer to owners: This transaction is not a non-reciprocal transaction. Since, a deal has been struck between these two parties as Land and Furniture are being exchanged. This exclusion from measurement at Fair Value has not been met. Recommendation: After reviewing the Handbook Analysis, I can safely suggest this transaction needs to be reported at the fair value of the assets given up or the fair value of the assets received. Since both the values appears to be reliable to me therefore this transaction needs to be measured at the fair value of the assets received $185,000 rather than land was reported in the financial statement at $200,000. The overall impact of this transaction on OTF Financial Statement would be assets will decrease by $15,000 and revenue and income would decrease by $15,000. Which will impact the profitability Issue: Leased Facility OTF leased a facility to carry out their business operations for spray painting. The building belongs to LAW Properties, an agreement has been signed between two parties on January 1. OTF would like to purchase the property, but the LAW is not willing to sell the property. The Fair Market value of the building is $1,200,000. The issue is lease payments were expensed without even safely determining if this lease qualify for Finance or Operating Lease. It is extremely important to distinguish before payments could actually be expensed. Hand Book Analysis: As per 3065.06 Leases: From the point of view of a lessee, a lease normally transfers substantially all of the benefits and risks of ownership to the lessee when, at the inception of the lease, one or more of the following conditions are present: (a) There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term. OTF will not obtain an ownership of the property at the end of the lease, LAW Properties Inc. does not show any intention to sell the property at all. Therefore, this condition has not been met. (b) The lease term is of such a duration that the lessee will receive substantially all of the economic benefits expected to be derived from the use of the leased property over its life span. This condition has not been met since the useful life of the property is 35 years, and lease terms is 15 years, the economic benefit from a leased property should be 75% or more of economic life of the leased property. In this case it turns out to be 42% only. (c) The lessor is assured of recovering the investment in the leased property and of earning a return on the investment as a result of the lease agreement. This condition exists if the present value, at the beginning of the lease term, of the minimum lease payments, excluding any portion thereof relating to executory costs, is equal to substantially all (usually 90 percent or more) of the fair value of the leased property, This condition meets the criteria where it is classified as finance lease, the reason it is classified as finance lease is because the present value of lease payment is substantially greater than 90% of the Fair Market Value of the building. N=15, I/Y=5%, PMT=$98000, FV=$500,000 Therefore PV= $1,308,575 greater than $1,080,000. FMV= $1,200,000 x 90%= $1,080,000. Recommendation: Considering the implications in terms of how the rent payments were previously recognized on the financial statement as they were expensed previously. After performing a test to determine, if this lease is an operating or finance lease; the test did meet the criteria for a finance lease. Therefore, instead payments to be entered as rent expense these payments must recorded as an obligation or a lease liability. The impact of such an implication would increase the liability and since expense was previously increased therefore, now expenses will be decreased resulting in an increase in the net income and overall profitability. Audit Impact: Design Contract Sales must have increased significantly in the past years due to the implementation of the new program: “Fees for designing the specialty furniture items”. There are reasonable grounds to determine that revenues are recorded prematurely. Customers are charged a non-refundable flat fee of $1500 to prepare a design plan, and the full amount of fee is credited to customer’s account resulting increase in revenue. Assertion: Occurrence and Cut off. Risk: Sales might be overstated, OTF management is recording revenue even before the customer proceeds were received from their projects, and even before the delivery of the furniture was made to customers. Audit Procedure: A sample of client contracts needs to be reviewed to determine the actual number of clients proceeded with design plans, match number of contracts to the determine the dollar value from Accounts Receivable Control Account which verifies credit amounts. Moreover, also trace back those sales invoices with the shipping documents to determine whether an actual sale has been recorded from furniture delivered in the correct period. OTF aggressive policy for recognizing revenue which increases net income, and it will also have considerable increase in management bonuses. Audit Impact: Non-Monetary Transaction- Land Sales would have increased considerably, when this transaction; exchange for land and furniture had taken place. The revenue amount has been incorrectly reported on the financial statement as Land was reported at $200,000 so did the revenue, instead of $185000. Assertion: Occurrence and Accuracy. Risk: Sales may overstated on the financial statement, inaccurate accounting knowledge. Audit Procedure: Select a sample of the of items from the inventory listing, for each selected sample inspect the recent sales invoice and recent purchase invoice, compare the per unit net book value of the items to determine whether items are lower than NRV or items have been recorded at their appropriate value. Overstating the value of the inventory will consequently increases the revenue recognized resulting an overall increase net income, which also increase management bonuses. Audit Impact: Leased Facility Expenses were overstated as lease payments were recognized as an expense instead they need to be realize as an obligation. There is reasonable ground to determine that expenses were recorded incorrectly. Assertion: Completeness and Valuation. Risk: There could unrecorded balance in the lease obligation due to inaccurate reporting. Audit Procedure: Obtain the copy of the lease contract from the customer for leased facility drafted by LAW Properties. Revisit the contractual obligations to determine if the Lease is Finance or Operating Lease. Match the outcome from the contractual obligation onto the financial statement to determine how lease payments are recorded. Reporting lease payment as an expense will understate the net income, and resulting decrease in the equity, which decreases profitability in general.