Attached is the report you requested recommending accounting treatments for unresolved issues in the financial statement of CTL Airways. In preparing this report, I have attempted to provide reasonable and justifiable alternatives for the outstanding accounting issues. In these situations, I have attempted to choose the alternative that serves the objective of increasing net income, assets and decreasing total debt, thereby resolving bank concerns and meeting the objectives of the company. Constraints: IFRS: Because this statement is also used by banks, shareholders, etc., and also as it is the companys desire to go public in a few years, it is important to use a recognized accounting practice as the standard basis for preparing the statement. Accordingly, I recommend implementing International Financial Reporting Standards (IFRS) going forward. All recommendations made in this report are supportable in terms of IFRS, fairness, and accrual accounting.
Public: The objective of CTLs investors is to build a sustainable business that is strong enough to go public in seven years. Terms of loan: It is required by the bank to maintain some assets as a security against bank loan and also to maintain a Debt/Equity ratio of below 0.7 to 1.
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Stakeholders: UBS: The bank that provides loans to CTL is going to be affected by the companys decisions and it will also affect the relation between the bank and firm for future landings. CRA: Any changes in income might affect the tax payable to Canada Revenue agency. Suppliers: Are affected by the companys decisions such as inventory control method, accounts payable turnover, etc. Management: CTL has implemented a profit sharing plan in which managers bonuses are affected accordingly. They are also affected by the overall wellbeing of the company. Owners: Are almost always the main stakeholder as both their capital and business are at stake. Customers: Decisions made by the company such as accounts receivable deadline, going public, will affect their customers considerably Objective: Going public in 7 years: The main objective of CTLs investors is to build a business strong enough to take public in seven years. Expanding the vacation package: Although it is not yet determined to be implemented, this plan it is within the companys desire to expand its business. Mend their relationship with their UBS: As a considerable amount of CTLs cash is provided by the bank, CTLs current and future profitability is dependent on its relationship with its bank. My recommendation for the following issues are based on the constraints mentioned above, and will try to satisfy desire of the stakeholders and objectives of the company.
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Issues and recommendations: 1- From Business Point of View: It is clear that Joes strongest motive for reducing the allowance for doubtful accounts receivable is decreasing the pool of allowance for doubtful accounts and hence, increasing the income. It is also a good justification for the bank that it is an ongoing and profitable business and we will be able to pay the debt we owe to the bank, yet very unethical and can hurt the reputation of the company significantly. From Accounting Point of View: Using Joes present implication will reduce net income of the next year significantly, as allowance for bad debt is not matched with aging method and companys experience. Moreover, there is no guarantee that extending the deadline for payment will result in a payment after that. Increasing the allowance for bad debt to its appropriate level will reduce the net accounts receivable amount, but at the same time would prevent it from a significant decline next year. My recommendation is to adjust allowance for doubtful accounts to $1,000,000 from $400,000 stated before (It is possible to resend the invoices and bring the payment due date to its previous condition, but customers will most likely reject them, also, this is bad for the reputation of the company. Thus, I dont recommend it). Journal Adjusting Entry is as below: Dr. Doubtful Account (Bad Debt) Expense $ 600,000 Cr. Allowance for Doubtful accounts (Bad Debt) $ 600,000
Dr. Allowance for Doubtful Account (Bad Debt) $ 600,000 Cr. Accounts Receivable (Net) $ 600,000
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2- The Patent was depreciated under straight line method which I recommend it to be replaced by Usage-Based Depreciation. Hence, $287,500 for 2009, $250,000 for 2010, and $250,000 for 2011 and the carrying price by the December of 2011 would be $212,500. However, managers are required by IFRS to estimate the fair value of the patent each year to determine if its impaired. Moreover, according to IFRS a capital asset is impaired if its recoverable amount is less than its carrying amount. As future cash flows produced by the patent at the end of 2011 are estimated to be $150,000, which is greater than the net realizable value of the patent which is estimated to be around $ 50,000 and since the recoverable amount is less than the carrying amount, CTL must write down the patent to its recoverable amount of $150,000. It is recommended to report a loss of $65,000 ($212,500 -$150,000). Journal Adjusting Entry is as below:
Dr. Loss due to impairment of patent (income statement) $65,000 Cr. Accumulated amortization (contra asset) $65,000
3- If inventory was controlled under the perpetual control system then the only adjustment needed is the ending inventory of 2010 and the beginning inventory of 2011. However assuming that a periodic system was used for inventory control, the beginning inventory of 2011 has been erroneously stated and as a result of the mistake in beginning inventory on January 1, 2011 The followings has occurred in that year:
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Inventory: Overstated Cost of Goods Sold: Overstated Net Income: Understated Retained Earnings: Understated My recommendation is that an adjustment is essential at this point to match the Inventory, Cost of sales, income statement, and retained earnings (for the sake of simplicity cost of sales will be deducted from flight operations and navigational charges in income statement). Hence, for 2010 Balance Sheet: Ending Inventory has to be decreased by $450,000 Retained Earnings has to be decreased by $450,000
For 2011 Balance Sheet & Income Statement: Beginning Inventory has to be decreased by $450,000. Cost of Goods Gold has to be decreased by $450,000. Net Income has to be increased by $450,000. Retained Earnings has to be increased by $450,000.
4- As both interest expense and administration expense are tax deductible, including interest expense in administration expense does not affect any of the main concerns; however, in assessments such as ROA we need to consider the fact that $400,000 of interest expense is included in the administration expense.
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5- From an accounting point of view: Forty per cent of the maintenance costs incurred during 2011 is related to major overhauls, mainly upgrading the engine of the aircraft in order to maximize its fuel consumption; Nevertheless, I recommend overhaul costs to be assessed as a Betterment, as it is increasing the assets useful life and is improving its efficiency and hence should be capitalized and depreciated during the new useful time. From Business Point of view: It will increase the capital assets which was the main concern of the bank. Journal Adjusting Entry is as below:
Dr. Capital Assets $600,000 Cr. Maintenance Expense $600,000
Other Issues: Note (2) frequent flyer liability For frequent flyer programs, it is necessary to estimate the number of outstanding miles that will be redeemed and the cost of the rewards the customer will receive. Assuming that the each seat redeemed using frequent-flyer point is equal to discounted seat sale price; it is a liability for affinity program (provision) and is correctly recorded as accrued liability.
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Note 2 (Litigation) From accounting point of view: Litigation: Has to be done for contingencies and as Codances, the competitor who has filed a lawsuit against CTL, has not provided enough evidence for its claim of $200,000 it is not possible to estimate the amount of such a settlement at this point. Hence, the Journal Adjusting Entry for misstatement of accrued liabilities is as below and a footnote is disclosed in the balance sheet (appendix1)
From Business Point of View: The adjustment of $200,000 will increase the net income and decrease the liabilities of the firm and hence provides a good respond to bank concern and also for the companys desire to go public. Dr. Accrued liability $200,000 Cr. Administration Expense $200,000
Note (2) Accrued Vacation Expense As a company policy, salaried employees are not allowed to accumulate vacation. Vacation entitlement for a particular year will be lost if the employee does not take the vacation during that particular year. Hence, it is recommended that the $23,000 accrued vacation of salaried employees be adjusted accordingly as below: Dr. Accrued Liabilities $23,000 Cr. Administration expense $23,000
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Note (3) Unearned Revenue As 25% of unearned revenue has been used, it should be accordingly adjusted. Dr. Unearned Revenue $25,000 Cr. Revenue $25,000 The expired 15% of unearned revenue should also be adjusted. Dr. Unearned Revenue $15,000 Cr. Gain (on expiry of discounted thickets) $15,000 These adjustments will decrease liabilities and increase shareholders equity
Implementation All the recommendations and alternatives mentioned above have been implemented, and the revised Balance Sheet, Income Statement, and Statement of Cash Flow are attached (appendix 1) and adjusted according to the adjusted journal entries. Accordingly, the following concerns have been addressed:
Bank Concern: The following recommendation is provided to tackle with the bank concern and mend the relationship with them.
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1) The current Debt to Equity of the company is 0.60 to 1 which is below the requirement of the bank (appendix 1). Debt/ Equity Ratio = (Total Liabilities / Total Shareholders Equity) $7,937,000 / $13,138,000 = 0.60 2) According to componentization of assets, the new land, building and furniture acquired should be adjusted and classified relatively and not under the building within capital assets for the end of 2011 Land; $222,000, Building; $533,000, Equipment; $445,000 based on the portion of their appraisal prior to purchase. An appraisal prior to the purchase indicates that all land, building and equipment carry a value greater than purchase price; hence, a proportional method is recommended for revaluation of the new asset in 2012 which will increase its carrying amount significantly and could be secured against bank loans. (Please note that componentizing under equipment will have greater depreciation expense than building, yet the gain resulted from fair market evaluation compensates for that and also decreases potential loss as a result of impairment of the building. As for calculating depreciation expense we would need to estimate residual value (whether it is 0 or not) and rate of depreciation for equipment at this point, 30 th of December 2011 is assumed as the date of purchase. 3) Return on assets of 38% indicates that the entity has used its assets efficiently to generate profit. ROA = (Net Income + After Tax Interest Expense)/ Average Total Assets = ($6,318,000 + $400,000) / ($14,130,000 + $21,075,000/2) = 0.38 4) Getting a guarantee on accounts receivable would increase companys expense, yet if implemented appropriately Accounts Receivable, which is a considerable portion of CTLs assets, could be negotiated to be used against loans on a future basis.
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Expanding the vacation package:
From Business Point of View: The increase in accounts receivable and bad debt expense could be covered as an offset against the increase in income. As the market is becoming more competitive and to prevent the company from losing its competitive advantage, it is a considerable stimulus for CTL to expand its vacation package and allow agencies to pay a week after their customers take holidays.
From accounting point of view: A considerable increase in expected income is foreseeable. However, Accounts Receivable and Bed Debt Expense (due to bankruptcy) will most likely increase provided that CTL implements the expansion and allows travel agencies to pay a week after the flight. Accordingly, average collection period of accounts receivable, which is currently 81 days (365/Accounts Receivable Turnover Ratio = 365/ 4.46), would increase. The increase in accounts receivable from $3,500,000 in 2010 to $14,700,000 in 2011 shows more than 300% increase in accounts receivable; moreover, the fall of $900,000 in cash in 2011 from $1,600,000 in 2010 shows a stiff decline in the companys cash and implementing the expansion will most probably worsen the situation. Hence, it is not recommended. Alternatively, if it is the wish of the owners to implement such plan, negotiations for guarantee, security, drafts and/or factoring for the payment of the agencies requesting an extension on their payment deadline is highly recommended.
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Conclusion: To sum up, in providing the above mentioned recommendations, I have tried to meet the requirements of all major stakeholders, as implementing these suggestions would increase the Net Income from $5,670,000 to $6,318,000, Capital assets (net) from $3,680,000 to $4,215,000, and retained earnings from $7,440,000 to $7,638,000 while decreasing its Total Liabilities from $8,200,000 to $7,937,000 in 2011; hence, Meet banks requirements and answer their concerns. Provide additional motivation for managers and increase the efficiency of said individuals. Fulfill owners desire for expansion and finally, show a healthy business to potential shareholders when company eventually decides to goes public.