Question

Sturdy Furniture Ltd.

Sturdy Furniture Ltd. is a Canadian manufacturer of public site furniture products. Sturdy’s products are designed for use in public places such as parks, malls, town squares—high-traffic locations that require high-quality, durable, and attractive furniture. Sturdy’s products include benches, bike racks, planters, recycling bins, and trash containers. Sturdy has a loan outstanding from the Bank of Ontario and is looking to increase the loan to help finance its ongoing expansion.

It’s late October 2019. You are a CPA with the Bank of Ontario’s regional office in Durham Region. You received a call from the loan officer responsible for the Sturdy loan regarding its 2017 third-quarter unaudited financial statements (the end of the quarter was September 30). The loan agreement requires that Sturdy maintain a current ratio greater than 1.25 and a debt-to-equity ratio below 1.6 at the end of each quarter. Sturdy is onside with the ratios, but just by a small amount. If Sturdy violates either of the covenants, the terms of the loan will be subject to renegotiation and perhaps repayment. In addition, violation would make it significantly less likely that the bank would provide Sturdy with the additional financing it’s looking for.

The loan officer expressed some concern to you about Sturdy’s accounting for three transactions and the impact on the covenants. She asked you to prepare a report that reviews the transactions and assesses the accounting Sturdy used. She would like full explanations of whether the accounting used was appropriate or inappropriate.

The loan officer provided you with the following information:

1. Summarized balances at the end of the third quarter of 2019 on September 30, 2019:
   1. Current assets                   $ 6,500,000
   2. Non-current assets           23,500,000
   3. Current liabilities                5,100,000
   4. Non-current liabilities       13,100,000
   5. Shareholders’ equity         11,800,000
2. In an effort to generate business in the south-western United States Sturdy planned to attend a large trade show in the southern US in September 2019. Because of a hurricane in late August the show had to be cancelled. In preparation for the show, Sturdy spent $225,000 on banners, handouts, videos, and other materials that were specifically branded for the show (the materials were all branded with the name, date, and location of the US show). The materials are currently being held in a storage room near the vice-president of marketing’s office.
3. During the third quarter, Sturdy completed a deal with one of the Canadian territories to supply outdoor recycling bins. The final design is based on an existing Sturdy product that has been modified to meet the rigours of the cold Canadian winters in the far north. No Sturdy product has ever been used under these conditions but the company tested the product extensively in the extreme-weather facility at the Ontario Tech University, and management is confident that the product is well designed for the conditions. Sturdy has provided the territory a two-winter guarantee that it will replace any bins that are broken or damaged due to weather conditions. The contract price is $750,000 and the bins cost $475,000. The revenue was recognized in the third quarter. Sturdy expects payment for the bins within 90 days of the end of the quarter. Sturdy recognized the revenue in the third quarter
4. During the year Surdy terminated a manager who had been with the company for many years. Surdy agreed to a $350,000 settlement to avoid a wrongful dismissal lawsuit. The $350,000 will be paid out in four equal installments over the next four years. Surdy expensed the $87,500 paid in the year when the 2019 payment was mailed in August 2019.
5. In early October 2019 (after the end of the third quarter) Sturdy cancelled a contract with a supplier. Cancellation is allowed under the contract but Sturdy is required to pay a cancelation penalty to the supplier of $150,000. The payment was made on October 10. The amount is not recorded in the third quarter financial statements.

1. What are the objectives of financial reporting of the loan officer/Bank of Ontario? Why do you think your client has these are the objectives?
2. Are the objectives of Sturdy and your client the same? Does it matter if the objectives of Sturdy and your client are different? Explain.
3. Explain why the objectives of financial reporting of Sturdy and your client are important to your analysis.

Answer 1

Let us analyse the facts briefly :

a. Sturdy Furniture Ltd (Sturdy) has loan from Bank of Ontario

b. Our role is to advise loan officer responsible for monitoring loan provided to Sturdy

c. Un-audited quarterly financial statements is available. As per loan agreement Sturdy needs to maintain current ratio greater than 1.25 and debt equity ratio below 1.6

Let us respond to questions now :

Q.1 What are the objectives of financial reporting of the loan officer/Bank of Ontario? Why do you think your client has these are the objectives?

Response :

- The main objective of bank providing finance is to assess the borrowers financial ability to pay interest on loans & also ability to make repayment of loan as per agreed schedule of repayment.

- The financial ability can be assessed through periodical financial statement. Bank usually also ask borrower to maintain specific finance ratio which will ensure financial health of the borrower

We believe that lender has all right to protect it's lending & it can be assessed through financial statement and monitoring various financial ratios

Q.2 Are the objectives of Sturdy and your client the same? Does it matter if the objectives of Sturdy and your client are different? Explain.

Response : The objective of Sturdy Furniture Ltd to prepare financial statement is to evaluate business performance and on that basis it can take various business decision to improve / correct business performance. Further having known that Banker is going to assess them & they are having need of loan, it may lead them to prepare healthy financial statement. For example not accounting transaction as discussed above not expensing out marketing material from prepaid expense, not providing for guarantee of outdoor recycle bin etc

While the objective of Banker for reporting of financial statement is to assess financial health of the borrower to ensure that they are in position to pay interest and principal repayment

Q.3 Explain why the objectives of financial reporting of Sturdy and your client are important to your analysis

Response : For preparing report as requested by client it is paramount to understand the requirement without which services cant be provided. Similarly the objective of Sturdy is also important to understand so that i can understand the financial better.

Considering the current situation (bad financial situation and not meeting the specified current ratio and debt equity ratio) there can be diagonally opposite objective : Sturdy might adopt practise to prepare financial statement which meets the requirement of bank whereas on other hand here objective of bank would be to ascertain that financial statement do not require any further adjustment so that they are able to assess financial position.

Report on review of quarterly un-audited financial statement ended Sept 2019 of Sturdy Furniture Ltd :

Objectives : To review un-audited financial statement & assess financial position of Sturdy Furniture Ltd & recommend further action

Observations :

Based on un-audited financial let us calculate the current ratio and debt-equity ratio :

a. Current Ratio = Current Asset / Current Liabilities

Current ratio works out to 1.27 (650,000/510,000)

b. Debt-equity ratio = Total Debt / Total Equaity

Debt-equity ratio works out to 1.11 (13,100,000/11,800,000)

There are three transaction which loan office brought into my attention :

A. Marketing Material issue :

225,000 spent on marketing material for trade show & due to cancelled trade show such marketing material is not usable. Usually the amount spent for forthcoming event is accounted as prepaid expenses and expensed out when even is completed. The circumstance indicate that this are not prepaid expense any more but actual expense and accordingly it should be expensed, which would reduce prepaid expense from Current asset and as a result the current asset ratio would change as under :

Revised Current Ratio is :1.230 ((6,500,000-225,000)/5,100,000)

However if it is already accounted as expense it will have no impact on Current Ratio

B. Outdoor Recycling bins contract

Sturdy furniture have provided guarantee of two winter for outdoor recycling bins contract however it appears that it has not provided any liability for replacement of Recycling bins contract

C. Manager Termination

350,000 termination payment is existing cost and it should have been accounted fully in quarterly financial statement notwithstanding that actual payment is to be made in 4 installment

D. Penalty for contract cancellation

150,000 is penalty impact for cancellation of contract however since this is post 30th September 2019 it has no impact on financial statement submitted

Recommendation :

- Get clarity on accounting treatment of 225,000 marketing material whether it is expensed out or accounted as prepaid expense. If it is prepaid expense, Sturdy Furniture needs to be informed on correct accounting treatment and ask to submit updated financial statement

- Ask Sturdy Furniture Ltd why no cost accrued or revenue is reduced for guarantee obligation on outdoor recycling bins and ask them to update financial statement for any adjustment arising due to this

- Ask Sturdy Furniture Ltd to account for 350,000 cost for manager termination and ask to provide updated financial statement after this adjustment