Question

Alpine Perceptions Ltd.

Alpine Perceptions Ltd. (APL) provides “technology solutions” to manufacturing companies. APL is a wholly owned subsidiary of Elevation Technologies Inc. (Elevation), a privately owned conglomerate. In 2016 APL was performing poorly and Elevation considered selling the company for the best offer. As a last resort Elevation hired turnaround specialist Kendal Wilson to more effectively manage and salvage APL. Ms. Wilson’s employment contract specifies that in addition to an annual salary she would receive a $1 million cash bonus after the end of the 2019 fiscal year if APL meets a number of performance goals over the 2017 to 2019 period. For 2017 and 2018 APL achieved the goals. To meet the performance goals for 2019 APL must report net income in excess of $20 million.

It’s now January 25, 2020. APL’s financial statements for the year ended December 31, 2019 have been received at Elevation’s corporate offices. APL’s net income for 2019 is $20,550,000. Elevation’s CFO has examined the financial statements and is satisfied with most aspects of them but is concerned with the reporting of some transactions and economic events. The issues of concern are described below:

1. On May 30, 2019 the company made a payment of $250,000 to a computer hacker who obtained access to the computer code to APL’s proprietary software that is used to produce some of APL’s products. The hacker had given the company ten days to pay or she would sell the information to a competitor. Management believed that if the information was obtained by a competitor it would have significant negative consequences for the company. APL has capitalized the amount of the payment and is amortizing it over the remaining life of the related assets, which is about four years.
2. APL has always shut down for one week in late December for routine maintenance of the company’s equipment. The annual maintenance is essential to ensure that the equipment can meet the precise specifications of customers. For the past three years, maintenance has been completed by the end of December. The annual maintenance originally scheduled for December 2019 was delayed until the first week of January 2020 because of scheduling problems with the company that does the maintenance and because APL had a number of contracts it wanted to complete by the end of December. The last maintenance was done in December 2018. APL paid $425,000 for the January 2020 maintenance work. The amount was paid in mid-January.
3. In October 2019 APL settled a lawsuit by an employee from an incident that occurred in 2015. APL agreed to pay the employee $350,000 and the payment was made on November 12, 2019. APL accounted for the settlement and payment by crediting cash and debiting retained earnings for $350,000. It was explained that since payment pertained to an incident in 2015, income in 2019 shouldn’t be affected.

The CFO has asked you, an accountant in the finance department, to prepare a report evaluating the issues. Ms. Wilson has already called the CFO to arrange a meeting to discuss the financial statements and the payment of the bonus. The CFO wants your report to explain the problem in each issue, identify reasonable alternatives, and provide full support for your recommendations.

1. For each transaction:
   1. Identify and explain the issue;
   2. Explain the impact of the method the preparer used to account for the transaction or economic event (how does the accounting for each issue affect the parties involved).
   3. Evaluate the accounting used for each issue. Do you think it’s appropriate (explain why or why not)? (To do this you need to apply your knowledge— definitions of elements, etc.).
   4. Is there a better (more appropriate, different) treatment that could be used for the transaction? If there is a better alternative, provide support. Support means referring to appropriate criteria, definitions, standards, etc. as well as to the facts defining the transaction/economic event. If the treatment currently used is appropriate, explain why. When thinking about the existing and alternative accounting treatments, be sure to keep in mind the interests of your client.
   5. Calculate/ (State) the impact of any changes you propose.
   6. Make a recommendation.

Answer 1

Ans:

a. There are three issues of concern that CFO has identified:

i) The company has made payment of $250,000 to a computer hacker who had obtained access to the computer code to APL’s proprietary software that is used to produce some of APL’s products and the company decided to amortize the amount over the remaining period (4 Years) of asset.

ii) The annual maintenance of company was regularly scheduled and conducted in the month of December but during the current year it was conducted in the month of January and expense of the same was recognized in the month of January which was $425,000.

iii) In the month of October company paid $325,000 for an lawsuits of employees related to Financial Year 2015. The same expense was charged by the management from retained earning directly as this expense is not related to Financial year 2019.

b. Due to above three transactions followings were the affect to parties involved:

i) In the first case the company has capitalized the payment amounting $250,000. Due to this only one-forth of the payment was recognized as expense in the current year. If the company has charged whole payment as expense in the current year itself the profit would have been reduced by $187,500 (assuming straight line depreciation method).

ii) In the second case the regular maintenance of the company was conducted in January 2020, due to which expense which should have incurred in the month of December was actually recognized in next financial year which inflated the current year profit by $425,000.

iii) In the third case company paid $325,000 for an lawsuits of employees related to Financial Year 2015 and directly debited the retained earning account without routing the same through current year profit and loss account, which increased the current year profit by $325,000.

c. Evaluation of accounting employed by the preparer:

i) The payment of $325,000 to the hacker was capitalized by the company. An expense is treated as capital expenditure only when it add value to an existing asset and expected to receive future benefits for a period of more than 1 year. In the current case payment made to hacker for preventing the negative consequences doesn't amount to receiving future benefits from the said expenditure. So the treatment done by preparer is not appropriate in case.

ii) Expenses for maintenance amounting to $425,000 was actually related to previous financial year. Although the expense was actually conducted in Financial year 2020. It belongs to Financial year 2019. So the treatment done by preparer is not appropriate in case.

iii) Payment of $325,000 was made for a lawsuit by an employee. The amount charged from retained earning because it belongs to Financial Year 2015. As per the concept of accounting provision should have been made in the year 2015. As the expense was not recognized earlier it has been charged directly to retained earning considering the expense doesn't belongs to Financial year 2019. Treatment done by preparer was correct.

d.) Appropriate treatment to record above transactions:

i) The payment of $325,000 should have been charged to profit and loss account of Financial year 2019 as a whole because this expense doesn't not create a new asset or add value to the existing asset. This expense is to be treated as extraordinary expense and charged to profit and loss account in Financial year 2019.

ii)   Expenses for maintenance amounting to $425,000 was actually related to financial year 2019. Therefore company should have made a provision for the same at the year end December 2019.

iii) See point iii. of c. above.

e.) Impact of proposed changes:

Current profit:    $20,550,000

Decrease in Profit due to issue i. $187,500

Decrease in Profit due to issue ii. $ 425,000

Net Profit should be: $ 19,937,500

f.) Hence as per above conclusion the target profit has not been achieved and CFO should not allow her to receive the cash bonus of $1 Million.