Question

YourTel Networks (YTN) is a leader in the communications equipment industry for both commercial and residential needs. Its shares trade on the Canadian TSX and the U.S. NYSE stock exchanges. The company had been experiencing unprecedented growth in company size and stock price, but then, in the 2^nd quarter of 2011, its revenues and profits declined dramatically and were well below analysts’ forecasts. However, its stock price did not decline too much because these were only quarterly financial results.

To improve future results, YTN decided to add a new telephone system called Magellan NorthStar. This system would be produced immediately at their current operating plant in Calgary because it is not at capacity. To finance the expansion, the company will issue new shares. This will not be a problem because their stock is still considered a ‘buy’ by investors.

As a consequence of the recent decline in revenues and profits, the Board of Directors wants to ensure the company’s earnings per share (calculated as net income available to common shareholders divided by the weighted average number of common shares outstanding) is above analyst’s expectations for fiscal year-ending December 31, 2011.

Today is January 31, 2011 and you have just been hired as “a” new financial accounting manager. This is your first week on the job and the financial accounting analyst has provided you with the draft 2011 financial statements for your review. You notice, during your review, that a number of items need to be re-examined and you have decided to write a report to the Chief Financial Officer (CFO), the person that hired you. The CFO is also on the board of directors. You will submit this report within 7 days well before the board meeting scheduled for late February. This is not your first time submitting a report of this nature and you want to impress the CFO.

1. YTN is confident that sales of the new Magellan NorthStar system during the last half of the year will bring it back to its regular level of profitability. Customers order these telephone systems, that can be as high as 1000 for a single commercial customer. The customer will be invoiced as the order is completed and the telephone systems are put into a separate section of the Calgary warehouse and tagged with the customer name. But the phones will not be delivered until requested by the customer. YTN’s bad debts expense has traditionally been less than 1%. During the last half of the month of December, YTN produced $100 million dollars of these phone systems and invoiced customers from previous experience of who has bought phone systems. The amount was booked to revenues.

2. In order to increase cash flow YTN, on December 10, 2011, transferred $1,200,000 of accounts receivable to Risk Financing Co. with no-recourse, notification basis, that effectively transferred legal control to Risk Financing Co. Risk is permitted to resell the accounts receivable without permission from YTN. Risk charges 5% commission on the Gross accounts receivable transferred for taking on the transfer. Although cash has been received from Risk, no entries have been done by YTN for the year ending December 31, 2011.   

3. During January of 2011, YTN had started preparing its Statement of Cash flows (SCF). Of particular interest to you was the cash Dividends paid was placed in the financing section for the first time. The amount was large and represented 10% of the revenue for the year. Another item that would likely need explaining is that tax expense was now included as a separate line in the operating section using the indirect approach. In past years, tax expense was already deducted from net earnings and therefore, not included as a separate line. Your review of the remaining items of the SCF is not materially different from previous years or unusual.

Required: (Total 30 marks)

Provide a report to the Chief Financial Officer. Ensure that you discuss and recommend to the CFO how each event should be accounted for. Be sure to also discuss financial statement implications and, if applicable, any numerical effects and potential journal entries, etc. (23 marks)

[3 marks for Grammar and Format]

Answer 1

Report to CFO

This report is for the discussion on the financial position and forward actions of the company YourTel Networks (YTN) which is a leader in the communications equipment industry for both commercial and residential needs. The report is for discussion purposes only and is completely based on the review of the draft financial statements of year 2011 and other relevant financial data of YTN and the industry.

YTN has achieved growing financial results in past which has earned it good reputation and regular trading at stock exchanges. However last quarter had shown a dramatic decline which were unanticipated seeing YTN’s regular growth and the trust that the industry has built in it. Though the results were of only the quarter and the industry and the stock prices were least impacted by the results, however the draft financial statements of the year 2011 has been reviewed and there are some suggestions with respect to their implications on YTN’s market position.

1. YTN is confident that sales of the new Magellan NorthStar system (which would be produced immediately at their current operating plant in Calgary because it is not at capacity) during the last half of the year will bring it back to its regular level of profitability. Customers order these telephone systems, that can be as high as 1000 for a single commercial customer. The customer will be invoiced as the order is completed and the telephone systems are put into a separate section of the Calgary warehouse and tagged with the customer name. But the phones will not be delivered until requested by the customer. YTN’s bad debts expense has traditionally been less than 1%. During the last half of the month of December, YTN produced $100 million dollars of these phone systems and invoiced customers from previous experience of who has bought phone systems. The amount was booked to revenues.

In this situation, as YTN is a listed entity, the IFRS 15 has following provision in terms of revenue recognition:

· identify the contract(s) with a customer.

· identify the performance obligations in the contract. Performance obligations are promises in a contract to transfer to a customer goods or services that are distinct.

· determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer. If the consideration promised in a contract includes a variable amount, an entity must estimate the amount of consideration to which it expects to be entitled in exchange for transferring the promised goods or services to a customer.

· allocate the transaction price to each performance obligation on the basis of the relative stand-alone selling prices of each distinct good or service promised in the contract.

· recognise revenue when a performance obligation is satisfied by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). A performance obligation may be satisfied at a point in time (typically for promises to transfer goods to a customer) or over time (typically for promises to transfer services to a customer). For a performance obligation satisfied over time, an entity would select an appropriate measure of progress to determine how much revenue should be recognised as the performance obligation is satisfied.

Here it is clearly provided that the revenue shall be recognised only when a performance obligation is satisfied by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). However in draft financial statements of 2011, the revenue has been recognized without the delivery of Magellan Northstar systems at the designated places. Moreover the same has further discussion over the point of time of satisfaction of the performance obligation under the contracts with the customers. In such a case IFRS 15 clearly states that A performance obligation may be satisfied at a point in time (typically for promises to transfer goods to a customer) or over time (typically for promises to transfer services to a customer). For a performance obligation satisfied over time, an entity would select an appropriate measure of progress to determine how much revenue should be recognised as the performance obligation is satisfied.

This report would endeavor to discuss the recognition of the revenue with regard to these systems as this revenue has key role to play in the overall financial performance of YTN.   

2. As per draft financial statements, in order to increase cash flow YTN, on December 10, 2011, transferred $1,200,000 of accounts receivable to Risk Financing Co. with no-recourse, notification basis, that effectively transferred legal control to Risk Financing Co. Risk is permitted to resell the accounts receivable without permission from YTN. Risk charges 5% commission on the Gross accounts receivable transferred for taking on the transfer. Although cash has been received from Risk, no entries have been done by YTN for the year ending December 31, 2011.

In this case IFRS 9 provides where the accounts receivables are factored on no recourse basis and advance has been taken against such factoring, the classification and measurement of the accounts receivables should be on fair value basis, which is not seemed to be followed in the draft financial statements.

3. During January of 2011, YTN had started preparing its Statement of Cash flows (SCF). Here the cash Dividends paid was placed in the financing section for the first time. The amount was large and represented 10% of the revenue for the year.

In this case, the discussion is required over the disclosure of the dividend payout as separate line item which is not in symmetry with the earlier disclosures. It is well understood that the amount is large and YTN is making separate disclosure for its stakeholders. As per provisions of IFRS, the disclosures with regard to dividend paid/interest paid should be consistent which is not satisfied under the current scenario. Thus the discussion with regard to same is required. However the primary objective behind the factoring should also matter and the classification and measurement shall follow, e.g. where primary objective to factor accounts recievables is to recover money beforehand, the classification and measurement should be done at fair value through Profit & Loss. Thus these things need to be discussed for the proper disclosures and further representation of the financial statements for the interest of the stakeholders of YTN.

4. Another item that would likely need explaining is that tax expense was now included as a separate line in the operating section using the indirect approach. In past years, tax expense was already deducted from net earnings and therefore, not included as a separate line.

Here the disclosure has changed from the past disclosures as opted by YTN. The same needs to be discussed with regard to the objective behind such disclosure and the same needs to be aligned with the applicable IFRS which provides that Income tax expense is generally classified as an operating activity, but a portion may be allocated to investing or financing activities if it is specifically identifiable with those activities.

In case of other disclosures, classifications and measurements reported under draft financial statements of 2011, there are no inconsistencies seemed to be observed with regard to the applicable IFRS provisions and the past financial reporting of YTN.

Hope this report finds you well and the discussion will soon follow to finalize these matters.