Chapter 22

Exercise 22.1

1. Sterling Inc. is owned by a close family member of a director of Kessel Ltd. This makes Kessel Ltd. and Sterling Inc. related parties. Disclosure is required for the relationship, any transactions during the period, and the fact that the amount was written off during the year.
2. Kessel Ltd.’s 35% share ownership of Saunders Ltd. would normally be presumed to give it significant influence, thus making the parties related. As such, the nature of the relationship and the transaction itself need to be disclosed. There is, however, no requirement to state that the transaction was at arm’s length unless this fact can be verified.
3. Mr. Chiang is a member of the key management personnel of Kessel Ltd., making them related parties. Therefore, the details of the transaction need to be disclosed along with the nature of the relationship. As well, the guarantee of the mortgage should also be disclosed.
4. Even where there is economic dependence, regular supplier-customer relationships do not indicate related party relationships. Thus, no separate disclosure of this transaction is required.

Exercise 22.2

1. Without any further information about cross shareholdings, the presence of a single common director between companies does not, in and of itself, indicate a related party relationship.
2. A single investor has influence, but not control, over the other two companies. This would not normally indicate a related party relationship between the two associate companies.
3. Each of the directors is individually related to each of the companies. The presence of common directors does not, in and of itself, indicate a related party relationship between the two companies. However, IAS 24 does require an examination of the substance, and not just the form, of the relationships. If the five directors have demonstrated a pattern of acting together as a single voting unit, then it can be argued that as a group, they control the two companies. In this case, the presence of a common controlling group would indicate that the companies are related.

Exercise 22.3

1. January 8, 2023: The appropriation was approved after the year-end and there is no indication that this action was substantively enacted prior to the approval date. As such, this was not a condition present at year-end, and no adjustment is required. However, disclosure should be made, as this event will likely have a material effect on future operations.
2. January 27, 2023: Although the bonus was approved after year-end, it clearly relates to the financial results of the year and was committed under employment contracts that existed at the year-end. The bonus should thus be accrued on December 31.
3. February 3, 2023: The additional taxes should be accrued, as the tax dispute already existed at the year-end. The change will be treated prospectively, (i.e., adjust in 2022 only) unless it can be demonstrated that the previous provision was made in error.
4. February 21, 2023: This should be adjusted, as the error caused by the fraud existed at the reporting date. As well, because there is an illegal act involved, there may be further disclosures required.
5. March 16, 2023: Dividends should not be adjusted, as there is no obligation to pay them until they are declared. However, disclosure of the declaration should be made.
6. March 18, 2023: The condition did not exist at the reporting date, so no adjustment is required. If the loss of the machine will have a material effect on future operations, then disclosure should be made.

Exercise 22.4

Although the damage only appeared after the reporting period, the engineers have indicated that the problem may have been present for several years. This would indicate the presence of an adjusting event. However, a provision should not be made as there is no legal obligation to make the repairs at year-end, that is, the building could simply be abandoned rather than repaired. What should be done, however, is an impairment review under IAS 36, and any impairment of the asset should be recorded.

Exercise 22.5

The auditor needs to consider if there is sufficient evidence available to support a clean opinion, that is, that the financial statements have not been materially misstated. The correspondence with the legal counsel should be examined carefully in order to determine if the assertion that the outcome cannot be determined is supportable. Contingent liabilities are not accrued as provisions if there is only a possible, but not present, obligation that will only be settled by an uncertain future event, or if a present obligation cannot be reliably measured. If accrual of the provision is not warranted, disclosure in the notes is still required. In this case, the effects appear material, so the auditor will need to make sure that the appropriate note disclosures are made.

The auditor will also need to assess management’s assertion that the plant will be closed if the legal case is lost as this may have a pervasive effect on future operations. The auditor may need to question the going concern assumption. Although it may be too early to make this determination, the compromise of the going concern assumption would lead to presentation of the financial statements using a different basis of accounting. If management refused to make this change, then the auditor would need to consider if a qualified, or adverse, opinion was warranted.

Even if the auditor is satisfied with the disclosures made, the pervasiveness of the matter may suggest the need for an emphasis of matter paragraph to be included in the audit report, thus drawing attention to the disclosures.

Exercise 22.6

Revenue test:

. Business lines 1 and 4 meet this threshold.

Profit/(Loss) Test:

The total profits of $52,000 are greater than the total losses of $14,000, therefore .

In absolute terms, ignoring the + and – signs, business lines 1, 2, and 4 meet this threshold.

Assets test:

. Business lines 1 and 4 meet this threshold.

Conclusion:

Based on the tests above, business lines 1, 2, and 4 all meet at least one of the three tests above.

For the 75% or greater test 

Sum of business lines 1, 2, and 4 

This test has been met by all of the reportable segments, which are business lines 1, 2, and 4. However, management can override these tests and report a business line as a reportable segment if they consider the segmented information to be useful to the stakeholders.

Exercise 22.7

Interim reporting has several challenges:

• Changes in accounting principles: If this change were to occur in the second or third quarter, how should this affect the first quarter interim financial statements? The general consensus is that, even if the change of a particular accounting policy, such as a depreciation method, is prospective, the annual change should be prorated to each of the interim accounting periods so as not to over/under state any specific quarter. This would lessen any tendency of management to manipulate accounting policies within a specific quarter to influence bonuses or operational results targets. Thus, even though the change in policy is applied prospectively for the fiscal year, if interim statements are prepared, the change in policy would be applied retroactively, but proportionally, between each quarterly period to smooth the results over each quarter for that fiscal year.
• Cyclical and seasonal swings experienced by businesses within a fiscal year: Revenue can be concentrated over a limited number of months, while expenses may be incurred monthly. If IFRS guidelines are followed, the principles of revenue recognition and matching (of expenses incurred to earn those revenues) will continue to be accrued and recorded within each of the interim periods and the same tests used for annual financial statements would be applied to the interim reports.
• Allocations for income taxes and earnings per share: The treatment requires each interim period to be independent of each other and for interim allocations to be determined by applying all the same tests as those used for the annual reports.
• Auditors: While some stakeholders continue to push for an examination of the interim reports in order to provide assurance, auditors are reluctant to express an opinion on interim financial statements. As such, there will always be a trade-off between the need for assurance through an audit opinion and the need to produce the interim report on a timely basis.

ASPE does not contain any guidance for reporting interim reporting or segmented information. The issues would be the same for companies following either IFRS or ASPE, except that IFRS requires more disclosures.

Exercise 22.8

1. Percentage (common-size) vertical analysis is as follows:

   		2021	2020	2019
   Net sales		100%	100%	100%
   Cost of goods sold (COGS)		65%	60%	63%
   Gross profit		35%	40%	37%
   Selling and administrative expenses		20%	21%	22%
   Income from continuing operations before income taxes		15%	19%	15%

   The company’s income before taxes declines in 2021 due to higher cost of goods sold (COGS) as a percentage of net sales, as compared with 2020. Moreover, the COGS in 2020 decreased by 3% from the previous year followed by a more than offsetting increase back to greater than the 2019 percentage levels. Was there a write-off of inventory in 2021 that would cause COGS to sharply increase from the previous year? More investigation would be needed to determine the reason for the difference. Selling and administration continues to slowly decrease over the three-year period as a percentage of sales, suggesting that management may be taking steps to make operations more efficient. Separating the selling from the administration expenses would be a worthwhile drill-down into the numbers.

   Horizontal (trend) analysis is as follows:

   	2021	2020	2019
   Net sales	119%	107%	100%
   Cost of goods sold (COGS)	123%	102%	100%
   Gross profit	113%	116%	100%
   Selling and administrative expenses	109%	104%	100%
   Income from continuing operations before income taxes	118%	132%	100%

   This trend-line analysis highlights the jump in COGS between 2020 and 2021. Note how sales increased by 19% from 2019 while COGS increased by 23%. This divergent trend between these two accounts should be investigated further. Even though selling and administration expenses were shown to be dropping as a percentage of sales, these expenses actually increased over the two years. Further investigation of the increasing selling and administration costs might be necessary.

   As can be seen from analysis of the two schedules above, different areas of operations may become targeted for further investigation depending on which schedule is examined. An area may not look particularly troublesome until another type of analyses is considered.

2. Limitations of these types of analyses include:
   • Vertical/Common Size Analysis: The downside to this type of analysis is the need to avoid management bias, or the temptation to use various accounting policies to favorably change a gross margin for personal reasons such as bonuses or positive performance evaluations. For example, if a gross margin decreased from 40% to 35% over a two-year period, the decline could be a realistic reflection of operations, or it could be the result of a change in estimates or of accounting policy. For this reason, any change in the ratios should always be further investigated.
   • Horizontal/Trend Analysis: If the company’s operations are relatively stable each year, this analysis can be useful. However, changes in these ratios could also be due to a change in pricing policy and not due to actual transactions and economic events. Again, more investigation is necessary to determine if the increase is due to true economic events or changes in policy made by management.

   It is important to remember that ratios are only as good as the data presented in the financial statements. For example, if quality of earnings is high, then ratio analysis can be useful, otherwise it may do more harm than good. Also, it is important to focus on a few key ratios for each category to avoid the risk of information overload; it is those few key ratios that should be investigated and tracked over time. It is also important to understand that industry benchmarks make no assurances about how a company compares to its competitors since the basis for the industry ratio may be different than the basis used for the company. As such, ratios provide good indicators for further investigation, but they are not the end-point of an evaluation.

Exercise 22.9

a. Liquidity Ratio: Measures the enterprise’s short-term ability to pay its maturing obligation:

Current ratio: .

If a guideline of 2:1 is the norm for this industry, then this company’s ratio is low. This company can meet its current debts provided that accounts receivable are collectible and inventory sellable. Too low could be an issue while too high could also be an issue and indicate an inefficient use of funds.

Quick ratio: 

If a guideline of 1:1 is the norm for this industry, this company’s ratio is low. More information is needed, such as historical trends or industry standards. Nearly 50% of the current assets are made up of inventory. Therefore, inventory risks such as obsolescence, theft, or competitors’ products could affect this company.

b. Activity Ratio: Measures how effectively the enterprise is using its assets. Activity ratios also measure the liquidity of certain assets such as inventory and receivables (i.e., how fast the asset’s value is realized by the company).

Receivables turnover:

If a guideline of 30 to 60 days is the norm for this industry, receivables are being collected too slowly and too much cash is being tied up in receivables. Comparison to industry standards or historical trends would be useful.

Inventory Turnover:  

An inventory turnover of less than three times per year appears to be very low. Too low may mean that too much cash is being tied up in inventory or there is too much obsolete inventory that cannot be sold. Too high can signal that inventory shortages may be resulting in lost sales. More information about the industry is needed.

Asset Turnover: 

This ratio appears low. Too low means that this company uses its assets less efficiently to generate sales. Industry standards and historical trends would be useful.

Exercise 22.10

Liquidity:

Current ratio =

Current ratio describes the company’s ability to pay current liabilities as they come due.

This company’s comparable current ratio is favourable.

Activity:

Days’ sale in inventory	=
	=
	=

Days’ sales in inventory measures the liquidity of the company’s inventory. This is the number of days that it takes for the inventory to be converted to cash. The company’s days’ sales in inventory are unfavourable when compared to the industry statistics.

Total asset turnover describes the ability of a company to use its assets to generate sales—the higher the better.

This company’s comparable asset turnover is unfavourable.

Account payable turnover	=
	=
	=

Accounts payable turnover describes how much time it takes for a company to meet its obligations to its suppliers. This company’s accounts payable turnover is lower than the industry average which means they are preserving their cash longer by comparison.

Solvency/coverage:

Debt ratio = 

Debt ratio measure how much of the assets are financed by debt versus equity. The greater the debt ratio, the greater the risk associated with making interest and principal payments. This company’s comparable debt ratio is favourable.

Profitability:

Measures the company’s ability to generate a profit from sales. This company’s profit margin is favourable.

Book value per common share	=
	=
	=

When compared to its market price of $97, it appears that the market considers the earning power of its assets to be greater than the value of the company on its books. It follows that most profitable companies try to sustain a market value higher than the book value. Conversely, if the book value was higher than the market price, then the market considers that the company is worth less than the value on its books.

Book value per preferred share	=
	=
	=

There are no dividends in arrears, so this ratio reflects the average paid-in amount, or the call price if they are callable.

Exercise 22.11

1. 1. Acid-test ratio for 2020: This is a liquidity ratio that is a more rigorous test of a company’s ability to pay its short-term debts as they come due. Inventory and prepaid expenses are excluded from this ratio and only the most liquid assets are included.
   2. The company’s acid-test ratio is favourable relative to the industry average.
2. 1. Accounts receivable turnover for 2020.  or every 59.64 days ()
   2. The company’s accounts receivable turnover is unfavourable relative to the industry average because the company’s turnover rate of 6.12 is lower than the industry rate of 8.2 times. In days, the company’s rate is every 59.6 days () as compared to industry’s every 44.5 days () which represents the average number of days to collect accounts receivable.
3. Using the return on assets ratio: * ;
   13.77% is higher (more favourable) than the industry average

Exercise 22.12

The balance sheet was strengthened from June 30, 2019 to June 30, 2020:

Debt financing (percentage of liabilities to total assets) decreased significantly, from 62.5% at June 30, 2019 ($75,000 ÷ $120,000) × 100 to 5.91% at June 30, 2020 ($10,850÷$183,550)×100

* (1,800+7,000+950+1,100) = 10,850 total liabilities

(29,000-3,800-1,400+10,000+15,000+17,000+14,000+750+75,000+25,000+2,500+500)=183,550 total assets

Equity financing (percentage of equity to total assets) increased from 37.5% at June 30, 2019 $45,000 ÷ $120,000 × 100) to 94.09% at June 30, 2020 ($172,700 ÷ $183,550) × 100

* (49,325+40,000+50,000-46,000+79,375 net income **) = 172,700
** Net income (2,000+314,000-22,000-20,000-123,900-4,875-5,000-1,200-17,900-41,750) = 79,375

Exercise 22.13

Calculations:

	2020	2019
Current ratio
Acid-test ratio

Yeo Company’s current ratio improved significantly from 1.73 in 2019 to 2.11 in 2020. This means that in 2020, Yeo Company had $2.11 of current assets available to pay each $1.00 of short-term debt. However, the acid-test is a more rigorous measure of short-term debt-paying ability because it excludes less liquid current assets such as Yeo Company’s merchandise inventory. Merchandise inventory is excluded because it is not available to pay short-term debt until it has been sold; there is also the risk that it might not be sold, due to obsolescence, spoilage, or poor sales. The acid-test for 2019 showed that there was $1.07 of quick current assets, or liquid current assets, available to pay each $1.00 of short-term obligations. The acid-test decreased in 2020 indicating that there was $0.78 of quick current assets available to pay each $1.00 of current liabilities, highlighting a potential cash flow problem. When there are insufficient current assets available to pay current liabilities, liquidity, or cash flow, is a concern, hence the relationship between short-term debt-paying ability and cash flow.

Exercise 22.14

Kevnar Corporation has strengthened its balance sheet because its debt ratio decreased from 2019 to 2020. Strengthening the balance sheet refers to how assets are financed—through debt or equity. The greater the equity financing, the stronger the balance sheet. This is because there is risk associated with debt financing (i.e., the risk of being unable to meet interest and/or principal payments). Therefore, although Kevnar Corporation has a greater percentage of its assets financed through debt than does Dilly Inc., it has increased equity financing which indicates a strengthening of the balance sheet because of the decrease in risk associated with debt financing.

Financing through equity also has its disadvantages. Having more equity-based financing can mean a dilution of ownership that results from the issuance of more shares to outside investors. Having more shareholders also means that there will be additional claims to the equity in the business. Conversely, debt does not dilute the ownership of a business since a creditor is only entitled to the repayment of the agreed-upon principal plus interest, so there is no direct claim on future profits of the business. Moreover, if the company is successful, the existing owners will reap a larger portion of the rewards than they would have if they had issued more shares to outside investors in order to finance the growth. Additionally, interest on debt can reduce net income and, hence, reduce income taxes, making equity financing potentially a more costly source of financing than debt. Because of the requirement to comply with federal laws and securities legislation, financing through issuance of shares is usually a more complicated and lengthy process than acquiring funds from debt sources. This certainly slows the financing process down, but it can also add to the costs of equity based financing.