Case Study

Case Study

SECTION V
Intermediate Accounting II Cases

Alpha Classic Car Restorations

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 John Wallace is an automotive enthusiast. He has over 25 years of experience as a mechanic for the dealership of a large car manufacturer in Oakville. John also gained experience doing minor body work and painting.

Recently, John decided to retire from the car dealership and pursue his interest of restoring classic American muscle cars. Accordingly, John started Alpha Classic Cars Restoration (ACCR). John leased an industrial building and converted it into a repair and body shop. The building’s land has a small parking lot that is used to showcase the restored vehicles that are for sale.

Generally, John selects the classic muscle cars that ACCR will restore and then places them for sale to the general public in the lot. John also posts his vehicles to various Internet sales sites, frequents car shows, and uses the classifieds of local newspapers to market his inventory. ACCR also takes custom jobs, whereby an individual can request the car to be restored.

ACCR has a December 31, 2020, year end, and just completed its first year of operations. John had a friend help him compile financial statements for the year end (draft financial statements can be found in Exhibit I). ACCR’s bank requires the preparation of annual audited financial statements in accordance with IFRS (details of the loan agreement can be found in Exhibit II), and the auditors are scheduled to commence year-end work on January 18.

Exhibit I

Draft Financial Statements

Statement of Financial Position

Income Statement

Exhibit II

Bank Loan Agreement

The Bank of Toronto has provided a $300,000 loan to help finance working capital and capital assets. The following are the terms and conditions of the loan.

• Security: The bank secures its loan with a first claim against inventory and accounts receivable.
• Repayment: The loan is to be repaid over a 10-year period, with blended monthly payments.
• Interest rate: The rate of interest is 6%, effective annual rate (EAR).
• Covenants: ACCR must comply with the following covenants:
  • The current ratio must not be below 2:1.
  • The debt to equity ratio must not exceed 3:1. Debt is defined as both current and long-term liabilities.

A violation of either covenant will result in the loan becoming payable upon demand.

• Financial statements: Audited financial statements are to be presented no later than 60 days after year end. Financial statements can be prepared with ASPE.

Realizing that ACCR needs accounting assistance, John has hired you, CPA, as a consultant on December 24, 2020. Your first task is to review the draft financial statements and provide any recommendations to comply with IFRS. In addition, John required some assistance preparing a statement of cash flow. John has provided you with a file for review, which outlines all of the significant transactions that have taken place during the year (Exhibit III).

Exhibit III

Notes of Significant Transactions

• During the first year of operations, ACCR made the following sales:

• ACCR is so confident in its workmanship that it offers a 10-year bumper-to-bumper warranty with all car sales. The warranty covers all defects and breakdowns that are not directly related to regular wear and tear. John is unsure of how much the warranty will cost to service, but is confident that his vehicles will stand the test of time. Based on his experience, John estimates the probability of a vehicle making a warranty claim during the 10 years of coverage are as follows:

• The average retail value per claim is $1,250. The average cost of parts and service at ACCR is about 60% of that of a dealership.

• ACCR sold the 1972 Chevy Camaro to a wealthy telecom CEO during the year. Shortly after delivery of the vehicle, John found out that the CEO resigned from the company due to various accounting irregularities and restatements. John has been in contact with the customer and knows that he is happy with the car, and fully intends to pay once things settle down.
• ACCR entered into a lease agreement on January 1 for the land and building that is used as the repair and body shop. ACCR is required to make monthly payments of $2,500, commencing January 31, for a 10-year period (at which point, John expects to be fully retired and live off of his pension). The following additional information is available regarding the lease:
  • The rate implicit in the lease is 7%.
  • The building and land have fair values of $170,000 and $56,667, respectively.
  • The building has a useful life of approximately 13 years.
  • The lease payments were set to provide the lessor with a return of 60% related to the building and 40% related to the land.
  • There is no bargain purchase option, or renewal option, at the end of the lease.
• The capital asset breakdown is as follows:

• The leasehold improvements include changes to the building and land (e.g., paving). The machinery and equipment is expected to have a residual value of $95,000 after their 10-year useful life. Both the office equipment and vehicle are expected to have useful lives of eight years, with no residual values.

• The income taxes presented in the financial statements are based on the pre-tax income times the tax rate of 16.5%. No adjustments have been made to calculate taxes in accordance with the Income Tax Act even though the deferred taxes method has been adopted. The following are the CCA rates relevant to the capital assets of ACCR:

• 1. Machinery and equipment: 30%
  2. Leasehold improvements: 10 years, straight-line
  3. Office equipment: 20%
  4. Vehicles: 30%
• The inventory balance includes a 1971 Corvette Coupe. The car was a custom order for a doctor. Due to financial problems, the doctor was unable to purchase the vehicle, at which point ACCR repossessed the vehicle. The vehicle is included in inventory at its cost of $35,000. The vehicle will require minor moderations, costing up to $5,000, to make it ready for resale at a price of $35,000.

Aside from the year-end statements, John would also like to know whether he will be able to pay any dividends in the current year. He has drawn a minimal salary and is hoping to supplement his income by paying a $35,000 dividend with the current cash balance.

Finally, John has asked you to provide some advice regarding the additional controls or procedures that could be implemented to improve the day-to-day operations of the company.

Required

John has asked you to prepare a report that discusses all of the material accounting issues (i.e., identify the issues, discuss the implications, offer alternative treatments, and provide a recommendation). Revised financial statements should be included in the report. The report should also address John’s other concerns. Provide journal entries, where appropriate.

Assume the company follows ASPE, NOT IFRS

IGNORE JOHN’S REQUEST OF PROVIDING ADDITIONAL ADVICE REGARDING CONTROLS OR PROCEDURES THAT COULD BE IMPLEMENTED. YOU DO NOT NEED TO ADDRESS THIS.

You must prepare a report that analyzes the following issues (identify the issue, discuss the implications, offer alternative treatments, and provide a recommendation):

• Warranty provision
• Lease agreement (hint: review real estate leases in Chpt 20 Appendix A)

IGNORE FUTURE INCOME TAXES. ASSUME THAT INCOME TAXES PAYABLE AND PROVISION FOR INCOME TAXES ARE CORRECT AS CURRENTLY RECORDED.

Provide all necessary journal entries. There should not be any adjustments to your financial statements without a journal entry to support it.

Once you have analyzed these issues, prepare a revised balance sheet, income statement, and cash flow statement, all in proper form. (Hint: make sure current portions of long-term debt are presented separately)

Finally, address the big picture issues: are the debt covenants violated? Is the company able to pay a $35,000 dividend to John?