Assignment Problem:
There are 4 separate parts to this assignment: (Assume all companies are privately held)
Part 1 - Bill and Hold and Going Concern
Facts: Background
A Chicago area defense subcontractor ("ABC") manufactures metal gear boxes for tanks and fighter aircraft. It has been in business since the 1960's -- & has a December 31st year- end.
In 2016, a Canadian Company ("Parent") purchased 100% of ABC.
Facts: Bill and Hold
Toward the end of each month, ABC used to ship the gear boxes it produced via common carrier to Northrop Grumman located in the northwest suburbs of Chicago. Since the gear boxes have to be made within an accuracy of .001 inches, invariably Northrop's quality control department would inspect the gear boxes, reject them and ship them back to ABC via common carrier for rework. This arrangement caused delays and was quite expensive since each gear box weighs approximately 60 pounds.
Effective with the current year, 2019, Northrop requested that at the end of each month, ABC bill Northrop for the month's production but hold the gear boxes until Northrop sent out a quality control inspector to ABC toward the end of each month. Northrop's purpose was to expedite the inspection and approval process & reduce common carrier costs.
Toward the end of December, 2019, Northrop's quality control inspector was on vacation and arranged to perform the customary inspection on January 6, 2020.
Facts: Going Concern
In 2017 the Company had a slight loss.
In 2018, the Company had a much larger loss, significant decline in sales & terminated about 25% of its workers. The sales decline was directly caused by a steep decline in orders for tanks & planes by the Department of Defense.
In 2019, preliminary numbers reviewed by your audit firm during October, 2019 (as part of the planning phase of the 12/31/2019 yearend audit), reflected a very large loss, a continued decline in sales & additional staff reductions.
In 2017, 2018, and 2019 ABC has suffered recurring losses from operations, and has had a net capital deficiency.
ABC expects continued weak demand for its defense products in 2020 & beyond.
ABC hopes to use its manufacturing expertise to enter into other non-defense oriented markets starting in 2020.
Since the acquisition, the ABC Company has maintained large bank loans pursuant to bank lines with a local bank. There is no additional borrowing capacity on these bank lines.
The audited financial statements are due 90 days after the 12/31/2019 year end - i.e. 3/31/2020. Your audit firm intends to release the audited financial statements on or prior to this due date.
The ABC Company bank debt is due on demand, is secured by its equipment and is guaranteed by Parent.
Pursuant to Canadian / U.S. banking procedures, the Parent obtains a Letter of Credit from its Canadian bank to serve as collateral for its guarantee of ABC's U.S. bank debt. (The letter of credit will be converted to cash to payoff ABC's local bank debt if ABC defaults on this bank debt). The Canadian Bank which issues the Letter of Credit is Canada's rd strongest Bank.
The letter of credit is for a 1 year term (i.e. from each March 1st to the following March 1st) & automatically renews each March 1st unless any of the parties to the arrangement wants to terminate the letter of credit.
Substantially all of the work for the 2019 audit is completed by February 15, 2020.
Required:
1. ABC wants to recognize the December, 2019 production which was billed in late December (and which would go through the customary Northrop inspection in early, January, 2020) as 2019 Revenue. Assuming you, the Auditor, agree there will be 12 months of billing recognized in 2019 Revenue in the financial statements.. Assuming you do not agree, there will be only 11 months of billing recognized in 2019 Revenue in the financial statements. Also, your research shows the only authoritative guidance in GAAP for bill and hold sales is literature released by the Securities and Exchange Commission.
In your opinion, should ABC recognize the December production / billing as revenue in 2019?
2. State whether you believe there is or is not substantial doubt about the Company's ability to continue as a Going Concern. Provide your supporting arguments, specifically addressing:
- Conditions and Events
- Management's Plans
Stating that you believe there is substantial doubt means that your Audit Firm's Independent Auditor's Report for the year ended December 31, 2019 will include an emphasis of a matter paragraph with the supporting footnote. (There is no need to formally draft the paragraph & supporting footnote.)
Stating that you believe there is not substantial doubt means that your Audit Firm's independent Auditor's Report for the year ended December 31, 2019 will not include an emphasis of a matter paragraph but the Audited Financial Statements will include a footnote describing the conditions and events and how management's plans alleviated the conditions and events. (There is no need to formally draft the footnote.)
Part 2 - Subsequent Events
Facts:
You are performing an annual audit of a company with a December 31, 20X1 year-end. Your firm is planning to complete the audit on March 1, 20X2 and release the report on March 31, 20X2. On March 20, 20X2, two material subsequent events occur:
A fire caused extensive damage to the company's manufacturing plant in France.
A large customer went bankrupt. At December 31, 20X1, the Company had a receivable of $1,500,000 from this customer; at December 31, 20X1 the Company had established an allowance for doubtful accounts of $350,000 for this customer.
Required:
1. Explain whether each subsequent event is a Type 1 or Type 2 Subsequent Event.
2. What is the impact of each subsequent event on the company's audited financial statements for the year ended December 31, 20X1? Be specific as to whether (a) there will be an adjustment which will cause the company's balance sheet and / or income statement to change plus footnote disclosure, (b) there will only be footnote disclosure, or (c) there will be no impact to either the financial statements or the footnote disclosures.
3. How should your Audit Firm date its audit report?
Part 3 - Contingent Liabilities
Facts:
Before year end, a company's truck driver is involved in a three vehicle wreck. One of the injured passengers in a separate vehicle is suing everyone involved. The company is being sued for $2 million. The company has $1 million of liability insurance. The company's outside legal counsel states in writing that it is unable to express an opinion as to the likelihood of an unfavorable outcome to the company or the amount of any potential loss.
A company has been involved in ongoing litigation with one of its competitors for many years. Before the end of the year being audited, the outside legal counsel sends a letter to the company's owners stating that it is probable that the company will have to make a payment to the plaintiff to settle the litigation. However, the law firm could only say that it is probable the company will have to pay somewhere between $50,000 and $200,000 in the settlement.
Required: For both cases discussed above, answer two questions:
1. Should the company record a loss reserve at year end, and if so, for how much?
2. Should the company disclose this matter in the footnotes to the company's financial statements at year end?
Part 4 - Ethics: Compilation
Facts:
A Chicago area manufacturing company ("JKL") has 2 unrelated owners. The CPA firm ("Flexible") for the manufacturing company prepares annual financial statements and corporate tax returns (1120S). In addition, Flexible prepares the personal income tax returns for one of the owners - a different tax accountant prepares the personal income tax returns for the other owner. The Company has a December 31st year end.
Toward the end of February each year, there is an annual meeting in the western suburbs, with the following in attendance: the 2 owners of JKL, Flexible's CPA Partner, the tax accountant for the other owner, and pension consultants.
In anticipation of the meeting, Flexible prepares and distributes draft financial statements, and a year to date General Ledger; everything is complete except the amount of any pension accrual and the final amount of inventory.
The purposes of the meeting are to determine:
1. The pension accrual
2. The desired taxable income for the year
3. The amount of inventory necessary to bring taxable income to the desired level (achieved through a debit or credit to inventory with an offsetting debit or credit to cost of goods sold).
Required - For the situation described above, please answer the following two questions:
1. What are the business ethical issues?
2. What are the professional ethical issues for Flexible's CPA Partner?
Note: The Written Case Analysis should be 3 - 4 pages in length, typed & single spaced. Each student must submit his/her own Case Analysis. Please provide references to any appropriate materials including course handouts, the textbook and professional pronouncements.