Harrison & Ford, Chartered Accountants

Case 2

Harrison & Ford, Chartered Accountants

Background and Introduction

As your hired firm, we have prepared a report that will be useful in discussing the need for an audit with Mitchem Lethbridge, Ltd.  Mitchem Lethbridge, Ltd. was recently awarded $100,000 for attaining the highest growth in net income between 2010 and 2011 of all Mitchem franchises.  A Mitchem franchise in Halifax has contested the win of Mitchem Lethbridge, Ltd.  Head office, in response to the accusation, has requested that an audit of the financial statements of Mitchem Lethbridge, Ltd. be completed.  The cost is to be shared between head office and the Lethbridge franchise.  In our report, we will outline some possible issues identified by the accountant of Mitchem Lethbridge, Ltd.  This include particulars such as tax loss carryforwards, inventory write downs, adjusting entries, and GAAP appropriateness.  Based on our findings, we have also prepared a recommendation as to whether an audit should be completed.

The company currently uses ASPE for their reporting. This is GAAP for the company as they are a private company. There is no indication that IFRS or special purpose reporting would be more appropriate in the future.  The general accounting standards apply; there is no indication of a continuity problem.  There are several users of Mitchem Lethbridge, Ltd. Financial statements.  These include:

Franchise owner:  Lisa is the sole shareholder of Mitchem Lethbridge, Ltd.  She likely uses the financial statements in order to predict cash flows as well as assess the performance of her investment.

Head office: The head office will likely use the financial statements to monitor the franchise’s performance.  As well, once every three years there is a competition between franchises to have the most improved overall performance.  The judgement of this competition is based solely on net income.

Management: The management of the franchise would use the statements to assess cash flows, monitor sales, and measure performance of the company.  As well, they are involved in the competition for increasing overall performance. It is important to note that because of the nature of the competition, franchises have motivation to invoke the “big bath” technique.  This involves lowering net income in year one and then raising the income in year two.  The financial statements created using this technique do not necessarily reflect the true performance of the company. Since the winner of the competition is based on after-tax net income, it is likely that management would attempt to manipulate the tax expense.

Analysis

Tax Loss Carryforward

        Jeff, the accountant at the Lethbridge Franchise decided to recognize the tax loss carryforward from 2010 in 2011 because that it when it was realized.  According to ASPE 3465.07, when a tax loss is used to recover income taxes, the benefit should be recognized in the period in which the tax loss occurred.  In keeping with this rule, we believe that the tax loss from 2010 should be recognized in 2010 as well, regardless of the fact that the benefit was realized in 2011.  This is because the roots of the benefit were in 2010.  We also do not have enough information to determine if the tax calculations for both years were correct. If an audit were completed, the auditor would likely request access to the documents which support the tax calculations.

Inventory Writedown

        There was an excess amount of inventory when Mitchem Lethbridge was nearing year-end of 2010.  Jeff was concerned that they may have to reduce the prices of the inventory to liquidation values in order to sell them quickly.  ASPE requires inventory to be recorded as the lower of historical cost and net realizable value; However, certain qualifications must be met in order that the inventory be written down to net realizable value.  According to ASPE 3031.07 these qualifications include an attempt to sell surplus or overpriced inventory to improve liquidity rapidly or to reduce holding expenses.  While Jeff mentioned his worries about needing to sell the inventory at liquidation values, however we see no indication that the company would have needed to rapidly improve their liquidity.  Thus, we do not believe Jeff’s decision to write down the inventory was rational.

ASPE also states that a “new assessment is made of net realizable value in each subsequent period. When the circumstances that previously caused inventories to be written down below cost no longer exist or when there is clear evidence of an increase in net realizable value because of changed economic circumstances, the amount of the write-down is reversed” (ASPE 3031.32).  If Jeff had additional information that caused him to believe he was justified in writing down the inventory in 2010, when economic conditions increased in 2011 the inventory writedown should have been reversed.  There is no mention of this reversal in the income statement or balance sheet.

Reduction in Lisa’s Salary

        In 2011, Lisa reduced her salary by $45,000 in order to improve the company’s bottom line.  It is also important to note that as Lisa is the sole shareholder of the Lethbridge franchise, hre reduction in salary led to an increase in retained earnings.  In the same year, dividends in the amount of $45,000 were paid out to Lisa.  This makes up for her $45,000 reduction in salary and Lisa is ultimately compensated the same amount in 2011 as she was in 2010.  This compensation type shift in has tax implications for Lisa as dividends are not taxed as heavily as salary and for the company as companies cannot legally deduct dividend payments before tax is calculated.  

As mentioned in the competition rules, the winner is chosen based on net income after tax.  In shifting her compensation from salary to dividends, Lisa has ensured her franchise’s net income is higher and the growth of the company appears better because dividends are not included in the net income calculation.  This treatment complies with ASPE; however we do not believe this is done within the spirit of the competition.  The goal of the contest is to reward the greatest improvement in overall performance of the franchises.  This shift in compensation does not improve the performance of the branch.  Instead, it solely manipulates net income.