ABC Limited (ABC) is a private company producing lunch packages. It mainly sells
ID: 2578659 • Letter: A
Question
ABC Limited (ABC) is a private company producing lunch packages. It mainly sells products to supermarkets and grocery stores. ABC has a loan from a local bank, which is secured by its accounts receivable and inventory. The loan is not to exceed 70% of accounts receivable and 40% of inventory as at the accounting year end (December 31, 2016). ABC uses perpetual inventory system. ABC must provide the bank with the reviewed financial statements within 60 days of its year end.
It is now in early January 2017, you are a CPA from a local accounting firm and will conduct a review of the ABC’s financial statements. You received a memo from the ABC’s management including the following accounting issues:
1. Super Software Co. (SSC), an ABC’s neighbour, is a software development company with high growth in recent years. On August 15, 2016, SSC signed a contract with ABC that SSC’s employees can pick up a lunch package every working day for one year beginning on September 1, 2016 for a yearly fee of $120,000, with 50% payable upfront. The fee is non-refundable, non-cancellable, and not dependent on the number of lunch packages picked up. When the contract was signed, ABC credited revenue for $120,000 and debited both cash and accounts receivable for $60,000 each.
2. During November 2016, ABC paid $10,000 to purchase frozen chicken meat from Fresh Meat Butcher (FMB), a small meat supplier in financial difficulty. ABC has not begun to use the FMB’s frozen chicken meat in producing lunch packages so far. In December 2016, there was an allegation that FMB’s chicken meat could be polluted in the production process. The Canadian Food Inspection Agency is now investigating this allegation, and the outcome is uncertain.
3. In December 2016, ABC just began to sell frozen lunch packages. To promote this new product, ABC signed contracts with stores, which specify that the actual number of packages sold to stores depends on the number of packages bought by consumers before the expiry date of packages. ABC has delivered 10,000 frozen lunch packages to stores by the end of 2016, with a price of $3.50 per package. ABC’s suggested retail price of this lunch package is $6.00 per package.
4. In October 2016, ABC launched a loyalty program. According to the program, consumers can earn one point for buying an ordinary lunch package (excluding frozen lunch packages), and can redeem 20 points for an ordinary lunch package in stores. ABC first uses packages purchased by stores for the redemption and then deducts them from its sales. On December 31, 2016, stores reported that they had sold 50,000 ordinary lunch packages to consumers at $7 per package since the beginning of the loyalty program, and that consumers had redeemed 6,000 points. Ordinary lunch packages are sold to stores at $4.00 per package. The cost of ordinary lunch packages is $1.80 per package.
Required
Provide a report to the ABC’s management to analyze these accounting issues and their implications for the bank loan.
Explanation / Answer
The following could be the content of the report to ABC's Management
As per the terms of the bank loan, ABC's loan is not to exceed 70% of Accounts Receivable and 40% of Inventory. Which means ABC's Accounts receivable and Inventory needs to be maintained at a minimum level. For Eg IF the loan from the bank is $28,000, then the Accounts Receivables balance shouldnt go below $40,000 (28000/70%) and the Inventory balance shouldnt go below $70,000( 28000/40%)
Looking at the Accounting issues one by one:
1. According to the contract with SSC, ABC has increased it's Accounts Receivable by $60,000. A receivable collection policy needs to be setup to ensure the cash is received timely. Since the Accounts Receivable is increasing it will have no impact on the loan term
2. In the case of FMB, since the investigation outcome is uncertain, the inventory can be maintained at level( However, no provision can be created as per IAS 37 since it's a future operating loss and no provisions are allowed for the same). Since the inventory level is the same it will have no impact on the loan term but the Inventory level could go down at any time (depending on the litigation) and sufficient extra inventory should be ensured to not allow breach of Loan term.
3. This is a case of Consignment sale with stores. As per IAS 2, Finished goods inventory can be recorded at value till the time the sale is made from the store. Since the inventory level is the same it will have no impact on the loan term
4. For the customer loyalty program redemption, ABC needs to reduce 300 units (6000 redemption points/20 per unit 6000/20=300) from the sales. Since the inventory level and Accounts Receivable level is the same it will have no impact on the loan term
Hope this helps.