Re: Current accounting issues, employment benefits and financing options. Thank you for the opportunity to address the current accounting issues, employment benefits and financing options facing Carroway Clothing Limited (CCL)
1. SR& ED and Development costs treatment:
In reviewing the financial statements it appears that the development costs and SR&ED treatment may not have been recorded appropriately. The SR&ED are tax credits to be used towards taxable income and should not have been recorded as government grants. Since CCL may not have needed them in the initial years, it can use SR&ED tax credits against taxable income in the future. It is necessary to identify all SR$ERD activities for proper recording practices so that the credits generated by the SR&ED can be used against future income.
The $975,000 development costs can be expensed or capitalized depending on if the following criteria are met
The project is technically feasible
CCL intends of complete the project
CCL has the ability to use or sell the product
There is probability of future economic benefit will be generated Availability of adequate technical and financial recourses
CCL has the ability to measure reliably the expenditures attribute to it.
Since the Walton Work Wear line is in the production stage, its accumulated development costs should be capitalized. The Carroway Cool Top has not started it commercial production which would allow the development costs not to be amortized yet. Also interest costs on loans to generate financing for the R&D activates of a product can be capitalized rather than expensed. The capitalization of interest would allow CCL to reduce taxable income in the future when it is more profitable.
I would recommend that CCL make the above changes immediately so that the financail statements are not incorrect. These changes would help CCL reduce its future taxable income when it may be more profitable.
2. Allowance for Doubtful Accounts.
CCL currently has no allowance for bad debts. Even though CCL does not have issue with uncollectible, having an allowance account will provide CCL with the ability to write off debts such as the disputed shipment. Without being able to write off the shipment, will leave the Accounts Receivables overstated, which in turn leads to misstated financial statements. Having an AFDA would allow CCL to record the sale but also recognise that they do not expect payment from the client. Leaving this account on the accounts receivable would be misleading to CCL’s stakeholders as it would lead them to believe that CCL is expecting to receive the cash in the near future. IF in the future, the dispute is resolved and the payment is received, CCL can recover the bad debt at that time.
I would recommend that CCL create a policy regarding Accounts Receivables immediately. The method for determining the bad debt amount should be determined by CCL management. Methods such a percentage of sales or a percentage of Account Receivables can be used. Whichever method is chosen, it should be consistent from year to year and the amount should be reasonable.
3. Long Term Debt or Initial Public offering.
CCL is currently looking at an initial public offering (IPO) and long term debt as two options to help finance the new research and development (R&D) of new products. The bank loan can provided financial stability but will have the interest repaid over a longer time is higher and would be tax deductible. Banks may require financial statements that are audited. CCL will need to be able to prove that it can repay the loan as well as the interest. It may also be required to maintain a debt to equity ratio that may prevent it from taking advantage of other opportunities in the future.
An IPO offering has the potential to increase capital which would improve financial rations such as the debt to equity. The increased cash flow will help CCL pay it current payables and reduce debt by negotiating better interest rates in the future. The disadvantage to an IPO would be the potential to lose control over the company and having to be more accountable to other investors. The IPO would also require the financial statement and note disclosure to conform to more stringent requirements, which increase the cost of producing the financial statements. Financial statements will need to follow IFRS and securities regulators generally require 3 years of annual audited financials. It should also be noted that there is a significant cost to offering an IPO and it can be difficult to evaluate the stock price of the shares.
I would recommend that CCL consider the IPO as a viable on to its financing issue as it will be more beneficial in the long term. The change from ASPE to IFRS will be a short term challenge but can be overcome with appropriate professional assistance. I would highly recommend that CCL seek the opinion and assistance of a professional who deals with IPO’s.
4. Employee Stock Options.
CCL is considering providing employees stock options as a way to reward its employees. As a CCPC, CCL will have no tax consequence for the employees receiving the stock options until they dispose of the shares. The amount taxed as employment income in the year of disposal is the difference between the option price and the FMV of the shares at the time of the option was exercised. The employee may be able to claim a deduction from taxable income equal to half this amount if the shares were worth less than the exercise price when the option was issued or the employee hold the shares for at least two years before selling the shares.
There are many alternatives to rewarding employees besides cash bonuses and stock options. Options can range from published recognition to merchandise such as shirts that the company makes. Time off with pay can also work to motivate employees for hard work.
I would recommend that CCL consider alternatives such as free products and time off as these will be less costly to provide than the stock options. Doing an employee survey would provide feedback to the rewards that the employees would value most.
5. Legal issues
CCL is currently facing a pending lawsuit regarding a chemical leak and the non-compliance with environmental regulations. When both of the following conditions are met the amount of the contingent loss must be accrued. Disclosure will be need if the following conditions are met: The likely hood that the verdict will be against CCL
A reasonable estimate of the amount o f the lawsuit can be made.
The lawsuit may also lead customers and the public to believe that CCL acted negligently. This will reflect poorly on CCL and may lead to decreased sales and a damaged reputation
If there is no accrual, there should be disclosure in the financial notes, stating the nature of the contingency, estimate of the amount or that an estimate cannot be made and exposure to loss in excess of the amount accrued. If CCL does not disclose, it would be misleading to the financial statement user.
I would recommend that CCL consult with their legal advisors immediately to determine the likelihood of a lawsuit and the potential liabilities. Also, CCL should be prepared to address the negative publicity that the lawsuit may create.
Should you require further clarification on any matters, please do not hesitate to contact me.