Mitten Manufacturing Ltd

Generally, mergers occur for the purpose of improving financial performance or shareholders – making the likelihood of this potential merger ideal. Angela has offered to sell ML to John for the book value of equity, based on the 2014 year. MUMS financial Statements are in accordance with FIRS. John has asked for our help as professional accountants with the firm of Label and Liana ALP (L&L) to assist in determining an estimate of the purchase price. In order to do so we must first address the accounting issues with Mil’s current financial statements.

It should be noted that Mil’s financial statements were prepared for internal purposes and have not been audited. John will want Mil’s financial statements to be accurate before agreeing to Angel’s suggested purchase price so that he is not overpaying. He will also want accurate financial statements to accurately determine Mil’s debt/equity ratio, going concern, and other important ratios/factors. Angela may be biased towards keeping her current balance sheet numbers as they most likely overvalue assets and undervalue liabilities, making the sale of her ownership a better deal for her, but not necessarily a better deal for John.

As John’s accountants we must approach this conservatively in order to ensure that he is not overpaying for the company, focusing primarily on the book value of equity which is to be the selling price. Analysis and Recommendations Issue: $500,000 loss ML experienced a loss of $500,000 during the year which could be due to problems with operations or Accounts Receivable collection. This may have encouraged Angela to bias the numbers to make ML look better to potential buyers. This loss should be kept in mind when reviewing the following issues.

While this is a one-time event, working capital, inventory turnover, and debt ratios should be considered when determining the company’s future sustainability. This loss will decrease or has decreased shareholders equity by $500,000. The loss may be a positive for John as he will be able to carry forward the loss to a positive net income in the next twenty years, which can potentially reduce Mil’s future taxable income. Should John decide to carry forward this loss, the journal entry should kick like the following: 1) Dry. Deferred tax asset 500,000 Cry.

Income tax benefit Issue: How to account for the new lease agreement Capital Lease Operating Lease Under FIRS, one of four classification criteria must be met in order to be lassie as a Capital Lease: 1) Reasonably assured that ownership will transfer to lessee at end of lease term 2) Lessee gets substantially all economic benefits from using the leased asset over the lease term 3) Lesser recovers substantially all investment, and earns a rate of return 4) Leased asset is specialized and can only be used by lessee According to the terms of Mil’s new lease agreement: 1) Yes, under the assumption that the Bargain Purchase Option of $4,500 will be exercised 2) No, lessee only uses 50% of economic life – not considered substantial as there is still 50% of its life left for economic benefits to be aimed 3) Yes, because the IV of Minimum Lease Payments (where 1=9%, N=5, and is equal to $88,000, which is 100% of the IV of the asset at January 1 , 2014 4) NINA.

Information was not provided to answer this The lease meets both the first and third classification criteria Capital Leases must record the asset and liability, depreciation of the asset, and interest expense following the effective interest method Under FIRS, one will account for a lease as operating if the risk and benefits of ownership of the leased asset are not transferred to the lessee If a lease does not meet any of the criteria necessary for a Capital Lease, then it will be ported as an Operating Lease Operating Leases are accounted for as a rental expense After considering the two alternatives, it is clear that the new lease agreement must be recorded in Mil’s books as a Capital Lease. This is due to two of the four Capital Lease classification criteria being met, which do not allow for the company to record it as an Operating Lease. The following journal entries should have been entered throughout 2014: 01/01/14: 1) Dry. Lease Equipment Obligation 88,000 88,000 2) or. Lease Obligation Cry. Lease 24,066. 26 Cry. Cash 12/31/14: 3) Dry. Interest Expense 3,057. 02 4) Dry. Amortization Expense Cry. Accumulated Amortization 3,057. 02 Cry.

Interest payable 4,400 While there are more incentives to classifying a lease as operating such as tax incentives, higher return on asset, and better solvency ratios, the lease must be classified as a Capital Lease so as to stay in accordance with FIRS. However, a Capital Lease does provide a company with a higher operating cash flow, and reduces Net Income, which potentially reduces income taxes. A lower Net Income will result in a lower shareholder’s equity. Issue: Entries to reflect changes in the plan asset and liability for current year FIRS ASPS FIRS requires that the same discount rate is used for plan asset and liability and the immediate recognition approach must be used.

Therefore, using the Projected Benefit Obligation method, and using a 10% discount rate, the Plan Liability would be: $ 694,969 + 35,000 + 69,497 – 40,000 = $759,466 And the Plan Asset, using the 10% actual return on plan assets, would be: $ 525,000 + 52,500 = $537,500 Making the Defined Benefit Obligation: $ 537,500 – 759,466 ($221,966) The Pension Expense: $ 35,000 – 52,500 = $ 51 ,997 And the Net Defined Benefit Liability: – (169,969) = ($ 51 ,997) ASPS allows for either the immediate recognition approach or the deferral and amortization approach ASPS also allows for the expected return on plan assets to be different from the discount rate used for the Accrued Benefit Obligation No calculations are necessary for the ASPS alternative of this issue, as they would not be in accordance with FIRS with which ML must follow. Therefore, in accordance with FIRS, we will account for the changes in the plan asset and liability as stated above.

Please note that the Accrued Benefit Obligation (ABA) will be referred to as the Defined Benefit Obligation (DB), s we are working under FIRS rather than ASPS. Following the restriction that the same discount rate (1 0% in this case) be used for both plan asset and liability, the following journal entries should be made to account for the changes for the current year: 12/31/14: 1) Dry. Pension Expense Cry. Net Defined Benefit Liability 51,997 51 ,997 This increase in Net Defined Liability will decrease Shareholder’s Equity. Issue: Depreciation of Capital Assets The depreciation of capital assets must be taken out of the provision for income taxes included in the financial statements for the current period.

This depreciation is to be included in taxable income, not accounting income and will incorrectly state Mil’s provision for income taxes if not removed. The CA amount needed to be removed is equal to x 30% $1 this amount will be deducted from the taxable income. The removal of $1 from the provision for income taxes will increase net income, subsequently increasing shareholders equity. Issue: How to account for the Super Shopper Account Receivable Estimate Unconvertible Receivables Writing Off Accounts Receivable There are two methods to estimate unconvertible receivables: 1) Balance Sheet Method – uses past collection experiences to estimate unconvertible amounts.

ML could estimate the amount required for Allowance for Doubtful Accounts as a percentage of the balance in Accounts Receivable. Using an aged receivables analysis, ML could forecast a percentage of estimated unconvertible Accounts Receivables accounts over 90 days old. The journal entry would look similar to the following: Dry. Bad Debts Expense Cry. Allowance for Doubtful Accounts xx 2) Income Statement Method – estimates cost of bad debts as a percentage of Sales. Mil’s journal entry using this method would look the same as the Balance Sheet Method journal entry. If ML determines Super Shoppers account specifically to be unconvertible, they may use the Allowance Method for writing off accounts.

The following journal entry would be made: Dry. Allowance for Doubtful Cry. Accounts Receivable -? Super Shopper Should the payment be received after the write – off, the account can be reinstated using the following journal entries: 1) Dry. Accounts Receivable 2) Dry. Cash Cry. Accounts Receivable If the amount is immaterial, ML may also use the Direct Write – Off Method, where no allowance account is used. The journal entry would be as follows: or. Bad Debt Expense Due to the age of Accounts Receivable -? Super Shopper (90 days old) and the financial difficulties that Super Shopper is currently facing, it is unlikely that the account will be paid off and should there for be written off.

ML should follow the Allowance Method of writing off journal entries stated above to record the write – off of the Accounts Receivable. This method would be preferred as it allows for the account to be restated should Super Shopper pay off their debt. The Direct Write -? Off Method would not suffice for this account as the amount of $200,000 is not considered immaterial. This Bad Debt Expense needs to be considered as it will impact Mil’s assets, and an increase in bad debts is a decrease in the value of the firm (shareholders equity) of the firm for John. This might not be as substantial to consider should ML have already had a bad debt reserve, meaning that the net income would not have been so greatly affected.

Issue: How to account for the Tech Outerwear Lawsuit Recognize lawsuit as a provision Recognize lawsuit as a contingent liability Under FIRS, ML should recognize the lawsuit as a provision if: 1) The company has a present legal obligation as a result of a past event 2) It is rabble – “more likely than not” – that an outflow of resources will be required to settle the obligation 3) A reliable estimate can be made of the amount of the obligation If the lawsuit meets these conditions, it should be recognized in the financial statements Under FIRS, ML should recognize the lawsuit as a contingent liability if either: 1) There is a possible legal obligation as a result of a past event, which will be confirmed on the occurrence of an uncertain future event, not within the reporting individual’s control; or 2) There is a legal obligation from past events, which is not recognized as it is to probable that an outflow of resources will be required to settle the obligation or a reliable estimate cannot be made of the amount of the obligation If the lawsuit meets these conditions, it should be disclosed in the notes of the financial statements. The notes should include the following: 1) Estimate of its financial effect 2) Uncertainties related to the amount and timing of any outflow of resources 3) Possibility of any an outflow of resources The lawsuit by Tech Outerwear for patent infringement has not been properly assessed by Mil’s lawyers yet, and therefore they have not determined the likelihood of losing the suit. This information allows us to determine that at this time the lawsuit should be recognized as a contingent liability in accordance with FIRS, as we are unable to meet the conditions to recognize it as a provision on the financial statements.

This lawsuit meets the criteria that there is a possible legal obligation that cannot be confirmed until Mil’s lawyers assess the lawsuit, and the probability of the outflow of resources and a reliable estimate of the obligation cannot be made. The numbers ($200,000 to $700,000) on past lawsuit settlements are not reliable information. The required disclosed notes stated above should be included in he financial statements. Determining the probability of the lawsuit and the estimated loss should be completed as soon as possible, as a loss could result in a going concern policy. This information will be very important to John as the company has already experienced a loss of $500,000 during the year. This note has no effect on equity; only when the lawsuit is official will it have an effect on equity.

Issue: Retractable Preferred Shares ML also has $50,000 of retractable preferred shares included in their capital stock. These shares a retractable if there is a change in the ownership of cuisines. This will be of concern to John, as the $500,000 loss incurred during the year does not leave the company with the funds available to pay the shareholders should they decide to sell their shares; John must consider day to – day cash requirements for the company’s expenditures that are not included in current liabilities. While it was not stated, which might have been done on purpose by ML, it is unclear if dividends were declared during the year for the preferred shares, which may affect John’s decision greatly.

Cash dividends should not have been declared unless the current and future uncial position justify it; the current loss of $500,000 does not suggest that they should have declared any. Cash dividends would have reduced shareholder’s equity. If stock dividends were distributed, then there would have been no effect on the balance of shareholder’s equity. On the other hand, non -? payment of dividends can also affect the company as the preferred shareholders may choose to sell their shares if they stop receiving dividends; receiving dividends is usually what attracts investors to preferred stock. John should examine the debt/equity ratio to determine if these referred shares were issued because the ratio became too high and they wanted the company to look more desirable to investors and buyers.

Issue: Accounting for Employee Stock Options Recognizing stock options While Compensatory Stock Option plans (COOP) do not involve a transfer of cash when first issued, they still must be recognizes in the financial statements and measured at fair value Coops are usually given instead of salary or a bonus, and the economic value lies in the prospective future gains when the options are exercised The Compensation Expense will be recognized as the services are being provided by the employees. Therefore, Total compensation expense is calculated on the day the options are granted and is equal to the fair value of the options. The first journal entry for Mil’s stock options should look like the following: 1 2/31 /14: 1) Dry. Compensation Expense XX,XX Cry. Contributed Surplus – Stock Options XX,XX If/when the options are exercised, ML should record the entry as such: XX/XX/1 5: 2) or. Cash XX,XX Dry. Contributed Surplus – Stock Options CALYX Cry.

Common Shares XX,XX If the options expire by the end of the three years, then the journal entries for the remaining balance should be the following: 3) Dry. Contributed Surplus – Stock Options Contributed Surplus – Expired Stock Options XX,XX cry. XX,XX Mil’s disclosures on the stock options should include the following: 1) Accounting policy 2) Description of plan 3) Details on numbers and values Of options issued, exercised, and expired 4) Assumptions and methods used to determine fair values 5) Total Compensation Expense and Contributed Surplus The recognition of these stock options is required under both ASPS and FIRS, and ML has no option but to record them as such.

The first journal entry that records the total Compensation Expense and Contributed Surplus must be made in order for ML to have accurate financial statements. The following journal entries are to be used in the future when options are exercised or expired. As no further information on dates and values were provided, the reporting individual is not able to provide completely finished journal entries. The Compensation Expense will lower the net income, which will subsequently lower shareholder’s equity. As well, if there is a large amount of option redemption’s, this will cause the share price to quickly drop. Investors who sell their shares during this time will incur capital losses, and these losses may be carried forward to reduce tax liabilities.

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