Lisa Jonas founded Modern leading manufacturer Inc Case study

Assessment Task

Scenario

Lisa Jonas founded Modern Inc., a leading manufacturer of custom wood and upholstered furniture, in 1997. Its head office and main manufacturing facility are in Montreal. Modern reports under accounting standards for private enterprises (ASPE).

Ten years ago, Lisa’s nephew, Darren Carter, became the controller of the company. At first, Darren was very focused on the company. He instituted many worthwhile changes and improved the financial reporting process. More recently, however, Darren’s attention has shifted to a petroleum exploration venture that he and a couple of his university colleagues are pursuing.

On June 1 of this year, Darren resigned from Modern, acknowledging that he was spreading himself too thin. Lisa was understanding, but disappointed that none of her family wished to be actively involved in the business.

Lisa will be turning 64 this year and is starting to think about retirement. Currently, she personally guarantees the company’s bank loans; however, she is in discussions with the bank to remove this personal guarantee. Lisa feels that the company is financially healthy and profitable, and she is hoping that the bank will agree when the financial statements and this year’s review report are issued.

Lisa is also considering selling her business in the next six months or so. She has reached out to a valuations expert who indicated to her that the value of the company will be based on a multiplier of net income. Lisa’s investment in the business is her primary source of savings for retirement.

Task #1

Lisa has come to you, CPA, for financial advisory services. Asha Patel, the accounting clerk who has been filling in for Darren, has some questions on financial reporting issues. She has sent over the draft financial statements (Appendix I) and her questions (Appendix II). Lisa has asked you to respond to Asha’s queries.

Lisa has also asked you to determine whether Modern is in compliance with its term loan bank covenant and, if necessary, provide next steps regarding the results of your covenant calculation.

Barbor sofa order

On December 11, we received an order from long-time customer Barbor Furniture Ltd. (Barbor) for 14 sofas, at a total price of $22,100. Barbor provided a deposit of $9,000, which I recorded as revenue when it was received on December 13. The order was completed on December 28, but because our delivery trucks were out of service, it wasn’t delivered to Barbor until January 2.

Barbor agreed to the January 2 delivery, at which time we billed them for the order. I recorded the remaining balance of the order ($13,100) as sales and accounts receivable on December 28. The sofas, which have a cost of $920 each, were excluded from the ending inventory count that was performed and completed on December 31.

Lumber inventory

Due to a favourable price offered by one of our suppliers at year end, we purchased an order of lumber (raw materials) costing $4,410. The order was received on December 31. However, the lumber was not put into production until January 3. The lumber arrived just after we had completed the inventory count, so it was not included in the count and the invoice was not recorded in accounts payable. The terms of the purchase were “FOB destination.”

Saw Repair

In July, one of our saws broke down. The cost of $11,500 in repairs is included in repairs and maintenance. The repair company claims the repairs will increase the saw’s service capacity, cut production time by 10%, and reduce waste by 5% to 10%. The manufacturing staff really did see a difference in the performance of the saw after the repairs. The saw is expected to last another five years beyond the date of repair. Modern uses the straight-line method for amortization purposes and pro-rates for the number of months the asset was owned in the year.

National Retail Chain Agreement

On November 29, a sales agreement was signed between Modern and a large national retail chain; Modern agreed to sell $50,000 of furniture per month over the next three years, commencing March 1 the following year. Modern received a bonus of $75,000 as per the agreement at the time of signing the sales agreement, which I recorded as revenue. Modern is required to fulfil the contract requirements by ensuring an adequate supply of product for the $50,000 monthly purchase. Lisa was anxious to see the bonus in revenue for the year-end financial statements.

Brief Summary of Assessment Requirements

You were asked to act as CPA adviser for Modern Inc. and to:

• Review the draft year-end financial statements and answer Asha’s accounting queries (Appendix II).
• Identify and explain required year-end adjustments under ASPE for the specific transactions below: Barbor sofa order (deposits, revenue timing, inventory cut-off), year-end lumber purchase (FOB terms / inventory cut-off), saw repair (expense vs. capitalise), and the national retail chain bonus (contract liability vs revenue).
• Determine whether Modern complies with its bank term-loan covenant after correcting the financial statements and, if not, recommend next steps.
• Prepare clear journal entries, explain the accounting rationale, and recommend practical next steps for Lisa (bank negotiation / disclosure / going-concern / sale planning).

Key pointers that must be covered

• Revenue recognition and cut-off (when to recognise revenue/control transfers).
• Treatment of customer deposits and contract bonuses (deferred revenue / contract liabilities).
• Inventory cut-off rules and FOB delivery terms (include goods that have legal title at year-end).
• Capitalisation criteria for repairs and improvements (when a repair is a betterment).
• Depreciation/amortisation treatment (prorating on capitalised improvements).
• Accurate presentation of current assets, liabilities and cost of goods sold (correct inventory/COGS errors).
• Recalculation of bank covenant(s) using adjusted statements and recommended remediation if breached.

• Required disclosures and subsequent-events considerations (resignation, guarantee removal negotiations, prospective sale).

How the Academic Mentor guided the student step-by-step

1. Issue spotting & fact mapping

• Mentor walked the student through the file line-by-line to identify the four technical issues (Barbor order, lumber receipt, saw repair, retail bonus) plus covenant and disclosure matters.

• Student prepared a single “issues” checklist linking each fact to the accounting question (cut-off, control, capitalisation, contract accounting).

2. Identify applicable accounting principles (ASPE focus)

• Mentor highlighted the relevant ASPE concepts: revenue recognition (performance / transfer of control), inventory cut-off and ownership (FOB terms), property, plant & equipment (capitalisation vs expense and useful life), and liabilities (deferred revenue/contract liability).
• Student noted where supporting professional judgement and materiality apply (e.g., capitalise only when future benefit probable and measurable).

3. Prepare correcting journal entries and computations

For each issue the mentor required the student to:

• Explain the accounting logic in plain language (why the original entry was incorrect).
• Draft corrective journal entries with amounts.
• Recompute affected statement line items (inventory, sales, COGS, accrued liabilities).

Worked adjustments (illustrative entries)

1. Barbor sofas (14 units, total price $22,100; deposit $9,000; cost $920 each = $12,880)

   • Problem: Deposit and full revenue were recognised in current year even though delivery occurred 2 Jan (next fiscal year); sofas were excluded from inventory count.
   • Correct treatment: Revenue recognised at delivery (customer control transfer). Deposit should be a liability until performance. Sofas should be included in closing inventory at cost.
   • Sample correcting entries:
     • Debit Sales $22,100; Credit Unearned revenue (contract liability) $22,100 to reverse premature revenue and record contract liability for deposit portion (so deposit is treated as liability).
     • If COGS was recorded prematurely, adjust: Debit Inventory $12,880; Credit Cost of goods sold $12,880 to add the sofas back into closing inventory.

   • Net result: sales for period reduced by $22,100; closing inventory increases by $12,880; accounts receivable (if incorrectly recorded) removed.

2. Lumber purchase ($4,410; FOB destination; arrived around count)

   • Problem: Goods arrived just after inventory count and invoice not recorded. Determine legal ownership at year-end.
   • Accounting logic: With FOB destination title passes on delivery to buyer. If delivery physically occurred on Dec 31 (even after count), title has passed and inventory should be included; if actually delivered after year-end (Jan 3) then exclude. Mentor advised verifying receiving/logistics time-stamp.

   • Typical correcting entry when title passed on Dec 31: Debit Inventory $4,410; Credit Accounts payable $4,410.

3. Saw repair ($11,500, July; extended service life by ~5 years and increased capacity)

   • Problem: Entire repair recorded as repairs & maintenance expense. Evidence shows the work improved service capacity and extended useful life.
   • Accounting logic: Under PPE rules, expenditures that result in a betterment or extend useful life should be capitalised and depreciated over the revised remaining life. (If immaterial, entity judgment may differ.)
   • Correcting entries:
     • Debit Machinery/Equipment (asset) $11,500; Credit Cash/AP $11,500 (capitalise).

     • Record depreciation for the remainder of the year: annual dep’n = $11,500 ÷ 5 = $2,300; prorate months owned after repair (e.g., July–Dec = 6 months) = $1,150. Entry: Debit Depreciation expense $1,150; Credit Accumulated depreciation $1,150.

4. National retail chain bonus ($75,000 received Nov 29; obligation to supply $50,000/month for 36 months starting Mar 1)

   • Problem: Bonus recognised as revenue immediately although it relates to future supply obligations.
   • Accounting logic: Upfront payments tied to future performance should be recorded as deferred revenue / contract liability and recognised over the performance period (systematic basis that reflects transfer of supplies).
   • Correcting entry: Debit Cash $75,000; Credit Unearned revenue $75,000. Then amortise to revenue from commencement of supply (e.g., $75,000 ÷ 36 ≈ $2,083.33 per month starting March 1).

4. Recalculate financials & covenant test

• Mentor required the student to: post the adjustments, rerun the income statement and balance sheet, and then re-calculate the bank covenant metric(s) specified in the loan agreement (example: minimum net worth, current ratio, interest-coverage or debt-service ratio).
• Where actual covenant terms were missing in the file, mentor instructed to (a) obtain covenant formula from the loan agreement, (b) compute the ratio using adjusted numbers, and (c) prepare sensitivity/forecast scenarios.

5. Draft client responses and advisory memo

• Mentor coached the student to prepare: (a) a concise memo to Asha explaining each adjustment and the journal entries, and (b) an advisory note to Lisa summarising covenant status, disclosure/subsequent-event implications (Darren’s resignation, guarantee negotiations, potential sale), and recommended next steps (discuss waiver, provide audited/reviewed adjustments, or consider equity injections or debt restructuring).

6. Quality control and professional judgement

• Mentor emphasized: document assumptions, include supporting working papers, consider materiality, and prepare suggested disclosures (e.g., nature of the revenue corrections, subsequent events disclosure regarding possible sale or guarantee removal). Student performed a final review to ensure consistency and clarity.

Outcome what was achieved and recommended next steps

Resulting Deliverables

• Correcting journal entries and working papers for each issue.
• Adjusted draft financial statements reflecting: deferred revenue for Barbor deposit and retail bonus; inclusion of sofas and lumber in closing inventory (if title passed at year-end); capitalised saw repair and prorated depreciation.
• Recalculated bank covenant(s) using adjusted balances and a short remediation plan where a breach was identified (or an implementation plan to negotiate waiver if borderline).
• Two client-facing documents: (1) explanatory memo to Asha with entries and rationale; (2) advisory note to Lisa on covenant status and negotiation/action plan.

Practical Next steps Recommended to Lisa

1. Finalise and post the correcting journal entries before issuing the year-end review report.
2. Recompute covenant(s) and, if there is a breach or a technical default, immediately open transparent communication with the bank present the adjusted statements, cash flow forecast, and request a waiver or covenant reset while discussing the guarantee removal.
3. Disclose the material accounting policy changes and the nature of any significant subsequent events (resignation, guarantee discussions, potential sale) in the review notes.
4. If selling is likely within six months, evaluate whether any classification as held-for-sale or additional disclosure is required (depends on sale commitment/contract).
5. Document all working papers carefully to support the review report.

Learning objectives covered

• Applied ASPE technical rules (revenue recognition, inventory cut-off, PPE capitalisation and depreciation, liabilities).
• Practical year-end adjustments drafting correcting entries, recalculating financial statements and COGS.
• Cut-off and contract accounting judgement identifying when revenue is earned and when cash is a contract liability.
• Bank covenant analysis translating adjusted accounting numbers into covenant tests and preparing remediation strategies.
• Client communication & professional practice preparing clear memos, documenting assumptions, and recommending commercial next steps (bank negotiation, disclosures, going-concern considerations).

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