Core 1 — Integrated Problem 1

Solution

The following solution is a “best” response, demonstrating a level much higher than
competent. However, there may be additional acceptable and reasonable points that
are not reflected in this response.

In addition, candidates are not expected to prepare a response of this level given the
time constraints involved and, if applicable, page limits provided.

Memo

To: Lisa Jonas

From: CPA
Subject: Accounting questions

Assessment Opportunity #1

The candidate discusses the accounting issue related to the Barbor sofa order.

The candidate demonstrates competence in Financial Reporting.

CPA Map Competencies:

1.2.1 Develops or evaluates appropriate accounting policies and procedures (Core –

Level A)
1.2.2 Evaluates treatment for routine transactions (Core – Level A)
1.3.1 Prepares financial statements (Core – Level A)

Barbor sofa order

Issue

The issue is whether Modern can recognize revenue on the undelivered sofas at year
end. We need to consider the guidance in ASPE 3400 Revenue to determine when
revenue should be recognized.

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2022-07-12
Core 1 — Integrated Problem 1 Solution

Handbook and analysis

Per ASPE 3400.A45-A48, when an upfront fee is received, the fee should be assessed
as to whether there is any utility separate and independent to the performance of the
main transaction or whether the fee is a part of the arrangement, in this case, the
delivery of goods (that is, sofas).

• In this case, it does not appear that the deposit is separate from the delivery of
sofas and there is no utility other than what appears to be an advance payment
for the future delivery of the sofa on January 2. Therefore, the recognition of the
upfront fee does not need to be considered separately.

Per ASPE 3400.04-.05, the recognition of revenue depends on whether all the following
criteria are met:

1. Performance has been achieved — in other words, the risks and rewards of
ownership have transferred to the buyer.
• This criterion is not met. The delivery of the sofas was not completed until
January 2, which is subsequent to year end. Modern had not transferred the risks
and rewards of ownership of the sofas by year end. Revenue can be recognized
in advance of delivery if certain arrangements exist, as per 3400.09; however,
these are not applicable here.
2. Consideration is reasonably measured.
• This criterion is met. The sales order provides evidence of the measurability of
the consideration.
3. Reasonable assurance exists that consideration will be received (collectability).
• This criterion is met. There was an agreement in place, and Barbor is a long-time
customer of Modern’s. This provides reasonable assurance that Modern will
receive the consideration. As well, some of the consideration was received
before year end in the form of a $9,000 deposit.

Recommendation

Based on the analysis of the revenue recognition criteria, Modern should not recognize
revenue on this transaction in its December 31 financial statements. Accounts
receivable and revenue on the sale must be reversed. In addition, the deposit should be
recorded as a liability (deferred revenue) because Modern had an obligation at year end
to provide Barbor with the sofas and the deposit is an advance payment for the delivery.
Finally, because this inventory was owned by Modern at December 31, we need to
adjust the inventory balance to include these sofas.

This adjustment will reduce net income and increase liabilities, which in turn worsens
the debt-to-equity ratio. This will also negatively affect the valuation of Lisa’s shares
based on net income.

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Core 1 — Integrated Problem 1 Solution

Assessment Opportunity #2

The candidate discusses the accounting issue related to the lumber inventory.

The candidate demonstrates competence in Financial Reporting.

CPA Map Competencies:

1.2.1 Develops or evaluates appropriate accounting policies and procedures (Core –

Level A)
1.2.2 Evaluates treatment for routine transactions (Core – Level A)
1.3.1 Prepares financial statements (Core – Level A)

Lumber inventory

Issue

The issue with the lumber inventory is whether it should be recorded as inventory at
year end. We need to consider the guidance in ASPE 3031 Inventories to determine
when the inventory should be recorded. We may also use basic accrual accounting
rules in ASPE 1000 Financial Statement Concepts.

Handbook and analysis

The asset is in the form of materials to be consumed in the production process and
therefore meets the definition of inventories as per ASPE 3031.07. The order of lumber
was received FOB destination, meaning that ownership of the lumber transferred to
Modern when the items were received at the Modern plant on December 31. The fact
that the items were received after the inventory count does not change the fact that
ownership of the inventory had transferred to Modern, in accordance with the shipping
terms, prior to year end.

Recommendation

Based on the analysis above, at year end, Modern owned the goods, and they were
ready and available to be consumed in the production process. As a result, an
adjustment is required to include this amount in inventory and accrue for the related
payable.

This adjustment will have no impact on net income and therefore will not affect the
valuation of Lisa’s shares based on net income. This adjustment will increase accounts
payable, which will negatively impact the debt-to-equity ratio.

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Core 1 — Integrated Problem 1 Solution

Assessment Opportunity #3

The candidate discusses the accounting issue related to the saw repair.

The candidate demonstrates competence in Financial Reporting.

CPA Map Competencies:

1.2.1 Develops or evaluates appropriate accounting policies and procedures (Core –

Level A)
1.2.2 Evaluates treatment for routine transactions (Core – Level A)
1.3.1 Prepares financial statements (Core – Level A)

Saw repair

Issue

The issue is whether to record the saw repair as a repair expense or to capitalize it as a
betterment to the saw. We need to consider the guidance in ASPE 3061 Property, Plant
and Equipment to determine which costs are considered a betterment to capital assets.

Handbook and analysis

Per ASPE 3061.14, costs incurred to enhance the service potential of capital assets are
considered betterments. Examples of enhancements of service potential include:
• The previously assessed physical output or service capacity is increased.
• Associated operating costs are lowered.
• The life or useful life is extended.
• The quality of output is improved.

The repair resulted in an increase in the service capacity and a 10% reduction in
production time, which has increased the physical output of the saw. In addition, the
repair resulted in a 5% to 10% reduction in waste, which has lowered the associated
operating costs. This suggests that the repair is a betterment.

Recommendation

Based on the analysis above, these costs represent betterments to the underlying saw,
and the repair costs should be included in the cost of the asset. As a result of the
capitalization of these costs, we must record amortization expense of approximately
$1,150 ($11,500/5 × 6/12 months).

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Core 1 — Integrated Problem 1 Solution

The net adjustment will increase net income, which supports Lisa’s desire to present a
strong set of financial statements to the bank, as the debt-to-equity ratio will improve. As
well, a valuation based on net income will be positively impacted by this adjustment.

Assessment Opportunity #4

The candidate discusses the accounting issue related to the national retail chain
agreement.

The candidate demonstrates competence in Financial Reporting.

CPA Map Competencies:

1.2.1 Develops or evaluates appropriate accounting policies and procedures (Core –

Level A)
1.2.2 Evaluates treatment for routine transactions (Core – Level A)
1.3.1 Prepares financial statements (Core – Level A)

National retail chain agreement

Issue

The issue with the signing bonus is when to record it — in full at the time it was received
or over the life of the contract.

Handbook and analysis

Per ASPE 3400.A45-A48, when an upfront non-refundable fee or payment is received,

the fee should be assessed as to whether there is any utility separate and independent
to the performance of the main transaction.

• In this case, the $75,000 signing bonus is not separate from the contract to
purchase a guaranteed amount of furniture as it provides no stand-alone value,
and therefore, the recognition of the signing bonus revenue does not need to be
considered separately.

To determine the appropriate treatment, we need to look to ASPE 3400 Revenue for the
criteria for revenue recognition:

1. Performance has been achieved — in other words, the risks and rewards of
ownership have transferred to the buyer.
• This criterion is not met. The agreement specifies that the bonus will be paid up
front, because Modern agreed to provide all the furniture required in the
agreement. The furniture will begin to be sold in March. As such, performance
has not yet been achieved, since the products have not been delivered to the

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Core 1 — Integrated Problem 1 Solution

customer and because the title and benefits of ownership of the furniture have
not been transferred to the customer.

2. Consideration is reasonably measured.

• This criterion is met. The performance bonus of $75,000 has already been
collected, so measurement of the consideration is certain.

3. Reasonable assurance exists that consideration will be received.

• This criterion is met. The agreement was signed on November 29 and the
$75,000 bonus was received on that date.

Recommendation

Based on the analysis above, the bonus should be recognized as deferred revenue
now, with revenue recognized over the three-year life of the sales agreement as it would
be considered an integrated package. This is consistent with the fact that the bonus was
paid up front. It should be recognized systematically over the periods that the fees are
earned in which the products are delivered and considered sold to the customer,
representing the period in which the risks and rewards are transferred.

While this alternative is not consistent with Lisa’s desire to record the bonus as revenue
now, it adheres to accounting standards. This will reduce net income and increase
liabilities, which has a negative impact on the valuation of the company and the debt-to-
equity ratio.

Assessment Opportunity #5

The candidate discusses the impact the accounting issues have on the bank covenant.

The candidate demonstrates competence in Financial Reporting.

CPA Map Competencies:

1.4.4 Interprets financial reporting results for stakeholders (external or internal) (Core –
Level A)

Impact on bank covenant

Modern is required to adhere to a maximum debt-to-equity ratio of 1.10. After adjusting

for the items above, the debt-to-equity ratio is 1.10 (Exhibit I). Therefore, the company is
in compliance, but only barely so. This analysis did not consider the tax impact of the
adjustments. Because the adjustments decrease net income overall, the tax impact of
the adjustments will be favourable for the debt-to-equity ratio.

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Core 1 — Integrated Problem 1 Solution

The situation is serious given that the bank could call the loan if the ratio worsens.
Modern would not have the means to pay off the full amount of the loan, given its
current cash balance is low.

Modern should implement plans to improve its working capital and debt management. In
addition, Modern should identify ways to improve its debt-to-equity ratio to ensure it is in
compliance with the bank’s covenant, such as selling any redundant assets and using
the proceeds to reduce accounts payable. Strategies should be communicated to the
bank proactively because attempts to improve the cash flow position will be seen
positively by the bank.

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