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If TTI acquires ABC, ABC will need to change its policies to conform with IFRS since ABC will be consolidated into TTI's results, and therefore must follow IFRS.
There is some conflict between the accounting policies that ABC will have to adopt in the future and TTI's immediate objective to establish a bid price based on earnings projects. A bid price would be based on TTI's evaluation of (1) earnings potential and (2) volatility of earnings and/or cash flows. High earnings is good, but volatility is bad-the risk vs. return trade-off
Report to Mrs. O'Malley
Dear Mrs. O'Malley:
I am pleased to report my findings concerning Ashwin Book Corporation's accounting policies and practices. I believe that it will be necessary to make some adjustments to ABC's reported numbers for 20X3, and take some additional factors into account when we project the company's earnings into the future in order to establish a bid price.
One overriding consideration is that ABC, as a private company, seems to use an amalgam of Canadian accounting standards for private enterprises and some eclectic accounting policies that appear to be rather unorthodox. In effect, ABC uses a disclosed basis of accounting. If we acquire ABC, the company will need to change its accounting policies to conform with IFRS, since we use IFRS and we will need to consolidate ABC.
My discussion of the major issues is as follows:
a. Inventory valuation. ABC develops and produces its own books. All of each title's development, production, and printing costs are included in inventory and allocated over the number of copies in each editions' initial press run. The result is that the first print run has a huge unit cost while succeeding press runs (if any) bear only the cost of that particular print run. As a result, cost of goods sold will be very high for the initial run, quite likely yielding a negative gross margin for that initial run, even for a very successful book. For performance evaluation and for earnings prediction, these numbers are apt to be very misleading. As well, loading all of these costs into the inventoriable cost will usually result in an inventory value that is significantly higher than net realizable value. Therefore, the development costs should be removed from
Inventory and accounted for separately.
b. Development and production costs. We have a dichotomy in this regard. For financial reporting purposes, ABC will have to change their accounting policy for development costs to accord with IFRS, once we acquire them. One option is to expense development costs when they are incurred-even for historically successful books. An edition's success may not be predictable with assurance, because new competitors enter the market regularly.
On the other hand, spreading the development and production costs over the 3-year life span of the book will assist with our prediction of future earnings (on which we base the bid price) as well as ongoing evaluation of ABC's management. However, it is questionable as to whether these costs can properly be considered as an intangible asset, and thereby capitalized and amortized. IFRS discourages treating expenditures for new products as intangible assets (IAS 38, paragraph 69). Every new edition is, in effect, a new product, and therefore I recommend that ABC's policy for these costs should be to expense them when incurred.
For our analytical purposes in developing a bid price, however, I suggest that we remove development and pre-production costs from inventories in recent prior years and amortize them over 3-year periods just so we can discern the underlying earnings. Then we can look at the cash flow volatility over the years to measure the risk potential of the erratic production levels.
c. Revenue recognition. ABC recognizes revenue when books are shipped. However, there is a 6-month official return policy that is unofficially stretched for college and university bookstores, which account for 90% of total sales. The return rate seems to be difficult to predict. If it is not feasible to make a reliable estimate of the return rate, either overall for book-by-book, revenue recognition probably should be deferred until the 6-month "official" return period has ended.
d. Supporting material for instructors. The cost of providing free supporting materials for instructors can be considerable. They have no inventory value in the usual sense because their net realiable value is zero (except to students who would love to get their hands on solutions manuals). The significant cost of these items suggests that instead of inventorying the costs, ABC should instead defer some of the revenue and treat each book's sale as really being a multi-deliverable contact: (1) a book delivered to the students when they buy them, and (2) supporting material prepared and made available for instructors. While there is no measurable value for the second deliverable, an allocation of revenue could be based on the relative costs of the two deliverables. ABC shouldn't be pouring more money into production and support than can be received in revenue. Such a revenue allocation would give ABC managers a better idea of the "real" price that they should be charging for the book.
e. Inventory valuation of returned books. ABC restores returned books to inventory at the unit cost they originally bore. This has two problems: (1) the original assigned cost is too high, as discussed above, and (2) if large quantities of a book are returned, it probably indicates that the book is unsuccessful and therefore that its net realizable value is much lower than the original unit cost. We will need to determine how much of the current inventory is comprised of returned books, and probably write off those books for our estimation process.
f. Inventory of old editions. An inventory of old editions should not be assigned any value as assets. By definition, they are obsolete, even if there may be some residual sales. By retaining some inventory at normal cost, ABC management may be tempted to retain more than necessary in order to avoid depressing earnings by a write-down.
g. Website development costs. It is doubtful that these costs would qualify as an intangible asset under IFRS. The success of the website is not predictable with reasonable assurance. The costs should be expensed when incurred. However, we should take into account in our projects that delivering support material electronically will significantly reduce the cost of printing and distributing instructors' supporting materials. That cost reduction may be offset, however, by the necessity to put more resources into development of electronic learning aids in order to keep up with the competition.
h. Sales discounts. The company currently is charging "discounts taken" on accounts receivable to interest expense. Instead, the discounts should be deducted from revenue.
I hope that I have identified the major issues that I see with ABC accounting. If you wish me to pursue any of these matters further, I will be happy to visit the company again and take a closer look at their accounting records.