Case 18-1 Bring-It-Home Inc.

Overview

This case presents the student with transactions that reflect several issues discussed both in this
chapter and in previous chapters—asset exchanges, leases, debt present valuate, revenue
recognition, and government assistance.1 Students are required to correct a draft SFP on the basis
of IFRS that will be consolidated with the statements of the majority owner corporation as well
as providing information to Bring-It-Home’s own bank. Students should assess the impact of
their adjustments relating to a restrictive covenant imposed by BIHI’s Canadian bank.

This is a good comprehensive review case. Although each component is fairly straight-forward,
in sum they require students to keep track of the combined SFP effects of the adjustments they
make.

Suggested response

Dear Mr. Power:

As you requested, I have reviewed Mr. McIroy’s draft financial statement based on my analysis
of the transactions underlying his draft. I present below a summary of my findings as they relate
to certain transactions, including recommended adjustments. Following this discussion, I present
a revised SFP.

I would like to draw your attention to an important point. Although I have endeavoured to keep
Canadiana Bank’s restrictive covenant in mind, my recommendations result in increasing your
debt-to-equity ratio at the end of 20X4 from 1.61:1.00 on Mr. McIroy’s draft statements to
2.88:1.00. The company’s recent transactions have placed your company at the upper margin of
acceptability.

I urge you to discuss this situation with your banker as soon as possible. If you wish, I will be
happy to accompany you on such a visit so I can explain the nature of and reasons for the
adjustments.

Transactions needing adjustment

1. Canadiana Bank loan

The bank loan from Canadiana carries a higher rate than comparable debt arranged by BIHI’s
parent company. However, this is due to the different credit standing of BIHI as compared to
the parent. No adjustment in needed. The 10% rate indicates BIHI’s incremental borrowing
rate.
This loan carries a restriction on BIHI’s debt:equity ratio. If there are alternative accounting
approaches within IFRS, we should bear that restriction in mind when choosing an alternative.

1
Accounting for government assistance is straightforward and is covered in Chapter 9, Appendix 2.
2. Lease
The equipment lease is being recorded as an operating lease because the lease term covers
only 62.5% of the equipment’s hypothetical life. On the surface, this treatment may seem
acceptable. However, the present value of the payments is close to 80% of the equipment’s
fair value. As well, the equipment is of no use to anyone else after the lease expires because it
was custom-made for BIHI.
There can be little doubt that the lessor will fully recover its investment in the leased asset,
even though the pre-tax lease payments seem to recover only 80%. The lessor probably will
recover the difference via a low rate of financing as well as through tax savings on CCA (as
the equipment’s owner under the income tax act).
This lease should be recorded as a capital lease. Capital lease treatment is not very good from
the standpoint of the bank’s restrictive covenant because such treatment will worsen the debt-
equity ratio. Nevertheless, it is essential that BIHI follow IFRS.
The PV of the lease payments on 2 January 20X4 = $25,000 × (P/AD, 10%, 5) = $25,000 ×
4.16987 = $104,250, which should have been recorded at the lease inception.
The necessary adjustments to correct the lease accounting are as follows:
Equipment under capital lease................................................. 104,250
Rent expense...................................................................... 25,000
...........................................................................................
Capital lease liability ($104,250 – $25,000)..................... 79,250

Interest expense ($79,250 × 10%)........................................... 7,925

Capital lease liability......................................................... 7,925

Depreciation expense ($104,250 ÷ 5)...................................... 20,850

Accumulated depreciation................................................. 20,850

The upcoming 1 January 20X5 payment of $25,000 should be shown as a current liability; the
remaining $54,250 is long-term.

3. Greenhouse
There are two aspects to accounting for the greenhouse acquisition: (a) properly recording the
acquisition itself at the present value of the amounts committed; and (b) properly account for
the government assistance as either a reduction of the cost or as part of the depreciable cost.
Neither was done correctly.
(a) The present value of the payments at the date of acquisition (1 July 20X4) is:
PV = $90,000 × (P/F, 10%, 5) + $2,700 × (P/A, 10%, 5)
= ($90,000 × 0.62092) + ($2,700 × 3.79079)
= $55,883 + $10,235 = $66,118
The correction can be made either by reversing Mr. McIroy’s entry and then recording it
correctly, or by adjusting his amounts, as follows:
 Loan payable ($90,000 – $66,118).................................... 23,882
Greenhouse................................................................ 23,882

It is necessary to recognize a half-year’s accrued interest (1 July to 31 December 20X4) at

BIHI’s IBR of 10%: $66,118 × 5% = $3,306. Since $1,350 interest expense had already
been recorded, the adjustment is as follows:
Interest expense ($3,306 – $1,350)................................... 1,956
Interest payable ......................................................... 1,956

Also, the half-year depreciation must be reduced:

Accumulated depreciation, greenhouse............................ 2,388
Depreciation expense [$9,000 – ($66,118) ÷ 5×½]... 2,388

(b) Mr. McIlroy recorded the $15,000 government assistance as a reduction of expense.
Instead, this should be recorded as either (a) a reduction in the cost of the greenhouse or
(b) a deferred credit to be recognized (on the same basis and as an offset to depreciation
expense) allocated over the five years during which the greenhouse will be in use. The
impact on net income will be identical under either method, which is to reduce expense by
$3,000 per year of the greenhouse’s use.
The first approach is better for BIHI because it avoids showing a liability of $15,000
(given the debt:equity covenant. The adjustment would be as follows:
Head office expenses......................................................... 15,000
Greenhouse................................................................ 15,000

After the cost greenhouse has been restated by the prior adjustments, depreciation must be
redetermined. The greenhouse now is stated at $51,118. A half-year depreciation is $5,112.
The adjustment to reduce the previously-charged depreciation of $9,000 is:
Accumulated depreciation, greenhouse............................ 3,888
Depreciation expense ($9,000 – $5,112)................... 3,888
4. Uncompleted sale
The sale to Mr. Doyle should not be recognized in 20X4 because the sale is not complete until
the goods are delivered, which won’t happen until January. That entry must be reversed. The
effect of reversal is to reduce earnings by the recorded gross margin of $2,640:

Sales revenue..................................................................... 10,000

Accounts receivable................................................... 10,000

Inventory............................................................................ 7,360
Cost of goods sold..................................................... 7,360

5. Patent
The exchange appears to have no commercial substance because it appears that the company’s
cash flows won’t be affected by the exchange; it’s just one type of asset exchanged for
another type of asset. Exchanges without commercial substance should be recorded at the
carrying value of the asset given up. In this case, BIHI’s recorded book value of the patent is
$15,125. However, exchanges also have a fair market cap—the exchange cannot be recorded
at higher than the surrendered asset’s fair value. Skerwink had received an offer of $14,400
for the equipment. The question then is whether this is really the equipment’s fair value or
was it just a low-ball pitch.

BIHI is facing a restrictive covenant. Given the questionability of the lower offer, I suggest
that the carrying value be used instead, as it has less impact on retained earnings. 2 An
adjustment is necessary to reverse the recorded gain and restate the carrying value of the
patent:

Gain on asset exchange...................................................... 3,625

Patent ($18,750 – $15,125)........................................ 3,625

2
Students may choose to use the $14,400, which can be defended.
6. Income tax effects

The adjustments recommended above will affect the 20X4 net income and thereby the amount
of income tax expense. The impacts are to increase (decrease) net income as follows:

Rent expense............................................................................ $ 25,000)

Interest expense (lease)............................................................ (7,925)
Depreciation expense (leased asset)........................................ (20,850)
Interest expense (greenhouse debt).......................................... (1,956)
Depreciation expense (greenhouse)......................................... 3,888
Head office expenses (government grant)............................... 15,000
Sales revenue........................................................................... (10,000)
Cost of goods sold................................................................... 7,360
Gain on asset exchange............................................................ (3,625)
Net increase (reduction) in net income.................................... $ 6,892

At a 20% rate, deferred income tax increases by $615. The adjustment should be as follows:

Income tax expense........................................................... 1,378

Deferred income tax.................................................. 1,378
Revised Statement of Financial Position (worksheet not required)

Bring-It-Home Inc.
Statement of Financial Position (revised)
31 December 20X4
As reported Adjustments Item Adjusted balance

Current assets 44,725 -10,000 4a 42,085

7,360 4b

Greenhouse, net 81,000 -23,882 3a 44,506

2,388 3a
-15,000 3b

Other PP&E 143,365 104,250 2a 223,140

-20,850 2c
-3,625 5

Total assets 269,090 41,312 309,731

Current liabilities 8,250 25,000 2d 35,950

2,700 3a

Loan payable, govt. agency 90,000 90,000

Capital lease liability 79,250 2a 62,175

7,925 2b
-25,000 2d

Other long-term liabilities 67,000 -23,882 3a 41,796

-2,700 3a
1,378 6

Total liabilities 165,250 229,921

Common shares 7,000 7,000

Retained earnings 96,840 25,000 2a 72,810

-7,925 2b
-20,850 2c
2,388 3a
 -15,000 3b
-10,000 4a
7,360 4a
-3,625 5
-1,378 6

Total shareholders' equity 103,840 79,810

Total liabilities and share equity 269,090 38,998 309,731