Dry Clean Depot Limited
- Pages: 4
- Word count: 879
- Category: Contract
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Dry Clean Depot is a private company, Max the CFO has asked me (Professional Accountant) to analyse any accounting implications with regarding a new loan and other issues within the company. Dry Clean Depot Limited (DCDL) has elected to report under the constraints of IFRS, although they could have elected ASPE as their reporting standards, since they are a private company. DCDL is a company with 40 dry cleaning stores in southern Ontario. DCDL has revenues of approximately $7 Million. DCDL has arranged for a $2,000,000 loan for the purchase of some new equipment for the business. The covenants of the new loan are as follows: * Maximum 2-to-1 debt-to-equity ratio
* Minimum cash balance of $500,000
* Maximum dividends of $100,000 per year
IFRS states that “An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.” The lease of the Sudbury retail location is therefore an onerous contract. DCDL has an obligation to pay $27,500 per year for the lease on the Sudbury location. The sub-contract agreement DCDL has is a sub-lease that pays $5,000 for year one, and $5,000 each year for the next three years, plus 10% of sales over $150,000. A liability of the difference $27,500 and $5,000 will need to be recorded $22,500/ year, today, in accordance with the time value of money; as this is a present obligation of the company, IFRS states that a liability will need to be recorded. This would worsen the debt-to-equity ratio, which is not aligned with management’s objectives. Contamination Issue:
DCDL uses perchloroethylene (perc) in its cleaning process in eight of its operating sites. This chemical is a hazardous air contaminant. There is an obligation for the cost of remediation if there is a contamination issue in any of the sites. One of the eight sites may have a contamination issue, and may have some remediation work needed. A liability will need to be set up, in accordance with IFRS, if there a present obligation for remediation, the costs musts be estimated based on historical data ($250,000 to $500,000). The liability must be set up accordingly and discounted on the time value of money. A note disclosure is also recommended regarding this liability and its possibility. The clean-up costs of vacating the premises contingent on the contamination issue will also be needed to be evaluated and recognised. This liability will worsen the covenant of debt-to-equity. New Loan:
The loan of $2,000,000 is being used to purchase equipment for the business, according to IFRS this loan can be capitalized, furthermore all the borrowing costs such as interest payments (measured using the effective interest rate method) and the upfront fee of $377,000 can also be capitalized in accordance with IFRS. IFRS (IAS23) states that “An entity shall capitalise borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset.” Therefore, the interest payments and the upfront fee may be capitalized. This will benefit the objective of lower debt-to-equity ratio. After the acquisition period the interest payments will be expensed. Cost of Equipment:
The following costs of the equipment will be capitalised, in accordance with IFRS:
* The invoice price of $2,450,000.
* The interest cost before the acquisition
* The shipping cost of $34,000
* The duty to be paid: 20% x 2,450,000 = $490,000
* Installation of the equipment : $17,000
* Labour and supplies during the testing: $21,000
The borrowing costs and cost of equipment that is capitalised must be disclosed in the notes to the financial statements. Capitalizing these costs will better the debt-to-equity ratio. Prepaid Card Revenue Recognition:
DCDL in the month of March offered customers the option of buying prepaid cards for their services. Customers could buy $100 card and receive $120 worth of dry cleaning services. DCDL has recognised the $120 as a liability (unearned revenue). Face value of the cards sold so far is $468,000; $78000 (20 x 3,900 cards) has been recorded as an expense. This idea of prepaid cards is basically the concept of a sales discount. Instead of expensing the entire $78,000 the amount estimated, used in this period must be recognised. This amount must be recorded as a contra sales account in the financial statements and not as promotion expense.
The $342,000 of prepaid cards used must be recorded as revenue less any discounts that customers have taken, as it meets all the performance criteria, according to IFRS. Max expects 5-10% of the value of the cards never to be used. This statistic should not be taken into consideration unless the company has some historical evidence to back up these figures. This is a new program for DCDL, so these figures will not be used, as IFRS states that revenue needs to be reasonably measured before being recognised. The recognition of the revenue and reduced expense both better the debt-to-equity ratio of DCDL and are aligned with the objectives of the company in acquiring the loan. Conclusion:
According to the issues discussed above, the revenue recognition of the prepaid cards betters the covenant for the loan, but the lease issue worsen the ratio.