Warmth Home Comfort Limited - Ifrs

SOLUTION UPDATED FOR IFRS

2001 II-1 Warmth Home Comfort Limited

Suggested approach 

The reader is reminded that the solutions are developed for the UFE candidate and that therefore all the complexities of a real life situation may not be fully reflected in the following situation. This solution is not an authoritative source of IFRS.

MEMORANDUM

To:        Partner

From:        CA

Re:        Warmth Home Comfort Limited engagement

Overview

This year the WHCL engagement poses a number of issues that are of particular concern. Management believes the company can be a major player in the heating and cooling markets, and steps have been taken to achieve this goal. In particular, the company has increased its debt significantly in the last year and the new debt has covenants specifying a minimum current ratio and a maximum debt-to-equity ratio. Violating these covenants may result in renegotiation of the terms of the loan or even a demand for immediate repayment. The financial statements will undoubtedly be used by the lenders to monitor WHCL’s adherence to the loan covenants.

The debt-to-equity ratio on December 31, 2000, calculated using the preliminary financial statements, is 1.96 and the current ratio is 1.26. The ratios have worsened since 1999, when the debt-to-equity ratio was 1.50 and the current ratio was 1.25. The ratios still meet the conditions of the loan, but some accounting issues need to be addressed, and their resolution may have a negative impact on these ratios.

The preliminary financial statements are very close to violation of the debt-to-equity ratio restriction and violation of the current ratio covenant. Because of the risks associated with violating the covenants, the company has an incentive to choose accounting policies that improve or at least do not worsen the ratios. The choices that WHCL must make for a number of controversial accounting issues present WHCL with the opportunity to use “aggressive” accounting methods to increase equity and current assets, and to avoid increases in liabilities. As a result, the covenants present audit risks to our firm. It will therefore be necessary to increase testing and reduce reliance on management and controls because of management’s incentives to avoid violation of the covenants. Any such violation of the covenants will have to be disclosed in the financial statements.

Warranty

Probably the most serious business and accounting problem facing WHCL is the potential warranty liability. Problems have arisen with a product that the company has sold since 1994 raising the prospect of large out-of-pocket costs for the company. The reporting issue is how much, if any, of these costs should be accrued and expensed in the 2000 financial statements (in accordance with IAS 37). The $4,500 actually spent in 2000 on warranty service was expensed in fiscal 2000.

The need to record a provision:

According to IAS 37, if the probability of having to pay out is greater that 50% (more likely than not) a provision is required under IAS 37. In this particular case, the lawyers are likely to confirm that there is a greater than 50% chance of settlement.  Therefore a provision should be recorded. [Note: should WHCL be unable to estimate the potential liability or should probability of settlement be less than 50% (not more likely than not), then WHCL has a contingent liability. A contingent liability is disclosed, and not recognized. Disclosures include the nature of the contingency and, when practicable, the estimated financial effect and indication of uncertainties.]

Estimating the provision:

IAS 37, paragraph 25, states “The use of estimates is an essential part of the preparation of financial statements and does not undermine their reliability. This is especially true in the case of provisions, which by their nature are more uncertain than most other balance sheet items. Except in extremely rare cases, an entity will be able to determine a range of possible outcomes and can therefore make an estimate of the obligation that is sufficiently reliable to use in recognising a provision.” A variety of estimates could be made. WHCL obviously wants to minimize the charge to the current period whereas fair reporting might require a larger accrual. Considering that there is a large population of furnaces, IAS 37 requires the provision to be measured at its expected value, which considers all possible outcomes weighted based on their probabilities. The various outcomes are outlined below.  

The estimate suggested by Mr. Kovacs is between $6,000 and $7,500. He argues that the problems are due to poor installation by contractors, which would limit the extent of the problem. However, Mr. Kovacs’ incentive to minimize expenses makes his position less reliable. At the other extreme, if all the furnaces require repair the cost will be $1.5 million (10,000 x $150). This cost is not as improbable as it may seem since the government could decide that there is a significant health risk and require the company to repair all the furnaces. Accruing repair costs for all the furnaces is very conservative—perhaps too conservative.

The chief engineer has suggested that the damage may be due to heavy usage, which occurs in more northerly communities. Since 1,500 to 2,000 furnaces were sold in the north, warranty costs ranging from $225,000 to $300,000 (1,500 x $150 – 2,000 x $150) could arise. The chief engineer has expertise in the field, but she too is speculating as to the actual cause of the problem.

Yet another basis is the year of manufacture. All of the furnaces repaired so far were made in 1998 or 1999. If the problem is associated with those furnaces only, the accrual would be about $600,000, assuming an equal number of furnaces were made in each year (2,000 per year x 2 years x $150). Combining the year of manufacture with the number sold in northern communities results in an estimate of about $120,000 (2,000 sold in northern climates x 40% (two years out of five) x $150).

All of these estimates, except Mr. Kovacs’, put WHCL in violation of the covenants. At this point the estimate of the chief engineer combined with the year of manufacture presents a credible and supportable amount. However, I cannot say I have more confidence in that estimate than in any other. If necessary, we should call in experts to help determine the source of the problem. The accrual made should be the amount less the $4,500 actually expended in the current period.

  A number of audit steps can be taken to improve our ability to assess the reasonableness of any estimate of the liability. All of the estimates should be thoroughly discussed with management. We could investigate Mr. Kovacs’s estimate by finding out whether all of the furnaces repaired to date were installed by the same person. We could also confirm whether all the repaired furnaces were in the north to assess the reasonableness of the chief engineer’s estimate. In addition, we should assess the objectivity of the chief engineer because our ability to rely on her depends on her credibility. Since she is as an employee of WHCL we should, of course, view her position with at least some skepticism. We should also examine the warranty document itself to determine the extent of WHCL’s liability for this problem. We should also examine any legal letters and ensure that we receive a response to the legal inquiry letter.