RTL is a family-owned and operated business that prints flyers and banners. It has been in operation for over 20 years and is being passed on to the next generation. Profits from the past two years have been significantly declining. This is a direct result of the changing landscape of the industry, which has been moving toward digital printing. RTL management has an aggressive plan to change the revenue mix from traditional to digital printing.

To finance this transition, RTL borrowed money from the bank at the end of 2018 to buy digital printing equipment. Some changes were made to the original equipment to accommodate the printing of banners.

Despite an increase in digital sales, RTL did not achieve its revenue target for 2019 or 2020. In addition to the slow digital revenue growth, RTL has recently lost its top two traditional print clients, who accounted for 50% of overall revenues. Management is concerned with RTL's ability to continue making payments on the outstanding loan under the current conditions.

Management is actively communicating with the bank regarding potential alternatives. Given RTL's history with the bank, the bank will make concessions, including a reduction of the interest rate from 10% to 8%, a three-year extension of the current maturity, and a reduction of principal from $2 million to $1.5 million. The restructuring agreement was signed just before year end. Management is confident that the old debt will be eliminated from the balance sheet. The current market discount rate is 9%.

RTL also has a new sales plan that it is offering to digital customers. Revenue contracts include an upfront non-refundable fee and a term of two to three years. Customers are charged a per-unit fee for each digital print and a flat fee for any change in concept or design. Each contract has a minimum value so RTL earns a flat rate even if digital printing jobs are never performed. The catch to the lucrative contracts is that RTL must be available to print on demand 24 hours a day, 7 days a week. All of RTL's current digital print customers are small businesses, two of which have recently filed for bankruptcy.

RTL plans to use the digital printing equipment only for five years. At the end of this period, RTL is expecting to pay $100,000 for any modifications needed to update and prepare the equipment for sale to another vendor. A liability of $100,000 has already been recorded in the books in 2018. The accountant who prepared the journal entry has asked the controller to review this past transaction for accuracy.

Instructions

It is the end of 2020. The financial controller is preparing notes for the upcoming meeting with the auditors. Adopt the role of the controller and discuss any financial reporting issues that should be addressed before the meeting. Identify the necessary journal entries. RTL would like to use more simplified GAAP if possible.

Answer :

Overview:

• RTL is a private family-run business so ASPE is an option. There are no future plans of going public, so IFRS is not required.
• The bank will use the financial statements to assess RTL’s going concern and ability to pay interest and principal.
• Management will use the financial statements to assess RTL’s transition to digital printing and achievement of revenue targets.
• The auditors will be auditing the financial statements with a transparent reporting objective.
• There is a potential for management bias and aggressive accounting policies.
  • RTL’s profits have been declining for the past 2 years and it has recently lost 50% of its revenue.
  • RTL also entered into an agreement with the bank for a restructuring of its loan.

• Our reporting objective as the controller is to fairly present the statements.

Issue: Recognition of the restructuring of debt.

A modification of debt can be treated as a settlement if the following condition is met.

If the discounted PV under the new terms (discounted at the original effective rate) is at least 10% different from the discounted PV of the remaining cash flows under the old debt, the old debt is treated as a settlement and removed from the books.

Old debt: $2,000,000 (debt is due end of 2020)

New debt: $1,500,000 (0.75132) + $120,000 (2.48685) = $1,425,402

10% of the value of the old debt is $200,000. The difference between the old and new debt is greater than $200,000. Therefore, this restructuring qualifies as a settlement of the old debt.

The discount rates are calculated using the following:

Discount rate of 0.75132 is the PV discount factor for a single sum (10%, 3 years)

Discount rate of 2.48685 is the PV discount factor for an ordinary annuity (10%, 3 years)   

On the books, the new debt is calculated using the current market discount rates using the following:

Discount rate of 0.77218 is the PV discount factor for a single sum (9%, 3 years)

Discount rate of 2.53130 is the PV discount factor for an ordinary annuity (9%, 3 years)

Resulting present value is $1,462,026

Excel formula =PV(rate,nper,pmt,fv,type)

The following journal entry is required (using the PV tables):

Issue: Revenue recognition of the digital contract sales.

Conclusion: Depending on the significance of the 2 digital customers that have filed for bankruptcy and RTL’s limited digital sales history - Collectibility may be a concern and RTL should recognize the nonrefundable fee and minimal contract fee at the end of the contract. Assuming collectibility – may recognize over time as earned.

Minor Issue: Recognition of an asset retirement obligation.

The $100,000 represents a constructive obligation. RTL is planning to sell the equipment to a vendor who will only purchase the digital printing equipment if RTL makes the necessary modifications to update the equipment and prepare it for sale.

The liability should have been recorded at PV (using the discount rate in effect at that time), not at $100,000. The printing equipment asset should have increased by the PV of the obligation. Accretion expense should have been recorded for 2019 and 2020. As the accounting ledger for 2019 is now closed the correction must be recorded in the 2020 ledger. An adjustment to opening equity will be required. For 2020, the appropriate accretion expense must be recorded in the operating statement.