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AIRFORCE TECHNOLOGY CORPORATION
AirForce Technology Corporation (AirForce) is a private company that manufactures heating, ventilating and air conditioning (HVAC) control systems. Its customers are HVAC manufacturers and installers. The company operated locally in the Greater Toronto market for many years, with net annual earnings in the $300,000 range. It launched a new version of its control system in late 2013 and has expanded its market reach considerably. One of the key selling features of the new system is that AirForce’s technicians can access it over the Internet. The technicians can collect data on system performance and adjust operating parameters to optimize the heating and cooling cycles, delivering energy savings to the customer. This also generates a new service revenue stream for AirForce.
AirForce is owned by the Ruud family. The founder, Emily “Terribly” Ruud, is now in her eighties. Emily’s motto, drummed into her children from day one, has always been that “a tax dollar saved is a dollar earned.” She is no longer a shareholder. Her three children now run the company, having purchased all the shares from her.
When the new system was launched and the children decided to grow the company, they needed funding. Emily was opposed to the plan, but rather than see her family risk losing control of the company, Emily offered to lend the necessary money. AirForce issued a $2,000,000 bond to Emily on January 1, 2014. The bond had a coupon rate of 10%, with interest payments to be made annually at the end of each year, and a maturity date of December 31, 2025. Rather than making the bond retractable, Emily insisted that if the debt-to-equity ratio of the company exceeded 2.5:1 on any annual financial statements, a penalty fee of $500,000 would be payable to her.
Because the company is privately held, its financial statements have always been produced mainly for internal purposes. The company has always followed generally accepted accounting principles, but departures from it are made if the resulting information is more useful for its purposes. Emily has agreed to use these statements but has insisted that she (or her representative) be allowed to review the annual statements to ensure that no accounting choices have been made solely to manipulate the debt-to-equity ratio. Emily and the children have agreed to meet each year specifically to review the statements in light of the covenants on the bond. Any disagreements will be settled by an independent arbitrator. They all agree that any tax effects can be left out of the discussion.
It is now February 2015. Emily has hired you, an accountant, and asked you to review the December 31, 2014 draft financial statements of AirForce. She would like you to prepare a report which recommends how to deal with any issues you identify and would like you to recalculate the debt-to-equity ratio based on any changes that you recommend. She would like supporting reasoning for your recommendations that she can use in the discussion with her children. She will be taking your report into the meeting and wants to be prepared for every issue.
You have reviewed the files of AirForce and have found the following:

1. Summarized Balance Sheets for the fiscal years ended December 31:
                                                            2014 (draft)          2013          2012
Total assets                                        7,500,000       5,000,000    4,500,000
Total liabilities                                     4,500,000      2,400,000    2,200,000
Capital stock                                           1,000             1,000          1,000
Retained earnings                               2,999,000       2,599,000    2,299,000
Total shareholders' equity                  3,000,000      2,600,000   2,300,000

2. In October 2014, one of AirForce’s long-standing customers placed a large order for system units, to be delivered in equal proportions in December 2014 and January 2015. The total price of the order was $750,000 for 620 units. As is normal with this customer, the full price was paid in advance. While AirForce normally recognizes revenue when units are shipped, in 2012 it began recognizing the payments of reliable, longstanding customers as revenue when the payment is received, for simplicity. “It all evens out in the end”, said one of Emily’s children when you asked about this change.
3. In reviewing the accounting for the bond issued to Emily, you discovered that the effective interest rate for a bond of that type was 8% and that Emily paid a premium of $301,436. The journal entry made was as follows:

DR Cash                                                 2,301,436
       CR Miscellaneous income                               301,436
       CR Bond payable                                              2,000,000
To record the issuing of a bond to Emily Ruud.

4. In reviewing the accounting for inventory, you discover that AirForce still has $1,200,000 of older HVAC units on its books. You discuss this with Emily’s children by the new Internet-connected version. They hope to sell it to a distributor in Atlantic Canada at a 50% of cost.
AirForce would be responsible for shipping costs, which are estimated at $5,000. The agreement with the distributor has been negotiated but has not yet been signed.
5. When you were going through AirForce’s files, you came across a folder labeled “R&D”. It lists the research and development costs on the new control system that were capitalized in 2014:

Engineering of control system               $ 640,000
Testing of prototypes                               80,000
Advertising and promotion                      100,000
Research on possible control algorithms 40,000
Legal costs related to patents                   50,000
Training of sales staff                               20,000
Senior management salaries                   200,000
                                                                $ 1,130,000

Write a report that Emily can use to prepare for the upcoming meeting.

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In light of the decision to grow and expand Airforce Technology Corporation, a substantive review on the financial statements and related transactions of the company was conducted. Based on the analysis of the financial statements of December 31, 2014, the company’s current Debt-to equity ratio is 1.5:1 with shareholder’s equity at 3 million and total debt at 4.5 million. In compliance with the bond issuance agreement that the debt to equity ratio be within the 2.5:1 threshold, review and assessment would be focused on accounts which would affect this ratio, namely, the liability and equity accounts. As per review with the financial statements, some items need to be restated for compliance with IFRS....
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