Introduction Lisa Martin, CMA, CPA, was recently promoted to the position of controller at International Retail Computer Solutions (IRCS).
Introduction
Lisa Martin, CMA, CPA, was recently promoted to the position of controller at International Retail Computer Solutions (IRCS). Her promotion resulted from eight years of hard work as a corporate accountant. Martin has been with IRCS since graduating from Big State University and was thrilled to have an opportunity to move up within the organization. She has a fantastic relationship with the other members of IRCS’s management team (all of whom are also Big State alumni) and enjoys tailgating with them before Big State sporting events.
The Company
IRCS is a privately held company headquartered in the southeastern United States. IRCS’s primary business activities involve buying and selling used point-of-sale (POS) computer systems. When a U.S. retailer upgrades its POS computer systems, IRCS purchases the used equipment (including handheld scanners, receipt printers, monitors, keyboards, CPUs, and servers) and resells it to retailers in developing countries, where it is considered to be top of the line. In addition, IRCS provides replacement parts to U.S. retailers that continue to use older POS computer systems.
Ernesto Rodriguez founded IRCS in 1984. He retired last year to engage in other pursuits and is no longer involved with the day-to-day operations. However, he still retains a majority ownership interest in the company and serves as the chairman of the board. The president and chief executive officer, Harvey Lang, has been with IRCS since the founding of the company. Upon Rodriguez’s retirement, Lang was promoted and given a small ownership interest in the company.
The Management Team
Besides Harvey Lang and Lisa Martin, IRCS’s management team includes Chief Financial Officer Christina Edmonds, Chief Information Officer Carl Miller, Vice President of Sales Ryan Scott, and Vice President of Logistics Elizabeth Conner. The members of the management team all have an excellent working relationship with one another and frequently spend time together outside of work, often at Big State University sporting events.
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Changing Circumstances
During the current year (2012), several large [retail] chains, which had expanded aggressively during the boom years preceding 2008, succumbed to the ongoing financial hardship and were forced into bankruptcy. IRCS’s management saw an opportunity to acquire a significant number of used, but relatively up-to-date POS systems at a significant discount. Therefore, the company obtained a $10 million loan from First National Bank (FNB) to help finance the purchase. In order to obtain the financing from FNB, IRCS agreed to several loan covenants. Specifically, IRCS is required to maintain a minimum interest coverage ratio of 3. Failure to do so violates the loan covenant and allows FNB to demand immediate repayment of the loan.
Costing the New Inventory
In June 2012, IRCS paid more than $12 million to acquire used POS systems from a bankrupt retail chain. Although IRCS frequently purchases and sells used POS equipment, this latest purchase is by far the largest the company has ever made, thus the need for the $10 million loan.
One day in late November, over lunch with the management team, Martin listened attentively as Lang, Edmonds, and Scott discussed the success of IRCS’s latest venture. She was delighted to hear that sales of the newly acquired inventory were proceeding briskly, and that the company’s profit margins were substantially higher than normal. The only items that were cause for concern were three remaining types of CPUs. Scott noted that there just did not seem to be much demand for these items, even when IRCS offered relatively deep discounts. However, he mentioned that his sales team had several promising leads, and that he was confident that they would be able to find buyers for these items, even if they had to offer even larger discounts.
Inventory Impairment Testing
Shortly after year-end, Martin was instructed to prepare the first draft of ICRS’s financial statements. As part of the preparation process, she conducted an inventory impairment test to determine whether inventories were appropriately recorded on IRCS’s books.
When she had completed the impairment test, she was surprised to see that her calculation indicated that there was an impairment loss of $538,005. Upon further examination, Martin determined that the impairment loss was attributable to the decline in market value of the three slow-moving CPU items. Concerned, she sought out Ryan Scott to determine whether the sales force had had any luck finding buyers for the three CPU items:
Martin: “Hey, Ryan. Do you have a minute to chat about those three slow-moving CPU items from the June purchase?”
Scott: “Sure, Lisa. What can I do for you?” Martin: “I need to know if you still think that we might be able to sell those items at any amount close
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to the cost we have on the books. In other words, is it reasonable to hope that we can sell them for a normal profit?”
Scott: “Well, Lisa, that’s a tough question. You know, we have a great sales team here at IRCS, and we are generally able to move our used inventory pretty quickly. We did have several promising leads, but unfortunately, those customers bought CPUs from our competition at a deeply discounted price relative to our carrying amount. Given the market, I think a more realistic expectation is that we will have to offer them at a significant discount if we want to sell them.”
Martin: “I see. Okay, Ryan, thanks for taking the time to talk things over with me.”
Scott: “Of course! Any time.”
Given her discussion with Scott, Martin recorded the loss, which directly reduced income before taxes and interest, and significantly reduced net income. She then sent the financial statements and impairment test documentation to Edmonds for review and approval. The next day, Lang called Martin into his office:
Lang: ”Thanks for dropping by, Lisa.”
Martin: ”No problem, Harvey. What’s up?”
Lang: ”I wanted to talk about the draft of the financial statements that you sent to Christina yesterday. I see that you’ve indicated that we should recognize an impairment loss in excess of $500,000 associated with our inventory. You do realize that amount would reduce our bonuses? I use my bonus to pay for my Big State luxury box and provide scholarships for deserving student athletes. In addition, these financial statements are going to our bankers. The impairment loss you booked will cause us to violate the interest coverage ratio debt covenant. In fact, any impairment adjustment above $72,000 will place us in violation of our debt covenants in the first year of our loan!”
Martin: ”I definitely don’t want us to violate our debt covenants. But do you really think the bankers would call our loan on our first violation?”
Lang: ”Look, the bank wasn’t really excited about extending us the loan to begin with; however, Ernesto was a friend of the bank president and that was what got us the loan. The down economy has really hurt the bank and they are in no position to have risky loans outstanding. So, to answer your question, yes, I believe the bank will call our loan if we violate our debt covenants this year. Doing so will probably send us to bankruptcy and put 25 people out of work, and Ernesto and I would be on the hook for the remaining loan balance. Do you want that to happen?”
Martin: ”Of course not, especially since I am one of those people that could be out of work! Look Harvey, I didn’t make up the accounting rules, but we have to follow them, especially since a CPA firm will review these financial statements before we send them to the bank.”
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Lang: ”The bankers are not interested in the nuts and bolts of our accounting, particularly an issue that doesn’t affect our cash flows. The bank just needs to get a big picture of our financial situation, and I am telling you, we are in good shape! Now, I need you to find a way to lower that adjustment, so that we don’t violate our debt covenants.”
Martin: ”Harvey, based on my reading of the authoritative guidance, I don’t think we have an option here. And I don’t feel comfortable with you pressuring me.”
Lang: ”Okay, okay. I’m sorry I got so riled up.” … ”I tell you what. I think I can see our way out of this. Let me have a few days to get things lined up, and I will touch base with you soon.”
Two days later, Martin received a note from Lang that read, “This should take care of our impairment problem! Once you’ve reversed the impairment loss and updated the financial statements, just send them on to Christina for final review.” Underneath was a copy of Lang’s impairment test, a purchase order from one of IRCS’s largest Indian customers, along with IRCS’s corresponding invoice and shipping documentation. Martin noticed that three items included in the order were the slow-moving CPU items. Concerned that there might have been a mistake in the pricing, she decided to check with Ryan Scott:
Martin: ”Ryan, can I ask you about Invoice Number 2011-00295? The latest sale we made to National Computers?”
Scott: ”Sure, Lisa. What do you need to know?”
Martin: ”First, great job selling some of those CPU units. I know we were all worried they would be tough to sell, but it looks like we were actually able to recover our cost. I do have a question about the other items on the invoice though. I think there might be a mistake on the prices?”
Scott: ”That’s no mistake. Just between you and me, Harvey said that for financial reasons, we needed to show that we could sell the CPU items above our carrying cost, so I was able to convince National Computers to ‘pay’ a substantial premium for the CPU items by giving them great prices on the other items. But Harvey said to make sure to keep that information confidential. He specifically asked that we not discuss it with the accountants coming to review the books in a few weeks.”
Martin: ”Whoa! That’s news to me. So you don’t think we could sell those CPU items, even at cost, without giving the customer ‘special’ pricing on the other item?”
Scott: ”No way. Those CPU items are pretty obsolete, even for our overseas customers. We’ll be lucky if we can sell them for half of the carrying value.”
Martin’s head was spinning as she returned to her office. She was very uncomfortable with what she had learned about the sale to National Computers. Unsure how she should proceed, she decided to request a meeting with Christina Edmonds to talk through the issue. At the meeting the next day, Martin began by describing the issues around the impairment loss, and her concerns about Harvey’s ”solution” to the problem. She then asked Edmonds what she should do:
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Edmonds: ”Well, Lisa, this is a tough situation.” … ”It’s true that the vast majority of our sales are on an item-by-item basis, but we do sell complete POS computer systems from time to time. For instance, our recent sale to National Computers included monitors, printers, scanners, and CPUs.”
Martin: ”But Ryan said the only reason National Computer was willing to buy the CPUs was because we gave them deep discounts on the other items.”
Edmonds: ”This is definitely a gray area, and we must use our professional j