CTL Airways

8/12/2019 CTL Airways

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Dear Mr. /Madam Chair,

Attached is the report you requested recommending accounting treatments for unresolved

issues in the financial statement of CTL Airways. In preparing this report, I have attempted to

provide reasonable and justifiable alternatives for the outstanding accounting issues. In these

situations, I have attempted to choose the alternative that serves the objective of increasing net

income, assets and decreasing total debt, thereby resolving bank concerns and meeting the

objectives of the company.

Constraints:

IFRS: Because this statement is also used by banks, shareholders, etc., and also as it is the

company’s desire to go public in a few years, it is important to use a recognized accounting

practice as the standard basis for preparing the statement. Accordingly, I recommend

implementing International Financial Reporting Standards (IFRS) going forward. All

recommendations made in this report are supportable in terms of IFRS, fairness, and accrual

accounting.

Public: The objective of CTL’s investors is to build a sustainable business that is strong enough to go

public in seven years.

Terms of loan: It is required by the bank to maintain some assets as a security against bank loan

and also to maintain a Debt/Equity ratio of below 0.7 to 1.



Issues and recommendations:

1- From Business Point of View:

It is clear that Joe’s strongest motive for reducing the allowance for doubtful accounts

receivable is decreasing the pool of allowance for doubtful accounts and hence, increasing the

income. It is also a good justification for the bank that it is an ongoing and profitable business

and we will be able to pay the debt we owe to the bank, yet very unethical and can hurt the

reputation of the company significantly.

From Accounting Point of View:

Using Joe’s present implication will reduce net income of the next year significantly, as

allowance for bad debt is not matched with aging method and company’s experience. Moreover,

there is no guarantee that extending the deadline for payment will result in a payment after that.

Increasing the allowance for bad debt to its appropriate level will reduce the net accounts

receivable amount, but at the same time would prevent it from a significant decline next year.

My recommendation is to adjust allowance for doubtful accounts to $1,000,000 from

$400,000 stated before (It is possible to resend the invoices and bring the payment due date to its

previous condition, but customers will most likely reject them, also, this is bad for the reputation

of the company. Thus, I don’t recommend it).

Journal Adjusting Entry is as below:

Dr. Doubtful Account (Bad Debt) Expense $ 600,000

Cr. Allowance for Doubtful accounts (Bad Debt) $ 600,000

Dr. Allowance for Doubtful Account (Bad Debt) $ 600,000

Cr. Accounts Receivable (Net) $ 600,000



2- The Patent was depreciated under straight line method which I recommend it to be replaced by

Usage-Based Depreciation. Hence, $287,500 for 2009, $250,000 for 2010, and $250,000 for

2011 and the carrying price by the December of 2011 would be $212,500. However, managers

are required by IFRS to estimate the fair value of the patent each year to determine if it’s

impaired. Moreover, according to IFRS a capital asset is impaired if its recoverable amount is

less than its carrying amount. As future cash flows produced by the patent at the end of 2011 are

estimated to be $150,000, which is greater than the net realizable value of the patent which is

estimated to be around $ 50,000 and since the recoverable amount is less than the carrying

amount, CTL must write down the patent to its recoverable amount of $150,000. It is

recommended to report a loss of $65,000 ($212,500 -$150,000).


Dr. Loss due to impairment of patent (income statement) $65,000

Cr. Accumulated amortization (contra asset) $65,000

3- If inventory was controlled under the perpetual control system then the only adjustment needed

is the ending inventory of 2010 and the beginning inventory of 2011.

However assuming that a periodic system was used for inventory control, the beginning

inventory of 2011 has been erroneously stated and as a result of the mistake in beginning

inventory on January 1, 2011 The followings has occurred in that year:



Inventory: Overstated

Cost of Goods Sold: Overstated

Net Income: Understated

Retained Earnings: Understated

My recommendation is that an adjustment is essential at this point to match the Inventory, Cost

of sales, income statement, and retained earnings (for the sake of simplicity cost of sales will be

deducted from flight operations and navigational charges in income statement).

Hence, for 2010 Balance Sheet:

Ending Inventory has to be decreased by $450,000

Retained Earnings has to be decreased by $450,000

For 2011 Balance Sheet & Income Statement:

Beginning Inventory has to be decreased by $450,000.

Cost of Goods Gold has to be decreased by $450,000.

Net Income has to be increased by $450,000.

Retained Earnings has to be increased by $450,000.

4- As both interest expense and administration expense are tax deductible, including interest

expense in administration expense does not affect any of the main concerns; however, in

assessments such as ROA we need to consider the fact that $400,000 of interest expense is

included in the administration expense.



5- From an accounting point of view:

Forty per cent of the maintenance costs incurred during 2011 is related to major

overhauls, mainly upgrading the engine of the aircraft in order to maximize its fuel consumption;

Nevertheless, I recommend overhaul costs to be assessed as a Betterment, as it is increasing the

assets useful life and is improving its efficiency and hence should be capitalized and depreciated

during the new useful time.

From Business Point of view:

It will increase the capital assets which was the main concern of the bank.


Dr. Capital Assets $600,000

Cr. Maintenance Expense $600,000

Other Issues:

Note (2) frequent flyer liability

For frequent flyer programs, it is necessary to estimate the number of outstanding miles that will

be redeemed and the cost of the rewards the customer will receive. Assuming that the each seat

redeemed using frequent-flyer point is equal to discounted seat sale price; it is a liability for

affinity program (provision) and is correctly recorded as accrued liability.



Note 2 (Litigation)

From accounting point of view:

Litigation: Has to be done for contingencies and as Codances, the competitor who has

filed a lawsuit against CTL, has not provided enough evidence for its claim of $200,000 it is not

possible to estimate the amount of such a settlement at this point. Hence, the Journal Adjusting

Entry for misstatement of accrued liabilities is as below and a footnote is disclosed in the balance

sheet (appendix1)

From Business Point of View:

The adjustment of $200,000 will increase the net income and decrease the liabilities of the firm

and hence provides a good respond to bank concern and also for the company’s desire to go

public.

Dr. Accrued liability $200,000

Cr. Administration Expense $200,000

Note (2) Accrued Vacation Expense

As a company policy, salaried employees are not allowed to accumulate vacation. Vacation

entitlement for a particular year will be lost if the employee does not take the vacation during

that particular year. Hence, it is recommended that the $23,000 accrued vacation of salaried

employees be adjusted accordingly as below:

Dr. Accrued Liabilities $23,000

Cr. Administration expense $23,000



Note (3) Unearned Revenue

As 25% of unearned revenue has been used, it should be accordingly adjusted.

Dr. Unearned Revenue $25,000

Cr. Revenue $25,000

The expired 15% of unearned revenue should also be adjusted.

Dr. Unearned Revenue $15,000

Cr. Gain (on expiry of discounted thickets) $15,000

These adjustments will decrease liabilities and increase shareholder ’s equity

Implementation

All the recommendations and alternatives mentioned above have been implemented, and the

revised Balance Sheet, Income Statement, and Statement of Cash Flow are attached (appendix 1)

and adjusted according to the adjusted journal entries.

Accordingly, the following concerns have been addressed:

Bank Concern:

The following recommendation is provided to tackle with the bank concern and mend the

relationship with them.



1) The current Debt to Equity of the company is 0.60 to 1 which is below the requirement of the

bank (appendix 1). Debt/ Equity Ratio = (Total Liabilities / Total Shareholder’s Equity)

$7,937,000 / $13,138,000 = 0.60

2) According to componentization of assets, the new land, building and furniture acquired should

be adjusted and classified relatively and not under the building within capital assets for the end

of 2011 Land; $222,000, Building; $533,000, Equipment; $445,000 based on the portion of their

appraisal prior to purchase.

An appraisal prior to the purchase indicates that all land, building and equipment carry a value

greater than purchase price; hence, a proportional method is recommended for revaluation of the

new asset in 2012 which will increase its carrying amount significantly and could be secured

against bank loans. (Please note that componentizing under equipment will have greater

depreciation expense than building, yet the gain resulted from fair market evaluation

compensates for that and also decreases potential loss as a result of impairment of the building.

As for calculating depreciation expense we would need to estimate residual value (whether it is 0

or not) and rate of depreciation for equipment at this point, 30 th of December 2011 is assumed as

the date of purchase.

3) Return on assets of 38% indicates that the entity has used its assets efficiently to generate profit.

ROA = (Net Income + After Tax Interest Expense)/ Average Total Assets = ($6,318,000 +

$400,000) / ($14,130,000 + $21,075,000/2) = 0.38

4) Getting a guarantee on accounts receivable would increase company’s expense, yet if

implemented appropriately Accounts Receivable, which is a considerable portion of CTL’s

assets, could be negotiated to be used against loans on a future basis.



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Expanding the vacation package:

From Business Point of View:

The increase in accounts receivable and bad debt expense could be covered as an offset

against the increase in income. As the market is becoming more competitive and to prevent the

company from losing its competitive advantage, it is a considerable stimulus for CTL to expand

its vacation package and allow agencies to pay a week after their customers take holidays.

From accounting point of view:

A considerable increase in expected income is foreseeable.

However, Accounts Receivable and Bed Debt Expense (due to bankruptcy) will most likely

increase provided that CTL implements the expansion and allows travel agencies to pay a week

after the flight. Accordingly, average collection period of accounts receivable, which is currently

81 days (365/Accounts Receivable Turnover Ratio = 365/ 4.46), would increase.

The increase in accounts receivable from $3,500,000 in 2010 to $14,700,000 in 2011 shows

more than 300% increase in accounts receivable; moreover, the fall of $900,000 in cash in 2011

from $1,600,000 in 2010 shows a stiff decline in the company’s cash and implementing the

expansion will most probably worsen the situation. Hence, it is not recommended.

Alternatively, if it is the wish of the owners to implement such plan, negotiations for guarantee,

security, drafts and/or factoring for the payment of the agencies requesting an extension on their

payment deadline is highly recommended.



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Conclusion:

To sum up, in providing the above mentioned recommendations, I have tried to meet the

requirements of all major stakeholders, as implementing these suggestions would increase the

Net Income from $5,670,000 to $6,318,000, Capital assets (net) from $3,680,000 to $4,215,000,

and retained earnings from $7,440,000 to $7,638,000 while decreasing its Total Liabilities from

$8,200,000 to $7,937,000 in 2011; hence, Meet banks requirements and answer their concerns.

Provide additional motivation for managers and increase the efficiency of said individuals.

Fulfill owners’ desire for expansion and finally, show a healthy business to potential

shareholders when company eventually decides to goes public.

John Taylor

Vice President of Finance

CTL Airways

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