Page 1 of 5 MGT 224 Assignment # 2 Due March 30/31, 2015 Worth 10% of total mark. The groups may be from different sections.

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MGT 224

Assignment # 2

Due March 30/31, 2015

Worth 10% of total mark.

This assignment must be done in groups of two (not 1 or 3). The groups may be from different sections.

Any evidence of plagiarism will result in a score of zero plus reporting to the Dean for all students involved.

Note that any authoritative guidance should be referenced—but need not be repeated here. For example—you may state per Handbook Section 3400 this is the proper treatment in this case—with a full explanation related to case facts…no need to repeat the general contents of S. 3400.

There is no standard format to a case response—use your own instincts in this area.

However I do encourage you to organize your response in a logical fashion and ensure that a clear conclusion is made.

You will also need to be concise because the limit is 8 written pages, plus one exhibit, with a TNR 10 point font with double spacing.

Bottom line—you will not be able to “google” this response—it is going to require you to think, analyze and conclude all in a clear concise writing style.

Good luck!

CHCL

COMPREHENSIVE CASE

Canadian Home Comfort Limited (CHCL) is a Canadian manufacturer of furnaces and air-conditioning units. The company was acquired by a group of 15 investors in the late 1990s. Three of the investors are senior managers with the company, including Jacob Kovacs, who is president and chief executive officer.

Over the years CHCL had been quite successful, but it has struggled in the face of increased competition from overseas competitors. The owners believe that three years from now CHCL will be poised to be a major player in the Canadian and the U.S. heating and cooling markets. Summary financial statements are provided in Exhibit I. Kovacs points out that the company’s financial performance seems to be improving, given the smaller loss in 2014 and the increasing revenues after two years of falling sales.

Your firm has been auditor of CHCL since its first audit in 2008. It is now January 2015. Yesterday, you visited CHCL and met with key personnel to discuss the forthcoming audit engagement. You obtained the following information.

 In early 2014, the company increased its debt load significantly by borrowing $300,000 from the bank. Excerpts from the loan agreement are as follows:

Canadian Home Comfort Limited (the borrower) covenants that:

a. A current ratio of 1.2: 1 or higher will be maintained, and

b. the debt-to-equity ratio will not exceed 3:1. Debt is defined as all liabilities of the company.

c. GAAP is to be followed in the determination of these amounts

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 In 2008, CHCL introduced a new model of gas furnace that was popular with consumers because its reduced gas consumption resulted in lower heating bills. The furnace design has remained virtually unchanged since it was introduced. The furnaces are sold with ten-year warranties on parts and labour. Historically, claims have been minimal.

However, in the summer of 2014, several warranty claims were made against CHCL. Routine inspections by gas-company employees revealed cracked heat exchangers, which could leak gases that might cause health problems when mixed with warm air in a home. Thirty claims were made, and CHCL paid for repairs. The cost of repairing each furnace was $150, which was expensed by CHCL.

Jacob Kovacs believes that the furnaces were damaged because of poor installation by contractors. He cannot see more than an additional 40 or 50 units being damaged. The 30 repaired furnaces were manufactured in 2009 and 2010. Over 10,000 units of this model have been sold over the past five years.

Later, in a discussion with the chief engineer, you learn that she had examined the heat exchanger used in the gas-furnace model in question and saw no evidence of a design flaw. However, she expressed concern that the problem might be due to heavy use of the furnace. She noted that the 30 reported problems were in northern locations where the demands on the equipment are considerable. Between 1,500 and 2,000 furnaces were installed in homes in those locations.

 CHCL has been working on a new technology for heating office buildings. Expenditures on the new technology are summarized in Note 1 of Exhibit I. The project began in early 2013.

According to management, the project is nearing the end of development, and it is now only a matter of time before it is successfully brought to market. Jacob Kovacs does not think that it will be possible to bring the project to market in the coming fiscal year without additional financing. He is optimistic that negotiations with a private investor will be successful, allowing the project to go forward. Kovacs estimates that an additional $150,000 to $200,000 is needed to bring the product to market.

 In January 2014, CHCL bid on and won a $1.05 million contract to supply heating and air conditioning equipment for a large commercial and residential project. Construction on the project began in March 2014.

The fixed-price contract calls for CHCL to start delivering and installing the equipment in early September 2014. In addition, CHCL has agreed to pay a penalty if the project is delayed because CHCL is unable to meet the agreed-to timetable. A brief strike by its factory employees has caused production and delivery to lag about two weeks behind schedule, so CHCL is shipping units as soon as they are produced. According to the agreement, half of the equipment has to be shipped and installed at the project site by the end of February 2015. Jacob Kovacs is confident that CHCL will be able to catch up to the promised timetable.

In 2014, CHCL recognized $350,000 of revenue based on the number of units shipped to year end. CHCL has received $50,000 for the units that have been installed by year end.

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 Economy and Efficiency Limited (EEL) is hired by corporations to find ways to minimize expenses. EEL is paid 75% of the first year’s savings and 50% of the second year’s savings. In addition to property tax and insurance fees, EEL investigates heating costs.

In early 2014, CHCL won a bidding competition to become EEL’s consultants on heating matters by claiming that it could, on average, lower heating costs by 20%. CHCL spent over $20,000 preparing and presenting its bid. This was deferred under “Other current assets” on the balance sheet.

The arrangements under the agreement are as follows. CHCL sends an employee to the site of each EEL client to estimate the savings that can be made if one of CHCL’s heating systems is installed. Provided that the client considers the projected savings worthwhile, CHCL then installs the system. CHCL sells the heating system at cost and is paid directly by the client. EEL is responsible for monitoring the client’s actual savings, and EEL pays CHCL 50% of the amount it collects for savings related to heating expenses. EEL remits the amount to CHCL after collecting the full amount from its client. However, if savings are less than 10%, EEL remits nothing to CHCL.

CHCL investigated some clients during 2014 and predicted savings of 15 to 25%. CHCL has accrued its share of the savings that it believes will be generated at the sites it investigated during the year. The feedback from EEL to date is that actual savings are not as good as predicted by CHCL and have ranged from nil to 15%.

 In a major move to expand operations, CHCL acquired 100% of the shares of Right Air Furnaces Limited in early January 2014 for $2.1 million. Right Air's assets consisted of inventory valued at $ 1.5 million as well as other assets totalling $ 200,000. Right Air has a fiscal year end of December 31 and has lost $ 500,000 since the acquisition. No dividends have been received from this investment. The investment was financed almost 100% by new debt.

 In order to protect itself against increases in the U.S. dollar relative to the Canadian dollar, CHCL decided in 2014 to enter into a number of “hedging” arrangements. As of December 31, 2014, they have several forward contracts in place to buy $US at fixed contract rates. The total amount is US$ 1,500,000 with an average contract rate of $ 1.15. The spot rate at year end was $ 1.10 and is currently at $ 1.12. The first contract comes due at the end of January and every 30 days after that. The Company is unsure how to account for these contracts at December 31, 2014.

 CHCL launched an extensive advertising campaign in October 2014. The campaign was targeted at the winter season as a time to replace aging furnaces. $250,000 of the amount expended in 2014 was debited to a deferred asset account due to the expected long term benefit from the campaign.

Your partner asks you to prepare a memo for her that thoroughly addresses the accounting issues that came to your attention as a result of your visit.

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EXHIBIT I

CANADIAN HOME COMFORT LIMITED

EXTRACTS FROM THE DRAFT FINANCIAL STATEMENTS

BALANCE SHEET

As at December 31

(in thousands of dollars)

2014 2013

(Unaudited) (Audited)

Assets

Current

Cash $ 15 $ 100

Accounts receivable 1,775 1,487

Inventory 500 540

Other current assets 56 120

2,346 2,247

Capital assets 2,026 2,026

Accumulated amortization (1,071) (926)

955 1,100

Product development – net (Note 1) 580 230

Investment in Right Air 2,100 -----

EEL receivable 25 -----

Deferred advertising 250 -----

Intangible asset -- 40

$6,256 $3,617

Liabilities

Current

Bank indebtedness $ 450 $ 400

Accounts payable 581 395

Other current liabilities 493 140

1,524 935

Long-term debt 2,825 525

4,434 1,460

Shareholders’ equity

Share capital 1,000 1,000

Retained earnings 907 1,157

1,907 2,157

$6,256 $3,617

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EXHIBIT I (continued)

CANADIAN HOME COMFORT LIMITED

EXTRACTS FROM THE DRAFT FINANCIAL STATEMENTS

INCOME STATEMENT

For the years ended December 31

(in thousands of dollars)

2014 2013

(Unaudited) (Audited)

Sales $7,900 $7,800

Cost of goods sold 6,478 6,400

Gross margin 1,422 1,400

Expenses

Selling, general and administrative 1,155 1,290

Amortization of capital assets 120 146

Amortization of product development 50 20

Interest 140 88

Other 147 160

1,612 1,704

Net loss (190) (304)

Retained earnings, beginning of period 1,157 1,561

Dividends (60) (100)

Retained earnings, end of period $ 907 $1,157

Note 1:

Expenditures relating to the project to develop new technology for heating office buildings that were made and capitalized:

2014 2013

Product development – opening balance $230 $ 0

Costs incurred during the period

Materials 150 93

Salaries and wages 125 78

Allocation of overhead 80 50

Amortization of capital assets 25 16

Interest 20 13

Total 630 250

Less amortization (50) (20)

Product development – ending balance $580 $230

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