The Proper Accounting Treatment of Auto World Inc - Essay Example

The Proper Accounting Treatment of Auto World Inc. This memo deals with the proper accounting treatment of Auto World Inc.’s (Auto World) sale of Pit Stop Service & Tire Center (Pit Stop) to Giant Private Equity Firm (Giant). It also deals with the relevant audit procedures and evidences needed to verify that the transaction has been properly accounted for in the books and financial repots of Auto World. From the facts given, Auto World should account for Pit Stop as a component of an entity in accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, and account for its operations as discontinued operations. However, there is still a need to verify, through certain audit procedures and audit evidences if Pit Stop is really a component of an entity. This includes assessing if the cash flows subsequent to the disposal can be classified as direct or indirect cash flows in accordance with EITF No. 3 – 13 and if Auto World will still have significant influence on Pit Stop’s operations after its disposal. Accounting Treatment The major accounting issue for Auto World is the proper accounting treatment, presentation and disclosure for Pit Stop’s operations in Auto World’s financial statements for the period ended June 30, 2007. All these will depend on whether or not Pit Stop is really a component of Auto World and whether it will qualify as discontinued operations. According to Paragraph 41 of SFAS No. 144, “a component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity”. Another definition in paragraph 10 of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, stated that an operating segment is one that has its own business activities where it derives and incurs revenues and expenses, respectively. One factor to determine whether it is an operating segment is that its operating results are consistently viewed and analyzed by top management for decisions related to resource allocation and to performance assessment. Lastly, a “component of an entity” (SFAS No. 144, par. 41) can also be a reporting unit, that is, “an operating segment or one level below and operating segment” (SFAS No. 142, par. 30). Using the above definitions, it seems that Pit Stop is a “component of an entity (SFAS No. 144, Par. 41). This is based on the facts that one, all 30 branches of Pit Stop will be disposed one time and two, Pit Stop is distinguishable from the other operations of Auto World, both in terms of physical branches and in terms of revenues and expenses. There are, however, two conditions Auto World must meet before accounting for Pit Stop as a separate component and these are the conditions on whether Pit Stop shall be reported as a “discontinued operations” (SFAS No. 144, Par. 42) or not. These two conditions, according to Par. 42 of SFAS No. 144, are that Pit Stop’s operations and cash flows will be significantly eliminated after the sale and that Auto World will have no significant influence in Pit Stop’s future operations. The second condition was already met based on the declaration of Auto World that the royalty agreement does not give Auto World significant influence over the operations of Pit Stop. As to the first condition on the elimination of operations and cash flows, we use here as basis the contents of EITF Issue No. 3 – 13. According to EITF Issue No. 3 – 13, if the cash flows will be considered direct and significant to the total operations of Auto World as per its definition, the sold operations will not be considered a discontinued one. In Auto World’s case, the royalty fees that it will receive after the disposition of Pit Stop are not direct cash flows as these are not the same as those generated by Pit Stop prior to its disposal. Thus, Pit Stop’s disposal may be properly accounted for as discontinued operations. Audit Considerations and Audit Evidence How to Determine if Pit Stop is a Component of an Entity For auditing procedures and the related audit evidence, the first set of audit procedures will be geared towards determining if Pit Stop is really a component of an entity. For this one, we have to obtain an understanding of the exact business purpose of Pit Stop as a component of Auto World and how Pit Stop relates to the rest of the operations of Auto World. This can be done through the following: (1) inquire from management the business purpose of Pit Stop, how Pit Stop relates to the rest of the operations of Auto World and how management analyzes the operations and financial results of Pit Stop; (2) obtain official documents (such as minutes of meetings, organizational structure and regulatory filings) that show how Pit Stop’s operations are reported and disclosed and how top management makes decisions on Pit Stop’s operations and financial balances; and (3) obtain Auto World’s consolidated financial statements, segment reports and Pit Stop’s own financial statements and see whether Pit Stop’s operating results are reported as a separate segment for Auto World. Number 3, above everything else, will provide direct evidence that Pit Stop’s operations, revenues and expenses, as well as cash flows, can be clearly identified from the rest of the group. How to Determine if the Results of a Component of an Entity that Has Been Disposed Have Been Properly Reported in Discontinued Operations Once it is determined that Pit Stop is a component of Auto World and that its disposal meets the conditions for discontinued operations, the next step in our audit will be to determine if Pit Stop’s results of operations prior to its final disposal are properly accounted for as discontinued operations. We will have to gain understanding on how Auto World accounted for the operations of Pit Stop and the subsequent gain or loss on its disposal. This will give an indication if Auto World properly segregated the revenues and expenses of Pit Stop. The next auditing procedure is to perform closing the books tests on Pit Stop and Auto World. That is, follow through from the separate accounting books of Pit Stop (after closing) to the accounting books and financial statements of Auto World to see if Pit Stop’s results of operations were really separated from the rest of Auto World’s financial results. Substantive audit procedures will also have to be performed. The first substantive audit procedure (and audit evidence) is to obtain the interim financial statements of Auto World (unaudited), showing separately the discontinued operations of Pit Stop and the gain or loss from the disposal of Pit Stop. The next audit procedure is to perform substantive analytical procedures which include “comparisons to prior years or budgets, ratio analyses, comparisons of financial and non-financial information” (Puttick, van Esch and Kana, p. 869). These procedures will be used to spot trends and unusual fluctuations (or lack thereof) between Auto World’s prior years’ and current year’s balances and to obtain reasonable explanations about such fluctuations. Inquiries from management are the next steps towards validating the results of the substantive analytical procedures. Additional audit procedures will have to be performed if we, as auditors, are not satisfied with the results of these audit procedures and top management’s explanations. We will also verify if the gain or loss on disposal of Pit Stop was properly calculated, recorded and reported. We will obtain evidence that the sale pushed through and that Auto World received the cash as stated in the agreement with Giant (or, if there is no cash collection, the proceeds were properly recorded by Auto World as receivables from Giant). In this case, direct evidences of the receipt of the cash, the subsequent acknowledgement of Auto World for the receipt and the deposit of the said cash to Auto World’s bank account will have to be obtained. After which, the gain or loss will have to be recalculated and compared with the actual gain or loss. A difference in our calculation and management’s resulting gain or loss should be accordingly reconciled with management. Determining If There are Direct and Indirect Cash Flows For the direct and indirect cash flows, we will perform audit procedures and obtain evidences to verify such cash flows. First step is to obtain the agreements for the sale and the royalty payments from Auto World’s management. We will review and analyze such agreements whether they contain any indication that there will be other cash flows after the disposal which can be construed as ‘direct’ and whether Auto World will no longer exercise significant control over Pit Stop’s operations after disposal. We will also determine if Auto World will migrate part or the whole operations of Pit Stop to its remaining operations by way of transfer of customers or transfer of products or both and if the cash flows from such migration are significant to Auto World’s cash flows pre-Pit Stop disposal. To this end, specific audit procedures and evidences will include reading the minutes of meetings for any discussions or approval of this migration; obtaining and inquiring about management’s plans after the disposal and obtaining an understanding of the operations of Auto World post – Pit Stop disposal. If there is a migration, audit procedures should be performed to assess if the cash flows from the migration is significant. With this, we will obtain, analyze and verify management’s estimation or budget for the results of the migration and compare it against the pre-Pit Stop disposal cash flows to ascertain if the cash flows are significant or not. Other critical audit procedures here are the procedures performed for subsequent events review. The subsequent events review will provide evidence of any migration of Pit Stop’s operations to Auto World’s remaining operations. Audit procedures for the subsequent events review will include post-June 30, 2007 analytical review wherein we will compare the results of operations up to the available period against the June 30, 2007 results of operations. There is a possibility that any migration of cash flows may be reflected on the subsequent financial results and this will be captured in our analytical review. Second is a review of customer agreements or contracts before and after June 30, 2007, to see if there is any evidence for the transfer of sales or customers from Pit Stop to Auto World. Lastly, inquiries from management and obtaining press releases after the sale may give an indication of any migration of operations. Other Considerations or Issues The case of Auto World’s sale of Pit Stop may look to be pretty straightforward but as auditors, we should not let go of our audit skepticism as to whether this transaction is properly accounted for or not. Some considerations may include the following: First, if the assets and liabilities of Pit Stop as of December 31, 2006 (Auto World’s last year-end prior to the actual disposal date) should actually be accounted for as held for sale in Auto World’s consolidated balance sheet as of the same period. According to SFAS No. 144, paragraph 46, “the assets and liabilities of a disposal group classified as held for sale shall be presented separately in the asset and liabilities section, respectively, of the statement of financial position”. Thus, we should determine if a definitive plan to dispose Pit Stop was already made as of December 31, 2006, as this will indicate that there was actually a need to separate Pit Stop’s financial position as of that period, and if there is a possibility of any restatement to the December 31, 2006 financial statements. Second, we should also determine how related Giant is to Auto World. Review of related party transactions, in this case, should be performed as such review will bring to light any additional disclosures or the possibility that this is not a case of discontinued operations at all. To this end, we will perform specific audit procedures to determine if there is a relationship between Giant and Auto World. Lastly, Giant’s main form of business seems to be to acquire private equities or stocks of companies. There is the possibility that it does not engage in the same kind of business or a related business as Pit Stop’s. We should, to the extent possible, obtain an understanding as to the business rationale behind the acquisition as this may have an impact on the proper accounting of Pit Stop’s disposal. Conclusion Auto World’s disposal and financial statement presentation of Pit Stop and its operations are two of the major accounting and audit issues for our audit of the June 30, 2007 interim financial statements. This means that, in our audit, we will consider the pertinent accounting provisions of SFAS No. 144, EITF No. 3 – 13 and other relevant accounting standards. Specific audit procedures will also be laid out and performed to ascertain if Pit Stop is really a component of Auto World, if its disposal can be classified as discontinued operations, if its results of operations should be properly segregated from the rest of Auto World’s operations and if there are any other issues in accounting or audit that we should consider during our audit of this transaction. Works Cited “EITF No. 3 – 13: Applying the Conditions in Paragraph 42 of FASB Statement No. 144 in Determining Whether to Report Discontinued Operations.” 13 October 2009 . Puttick, G. van Esch, Sandy and Kana, Suresh (Ninth Edition, 2007). “The Principles and Practice of Auditing.” South Africa: Juta & Co. Ltd. 12 October 2009 http://books.google.com.ph/books?id=jQSDMo-a9_4C&printsec=frontcover#v=onepage& q=&f=false. “SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information.” Financial Accounting Standards Board (FASB). 12 October 2009 < http://www.fasb.org/cs/ BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175818779186&blobheader=application%2Fpdf>. “SFAS No. 142, Goodwill and Other Intangible Assets.” FASB. 12 October 2009 . “SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.” Financial Accounting Standards Board. 12 October 2009 . Read More