Adirondacks Fixtures Inc. (AFI) is a private company that has experienced years of declining sales and profits, and has finally taken some decisive action to address this situation. An aggressive restructuring plan is now in place, and the related severance costs will put AFI into a significant loss position for 2012. Management expects to incur a further loss in 2013 before the cost-saving and revenue increasing effects of the restructuring plan start coming to fruition. Of course, in the competitive environment AFI faces, there are no guarantees that the restructuring plan will succeed.
One of the near-term complications AFI is facing is that its $10 million bank loan is coming due next year. Given the company’s recent business experience, and the severance payments it has committed to as part of the restructuring, there is no way there will be sufficient cash on hand to retire the loan on the due date – it must be refinanced. In fact, in order to carry out the restructuring plan with the greatest chance of success, AFI must borrow $12 million on the refinancing, rather than just $10 million. The extra $2 million will be spent on marketing next year.
Fortunately, AFI’s only other long term debt, a second bank loan amounting to $8,000,000, is not due for another 5 years. Nevertheless, AFI will continue to be bound by that loan’s 2:1 debt:equity covenant*. Any violation of the covenant would mean the loan would immediately become payable in full. As of December 31, 2011, AFI was in comfortable compliance with these covenants, at a D:E ratio of 1.50:1. Liabilities other than long term debt amounted to $14 million, and were expected to remain about the same for the 2012 year end. Management is concerned about the effect of reduced equity on the debt:equity ratio, given the losses that must be recognized in 2012.
AFI’s treasurer has been investigating the company’s refinancing options (see Appendix 1), in part with the help of a private investment firm that does private placements. The investment firm strongly advises that AFI switch to IFRS before embarking on the refinancing. IFRS-based F/S would ensure completion of the placement, and the best possible response (highest price) from potential investors.
After a preliminary review, you have determined that the only thing on the balance sheet that would be significantly affected by a switch to IFRS is likely related to tax. AFI has historically opted for the taxes payable approach under ASPE. Information on AFI’s tax situation at the end of 2011 is shown in Appendix 1.
* debt is defined as total liabilities; equity as total equity under the loan agreement
You are the controller for AFI, which has always reported under ASPE. Prepare a report for the CFO that addresses the refinancing options that AFI faces, and the financial reporting ramifications thereof. Your report should include the following:
(a) Some background information on the differences between the way taxes have been accounted for in the past, and how and why it will change in the future. The CFO will use this information in her presentation to the Board of Directors when the recommended refinancing option is discussed.
(b) The adjustments that will be required to the December 31, 2011 balance sheet to convert to the IFRS approach to accounting for income taxes.
(c) Projected taxable income for 2012.
(d) Draft the bottom of the income statement
( e ) Calculate future depreciation charges and what the effect on income will be
(f) The journal entries that will be required under the new approach to accounting for income taxes, based on the expected net loss for accounting purposes for 2012. Ensure you clearly discuss and justify any assumptions that need to be made about AFI’s future earnings performance.
(g) A brief conclusion summarizing all that has been done
Appendix 1: Refinancing possibilities
The investment firm has found a private lender willing to refinance the loan, however the lender views AFI as a higher risk borrower and will require a higher interest rate (15%) as well as security over all of AFI’s assets.
• The firm has also proposed that AFI could issue preferred shares with a cumulative dividend of 10%, in a private placement. This dividend could be reduced to 8% if AFI were willing to enhance the shares with a retraction feature, under which shareholders would have the right to retract the shares at their issue price at any time.
• Finally, the firm suggested that common shares could be issued, again in a private placement. They felt these shares would be more difficult to place given AFI’s recent difficulties. Existing shareholders would have to give up a significant portion of the company to the new owners; perhaps up to 40%, far more than the existing shareholder group would like to give up.
Projected accounting income for 2012 is a loss of $1,400,000. The government announced in November 2012 that the tax rate would increase to 32% for 2013 and all future years.
Appendix 2: Tax-related information December 31, 2011