Baker Company Limited (BCL) was founded in 2009 and its first year of operations turned out to be a good one

Baker Company Limited (BCL) was founded in 2009 and its first year of operations turned out to be a good one, as start-up years-go, since the company not only broke even but actually showed a very small profit. Just as the company was getting established in the market, however, a full-fledged recession hit in 2010 and had devastating effects.

Demand for BCL's products in retail markets declined as consumers tightened their purse strings. Through tight cost controls, however, BCL managed to hold its own and still recorded a small profit in 2010.

While the recession finally petered out by the end of 2011, BCL did end up feeling its effects, as the company was unable to remain profitable and suffered large operating losses that year. In fact, the losses were significantly greater than the profits that were reported in the previous two years. Despite this change, BCL management was not overly alarmed by the losses and had the following comments to make:

The losses were expected given the widespread recession. Since the bulk of our sales are in retail markets, and with unemployment levels being at record highs, it is not surprising that consumer demand has fallen off. If BCL is compared with the industry, you will see that we did much better than our competitors, some of whom went bankrupt.

Keep in mind that we are a relatively new company and managed to record a profit in two out of our first three years. We attribute this to our strong management team and our ability as a streamlined company to react to the recession with cost control measures and an aggressive, yet flexible sales staff.

We see ourselves positioned for a new growth spurt given that the economy seems to have recovered and a lot of "dead wood" (i.e., competition) has been cleared out. As a matter of fact, in that regard, the recession will have a positive impact on our short- to mid-term growth potential.

BCL is on the verge of introducing two new products that will revolutionize the industry and assure us a solid earnings base for the future. These products will be introduced in 2012 and we have already lined up sufficient buyers such that we predict we will at least break even in terms of net income in 2012. This is a very conservative forecast.

Although the effects of the recession were lessening, unemployment was still high in early 2012 and consumer spending had not increased significantly. Some economists were predicting that it would take two or three years for consumer confidence and spending to pick up to pre-recession levels.

Instructions

Adopt the role of the company's auditor and determine whether BCL should recognize the benefits of the losses suffered in the 2011 financial statements. Assume BCL is a private company.

Overview

-       Assume that GAAP is a constraint since the financial statements are being audited. As a private company, the company could use ASPE or IFRS.

-       The role is that of company auditor and, therefore, the auditor would ensure transparency.

-       Management has high expectations of the company’s ability to turn around and continue to grow—and may be biased to show this.

-       Users include shareholders/investors who will want transparent statements. Given loss situation—they will be looking to decide whether to divest or not.

Analysis and Recommendations

Issue: The issue is whether the benefit from the losses should be recognized in the current financial statements.

To the extent that taxes were paid in previous years, the losses would first be carried back to recover these taxes and a partial benefit could be recognized.

The real issue is whether there is sufficient certainty to recognize the benefits that might be realized if the losses are carried forward. The benefits may be recognized if it is more likely than not that the benefits will be realized (under ASPE) or probable (under IFRS).  This ultimately depends on the existence of sufficient taxable income in the carry forward period to be able to utilize the loss and shelter future taxable income. Note that under ASPE, the entity has a choice to use the taxes payable method or future income taxes method.

Recognize benefit of losses

Do not

-       On the one hand, management has big plans to expand into new markets with new products. Two new products are scheduled to be introduced and there are sufficient customers lined up to purchase the products, such that the company is predicting at least a break even situation using conservative estimates. -       The fact that the company did not suffer pre-recession losses in its first two years is a signal that they must be doing something right. With respect to the economists, it might be argued that no one can really predict the future. Management has better insight into its own company and customers and, therefore, might be in a better position to predict the future. -       The fact that numerous competitors have gone under will hopefully open up new markets and help increase market share. -       In addition, this option would not be allowable under the taxes payable method (ASPE).

-       Forming a conclusion that the benefits are likely to be realized is difficult when certain unfavourable evidence exists. -       In this case, unfavourable evidence would include the fact that there is a history of marginal profits only (and, of course, the loss) and the fact that this company is still in its formative years. It is not unusual for companies to sustain losses in the start-up period. -       Furthermore, it might be argued that the current state of the economy is unsettled. Unemployment is still high and consumer spending has still not increased significantly. The fact that economists are predicting that it might take two to three more years for consumer spending to recover results in more uncertainty. -       In addition, if using the taxes payable method (ASPE), would only recognize taxes receivables based on current and/or refilled tax returns. Therefore no tax assets would be recorded in advance.

In conclusion, although management might be able to make a strong case for profitability, it is still a projection at best and, given that the economy still appears to be slow, it might be more conservative not to recognize the benefit. This is in keeping with the role of auditor. The unrecognized benefits and expiry dates would be note disclosed.