The Melville Credit Union has operated in small- town, rural Nova Scotia for the last 27 years. In the summer of 20X4, ater decades of operation as a prosperous paper mill, the Lancaster Mersey Mill was abruptly shut down. Lancaster had been a major employer of many clients of Melville Credit Union. In fact, of the 1,000 residents of the town in which Melville operates, over 320 were employed by Lancaster. he following information relates to loans receivable of Melville as of 30 June 20X4:
.:.
You, Karilyn Zinck, are in charge of the field work for the Melville audit. Melville has been a client of your firm for many years and has always received an unmodified audit report. Your audit senior reported the following discussion that took place between her and Colin Rodenizer, the chief accountant at Melville:
Required:
You are now working to identify the accounting issues that low from the above information. You have scheduled a meeting with the audit partner tomorrow and decide, in advance of the meeting, to document the issues/ areas of concern in a memo. he memo will include the quantitative impact of issues, to the extent possible.
SOLUTION:
To: Partner
From: Karilyn Zinckhpj
Overview
Melville Credit Union (MCU) is a long-time audit client that has always received an unmodified audit report. As a credit union, the entity must comply with GAAP and are subject to regulation. The Credit Union movement is community-based, with significant community roots. The Lancaster Mersey Mill has recently closed, putting 320 of 1000 town residents out of work. Houses serve as collateral for the loans receivable portfolio. House valuations (value of collateral) are an issue because of the over-supply on the real estate market.
Issues
1. Allowance for doubtful accounts
2. Accrued interest
3. Valuation of foreclosed homes
4. Going concern
1. Allowance for doubtful accounts
Valuation of the loans is a key concern. Loans have increased 36% from 20X3 to 20X4, with only a marginal (4%) increase in the allowance for doubtful accounts. The allowance is 10% of receivables in 20X4, and was 13% in 20X3. One would expect the allowance for doubtful accounts to have increased as a percent of the loan portfolio, rather than decreased, given that a major employer in the town has shut down and many of its employees are clients of MCU. There is increased risk that the loans will not be repaid. Accordingly, the reduction does not seem appropriate.
If the allowance were adjusted to the same rate as last year (i.e., 13%), the allowance for this year would increase by approximately $130,000.
In fact, the loan loss provision should most likely be increased to a higher percentage than the prior year percentage. If the allowance for doubtful accounts is understated, income will be overstated as a result of understating bad debt expense. Net assets would be overstated.
The aging of receivables in 20X4 as compared to 20X3 shows that the quality of the loan portfolio has declined. The aging shows that 26% of loans receivable are older than 120 days as compared to 16% in the prior period. In the over 60 day category, 20X4 has 33% versus 24% for 20X3. Overall, the current and over 30 day category was 60% in 209X3 but is now only 41%.
The complete ageing:
| 20X4 | 20X3 |
|---|
| Current | 26% | 32% |
| Over 30 days | 15 | 28 |
| Over 60 days | 33 | 24 |
| Over 120 days | 26 | 16 |
Overall, an impairment loss results when the carrying value of the loans is higher than the present value of the estimated future cash flows discounted at the financial asset’s original effective interest rate.
The cash flows associated with the loan portfolio must be measured, and discounted. Cash flows include cash paid by the borrowers, but also the expected cash flow from house sales. These sales may take place at distressed prices, but the cash flow model must be realistic about the timing and amounts of cash to be collected.
The loss should be recognized in income immediately. The amount is not quantifiable until cash flows are assessed. Additional audit work must be done to provide evidence of the accuracy of cash flow estimates.
If the value of the receivable written down subsequently increases, a reversal is permitted, with the amount of the reversal recognized in income, or by adjusting the allowance account.
2. Accrued Interest
MCU has continued to accrue interest on overdue loans. Since the loans are aging and there is decreased likelihood of receiving full payment, this practice is not acceptable. MCU must write off any amounts in the receivables related to accrued interest and adjust interest revenue recognized accordingly. The amount of this adjustment is not quantifiable.
3. Foreclosures
MCU holds foreclosed homes as assets. The loan receivable asset must be removed from the books, and replaced with the property asset. They key element is valuation, since their value provides a reference (floor) value for what can be recovered from the unpaid loans.
Determining a value of the properties will be difficult because house prices are depressed given the closure of the mill. Low housing prices in the area may be permanent. On the other hand, low price conditions may be temporary. Is there a reasonable prospect that housing prices will rebound an appropriate amount of time? This scenario is most likely if a new employer enters the market.
The classification of these homes for accounting purposes depends on MCU’s intent with respect to the homes. Essentially, if MCU plans to sell the homes, they should be reflected as a (presumably current) asset held for sale. If MCU plans to keep the homes to wait for an upturn in the market, these should be reflected as a long-term asset held for sale.
If MCU plans to dispose of the properties in the short term, this would provide the lowest likely value for the properties. This is because evidence for valuation most likely (absent a new employer) would be based on current conditions. However, if management intends to liquidate the properties in the short term, then this value makes sense.
In general, it seems questionable whether the fair value of the houses will offset the amount of the recorded loans receivable A write down may be required. This situation will need to be further assessed when preparing the financial statements.
Going Concern
Finally, we must assess whether MCU is a going concern. As a credit union, MCU’s core operations are dependent on the town which is potentially facing economic demise given its major employer has been abruptly shut down. The going concern assumption may not be valid. Plans/forecasts of MCU must be assessed.