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Andrews then moved the discussion to the issue of the seventh store, which Lakeside had
begun operating on December 1, 2009, In Williamsburg, Virginia. Carole Mitchell had
informed Andrews that Lakeside made a $21.000 payment on November 28, 2009, to
Rogers Development Company, the corporation, which constructed this building and was
leasing it to Lakeside. She also revealed that Benjamin Rogers and his wife own Rogers
Development Company. The entire $21.000 had been charged by Lakeside to a prepaid
rent account with 1/12 of this total being subsequently reclasiffied to Rent Expense for
the month of December. Andrews was very concerned as to whether this rental agreement
constituted a capitalized lease based on the criteria established by statement 13 of the
FASB. He was also concerned as to the possibility that Rogers Development Company
might actually be a variable interesr entity (also known as a special-purpose entity) that
may need to be consolidated with the Lakeside Companys financial statements.
Roger adamantly refused to even entertain the possibility that this arrangement might be
a capital lease or that Rogers Development Company might be a special-purpose entity.
He immediately brought out the rental contract (see Exhibit 9-3) between Lakeside and
his construction company. The agreement is for one year only. We will renegotiation on
a year-by-year basis; the board of directors fully agrees with the handling of this matter.
In addition, the price is quite reasonable for that store at that location. I even checked into
this matter with a lawyer before drawing up the contract. Neither a bargain purchase
option nor a transfer of ownership is included in the lease. The building has a useful life
of at least 25 years; thus, the one-year contract is for a period of time less than 75% of the
propertys economic life. Finally, since the residual value is not guaranteed, the $21.000
payment fails to satisfy the 90% present value criterion. This lease simply does not meet
any test for being a capital lease.
Andrews was quite surprised by Rogers fervor and knowledge of this FASB Statement.
Upon further questioning, the president indicated that growth is important to me. To
grow, Lakeside has to be able to borrow money and, thus, needs a good debt/equity ratio.
By financing the building in this manner, the construction debt is actually mine and not
that of the company. I plan to earn a reasonable return on my investment but, even more
importantly, Lakeside maintains its borrowing potential. I do realize that this lease
qualifies as a related party transaction and will have to be disclosed in a note to the
financial statements. However, Im not sure that anyone actually reads those notes.
Andrew was concerned by Rogers contentions and decided to discuss the issue with Dan
Cline, the audit partner on the engagement, before taking further action. He wanted to
read statements 13 once again to see if any guidance was offered by the pronouncement
about capital leases. Andrews also wanted to review FASB Interpretation 46 about
variable interest entities. Thus, he chose to forgo additional discussion with Rogers
concerning the lease and moved to his final agenda item: Lakesides store six.
Store Six began operations in November 2007 but had never proven successful. The
previous audit firm had even qualified its opinion on Lakeside s 2008 financial
statements because of Rogers unwillingness to record or disclose the impairment of the
value of the companys investment. Although sales were up slightly in 2009, the store
continued to show a considerable loss after two years of operation. The adjacent shopping
center was still having its own problems, with less than 60% of the available space being
rented. Andrews did not believe that store six was capable of generating a profit in the
foreseeable future.
When questioned, Rogers was somewhat philosophical about the situation. We studied
that marked before we went into it. We felt that the location had longrange potential and
we still do. Lakeside is not the kind of company that enters an area on an impulse and
then pulls up stakes if things dont go our way at first. We can make that store profitable,
and we will. I wasted too much time last year arguing with king and company over this
issue. As you know, that firm is gone and the store is still at the shopping center making
sales. Store Six will be doing business for as long as Lakeside is in business. I really have
nothing further to say on the matter.
DISCUSSION QUESTIONS
Perform the necessary steps to test the warehouse account (#111-1) and document
your procedures on an audit document similar to the one in Exhibit 9-4. Indicate
and prepare on the audit document any proposed correcting entries that are needed
to ensure fair presentation of this financial information. (case 9-1.doc)