The Chinese tax authority will be the next most significant user of these recommendations. Hotye has the option of applying to the local government for a designation of a high-tech venture, which would result in their tax rate being reduced to 15% in the first few years if the tax authority grants them this status (Telecommunications Industry Association). The accounting policies selected by Hotye will have to be reported to the tax collection bureau and other regulatory bodies for approval. The result of this will be that these government authorities will look to see that Hotye will be paying a fair amount of tax, and portraying the true economic situation of the firm.
Teffen Li and the remaining members of the Regical and Hotye management teams will also be significant users of the analysis. The recommendations made will be used as a basis for the creation of Hotye’s accounting policies, which will impact the pro-forma income statements that will be shown to the aforementioned potential creditors and investors. Management will look to see that the financial statements show the company in the most positive light in order to attract financial resources. Mr. Li has stated that he is looking for ways to reduce the amount of income tax the firm pays, meaning that he would prefer an income minimization strategy which sophisticated investors would realize would improve after-tax cash flows.
In a similar manner to the Chinese tax collection bureau, the Guangzhou Municipal Government will be a significant user of the financial statements of Hotye. Mr. Li is required to submit the accounting policies of the firm to the Guangzhou Municipal Government for approval. This group will look to see that the accounting choices of Hotye accurately represent the true economic reality of the firm. This will also be the objective for the final user of the financial statements, which will be customers of Hotye. Clients will look to see the true nature of the firm’s economic reality to identify potential inventory shortages or an opportunity to use growing revenues as a source of bargaining power. The firms that subscribe to Hotye’s payment system will want to ensure that the firm continues to be a going concern, as it will be a source of their revenue. The primary objective will therefore be to choose accounting policies that make the firm appear to be a sound investment decision with future growth prospects, with a secondary objective of tax minimization in order to improve after-tax cash flows.
Constraints
The only constraint that will be forcefully imposed on Hotye will be the limited ability to alter accounting policies in the future should the economic reality surrounding these policies change. While firms in North America have greater flexibility in changing their accounting policies, Chinese firms must overcome significant political red tape in order to implement such changes. This means that Hotye anticipate changes in the future and choose accounting policies that will best represent the company over the long run. Although GAAP is not a constraint, the North American perspective from which this report is being written will mean that GAAP will serve as a basis for analysis and recommendations. Furthermore since a there is a possibility that Hotye may list their shares on a foreign stock exchange, GAAP may prove to be a constraint in the future.
Issues & Alternatives
Amortization
The first of two material issues for Hotye is in regards to the depreciation of the firm’s terminal machines. Traditionally, Chinese companies have tended to use the straight-line method, but exceptions have been made that allow firms in some industries to use accelerated depreciation. The use of the latter method requires approval by certain governmental regulatory bodies, a process that would have to be adhered to by Hotye management. Under the assumption that Hotye’s management receives approval for the accelerated method, then the company would be facing an accounting policy choice in which their objectives could be taken into consideration. The firm must consider the income statement impact of this decision, with the accelerated method resulting in higher expenses during the early years and the straight line method distributing equivalent costs over the useful life of the assets. Sophisticated users such as venture capitalists will recognize amortization as a non-cash expense, and realize the potential income tax minimization benefits. Hence, the company should utilize the accelerated method of depreciation to ensure improved positive cash flows after tax. The decision of the appropriate useful life also represents an accounting decision faced by management. If classified as ATMs, the terminals could have a useful life of ten years, whereas if they are treated as a computer they will have a useful life of three years. The final decision is based on Mr. Li’s belief that internet based transactions will prove the services of Hotye irrelevant in five years. This would serve as the most accurate estimate of useful life as it pinpoints the time at which the terminals will no longer be useful.
Based on the North American GAAP principles it would appear as though Hotye’s treatment of placing the depreciation expense in the cost of sales would be incorrect. Amortization is the act of spreading the cost of the asset purchase over its useful life, not assigning the cost of the asset to specific products if the item can provide a future benefit. The argument of Hotye stands to be that as they will gradually deploy the terminals, the stream of depreciation will not match the influx of income. However, based on North American GAAP, this reasoning is not justifiable. Inventory produced by a machine may be sold years after the machine has stopped working, but the depreciation should not be diverted to later years. Therefore, the depreciation should be recorded in accordance with the decline in the assets useful life and separated from the cost of sales account.
Revenue Recognition
The next material accounting issue facing Hotye’s management is their revenue recognition policies. The company collects commissions using a pre-determined rate based on the transaction volume of each client company. The company essentially has two alternatives for the point at which to record revenue: delivery or cash collection. Delivery would occur when Hotye provides the service to the client company, which would be when a customer completes a transaction using a Hotye terminal. The cash collection alternative is straightforward, which would be to wait until cash has been received before recording the revenue. The customers of Hotye will differ in their payment periods, with payment times varying from a week to three months after the customer’s transaction. It can be argued however that due to the nature of the clients of Hotye, large telecommunications companies, waiting until the point of collection may be too conservative of an approach. When using Canadian GAAP as a basis point, the recommendation is that,
Revenue from service transactions and long-term contracts is usually recognized as the service or contract activity is performed, using either the percentage of completion method or the completed contract method (CICA 3400.13).
In this scenario, the CICA handbook would recommend that the revenue be recorded as the service is performed, which would be when the customer completes the transaction at the Hotye terminal. Furthermore, when taking into consideration the objectives of the potential investors and creditors, they would clearly prefer to see revenues being accrued as earned, even if this requires an allowance for doubtful accounts.
Leasehold Improvements
The company has leased two new offices and operating places for Hotye model shops beginning in August of 2001. The manner in which the agreements for the leases are structured do not meet any of the three criteria inherently required for a capital lease under GAAP. However, Mr. Li does state that the offices require improvement, meaning the company faces the decision of whether or not to capitalize the renovations. Capitalizing the improvements would increase the level of assets of the company, while minimizing cash expenses. Conversely, expensing the improvements would result in lower income taxes, providing improved after tax cash flows. However, unlike depreciation which is seen by sophisticated users as a non-cash expense, lease improvements would be combined with administrative and selling expenses resulting in a higher cost of sales, a lower EBITDA, and lower margins. Furthermore, the capitalization would more accurately represent the true economic nature of the transaction considering the company will receive the benefits from these improvements for longer than one year. Therefore it is recommended that these leasehold improvements be capitalized and placed on the balance sheet. Once the decision has been made to capitalize these elements, the company must decide on an appropriate useful life and amortization policy. As seen in appendix A, it has been assumed that the useful life of the leasehold improvements is four years, which is equivalent to the likely amount of time that the buildings will be leased for.
Non-Arms Length Transactions
Regica is selling the terminals to Hotye at a reduced price of RMB68,000 in comparison with its regular sale price of RMB80,000, representing a non-arms length transaction. Because the exchange was in the normal course of business and a monetary transaction occurred then it should be valued at fair market value and a gain would be recorded to account for the difference. If these criteria were not met then the terminals would be recorded at their carrying value of RMB68,000. Under this scenario the company would not record a gain, and Hotye would show a lower asset value of RMB68,000 per terminal. Therefore, the most reasonable method of valuation for these assets would be to record them at the value of RMB80,000 as this value represents the fair market value of the asset. To further this rationalization, the company would also incur larger non-cash amortization expenses as a result of this higher valuation, showing stronger after tax cash flows for investors. These would however be partially offset by the recorded gain on each machine.
Labour Cost & Cost of Consumables
Mr. Li has stated confusion regarding the accounts to which he should charge items such as labour and consumables (printing paper, ink, etc.). The two options that he has posed are applying these costs to the cost of sales or a general expense in the system maintenance account. The main justification for placing these costs in the cost of sales account is the variable nature of these fees. More frequent use of these machines will result in higher labour and consumable costs, implying that they are a variable part of the selling process.
Communication Cables & Other Added Accessories
After the initial purchase the company has required a number of current and possibly future upgrades to the terminals. At the time of purchase, the company required an additional RMB3,000 worth of cables in order to set up each terminal. As the company continues to expand and add more features to their current product offering they are continuing to add supplementary software and electronic accessories. The company faces the decision of whether to capitalize or expense these additions to their terminals. As with the aforementioned leasehold improvements, these additions would be seen as cash expenses if they were not capitalized. This would result in a lower EBITDA and decreased margins, both of which would have a negative impact on the views of potential investors. Therefore, the company should capitalize the costs of the communication cables as well as any future improvements made to the terminals. Once this decision has been made, the company will need to determine an appropriate useful life as well as an amortization policy. The RMB3,000 worth of cables needed to initially set up each terminal can be added to the cost of each terminal and amortized over the same useful life, since under GAAP costs incurred to install and make a capital asset operational are part of the total cost for that asset.
Conclusion
The overall objective of this report was to provide accounting policy recommendations that are consistent with the objectives of portraying the firm as a sound investment with future growth prospects, while minimizing taxes in order to provide investors with increased after-tax cash flows.
The three most material issues facing Hotye and Mr. Li are those of depreciation policies, revenue recognition and income tax minimization. In order to better reflect economic reality, to minimize taxes in the initial years of operations and to improve the future growth prospects of the company, an accelerated depreciation policy should be implemented. Appendix A demonstrates the effect this depreciation policy will have on the firm’s pro-forma income statement. The revenue recognition policy has been derived from the recommendations from the CICA handbook, which states that revenues from the provision of services should be recorded as the service is performed. It is therefore recommended that Hotye recognizes revenue once the customer has completed the transaction at the terminal. Income tax minimization strategies were implemented where appropriate in order to maximize after-tax operating cash flows for investors.
The company faces choices on how to account for various items that could either be capitalized or expensed. These items, such as communication cables, leasehold improvements, and future service features should be capitalized as discussed in the issues portion of the report. Once the decision has been made to capitalize these items, it will be necessary for management to determine an appropriate useful life estimate and amortization methodology.
Appendix A represents the company’s pro-forma income statements for the years 2001 through 2004. This statement embodies the recommendations provided in the report, and will serve as a useful tool for potential investors. Investors will see that the company shows resounding revenue growth in its operations, and that year-over-year Hotye will be able to dramatically improve its net profit margin. Although showing a loss in the first year of operations, the company is able to demonstrate its ability to grow and prosper in the following years. The statement represents the fulfillment of the objectives for several key users of this report. Investors who are looking for future growth prospects, creditors who are looking for a sound financial position and management who wish to see their company as a flourishing enterprise. Furthermore, conservative accounting principles such as GAAP have been implemented in order to ensure the expedient approval of Hotye’s accounting policies and to demonstrate to potential investors that the forward looking statements have not been prepared using aggressive accounting policies.
Appendix A: Pro-forma Income Statement
Appendix B: Capital Cost Allowance
(Canada Revenue Agency)
Works Cited
Canada Revenue Agency. T2 Corporation – Income Tax Guide. Canada: Canada Revenue Agency, 2005.
Canadian Institute of Chartered Accountants. CICA Standards and Guidance Collection (CICAHB). Knotia Canada Limited Partnership, 2007.
Central Bank of China. "Central Bank of the Republic of China." 12 October 2007. Monetary Statistics. <http://www.cbc.gov.tw/EngHome/Eeconomic/Statistics/FS/history/EINTEREST-H.pdf>.
Telecommunications Industry Association. China Focuses on Competition and Tax Incentives to Spur Telecom Sector. June 2001. <http://pulse.tiaonline.org/article.cfm?id=487>.
