Ferry Services Incorporated (FSI) is a public company that has three divisions. The first division provides coastal ferry services on the West and East coasts of Canada. The second division designs and builds ferries for their own use as well as for external customers. The third division operates and manages ferry terminal buildings.
In 2011, FSI anticipates a taxable loss of $20 million due to a major hurricane that sunk one of their ferry ships and caused extensive damage to one of their terminal buildings. For the past three years they have had taxable income of 2008 – $5 million; 2009 – $10 million; and 2010 – $8 million.
FSI has a number of long-term bank loans with Canadian Big Bank. In 2011, they obtained additional financing to recover from the costs associated with the hurricane. The bank requires annual audited financial statements. The new loan has a financial covenant requiring that FSI maintain a certain current ratio, as well as dividend distribution is restricted until the loan is paid off.
You have recently been hired to develop new accounting policies for FSI’s Dec 31 year-end. You have been asked by the Board to discuss alternatives and provide recommendations on the appropriate accounting policies for events that have occurred during 2011. Where possible you have been asked to quantify the impact of the accounting policies. The incremental borrowing rate for FSI is 8%. The tax rates for the last few years were: 2008 (40%), 2009 (38%), and 2010 (38%). The tax rate for 2011 is 40%.
1) A major hurricane hit the Eastern Coast in the fall of 2011. This hurricane was tracking to miss the Eastern Seaboard but had a sudden change in direction. FSI was caught off guard and one of their ferries as well as a ferry terminal was in the direct path of the hurricane. Unfortunately, FSI found out that their insurance did not cover hurricane damage. To cover the costs associated with the damages FSI obtained a new five year bank loan of $25 million with quarterly interest payments. Their cost of borrowing was 8% a year. To obtain the loan FSI had to pay $1 million of transaction costs.
2) The ferry was one of their older ferries with a carrying amount of $2 million dollars. The costs to recover the ferry are approximately $3 million and it is anticipated they will receive $0.5 million worth of salvaged material. The ferry will need to be replaced and construction was initiated in December 2011. The estimated construction costs are $20 million since the ferry will be state of the art with a new weather warning software system. Construction is expected to be completed in the spring of 2013. Until that time a ferry was brought out of retirement. The ferry had been retired due to extensive renovations required to meet environmental legislation. These renovations cost FSI $2 million in 2011.
3) The damage to the terminal was $7 million. FSI leases all of their terminals from Leasing Incorporated (LI). This lease has a remaining lease term of 2 years. Due to the terms of the lease agreement FSI is required to pay a large penalty of $5 million dollars for repairs to the terminal. This cost far exceeds the remaining benefits of the lease agreement.
4) A lawsuit was launched in December 2011 against FSI due to the tragedy of the sinking of the ferry. FSI decided that they want to settle quickly out of court to avoid negative publicity. They have offered $5 million to the families. Their lawyers have not responded to this offer.
5) Passengers can purchase their ferry tickets on-line through Tickets.com. To encourage use of the ferry FSI provides passengers free parking if they purchase an annual pass. Otherwise passengers pay a daily rate to park their vehicle.
6) Some of the ferries contain asbestos. Changes in government legislation in 2011 require FSI to remove the asbestos in 2016. The anticipated cost of removal is $5 million.
7) FSI leases their ferry terminals from Leasing Incorporated. In 2011, FSI obtained the rights to operate a ferry on a new route. They entered into a lease agreement for a newly constructed terminal and the land. The lease term is for 60 years with a 20 year bargain renewal term.
8) In 2011, FSI issued $10,000,000 of 8% convertible bonds at the option of FSI into common shares. These bonds mature in five years and are convertible at that time by FSI into common shares at a rate of 50 shares for each $1,000 bond.
