Southern Loom: Development Costs, Covenant Pressure and a Related-Party Loan
Southern Loom Ltd is a Dunedin software company. In FY2025 it spent $2.4 million on Project Tidal, a new cloud-based inventory module. Technical feasibility was not demonstrated until 1 February 2025, when a working prototype passed stress testing. Expenditure before that date was $1.7 million; expenditure from 1 February to 31 March 2025 was $0.7 million. The project is expected to generate benefits over five years. The company has a bank covenant requiring EBITDA of at least $3.0 million. Draft EBITDA before any Project Tidal adjustment is $1.9 million. The managing director wants to capitalise the full $2.4 million so the covenant is met, arguing that the project is clearly viable now. The CFO also discovers a $300,000 loan from the managing director to the company at 2% interest, approved by the MD alone and not disclosed in the draft related-party note. The auditor has requested a memo on accounting and ethical issues.
1. Determine how much of the $2.4 million may be capitalised under NZ IAS 38 and explain the effect on EBITDA and the covenant.
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NZ IAS 38 separates research from development. Development costs may be capitalised only after all criteria are met, including technical feasibility, intention and ability to complete, probable future economic benefits, available resources and reliable measurement. Technical feasibility was demonstrated on 1 February 2025, so only the $0.7 million spent from that date is eligible. The earlier $1.7 million must be expensed.
On the stated draft EBITDA of $1.9 million before the project adjustment, expensing $1.7 million gives EBITDA of $0.2 million. Capitalising the full $2.4 million would add $2.4 million to EBITDA and produce $4.3 million, but that is not compliant. Capitalising the eligible $0.7 million does not add to EBITDA, so the covenant still fails. Amortisation should begin when the module is available for use, over its five-year benefit period. The board cannot capitalise the full amount to meet the covenant; it should negotiate with the bank.
2. Analyse the ethical and governance issues raised by the related-party loan and the managing director’s pressure.
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The managing director is using accounting judgement to protect a covenant and has also entered into an undisclosed related-party loan approved by himself. That creates a conflict of interest. The loan should be disclosed under NZ IAS 24, with its terms, security, interest rate and outstanding balance. The 2% rate may be below market and may benefit the MD if the company repays cheaply, or benefit the company if the MD is funding it cheaply; either way, independent directors should approve it. The CFO’s integrity and objectivity are tested: the CFO should not sign accounts that conceal the loan or overstate EBITDA. The matter should go to the audit committee or independent directors, with legal advice on the Companies Act and the constitution. The accounts should be corrected, the covenant breach disclosed and the auditor given the facts.