RSM 220H1F Final Exam Page 15 of 15
QUESTION 8 (60 marks)
George Smith founded Fitness Institute Toronto (FIT) in March of this year. His goal is to give members the
opportunity to live a healthier and happier life which is achieved by making fitness fun, painless and affordable. The
club is built on a foundation of highly trained staff and a top-notch facility.
George created FIT by purchasing an existing fitness club that closed the previous year. To do this he borrowed 20%
of the required money from his father-in-law who is a successful businessman and the remainder from his local bank.
Under the terms of the loan agreement with the bank, George is required to prepare GAAP financial statements and
maintain a current ratio of 1.5. While the loan is up for renewal in March 2019, the bank would like to see the
December 31, 2018 financial statements to ensure FIT is not in breach of the debt covenant.
As an incentive to attract members, FIT had a grand opening special for the month of March. Any new member who
signed a one year contract and paid the full 12 month membership fee upfront would receive a full year’s
membership and a free MP3 player for $500. Normal annual membership is $600 and the MP3 player is valued at
$100. These customers were locked into the one year membership and could not cancel the contract. As a result of
this MP3 player campaign, FIT was able to attract 900 new members.
As another way to attract members, FIT paid a premium salary to recruit Billy Flanks, a well known personal trainer,
when he opened the club. George requested that Billy sign a two year contract to ensure that he would remain with
FIT for the near future. By September, George and Billy began to have differences of opinion regarding how the club
should be run. The problems continued to get worse. George decided he needed to release Billy from his contract
and in December he had a meeting with Billy and presented him with a termination package which included the
immediate payment of one year’s salary. Billy has until January 31, 2019 to accept the offer and has not yet informed
George of his final decision.
To ensure that FIT continues to be a top-notch facility and to attract more members, George decided to tear down the
existing roof of the swimming pool facility and install a retractable roof. George hoped this special and costly feature
would attract more members and also encourage pool usage during the summer months. The original pool facility
was built just four years ago. The retractable pool roof was completed in June right in time for summer and it was a
huge success with the members. New members were joining specifically for this state of the art pool.
In September, FIT had a major setback, one of the glass panels fell one evening when the roof was being closed. This
caused injury to one swimmer. The swimmer filed a lawsuit against FIT for $1 million. FIT hired a well respected law
firm who estimated that settlement would likely be $600,000.
It is now January 15, 2019 and George, who does not have an accounting background, has employed Chris Cox to act
as FIT’s accountant. Chris is a recent accounting graduate and will be responsible for preparing the December 31,
2018 financial statements. He has informed Chris that the debt covenant cannot be breached no matter what has to
be done.
REQUIRED: Assume the role of Chris Cox. Use the case-analysis framework covered in this course to analyze the
accounting issues.
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