Marge Roman has received a valuation report valuing the company at $12 million — Systems Inc RSI Canadian private was incorporated Year its sole common shareholder
Roman Systems Inc. (RSI) is a Canadian private company. It was incorporated in Year 1 by its sole common shareholder, Marge Roman. RSI manufactures, installs, and provides product support for its line of surveillance cameras.
Marge started the company with a small investment. For Years 7 through 9, the company grew rapidly. Most of the expansion was funded through debt financing. The rapid growth is attributable to several large contracts signed with banks for the installation of security camera systems at their branches.
RSI has a June 30 year-end. You, the CA, are with the firm of Sylvain and Cha rest, Chartered Accountants (SC). Your firm has performed the audit of RSI since its incorporation and prepares RSI's corporate tax returns and those of Marge Roman and her family.
Marge Roman called you in April Year 12 to inform you that she plans to take RSI public within the next year. Marge is negotiating with several underwriters, but no deal is in place yet. She plans to highlight the company's revenue growth in its annual press release publicizing its year-end results. Marge wants to show strong revenue growth to attract investors.
During the telephone conversation, Marge asked you and the partner on the audit to meet with her sometime in early June to discuss and resolve potential issues related to the June 30 audit of RSI. In prior years, financial statements were issued in September, but this year the deadline for finalizing the financial statements will likely be in early August. Marge agreed that you would perform your interim audit procedures based on RSI's results as at April 30, Year 12.
It is now June Year 12. The planning and interim work for the fiscal Year 12 audit has been completed. A summary of items noted in the April 30, Year 12, interim financial statements as a result of work done to date is included in Exhibit I.
You are about to leave for the day when the partner in charge of the account comes into your office and announces that he has just received a call from Marge and she would like to meet with him within the next few days. He asks you to prepare a memo discussing the financial reporting issues arising from the interim audit work and any other matters that he should raise at the meeting. Ignore any additional audit procedures that should be considered as a result of the issues raised during the interim audit.
Required:
Prepare the memo.
EXHIBIT 1
NOTES FROM THE INTERIM AUDIT
General
Pre-tax earnings for the period ended April 30, Year 12, were $1,375,000. For the fiscal years Year 11 and Year 10, RSI recorded pre-tax earnings of $435,000 and $325,000, respectively.
Marge Roman has received a valuation report valuing the company at $12 million.
Shareholders' equity as at April 30, Year 12, consisted of:
100 common shares (voting) ………….. $100
Retained earnings ………………………. $9,159,000
New Software
The company has been using a standard general ledger software package originally installed in Year 6 by a local computer consulting firm and upgraded annually.
In January Year 12, RSI hired BBC to oversee the implementation of a new third-party package. In March Year 12, RSI began converting its financial reporting system. The new general ledger software was installed in parallel with the old software and went live on April 1, Year 12.
The new general ledger software has been used to generate RSI's financial results since April 1, Year 12. Starting July 1, Year 12, the old system will no longer be used in parallel.
To date, RSI has been invoiced $720,000 by BBC. These costs have all been
capitalized in the April 30, Year 12, financial statements. The invoices show the following services and costs:
Initial review and recommendations ……………….. $110,000
Cost of new software ………………………………. 200,000
Implementation work ……………………………… 120,000
Training work ………………………………………. 225,000
Monthly support fee (April) ……………………… 25,000
Other consulting (to April 30) ……………………….. 40,000
$720,000
In addition, as at April 30, Year 12, RSI also capitalized $70,000 related to the salaries of four employees who have worked on the accounting software project since January 1, Year 12. As a result of these individuals being pulled out of their regular jobs to handle the problem, RSI had to hire two additional employees.
The costs will be amortized beginning on July 1, Year 12, on a straight-line basis over three years. RSI intends to treat approximately $135,000 of carrying amount for the old software as part of the cost of the new software by reallocating this balance.
Revenues During fiscal Year 11, total product revenue was $18.2 million and maintenance contract revenue was $5.6 million. For the period ended April Year 12, product revenue was
$13.2 million, and maintenance contract revenue was $5.2 million.
RSI recognizes product revenue when shipment and installation take place. It is RSI's standard practice to request a customer sign-off for any installation work. The installation crew normally gets sign-off on the day of installation. During interim work for fiscal Year 12, it was noted in the audit file that approximately $640,000 of revenue recognized in April Year 12 related to work installed and invoiced in April, but customer sign-off was obtained only in early May. Such situations have not caught anyone's attention in previous years. RSI explained that it had recently hired new service technicians who were unfamiliar with the policy of customer sign-off and, accordingly, had to send technicians back to the client days after the installation was completed to get the sign-offs.
Maintenance contract revenues relate to one-year agreements that RSI signs with customers wanting product support. During the year, the company changed its revenue recognition policy on maintenance contracts to recognize revenue based on estimated costs incurred on the contract. Revenue is recognized as follows: 25% in each of the first two months of the contract and 5% in each subsequent month. This allocation is based on a study done by RSI in Year 10, which showed that the costs incurred on the contracts are mostly incurred in the first two months, during which RSI sends out a technician to perform preventive maintenance. The preventive maintenance reduces the number of future service calls and, therefore, overall costs.
ABM Business As a result of RSI's strong relationship with its financial institution and Marge's desire to diversify RSI's product line, RSI began selling "Automated Bank Machines" (ABMs) in fiscal Year 12. The machines are purchased from a large electronic equipment manufacturer that is responsible for ongoing maintenance of the ABMs. RSI sells the ABMs to restaurants, bars, and clubs at margins of 5%. The sales revenue is included as product revenue.
The standard ABM sales agreement states that for a three-year period from the date of sale, RSI receives 40% of the transaction fee charged to customers using the machine, in addition to the sales revenue. A further 40% of the fee is payable to the financial institution for managing the cash in the machines, and the remaining 20% is remitted to the machine owners. The transaction fee charged to customers using an ABM is normally $1.50, and is set by the financial institution. RSI is not responsible for stocking the ABM with cash or emptying the cash machine. The financial institution performs all cash management duties and remits to RSI, at month-end, a statement showing money owed to RSI for its share of the transaction fee. A day later, the funds are deposited directly into RSI's main bank account.
A total of 2,830,000 ABM transactions were processed in Year 12 for a total fee of $4,245,000. RSI has booked transaction-fee revenue of $4,245,000 and an expense of $2,547,000 related to the fees, attributable to the financial institution and the machine owners.
Debentures In January Year 12, RSI needed long-term financing and issued to a third-party venture capitalist $2,500,000 of debentures maturing in 10 years, with interest at 7.35%. The debentures are included as long-term debt in the accounts. The debentures are convertible at the option of the holder, at a rate of one voting common share for every $5 of debenture, if RSI issues shares to the public. If RSI does not issue shares to the public before June 30, Year 13, the debentures are repayable upon demand. Accounts Receivable Review of the aging of accounts receivable at April 30, Year 12, showed an amount of $835,000 in the over-120-day category. According to RSI's collection department, the balance relates to payments withheld by one of RSI's largest customers, Mountain Bank. RSI had contracted to install security cameras at all of its branches. The work was performed in August Year 11, a customer sign-off was received at each branch, and invoices were sent in early September. Mountain Bank refused to pay individual invoices. It wants to pay the total of all invoices in one payment.
In October Year 11, a few branches of Mountain Bank contacted their head office and requested that no payment be made to RSI until certain corrections were made to the angles at which the cameras were installed. Although not required to do so under its agreement with Mountain Bank, RSI fixed the problems, as Mountain Bank is one of its largest customers.
On June 1, Year 12, $450,000 was received. Mountain Bank asserts that some work remains to be done at 5 to 10 sites and is withholding final payment until it is completely satisfied. All amounts related to the contract are recorded as revenues. Internal reports reveal that it takes a service person approximately one hour to fix the problems at each branch. No significant materials costs have been incurred for the follow-up visits.
SOLUTION
Memorandum
To: Partner
From: CA
Re: Roman Systems Inc. Interim Audit Issues
Given that Roman Systems Inc. (RSI) plans to go public within the next year, it should probably follow IFRS. This will avoid retrospective restatement of the financial statements at a later date. RSI’s bias is to maximize revenue, net income and shareholder’s equity in order to attract potential investors.
The major financial reporting issues arising from our interim work are:
Accounting for the costs of the new accounting system
Revenue recognition
Maintenance and contract revenue
Product revenue
ABM revenue
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Convertible debentures
Receivable from Mountain Bank
Accounting for new accounting system costs
During fiscal Year 12, RSI implemented a new general ledger package. The new package has been functioning in parallel with the old system since April 1, Year 12, and will no longer be used in parallel effective July 1, Year 12. The new package has been used to generate RSI’s financial results since April.
RSI has incurred $720,000 in third-party costs associated with the new general ledger package, together with $70,000 of internal salary costs. These costs have all been capitalized in Year 12.
IAS 38 offers guidance as to the costs that may be capitalized when internally developing intangible assets. In particular:
The cost of an internally generated intangible asset comprises all directly attributable costs necessary to create, produce, and prepare the asset to be capable of operating in the manner intended by management. Examples of directly attributable costs are:
(a) Costs of materials and services used or consumed in generating the intangible asset; and
(b) Costs of employee benefits (as defined in IAS 19) arising from the generation of the intangible asset;
The following are not components of the cost of an internally generated intangible asset:
(a) Selling, administrative and other general overhead expenditure unless this expenditure can be directly attributed to preparing the asset for use;
(b) Identified inefficiencies and initial operating losses incurred before the asset achieves planned performance; and
(c) Expenditures on training staff to operate the asset.
Based on the above:
Costs of $110,000 related to initial review and recommendations would be considered business process re-engineering activities and not directly related to the creation of the new system. These costs should be expensed.
Costs of $320,000 for new software and implementation costs represent a betterment, as they extend the life of the accounting system and enhance the service capacity. They should be capitalized.
Training costs of $225,000 should be expensed, as the costs are not directly attributable to the development, betterment, or acquisition of the software.
The monthly support fee of $25,000 (and all future monthly fees) is an operational cost of the system and should be expensed.
The other consulting fees of $40,000 should be reviewed in more detail, but they appear to be part of the ongoing costs of the new system with no specific value added, and should likely be expensed.
The salaries of $70,000 could be capitalized if they are directly attributable to the implementation of the new software package. Since only two additional individuals were hired to handle the work previously done by the four employees, it is questionable whether the four employees were 100% dedicated to the task of implementing the new software. Only the costs related to the implementation should be capitalized.
Effective July 1, RSI should start amortizing the new system and effective June 30, Year 12, it should write off the remaining carrying amount of the old system.
Revenue Recognition
Product Revenue
Product revenue is recognized at the time of delivery and installation. Customer acceptance is evidenced by customer sign-off once installation is complete. It is RSI’s standard practice to obtain such evidence of acceptance. It would therefore be inappropriate to recognize revenue without such evidence of customer acceptance.
In performing the interim work, we determined that revenue of $640,000 was recorded prior to obtaining customer sign-off. This has not been an issue in the past and may be an isolated case related to new employees who may be unfamiliar with RSI’s standard procedures. We need to ensure that Marge communicated the policy to all staff members and ensure that customer sign-off is obtained for all installations prior to year-end. Since it is early June, Marge would have a month to ensure that there are no issues at year-end.
Maintenance contracts
During the year, the company changed its revenue recognition policy on maintenance contracts. Assuming that the company previously recognized maintenance revenue on a straight-line basis over the course of the contract, the new method will recognize a greater proportion of the revenue earlier in the contract life. This new method recognizes 25% of the revenue in each of the first two months and may not be appropriate. Maintenance services must be provided over the full life of the contract. The preventive maintenance is entirely at the discretion of the company. It may not be continued in the future and may not consistently reduce future service calls. As well, the study serving as a basis for the policy is two years old, and may no longer be an accurate reflection of the pattern of maintenance calls. Revenue recognition for service contracts should be based on the service obligation over the term of the contract.
ABM business
RSI began selling ABMs in fiscal Year 12. The machines are purchased from an electronic manufacturer and resold at margins of 5%. It is important to consider whether RSI is recording revenue on a gross or net basis.
Recognizing revenue on a gross basis is appropriate if RSI bears the risk of selling the product. Recognizing revenue on a net basis is more appropriate if RSI is simply fulfilling orders obtained by the manufacturer, for a fee. It is important to better understand the relationship between RSI, the manufacturer, and the end-party customer in order to recommend an appropriate revenue recognition policy.
Transaction fee revenue
The company has begun a new line of business related to transaction fee revenue generated from the sale of ABM machines. A total of 2,830,000 ABM transactions were processed at a fee of $1.50 per transaction, for a total of $4,245,000. RSI’s share of this fee is 40%. RSI is currently recording the transaction fee revenue on a gross basis, with an associated expense for the 60% attributable to other parties.
The following factors suggest that the ABM transaction fee revenue should be recorded on a net basis:
RSI has no ownership of the ABM machines;
RSI has no responsibility for stocking or emptying the machines;
RSI has no responsibility for cash collection;
RSI is being paid on a net basis;
RSI does not have responsibility for maintenance of the ABMs, and
RSI cannot set the transaction fee amount.
On this basis, it would be appropriate for the ABM transaction fee revenue to be recorded on a net basis i.e. record revenue of $1,698,000 (40% x 4,245,000) and no expenses. This will reduce revenue and expenses by $2,547,000 but will have no impact of net income or shareholders’ equity.
Convertible debentures
The debentures are currently classified as long-term debt. Since they are convertible into common shares, RSI should consider the reclassification of a portion of the debentures based on the fair value of the conversion feature. This reclassification will result in higher charges to the income statement through the addition of the debt discount. The reclassification is currently not required since RSI is not a public company. Marge Roman should be made aware that if RSI is going public, a detailed analysis should be done related to the split between debt and equity. The financial statements in an offering document would have to be modified to split the debenture between debt and equity. The debt is repayable on demand should RSI not go public by June 30, Year 13. The debt may therefore have to be reclassified as a short-term item in the current financial statements. While there are plans to go public and negotiations have begun (which supports a long-term classification), there is no document such as terms of agreement or a memorandum of understanding providing evidence that this will likely occur. Also, the ability to issue the IPO is beyond the strict control of the company. Reclassifying the debentures as short-term appears to be the more appropriate form of presentation.
Receivable from Mountain Bank
In reviewing the aged accounts received at April 30, Year 12 we determined that there was a balance of $835,000 from Mountain Bank, which was overdue by more than 120 days. On June 1, $450,000 was received from the customer and the balance remains outstanding. There are between five and ten sites where the Bank is not completely satisfied with the way the cameras were installed.
Two issues arise which must be analyzed in succession. First, is it appropriate to recognize revenue upon delivery, installation, and sign off by the customer? And second, if revenue recognition is appropriate, is collection of the remaining accounts receivable doubtful?
On the issue of revenue recognition, IAS 8 par .14 says that revenue from the sale of goods can be recognized when all of the following conditions have been met:
(a) The entity has transferred to the buyer the significant risks and rewards of ownership of the goods;
(b) The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
(c) The amount of revenue can be measured reliably;
(d) It is probable that the economic benefits associated with the transaction will flow to the entity; and
(e) The costs incurred or to be incurred in respect of the transaction can be measured reliably.
In this case all of the above conditions were met upon delivery and installation of the cameras. Revenue may be held back, however, to the extent that a customer acceptance term exists in the arrangement. Although no terms exists in the contract with Mountain that requires the client to come back and adjust the installation of the cameras, it could be argued that such a term exists implicitly since the client has been willing to do so and has accommodated the customer. The question then becomes whether this implicit acceptance is material such that it could be argued that the delivery criterion has not been met. In this case I believe the answer is no. The work required to complete the adjustments is minimal and within the control of RSI, and has nothing to do with the quality of the product. On this basis, it appears that revenue recognition was appropriate.
On the issue regarding collectibility, it must be determined whether collectibility is reasonably assured. In this case, there is evidence that the customer is willing to pay once the minor fixes are complete given the $450,000 payment that was made in June. It appears unlikely that the customer will not pay. We should examine Mountain’s payment history a little closer to determine whether amounts were unpaid regarding prior work/product sold and whether any amounts were written off/forgiven. In the absence of either, it would appear supportable that the accounts receivable related to this sale are collectible and do not need to written down/off.
Overall Impact
Based on the recommendations above, RSI’s revenue, net income and shareholder’s equity will decrease. RSI will not like these adjustments because they worsen the key financial metrics. The adjustments are appropriate as they better reflect the results of operations and financial position of RSI in accordance with GAAP.