- 1.2.2 Evaluates treatment for routine transactions(A)
- 1.2.3 Evaluates treatment for non-routine transactions (A)
4.1.1 Assesses the entity’s risk assessment processes (A) 4.2.1 Advises on an entity’s assurance needs (A)
- 4.3.2 Assesses which set of criteria to apply to the subject matter being evaluated (A)
- 4.3.3 Assesses or develops which standards or guidelines to apply based on the nature
- and expectations of the assurance engagement or project (A)
- 4.3.5 Assesses the risks of the project, or, for audit engagements, assesses the risks of
- material misstatement at the financial statement level and at the assertion level for
- classes of transactions, account balances, and disclosures (A)
- 4.3.6 Develops appropriate procedures based on the identified risk of material
- misstatement (A)
- 4.3.7 Performs the work plan (A)
5.4.1 Determines the value of a tangible asset (B) 5.4.3 Estimates the value of an intangible asset (B)
Innovative Sound Limited (ISL) is a private company located in Toronto, Ontario. It commenced operations on January 1, 2013, and recently developed a new technology to transcribe voice into print or hard copy at an affordable cost. This technology has been well received in those industries that require extensive and accurate documentation of oral information (for example, court proceedings and parliamentary debates). ISL sells software and also conducts special consulting assignments and long-term contracts for individual clients. Some contracts are cost-plus arrangements, but others are completed for a fixed price. To maintain its competitive edge, ISL must engage in continuous research and development. Some research is to improve its popular software, but other research leads to the development of new products.
ISL is owned by three shareholders: Tom Baker owns 55 common shares, Mary Smith owns 35 and Katie Brown owns 10, representing ownership interests of 55%, 35% and 10%, respectively. Katie also holds a convertible debenture that, if converted by her in three years, could result in her holding up to an additional 50 common shares. The conversion ratio of shares to debenture principal is based on the dollar amount of shareholders’ equity of ISL, excluding issues of additional shares. The greater ISL’s shareholders’ equity, the higher the conversion ratio of shares to debenture principal, resulting in Katie being issued more shares on conversion. The conversion ratio of shares to debenture principal is capped, so the maximum number of shares that may be issued to Katie upon conversion is 50.
If a certain maximum threshold of shareholders’ equity is reached at any fiscal year-end date, Katie’s convertible debenture will be automatically converted by ISL at its
maximum conversion ratio, resulting in the issuance of 50 shares to Katie. An excerpt from the shareholders’ agreement describing the basis of accounting ISL’s shareholders have chosen to use for the financial statements is included in Exhibit I.
The shareholders all understand that because of Katie’s convertible debentures, the determination of ISL’s shareholders’ equity is important. For the purposes of determining the conversion ratio of the convertible debentures, Katie and Mary agreed to a suggestion made by Tom that ISL’s financial statements would reflect a measure for shareholders’ equity that approximates the fair value of ISL’s net assets. Shareholders’ equity is to be based on the “value-to-the-firm” of assets less liabilities. All three shareholders agreed that it would not be practical to attempt to capture goodwill in such a measure of shareholders’ equity.
After Tom completed the financial statements for the year ended December 31, 2013, Katie was surprised to learn that her convertible debentures were not converted to common shares by ISL, as she thought ISL’s shareholders’ equity would easily have reached the maximum threshold stipulated in the shareholders’ agreement. After much discussion, the owners decided to resolve their dispute using an alternative dispute resolution (ADR). Katie is considering her right to request an audit or review of the financial statements.
Sam Jordan is a retired judge employed by Dispute Ltd., an independent company. He has been engaged to render a binding decision on the dispute between the ISL shareholders. Sam has also agreed to provide suggestions to the shareholders on how the shareholders’ agreement might be revised to avoid disputes going forward.
You are a CPA employed by the accounting firm of Ascot and Palm, LLP, and Sam has retained the assistance of your firm in connection with the ISL shareholder dispute.
Sam would like you to analysis and give recommendation for each disputed accounting issue. He would also like to understand the types of reports your CPA firm may be able to provide to assist in his mandate, and how the financial statements could be audited given the alternative accounting methodology used by ISL. Regardless of what type of report you ultimately recommend to him, he asks that you outline the procedures that would likely be required to address the risk of misstatement for each of the identified accounting issues. Finally, Sam is also interested in any suggestions you may have for modifying the shareholders’ agreement for the 2014 fiscal year and beyond. He is specifically interested in your opinion on the use of discounted cash flows and fair value measurements — this is mentioned in the agreement a few times, but is inconsistent with his understanding of accounting rules.
You have been able to gather some additional information regarding ISL from Katie (Exhibit II).
Excerpts from the shareholders’ agreement
At the end of each fiscal year, ISL’s financial statements shall be prepared using the following basis of accounting:
- The over riding accounting principle is that the resulting balance sheet reflects assets and liabilities measured at “value-to-the-firm.”
- At year end,assets will be recorded in ISL’s financial statements as follows:
- accounts receivable — recorded at cash-equivalent values
- goods to be sold — recorded at net realizable values
- assets held for use in the business — recorded at discounted future cash flows
- At year end,liabilities will be recorded in ISL’s financial statements at the amount of future cash flows that would be required to discharge or settle the liability, as follows:
- current liabilities — recorded at cash-equivalent values
- non-current liabilities — recorded at present values, based on the likely date of
- cash settlement and
- using current discount rates
- all non-cancellable leases — recorded as liabilities at their present values
- Any associates or subsidiaries shall be recorded in a single line item,representing the fair value of the subsidiary as a whole at year end, based on the discounted future cash flows.
- The balance sheet must fairly present shareholders’ equity,in accordance with this agreement, keeping in mind the interests of all shareholders.
- All shareholders have a right to access the financial statements.
- In the event of disagreements over accounting decisions,any shareholder has the right to request an audit of the financial statements, as well as an alternative dispute resolution (ADR) process. ADR decisions are binding on all parties.
Additional information provided by Katie Brown
- Approximately $10 million in research and development expenditures had been capitalized, but were subsequently expensed as a year-end adjustment. Tom stated that these costs were expensed because it is uncertain whether the research and development activities will result in incremental revenue for ISL in the near future.
- ISL provides a one- or two-year warranty on much of its software and consulting engagements. The December 31, 2013, balance sheet includes a provision for warranty costs of $8.5 million.
- ISL used the completed-contract method for reporting revenue from long-term contracts not completed by December 31, 2013. Unbilled work was recorded at cost and will be completed evenly over the next two years.
- During 2013, ISL earned discounts of $450,000 on the purchase of some goods to be sold. The discounts are computed on an annual basis and paid 120 days later. ISL elected to account for the discount on a cash basis.
- ISL used direct costing for inventory valuation purposes.
- ISL had a trademark designed for $275,000, which has been very effective in identifying its products and has been extensively used in its advertising. ISL’s senior managers feel that the trademark has had a positive impact on marketing and expect that it will continue to do so in the future. Tom recorded this amount as marketing and promotion expense for the year.
- ISL recorded a $500,000 provision for obsolete inventory regarding both finished goods and work-in-progress as at December 31, 2013.
- During the year, ISL formed a 90% owned subsidiary, with the other 10% owned by Tom. The subsidiary plans to pay dividends based on earnings to its shareholders.
- Despite it being the first year of operations, ISL has established marketable products, developed a customer following and created an employee and executive group that works well together and has become very effective. Katie and the senior managers of ISL feel that this “asset” has added to the value of the company overall.