Question

intermidate accounting 1

Question 2 – Case

International Technologies Ltd.

Trusted Technologies Ltd. (TTL) provides “technology solutions” to manufacturing companies. TTL is a wholly owned subsidiary of Global World International Inc. (GWI), a publicly owned conglomerate. In 20X5, TTL was performing poorly and GWI considered selling the company for the best offer. As a last resort, GWI hired turnaround specialist, Jane Bowen, to more effectively manage and salvage TTL. Ms. Bowen’s employment contract specifies that in addition to an annual salary she would receive a $10 million cash bonus after the end of the 20X8 fiscal year if TTL meets a number of performance objectives over the 20X6 to 20X8 period. For 20X6 and 20X7, Ms. Bowen achieved the objectives. To meet the performance objectives for 20X8, TTL must report net income in excess of $30 million.

It is now January 25, 20X9. TTL’s financial statements for the year ended December 31, 20X8 have been received at GWI’s corporate offices. TTL’s net income for 20X8 is reported to be $30,550,000. GWI’s CFO has examined the financial statements and is satisfied with most aspects of them but is concerned with the reporting of some transactions and economic events. The issues of concern are described in the following Exhibit A.

Ms. Bowen has already called the CFO to arrange a meeting to discuss the financial statements and the payment of the bonus.

You are the staff member with Friedlan & Jones LLP, CPAs, GWI’s external auditor. The CFO met with the engagement manager and asked her to examine the issues of concern as a special engagement between your firm and GWI. The CFO wants a report that explains the problem in each issue, identifies reasonable alternatives, and provides full support for any conclusions. The engagement manager asked you to prepare a report to her that she will use in her next meeting the CFO on this issue.

Required:

Prepare the report requested by the audit manager.

Exhibit A Issues Identified on Your Review of TTL’s 20X8 Financial Statements

1) In the last week of December 20X8, TTL shipped a $1,250,000 control system to a new customer. The system is a standard product that had some minor modifications to meet needs of the customer. For the first time TTL bundled the control system with a number of other services. Jane indicated that she thought this would generate more business. The customer has been having financial difficulties, so TTL provided special financing terms that gave the customer four months to pay instead of the usual 30 days. Payment is guaranteed by the company that owns the customer. Included in the selling price is:

Control system—standalone value $1,100,000. Cost of system $710,000;

Standard two-year warranty against defects and failure to meet specification. This warranty is not sold separately. Average cost of fulfilling warranty claims per contract is $28,000;

Training—TTL will provide onsite training for staff on how to use the control system and maximize the benefit from it. Training will be provided in late January over a one-week period. Standalone value $85,000. Cost of providing training is $60,000;

Technical support—TTL will provide comprehensive technical support to address technical and operation problems with the system. This service can be purchased separately but was included in the overall purchase price following negotiations. Standalone value is $105,000;

Parts service—TTL will provide ship all needed replacement parts to the customer as needed for three years. The customer is responsible for installing the parts. Standalone value is $180,000. Average cost of providing parts in contracts like this over the term of the arrangement is $82,000

The order was scheduled to be shipped in early January, but because of an opening in the production schedule TTL was able to complete the order several weeks early. Once the order was completed, it was shipped to the customer. The customer agreed to accept early delivery before TTL shipped the order. The goods were received in good order by the customer on December 31, 20X8. TTL recognized revenue when the goods were delivered, as it normally does.

2) In September 20X6 TTL introduced a new type of system for auto parts manufacturers, based on a new technology. Because it was a new product using a new technology it came with a four-year rather than the standard two-year warranty. Once the product is established TTL plans to reduce the warranty coverage to two years. Since this product was introduced TTL has sold 385 systems.

Until August 20X7 warranty claims were small. However, beginning in September 20X8 warranty claims, particularly on older systems—ones sold in 20X6—became more frequent. To date, warranty claims that have cost TTL between $1,000 and $2,000 to fulfil have been made on seven of the 28 units sold in the fourth quarter of 20X6 (the first quarter the product was sold).

Jane Bowen thinks that most of the problems have arisen because of poor installation by third-party installers. She contends that since mid-20X7 all installers have been trained by TTL on how to do the job. Jane doesn’t think there will be more than 15 or 20 systems needing extensive service.

Information obtained from the chief engineer indicated that she examined the system and is satisfied there is no design flaw. However, she is concerned that there may be a problem with units that operate in humid conditions. She said that all seven of the systems that had the large warranty claims operated in humid conditions. Of the 385 systems sold about 170 are operated in humid conditions.

3) Early in 20X8, TTL entered into a contract to with a digital marketing company called “Digital Consultants” (DC). DC will provide TTL one year of service around the latest trends in digital technology, and will provide recommendations on how to reach a broader audience through their online platforms. In return, TTL will help to update DC’s internal reporting systems. TTL would normally charge $80,000 for this type of work. DC recently quoted a similar project for digital marketing consultations for around $65,000.

Answer 1

Answer:

In the report to be prepared, the following points need to be highlighted that need to be discussed with CFO of GWI:

1. Cash bonus to Ms. Ms. Jane Bowe

Ms. Jane Bowe is eligible for $10 million cash bonus on meeting of performance objective given in fiscal years 20X16 to 20X8.

In the fiscal year 20X8, the performance objective is to achieve the net income of $30 million.

It is assumed that, the performance objective set in the previous years is also related to net income.

2. The below issues require to special consideration with respect to issue in cash bonus:

A. Boosting of revenue:

1. The net income reported without considering control system sale to new customer is $ 29,300,000 (i.e. 30,550,000 - 1,250,000). The transaction with new customer for sale of control system worth USD 1,250,000 is understood to be significantly influenced by
Ms. Jane to get the undue benefit of cash bonus by boosting the net income. The following are the reasons:

a. Goods sold to new customer

b. Credit terms given are against the company standards and are very much beneficial to customer.

c. Warranty cost is not billed to the customer

d. New services have been bundled with the product for the first time.

2. The revenue recognized on the above sale includes 85,000 pertaining to Training. This training is still pending from TTL side at the end of December 20X8. The same shall not be recognized as revenue.

3. Revenue allocable to Technical support is amounting to USD 105,000. The revenue shall accounted on performance of the service. Therefore, this portion of revenue shall not be recognized in financial statements of fiscal year ending December 20X8.

4. Replacement parts standalone selling price is 180,000. These parts are to be delivered on need basis. Therefore, revenue shall also be recognized on the date of supply.

5. It can be observed from the above points that, the revenue recognized from the above new customer could be to increase the revenue. Therefore, following need to be asked to CFO:

a. Details of the customer and their background verification shall be requested to ensure that the party exists.

b. Why credit terms are not in line with company policies

c. How team managed to complete the order several weeks early. Clear picture of the order execution cycle need to be understood.

d. Why revenue pertaining to training, technical support and spare parts is recognized in the current fiscal year. These sales revenue is recognized in the year in which the performance obligation is satisfied.

B. Understatement of warranty expenses:

From the facts given with respect to warranty period given to auto parts manufacturers, it is understood that the company is not properly creating provision. The reason may be because to increase the net income by keeping warranty provision at low level. As per the chief engineer report, large warranty claims reported are pertaining to those systems that are being operated in humid conditions. Sine more than 40% (170/385) systems are operating in humid conditions, the warranty provision shall be increased to that extend and net income shall be reduced.

Therefore contention of Ms. Jane that there will not be more than 15 or 20 systems needing extensive service is not correct.

Note:

Contract with digital marketing company has not material impact. Hence, ignored.

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Please revert for if any further clarifications required,.