Question

Cybernetronics Inc. (Cyber) is a Canadian-owned public company which designs and manufactures communications and control systems. The company's year end is May 31. It is now June 2018.

You, CPA, are the manager for the audit of Cyber and yesterday had met with the treasurer to discuss the year-end audit. The partner responsible for this client has asked you to prepare a report for the client which discusses important financial accounting issues and a memo to him regarding the audit issues you believe are important.

Notes from the Meeting with the Treasurer

1.          In December 2017, Cyber won a $40 million contract to design autonomous robots for use in mining activities. In April 2018, the customer exercised the cancellation clause included in the contract. Cyber has capitalized design and development costs related to this contract. The cancellation clause requires the mining company to pay a penalty of $12 million. The penalty has not yet been paid to Cyber.

In June 2017, Cyber entered into an agreement with a university whereby Cyber received assistance in the development of fuzzy logic software which was to have been used in the robots designed for the contract with the mining company. The agreement requires Cyber to make an annual contribution of $0.5 million to the university for four years. The first payment of $0.5 million was made in March 2018 when the university's work was completed.

Management of Cyber is confident that the technology developed, including the fuzzy logic software, can be applied to future contracts involving the design of robots.

Cyber entered into a five-year lease on June 1, 2017 for facilities dedicated to the design and future manufacture of the robots for the mining company. Management of Cyber is presently negotiating a buy-out of the lease and has offered to make lump-sum payment of $750,000 to the lessor on September 1, 2018. The annual lease payment is $500,000.

The draft balance sheet prepared for Cyber's May 31 year end included capitalized design and development costs in the amount of $8.2 million. This amount includes the $0.5 million paid to the university. The draft income statement includes the $12 million cancellation penalty as 'other income -- gain on cancellation of contract'.

*Identify the accounting and auditing issues*

Answer 1

Independent auditor's report for Cybernetronics Inc.(Cyber).

We have audited the financial statements of Cybernetronics Inc.(Cyber) which is a Canadian Controlled Private Corporation (CCPC). Our responsibility was to express our views on the financial statements of the company.

Company is in the business of deigning and manufacturing communication and control systems. Company won a $40 million contract in December 2017 to design autonomous robots, which included a cancellation clause in the contract. The customer in the month of April 2018, cancelled the contract by exercising the cancellation clause and Cyber will receive $12 million from the customer which Cyber has already recognized in their Income Statement as Other income. In our view the revenue should not be recognized until received. Cyber has not followed the concept of prudence while preparing the Income Statement.

We noted that there are expenses like large capital expenditures and payments to universities or other research institutes which indicates that company would be eligible for SR&ED deductions and credits. Since, the company is a CCPC then company can claim enhanced credit of 35% on first $3 million of eligible expenses for CCPC's. Eligible expenses include expenses, on labor, Materials, Contract and Overhead expenses. But does not include lease expenses. So, out of 8.2 million expenses 0.5 million are for university lease which would not be allowed credits in SR&ED.

0.5 million paid to University would be amortized over a period of 5 years under Class 13 assets. For $750,000 which are offered to University as a buy out amount will fall in the next accounting year and would also be amortized in the similar manner starting from next year.