CarProof is a public company founded in 2002 to manufacture and sell specialty auto products mainly relating to paint protec-tion and rustproofing. By 2011, the CarProof board of directors felt that the company’s products had fully matured and that it needed to diversify. Car- Proof aggressively sought out new products, and in March 2012 it acquired the formula and patent for a specialized motor lubricant (Run- Smooth) from SIM, LLC. In addition, the company purchased 15 percent of SIM’s out-standing common stock. At the time of the stock purchase, Steve Matthews owned 100 percent of SIM; he retained ownership of 85 percent of SIM after CarProof’s 15 percent purchase. In December 2012, the board of directors appointed Mr. Matthews to be president of CarProof.

Run- Smooth is unlike conventional motor lubricants. Its innovative molecular structure accounts for what management believes is its superior performance. Although it is more expensive to produce and has a higher selling price than its conventional competitors, management believes that it will reduce maintenance costs and extend the life of equipment in which it is used.

CarProof’s main competitor is a very successful multinational conglomerate that has excellent customer recognition of its products and a large distribution network. To create a market niche for Run- Smooth, CarProof’s management is targeting commercial businesses in western states that ser-vice vehicle fleets and industrial equipment.

CarProof’s existing facilities were not adequate to produce Run- Smooth in commercial quantities. In June 2013 CarProof commenced construction of a new plant in Nevada. After lengthy negotiation, it received a $ 900,000 grant from the state government. The terms of the grant require CarProof to maintain certain employment levels in Nevada over the next three years or the grant must be repaid. The new facilities became operational on December 1, 2013. CarProof financed its recent expansion with a term bank loan. Management is considering issuing additional stock later in 2014 to address the company’s cash flow problems.

CarProof’s auditors resigned in February 2014, after which Steve Matthews contacted your firm. The previous auditors informed Mr. Matthews that they disagreed with CarProof’s valuation of deferred development costs for Run- Smooth.

It is now April 20, 2014, and you and a partner in your firm have just met with Steve Matthews to discuss the services your firm can provide to CarProof for the year ending March 31, 2014. During your meeting, you collected the following information:

• CarProof incurred substantial losses during each of the past three fiscal years.

• There have been no significant orders of Run- Smooth received to date.

• CarProof has commenced a lawsuit against a major competitor for patent infringement and industrial espionage. Management has evidence that it believes will result in a successful action and wishes to record the estimated gain on settlement of $ 4 million. Although no court date has been set, legal correspondence shows that the competitor intends “to fight this action to the highest court in the land.”

• Deferred development costs of $ 2 million represent material, labor, and subcontract costs incurred during 2012 and 2013 to evaluate the Run- Smooth product and prepare it for market. CarProof has not taken any amortization to date but thinks that a period of 20 years would be appropriate.

• Royalties of $ 0.25 per liter of Run- Smooth produced are to be paid annually to SIM.

• The $ 3.514 million term bank loan is secured by a floating charge over all corporate assets. The loan agreement requires CarProof to undergo an annual environmental assessment of its old and new blending facilities. As you return to the office, the partner tells you that he is interested in having CarProof as an audit client. She wants a memo from you covering in detail the audit and business risks you foresee arising from this potential engagement.

Required:

Prepare the memo requested by the audit partner.