Minink Limited (ML) is a subsidiary of a large public company, federally incorporated 50 years ago. Until this year, ML's corporate structure consisted of three operating divisions and a corporate head office. Senior management receives financial reports on each division on a monthly basis. Bonuses are awarded annually to divisional managers based on the growth in net income on a year-over-year basis.
The corporate head office oversees the divisions and provides financial, pay roll, legal, and administrative services. Corporate head office charges the divisions one-half of the cost of providing these services and absorbs the other half.
The Ladium Extraction Division (Extraction) mines ladium, a metal used in many industrial chemical processes. This division also performs the first stage in the refining process. The Ladium Processing Division (Processing) buys ladium from Extraction and further refines the metal before selling it to customers in North and South Americas. Both stages of the refining process cause airborne pollutants whose levels the government regulates (see Exhibit II for new legislation).
Processing's operations were sold to Donaz Integrated Limited (DIL) effective August 15, Year 4. An integral part of this sale is a long-term contract for Extraction to supply ladium to DIL. The negotiations leading up to the sale lasted nearly a year. An agreement was finally reached after DIL threatened to break off negotiations. Two offers were made by DIL, summarized in Exhibit III. ML management favored the second offer but accepted the first offer under pressure from its parent company. The balance sheet of Processing
EXHIBIT II
HIGHLIGHTS OF NEW LEGISLATION ON EMISSIONS
New legislation to be implemented on January 1, Year 5, imposes a quota, or limits, on total annual emissions of sulphur by the mining industry in Canada. Each company in the min ing industry, depending on its level of production, will annually be allocated a portion of the fixed, industry-wide quota. All companies will be required to file documents certifying actual emission and production levels for each calendar year.
At the beginning of each calendar year, the government will grant companies "pollution rights" that represent their portion of the annual sulphur emission quota. The rights will be valid for that year only. A company exceeding its own pollution rights (i.e., emitting more sulphur than it is allowed to emit) will have to buy pollution rights from other companies to make up the difference. On the other hand, a "clean company" (one emitting less sulphur than the amount permitted) will be allowed to sell its unused pollution rights. The big mining companies gained this compromise on the grounds that business should be allowed to find the least costly, most efficient way of meeting an annual target. "Dirty" companies will have until March 31 of the following year to purchase pollution rights from clean companies.
Companies that violate the legislation will be subject to heavy fines or closure.
The government's objective is to give mining companies an incentive to invest in the innovative technology needed to reduce their current sulphur emission levels. Over time, the government will lower the emission levels for the industry; therefore, fewer pollution rights will be granted.
EXHIBIT III
LETTER CONCERNING SALE OF LADIUM PROCESSING DIVISION
May 2, Year 4
Mr. I. P. Labigne
President and Chief Executive Officer
Minink Limited
Dear Mr. Labigne,
For nearly a year now, we have been negotiating the purchase price of the operating assets of Minink Limited's Ladium Processing Division and the related long-term ladium supply contract. Following our telephone conversation yesterday, this letter confirms that Donaz Integrated Limited is not prepared to continue these negotiations.
We require a fax confirming acceptance of one of our two offers by midnight on May 4, Year 4. Our offers are summarized as follows, within the context of the detailed Purchase and Sale Agreement already agreed to:
1) $398.6 million for the operating assets of the division and $3,450/tonne adjusted annually for inflation as the price for ladium under the long-term supply contract.
2) $97.1 million for the operating assets of the division and $4,100/tonne adjusted annually for inflation as the price for ladium under the long-term supply contract.
I look forward to receiving your response by the deadline.
Yours sincerely,
Ms. S.N. Wong, CA
Vice-President, Finance and Chief Financial Officer
Donaz Integrated Limited
EXHIBIT IV

At July 31, Year 4, is found in Exhibit IV, and selected information on Extraction is in Exhibit V. The third division is the Mining Equipment Division (Equipment) which designs, builds, and sells sophisticated mining equipment. During Year 4, Equipment built six Crushones. Crushones are a new breed of open-pit mining machines.
EXHIBIT V
LADIUM EXTRACTION DIVISION
SELECTED INFORMATION
(in thousands of dollars)
Year 4/5 Fiscal Year Budget
Sales (volume 84,000 tonnes @ $3,700 per tonne) ... $310,800
Variable cost of sales ($3,400 per tonne) ....... 285,600
Contribution margin .............. 25,200
Expenses
Head office charges ............... 3,100
Fixed costs .................. 9,610
12,710
Divisional income before taxes ........... $12,490
Additional information:
1. This budget was prepared on the basis that the Extraction Division would sell its ladium to the Processing Division.
2. When annual volumes exceed 90,000 tonnes, variable ladium extraction costs increase by $562/tonne on the additional volume. New extraction equipment with a useful life of 5 years must also be purchased, at a cost of approximately $58 million, to handle annual volumes over 85,000 tonnes.
3. The carrying amount of Extraction's equipment and buildings that are dedicated to ladium extraction at July 31, Year 4, was $76 million.
that have a very high output relative to capital cost. The provincial government agreed to fund 90% of the total production costs of $165.46 million. In return, the provincial government is entitled to 90% of the net proceeds on sale of the Crushones. Management expects that due to the nature of these machines, ML may have to wait several years to sell the Crushones that have been built. As of late July Year 4 the six Crushones were included in inventory and measured at their production cost of $165.46 million.
ML is the largest subsidiary of its parent and its financial statements are material to its parent's financial statements. The parent company has reported losses for the past few years, and the price of its shares has dropped. The parent company plans to issue additional shares in the near future.
The request for proposal for the audit of ML and its parent company for the year ended August 31, Year 4, resulted in the appointment of your firm, Douglas & Co., Chartered Accountants (DC). DC has already sent out an engagement let ter to ML and corresponded with the previous auditors, who said they knew of no reason why DC should not accept the engagement. You, the CA, have been selected as the audit senior for the assignment. The manager in charge of the audit has requested that you prepare a memo covering the major accounting issues aris ing from this year's audit of ML.
It is now early August Year 4. Ian Kao, the audit partner, has met with the CFO of ML who is in charge of coordinating the external audit. The partner's notes from these meetings are summarized in Exhibit VI .
Required:
Prepare the memo requested by the audit manager.
EXHIBIT VI
NOTES FROM DISCUSSIONS WITH ML€™S CFO
1. In February Year 4, ML started to receive $3 million per month from the provincial government to help fund research and development (R&D) into new mining techniques. ML has recorded these funds as revenue. R&D work will commence in September Year 4.
2. The Purchase and Sale Agreement with DIL specifies that Extraction must sell between 102,000 and 124,000 tonnes of ladium per year to DIL at the agreed price. The price for any sales beyond this range will be agreed upon at the time the order is made.
Extraction is not permitted to sell to any other party. The duration of the agreement is 9 years from the closing of the sale.
3. Selling costs for the disposal of Processing are expected to amount to $6.7 million.
4. In response to public pressure to reduce pollution and protect the environment, the Canadian government will require all companies in the mining industry to maintain emissions at or below levels prescribed under the new legislation by allocating pollution rights.
In June Year 4, ML purchased equipment that will reduce emission levels below the prescribed level. ML will therefore be able to sell pollution rights to other companies when the new legislation comes into effect. The equipment purchased by ML was more expensive than other equipment it could have purchased that would have reduced emissions only to the level prescribed for Year 5. Management wants to know how to account for the pollution rights.

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LADIUM PROCESSING DIVISION BALANCE SHEET July 31, Year 4 (unaudited, in thousands of dollars) Year 4 Year 3 $ 51,223 23,454 4,002 17,846 18,010 $114,535 19,123 14,569 80,843 $114,535 S 47,228 21,460 5,103 18,105 19,385 $111,281 18,614 12,665 80,002 $111,281 Accounts receivable Inventories Prepaid expenses Production equipment, net Buildings, net Accounts payable and accruals Advance from corporate head office Divisional equity