Roman Systems Inc. (RSI) is a Canadian private company. It was incorporated in Year 1 by its sole common shareholder, Marge Roman. RSI manufactures, installs, and provides product support for its line of surveillance cameras.
Marge started the company with a small investment. For Years 7 through 9, the company grew rapidly. Most of the expansion was funded through debt financing. The rapid growth is attributable to several large contracts signed with banks for the installation of security camera systems at their branches.
RSI has a June 30 year-end. You, the CA, are with the firm of Sylvain and Cha rest, Chartered Accountants (SC). Your firm has performed the audit of RSI since its incorporation and prepares RSI's corporate tax returns and those of Marge Roman and her family.
Marge Roman called you in April Year 12 to inform you that she plans to take RSI public within the next year. Marge is negotiating with several underwriters, but no deal is in place yet. She plans to highlight the company's revenue growth in its annual press release publicizing its year-end results. Marge wants to show strong revenue growth to attract investors.
During the telephone conversation, Marge asked you and the partner on the audit to meet with her sometime in early June to discuss and resolve potential issues related to the June 30 audit of RSI. In prior years, financial statements were issued in September, but this year the deadline for finalizing the financial statements will likely be in early August. Marge agreed that you would perform your interim audit procedures based on RSI's results as at April 30, Year 12.
It is now June Year 12. The planning and interim work for the fiscal Year 12 audit has been completed. A summary of items noted in the April 30, Year 12, interim financial statements as a result of work done to date is included in Exhibit I.
You are about to leave for the day when the partner in charge of the account comes into your office and announces that he has just received a call from Marge and she would like to meet with him within the next few days. He asks you to prepare a memo discussing the financial reporting issues arising from the interim audit work and any other matters that he should raise at the meeting. Ignore any additional audit procedures that should be considered as a result of the issues raised during the interim audit.
Required:
Prepare the memo.
EXHIBIT 1
NOTES FROM THE INTERIM AUDIT
General
Pre-tax earnings for the period ended April 30, Year 12, were $1,375,000. For the fiscal years Year 11 and Year 10, RSI recorded pre-tax earnings of $435,000 and $325,000, respectively.
Marge Roman has received a valuation report valuing the company at $12 million.
Shareholders' equity as at April 30, Year 12, consisted of:
100 common shares (voting) ...... $100
Retained earnings .......... $9,159,000
New Software
The company has been using a standard general ledger software package originally installed in Year 6 by a local computer consulting firm and upgraded annually.
In January Year 12, RSI hired BBC to oversee the implementation of a new third-party package. In March Year 12, RSI began converting its financial reporting system. The new general ledger software was installed in parallel with the old software and went live on April 1, Year 12.
The new general ledger software has been used to generate RSI's financial results since April 1, Year 12. Starting July 1, Year 12, the old system will no longer be used in parallel.
To date, RSI has been invoiced $720,000 by BBC. These costs have all been
capitalized in the April 30, Year 12, financial statements. The invoices show the following services and costs:
Initial review and recommendations ........ $110,000
Cost of new software ............. 200,000
Implementation work ............ 120,000
Training work ................ 225,000
Monthly support fee (April) ......... 25,000
Other consulting (to April 30) ........... 40,000
$720,000
In addition, as at April 30, Year 12, RSI also capitalized $70,000 related to the salaries of four employees who have worked on the accounting software project since January 1, Year 12. As a result of these individuals being pulled out of their regular jobs to handle the problem, RSI had to hire two additional employees.
The costs will be amortized beginning on July 1, Year 12, on a straight-line basis over three years. RSI intends to treat approximately $135,000 of carrying amount for the old software as part of the cost of the new software by reallocating this balance.
Revenues During fiscal Year 11, total product revenue was $18.2 million and maintenance contract revenue was $5.6 million. For the period ended April Year 12, product revenue was
$13.2 million, and maintenance contract revenue was $5.2 million.
RSI recognizes product revenue when shipment and installation take place. It is RSI's standard practice to request a customer sign-off for any installation work. The installation crew normally gets sign-off on the day of installation. During interim work for fiscal Year 12, it was noted in the audit file that approximately $640,000 of revenue recognized in April Year 12 related to work installed and invoiced in April, but customer sign-off was obtained only in early May. Such situations have not caught anyone's attention in previous years. RSI explained that it had recently hired new service technicians who were unfamiliar with the policy of customer sign-off and, accordingly, had to send technicians back to the client days after the installation was completed to get the sign-offs.
Maintenance contract revenues relate to one-year agreements that RSI signs with customers wanting product support. During the year, the company changed its revenue recognition policy on maintenance contracts to recognize revenue based on estimated costs incurred on the contract. Revenue is recognized as follows: 25% in each of the first two months of the contract and 5% in each subsequent month. This allocation is based on a study done by RSI in Year 10, which showed that the costs incurred on the contracts are mostly incurred in the first two months, during which RSI sends out a technician to perform preventive maintenance. The preventive maintenance reduces the number of future service calls and, therefore, overall costs.
ABM Business As a result of RSI's strong relationship with its financial institution and Marge's desire to diversify RSI's product line, RSI began selling "Automated Bank Machines" (ABMs) in fiscal Year 12. The machines are purchased from a large electronic equipment manufacturer that is responsible for ongoing maintenance of the ABMs. RSI sells the ABMs to restaurants, bars, and clubs at margins of 5%. The sales revenue is included as product revenue.
The standard ABM sales agreement states that for a three-year period from the date of sale, RSI receives 40% of the transaction fee charged to customers using the machine, in addition to the sales revenue. A further 40% of the fee is payable to the financial institution for managing the cash in the machines, and the remaining 20% is remitted to the machine owners. The transaction fee charged to customers using an ABM is normally $1.50, and is set by the financial institution. RSI is not responsible for stocking the ABM with cash or emptying the cash machine. The financial institution performs all cash management duties and remits to RSI, at month-end, a statement showing money owed to RSI for its share of the transaction fee. A day later, the funds are deposited directly into RSI's main bank account.
A total of 2,830,000 ABM transactions were processed in Year 12 for a total fee of $4,245,000. RSI has booked transaction-fee revenue of $4,245,000 and an expense of $2,547,000 related to the fees, attributable to the financial institution and the machine owners.
Debentures In January Year 12, RSI needed long-term financing and issued to a third-party venture capitalist $2,500,000 of debentures maturing in 10 years, with interest at 7.35%. The debentures are included as long-term debt in the accounts. The debentures are convertible at the option of the holder, at a rate of one voting common share for every $5 of debenture, if RSI issues shares to the public. If RSI does not issue shares to the public before June 30, Year 13, the debentures are repayable upon demand. Accounts Receivable Review of the aging of accounts receivable at April 30, Year 12, showed an amount of $835,000 in the over-120-day category. According to RSI's collection department, the balance relates to payments withheld by one of RSI's largest customers, Mountain Bank. RSI had contracted to install security cameras at all of its branches. The work was performed in August Year 11, a customer sign-off was received at each branch, and invoices were sent in early September. Mountain Bank refused to pay individual invoices. It wants to pay the total of all invoices in one payment.
In October Year 11, a few branches of Mountain Bank contacted their head office and requested that no payment be made to RSI until certain corrections were made to the angles at which the cameras were installed. Although not required to do so under its agreement with Mountain Bank, RSI fixed the problems, as Mountain Bank is one of its largest customers.
On June 1, Year 12, $450,000 was received. Mountain Bank asserts that some work remains to be done at 5 to 10 sites and is withholding final payment until it is completely satisfied. All amounts related to the contract are recorded as revenues. Internal reports reveal that it takes a service person approximately one hour to fix the problems at each branch. No significant materials costs have been incurred for the follow-up visits.