Dr. Gary Morrow, a former surgeon, is the president and owner of Morrow Medical (MM), a private Ontario company that focuses on the design and implementation of various medical and pharmaceutical products. With the recent success of various products put to market by MM, Dr. Morrow has decided that this would be a good opportunity to sell his company and retire to the Arizona desert. Dr. Morrow has found a potential buyer for the business and an agreement has been put in place that would see MM being sold at five times the December 31, 2019 net income. The potential buyer is extremely interested in an MM product that is currently in the development stage—the MM Surgical Drill.

During 2019, MM launched into production a special latex glove for use during surgery. This glove is laced with a special antibacterial agent that significantly reduces the risk of infection during surgery.

The product had been in the development phase since 2016, and in early 2018, it was approved by Health Canada for production and use.

Dr. Morrow was pleased with the initial demand for the product after trial runs conducted by surgeons during late 2018. After the success of the trial testing, MM landed contracts with several hospitals in the province and early feedback was favourable. Dr. Morrow was surprised, however, with how small the quantity of orders placed by hospitals actually was. He was certain that hospitals would quickly run out of the gloves and was beginning to fear that they would buy a competitor’s product.

Since Dr. Morrow wanted to prevent hospitals from buying elsewhere, as it would result in a loss of sales for MM, for each purchase order received from a hospital, Dr. Morrow shipped several more units than were ordered. He was certain that all of the extra inventory would eventually be consumed and this was MM’s way of avoiding the hospitals’ running out of inventory. To prevent hospitals from returning the extra inventory, he allowed them eight months to either pay for the entire shipment or return any unused gloves in excess of the initial amount that was ordered. Dr. Morrow’s first priority is always getting the product out of the warehouse and into the hospitals. Orders are generally filled and shipped within two days of receipt of a purchase order. Because MM is dealing with hospitals, there is little concern over collectibility.

During 2016, under the supervision of Dr. Morrow, MM began the research and development of a special surgical drill (the MM Surgical Drill mentioned above) that would allow for more precise handling by surgeons than any other drill currently on the market. The development of this product grew from various market surveys conducted in hospitals throughout Ontario that showed that surgeons were unhappy with the drills that were currently available.

The following costs were incurred in 2019:
Cost of setting up production lab ............................................. $ 30,000
Testing of Surgical Drill ................................................................ 100,000
Design of the moulds involved in Surgical Drill technology ...... 17,500
Testing to evaluate product alternatives ..................................... 12,000
Marketing and promotion costs in connection with launching the
surgical gloves ................................................................................. 15,000

Dr. Morrow intends to capitalize all of these costs for the December 31 year end. In addition, $25,000 of tool design costs that were expensed in 2018 will be capitalized in 2019.

MM has the technical resources available to complete the Surgical Drill project and, since testing to date has been successful, management intends to bring this product to market in early 2021. MM has been faced with cash flow problems in the past few months but hopes that, once MM is sold, additional funding will be available to see this product into its production stage.

In early 2019, an engineer testing the Surgical Drill was severely injured as a result of a product malfunction. This glitch was subsequently identified and fixed. MM has recently been sued. The claim is for $500,000 and alleges that MM was responsible for the engineer’s injuries. MM’s lawyer’s best estimate of what the company will end up paying is $100,000 to $200,000. As the trial does not begin until 2020, MM has no intention of recording this in its December 31, 2019 financial statements.

Instructions

Audit Adopt the role of the auditor hired by MM’s potential buyer and analyze the financial reporting issues.