Stabilize It Ltd. Stabilize It Ltd. (SIL) is the creator of a new technology that can be
Question:
Stabilize It Ltd.
Stabilize It Ltd. (SIL) is the creator of a new technology that can be used in smart phones in order reduce distortion (blurriness) in motion pictures. The technology is currently being used by various companies across the globe. SIL also has a portfolio of other technologies and products that have been developed through its research initiatives. SIL's shares are currently being traded on the Toronto Stock Exchange, and the company is experiencing shareholder pressure to improve profitability. You are the audit manager in charge of SIL's file for the December 31, 2020, year end. Your audit team is progressing well through the engagement, and you schedule a progress meeting with the senior auditor. The following dialogue takes place: Audit manager: How is the audit coming along so far? Any issues or concerns?
Senior auditor: It's going well. I do have a few concerns. First, I have found some evidence that leads me to believe that the 2019 financial statements may have been misstated.
Audit manager: Wowthis can be serious. What is the issue?
Senior auditor: Well, as you know, a new inventory information system was installed during the 2020 year. This new system results in a new way to estimate inventory obsolescence. If this new system's method is applied to the previous year, our cost of goods sold will differ.
Audit manager: Okay. Let me look into this further and determine how to proceed. Any other challenges?
Senior auditor: Yes. As you are aware, SIL's voice-clarifying technology has been actively sought after by many companies. It appears that the division will be sold. I'm not sure how to deal with the impact of a potential sale on the financial statements. Also, it appears that management has changed the depreciation method for equipment and the amortization of the useful life of certain patents.
Audit manager: Okay, I will look into these issues further. The senior auditor provides you with a copy of the most recent draft income statement (Exhibit I) and summary notes related to the above issues (Exhibit II).
Exhibit I Excerpts from the Financial Statements
Stabilize It Limited Statement of Income
For the year ended December 31 (audited) 2020 2019
Revenue and income $4,875,200 $4,643,048
Cost of sales 1,243,176 1,137,547
Gross profit $3,632,024 $3,505,501
Expenses
Advertising and promotion 255,000 242,857
Depreciationequipment 275,000 350,000
Amortizationintangibles 100,000 250,000
Insurance 22,500 21,430
Interest and bank charges 27,040 25,752
Legal and accounting 12,100 11,524
Lease expense 34,500 32,857
Office and general expenses 255,000 242,857
Repairs and maintenance 97,500 92,857
Utilities 112,575 107,214
Wages and benefits 625,000 595,238
1,816,215 1,972,586
Operating income 1,815,809 1,532,915
Other income 275,790 262,657
Abnormal inventory write off (200,000) 0
Government assistance 150,000 142,857
Earnings from continuing operations before taxes 2,041,599 1,938,430
Provision for income taxes (30%) 612,480 581,529
Net income $1,429,119 $1,356,901
Retained earnings, beginning $5,859,401 $4,502,500
Retained earnings, ending $7,288,520 $5,859,401
Exhibit II Summary Notes
New Inventory System During the year, a new system was installed by SIL. The controller and inventory manager were proponents of the new system as they both complained that the previous system was outdated and not sophisticated enough to provide information on the various items in inventory. A new system was installed that provides management with more information at the individual item level regarding inventory turnover, discontinued products, and daily market prices. As a result, the controller and the inventory manager have new information by which to track inventory and to estimate inventory obsolescence. Accordingly, the inventory obsolescence policy was modified to reflect the more relevant and reliable information. The inventory system was tested extensively as part of the interim audit, and the audit team is satisfied with the reasonableness and reliability of the information that comes from the new system. The amount of additional year-end inventory write off required under the new methods for 2020 is $500,000. Of this amount, management has estimated that $150,000 should have been written off in 2019 and $50,000 in 2018. Management has presented $300,000 of the write off as part of the cost of goods sold, and the remaining $200,000 as a separate line item.
Voice Stabilization Technology Management is planning to sell SIL's voice stabilization technology. The technology has been successful; however, voice technology competencies vary from those related to video stabilization. Accordingly, management has decided to focus on SIL's core competencies, which are video-related technologies. On October 1, 2019, the board of directors met and voted in favor of divesting the company of the voice stabilization technology. On October 15, management hired an investment banking firm in order to develop a divestiture plan and to identify a potential buyer. The divestiture plan was created and approved by the board on December 1, 2019. The investment banking firm is paid a fee of 10% of the sales price. The investment banking firm did express some concerns about current market conditions and its impact on the sales price and the time required to close a deal. Merger and acquisition activity is down due to global economic activities; however, the investment bankers suggested that these assets could be sold for approximately $650,000 in current market conditions. The sales price could increase if there is a large number of purchasers and market conditions improve. The tangible and intangible assets related to voice stabilization products are currently being carried at $765,000 (amortized cost). The voice stabilization operations generated sales of $750,000 in 2020 ($725,000 in 2019) and had total operating costs of $350,000 ($340,000 in 2019).
Change in Depreciation Policy During 2020, management changed from straight-line to the double declining-balance method for depreciating certain equipment. The change was made because in today's business environment, machinery and technology changes rapidly, leading to more benefits being received when the equipment is still relatively new. The following table presents the difference in depreciation under both methods over the years affected:
Year Double Declining-Balance Depreciation Straight-Line Depreciation Difference
2018 $675,000 $350,000 $325,000
2019 475,000 350,000 $125,000
2020 275,000 350,000 $(75,000)
In addition, management changed the useful life of the patents being amortized from five years to eight years. The change was made because the technology is being adopted by more companies than expected and there are very few competitors doing research in this field. The intangible assets were being amortized on a straight-line basis, have a historical cost of $1,250,000, and had an average useful life of five years beginning on January 1, 2017.
Required Assume the role of the audit manager and draft a memo that will be included in the audit file.