Investigation of Accounting Implications for Smart Pet Inc. and Kibble Inc.

KIBBLE INC. (Suggested Time: 120 minutes)

You, CPA, recently started work as a senior auditor in the internal audit department of Smart Pet Inc. (SP). SP is a small public company that operates veterinary clinics across Canada and sells pet health insurance. You are really excited to be a part of these operations. Secretly, you always wanted to be a vet and this was the closest you could get without going back to university.

 

It is now February 1, 2021 and your boss just called you into her office to discuss an issue passed along to her by the company’s President. The President received a written complaint from a SP manager (Appendix I) in early December. Your boss wants you to investigate the complaint to see if there are any accounting implications that need to be addressed. She also wants to know what additional work will need to be performed by the external auditors as a result of the issues raised.

 

Effective January 1, 2020, SP acquired 100 percent of the shares of Kibble Inc. (KI). KI specializes in the production of low calorie and organic foods for dogs. SP has announced plans to expand KI’s product offerings in mid-2021 to include specialty cat foods. As a result of the employee complaint, the President is now concerned that the current reporting from KI is not presenting an accurate report of its operations and your boss wants to know if you agree. The managerial bonus structure of SP is mainly based on the financial performance of SP on a stand- alone basis and the President wants to make sure everyone is being rewarded fairly.

 

The external auditors arrived last week to complete the year-end audit procedures for the consolidated SP financial statements. They reviewed KI’s new information technology system when the interim audit procedures were performed in November as it was a new system with a material impact on SP. Although they were generally satisfied with the controls in place, the auditors have indicated that they will be raising some issues in their management letter. Your boss needs you to review the notes she made on the new system to identify possible weaknesses. She wants to make sure that SP can state that the auditors’ concerns have been dealt with when the management letter is issued.

 

You began by obtaining statements of income for both companies (Appendices II and III). You also gathered information regarding KI’s operations (Appendix IV) and notes on KI’s new information technology system (Appendix V).

Issues Raised by SP Manager

Appendix I- Issues Raised By Sp Manager

There are several instances in which costs incurred by SP to support the activities of KI are not being charged to KI. SP is not charging KI for the salary being paid to Josh Burton, the executive hired to oversee KI’s profitability and expansion activities. Payroll records show an annual salary of $100,000 for Josh Burton in 2020.

 

The information technology department of SP incurred costs of $75,000 to build an information system for KI. It is expected that this system will support KI’s business activities for the next five years. The system was implemented on April 1, 2020. The costs have been capitalized in SP and no costs have been allocated to KI.

 

Several SP executives travel to KI’s head office on a regular basis. These travel costs are tracked separately by the SP accounting system but are not charged directly to KI. Instead, they become part of an overall overhead cost allocation to KI. The actual travel costs incurred by the SP executives related to KI during 2020 totaled $14,500 but only 15% of these expenses were actually allocated to KI based on the overhead formula.

 

The SP Controller noted that Josh Burton was hired to provide SP with improved oversight of KI, the benefits of which would eventually accrue to SP through dividends. The Controller also indicated that SP intends to market the new KI information system to other pet food manufacturers. SP expects to recover the development costs relating to the information system from future license fees.

 

To date, KI has incurred approximately $100,000 in costs to develop specialty cat food products. These costs have been capitalized but no amortization has been taken to date as commercial production of the products has not yet started. These products are still awaiting approval from Health Canada but the chief scientist on the project expects such approval to be forthcoming relatively soon. There have been concerns about tainted pet food from China so the approval process is taking longer than normal.

 

Included in the capitalized amount are $50,000 of materials and molds used to manufacture prototype foods and $10,000 in salaries and benefits for the staff working directly on the project. Initial development efforts ran into a problem when the products kept breaking apart. A $20,000 patent and a $5,000 piece of specialty equipment had to be purchased so that a special binding process could be used on the products. The patent will expire in five years and the equipment will also be technologically obsolete at that point. The binding process and new equipment solved the production problem. There was also an allocation of $15,000 of the KI Vice President of Marketing’s salary as an overhead allocation. He noted that since the specialty cat food products were his idea, a portion of his salary should be attached to the project.

Financial Statements Overview

 

The KI Vice President of Marketing noted that other companies already have high-end cat foods on the market. Results to date for those products have been mixed but his instincts tell him that KI’s low calorie and organic products will appeal to cat owners. No market study has been completed because the Vice President is sure that KI’s specialty cat food products will be as popular as its dog specialty products.

 

The SP Controller mentioned that SP is not prepared to show a loss from KI in 2020 or from the planned expansion into specialty cat foods in 2021. Several staff confided to you that there have been rumblings that the SP Vice President responsible for the purchase of KI will be fired if the acquisition is not profitable. Some SP managers receive a bonus based on a number of criteria. One of those criteria is SP stand-alone pre-tax profitability.

You have gathered a copy of Josh Burton’s employment contract and listings of costs incurred to develop the system for KI and the executive travel costs. You have confirmed that amounts and details in the complaint are accurate. You also determined that there are no pending agreements to license the KI software to other companies.

 

You contacted the manager assigned to the financial statement audit. You were advised that materiality for the SP audit is based on standard auditing guidelines.

Appendix II

Sp Consolidated Statement Of Income

Smart Pet Inc. 

Consolidated Statement Of Income

For the year ended December 31, 2020 (unaudited) 

Revenue	Â
Insurance and veterinary	$ 9,852,800
Manufacturing	5,425,100
Interest and other income	    3,747,400
Â	19,025,300
Expenses	Â
Advertising	1,062,000
Amortization	565,100
Cost of sales	3,271,800
Insurance	1,064,000
Office	501,000
Pet health claims	4,802,200
Professional fees	125,500
Rent	1,140,000
Repairs and maintenance	117,600
Telephone and utilities	1,147,900
Wages	    1,932,200
Â	  15,729,300
Income before income taxes	3,296,000
Income taxes	  889,920
Net income	$ 2,406,080

Appendix III

Ki Statement Of Income

Kibble Inc. Statement Of Income

For the years ended December 31 

Â	2020	2019
Â	(unaudited)	(audited)
Revenue	$ 5,425,100	$ 4,423,700
Cost of goods sold	    3,271,800	    2,785,800
Gross margin	2,153,300	1,637,900
Expenses	Â	Â
Advertising	350,100	274,500
Amortization	20,100	23,400
Insurance	197,500	100,200
Office	77,500	55,000
Professional fees	26,400	15,900
Rent	240,000	220,000
Repairs and maintenance	10,200	1,300
Telephone and utilities	237,100	179,300
Wages	  885,600	  641,600
Â	   2,044,500	  1,511,200
Income before income taxes	108,800	126,700
Income taxes	  29,376	  20,272
Net income	$ 79,424	$ 106,428

Appendix IV KI’S Operations

Tika Bradshaw, the original owner of KI, is still actively involved in the business and Josh relies on her to handle much of the day-to-day operations. For example, Tika negotiated KI’s insurance contract for 2020. The coverage was nearly identical to the prior year’s contract. Tika’s husband is KI’s insurance broker.

 

Tika hired her niece and nephew as research assistants for the summer of 2020. Both are finishing their third year of a food sciences degree at a local university. They were each paid $20,000 for their work.

 

Josh approved the issuance of an iPhone with an unlimited monthly minutes plan to all KI employees. He told staff that it was important that they always be able to communicate with each other.

 

KI recorded revenue of $312,500 relating to product sold to a new customer in late November 2020. The sales contract included a provision that allowed the customer 90 days to test the product and assess its market potential. The customer can give written notice of acceptance or rejection of the product within the 90-day period. The product is considered automatically accepted at the end of the 90-day period.

 

KI sold a storage facility to SP in December 2020 for $300,000. The original cost was $400,000 and accumulated amortization was $150,000. KI recorded the gain in its statement of income.

 

A $50,000 marketing campaign had to be withdrawn after objections from animal rights groups to the tag line “Well, that cat used up its ninth life”. The advertisements were promoting the concept that KI’s dog products made them stronger and cats had better beware. Josh signed off on the campaign.

Appendix V- Notes On Ki’s New Information Technology System

• The external auditors assessed KI’s new information system as part of their interim audit procedures. This included reviewing documentation regarding the development activities and thoroughly testing the conversion from the old to new system. No significant issues were identified that affect the 2020 audit.
• The SP information technology department recognizes the importance of regular system back-ups. The KI system was designed to automatically record a series of backups to the company’s server every Friday night following the close of business. As KI is a relatively new business, it has never had a manual way to record sales transactions. Accordingly, it is very important that the business can recover from any system difficulties within a short period of time. The server is located at KI’s head office. The anti-virus software is also updated as part of the procedures that occur each Friday night.
• Since taking on his new role, Josh Burton has become KI’s resident IT “expert”. He assists staff calling in from KI’s various locations with issues such as computers that freeze up or lost network connections. Just last week, Josh decided one of the predesigned reports was not giving him the information he needs to assess KI’s performance. He obtained the relevant system documentation and changed the code so that the report would give him the information he requires. Josh immediately implemented the change and refiled the documentation without updating it.
• During your discussion with staff in the SP information technology department, you determined that the KI information system was built to develop a profile of each customer. The customer profile includes the customer’s name, mailing address, employer, purchase history, including product preferences and payment information such as credit and debit card numbers. Access to the customer profiles is controlled with user IDs and passwords.