Aquatic Biotechnology Inc. (ABI) is a medium-sized, public company operating an aquaculture business in eastern Canada. The company has been in operation since the mid-1990s, and during the latter half of the 2000s it grew at a rapid pace through both increased sales and the acquisition of minor competitors.

ABI has an October 1 year end. It is now November 15, 2013 and you, CA, are working on the 2013 audit. Your firm, Linkletter & Cormier Chartered Accountants, has conducted the audit of ABI for several years and has always considered it to be a routine audit engagement. The audit senior on the engagement recently resigned from the firm, and you have been asked to act as senior on the audit. All October 31 inventory counts and routine confirmations have been dealt with, and you have been provided with the audit planning files. These files are summarized in Exhibit C4-2(a).

The corporate structure of ABI is based on management's philosophy that vertical integration will allow this growth-oriented business to achieve its objectives. ABI controls nearly all aspects of the supply chain, from growth of the product to processing and delivery to the customer. ABI operates the hatchery, where each of the three major products (salmon, trout, scallops) are hatched, the fish farms where growth takes place, and the processing plant where smoking and packaging occur. ABI also owns Marine Tech Limited (MTL), a supplier of boats, nets, and gear to the Canadian market. MTL provides nearly all supplies, repairs, and maintenance for the corporate group.

Scallop farming is a relatively new area of aquaculture, in which ABI has invested a substantial amount of capital for research and development. Scallops are grown in a "cage" which sits on the ocean floor in an area that does not experience problems such as strong tides and bacteria which could destroy the crop. As with many other aquaculture products, scallops can take from 24 to 30 months to reach a marketable size. ABI has yet to earn any revenue from scallop farming, but it is confident that its new system will be successful.

ABI has been working on scallop farming technologies for about five years. Previous years' audit files indicate that the costs related to scallop farming had been expensed, as the company lost much of its stock during the winter months. ABI is confident that its new cage style, developed in 2012, will result in a tremendous crop ready for harvest in 2013.

At the year end, the scallop stocks were checked by the company and by an aquaculture expert hired by your firm, and it was determined that the stock is at 75% of its marketable size. However, the aquaculture expert would not comment on the likelihood that the stock would reach full maturity. At maturity, it is estimated that the crop will be 500,000 kilograms. Costs to date related to the 2013 harvest have been $1.425 million, of which $1.2 million has been incurred in fiscal 2013.

Salmon and trout farming are major divisions of ABI. Both have been successful for a number of years, although the selling price of salmon decreased slightly in 2013. The salmon division has provided substantial cash flow to the company, due to the perfected method of growth and the low market costs associated with the product. Trout farming is a relatively new division of the company and has been moderately successful for the past two years.

Despite the positive cash flows generated by the salmon division, ABI has had difficulty in managing its cash flows due to its substantial investment in scallop farming. In August 2013 ABI decided to refinance much of its debt to consolidate loans. The Business Development Bank, a federal government agency, agreed to consolidate most of ABI's debt and loaned ABI an additional $5 million for five years, with the first year to be interest-free. The bank further agreed to extend the interest-free period for each fiscal year that ABI is able maintain net income at $1 million or more. A loan arrangement fee of $500,000 was paid in order to cover the bank's costs to consolidate the debt. The bank requires ABI to maintain a current ratio above 1, given the current level of debt. The new debt structure has allowed ABI to improve its cash situation.

You have just reviewed the working paper files and have met with ABI's controller, Jim Gibbins, to gather a set of draft financial statements [Exhibit C4-2(a)]. The engagement partner has asked you to prepare a memo summarizing the relevant accounting issues in preparation for her meeting with ABI.

Required

Prepare the memo.

EXHIBIT C4-2(a)

INFORMATION OBTAINED FROM JIM GIBBINS

1. During the year ABI acquired Bay Mussels Limited (BML), a large mussel grower in the area, to diversify its product lines, ABI paid $4.7 million to acquire 100% of the outstanding shares of BML. BML's net tangible assets were valued as follows on the date of acquisition:

2. Jim has not yet recorded revenue for the scallop production, but would like to record as much revenue as possible in 2013, since the product is 75% of its marketable size and orders for the coming year are already being received. The price per kilogram can be reasonably estimated at approximately $20.00, although supply may affect the market price.
3. Since early November ABI has been holding discussions with a major competitor to sell its trout division. ABI believes that, although the division has been relatively successful, scallop farming is much more attractive in the long run. The buyer has made a preliminary offer of $2.8 million for the trout division, and ABI management expects that the cash flow will assist the company in getting through the winter until scallop sales begin. The buyer's offer expires on November 30, but the buyer may be open to further negotiations.

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EXHIBIT C4-2(a) INFORMATION OBTAINED FROM JIM GIBBINS 1. During the year ABI acquired Bay Mussels Limited (BML), a large mussel grower in the area, to diversify its prod- uct lines, ABI paid $4.7 million to acquire 100% of the outstanding shares of BML. BML's net tangible assets were valued as follows on the date of acquisition: Book Value Market Value Current assets Non-current assets Current liabilities Non-current liabilities $ 1,986,773 14,686,934 2,089,657 10,768,540 1,968,773 16,437,593 2,089,657 11,239,415 EXHIBIT C4-2(b) AQUATIC BIOTECHNOLOGY INC. Extracts From Consolidated Balance Sheet As at October 31 (in thousands of dollars) 2013 2012 (unaudited) (audited) Assets Current $ 283 1,030 4,396 Cash Accounts receivable, net Inventory salmon and other Inventory- scallops Prepaid expenses $ 115 1,650 4,568 1,425 543 8,301 6,264 Property and equipment, net Deferred costs scallop cages Other 67,913 3,007 2,684 $81,905 64,423 500 3,774 $74,961 Liabilities Current Bank indebtedness Accounts payable and accruals Current portion of long-term debt $ 2,103 2,804 3,145 $1,131 2,332 2,365 5,828 8,052 Long-term debt Future income taxes 61,500 1,345 58,243 1,297 Shareholders' equity Share capital Retained earnings 10,998 11,008 $81,905 10 9,583 9,593 $74,961 AQUATIC BIOTECHNOLOGY INC. Extracts From Consolidated Income Statement For the years ending October 31 (in thousands of dollars) 2013 2012 (audited) $29,879 (unaudited) (audited) Revenue $27,345 $26,567 9,453 Salmon rou Mussels Fishing gear and other 13,588 32,486 75,066 10,673 30,788 71,340 1,647 29,453 65,785 Cost of goods sold 15,714 6,280 1,400 Salmon 15,917 13,359 7,860 rouu Mussels 2013 2012 (audited) 21,899 44,266 27,074 2011 (unaudited) (audited) 1,260 20,324 42,803 Scallops Fishing gear and other 22,962 46,356 Gross margin Expenses 28,710 22,982 Salaries and benefits Selling and advertising General, administrative, and other Interest on long-term debt Research scallop cages Loan arrangement fee 12,879 5,225 3,423 4,288 10,547 3,426 2,879 4,562 5,250 9,643 2,784 1,866 4,848 3,078 500 22,219 Total expenses Income from operations Gain on acquisition of BML Net income before income taxes Income taxes Net income 26,315 26,664 2,395 345 2,740 1,325 763 763 298 $ 465 156 $ 254