Autotech Corp. (Autotech) is a federally incorporated public company formed in 2009 to manufacture and sell specialty auto products including paint protection and rust proofing. By 2013, Autotech€™s board of directors felt that the company€™s products had fully matured and that it needed to diversify. Autotech aggressively sought out new €œconcepts,€ and in November 2013 it acquired the formula and patent of a synthetic motor lubricant (Synlube) and 25% of the outstanding voting shares of JDP Ltd. (JDP) for $400,000 cash. The formula was developed by JDP, a company then owned 100% by Jack Douglas. Although some members of the board of directors felt and continue to feel some concern about Mr. Douglas€™s continuing ownership of JDP, Mr. Douglas became the president of Autotech in February 2014.
Synlube is unlike conventional motor oils. Its innovative molecular structure accounts for what management believes is its superior performance. Although it is more expensive to produce and therefore has a higher selling price than its conventional competitors, management believes that its use will reduce maintenance costs and extend the life of the equipment in which it is used.
Autotech€™s main competitor is a very successful multinational conglomerate that has excellent customer recognition of its products and a large distribution network. To create a market niche for Synlube, management is targeting commercial businesses in western Canada that service vehicle fleets and industrial equipment.
Autotech€™s existing facilities were not adequate to produce Synlube in commercial quantities. Management believed that there was a growing market for this product in western Canada, and in June 2015 Autotech commenced construction of a new blending plant in Alberta. After lengthy negotiation it received a $900,000 grant from the provincial government. The terms of the grant require Autotech to maintain certain employment levels in the province over the next three years or the grant must be repaid. The new facilities became operational on December 1, 2015.
In addition to the grant monies received, Autotech has financed its recent expansion with a term bank loan. Management is considering a share issue later in 2016 to solve the company€™s cash flow problems. Autotech€™s March 31, 2016 draft balance sheet is provided in Exhibit I.
Although they had been with the company since its inception, Autotech€™s auditors have just resigned. It is now April 22, 2016. You, a CA, and a partner in your firm met with Jack Douglas to discuss the services your firm can provide to Autotech for the year ended March 31, 2016. During your meeting, you collected the information contained in Exhibit II .
As you return to the office, the partner tells you that he is interested in having Autotech as an audit client. Before making a decision, however, he wants a memo from you covering in detail the accounting and audit issues that you see arising from this potential engagement.

Required:
Prepare the memo to the partner.

Exhibit II

1. The €œCapital assets€”new plant€ account in the general ledger has increased by $1.435 million during the year. An analysis of this increase is as follows:

Land $ ....................................................................................................... 200,000
Building, net of grant of $900,000 ........................................................  416,000
Advertising (promotion of Synlube product) ....................................... 125,500
Relocation costs (moving plant management) .................................... 216,300
Equipment ................................................................................................ 319,200
Legal fees (Synlube patent-infringement lawsuit) ...............................   67,400
Labour costs (amounts paid to employees during training period) ... 90,600
                                                                                                                  $1,435,000

As no significant orders of Synlube have been received to date, no amortization has been charged this year.

Exhibit II

2. Autotech has commenced a lawsuit against its major competitor for patent infringement and industrial espionage. Management has evidence that it believes will result in a successful action and wishes to record the estimated gain on settlement of $4 million. Although no court date has been set, legal correspondence shows that the competitor intends €œto fight this action to the highest court in the land.€
3. Deferred development costs represent material, labour, and subcontract costs incurred during 2014 and 2015 to evaluate the Synlube product and prepare it for market. Almost 80% of the subcontract costs were paid to JDP. Autotech has not taken any amortization to date but thinks that a period of 20 years would be appropriate.
4. Jack Douglas contacted your firm after Autotech€™s former auditors resigned. The previous auditors informed Mr. Douglas that they disagreed with Autotech€™s valuation of deferred development costs and believed that the balance should be reduced to a nominal amount of $1.
5. Royalties of $0.25 per liter of Synlube produced are to be paid annually to JDP.
6. Inventory consists of raw materials, semi-processed liquids, and finished goods. Approximately 60% of the value of inventory relates to Synlube production at the new plant. The fourth-quarter inventory count resulted in a significant book-to-physical adjustment. Management thinks that the standard costs used may have caused the problem.
7. The $3.514 million term bank loan is secured by a floating charge over all corporate assets.
8. Autotech has incurred substantial losses during the past three fiscal years.

Transcribed Image Text:

Autotech Corp. draft balance sheet Exhibit I 2016 2015 (Unaudited) (Audited) As at March 31 (in $000's) Current assets Accounts receivable 213 195 Inventories 1,650 615 Prepaid expenses 45 30 1,908 840 Non-current assets Property and equipment 2,120 716 Investment in JDP Ltd. Deferred development costs 1,979 686 Patent 835 835 Total assets 6,843 3,078 Current liabilities Bank indebtedness 1,225 462 Accounts payable 607 476 Current portion of long-term debt 400 98 Advances from shareholders 253 2,485 1,036 Non-current liabilities 3,114 5,599 Long-term debt 650 Total liabilities 1,686 Share capital 2,766 2,766 Deficit (1,374) (1,522) Total shareholders' equity 1,244 1,392 Total liabilities and shareholders' equity 3,078 6,843