You have recently been hired by International Products Inc.’s (IPI) internal audit department and are sitting in your office planning for your upcoming meeting with the head of internal audit. It is January 20, 2014. You just returned from a week visiting Air Technologies Ltd. (Air), IPI’s newest subsidiary. Air has been part of the IPI group of companies since late in 2012 and up to now had never been visited by internal auditors. As is standard practice at IPI, the internal audit department visits the subsidiary companies once a year to check on the functioning of the accounting systems and internal controls, and to make sure that policies and procedures are being adhered to. This was your first assignment and you thought it was a tough one because you have to prepare a report not only addressing the internal audit findings, but also discussing the financial reporting issues you found related to IFRS.
As you sit down to write your report, you once again review the material gathered in your investigation. Exhibit I is a brief history of Air; Exhibit II contains notes from your meeting with Louis Shayne, Air’s president; Exhibit III is a summary of the development costs incurred during 2013; Exhibit IV provides Air’s financial statements for the year ended December 31, 2013; and Exhibit V contains other information you gathered.

Exhibit I

Louis Shayne is an amateur inventor. He developed a new technology for air cleaning that is especially useful for spaces that do not have central forced air heating and cooling. The technology is more effective at removing airborne pollutants than any existing technology. Air was formed in 2009. Louis’s goal for the company was to develop and market a new method for residential and commercial air cleaning. In 2011, Louis built and tested commercial prototypes for the new technology, which performed very well under difficult conditions. Because of the increase in asthma in children and the perceived decrease in air quality in many parts of Canada, Louis knew his technology would be very successful.
While Louis was convinced that the product would be successful, he did not have the resources to take the project any further. He was unsuccessful in obtaining financing from banks or venture capitalists and could not find anyone interested in purchasing an equity stake in Air. Louis was about to give up when, in November 2011, he had a hance meeting with the chief executive officer of IPI, Fred Irving, at a local meeting of the asthma association. Mr. Irving is the father of two children who have severe asthma and Louis was demonstrating his product. Mr. Irving took an immediate interest. Louis loaned Mr. Irving his prototypes; Mr. Irving was very pleased that they helped improve his children’s symptoms. Based on his personal experiences with the prototypes, Mr. Irving saw that the product had significant market potential and agreed to get involved in developing and marketing it.
In late 2012, Louis sold all the outstanding shares in Air to IPI for $250,000. IPI agreed to finance the remaining research and development necessary to complete the product and bring it to market. The sale agreement required that Louis remain as president of Air until December 31, 2013, to complete development of the product and launch it. Mr. Irving believed that Louis’s knowledge was vital for the product’s success. Louis’s agreement with IPI stipulates that he receive a salary of $50,000 per year. In addition, he is to receive a bonus of $1 million if (i) the product is successfully brought to market, (ii) at least 10,000 units of the product are sold at a minimum average price of $65 per unit by December 31, 2013, and (iii)Air generates a profit for the year ended December 31, 2013.
Exhibit II
Louis explained that, from the time IPI acquired Air until the end of 2012, his efforts were directed toward refining the product. During that time, $300,000 was spent on improvements to the product and the full amount was expensed. Air reported a loss for tax purposes of $424,000.
In early 2013, everything came together. All the glitches with the product were solved, and testing results were consistent and met the specifications. Sure that the product would be successful, Louis then turned all of his attention to selling the product. In January and February 2013, marketing studies and production feasibility studies were carried out. In late April, Louis made a presentation to Fred Irving and received commitment of the funds required to get production underway. The manufacturing process is quite straightforward and relatively inexpensive, requiring only about $800,000 for manufacturing and assembly equipment. Despite a number of initial problems, the first full production run occurred in July. The first 900 units produced did not meet specifications and could not be shipped. The first shipment of units to customers was in August. Louis explained that the 900 units with specification problems are currently in inventory and he expects that, when time permits, they will be repaired and sold.
Louis said that he agreed to stay on with Air for an additional three months (until March 31, 2014) by which time a new president for Air should be hired. He said that Fred Irving did all he could to convince him to stay on longer but Louis explained that he is an inventor at heart, not a manager, and that, with the right president, Air would continue its success.
Exhibit II
Louis was very satisfied with initial demand for the product. He had arranged contracts with a number of national and local distributors, and early feedback from the distributors was favourable. However, Louis thought that the initial orders made by the distributors were unrealistically low and that they would quickly run out of inventory, which would cost Air significant sales because customers might buy a competitor’s product.
Louis thinks that market penetration is key and he is not prepared to miss any sales. As a result, he often shipped significantly more units to distributors than ordered. While Louis assured any distributors that objected that they would see that the extra units were merited, he allowed them to delay payment until six months after delivery. At that time, they have to pay in full or return any unsold units shipped in excess of the initial amount ordered. Louis’s first priority is getting product out the door. Once orders are sent to the shipping department, Louis wants the goods shipped within a day or two. Louis keeps production operating at full capacity to ensure there is enough inventory in place to meet the anticipated demand.
Louis acknowledged that paperwork was a bit sloppy. Because of the strong demand for Air’s product, Louis had little time to pay attention to administrative tasks, devoting his time instead to selling, and to making sure production was kept on schedule and orders were shipped on time. He pointed out that IPI had kept Air on a fairly tight budget and, as  result, he was under staff ed in the office.
Louis expects the paperwork to flow better once everyone gets used to the computer system and its glitches are fixed. The computer system was mandated by IPI and was installed by a small company recommended by IPI. The system was installed in May 2013. Louis complained that the computer company simply showed up one day, installed the system without any discussion of what was wanted or needed, and then left. It was never heard from again, except to render the bill.

Exhibit III

Costs incurred from January to March 2013                                                                                
Marketing surveys ......................................................................................................    $ 65,000
Consultant’s report on air quality issues ....................................................................    80,000
Search costs for production facility ............................................................................    70,000
Feasibility study for production facility ......................................................................    92,000
Costs incurred from April to July 2013                                                                                          
Cost of setting up production facility ..........................................................................    37,000
Training of production staff .........................................................................................    48,000
Costs incurred from August to December 2013                                                                          
Production cost overruns during first three months of production ......................     97,000
Selling, marketing, and promotion costs ...................................................................   118,000
Total development costs incurred .............................................................................  $607,000

Exhibit IV

Balance sheet as at December 31 2013                                                                2013
Current assets                                                                                                                    
Cash .................................................................................................................. $ 75,000
Accounts receivable ......................................................................................... 475,000
Inventories ........................................................................................................ 303,620
Prepaid expenses .............................................................................................   35,000
                                                                                                                                 888,620
Property, plant, and equipment ..................................................................... 767,650
Development costs .......................................................................................... 607,000
Total assets .................................................................................................. $2,263,270
Current liabilities                                                                                                                
Accounts payable .......................................................................................... $ 302,000
Loan from parent company ......................................................................... 2,500,000
                                                                                                                              2,802,000
Share capital ...................................................................................................   278,670
Deficit ............................................................................................................... (817,400)
Total shareholders’ equity (deficiency) ........................................................ (538,730)
Total liabilities and shareholders’ equity .................................................. $2,263,270
Income statement                                                                                                              
For the year ended December 31 2013                                                                 2013
Revenue (Note 1) .........................................................................................  $ 770,352
Cost of goods sold .......................................................................................     295,352
Gross margin ................................................................................................     475,000
Amortization of equipment (Note 2) ..........................................................      32,000
Selling, general, and administrative costs ..................................................   201,000
Income before income taxes .......................................................................   242,000
Income taxes ..................................................................................................     75,400
Net income ...................................................................................................  $ 166,600

Note 1: Air recognizes revenue when merchandise is shipped to customers. This method is consistent with IPI’s standard accounting policy for other manufactured products.
Note 2: Amortization of the equipment began in August 2013 and is calculated on a straight-line basis over 10 years.
Exhibit V

Air shipped the first units to customers in August 2013. Total units shipped during 2013 were 11,672. No other products are produced by Air.
During 2013, Air shipped 500 units as demonstration models to potential customers, and to a variety of lung and asthma associations. The units were treated as sales with a selling price of $0.
Discussion with the accounts receivable clerk found considerable dissatisfaction with Air’s computer accounting system. When the clerk tried to reconcile the receivables list to the general ledger, she found that the listing sometimes had the same invoice number assigned to more than one shipment. The clerk said that she knows “for a fact” that different numbers were assigned but the computer seems to have its own ideas.
She also complained about difficulties with the monthly bank reconciliation, explaining that the accounting system keeps reporting as outstanding cheques that have cleared the bank. “No matter how hard I try, I can’t figure out how to get those cheques off the computer generated list. Now when I do the bank reconciliation, I ignore the outstanding cheque list generated by the system because I have no confidence in it. Instead, I rely on a manual record that I keep.”
The accounts payable clerk complained that many of the outstanding payables balances are not true payables but that they cannot be removed from the system. He explained that Air uses a purchase order system. He thinks that the problem might be that the receiver enters the receipt of the back-ordered items as a new-order receipt instead of going back to the original order. When the accounts payable clerk tried to fix the problem using the “over/under shipment” menu item, access was denied. So he has had to leave the old balances on the aged accounts payable report. The accounts payable clerk is frustrated because he is sure that there is an easier way to handle the shipments but can’t figure it out.
Other members of Air’s staff complained that they weren’t consulted in the development of the computer system and that they didn’t receive any training. It seemed they were supposed to figure it out for themselves. Some people complained that the system doesn’t produce the information they need to do their jobs properly, generating useless reports instead. Some of these people have figured out how to circumvent the system to obtain the information they need.
From discussions with the shipper, there appear to be significant problems in the shipping department. The shipper seems overworked and extremely dissatisfied with the way shipping is managed. The shipper has been involved in shipping for 15 years and has never seen a mess like Air’s. It’s virtually impossible for him to keep up with the orders that have to be shipped. “I’d say I’m two to three weeks behind getting orders out.” The shipper said that he could use more help in the department, but he could probably get the job done if Louis didn’t get involved in what gets sent out. “It seems he’s down here every day telling me to add a few more units to this order and to that order. The shipping documents are almost useless. I’d say that most orders go out of here with a different number of units than what is recorded on the shipping documents I receive from sales. In fact, they’re so useless I don’t even bother filing them anymore. I just toss them into that box in the corner.”
A review of the accounting system showed that the billing process is initiated as soon as an order is confirmed and sent to the shipping department. Trade receivables and sales are recorded at that time. Inventory records are perpetual. The inventory is reduced when goods are shipped. The shipper maintains a log of units shipped and the log is used to update the inventory records each day.
Air operates in a rented facility. The production department occupies about 45% of the building, storage 25%, and offices and administration the rest. The full amount of rent is treated as a product cost and included in inventory. IPI’s accounting policies state that only the rental cost associated with production should be inventoried. Air also includes the cost of office staff , managers, and production supervisors in the cost of inventory.