Cybernetronics Inc. (Cyber) is a Canadian-owned public company which designs and manufactures communications and control systems. The company's year end is May 31. It is now June 2018.
You, CPA, are the manager for the audit of Cyber and yesterday had met with the treasurer to discuss the year-end audit. The partner responsible for this client has asked you to prepare a report for the client which discusses important financial accounting issues.
Notes from the Meeting with the Treasurer
1. In December 2016, Cyber won a $40 million contract to design autonomous robots for use in mining activities. In April 2018, the customer exercised the cancellation clause included in the contract. Cyber has capitalized design and development costs related to this contract. The cancellation clause requires the mining company to pay a penalty of $12 million. The penalty has not yet been paid to Cyber.
In June 2017, Cyber entered into an agreement with a university whereby Cyber received assistance in the development of fuzzy logic software which was to have been used in the robots designed for the contract with the mining company. The agreement requires Cyber to make an annual contribution of $0.5 million to the university for four years. The first payment of $0.5 million was made in March 2018 when the university's work was completed.
Management of Cyber is confident that the technology developed, including the fuzzy logic software, can be applied to future contracts involving the design of robots.
Cyber entered into a five-year lease on June 1, 2017 for facilities dedicated to the design and future manufacture of the robots for the mining company. Management of Cyber is presently negotiating a buy-out of the lease and has offered to make lump-sum payment of $750,000 to the lessor on September 1, 2018. The annual lease payment is $500,000.
The draft balance sheet prepared for Cyber's May 31 year end included capitalized design and development costs in the amount of $8.2 million. This amount includes the $0.5 million paid to the university. The draft income statement includes the $12 million cancellation penalty as 'other income -- gain on cancellation of contract'.
2. On September 1, 2017, Cyber transferred one of its divisions to a partnership formed with an unrelated party to own and operate the division. Cyber received a non-interest bearing promissory note in the amount of $20,025,000 from the unrelated party and a 19.9% interest in the partnership. The note is to be repaid by the unrelated partner in the amount of $4,005,000 annually for five years with the first payment due August 31, 2018.
Cyber is obligated to provide cash advances to cover 50% of the partnership's cash flow deficiencies from operations. If the performance of the partnership does not achieve
specified income and cash flow targets by August 31, 2018, the other partner, which has an 80.1% interest in the partnership, has the right to have the partnership wound up. In the event the partnership is wound up, Cyber would be required to pay back the payments made on the note, the balance owing on the note would be cancelled and the assets and liabilities of the partnership would revert to Cyber.
The net assets of the division had a carrying value of $12 million at the date of sale, September 1, 2017. Cyber has been informed that the partnership will be reporting a loss of $5,030,000 for the nine months ended May 31, 2018 which is its first fiscal year end. Cyber has also been advised that the partnership incurred a cash flow deficiency from operations of $2,100,000 during this period.
Cyber's investment in the partnership is reported on the draft balance sheet in the amount of $4,975,000 and the draft income statement includes a gain on the sale of the division of $13,000,000.
3. In April 2018, Cyber introduced a price protection policy for its customers to stimulate sales. Cyber promised customers that if it reduced prices after the customer made its purchase Cyber would reduce the customer's liability accordingly or refund the appropriate amount. On June 14, 2018, Cyber reduced its selling prices by 15%. Sales affected by the price protection policy as at May 31, 2018 were recognized in the amount of $2.4 million.
4. In May 2018, Cyber entered into an arrangement with a real estate company whereby Cyber provided robotic cleaning machines in exchange for free rent at its head office location. The cost of the machines delivered to the real estate company was $900,000 and would have a selling price of $1,500,000. Cyber is not required to pay rent for twelve months commencing June 1, 2018. This represents a savings in lease costs of $1,200,000 to Cyber. This transaction allowed Cyber to reduce its inventory of these machines which management felt was too high. Cyber's draft year-end financial statements do not reflect this transaction.
5. Senior management of Cyber is concerned about the new requirement to disclose management compensation figures. They want to avoid any criticism that their total compensation is not warranted based on Cyber's financial performance.
REQUIRED:
Prepare the report to the client.