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2001 Uniform Final Examination Paper III Page 77 QUESTION 2 (35 marks) (84 minutes) 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-1980s, and during the latter half of the 1990s it grew at a rapid pace through both increased sales and the acquisition of minor competitors. ABI has an October 31 year end. It is now November 15, 2001 and you, CA, are working on the 2001 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 I. 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 2000, will result in a tremendous crop ready for harvest in 2002. At 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 2002 harvest have been $1.425 million, of which $1.2 million has been incurred in fiscal 2001. 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 2001. The salmon division has provided substantial cash flow to the company, due to the perfected method of growth and the low marketing 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. 2001 Uniform Final Examination Paper III Page 78 QUESTION 2 (continued) Despite the positive cash flows generated by the salmon division, ABI has had difficulty in managing its cash flows due to its substantial investments in scallop farming. In August 2001, 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 to 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 information related to the audit (Exhibit II) and a set of draft financial statements (Exhibit III). The engagement partner has asked you to prepare a memo summarizing the relevant accounting and audit planning issues in preparation for her meeting with ABI to discuss the ongoing audit. Required: Prepare the memo. (CONTINUED ON PAGE 12) 13) 2001 Uniform Final Examination Paper III Page 79 QUESTION 2 (continued) EXHIBIT I EXTRACTS FROM ABI AUDIT PLANNING FILES 1. Materiality has been set at $1.4 million since ABI is a continuing client and has always had low business risk and strong controls. 2. Preliminary tests of controls were performed in August during the audit planning, and no weaknesses were noted. 3. Bank confirmations have been sent to the appropriate financial institutions. 4. A signed engagement letter for the audit has been obtained from ABI. 5. Computer assisted audit techniques have not been carried out in previous years due to difficulties in extracting data from ABI's database system. Therefore, additional tests of controls and analytical procedures are necessary. (CONTINUED ON PAGE 14) 2001 Uniform Final Examination Paper III Page 80 QUESTION 2 (continued) EXHIBIT II 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 $4.75 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 Current assets Non-current assets Current liabilities Non-current liabilities $ 1,986,773 14,686,934 2,089,657 10,768,540 Market value $ 1,986,773 16,437,593 2,089,657 11,239,415 2. During September ABI began the phase-in of its new information system. It is a resource planning software package for medium-scale enterprises which allows integration of all aspects of business, from production to sales to financial accounting. As of October 31 the financial accounting modules were fully implemented, and ABI was conducting its own testing while running the system in parallel with the old database system. During testing Jim Gibbins uncovered a number of unauthorized transactions in the old database. Since their dollar amounts were insignificant, they have not been adjusted for. Jim believes the new system will allow ABI to better establish strategic direction and evaluate its profitability by product line. 3. Jim has not yet recorded revenue for the scallop production, but would like to record as much revenue as possible in 2001, 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. 4. 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. (CONTINUED ON PAGE 15) 2001 Uniform Final Examination Paper III Page 81 QUESTION 2 (continued) EXHIBIT III AQUATIC BIOTECHNOLOGY INC. EXTRACTS FROM CONSOLIDATED BALANCE SHEET As at October 31 (in thousands of dollars) 2001 (unaudited) 2000 (audited) Assets Current Cash Accounts receivable, net Inventory - salmon and other Inventory - scallops Prepaid expenses $ Property and equipment, net Deferred costs - scallop cages Other 115 1,650 4,568 1,425 543 8,301 $ 283 1,030 4,396 555 6,264 67,913 3,007 2,684 64,423 500 3,774 $81,905 $74,961 $ 2,103 2,804 3,145 8,052 $ 1,131 2,332 2,365 5,828 61,500 1,345 58,243 1,297 Liabilities Current Bank indebtedness Accounts payable and accruals Current portion of long-term debt Long-term debt Future income taxes Shareholders' equity Share capital Retained earnings 10 10,998 11,008 10 9,583 9,593 $81,905 $74,961 (CONTINUED ON PAGE 16) 2001 Uniform Final Examination Paper III Page 82 QUESTION 2 (continued) EXHIBIT III (continued) AQUATIC BIOTECHNOLOGY INC. EXTRACTS FROM CONSOLIDATED INCOME STATEMENT For the years ending October 31 (in thousands of dollars) 2000 (audited) 1999 (audited) $27,345 13,588 1,647 32,486 75,066 $29,879 10,673 30,788 71,340 $26,567 9,453 29,765 65,785 15,714 6,280 1,400 22,962 46,356 15,917 5,140 1,310 21,899 44,266 13,359 7,860 1,260 20,324 42,803 Gross margin 28,710 27,074 22,982 Expenses Salaries and benefits Selling and advertising General, administrative, and other Interest on long-term debt Research - scallop cages Loan arrangement fee Total expenses 12,879 5,225 3,423 4,288 500 26,315 10,547 3,426 2,879 4,562 5,250 26,664 9,643 2,784 1,866 4,848 3,078 22,219 2,395 345 2,740 1,325 410 410 156 763 763 298 2001 (unaudited) Revenue Salmon Trout Mussels Fishing gear and other Cost of goods sold Salmon Trout Mussels Scallops Fishing gear and other Income from operations Gain on acquisition of BML Net income before income taxes Income taxes Net income $ 1,415 (CONTINUED ON PAGE 17) $ 254 $ 465 2001 Uniform Final Examination PRESENT VALUE OF $1 RECEIVED AT THE END OF THE PERIOD Periods Hence 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 0.97 0.94 0.92 0.89 0.86 0.96 0.92 0.89 0.85 0.82 0.95 0.91 0.86 0.82 0.78 0.94 0.89 0.84 0.79 0.75 0.93 0.87 0.82 0.76 0.71 0.93 0.86 0.79 0.74 0.68 0.92 0.84 0.77 0.71 0.65 0.91 0.83 0.75 0.68 0.62 0.90 0.81 0.73 0.66 0.59 0.89 0.80 0.71 0.64 0.57 0.88 0.78 0.69 0.61 0.54 0.88 0.77 0.67 0.59 0.52 0.87 0.76 0.66 0.57 0.50 0.86 0.74 0.64 0.55 0.48 0.85 0.73 0.62 0.53 0.46 0.85 0.72 0.61 0.52 0.44 0.84 0.71 0.59 0.50 0.42 0.83 0.69 0.58 0.48 0.40 6 7 8 9 10 0.89 0.87 0.85 0.84 0.82 0.84 0.81 0.79 0.77 0.74 0.79 0.76 0.73 0.70 0.68 0.75 0.71 0.68 0.64 0.61 0.70 0.67 0.63 0.59 0.56 0.67 0.62 0.58 0.54 0.51 0.63 0.58 0.54 0.50 0.46 0.60 0.55 0.50 0.46 0.42 0.56 0.51 0.47 0.42 0.39 0.53 0.48 0.43 0.39 0.35 0.51 0.45 0.40 0.36 0.32 0.48 0.43 0.38 0.33 0.29 0.46 0.40 0.35 0.31 0.27 0.43 0.38 0.33 0.28 0.25 0.41 0.35 0.31 0.26 0.23 0.39 0.33 0.28 0.24 0.21 0.37 0.31 0.27 0.23 0.19 0.35 0.30 0.25 0.21 0.18 0.33 0.28 0.23 0.19 0.16 11 12 13 14 15 0.80 0.79 0.77 0.76 0.74 0.72 0.70 0.68 0.66 0.64 0.65 0.62 0.60 0.58 0.56 0.58 0.56 0.53 0.51 0.48 0.53 0.50 0.47 0.44 0.42 0.48 0.44 0.41 0.39 0.36 0.43 0.40 0.37 0.34 0.32 0.39 0.36 0.33 0.30 0.27 0.35 0.32 0.29 0.26 0.24 0.32 0.29 0.26 0.23 0.21 0.29 0.26 0.23 0.20 0.18 0.26 0.23 0.20 0.18 0.16 0.24 0.21 0.18 0.16 0.14 0.21 0.19 0.16 0.14 0.12 0.20 0.17 0.15 0.13 0.11 0.18 0.15 0.13 0.11 0.09 0.16 0.14 0.12 0.10 0.08 0.15 0.12 0.10 0.09 0.07 0.13 0.11 0.09 0.08 0.06 16 17 18 19 20 0.73 0.71 0.70 0.69 0.67 0.62 0.61 0.59 0.57 0.55 0.53 0.51 0.49 0.47 0.46 0.46 0.44 0.42 0.40 0.38 0.39 0.37 0.35 0.33 0.31 0.34 0.32 0.30 0.28 0.26 0.29 0.27 0.25 0.23 0.21 0.25 0.23 0.21 0.19 0.18 0.22 0.20 0.18 0.16 0.15 0.19 0.17 0.15 0.14 0.12 0.16 0.15 0.13 0.12 0.10 0.14 0.13 0.11 0.10 0.09 0.12 0.11 0.09 0.08 0.07 0.11 0.09 0.08 0.07 0.06 0.09 0.08 0.07 0.06 0.05 0.08 0.07 0.06 0.05 0.04 0.07 0.06 0.05 0.04 0.04 0.06 0.05 0.04 0.04 0.03 0.05 0.05 0.04 0.03 0.03 21 22 23 24 25 0.66 0.65 0.63 0.62 0.61 0.54 0.52 0.51 0.49 0.48 0.44 0.42 0.41 0.39 0.38 0.36 0.34 0.33 0.31 0.30 0.29 0.28 0.26 0.25 0.23 0.24 0.23 0.21 0.20 0.18 0.20 0.18 0.17 0.16 0.15 0.16 0.15 0.14 0.13 0.12 0.14 0.12 0.11 0.10 0.09 0.11 0.10 0.09 0.08 0.07 0.09 0.08 0.07 0.07 0.06 0.08 0.07 0.06 0.05 0.05 0.06 0.06 0.05 0.04 0.04 0.05 0.05 0.04 0.03 0.03 0.04 0.04 0.03 0.03 0.02 0.04 0.03 0.03 0.02 0.02 0.03 0.03 0.02 0.02 0.02 0.03 0.02 0.02 0.02 0.01 0.02 0.02 0.02 0.01 0.01 Tables 0.98 0.96 0.94 0.92 0.91 TABLE I (CONTINUED ON PAGE 28) 1 2 3 4 5 Page 113 2001 Uniform Final Examination PRESENT VALUE OF AN ANNUITY OF $1 RECEIVED AT THE END OF EACH PERIOD 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 1 2 3 4 5 0.98 1.94 2.88 3.81 4.71 0.97 1.91 2.83 3.72 4.58 0.96 1.89 2.78 3.63 4.45 0.95 1.86 2.72 3.55 4.33 0.94 1.83 2.67 3.47 4.21 0.93 1.81 2.62 3.39 4.10 0.93 1.78 2.58 3.31 3.99 0.92 1.76 2.53 3.24 3.89 0.91 1.74 2.49 3.17 3.79 0.90 1.71 2.44 3.10 3.70 0.89 1.69 2.40 3.04 3.60 0.88 1.67 2.36 2.97 3.52 0.88 1.65 2.32 2.91 3.43 0.87 1.63 2.28 2.85 3.35 0.86 1.61 2.25 2.80 3.27 0.85 1.59 2.21 2.74 3.20 6 7 8 9 10 5.60 6.47 7.33 8.16 8.98 5.42 6.23 7.02 7.79 8.53 5.24 6.00 6.73 7.44 8.11 5.08 5.79 6.46 7.11 7.72 4.92 5.58 6.21 6.80 7.36 4.77 5.39 5.97 6.52 7.02 4.62 5.21 5.75 6.25 6.71 4.49 5.03 5.53 6.00 6.42 4.36 4.87 5.33 5.76 6.14 4.23 4.71 5.15 5.54 5.89 4.11 4.56 4.97 5.33 5.65 4.00 4.42 4.80 5.13 5.43 3.89 4.29 4.64 4.95 5.22 3.78 4.16 4.49 4.77 5.02 3.68 4.04 4.34 4.61 4.83 11 12 13 14 15 9.79 9.25 8.76 8.31 10.58 9.95 9.39 8.86 11.35 10.63 9.99 9.39 12.11 11.30 10.56 9.90 12.85 11.94 11.12 10.38 7.89 8.38 8.85 9.29 9.71 7.50 7.94 8.36 8.75 9.11 7.14 7.54 7.90 8.24 8.56 6.81 7.16 7.49 7.79 8.06 6.50 6.81 7.10 7.37 7.61 6.21 6.49 6.75 6.98 7.19 5.94 6.19 6.42 6.63 6.81 5.69 5.92 6.12 6.30 6.46 5.45 5.66 5.84 6.00 6.14 5.23 5.42 5.58 5.72 5.85 16 17 18 19 20 13.58 14.29 14.99 15.68 16.35 12.56 13.17 13.75 14.32 14.88 11.65 12.17 12.66 13.13 13.59 10.84 11.27 11.69 12.09 12.46 10.11 9.45 10.48 9.76 10.83 10.06 11.16 10.34 11.47 10.59 8.85 9.12 9.37 9.60 9.82 8.31 8.54 8.76 8.95 9.13 7.82 8.02 8.20 8.36 8.51 7.38 7.55 7.70 7.84 7.96 6.97 7.12 7.25 7.37 7.47 6.60 6.73 6.84 6.94 7.02 6.27 6.37 6.47 6.55 6.62 21 22 23 24 25 17.01 17.66 18.29 18.91 19.52 15.42 15.94 16.44 16.94 17.41 14.03 14.45 14.86 15.25 15.62 12.82 13.16 13.49 13.80 14.09 11.76 12.04 12.30 12.55 12.78 10.02 10.20 10.37 10.53 10.68 9.29 9.44 9.58 9.71 9.82 8.65 8.77 8.88 8.99 9.08 8.08 8.18 8.27 8.35 8.42 7.56 7.65 7.72 7.78 7.84 7.10 7.17 7.23 7.28 7.33 6.69 6.74 6.79 6.84 6.87 17% 18% 20% 0.85 1.57 2.17 2.69 3.13 0.84 1.55 2.14 2.64 3.06 0.83 1.53 2.11 2.59 2.99 3.59 3.92 4.21 4.45 4.66 3.50 3.81 4.08 4.30 4.49 3.41 3.71 3.95 4.16 4.34 3.33 3.60 3.84 4.03 4.19 5.03 5.20 5.34 5.47 5.58 4.84 4.99 5.12 5.23 5.32 4.66 4.79 4.91 5.01 5.09 4.49 4.61 4.71 4.80 4.88 4.33 4.44 4.53 4.61 4.68 5.95 6.05 6.13 6.20 6.26 5.67 5.75 5.82 5.88 5.93 5.41 5.47 5.53 5.58 5.63 5.16 5.22 5.27 5.32 5.35 4.94 4.99 5.03 5.07 5.10 4.73 4.77 4.81 4.84 4.87 6.31 6.36 6.40 6.43 6.46 5.97 6.01 6.04 6.07 6.10 5.67 5.70 5.72 5.75 5.77 5.38 5.41 5.43 5.45 5.47 5.13 5.15 5.17 5.18 5.20 4.89 4.91 4.93 4.94 4.95 Page 114 19% Tables 10.84 11.06 11.27 11.47 11.65 16% TABLE II (CONTINUED ON PAGE 29) No. of Periods Received 2001 Uniform Final Examination Tables Page 115 TABLE III A FORMULA FOR CALCULATING THE PRESENT VALUE OF REDUCTIONS IN TAX PAYABLE DUE TO CAPITAL COST ALLOWANCE Investment Return Cost ( x Marginal Rate of Income tax Rate of Return + x ( )( Rate of Capital Cost x 1 +Rate Allowance of 2 Rate of Capital Cost Allowance x 1 + Rate of Return ) ) MAXIMUM CAPITAL COST ALLOWANCE RATES FOR SELECTED CLASSES Class 1................................................ 4% Class 3................................................ 5% Class 8................................................ 20% Class 9................................................ 25% Class 10.............................................. 30% Class 10.1........................................... 30% Class 12.............................................. 100% Class 13.............................................. original lease period plus one renewal period (Minimum 5 years and Maximum 40 years) Class 14.............................................. Length of life of property Class 17.............................................. 8% Class 39.............................................. 25% Class 43.............................................. 30% Class 44.............................................. 25% SELECTED PRESCRIBED AUTOMOBILE AMOUNTS Maximum depreciable cost - Class 10.1 Maximum monthly deductible lease cost Maximum monthly deductible interest cost $30,000 + GST $800 + GST $300 Operating cost benefit - employee 16 per kilometre of personal use Non-taxable car allowance benefit limits - first 5,000 km 41 per kilometre - balance 35 per kilometre (CONCLUDED ON PAGE 30) 2001 Uniform Final Examination Tables Page 116 TABLE IV INDIVIDUAL FEDERAL INCOME TAX RATES Income Tax Rate Schedule - Individuals Taxable Income Tax $30,754 or less $30,755 to $61,509 $61,510 to $100,000 $100,001 or more 17% $4,921 + 22% on next $30,754 $11,687 + 26% on next $38,490 $21,694 + 29% on remainder SELECTED NON-REFUNDABLE TAX CREDITS PERMITTED TO INDIVIDUALS FOR PURPOSES OF COMPUTING INCOME TAX The tax credits are 17% of the following amounts: Basic personal amount Married and equivalent to spouse amount Net income threshold for married or equivalent amount Age 65 or over in the year Disability amount 6,000 Disabled dependents who reach 18 in the year Net income threshold for disabled dependents 18 and over Basic amount for: Age credit, child tax benefit, and GST credit OAS clawback $7,412 6,294 629 3,619 3,500 4,845 26,941 55,309 CORPORATE FEDERAL INCOME TAX RATE The tax payable by a corporation under Part I of the Income Tax Act on its taxable income is 38% before any additions and/or any deductions. PRESCRIBED INTEREST RATES Year 2001 2000 1999 1998 1997 Jan. 1 - Mar. 31 8 7 7 6 6 Apr. 1 - June 30 July 1 - Sept. 30 8 8 7 7 5 7 8 7 7 6 Oct. 1 - Dec. 31 8 7 7 6 The rate is 2 percentage points higher for late or deficient income tax payments and unremitted withholdings. The rate is 2 percentage points lower for deemed interest on employee and shareholder loans. ***********