Intermediate accounting 1

Question 3 Case

Isaac Technologies Corp. (ITC) is an engineering services company based in Winnipeg. The companys Class B common shares are listed on the Toronto Stock Exchange. The Class A common shares are all owned by Joshua Isaac, the company founder, and his immediate family. The Class A shares are multiple voting shares that enable the Isaac family to retain voting control over the company. Each Class A share contains a super vote, which is equivalent to 100 votes (i.e. a common shareholder would need to own 100 shares to have the equivalent number of votes).

The companys shares have risen sharply in price over the past two years, driven mainly by the strength of the Canadian economy and the need for engineering services by the many resource and exploration companies in the prairies. Stock analysts have been very enthusiastic about ITC shares and analysts have issued very favorable earnings forecasts for ITCs 2018 year-end results.

In 2018, ITC entered into special long-term contracts with two of its largest clients. The companys accounting staff recorded the transactions as directed by the ITC chief financial officer. The two transactions were as follows:

1. ITC entered into a three-year contract with Howard Ltd. to provide engineering services. The services would be rendered on an as-needed basis over the three years. The contract stated that Howard would pay $3 million to ITC during 2018, $2 million during 2019, and $1.6 million during 2020. Howard paid for the first years service as agreed. ITC recorded the payment as revenue for 2018. The cost of services rendered by ITC to Howard is not separately tracked but is part of the regular service provided by ITC to many clients.

2. ITC and Parker Inc. signed an agreement on August 15, 2018. As one part of the agreement, ITC designed and built a special-purpose piece of equipment for Parker. Parker did not solicit bids from other manufacturers due to the close working relationship that has been established between Parker and ITC over the years, even though similar equipment might have been obtained for about 20% less from a heavy equipment manufacturer in Japan. The agreement provided that Parker would pay $5.6 million for the equipment. The equipment was delivered to Parker on 22 December 2018. Parker paid 40% of the purchase price on 30 December, with a promise to pay the remaining 60% within the first 90 days of 2019. The equipment cost ITC $3.4 million to construct. The agreement provided that Parker could not sell or otherwise convey the equipment to any other user.

In addition to the equipment sale, the agreement stipulated that Parker would pay $1.5 million per year for the next four years as a service contract with the first payment due within 120 days of delivery. The price is about 25% less than ITC would normally charge a client for that type of service.

ITC recorded revenue of $5.6 million for the equipment and included $3.4 million in the cost of services. The company also recorded the first years service revenue by crediting $1.5 million to revenue and debiting accounts receivablelong-term. This revenue was matched by charging $1.0 million to cost of services (for the estimated cost of providing the service) and crediting an equal amount to estimated service liability.

It now is January 2019. You are working for the audit firm of Ngo and Macfarlane LLP on the annual audit of ITC. The audit manager is preparing to meet with the ITC CFO tomorrow morning. She has asked you to prepare a memorandum in which you set out your views on the accounting used by ITC for these two contracts, with a recommendation on whether or not to accept ITC accounting, and any alternatives that you propose.

Required:

Prepare the memorandum for your audit manager.