Munich IT Solutions (MITS) is a fast-growing, medium-sized business that primarily provides integrated server solu- tions that manage the storage, organization, and retrieval of information. MITS provides IT solutions by offering both server hardware and database management softwarc. MITS's CEO, CFO, and COO are compensated based on a 10% bonus of pretax net income if revenues exceed $4 million. The net income and revenue measures are based on the financial statements prepared in accordance with IFRS. The board of directors implemented such a bonus structure in order to help align the goals of top management and shareholders, and also ensure that executives do not cut discretionary spending in order to reach a net income bonus threshold. MITS's top management team is excited about the current year's results because the draft financial statements reveal revenues in excess of the $4-million threshold and a bonus of $156,390 will be payable. The draft financial statements are to be reviewed by the Internal audit department, in anticipation of the external auditor's field work next week. You have just been hired as an internal auditor, reporting directly to the internal audit manager. The manager has called you into her office to discuss your first engagement: MANAGER: "Welcome to the team. We are very happy that you decided to accept our offer of employment." You: "Thank you. I am very excited to be here, and look forward to being a part of the team." MANAGER: "Excellent. Well, your first engagement is a very important task. I would like you to review our draft income statement prior to the external audit next week. Specifically, I would like to you focus on the revenue line item. Please prepare a report that outlines any concerns that you have, and addresses any accounting issues." You: "Okay, sounds interesting. How can I start?" MANAGER: "Well, here is a copy of the draft income statement (Exhibit 1). In addition, I have prepared the follow- ing notes of the current year's operations for your review (Exhibit ID). This should be enough to get you started on your report. We can meet again once you have prepared your report." You: "Sounds good. I'll get started right away." Required Prepare the report. A Draft Income Statement For the year ended December 31 (unaudited) Sales Mainframe server sales Small business solution sales $2,200,000 2,625,000 54,825,000 Cost of sales Mainframe server Small business solutions 1,200,000 1,350,000 2,550,000 $2,275,000 Gross profit Expenses Advertising and promotion Amortization Insurance Interest Legal and accounting Lease expense Office and general expenses Repairs and maintenance Utilities Wages and benefits $ 187,950 98,000 16,540 19,560 8,900 44,500 25,000 17,000 34,000 272,000 723,450 Operating Income Other service Income Income before taxes and bonus Bonus (10%) Income before taxes Current taxes (30%) Net Income $1,551,550 12,350 1,563,900 156,390 1,407,510 422,253 $ 985,257 Whili Information Regarding the Current Year's Operations 1. Mainframe Servers: MITS sells large mainframe servers for 3350,000. The cost of the server is $300,000. MITS delivers and installs the server at the customer's site. The customer signs off on an acceptance form once the server is instalad and tested. MITS has never had a customer reject the installation of a mainframe server. In order to help promote sales, MITS began to offer a two- year warranty with all mainframe servers. The warranty is expected to cost an average of $45,000 per server to service the warranty over the two-year period. Industry competitors that offer similar warranties set the warranty price as two times expected cost. MITS has received orders for four mainframe servers dur- ing the current year, of which all four have been delivered and instaled and three have been accepted by the customer. During the current year, the periods of the warranties for the servers covered by MITS totaled 13 months. 2. Small Business Solutions: MITS's typical small business solution customer is a growing business without a designated information technology department that purchases server hardware, MITS sells a small business solution of $175,000, with payment in advance to allow MITS to order the servers. The small business servers cost $90,000 Included with the purchase of server is one year of database management services. If a customer does not want the database management services, MITS provides a discount of $25,000 from the mainframe purchase price. All customers wanted the services in the current fiscal year and MITS provided a total of 47 months of DMS services as a result of these sales. 3. Database Management Services (DMS) "TS recently began marketing its DMS on a stand-ali basis for $3,500 per month, which is consistent with coritor prices. As of year end, the company has not received orders for only DMS, however, management expects orders to begin to pick up shortly. 4. The gross margin percentage on the small business server and mainframe server is expected to be the same. 5. Small business solutions server revenue is recorded when the cash is received Munich IT Solutions (MITS) is a fast-growing, medium-sized business that primarily provides integrated server solu- tions that manage the storage, organization, and retrieval of information. MITS provides IT solutions by offering both server hardware and database management softwarc. MITS's CEO, CFO, and COO are compensated based on a 10% bonus of pretax net income if revenues exceed $4 million. The net income and revenue measures are based on the financial statements prepared in accordance with IFRS. The board of directors implemented such a bonus structure in order to help align the goals of top management and shareholders, and also ensure that executives do not cut discretionary spending in order to reach a net income bonus threshold. MITS's top management team is excited about the current year's results because the draft financial statements reveal revenues in excess of the $4-million threshold and a bonus of $156,390 will be payable. The draft financial statements are to be reviewed by the Internal audit department, in anticipation of the external auditor's field work next week. You have just been hired as an internal auditor, reporting directly to the internal audit manager. The manager has called you into her office to discuss your first engagement: MANAGER: "Welcome to the team. We are very happy that you decided to accept our offer of employment." You: "Thank you. I am very excited to be here, and look forward to being a part of the team." MANAGER: "Excellent. Well, your first engagement is a very important task. I would like you to review our draft income statement prior to the external audit next week. Specifically, I would like to you focus on the revenue line item. Please prepare a report that outlines any concerns that you have, and addresses any accounting issues." You: "Okay, sounds interesting. How can I start?" MANAGER: "Well, here is a copy of the draft income statement (Exhibit 1). In addition, I have prepared the follow- ing notes of the current year's operations for your review (Exhibit ID). This should be enough to get you started on your report. We can meet again once you have prepared your report." You: "Sounds good. I'll get started right away." Required Prepare the report. A Draft Income Statement For the year ended December 31 (unaudited) Sales Mainframe server sales Small business solution sales $2,200,000 2,625,000 54,825,000 Cost of sales Mainframe server Small business solutions 1,200,000 1,350,000 2,550,000 $2,275,000 Gross profit Expenses Advertising and promotion Amortization Insurance Interest Legal and accounting Lease expense Office and general expenses Repairs and maintenance Utilities Wages and benefits $ 187,950 98,000 16,540 19,560 8,900 44,500 25,000 17,000 34,000 272,000 723,450 Operating Income Other service Income Income before taxes and bonus Bonus (10%) Income before taxes Current taxes (30%) Net Income $1,551,550 12,350 1,563,900 156,390 1,407,510 422,253 $ 985,257 Whili Information Regarding the Current Year's Operations 1. Mainframe Servers: MITS sells large mainframe servers for 3350,000. The cost of the server is $300,000. MITS delivers and installs the server at the customer's site. The customer signs off on an acceptance form once the server is instalad and tested. MITS has never had a customer reject the installation of a mainframe server. In order to help promote sales, MITS began to offer a two- year warranty with all mainframe servers. The warranty is expected to cost an average of $45,000 per server to service the warranty over the two-year period. Industry competitors that offer similar warranties set the warranty price as two times expected cost. MITS has received orders for four mainframe servers dur- ing the current year, of which all four have been delivered and instaled and three have been accepted by the customer. During the current year, the periods of the warranties for the servers covered by MITS totaled 13 months. 2. Small Business Solutions: MITS's typical small business solution customer is a growing business without a designated information technology department that purchases server hardware, MITS sells a small business solution of $175,000, with payment in advance to allow MITS to order the servers. The small business servers cost $90,000 Included with the purchase of server is one year of database management services. If a customer does not want the database management services, MITS provides a discount of $25,000 from the mainframe purchase price. All customers wanted the services in the current fiscal year and MITS provided a total of 47 months of DMS services as a result of these sales. 3. Database Management Services (DMS) "TS recently began marketing its DMS on a stand-ali basis for $3,500 per month, which is consistent with coritor prices. As of year end, the company has not received orders for only DMS, however, management expects orders to begin to pick up shortly. 4. The gross margin percentage on the small business server and mainframe server is expected to be the same. 5. Small business solutions server revenue is recorded when the cash is received