Munich IT Solutions (MITS) is a fast-growing, medium-sized business that primarily provides integrated server solutions that manage the storage, organization, and retrieval of information. MITS provides IT solutions by offering both server hardware and database management software.

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 construct 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 I). In addition, I have prepared the following notes of the current year's operations for your review (Exhibit II). 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."
Exhibit I
Draft Income Statement
For the year ended December 31 (unaudited)

Sales  
 Mainframe server sales $2,200,000
 Small business solution sales   2,625,000
$ 4,825,000
Cost of sales  
 Mainframe server 1,200,000
 Small business solutions  1,350,000
 2,550,000
Gross profit  $ 2,275,000
Expenses  
 Advertising and promotion  $   187,950
 Amortization  98,000
 Insurance  16,540
 Interest  19,560
 Legal and accounting  8,900
 Lease expense  44,500
 Office and general expenses  25,000
 Repairs and maintenance  17,000
 Utilities  34,000
 Wages and benefits     272,000
723,450
Operating income  $   1,551,550
Other service income          12,350
Income before taxes and bonus  1,563,900
 Bonus (10%)     156,390
Income before taxes  1,407,510
Current taxes (30%)     422,253
Net income  $    985,257
Exhibit II
Information Regarding the Current Year's Operations
Mainframe Servers: MITS sells large mainframe servers for $550,000. 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 instaled 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 during 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.

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 a 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.

Database Management Services (DMS): MITS recently began marketing its DMS on a stand-alone basis for $3,500 per month, which is consistent with competitor prices. As of year end, the company has not received any orders for only DMS; however, management expects orders to begin to pick up shortly.
The gross margin percentage on the small business server and mainframe server is expected to be the same.
Small business solutions server revenue is recorded when the cash is received.
 

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