Question: What are the accounting issues and possible recommendations

It is May 7, 2020, and you, CPA, have recently started your new job as the Special Projects Accountant at Canadian Chemical Incorporated (CCI), reporting directly to the majority shareholder, Jamie Leung. You accepted the position as an opportunity to learn the manufacturing and wholesale industries. Your respect for Bob Chowdry, CPA, the companys controller, also helped you make the decision to leave your position with a public accounting firm.

CCI is 60% owned by Jamie, and has no debt or equity securities that are traded in a public market. The remaining 40% of the shares are held by friends, family members, and others involved in the agricultural and plastics industry. Jamie is actively involved in the operations of the company, so he is aware of how the company is doing, but doesnt always understand the financial statements. CCI has a December 31 year-end. Bob is too busy in his role as controller to explain everything to Jamie. Therefore, part of your responsibilities include helping Jamie understand the more complicated financial accounting and business issues facing CCI.

Jamie has built CCI into a fully-integrated, multimillion dollar company in the Chemical industry (Exhibit I). CCI produces and sells chemicals that are used as either additives and/or modifiers, an important component/ingredients in manufacturing finished goods such as preservatives, plastics, insect repellants, disinfectants and other every day household items.

CCI spends a great deal of time and money developing new products in its research division. There are many chemical engineers on the company payroll, including a few scientists who specialize in plastics and food additives. The divisions research is used solely for the benefit of CCI; so CCI can maintain control over the results of the research, the research division has no external customers. CCI also does not hesitate to make financial commitments to acquire new technologies as they arise. Overall, the industry is quite stable, and CCIs financial results have not fluctuated much in the past few years, nor are they expected to fluctuate much in the near future. CCI is partially financed through bank loans; as part of the loan agreement, the bank requires financial statements be prepared in accordance with accounting standards for private enterprises (ASPE).

Although there has never been any trouble, Jamie is aware that the research done by the engineers and scientists in the research division is riskier than other activities performed by the company, and could create legal problems. He wants a way to minimize the risk, and Bob has suggested transferring all the assets of the research division to a newly-created subsidiary that would be called ABC Ltd. (ABC). Bob explained that, if the research and development activities result in a lawsuit, CCI will not lose anything. He also explained that the transfer could be done without incurring any tax. After the transfer, all staff members in the research division would become employees of ABC. ABC would be financed through loans from CCI (Exhibit II).

Jamie would like your opinion on Bobs proposal

EXHIBIT I

STATEMENTS OF EARNINGS AND RETAINED EARNINGS

FOR THE YEAR ENDED DECEMBER 31, 2019 2019 ($000s) (Unaudited)
Revenue
Sales	68,550
Interest income	15
	68,565
Cost of sales	59,655
Gross profit	8,910
Expenses
Amortization property and equipment	1,000
Amortization deferred development costs	500
Office and administration	2,600
Professional fees	100
Research	1,500
Selling expenses	400
	6,100
Earnings before other income and taxes	2,810
Other income
Foreign exchange gain/(loss)	15
Write-down of inventory	(5)
Earnings before income tax	2,820
Income tax	831
Net earnings	1,989
Retained earnings, beginning of year	6,320
Dividends	-
Retained earnings, end of year	8,309

EXHIBIT II

NEW ABC CORPORATION

CCI amortizes its capital assets, using the declining method. In 2019, amortization expense pertaining to the research division was $542,000. The assets and declining rates of the research division consist of the following:

	Cost	NBV	FMV
Land	$2,000,000	N/A	$14,000,000
Building (4%)	3,000,000	$2,000,000	4,000,000
Research equipment (30%)	5,000,000	1,400,000	2,000,000

Bobs plan is to transfer the land, building, and research equipment to the new subsidiary, ABC. Although Jamie is particularly interested in learning how these assets can be transferred to ABC from an accounting and tax perspective, it is outside the scope of the special project. Bob wants you to seek tax advise at a later date.

Since the operations of ABC will be financed by loans from CCI, interest will be paid on these loans at 8% per annum to compensate CCI for the use of its funds. It has been previously determined that the development expenses of the research division meet the criteria for deferral, as set out in ASPE.