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KIBBLE INC. (Suggested Time: 120 minutes)

You, CPA, recently started work as a senior auditor in the internal audit department of Smart Pet Inc. (SP). SP is a small public company that operates veterinary clinics across Canada and sells pet health insurance. You are really excited to be a part of these operations. Secretly, you always wanted to be a vet and this was the closest you could get without going back to university.

It is now February 1, 2021 and your boss just called you into her office to discuss an issue passed along to her by the company’s President. The President received a written complaint from a SP manager (Appendix I) in early December. Your boss wants you to investigate the complaint to see if there are any accounting implications that need to be addressed. She also wants to know what additional work will need to be performed by the external auditors as a result of the issues raised.

Effective January 1, 2020, SP acquired 100 percent of the shares of Kibble Inc. (KI). KI specializes in the production of low calorie and organic foods for dogs. SP has announced plans to expand KI’s product offerings in mid-2021 to include specialty cat foods. As a result of the employee complaint, the President is now concerned that the current reporting from KI is not presenting an accurate report of its operations and your boss wants to know if you agree. The managerial bonus structure of SP is mainly based on the financial performance of SP on a stand- alone basis and the President wants to make sure everyone is being rewarded fairly.

The external auditors arrived last week to complete the year-end audit procedures for the consolidated SP financial statements. They reviewed KI’s new information technology system when the interim audit procedures were performed in November as it was a new system with a material impact on SP. Although they were generally satisfied with the controls in place, the auditors have indicated that they will be raising some issues in their management letter. Your boss needs you to review the notes she made on the new system to identify possible weaknesses. She wants to make sure that SP can state that the auditors’ concerns have been dealt with when the management letter is issued.

You began by obtaining statements of income for both companies (Appendices II and III). You also gathered information regarding KI’s operations (Appendix IV) and notes on KI’s new information technology system (Appendix V).

The information technology department of SP incurred costs of $75,000 to build an information system for KI. It is expected that this system will support KI’s business activities for the next five years. The system was implemented on April 1, 2020. The costs have been capitalized in SP and no costs have been allocated to KI.

Several SP executives travel to KI’s head office on a regular basis. These travel costs are tracked separately by the SP accounting system but are not charged directly to KI. Instead, they become part of an overall overhead cost allocation to KI. The actual travel costs incurred by the SP executives related to KI during 2020 totaled $14,500 but only 15% of these expenses were actually allocated to KI based on the overhead formula.

The SP Controller noted that Josh Burton was hired to provide SP with improved oversight of KI, the benefits of which would eventually accrue to SP through dividends. The Controller also indicated that SP intends to market the new KI information system to other pet food manufacturers. SP expects to recover the development costs relating to the information system from future license fees.

To date, KI has incurred approximately $100,000 in costs to develop specialty cat food products. These costs have been capitalized but no amortization has been taken to date as commercial production of the products has not yet started. These products are still awaiting approval from Health Canada but the chief scientist on the project expects such approval to be forthcoming relatively soon. There have been concerns about tainted pet food from China so the approval process is taking longer than normal.

Included in the capitalized amount are $50,000 of materials and molds used to manufacture prototype foods and $10,000 in salaries and benefits for the staff working directly on the project. Initial development efforts ran into a problem when the products kept breaking apart. A $20,000 patent and a $5,000 piece of specialty equipment had to be purchased so that a special binding process could be used on the products. The patent will expire in five years and the equipment will also be technologically obsolete at that point. The binding process and new equipment solved the production problem. There was also an allocation of $15,000 of the KI Vice President of Marketing’s salary as an overhead allocation. He noted that since the specialty cat food products were his idea, a portion of his salary should be attached to the project.

The KI Vice President of Marketing noted that other companies already have high-end cat foods on the market. Results to date for those products have been mixed but his instincts tell him that KI’s low calorie and organic products will appeal to cat owners. No market study has been completed because the Vice President is sure that KI’s specialty cat food products will be as popular as its dog specialty products.

The SP Controller mentioned that SP is not prepared to show a loss from KI in 2020 or from the planned expansion into specialty cat foods in 2021. Several staff confided to you that there have been rumblings that the SP Vice President responsible for the purchase of KI will be fired if the acquisition is not profitable. Some SP managers receive a bonus based on a number of criteria. One of those criteria is SP stand-alone pre-tax profitability.

You have gathered a copy of Josh Burton’s employment contract and listings of costs incurred to develop the system for KI and the executive travel costs. You have confirmed that amounts and details in the complaint are accurate. You also determined that there are no pending agreements to license the KI software to other companies.

You contacted the manager assigned to the financial statement audit. You were advised that materiality for the SP audit is based on standard auditing guidelines.

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