It’s Close Enough, Inc.
Jack Hunts, an audit manager, is considered a star performer. Jack has earned his stellar reputation by quickly completing numerous audits of complex clients. In connection with the year-end audit of It’s Close Enough Inc. (ICE or the “Company”), a fast-growing, high-tech entity planning an initial public offering in the next year, Jack has prepared the attached memorandum of significant financial statement issues that he identified and resolved during fieldwork. Amy Heinz, audit partner, is currently reviewing Jack’s memorandum of significant financial statement issues.
It’s Close Enough Inc. Prepared by: J. Hunts
Software Development Costs
ICE has engaged in significant software development activity during the past year to upgrade its internal back-office systems. The client accounts for costs incurred under AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use (SOP 98-1). Numerous costs incurred in the preliminary stage of each project were capitalized despite the requirement in SOP 98-1 that such costs be expensed as incurred. According to “Fast” Eddie, the controller, the client recognized that these costs should be expensed immediately in accordance with SOP 98-1. Accordingly, the client identified all such capitalized costs and fully wrote off these amounts as depreciation expense in the quarter in which the costs were incurred. On the basis of the above, the balance sheet or net income was not affected in any quarter.
Grant of Warrants to New Customer
During the fourth quarter, to encourage sales and build the customer relationship, ICE issued fully vested, nonforfeitable warrants on its own stock to a new customer. ICE simultaneously signed a binding supply agreement requiring the customer to purchase a specified quantity of goods annually for the next five years at a fixed price. Since the warrants are characterized as fully vested and nonforfeitable, ICE has expensed the fair value of the warrants as a customer acquisition cost.
Exchange of Inventory for Barter Credits
ICE conducted a strategic review of its business lines during the fourth quarter. In connection with this review, ICE decided to exit the printer cartridge business. While “Fast” Eddie stated that ICE believes this business has the potential for high growth, management has decided to focus on certain other core competencies. Upon announcement of this decision, management was approached by a third-party broker, Good as Gold, which specializes in structuring transactions in which companies are able to exchange excess merchandise for much-needed goods and services. Good as Gold informed ICE that it was aware of a company that was building its printer cartridge business and was willing to pay Good as Gold $14 million for the cartridges.
ICE decided to accept an offer in which Good as Gold would pay ICE $14 million for its printer cartridge inventory. Payment was received by ICE in the form of $14 million of service credits, redeemable by ICE for a variety of services performed by other clients of Good as Gold, such as office cleaning and waste disposal. While ICE received service credits in an amount in excess of the $10 million book value of its printer cartridge inventory, to be conservative, ICE did not record a gain upon consummation of the exchange. The service credits have been recorded as an asset in the amount of $10 million. We audited the value the Company assigned to the service credits, and determined that the services for which the credits can be redeemed have a value of more than $10 million. Accordingly, the transaction appears to have been accounted for appropriately.
Inventory Reserve Adjustments
During the first quarter, ICE recorded an additional inventory reserve of $24 million. The additional reserve was recorded in response to the downturn in ICE’s business. At the time, management believed certain inventories would be sold at an amount substantially below cost. During the fourth quarter, ICE’s business improved substantially. The previously reserved inventory is selling rapidly. About half of the previously reserved inventory has already been sold, and the other half is expected to be sold by the end of the first quarter of the following year. Half of the reserve recorded in the first quarter ($12 million), therefore, was reversed as the related inventory was sold, and the other half of the reserve was released at year-end, because of the revised expectation that the remaining inventory will be sold at a price above cost within the next three months. On the basis of our analysis of sales orders received after year-end, it appears reasonable that all of the remaining inventory will be sold above cost; accordingly, reversal of the reserve appears appropriate.
In connection with our audit of ICE’s investment portfolio, we selected the company’s 10,000 share investment in Company X (X), a publicly traded entity, for detailed testing. ICE acquired its investment in X during October of the prior year at a cost of $20 per share, or $200,000. We obtained evidence that the security is appropriately classified by ICE as available-for-sale. At the end of the previous year, the investment in X had a market value of $160,000; the $40,000 decline was reported as a component of other comprehensive income. Our review of the current year’s market activity report revealed that the security traded between $14 and $16 throughout the year, with a December 31 market value of $15 per share, or $150,000 in total. The client has appropriately recorded the incremental decline of $10,000 as a component of other comprehensive income in the current year.
Modifications to Terms of Sale
To incentivize customers to purchase certain new product lines, ICE has modified certain of its normal sales terms. Historically, ICE has allowed a return period of 30 days. The return period has been extended to 90 days. In addition, ICE has informed its retail customers that it will “price protect” the new product lines, such that any discounts provided by the retailer to the end consumer will be reimbursed. ICE has based estimates of its returns on extensive market research studies, and has reduced sales by these estimated return amounts. In addition, consistent with industry practice, ICE has accrued a liability for all amounts that are expected to be paid out under the price-protection guarantee. We audited both the sales return and price-protection estimates and concluded that the amounts appear reasonable. We also noted that ICE has disclosed the revised sales terms in its financial statements.
You are required only to do a top ten based on your current knowledge of generally accepted accounting principles. You do not have to identify the correct treatment of the item per GAAP, just what you think the proper treatment would be. Address all six issues in your top ten.