[SOLVED] Digital Future Technologies (DFT) is a public

Digital Future Technologies (DFT) is a public technology company. It has a September 30 year-end, and last year it adopted IFRS. Kin Lo is a partner with Hi & Lo, the accounting firm that was newly appointed as DFT's auditor in July for the year ending September 30, Year 12. Kin met with the CFO, Anne Rather, to gather information on the business. It is now September 12, Year 12. You, CPA, work for Hi & Lo. Last week, Kin provided you with the notes that he took in his initial meeting with Anne (Exhibit IV). You met with Anne a couple of days ago to find out what has happened at DFT since Kin's meeting, and have summarized your discussion in Exhibit V. Anne gave you updated projected results for September 30, Year 12 (Exhibit VI). Kin asks you to prepare a memo summarizing the accounting issues of significance. He is particularly concerned about issues that affect earnings because management is anticipating a more profitable year than previous years. Management is now part of a new bonus program that is based on earnings before interest, income taxes, depreciation, and amortization (EBITDA). The bonus begins to accumulate once EBITDA exceeds $14 million. Exhibit IV:

Exhibit V:

Exhibit VI:

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Knowledge of the Business DFT manufactures electronic components for telephone and cable in both the wired and wireless markets. While quarterly sales can be quite variable due to inconsistent demand, the company has grown significantly over the past few years. It must constantly reinvest in research and development to ensure that its products remain rele- vant and can integrate with the latest technology. A new growth market in the industry is the development of equipment that can convert transmissions from analog to digital signals. The equipment allows companies to maximize their transmissions through the band- width of existing infrastructure. DFT is anticipating completion of Zeus, a new product that is targeted to this growth market and is expected to be the first of its kind on the market, by mid-August, Year 12. A new bonus program was instituted at the beginning of fiscal Year 12 with the objective of motivating man- agement to contribute to profitability by being innovative and developing new products. (continued) Revenue Recognition • Product. Most revenue relates to product sales. Revenue is recognized once the products are shipped, assum- ing collection is reasonably assured. DFT targets an average margin of 40%. • Service. DFT also has non-recurring engineering (NRE) revenue, which it expects to be $1.5 million by year- end. Customers pay DFT to research and develop add-on components for existing DFT products. In most cases, DFT is not required to do anything beyond the initial engineering phase. NRE revenue is therefore rec- ognized as soon as the work for the specific component is complete. DFT targets a margin of 60%. A number of events have occurred since July that gave rise to revisions to the projected results for the year end- ing September 30, Year 12. Indo-Tech DFT had been negotiating since early in Year 12 with Indo-Tech (Indo), a major customer based in India. The deal described below was signed. DFT and Indo have contracted with Safe Storage, an unrelated third-party warehouse in India. Indo provided DFT with its forecasted production needs by component and the dates the components are required to be at the warehouse. DFT must ensure that the components arrive at the warehouse in time. Inventory stored at the ware- house is owned by DFT. Safe Storage must notify DFT when Indo takes components from the warehouse, and ownership of the inventory transfers to Indo once it is taken. At no time shall inventory remain in the warehouse for more than 60 days. Any inventory not taken within 60 days of arrival is considered sold to Indo and shall be segregated for removal by Indo as soon as possible. A minimum of $1.5 million in components inventory had to be at the warehouse by June 30, but nothing was taken by Indo from the warehouse until August 2. DFT could only recognize the $1.5 million in revenue at that time. Because DFT had not included the sale in the projection done on July 8, the sale was picked up in the revised projection. Since August 2, DFT has sold another $1.85 million in components and shipped them to the warehouse. Based on Indo's forecasted needs, DFT will not be shipping any more components prior to year-end. Indo has not taken out any of the $1.85 million in inventory that is in the warehouse, but DFT is confident it will do so and has recorded the revenue. Non-Recurring Engineering (NRE) Contract DFT has booked a total of $2.5 million in NRE revenue. The amount exceeds expectations because DFT had additional NRE revenue in July that was worth $1 million. The customer only accepted our normal price on the NRE portion because DFT agreed to provide a discount in fiscal Year 13 of $225,000 on product sales with a usual selling price of $750,000. Of the total contract, the $1 million NRE revenue portion was recorded in the current year's projection as the work was completed before the September 15, Year 12 deadline. Zeus Due in part to the focus on the above NRE project, as well as unanticipated technical difficulties, development of the new product, Zeus, was delayed. DFT will likely only realize total sales of $200,000 for Zeus by year-end. It will also likely have $400,000 of units in inventory at year-end. However, production has just begun. Also, due to the delay, a competitor was able to place a similar product on the market first. As a result, DFT isn't sure it can sell Zeus at the planned price. Research and Development DFT defers and amortizes eligible development costs. Deferral ceases once a product is ready for market, and the costs are amortized over the estimated life of the product, generally three years or less. DFT successfully (continued) pursued government funding for research and development. The funds received from the grants, totaling $800,000, were not anticipated in the July projection, and have now been included in revenue. Approximately 75% of the related development costs remain in deferred development costs. DFT has now abandoned development of one of its products, Ares, which still had approximately $450,000 in deferred development costs. However, DFT's R&D manager believes that the development can be leveraged for a new product, Hades, so it continues to defer the development costs. Business Acquisition Crolla purchased 70% of the outstanding common shares of Dao on August 31, Year 12, at a cost of $5,600,000. On that date, Dao had common shares of $1,000,000 and retained earnings of $4,000,000, and fair values were equal to carrying amounts for all its recognized net assets. In determining the purchase price, the management of Crolla noted that Dao had a five-year agreement to supply goods to Customer Co. Both Crolla and Dao believe that Customer will renew the agreement at the end of the current contract. Neither party to the agreement can transfer, assign or sell their rights or obligation under the agreement to any other party. Management of Crolla would prefer to assign any acquisition differen- tial on the acquisition of Crolla to goodwill for three reasons: the agreement between Dao and Customer is not separable; it would be impracticable to determine the fair value of the agreement; and there would be no annual amortization expense if the entire acquisition differential is assigned to goodwill. Other A HST audit was finally completed in late August Year 12. It resulted in a reassessment of $125,000. DFT paid the amount immediately to prevent incurring any penalties, but has recorded it as a prepaid expense. It is appealing the reassessment, based on the belief that it is incorrect. DFT has incurred an impairment loss of $100,000 on production equipment that is becoming obsolete. The impairment loss has been included in amortization of capital assets. Based on the revised projection for September, Anne believes that everyone in the program will receive a bonus. Therefore, she will accrue an estimate of $300,000 before year-end and needs to adjust the projection. PROJECTED NET INCOME FOR THE YEAR ENDING SEPTEMBER 30, YEAR 12 (in thousands of Canadian dollars) Sept. 30, Year 12 Original Projection Sept. 30, Year 12 DFT Adjusted Projection (prepared on July 8, Year 12) (prepared on Note Sept. 1O, Year 12) Note Adjustments Revenue $55,374 1 $3,850 $59,224 Cost of sales 31,942 23,432 2 1,930 33,872 25,352 Gross margin 1,920 Operating expenses: Research and development 3,991 3 3,991 Sales and marketing 2,622 2,622 General and administrative 7,824 100 6 7,924 Interest 314 14,751 8,681 314 Total operating expenses 100 14,851 Income before taxes 1,820 10,501 546 $1,274 Income taxes (30%) 2,604 $ 6,077 7 3,150 $7,351 Net income EBITDA (for bonus calculation) to be determined. Notes (also in thousands of Canadian dollars): (continued) Initial Projection Notes (as of July 8) 1. Revenue includes anticipated sales of $1,500 for the new Zeus product. The related costs are reflected in cost of sales. 2. Cost of sales includes cost of Zeus product and projected amortization of $430 for production-related assets. 3. Research and development expenses include projected amortization of $1,620 related to deferred develop- ment costs. 4. General and administrative expenses include projected amortization of $2,995 related to capital assets. Revisions to Projection (as of September 10) 5. Revenue and cost of sales • For Indo, sales have been increased by $3,350 ($1,500 + $1,850), and cost of sales has been increased by $2,010 ($900 + $1,110) (based on 40% gross margin). For new NRE revenue, sales have been increased by $1,000, and cost of sales has been increased by $400 (based on 60% gross margin). Nothing was booked for the product sales since they only occur in Year 13. • Government grants of $800 were recorded in revenue. For Zeus, sales have been decreased by $1,300 and cost of sales has been decreased by $480 (based on 40% gross margin) due to lower than projected sales. 6. Impairment loss related to production equipment is $100. 7. Tax provision has been adjusted by $546.

Question: Digital Future Technologies (DFT) is a public

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