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CEM (90 minutes)

Avalanche Construction Company (ACC) is a small company listed on the Toronto Stock Exchange(use
IFRS) (TSX) that distributes a line of lightweight equipment directly to customers in the construction
industry. ACC has been in business for over 20 years and during that time has experienced consistent
growth through expanding its product offerings. ACC sells to customers across Canada from its single
facility in Ancaster, Ontario.

On November 1, 2011, ACC acquired Custom Equipment Manufacturing (CEM), a private company that
manufactures custom-designed heavy equipment (cranes, mining equipment, etc.). This is a significant
acquisition for ACC that effectively doubles both its revenue and asset base.

It is now mid-November and you, the audit senior on the ACC account, have been asked by the
engagement partner to attend a meeting she is having with ACC’s chief executive officer (CEO), Jack
Lowell. The purpose of the meeting is to discuss the implications the acquisition of CEM will have on
ACC and its operations, and to consider the impact on your year-end audit work.

During the meeting, Jack admitted that he knew he was taking a risk when ACC acquired CEM, as there
was not sufficient time for a due diligence review to be performed. At the time, there were rumours of
competitive bids and ACC was eager to acquire CEM. Jack also confessed that he anticipates the
integration of the CEM operations into ACC will be a bit rough. Although both businesses operate in the
construction industry, custom heavy equipment manufacturing is very different from ACC’s distribution
business. Jack admitted that he finds some of CEM’s contracts difficult to understand.
(should inform should implement at least some changes, which are necessary, too late to perform due
diligence review )

Further, he finds the corporate culture in CEM to be very casual and entrepreneurial, a stark contrast to
ACC’s philosophy of strong leadership and policy-oriented tone from the top. Jack also indicated that
ACC’s Board of Directors shares his view. In addition to the December 31, 2011 year-end audit, the
Board agreed to engage your firm to immediately prepare a preliminary assessment of CEM’s control
environment (control environment)and to make recommendations (need to look at it as a whole) or
improvement. Your detailed notes from the meeting are in Exhibit I.

Upon your return to the office, the partner suggests that you set up a meeting with CEM’s chief financial
officer. A couple of days later you meet with the chief financial officer to gain a better understanding of
CEM’s business. It is obvious from the start that the chief financial officer’s approach to business is very
different from what you are used to in ACC. When you attempt to discuss details regarding the contract
processes and how CEM records its more complex contracts, he gives you a brief overview but then
quickly points to CEM’s strong earnings. He states, “At CEM, we worry about the bottom line. How we
get there is less important. That’s why ACC was so keen to acquire us. They know we make money…
period.” Your detailed notes from the meeting are in Exhibit II.

The next day, you meet with the partner and give her a summary of your conversation with CEM’s chief
financial officer. In light of some of the comments, she asks that, in addition to responding to Jack’s
request on CEM’s control environment, you provide her with an audit planning memo. She asks that the
memo clearly identify the general audit planning considerations and discuss the related audit strategy for
the areas of significant risk for the consolidated ACC. She also asks you to discuss any related accounting
issues. You pull out the 2010 audit planning notes as reference (Exhibit IV) and begin your work.

ACC and CEM are generally managed independently, and there are different information and accounting
systems in both companies. Jack is leaning towards integrating the management of the two companies in
the future but, for the rest of 2011 and 2012, they would continue to operate independently.
(how does this going to impact the audit – consolidate the F/S, for month after purchase)

ACC is a public company with a strong management team that supports an effective control environment.
For example, during 2009, ACC established a Code of Conduct. Employees took a one-time training
course and an on-line test of their knowledge of the Code. Ninety percent of employees scored over 80%
on the test and those that did not had to re-take the test until they achieved 80%. Since then, employees
have been required to sign an annual declaration that they have re-read the Code and understand it. A
similar process was used to implement the Code at CEM. However, only 50% of the employees took the
on-line test and, of those, less than 40% achieved the 80% requirement. Many employees didn’t bother to
take the required re-test.
ACC has very strong hiring practices, including background checks of potential new hires, multiple
interviews, and reference checks. Since CEM did not have similar practices, the ACC hiring process was
implemented at CEM. However, existing employees of CEM were not put through these checks.

CEM implemented ACC’s established whistleblower program. However, CEM’s chief financial officer
says it is still too early to assess its effectiveness as he has yet to receive a call.

ACC’s performance incentives are determined based upon a combination of revenue, profitability, and
human resource and market penetration measures. Incentives have never been more than 10% of total
compensation for an individual. At CEM, performance incentives are based on the full value of each
contract in the year the contract is signed. Further, there is no cap on incentives. In some cases, the
incentive has been almost 50% of total compensation for high-performing sales people.

CEM’s business is fairly simple. CEM enters into very large contracts (typically 20-30 per year) with
large construction companies to design and build heavy equipment. CEM wants complete control over the
quality of the end product and therefore never performs design services without performing the related
building services. In some cases, the contracts involve inter-connected pieces of equipment that can take
several years to build, test, and install. The sales people at CEM have a lot of autonomy and are “not
bogged down by the bureaucracy that they have in place over at ACC.” CEM sales people are “their own
bosses” – consulting with the engineers for pricing, negotiating contract terms, setting prices, progress
payments, establishing bonus and penalty clauses, etc. There is a requirement for senior management
approval of deals only if the total contract value exceeds $500,000. However, the chief financial officer is
contemplating removing this requirement as it often gets in the way of doing business.
(LT contracts, IAS 11)

Pricing of the projects is very informal at CEM – as long as the company makes money overall, how
CEM does on individual contracts is really not all that important. CEM does have good systems in place
to assess progress and costs on contracts, including engineering studies etc, so the sales people can track
progression quite easily. The chief financial officer let me choose one of CEM’s contracts and related
progress reports to review in more detail. A summary of my review of the contract is provided in Exhibit
(Have a formal pricing of projects)
(if in a loss position, book the loss immediately)

CEM has five locations across Canada: Vancouver, Calgary, Hamilton, Montreal, and Halifax.
Procurement of materials is done in Hamilton, but materials are shipped directly to all five locations by
vendors. Each location has its own approach to tracking inventory.

Every location uses a significant amount of oil, so each location has its own tank. A dip stick is used to
measure the amount in the tank, as the value of oil on hand can be over $75,000 per tank. The tank levels
used to be checked all the time, but, the chief financial officer doesn’t ask for a reading as often anymore,
now that some of the tanks are getting older and the dip stick readings aren’t as useful. Last week
readings were taken at two locations and the quantities didn’t seem to make sense. They were lower than
they should have been. The chief financial officer is going to check Montreal’s underground tank on Ile
des Soeurs next week since the last couple of readings were low there too. He thinks it might be time to
replace the tanks.
(Asset retirement obligation with IFRS – IAS 37, provision)

In addition to the tanks, CEM will likely have to replace several major pieces of manufacturing
equipment. The wear and tear on CEM’s equipment is significant given that it typically runs at capacity.
CEM amortizes equipment on a straight-line basis over 20 years. CEM will record a loss on this
equipment since it is not quite 10 years old.
(Impairment – IAS 36, test for impairment
Acquisition – equipment is recorded at FV -initially value, overstated, potentially created more goodwill)

On a tour of CEM’s manufacturing facility, I noticed a large holding area with various parts, nuts, bolts,
and wire coils, etc. The chief financial officer indicated that CEM keeps these leftover parts and supplies
from the finished construction projects in inventory “just in case we ever find a use for them. This
inventory is set up in our accounting records”.

Customer: Reynolds Shipping Company (Kingston, Ontario)

Product: Dockside Crane System
Contract signed: January 31, 2011
Installation date: April 30, 2012
Acceptance date: July 31, 2012
Total contract value: $850,000

Contract review notes

The file contained numerous versions of the contract. The first version was based upon a standard-form
contract that covers all aspects of the work – design, construction, progress payments, holdbacks, etc.
Each subsequent version had numerous penciled-in changes. Based upon a preliminary review, the final
contract was significantly different from the original contract.

The contract indicated review by the Vice-President Sales and was signed off by one of the senior sales
personnel. However, the contract had several changes to it and there was no indication whether they were
made prior to the Vice-President Sales’ review.

The contract provides for payments to be made using the following schedule:
At the time of completion and approval of design: $25,000

March 31, 2011: $200,000

June 30, 2011: $200,000

September 30, 2011: $200,000

December 31, 2011: $200,000

Upon acceptance of the equipment: $25,000

(have to use % of completion – IAS 11, a reliable estimation

If not able to estimate, cost recovery: revenue = expense)
% of completion criteria
- Measure total contract revenue reliability; YES
- Probably future economic benefits (nothing stops the completion of the contract); YES
- Totally contract cost + cost to day can be measured reliably; YES
- Costs are clearly identifiable & measurable so you can compare with prior estimates YES

% of completion
- Total revenue recognized at Dec 31, 2011 $
- Total costs recognized at Dec 31, 2011 %
1. Estimate POC at Dec 31, 11  based on costs

CEM’s chief financial officer indicated that CEM recognizes these payments as revenue when collected
and expenses the costs related to the contract as incurred. CEM anticipates the total cost to complete the
work will be $700,000, generating a margin of $150,000.
A review of the project progress reports indicated the following points of interest:
Although the design was completed and approved on February 21, 2011, there was a backlog of work and
actual construction of the equipment did not begin until May 1, 2011. Engineering time reports showed
$75,000 in costs incurred for the initial design phase, which is a labour intensive process. The
construction schedule for the equipment provides for constant engineering work and costs on the project
from April 1, 2011 until the planned installation date of April 30, 2012. Based on CEM’s experience with
other contracts, $20,000 in costs are typically incurred between installation and final acceptance.
EXHIBIT III (continued)
In mid-June, a design flaw was identified in the construction plans which resulted in immediate re-work
costs of $22,000. These design revisions will also result in an estimated additional $28,000 in
construction costs. It is also anticipated that these changes will result in a one-month delay in the
acceptance of the equipment.
A clause in the initial contract states that the customer must pay for additional costs. However, the clause
was struck out of an early draft of the contract with a note “This won’t fly with Reynolds…take it out.”

ACC is a public company. Its business is largely based upon equipment distribution. ACC buys
equipment from a group of brand-name manufacturers it has distribution rights with and then resells the
equipment to construction companies. It tracks the construction industry closely and knows
approximately what the sales volume will be 12 to 18 months in advance. As such, ACC is able to
effectively manage purchases and closely monitor its inventory levels. It also only works with reputable
customers and, as such, has a very low incidence of uncollectible accounts.

ACC also provides repair and maintenance services on the equipment it sells. Its products are high quality
and, when well maintained, can perform for 10 to 20 years. Many of ACC’s customers enter into service
agreements from one to three years long whereby they can schedule one preventative maintenance tune-
up of their equipment per year. The agreements also provide for repair if the equipment breaks down other
than through abuse. Payment for the service agreements is made at the time of signing the agreement.

Given the long life of the equipment, ACC maintains a very large inventory of parts. Although some may
have been in stock for years, ACC contends it needs them just in case an older machine comes in for
repair. ACC has an inventory tracking system that manages quantities and also generates parts aging
reports for management. Parts inventory is valued at the lower of cost and net realizable value, where net
realizable value is determined as follows:
Less than 1 year old,, at original cost;

1-3 years old, 75% of original cost;

3-5 years old, 50% of original cost;

5-7 years old, 25% of original cost;

Greater than 7 years old, 100% write-down, or nil net realizable value.

ACC’s policy is to carry capital assets at cost less accumulated amortization. Amortization is calculated
on a straight-line basis over the estimated useful lives of the assets, as follows:

Machinery and equipment 10 years

Buildings 40 years
Office equipment 10 years
Computer equipment 5 years