To: Joe Insalacco From: Accounting Advisor RE: Accounting issues on the financial statements of Daphnes Catering Ltd.

As an accounting advisor, it is my role to examine the financial statements of Daphnes Catering Ltd. to provide recommendations on accounting issues and give explanations regarding the purchase of DCL. Users/Objective You, Joe Insalacco, are a potential buyer of Daphnes Catering Ltd. With the financial statements, you are looking to evaluate the performance to determine whether this is a company worth purchasing. You are not familiar with the accounting matters of DCL but your objective is to minimize net income so that you can purchase DCL for a lower price. Daphne Flatt is the owner and CEO of Daphnes Catering Ltd. We can assume that she is the preparer of the financial statements. She is not an important use of the financial statement because she operates the business. However, for the time being, she is interested in the financial statements because she has the objective of maximizing net income to sell her business at a higher price. CRA (Canada Revenue Agency) is another user of the financial statements because they will look to see if the business is making the correct accounting decisions to record revenue and expenses according to the standards stated in Income Tax Act; not taking any illegal steps to avoid paying tax. I have concluded that you are the most important user of financial statements, because you are considering purchasing DCL. Since your opinion and questions about the DCLs financial statements are the most important at this point in time, you are the primary user of the financial statements. In addition, your primary objective would be to minimize net income to minimize the purchase price of DCL. Constraints Since Daphnes Catering Ltd. is a private company, it will follow ASPE (Accounting Standards for Private Enterprise) to avoid accounting complication and high costs of IFRS. It is not to be mistaken that ASPE will not provide an acceptable level of objectivity. The ASPE is capable of providing the same level of reliable financial information for private companies. Therefore, ASPE would be an acceptable constraint for DCL. Conflicts Your primary objective is in direct conflict with Daphnes objective. You would like to minimize net income, whereas Daphne would like to maximize net income. If Daphne acts on her bias in the process of preparing the financial statements, they would reflect her needs and bias. Therefore, you would have to be concise and clear about your reasons for requesting necessary revisions in the accounting policies followed by DCL when you are negotiating with Daphne for the purchase of DCL. Issues and Alternatives Issue #1: Revenue Recognition DCL has an issue with recognizing revenue because the timing of their recognition of revenue is different from the timing of the recognition of expense. Since Daphnes Catering Ltd.s fiscal year ends on September 30, 2015, revenue is recognized in a different fiscal year than the expense. As well, it cannot

be said that upon receipt of $45,000, performance criteria has been met. Until the date of the event the performance criteria would not be met. Therefore, the current treatment of recognizing $45,000 upon receipt is unacceptable. Alternative #1: Recognize revenue when the contract is signed. Recognizing revenue when the contract is signed would be prior to or on the day of August 18, 2015. According to the criteria for recognizing revenue, 1. Performance has to have occurred 2. Cost should be measurable 3. Revenue should be measurable 4. Collectability must be assured However, when the contract is signed, even though cost and revenue would be measurable (cost would be measurable because Daphnes Catering Ltd. has been in business for a long time so estimate is possible, and revenue is measurable because the case states that the there is an agreed price), risk and rewards have not been transferred yet. Even though the contract is signed, we cannot say that performance has occurred. Also, even though collectability is probable due to the large size of the corporation holding the event (assuming large companies dont have problem paying their due amount), it is not assured at this point because the event could be cancelled. This method will cause revenue to be recognized in the fiscal period ended on September 30, 2015. Alternative #2: Recognize revenue on October 2, when event takes place. Recognizing revenue on October 2, on the day of the event, is reasonable because now, performance has occurred and all of the risk and rewards have been transferred to the corporation holding the event. Revenue is measurable because the price was already set ($60,000) at the time when the contract was signed. Cost is measurable because the event has already occurred and the case states that DCL has incurred cost of $44,000 on the day of the event. Assuming that collectability is reasonably assured due to the size of the event, this method will cause revenue to be recognized in the fiscal period ended on September 30, 2016. Alternative #3: Recognize revenue on October 4, when all the payment is received. The conditions for this alternative are very similar to alternative #2 in the aspect that the only thing that has changed is the condition for the collectability. If we decide to recognize the partial revenue of $15,000 on October 4, 2015, when the customer pays the remaining $15,000, collectability is assured 100 percent because all the payment has been paid. In this case, risk and rewards has been transferred 100 percent, revenue and cost is measurable to the exact amount and collectability is definite. This method will cause revenue to be recognized in the fiscal period ended on September 30, 2016. Recommendation: This issue is dealing with when recognizing revenue for catering event would be the most fitted for the situation. There are three alternatives, which are recognizing revenue when the contract is signed, when the event takes place and after the payment is received. To recognize revenue we have to look at three major categories; performance, measurability, and collectability. For

this situation, performance occurs when the catering service for the large corporate function takes place (October 2, 2015). Measurability is pretty clear for both revenue and cost by the time the event takes place on October2, 2015. Collectability is also almost certain by the time that event takes place on October2, 2015. Otherwise, bad debt could reasonably be estimated as DCL has been in business for a reasonably long-time. Since alternative #1 does not fit the category for performance, we do not take that alternative into further consideration. Taking a closer look at alternative #2 and #3, these two alternatives have one difference which is that for alternative #3, part of the payment, $15,000, is recognized when it is paid whereas in alternative #2, entire amount would be recognized on the day of the event. Since both these alternatives lower the average net income for the fiscal year of 2015 by recognizing revenue at a later date, using either one is okay. However, I would recommend the use of alternative #2 where bad debt can be reasonably assured, thus, satisfying every criteria for recognizing revenue. Choosing this method will reduce the net income for fiscal year ended September 30, 2015 by $45,000. Issue #2: Capitalize vs. Expense DCL is trying to introduce a new business line of packaged foods for distribution in grocery stores. Their purpose is to promote their food and make it more available and convenient for customers to enjoy the high-quality catered meal. Since this is the first time DCL is introducing this type of business line, they have no history. The investment amount of $55,000, which was used to develop the product over the course of 18 months, is currently recorded as a product development cost (asset) on September 30, 2015. However, since Daphne is confident that this product will be a success, there is room for question if this should be recorded as an asset or be expensed. Therefore, there are two alternative for this situation which are listed below. Alternative #1: Expense the investment of $55,000 as product development cost. To recognize expense, three criteria should be met. First, economic sacrifices are made and costs are incurred to earn revenue. Second, its probable the economic costs will occur. Third, the cost is measurable. In this case, we can say that economic sacrifices are made and the event of economic cost occurring is definite because $55,000 has already been paid to invest in the new line of product; this is costs incurred to earn revenue because developing a product and releasing into the market will lead to revenue. Also, it is measurable because the economic sacrifice has already been made and there is a definite dollar amount for the cost incurred. Alternative #2: Record the investment of $55,000 as an asset. An asset must provide future benefit to the entity and it must be reasonably assured that the entity will enjoy the benefit. It should also be controlled by the entity, be a result of a transaction already occurred and be reasonably measurable. The companys investment of $55,000 is controlled by the entity and it is a result of a transaction already occurred because the investment amount is the result of transactions occurred to contribute to product development. However, even though through the words of Daphne, the product will be definite success, we cannot assume that Daphne is going to be right. She does have a lot of experience in the catering field but she has no experience in releasing her products in to a retail market. Therefore, we cannot predict the success of Daphnes products in the actual market. Also, since Daphne states that there are still a lot of steps to take and obstacles to overcome before releasing the product, we do not know if the product is actually going to be put into the market

in the future. Therefore, even though there are possibilities that the investment of $55,000 may bring future benefits to the entity, it is not reasonably assured that the entity will enjoy the benefit nor is the benefit reasonably measurable. Recommendation: The issue here is regarding whether it is more appropriate to capitalize or expense the product development cost of $55,000 given that Daphne is confident that the product will be a huge hit. Future benefit exists if the product becomes a big hit in the grocery stores, in which case the product development cost has an argument to be capitalized as an asset because it will generate cash for the business. However, since DCL has no previous experience in the field and, therefore, the future benefit is not measureable in which case we have to expense the cost in cured to develop the new product line, following alternative #1. The facts of the case point to alternative #1 as the recommended decision, which is also aligned with your primary objective of minimizing net income. If DCL recognizes the cost as an expense rather than an asset, the expense amount will decrease the net income which will result in lower purchase price of DCL. Choosing this method will reduce the net income for fiscal year ended September 30, 2015 by $55,000. Issue #3 Expense Recognition DCL currently has an issue of recognizing expense of printed brochures. In October 2014, DCL printed several thousand brochures for distribution to promote its service over Christmas (2014) and New Years (2015) duration. The fact that the undistributed brochures are reported on the September 30 balance sheet as a prepaid expense is a problem because there is no value for the brochures anymore; the brochures were for the purpose of promoting last Christmas so it cannot be used this year. Prepaid expense is an asset; asset means it has a future benefit for the business. Since the brochures have no future benefit for the business, it cannot be kept as an asset on the balance sheet. Also, the fact that some of the cost of brochures was expensed in the fiscal year of 2014 is controversial. Alternative #1: Recognize as expense when brochures are printed and paid for. All of the expense incurred to print the brochures can be recognized when the brochures were printed and the cost of printing is paid for. The criteria for expense recognition as follows, 1. Economic sacrifices are made and costs are incurred to earn revenue 2. Its probable the economic costs will occur 3. Cost is measureable Recognizing expense when the brochure are printed and paid for in October meets all of the criteria: economic sacrifices are made because DCL has already paid the due amount for printing brochures, the costs are incurred to earn revenue because it is marketing for the Christmas and New Years season, it is definite that the economic costs will occur and the cost is measurable because the costs have already been paid for. Alternative #2: Recognize as expense according to the percentage of distribution (current policy).

Expense of printed brochures can be recognized according to the percentage of distribution. This alternative will direct DCL to capitalize the full cost as prepaid expense at the time of pay, and amortize the cost accordingly based on the percentage of distribution. This alternative matches the expenses to capitalized assets on a continuous basis, which is similar to the concept of percentage of completion. To use this method, you need to divide the total cost of printing by the number of copies of brochures and recognize expense according to the number of copies that are distributed. Using this method will follow the entire criteria for recognizing expense. Since 60% of the brochures are still stored, we cannot use this method because any brochures left over after the New Years season is of no value to the business; DCL cannot recognize cost of brochures as expense after New Years season because it will not help generate any revenue. Recommendation: Since alternative #2 cannot be used because it would violate the constraint of ASPE, I would recommend using alternative #1. At the time of printing and paying for the brochures, all the criteria for recognizing expense are met. Since recognizing the expense in October 2014 can be matched with revenue in December 2014 and January 2015 (because the fiscal year of 2015 is from October 1, 2014 to September 30, 2015; same fiscal year), it does not violate the matching principle. Recognizing the full amount of expense at the time of printing also gets rid of the prepaid expense that was remaining in the balance sheet of September 30, 2015 which incorrectly reflects the value of the business. This alternative reduces the net income (net income is reduce by $19,000) for the fiscal year end on September 30, 2015 because the expense is increases by $19,000 due to the alternatives method of expensing the full amount instead of leaving it in the balance sheet as an asset. Choosing this method will reduce the net income for the fiscal year ended September 30, 2014 by $19,000 Issue #4 - Expense Recognition DCL currently has another issue related to expense recognition. Every year, DCL has a major maintenance program on its kitchen and banquet hall during the last week of September, which is all the fiscal year end time for DCL. However, this year (2015), the maintenance program was delayed into October because of the corporate function held on October 2. In fiscal 2014, the maintenance program was carried out and completed in late September; therefore, within the fiscal period of 2014. The cost of maintenance program in 2015 is given as $18,000 in the case. Alternative #1: Recognize maintenance program expense in the year-end of September (September 30, 2015) for the sake of comparability between each fiscal year. Even though actual maintenance program is going to be held in October, the cost of the maintenance program could be recorded in September to include the cost for the fiscal period ended on September 30, 2015. We can assume that maintenance cost has always been recorded in the month of September because the case fact states that DCL has major maintenance

program on its kitchen and banquet during the last week of September. Therefore, if we decide to record the maintenance cost in October for this year, this cost will be recorded as an expense in the income statement for the fiscal period ended on September 30, 2016; this will disrupt the comparability between each business years. Also the maintenance expense that was incurred as part of the cost to incur revenue for the fiscal year ended September 30, 2015 will not be reflected if it was decided to be recorded in the October. If there were no delays in the fiscal year ended September 30, 2016 and maintenance was completed in September (as any other year), choosing to record this years maintenance cost in October will cause two maintenance expenses to be recorded for the fiscal year of 2016. Alternative #2: Recognize expense when the maintenance takes place and is completed (October 2015). Another alternative is to record the maintenance expense at the time when maintenance takes place. At this point, everything is 100% certain because the event has already occurred. Therefore, we know that economic sacrifice is made and that this cost also reflects the business activity of year 2015. It is definite that the economic cost is going to occur because the maintenance has already been completed; we have received all the due service for maintenance which DCL now has to pay for. Also, since the maintenance has already been completed, DCL knows the exact amount of the maintenance cost which is $18,000 as stated in the case. Recommend: In this case alternative #2 would be the correct decision to be made according to the standards as the actual maintenance occurred in October. However, the downside to using alternative #2 is that is does not reflect the cost incurred to make revenue for the fiscal year ended September 30, 2015 in the same period. This makes it look like the business made more net income in September 30, 2015 because the cost of maintenance has not been recorded. This will also affect the income statement of the next fiscal year, fiscal year ended September 30, 2016, because it will have two maintenance costs (one incurred on October, 2015 and the other incurred in September, 2016). Using alternative will ultimately cause disruption in comparability of net income between each business years, it should not be used. Therefore I would also recommend that you negotiate with Daphne to deduct the amount from the computation of the purchase price of DCL. As the maintenance cost is a recurring cost that incurs every year, it should have been deducted in 2015. However, due to a delay, it hasnt been deducted. Therefore, to determine the normal income, it should be deducted. If negotiated successfully, you will be able to lower the purchase price, which is aligned with your primary objective. Choosing this method will reduce the net income for fiscal year ended September 30, 2015 by $18,000.

Conclusion: I have made the above recommendations according to the facts given in the case to keep the accounting policies to meet your objective, minimizing net income, while keeping everything legal by following the constraints given by ASPE. I hope these recommendations assist you in securing your deal with Daphne to your advantage. After the proposed recommendations take place, the net income in 2014 is $141,0000 (***originally $160,000; reduced by $19,000) - The net income in 2015 is $157,000 (***originally $275,000; reduced by $118,000) Therefore, the purchase price for DCL would be $1,295,000 (550,000+ [(141,000+157,000)/2]*5) (***The purchase price originally would have been $1,637,500)

Best regards,

Accounting Advisor