QUESTION 1 (70 minutes )

Chimo Air Ltd. (Chimo) is a large regional airline. Operating out of Edmonton,
over the last four years Chimo has expanded its coverage to Vancouver, Calgary
and Saskatoon as well as operating charter flights to Hawaii and the Pacific Rim
countries.

Chimo was founded by Andrew Gregg in the early 1960s. Although the founder
died in 1976, the company is still partly owned and operated by members of the
Gregg family, who own 25% of the outstanding common shares. In 1992, the
company issued $20 million of preferred shares to provide capital to expand into
the charter market. Both classes of shares are listed on the Toronto Stock
Exchange.

In late 2008, the company fought off a takeover bid by another airline, which now
owns 10% of the issued common shares. All aspects of the share transactions
were examined closely by Exchange officials and approved. Arthur Gregg, a
grandson of the founder and formerly a senior vice-president, was appointed new
CEO & President on January 1, 2012 due to the increasing pressure of
shareholders wanting to see better results after four straight operating losses
posted in the previous four year ends. Arthur has been quoted as saying “I
guarantee better results!”

It is now mid-January 2013. You, Samantha Jones, a CA with PWCC, are

responsible for the Chimo December 31 audit engagement. You and your staff
have just performed an audit of the results of Chimo and have prepared the
attached notes (Exhibit I). You have already visited the offices of Chimo,
reviewed the working-paper files related to the prior year-end, and addressed all
applicable first audit engagement matters. Chimo’s controller has prepared a
Summary Draft Income Statement as at December 31, 2012 (Exhibit 2).

The engagement partner has asked you to provide him with a memo outlining the
accounting issues and any other important matters concerning the upcoming year-
end engagement.

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 EXHIBIT 1
CHIMO AIR LTD.
NOTES FROM AUDIT
As at December 31, 2012

1. In 2012, Chimo has recognized revenue based on ticket sales; not upon flight service.

2. A review of the repair parts inventory has been aged which resulted in 10% of the
inventory being aged over 2 years since their last usage. The total inventory as at
December 31, 2012 is approximated at $8.5M. The controller has not taken any
provision on inventory.

3. The following matters were noted regarding Property and Equipment:

a. The company owns 23 aircraft, with a net book value of $159M. Three older
airplanes, DC-8s (total net book value of $8M) have been placed in storage in
Yellowknife, as changes in North American regulations have made their use
impractical. However, management believes that there is a market for these
airplanes (a similar aircraft was sold in 2009 to a Central American freight
company for a minimal gain). Alternatively, each airplane could be converted for
cargo use in Canada at a cost for refitting of $2.7 million each. There is no
detailed or formal plan in place to take either alternative for the 3 planes.

b. Chimo follows the Revaluation Model over PPE and conducts a valuation of its
airplane fleet every year on December 31; the following are the results of that
valuation:

NBV FV
3 DC-8s stored in Yellowknife $ 8M $6M
12 737 Jets $95M $90M
5 747 Jets $30M $28M
3 767 Jets $26M $27M

It was noted that as at December 31, 2011, the most recent completed year end, a
revaluation surplus existed relative to the above fleet of airplanes in the amount of
$4M. The controller has not yet recorded anything related to the current
valuation. It has also been noted that there is old inventory relating to the 3
Planes stored in Yellowknife in the year end inventory.

c. During the year, the company refitted four 737 airplanes at a total cost of $5M,
which was capitalized. The refitting including the seats and interior cabins of the
planes. Chimo classified these costs in the Engines bucket which has a 20 year

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 amortization period. The Interior Cabin bucket has a 15 year amortization period.
The old cabins had an NBV of zero.

4. Chimo owns its own hangar and repair shop in Edmonton where it repairs all its fleet.
The hangar has an NBV of $10M and is located right beside the airport. The controller
has also had a valuation performed on this asset which resulted in a fair value of $12M.
The controller has booked the gain into income as he stated “Chimo occasionally rents a
small portion of the hangar to other airlines for storage purposes when smaller
propeller planes do not have a second flight and need a parking spot to rest their
wings”. In the prior year, a small valuation deficit was recognized into the P&L for
$200K related to this property.

5. At December 31, 2012, Chimo had approximated that it sold 1500 tickets in 2012 for
flights taking off in the first quarter of 2013. The average price of a ticket is $350.

6. The following costs were capitalized as part of a project undertaken at the beginning of
2012:

Engineer’s salaries and benefits $300K

Executive salaries $450K
Materials Consumed $300K
Consultants hired $200K
Prototypes built $100K
$1.350M

The project involves the development of a robotic drink and snack service-cart that
makes its way down the cabin’s passenger capsule to attend to the needs of passengers.
The reason for developing this technology is to reduce airline attendants per plane trip
and to “appear” upon the cutting edge of the airline industry. FAA has not given their
approval on the project and other airlines have been quoted as the project posing several
safety concerns.

7. The Regal Crown Bank has a large debt owing from Chimo that requires the company to
maintain a Debt Equity ratio of a maximum of 2:1 otherwise they can recall the
outstanding balance of the debt. You calculated that a negative adjustment to Equity of
more than $6M will mean that the ratio will be in breech.

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 EXHIBIT 2
CHIMO AIR LTD.
DRAFT INCOME STATEMENT
As at December 31, 2012

Revenues $47,550,000

Operating Expenses:
Salaries $15,350,000
Fuel $12,400,000
Repairs $7,500,000
Depreciation $5,550,000
Other Operating Expenses $2,900,000
Gain on Airport Hangar ($2,000,000)
$41,700,000

Operating Income Before Taxes $5,850,000