2012 UFE Report

Transcription

2012 UFE Report

2012 Uniform Evaluation Report
The Institutes of Chartered Accountants in Canada and Bermuda
i
Janique Caron CPA, CA
Canada Revenue Agency
Ottawa, Ontario
Mike Fitzpatrick, CA
Fitzpatrick & Company
Charlottetown , Prince Edward Island
Patricia Gonsalves, CPA, CA
BDO Canada LLP
Burlington, Ontario
Sylvie Héroux, Ph.D., M.Sc., CPA, CA
Université du Québec à Montréal-ESG
Montréal, Québec
John Kelly, FCA
Scarrow & Donald LLP
Winnipeg, Manitoba
Kim Langille, CA
Deloitte
Halifax, Nova Scotia
Jo-Ann Lempert, CPA, CA
MNP SENCRL srl
Montréal, Québec
Barbara Sainty, Ph.D, CPA, CA, CMA
Brock University
St. Catharines, Ontario
Rik Smistad, CA
Mount Royal University
Calgary, Alberta
Eric Thibault, CPA, CA
Société immobilière du Québec
Québec City, Québec
Kathy Létourneau, CPA, CA, Principal, CA Qualification
Paule Massicotte, CPA, CA, Principal, CA Qualification
Silka Millman, CPA, CA, Principal, CA Qualification
Andy Thomas, CPA, CA, Principal, CA Qualification
Wendy O. Yan, Administrative Coordinator
Linda Clarke, Administrative Assistant
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Institutes of Chartered Accountants in Canada and Bermuda
Uniform evaluation report [electronic resource] = Annales de l'évaluation uniforme.
Annual.
2007Title from disc label.
Issued also in other formats.
Text in English and French.
ISSN 1717-9130
ISBN 978-1-55385-742-6 (2012 Edition)
1. Accounting--Examinations, questions, etc. 2. Auditing--Examinations, questions, etc.
I. Canadian Institute of Chartered Accountants II. Title. III. Title: Annales de l'évaluation
uniforme.
HF5630.I529
657/.076
C2007-301605-2E
Copyright
2013
277 Wellington Street West, Toronto, Canada M5V 3H2
iii
Page
The Board of Evaluators’ Report on the 2012 Uniform Evaluation.......................
1
Comments on Candidate Performance on the 2012 Uniform Evaluation ..............
6
Exhibit 1
The Decision Model .....................................................................
15
Appendix A
Design, Guide Development, and Marking of
the 2012 Uniform Evaluation ......................................................
16
Candidates Performance on Primary Indicators by
Competency Area.........................................................................
20
2012 Simulations, Evaluation Guides and Sample Responses ....
25
Paper I ....................................................................................
Evaluation Guide .............................................................
Sample Response .............................................................
26
44
92
Paper II ...................................................................................
Simulation 1.....................................................................
Sample Response .............................................................
Simulation 2.....................................................................
Sample Response .............................................................
Simulation 3.....................................................................
Sample Response .............................................................
109
110
118
141
148
153
172
178
183
203
Paper III..................................................................................
Simulation 1.....................................................................
Sample Response .............................................................
Simulation 2.....................................................................
Sample Response .............................................................
Simulation 3.....................................................................
Sample Response .............................................................
209
210
217
234
243
248
263
268
273
291
Evaluation Booklet Tables .....................................................
299
Appendix B
Appendix C
Uniform Evaluation Report — 2012
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The objectives of this report are:
1. To assist education committees and councils of the provincial and Bermuda institutes and
provincial boards of examiners in their review of the results of the 2012 Uniform Evaluation
(UFE).
2. To assist the profession in improving pre-examination educational and screening processes
and, in turn, the performance of candidates on the UFE.
The report sets out the responsibilities of the Board of Evaluators, the methods of guide development
and marking the UFE, and the results of the marking process. The report concludes with the
recommendation of the Board of Evaluators. Three appendices provide more detailed information on
the design, guide setting, and marking of the 2012 UFE, the evaluators’ comments and expectations of
candidates on the simulations, and sample responses. Readers are cautioned that the solutions were
developed for the entry-level candidate and that therefore all the complexities of a real life situation
may not be fully reflected in the content. The UFE report is not an authoritative source of GAAP.
The Board of Evaluators (BOE or board) comprises a chair and nine members. The chair and one
bilingual member are appointed by the Professional Learning Committee (PLC); the other eight are
appointed by the provincial institutes. Board members are appointed for a three-year term and the
chair for a two-year term.
The BOE’s responsibilities, as set out in its terms of reference, include:
- Setting the UFE in accordance with the UFE Candidates’ Competency Map (the Map) and other
directions from the PLC.
- Submitting the UFE and the evaluation guides to the provincial institutes for review.
- Marking the candidates’ responses and recommending to the provincial institutes the pass or fail
standing that should be given to each candidate.
- Reporting annually on the UFE to the provincial institutes, in such form and detail and at such time
as is satisfactory to the Education and Qualification Committee (EQC) and the PLC.
Each board member is actively involved in the preparation of the UFE simulations, the setting of the
passing profile, the preparation of evaluation guides, and the supervision of the evaluation process.
Board members are jointly responsible for determining the passing standard.
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Board of Evaluators’ Report
The purpose of the UFE is to assess whether candidates possess the competencies required of an entrylevel CA through a uniform written evaluation that all CAs must pass in order to qualify for entry to
the profession.
The pass/fail decision model used by the board is presented in Exhibit 1. Three key decision points, or
levels, are applied in reaching the pass/fail decision, as follows:
1. The response must be
, i.e., the candidate must demonstrate competence on the primary
indicators (Level 1). In assessing sufficiency, the board considered the number of times that a
candidate achieved “Competent” and/or “Reaching Competence” across all primary indicators (both specific competencies and pervasive qualities).
2. The response must demonstrate
in the areas of Performance Measurement and Reporting
and Assurance (Level 2). In assessing depth the board considered the number of times that a
candidate achieved “Competent” in each of the Assurance and Performance Measurement and
Reporting primary indicators.
3. The response must demonstrate
across all areas of the Map (Level 3). In assessing
breadth the board considered the number of times that a candidate achieved “Reaching
Competence” across primary indicators in each of the specific competency areas, except for
Assurance and Performance Measurement and Reporting. If a candidate failed to demonstrate
breadth on the basis of the primary indicators, the board considered the information provided by
the secondary indicators for the deficient competency area.
An evaluation guide was prepared for each simulation included in the 2012 Uniform Evaluation.
Besides identifying the primary and secondary indicators of competence, each evaluation guide
includes carefully defined performance levels to assist markers in evaluating a candidate’s competence relative to the indicators. Five categories of performance are given for each
indicator. The
candidate’s performance must be ranked in one of the five categories, namely:
Not addressed
Nominal competence
Reaching competence
Competent
Highly competent
For each
indicator, the candidate’s performance is ranked in one of three categories:
Not addressed
Nominal competence
Competent
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The CA Qualification staff of the Education Services department of the CICA maintains a pool of
simulations sufficiently large and broad in scope to provide a variety of alternative simulations
embracing all sections of the Map. The board provides guidance as to the content and nature of
simulations to be included in the pool.
The board staff work in conjunction with authors to ensure that simulations achieve the overall intent
and design objectives while adhering to the competencies and the proficiency levels specified in the
Map. The board selects simulations from the pool maintained by the staff, and reviews and refines
these simulations to make up the annual three-paper evaluation.
Taken as a whole, the three papers must meet the requirements laid down by the PLC for Map
coverage and simulation type.
shows that the 2012 UFE met the Map coverage
requirements.
The 2012 UFE comprised a balanced combination of comprehensive and multi-subject simulations,
which were both essential and effective in evaluating the candidates with regard to their readiness to
practise public accounting. The first paper was a five-hour paper consisting of a single, comprehensive
simulation. The board designed a four-hour comprehensive simulation, but allowed candidates an
extra hour in which to complete their responses. The second and third papers were four-hour papers,
each consisting of three simulations.
Detailed comments by the Board on each of the 2012 UFE simulations appear in
.
The board applies evaluation procedures that enable it to decide which candidates demonstrate
readiness to practise public accounting.
contains a comprehensive description of the
evaluation process.
To attain a “pass” standing, candidates must address the issues in the simulations that are considered
mission critical. The board distinguishes between the mission critical issues and other relevant issues
by classifying them as primary indicators and secondary indicators of competence respectively.
Primary indicators of competence answer the question: “What would a competent CA do in these circumstances?” If the issues identified in primary indicators are not adequately addressed, the CA could, in real life, be placed in professional jeopardy or could place the client in jeopardy.
Secondary indicators of competence answer the question: “What other issues could a CA raise?” Although such issues are valid, it is not essential for a competent CA to address them.
Board members devote a great deal of time to reviewing and refining evaluation guides to ensure the
expectations for achieving competence are fair and reasonable for an entry-level CA.
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Board of Evaluators’ Report
Marking-centre leaders and assistant leaders provide valuable input to the evaluation guides before
live marking begins. Board members hold regular meetings with the leaders and their assistants during
both the guide-setting and the marking process. In the board’s opinion, the commitment, energy, and skill demonstrated by all the markers were outstanding, resulting in the sound application of marking
procedures and producing an appropriate evaluation of the candidates.
The marking results for the secondary indicators do not appear in the statistical reports (
),
as they reflect the performance of only that segment of the population whose responses were deemed
borderline. However,
does contain comments on the candidates’ performance for the responses that were marked.
In determining which candidates pass the UFE, the Board uses a passing profile. A candidate is judged
in relation to the board’s pre-established expectations of an entry-level chartered accountant. To meet
the passing profile, a candidate’s response must meet the three levels defined earlier (see Exhibit 1).
In setting the passing profile, the board considers the following:
-
The competency area requirements.
The level of difficulty of each simulation, as a whole.
The level of difficulty of each individual competency indicator.
The design and application of the evaluation guides.
Comments from leaders and assistant leaders regarding any marking difficulties encountered or any
time constraints noted.
- Possible ambiguity of wording or of translation of a simulation.
Near the completion of the marking process, board members each read a sample of candidate
responses for their assigned simulation to satisfy themselves that the markers had applied the
judgments as intended. Based principally on these readings, and on the evaluation of each candidate
made by the markers, the board reviewed its pre-established passing profile and set preliminary
requirements for Level 2-depth in the areas of Performance Measurement and Reporting and
Assurance, and for and Level 3-breadth across all competency areas.
Prior to the fair pass meeting, board members each read another sample of candidate responses, this
time for their assigned competency area, to satisfy themselves as to the levels they had set for Levels 2
and 3. They finalized those Level 2 and 3 requirements at their fair pass meeting, taking into account
the number of valid opportunities available to candidates to demonstrate their competence in each of
the competency areas. The board then established the Level 1 requirement for the three-paper set. In
establishing the Level 1 requirement, the board considered whether the results could be wholly or
partly explained by any inconsistency in the evaluation or in the board’s process. Uniform Evaluation Report — 2012
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After considerable discussion, the board concluded that the 2012 evaluation was easier than the 2011
evaluation. After taking into account that the 2012 UFE was easier, candidate performance on this
evaluation was assessed as stronger than that of 2011. Based on the weaker candidate performance,
the board set a Level 1 standard that yielded 3,077 successful candidates (2,857 candidates in 2011).
In reaching its decision, the board determines which candidates pass on a national basis only, without
regard to provincial origin or language. Similarly, the detailed comments are based on analyses of the
performance of all candidates. The board leaves the interpretation of provincial results to the
provincial institutes.
The board assigned a pass or fail standing to candidates for the three-paper set.
The board reported the following information to each province by candidate number:
- Overall pass/fail standing and pass/fail standing for each of Levels 1, 2 and 3.
- For failing candidates at Level 1, a sufficiency grouping for Level 1 and a decile ranking for both
the comprehensive simulation and the non-comprehensive simulations.
- For failing candidates, a colour code (red, yellow, green) reflecting their performance for each of
the competency areas.
The Board of Evaluators recommended that only those candidates who succeeded at each of Levels 1,
2, and 3 should earn a pass standing on the 2012 Uniform Evaluation.
In conclusion, all board members wish to express their warm and sincere appreciation for the
outstanding energy, support, and commitment of the small group of Board of Evaluators staff
members whose dedication and talent contributed in large measure to the achievement of our
objectives and the fulfilment of our responsibilities.
We also wish to acknowledge the contributions made by our markers, authors, translators, provincial
reviewers, and editors. Their commitment to the quality and fairness of the process is appreciated.
Janique Caron, CPA, CA
Chair
Board of Evaluators
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Comments on Candidates’ Performance
To attain a pass standing, candidates must demonstrate sufficient competence in all areas, as well
as appropriate depth and breadth in their responses.
The Board of Evaluators analyzed the performance of candidates on the 2012 UFE. Overall, because
of the various roles that the candidates had to assume, sometimes in unusual contexts, the Board
concluded that candidates’ performance in 2012 was stronger than in the prior year. Information on
candidates’ performance on the 2012 UFE is provided here, in a summary format, to help candidates understand how to continue to improve their performance. Detailed comments on the performance for
each simulation can be found in the evaluation guides in
. The following paragraphs
elaborate further on the improvements as well as the common detracting characteristics identified by
the Board.
Last year, the Board noted that there was some evidence to suggest that candidates were including
large sections from the CICA Handbook in their responses but failing to apply the guidance to the case
facts. This practice did not seem to be as prevalent on the 2012 UFE; however, some candidates
continued to include a fair amount of information from the Handbook without always applying this
information to the relevant case facts. Again this year, candidates are reminded that simple repetition
of technical rules does not demonstrate competence.
The Board also noted last year that there was evidence that candidates were confused by all the recent
changes in standards, since some candidates used terminology from Handbook sections that were no
longer in use. It would appear that after a couple of years of transition, candidates are now more
comfortable with the various reporting frameworks. The Board encourages candidates to continue to
stay current with changes in accounting and auditing standards.
The Board commented on the candidates’ inability to see non-directed issues in 2011. The candidates’ overall performance on the non-directed indicators has improved in the current year, specifically with
regard to non-directed indicators in the specific competency areas. However, candidates’ performance on the Pervasive Qualities and Skills indicators is only slightly better than in 2011 and still
significantly below their performance in 2010. There are still a number of candidates who continue to
not address the Pervasive indicators. For example, on Paper I, Primary Indicator #8, candidates were
expected to identify and analyze the big-picture issues facing HandySide, including its flawed strategic
objectives. Few candidates commented on these plans at a strategic level. On Paper II, Simulation 1,
Primary Indicator #5, candidates were not explicitly asked to comment on Kevin’s increased absence;
however, many facts in the simulation indicated that his absence was creating problems for the
business. Most candidates failed to address this issue. Also, in Paper II, Simulation 2, Primary
Indicator #4, many candidates were not able to provide Louise with insight on how to determine which
babies should receive donated milk and whether she should compensate donor mothers, despite the
fact that Louise had herself raised both of these concerns. Once again, candidates are reminded that
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they will not be specifically directed to all of the issues that the Board considers to be mission critical.
Candidates need to take the time to read a simulation carefully; understand the situation, their role, and
the needs of their client; and address all the significant issues, whether directed or not. Candidates also
need to discuss the pervasive issues in order to be able to demonstrate an understanding of the
importance of these issues to the users of their report.
In 2011, the Board cautioned candidates on what it saw as a downward trend in candidates’ performance on indicators that require quantitative analysis, despite most of these indicators being
directed. The Board is pleased to see that the candidates’ performance in this area is improving, but
there were still instances where candidates struggled to perform the quantitative analysis required. On
Paper I, Primary Indicator #4, the quantitative analysis provided by the majority of candidates was
very poor. Most candidates struggled to compare the three financing options on an equal footing.
Many candidates simply discounted the payment streams using different discount rates for the three
options, which provided no basis for comparison. This type of analysis provided no added value to the
response.
In addition, while candidates were generally able to perform a reasonable quantitative analysis on
other indicators, the Board noted that some candidates were not stepping back after performing their
calculations to assess whether the results were reasonable. For example, in Paper III, Simulation 1,
Primary Indicator #2, many candidates came up with a negative value for the business and yet
continued to use this negative figure to calculate the purchase price of the business. Also, in Paper II,
Simulation 2, Primary Indicator #2, some candidates came up with a price per bottle of milk that was
unrealistic under the circumstances. Candidates could have used the information provided in the
simulation (the price that the hospital and private sector were ready to pay per bottle) to realize that the
cost per bottle they had calculated was not reasonable.
Regarding major detractors, the Board would like to highlight the following:
The Board would like to caution candidates about a dangerous exam-writing strategy the Board
believes is occurring. It appears as though some candidates are assuming there is a specific number of
issues that the Board is looking for on each indicator. As a result, candidates appear to be repeatedly
choosing to address only a few issues on each indicator even when numerous issues are outlined in the
simulation. By choosing to limit the breadth of their discussions to a particular number of issues,
candidates are risking not being able to demonstrate their competence in a specific area. Candidates
should attempt to discuss all the issues they deem significant in the simulations, and not limit their
analysis because they think they have reached the minimum number of issues the Board is looking for.
There is no pre-set number of issues in terms of the Board’s expectations, and the Board is concerned
that candidates’ performance is being negatively affected as a result of them thinking there is.
Overall, the 2012 UFE contained two additional primary indicators when compared with 2011, and
three additional primary indicators when compared to the 2010 UFE. The number of opportunities in
Performance Measurement and Reporting; Assurance; Finance; Taxation; and Governance, Strategy,
and Risk Management was the same as in 2011. There was one more indicator in Management
Decision-Making and one more in Pervasive Qualities and Skills, compared to 2011. The number of
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secondary indicators was the same as in the prior year, which again resulted in many of the
simulations having no secondary indicators at all.
The 2012 UFE was slightly less directed in nature when compared with the 2011 UFE. This is
partially due to an additional Pervasive Qualities and Skills indicator this year. As indicated above,
candidates struggled with most of the Pervasive Qualities and Skills indicators. The Board continues
to believe that candidates’ ability to identify hidden issues is important, and future exams will continue
to have a mix of directed and non-directed indicators.
The Board did not see evidence of time constraint on both the comprehensive and non-comprehensive
simulations again this year.
The roles assigned and scenarios presented to the candidates on the 2012 UFE continued to be varied,
with only three of the simulations presenting a traditional assurance role (Paper II, Simulation 1; Paper
II, Simulation 3; and Paper III, Simulation 2).
The other roles presented to the candidates included that of a newly hired member of the finance and
accounting department asked to assist with the review of the package prepared for the finance and
audit committee (Paper I); an advisor to a client planning to start a not-for-profit organization (Paper
II, Simulation 2); a controller of a manufacturing business (Paper III, Simulation 1); and an advisor to
a long-time client who’s considering selling his business (Paper III, Simulation 3). Most candidates
were able to adapt to the roles and presented information that was suited to these roles. For example,
on Paper III, Simulation 1, Primary Indicator #3, candidates were asked, as the new controller of
Chinook, to establish a risk management plan. While this was the Board’s first time testing this specific Governance competency, candidates performed well on this indicator. Most candidates were
able to identify specific problems that occurred with the introduction of the Yukon trailer and devised
plans for avoiding these pitfalls in future product launches. However, candidates appeared to struggle
with some of the more unique roles on the 2012 UFE. For example, on Paper II, Simulation 2, Primary
Indicator #1, candidates were expected to provide controls to help MMB meet the Breast Milk
Agency’s requirements for quality control. Candidates would sometimes lose sight of their role and
provide ways to audit the controls rather than suggesting controls themselves, which is not what the
client needed.
Assurance
Candidates were asked to perform a variety of assurance-related tasks on the 2012 UFE, since most
simulations addressed Assurance in some way. In the examination, candidates were expected to:
consider whether the independent auditors could use the work of the internal audit function,
and suggest procedures that the internal audit function could perform;
prepare a review engagement planning memo;
provide examples of the required controls to ensure the proper collection, storage, and
distribution of breast milk;
discuss the significant first-time audit issues and suggest procedures to address them;
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discuss the significant audit issues and suggest procedures to address them;
discuss the indicators of a potential going concern issue and the impact on the auditor’s report;; and
discuss some of the underlying assurance issues related to the work being requested.
Candidates’ performance in Assurance was weaker than in 2011. However, the Board acknowledges
that some of the Assurance indicators were more unique and challenging than in prior years.
Historically, candidates perform better on indicators in which they are asked to evaluate internal
controls. The 2012 UFE contained only one such indicator, and the context was somewhat unusual as
candidates were asked to recommend operational controls to ensure the quality of breast milk. This
required candidates to think outside the box a little since they had to try to understand the risks
involved with this type of organization, which most were unfamiliar with.
Candidates also struggled with other indicators for which their role was different than the typical
auditor role. On Paper III, Simulation 2, Primary Indicator #1, through the identification of numerous
indicators that were present in the simulation, candidates were expected to identify that there was a
going concern issue. Candidates were expected to discuss why these indicators put into question the
going concern assumption, what evidence the client could provide to support that the company was
still a going concern, and the impact on the audit report of the potential going concern issue.
Candidates struggled with this role. Most of them were able to identify some of the factors that
suggested a going concern issue, but were not able to take their analysis beyond the identification of
the issue. Candidates stopped short of explaining the impact of their findings on either the going
concern assumption or the auditor’s report. Although this indicator was not directed, there were
numerous facts provided in the case to point towards the going concern issue. There was also a
comment from the CFO that she was “optimistic about the future and is prepared to provide us with whatever documentation we require to support her point of view.” This should have led candidates to recognize that simply identifying some of the indicators of a going concern issue and concluding that
Razor was no longer a going concern was not sufficient. Clearly the client would not just have
accepted that conclusion. Candidates should have explained to the client what documentation she
could provide to support her claim that Razor was still a going concern.
Candidates also had difficulty with the Assurance indicator on Paper III, Simulation 3, which required
them to discuss conflicts of interest and other engagement issues related to Funky Tire. This was an
unusual setting that required candidates to think of the potential conflicts of interest and find solutions
to address them, additional services being a potential solution. Candidates often did not see the big
picture;; they recognized that there was a conflict between Ron’s objectives and Paul’s objectives, but did not determine how their differing objectives created a conflict for CA. In addition, many of those
who did identify this conflict were unable to provide a reasonable solution to mitigate the issue.
Candidates did not seem to have a good understanding of the factors that might make them question
whether or not they should accept an engagement.
In contrast, candidates seemed to perform better than usual on the traditional Assurance indicators that
involved planning an audit or review engagement, including the development of procedures. On Paper
II, Simulation 1; Paper II, Simulation 3; and Paper III, Simulation 2 candidates were asked to plan
procedures for the engagement at hand. Candidates did a better job than in prior years of providing
procedures that were specific and would address the relevant risk.
10
Where some candidates had difficulty was in the planning portion of their memo, in particular in a
situation where some of the engagement planning had already been completed (such as in Paper II,
Simulation 3 or Paper III, Simulation 2). Given the circumstances, candidates should have focused on
the impact on the engagement of the changes or events that had occurred since the planning was done,
or on elements of the planning that appeared questionable in light of other case facts, rather than reperforming the entire planning section.
Performance Measurement and Reporting
All simulations contained accounting issues that required the understanding and ability to apply
technical accounting knowledge. Throughout the three days of the 2012 UFE, candidates were
examined on a range of issues, some of which were complex, and others more straightforward.
Overall, candidates’ performance on Performance Measurement and Reporting was better than in
2011.
Again in 2012, candidates appeared to be well prepared for IFRS. They were placed in an IFRS
environment in two of the simulations. Candidates seemed to be comfortable applying the relevant
technical guidance to the accounting issues when in an IFRS setting since their performance was the
strongest on these two indicators. On both Paper II, Simulation 3, and Paper III, Simulation 2,
candidates were required to provide an analysis of the IFRS accounting issues. Candidates were able
to recognize the significant accounting issues, and attempted to analyze the issues using case facts.
Candidates performed well because they were able to identify the issues, and most were able to
discuss them in sufficient depth.
The scenarios presented in Paper I; Paper II, Simulation 1; and Paper III, Simulation 3 — in which
candidates were required to discuss the accounting issues that needed to be addressed in order for the
statements to be in accordance with ASPE — were traditional ones. Candidates performed relatively
well on these indicators. They generally were able to recognize a number of relevant accounting issues
and attempted to analyze them using case facts and Handbook guidance to support their analyses.
Candidates who were unable to demonstrate their competence in this area typically did not provide indepth discussions of the issues. Generally, they did not support their discussions with relevant case
facts and Handbook guidance, but instead jumped to conclusions. Some candidates also performed
poorly as a result of not addressing a sufficient number of issues, as mentioned above in the discussion
of overall deficiencies in candidates’ performance. There were also two indicators that were quite different. On Paper III, Simulation 1, Primary Indicator
#2, candidates were asked to calculate the value of the WIP inventory and the warranty provision, as
required for the completion of the audit. This was unusual because it didn’t require candidates to analyze the accounting issues from the perspective of determining whether the policies chosen were in
accordance with the Handbook. Rather, the candidates needed to understand the mechanics behind the
two accounting balances and perform calculations of these outstanding balances. The Board was
pleased to see that most candidates were able to perform reasonable calculations. On Paper II,
Simulation 2, candidates were placed in a not-for-profit environment. Candidates did not seem to be
familiar with the standards applicable to not-for-profit organizations. They did not address some of the
accounting issues central to not-for-profit organizations, such as how to recognize donated goods and
services, as frequently as the Board had hoped.
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Taxation
This year, the Board saw a slight improvement in candidates’ performance on the Taxation indicators.
However, although the level of taxation knowledge displayed by candidates on some of this year’s Taxation indicators was stronger than in the 2011 examination, there was still room for improvement.
Candidates performed well on the two simulations in which the tax issues tested were less complex:
Paper I and Paper II, Simulation 1. On Paper I, Primary Indicator #6, candidates were provided with a
schedule of taxation issues for HandySide and were asked to review and comment on the issues
presented. Most candidates were able to identify the issues, and many provided an appropriate
analysis. However, some candidates failed to address enough issues to demonstrate competence. As
well, some candidates discussed personal tax issues for John or Alex that were not relevant to
HandySide. On Paper II, Simulation 1, Primary Indicator #3, candidates were asked to provide
recommendations regarding the tax issues presented. Among the issues presented were the contractor
versus employee status of the display supervisors, the CCA class and tax benefits related to the
vehicles, and the tax treatment in relation to accommodations, meals, frequent flyer points, and other
events and gifts. Most candidates were able to identify and properly discuss these issues, providing the
client with useful information regarding the tax treatments reserved to these items.
Candidates struggled the most on Paper III, Simulation 3, Primary Indicator #3, in which they were
asked to discuss the significant taxation issues associated with the buyout. Most candidates discussed
the simple issues, such as the deductibility of interest if incurred to earn income or the fact that the
RRSP withdrawals are taxable. Only strong candidates were able to address the taxation of the share
redemption, recognizing that it would result in a deemed dividend, or to discuss the potential use of a
holding company in order to proceed with the transaction with minimal tax consequences. In general,
candidates seemed to struggle with the more complex tax concepts tested, and provided extensive
discussions on the basic concepts they were comfortable with (such as interest deductibility or RRSP
withdrawals). The Board reminds candidates that ranking of issues remains an important skill, and as a
result, they should not avoid more complex issues if they are significant to the simulation.
Management Decision-Making
There were four opportunities to demonstrate competence in Management Decision-Making on the
2012 UFE. The Board was pleased to see that candidates performed significantly better this year than
the prior year in this competency area. There were two indicators in Management Decision-Making
that tested information technology (IT) competencies this year. Candidates performed well on these
indicators. They seemed comfortable analyzing IT systems and providing recommendations. In
contrast, there were still indicators on which the candidates struggled. For example, on Paper I,
Primary Indicator #5, a significant number of candidates simply performed a reallocation of all of the
expenses from the information supplied without recognizing that certain costs were irrelevant to the
analysis because they would be eliminated if the division was closed. As a result, their analyses were
not as useful to the decision at hand as they should have been.
Finance
Candidates performed similarly in Finance on the 2012 UFE when compared to the 2011 UFE.
However, there is substantial room for improvement, since many candidates struggled with some of
12
the concepts tested.
Candidates struggled the most with Paper I, Primary Indicator #4, where they were provided with a
schedule of three different financing options for HandySide to consider in order to purchase the
distribution centre from John Maarten. Each of the options presented excluded one variable from a
financial perspective: option 1 omitted an interest rate, option 2 excluded the monthly payment
amount, and option 3 left out the term of the loan. Candidates performed very poorly with respect to
the quantitative aspects of this indicator. Most candidates struggled to place the three financing
options on an equal footing and compare them. One way to do this would have been to compute the
implicit rate in the first option and compare this interest rate with the remaining two options. Another
method would have been to compute the present value of the payments for the three options using the
same discount rate for each of the options, and compare the three present values. Instead, many
candidates discounted the payment streams using different rates for the three options, which provided
little to no basis for comparison. This type of analysis provided no added value to the response. Before
deciding what type of analysis to perform, candidates need to reflect upon what their analysis needs to
accomplish quantitatively and what would be useful to the client.
Candidates performed well on Paper III, Simulation 1, Primary Indicator #2, for which they had to
normalize earnings in order to estimate the purchase price for Chinook. The majority of candidates
were able to recognize most of the non-recurring items and integrate their accounting adjustments into
their calculations of the purchase price. Some candidates were able to recognize that there should also
be an adjustment for the gross margin since 2011 was not a typical year, but this more insightful
comment was missed by most candidates.
Candidates struggled on Paper III, Simulation 3, Primary Indicator #2, where they had to determine
the amount of financing needed and discuss the potential sources of financing for the proposed buyout
transaction. Candidates struggled with basic principles such as the fact that the existing mortgage on
the house and the business assets needed to be taken out before calculating the additional financing
that was available to Paul. Some candidates did not even attempt a calculation, instead only discussing
the sources of funds available and not coming to a conclusion as to whether the available funds were
sufficient. Many of those who did calculate a shortfall did not discuss solutions to cover it, and many
of those who did discuss solutions failed to realize that the future cash flows generated by the business
could be used to pay back Ron. Given that Paul mentioned that “sometimes the vendor is paid from the cash flow of the company, either from the holding company or the operating company,” and asked CA to explore the option, the Board was disappointed that most candidates did not discuss that option.
Governance, Strategy, and Risk Management
Candidates continued to perform well in this area despite the fact that the Governance indicators this
year involved some unusual contexts. On Paper I, Primary Indicator #7, candidates were asked to
analyze the draft terms of reference for the newly formed finance and audit committee, identify
weaknesses, and recommend improvements. In general, candidates performed well on this indicator.
They were able to identify a number of weaknesses in the draft terms of reference as presented,
discuss the implications of these weaknesses, and then suggest improvements. The Board was pleased
to see that, overall, candidates appeared to understand the purpose of an audit committee and its
function. On Paper III, Simulation 1, Primary Indicator #3, candidates were asked to develop a risk
management plan for Chinook to follow when developing new products. As mentioned above, despite
13
the fact that this was a challenging indicator since this was the first time this Governance competency
had ever been tested, candidates were able to adapt to this scenario. This indicator required candidates
to not only use case facts to identify problems that Chinook had encountered in the development of
previous products, but also think outside the box and anticipate what problems could occur with this
type of business. Candidates performed well on this indicator.
Pervasive Qualities and Skills
The 2012 examination included five Pervasive Qualities and Skills indicators, one more than on the
2011 UFE. Candidates’ performance in this area has slightly improved over last year, but is still worse
than that of the 2010 UFE. Again this year, candidates had difficulty identifying underlying issues in
which a high level of integration and analysis was needed to get to the issue. There were three
Pervasive indicators on which candidates’ performance was very weak: Paper I, Primary Indicator #8;
Paper II, Simulation 1, Primary Indicator #5; and Paper II, Simulation 2, Primary Indicator #4.
The purpose of Primary Indicator #8 on Paper I was to reward those candidates who could properly
identify and assess the big-picture issues facing HandySide. There were many hints throughout the
simulation that may have indicated to the candidates that these issues were important. These hints
included the discussions about the price adjustment clause, the facts supplied for the big-box-store
strategy, the national expansion plans, and the financials indicating a significant increase in
HandySide’s debt level year over year. Candidates were expected to identify these big-picture issues
and analyze them from HandySide’s perspective. Candidates performed very poorly on this indicator,
and had great difficulty seeing any of the broad issues in this scenario. While this is not unusual,
candidates are encouraged to always step back and perform an overall analysis of any simulation or
business situation that they encounter, and to provide meaningful insight where appropriate.
On Paper II, Simulation 1, Primary Indicator #5, despite the fact that Kevin admitted to being away
from the business a lot, that he had to increasingly rely on Ella to manage FSI, that some issues had to
wait to be solved (tax issues, remittance cheques to be signed, negotiations with a supplier), and that
Ella had taken the lead in picking two vendors for final consideration on the new inventory tracking
system, almost half of the candidates did not see that there was an issue with Kevin often being away.
Some candidates identified the impact of Kevin’s absence on their audit risk, but did not push their
analysis further to discuss the pervasive nature of this issue on the business. In addition, most of the
candidates who did see the issue were not able to discuss the implications of it and propose reasonable
solutions to help Kevin.
On Paper II, Simulation 2, Primary Indicator #4, candidates were expected to discuss some of the
important decisions Louise needed to make about MMB. Although many candidates realized they had
to discuss whether Louise should compensate donor mothers or how she should determine which
babies to help, most were unable to provide any valuable insight to Louise.
In contrast, candidates performed well on Paper II, Simulation 3, Primary Indicator #3, where most
recognized management’s bias related to the bonus plan. On Paper III, Simulation 1, Primary Indicator #4, candidates also did a good job of raising concerns with regard to the potential sale of a portion of
Chinook to Super based on Super’s history.
14
The Board continues to emphasize the importance of being able to identify and appropriately address
underlying issues on the UFE. These analytical skills are critical for a chartered accountant, and will
continue to play an important part not only in the Level 1 assessment on the UFE, but also in the
assessment of competence at Levels 2 and 3.
NO
Was the aggregate competency
demonstrated
?
F
YES
NO
A
I
L
Were the
demonstrated
and
Level 1
P
competencies
enough?
Level 2
YES
Primary
indicators
only
Was the competency demonstrated
enough?
Level 3
A
YES
S
NO
NO
Review additional information
from secondary indicators to
enhance the ability to assess
YES
breadth – 2nd assessment of “Was
the competency demonstrated
Secondaries
enough?”
QUALITY
CONTROL
S
15
16
Appendix A
The Professional Learning Committee (PLC) determines the policies for the minimum coverage of the
UFE Candidates’ Competency Map on each Uniform Evaluation. The coverage requirements for the
2012 UFE were identical to those in the prior year.
The coverage requirements and the actual percentage coverage on the 2012 Uniform Evaluation for
each section of the Map when both the primary and the secondary indicators of performance are
considered together are set out below:
Governance, Strategy and Risk Management
5 – 10%
9%
Finance
10 – 20%
13%
Taxation
10 – 20%
13%
Assurance
25 – 35%
25%
Performance Measurement and Reporting
20 – 30%
25%
Management Decision-Making
10 – 20%
15%*
*The BOE is required to include a minimum of two Information and Information Technology
indicators on the UFE. The board fulfilled its commitment on the 2012 UFE by including two
indicators in Management Decision-Making.
All simulations were designed to fit within the “normal circumstances” in which all entry-level CAs
are expected to demonstrate the required competencies.
are circumstances where:
The entity, situation, event or transaction is of a size or degree of complexity likely to be encountered
by an entry-level CA, and
The entity is a business in the private sector, formed as a proprietorship, as a partnership, as a
private corporation; or
The entity is a small public corporation, or as a division of a large public corporation; or
The entity is in the public sector or is a not-for-profit organization or a division of either; or
The entity is an individual.
17
The evaluation is made up of a comprehensive case and several multi-subject simulations. The
indicators on the comprehensive case are weighted so that the comprehensive case represents one third
of the evaluation.
In June 2012, provincial reviewers met to examine the 2012 Uniform Evaluation and the preliminary
evaluation guides. The provincial reviewers’ comments on the 2012 Uniform Evaluation were
considered by the board when it finalized the evaluation set in June 2012 and again when the senior
markers reviewed the guides in the context of actual responses in September 2012.
From the marker applications received, the board carefully selected 172 chartered accountants to
participate in the 2012 evaluation centre. The criteria for selection included marking experience,
motivation, academic achievement, work experience, personal references, and regional representation.
Before the opening of the evaluation centre, board members, leaders, and assistant leaders attended a
five-day meeting, the preliminary evaluation centre (PEC). Participants reviewed the evaluation
guides, applied them to randomly selected candidate responses, and made appropriate revisions. The
written comments on the evaluation guides received from provincial reviewers were carefully
considered at this meeting, with the board approving necessary changes.
The comprehensive simulation was marked by English-speaking and French-speaking teams of
between 7 and 10 markers in Montreal from October 11 to October 26, 2012. Paper II was marked in
Montreal from October 11 to October 22, 2012, and Paper III was marked from October 15 to October
26, 2012. Each non-comprehensive simulation was assigned marking teams of between 17 and 19
people, with each team having a leader and an assistant leader, and both French-speaking and Englishspeaking markers. Each team had one or more markers who were capable of marking in both
languages. Borderline marking took place on October 27, 2012.
At the beginning of the comprehensive and non-comprehensive centres, the leaders and the assistant
leaders presented the evaluation guides to their teams. The team undertook a two-phase test marking
procedure prior to actual marking. Phase one consisted of two steps: guide familiarization, during
which markers applied the guide for the primary indicators to copies of candidates’ responses, and joint review, when markers collectively reviewed their results. Phase one thus ensured that all markers
understood the issues in the evaluation guide and the basis on which to apply each proficiency level
Phase two was an expanded test marking of another set of responses to establish marker congruence.
When marker congruence was achieved for a simulation, live marking of that simulation began. The
start-up period varied between two and three days for the various simulations.
18
Appendix A
After the training and test marking phases, live marking commenced. The simulations were marked by
English-speaking and French-speaking markers.
The BOE strives for the highest possible marking consistency and quality control. This means that
leaders and assistant leaders devoted much of their time to cross marking and other monitoring
activities. Markers’ statistics were reviewed to ensure that marking was consistent. Based on analysis
of the statistics, leaders reviewed papers marked by their team members to ensure that the indicators
were assessed fairly. Bilingual markers marked papers in both languages, and their results were
compared to ensure that the marking was consistent in both languages. Leaders also discussed, on a
selective basis, the results of arbitration with their markers once the second marking began.
Each candidate’s paper was marked independently for the primary indicators by two markers. If the
two initial markings differed on any indicator, an arbitrator (the leader, assistant leader, or a senior
marker) compared the two initial markings and determined the final result for that indicator. Based on
the results of this marking, borderline responses that had met Level 1 and 2, but not Level 3, for the
primary indicators were identified and were marked for secondary indicators. Only the leaders and the
assistant leaders marked responses for secondary indicators.
As an added measure to ensure that markers were consistently applying the marking guide, a two-day
rule was put in place. This meant that the second round of marking did not begin until two days had
elapsed since the first marking. This rule ensured that any movement of the guides due to marker
interpretations being established during the first two days of live marking were stabilized before the
second marking and arbitration procedures began.
Reviews of evaluation results are allowed by all provincial institutes. In addition, failing candidates
may apply for a performance analysis review to assist them in assessing their performance on the 2012
UFE.
How to apply for a review of results
Applications for a review of a candidate’s evaluation results must be forwarded to the Board of
Evaluators through the provincial institutes. If candidates wish to apply for such a review, they should
notify their respective institutes within the specified time limit.
Candidates may only apply for review of their examination results as a whole.
Review approach
The following review procedures are applied to all three papers constituting the Uniform Evaluation:
Under the supervision of the Chair of the Board of Evaluators, and the Principals CA Qualification,
the papers are reviewed by the leaders and assistant leaders who did the original marking. The team
leaders and assistant team leaders read the answers and compare them to the evaluation guides used at
19
the original marking centre. In reviewing candidates’ results, two aspects are considered by the board. First, it must be determined that the basis of marking the papers has been consistent with that accorded
other candidates who wrote the evaluation. Second, all papers reviewed are subjected to a careful
check to ensure that the markers have indicated that consideration has been given to all material
submitted by the candidate.
The results are then tabulated and the decision made whether any candidates have been treated unfairly
and should be granted a pass in the examination. There have been a relatively insignificant number of
changes made to reviewed papers over the years, which is attributable to the care exercised in the
original marking and tabulating of the papers and results and to the consideration given to individual
papers in the review procedure.
The results of the review are forwarded to the provincial institutes for approval and notification to the
candidates.
How to apply for a performance analysis review
Applications for a performance analysis review must be forwarded to the Board of Evaluators through
the provincial institutes. If candidates wish to apply for both a review of their examination results and
a performance analysis review, they can do so. Should the review of a candidate’s paper result in his or her standing being changed to a pass, the performance analysis review will not be performed and
any associated fees will be refunded.
20
Appendix B
The candidate
understands the significant financial
constraints faced by HandySide, the flaws
in the strategic direction contemplated by
Alex and the importance of the price
adjustment clause.
The candidate
identifies that FSI is not operating
effectively due to Kevin’s increased absence, and presents possible solutions to
address the situation.
The candidate
discusses important decisions Louise needs
to make about MMB.
The candidate
discusses the potential for management
bias towards a higher EBITDA due to their
bonus.
The
candidate raises issues with the sale that
Chinook may not have considered.
The candidate
analyzes the draft terms of reference for
the finance and audit committee, identifies
weaknesses and recommends
improvements.
The
candidate helps establish a risk
management plan for Chinook.
The candidate
analyzes the three options for financing the
distribution centre (DC) acquisition.
The
candidate normalizes earnings in order to
estimate the purchase price of Chinook.
The
candidate determines the amount of
financing needed and discusses the
potential sources of financing for the
proposed transaction.
The candidate
analyzes the tax issues for HandySide.
The candidate
provides recommendations regarding the
tax issues presented.
The
candidate discusses the significant taxation
issues associated with the proposed
transaction.
21
22
Appendix B
The candidate
considers whether the independent auditors
can use the work of the internal audit
function and provides specific audit
procedures to substantiate net income
before tax for the price adjustment clause.
The
candidate does some preliminary planning
for the year-end review engagement,
concentrating on areas requiring extra
work.
The
candidate provides examples of the
required controls to ensure the proper
collection, storage and distribution of
breast milk.
The
candidate identifies the impact of the
accounting issues on the planning of the
audit and suggests procedures to be
performed.
The
candidate discusses the potential going
concern issue and its impact on the
auditor’s report.
The
candidate identifies the impact of the
accounting issues on the planning and
performance of the audit and suggests
additional procedures.
The
candidate discusses engagement issues
related to the work being requested,
including potential conflicts of interest,
and suggests ways to manage them, while
considering useful additional services that
could be provided to Ron and Paul.
The candidate
identifies areas whereby HandySide was
not reporting in accordance with ASPE
and provides recommendations.
The
candidate discusses the accounting issues
that need to be addressed by FSI in order
to comply with ASPE.
The candidate
discusses appropriate accounting policies
to implement at MMB.
The
candidate provides appropriate analysis of
the accounting issues.
The
candidate calculates the value of the WIP
inventory and the warranty provision, as
required for the completion of the audit.
The
candidate provides appropriate analysis of
The
candidate discusses some of the accounting
policies that would be required for the
Funky Tire financial statements to be in
accordance with ASPE.
23
24
Appendix B
The candidate
analyzes the two replacement systems and
the associated implementation issues.*
The candidate
analyzes the profitability of the divisions
The candidate
evaluates the two systems and compares
them against the ERD requirements.*
The
candidate calculates the cost per 120 ml
bottle of breast milk that MMB needs to
charge in order to cover its operating costs.
* Information and Information Technology indicator
25
26
Appendix C — Paper I
THE INSTITUTES OF CHARTERED ACCOUNTANTS
OF CANADA
2012 Uniform Evaluation
PAPER I
Time: 5 hours
(1) Simulations that require knowledge of the Income Tax Act, the Income Tax Application Rules 1971,
and the Income Tax Regulations are based on the laws enacted at March 31, 2012, or in accordance
with the provisions proposed at March 31, 2012.
Provincial statutes, including those related to municipal matters, are not examinable.
(2) Tables of present values, certain capital cost allowance rates, and selected tax information are
provided at the end of the evaluation paper as quick reference tools. These tables may be used in
answering any simulation on the paper.
(3) Answers or parts of answers to simulations will not be evaluated if they are recorded on anything other
than the CICA-provided USB key or the writing paper provided. Rough notes will not be evaluated. You
are asked to dispose of them rather than submit them with your response.
**********
2012
The Canadian Institute of Chartered Accountants
277 Wellington Street West, Toronto, Ontario, Canada M5V 3H2
Printed in Canada
I
27
You, CA, have just been hired by HandySide Home Improvement Ltd. (HandySide) in the finance and
accounting department. Prior to HandySide, you worked for a public accounting firm in an assurance
capacity.
Today is October 11, 2012. Alex Victor, the chief executive officer (CEO) and owner of HandySide, calls
you into his office. Alex begins, “CA, I have a new and exciting project for you. As you know, on
January 1, 2012, I purchased all of the shares of HandySide from the previous owner, John Maarten.
“John ran this company very conservatively, never borrowing a dime throughout its history. He acquired
all the company’s real estate, except the head office, in a related company, Maarten Real Estate Inc.
(MRE), and then leased those properties to HandySide. As a result, HandySide never incurred debt and
only produced Notice to Reader financial statements for tax purposes. John continues to own MRE, since
the real estate was far too valuable for me to buy at the same time as the operations. However, as part of
the acquisition, I was able to negotiate a new five-year lease for each store and the distribution centre at
market rates, consistent with prior years. The leases include a 12-month rent-free period for 2012.
“I purchased the shares for $85 million. I have worked at HandySide for the last five years as chief operating officer, so I thought I understood the value of the company and therefore did not have a formal
business valuation performed. In addition, John and I agreed to a price adjustment clause to protect me
from any deterioration in profitability. I incorporated a holding company called Victor Holdings Ltd.
(VHL), which borrowed $75 million at 6.5% over 10 years to purchase the shares from John. John was
willing to provide an interest-free $10-million loan to VHL for the remainder. Because of the significance
of the borrowings, VHL’s lender, the Canadian National Venture Fund (CNVF), requires audited financial statements for HandySide prepared under Canadian Accounting Standards for Private
Enterprises (ASPE).
“I have big plans for HandySide, which require a strengthening of the company’s governance. While we
have a board of directors that has been in place for several years, I have also created a new finance and
audit committee. The first meeting of this committee is scheduled to take place in one week. Your task is
to prepare me a report summarizing your analysis of all the agenda items (attached) to help me anticipate
and prepare for any issues susceptible to be raised at that meeting.
“As well, given your professional background, I would like you to assist our internal audit department. In the past our internal audit department has performed only ‘operational audits’ of the various departments and stores of HandySide, but given the new requirements of CNVF, I would like them to perform some
procedures on HandySide’s financial statements to ensure that the statements are accurate before the independent auditors arrive. Please suggest procedures the internal audit department could perform to
substantiate the high-risk account balances in the financial statements. As well, I would like the
independent auditors to rely on the procedures that the internal audit department will perform, to help
contain our audit fees. What will the independent auditors consider when determining whether and to
what extent they use the work of the internal audit department?
28
“I had been planning the purchase of HandySide for a long time. My prime objective is to compete with
the big box retailers, who often have lower prices than ours. Wherever there is a big box store, I want
there to be a HandySide. For too long, we have been distracted by divisions that are not part of our core
business. For example, I always believed that the Trade Contractor division was not part of our strategy,
and have wanted to close it down. Do you think that is a good idea?” Uniform Evaluation Report — 2012
A
B-1
B-2
B-3
B-4
C
Finance and Audit Committee — Draft
Terms of Reference
Financial Analysis:
Background Information
Interim Financial Statements
Additional Financial Information
VHL Opening Balance Sheet
Financing Alternatives for Distribution
Centre (DC) Acquisition
Review and comment before
submitting to the board for approval
For information
Review and comment
D
Ready-To-Move (RTM) Software
Review and comment; raise
potential implementation issues
E
Internal Audit Department
For information
F
Adjustment Clauses
Review and assess whether the
adjustment clauses can be invoked
G
Taxation Considerations
Review and comment
29
30
FINANCE AND AUDIT COMMITTEE — DRAFT TERMS OF REFERENCE
The primary functions of the finance and audit committee (the “Committee”) are to
1) assist the board of directors in overseeing the company’s financial affairs;;
2) liaise with the company’s independent auditors;; 3) oversee the activities of the internal audit department.
1)
2)
3)
4)
5)
6)
One member from the board of directors
One member from the Canadian National Venture Fund (CNVF)
HandySide’s CEO
HandySide’s vice-president of internal audit, who will serve as chairperson
HandySide’s controller
A representative of the independent auditors
Members will not receive compensation. At least one member must possess a working familiarity with
finance and accounting practices. The members shall be appointed by the CEO for a term of three years.
The Committee shall meet at a minimum once a year. A majority of the Committee shall constitute a
quorum for the transaction of business. Each meeting’s agenda will be prepared by the CEO.
1) Report periodically to the board of directors.
2) Review and discuss with management and the independent auditors the annual audited financial
statements and income tax returns.
3) Prepare the annual operating budget.
4) Review and discuss with management significant operational issues.
5) Negotiate the compensation packages for all divisional managers.
6) Identify business risks associated with HandySide’s strategic direction.
7) Design and implement systems for internal control.
The Committee shall sign the engagement letter and representation letter prepared annually by the
independent auditors. The Committee shall approve the annual audited financial statements.
31
BACKGROUND INFORMATION
John Maarten
100%
Alex Victor
100%
Maarten Real Estate Inc. (MRE)
[land & buildings — retail stores
and distribution centre (DC)]
Rent Paid
Victor Holdings
Ltd. (VHL)
100%
HandySide Home Improvement Ltd.
100%
(HandySide) [head office land & building
and HandySide operations]
John Maarten (the previous owner) opened his first home improvement store in Regina in 1972. Over
time, the company opened new and larger locations, and now operates a chain of 28 home improvement
stores located throughout western Canada. In the late 1990s, the industry became much more competitive
as US-based big box retailers began opening stores throughout Canada.
Currently HandySide operates four divisions:
1)
—
Stores are located in cities, where HandySide competes with many big box stores.
2)
—
Stores are located in towns, where HandySide is usually the only home improvement
store.
3)
HandySide sells supplies, such as lumber, nails, and tools, to trade contractors.
This division is located inside the retail stores but operates independently.
4)
HandySide will custom-build a home to a customer’s specifications and transport the finished home to the customer’s land.
HandySide has entered into preliminary discussions with a home improvement retail chain in Atlantic
Canada that would see HandySide acquire 65 retail stores with revenues totalling over $225 million. The
current owner of the chain will retire in approximately five years and has approached Alex about a
potential acquisition in 2017.
32
BACKGROUND INFORMATION
HandySide believes it has several options to finance the purchase, including the following:
CNVF term loan
under terms similar to the financing of the HandySide acquisition by VHL.
Initial public offering offering HandySide shares to the public.
Venture capital financing
issuing a 3% convertible debenture to a venture capitalist. The debenture
would be convertible at the option of the debenture holder.
To date, HandySide has not analyzed the options.
INTERIM FINANCIAL STATEMENTS
HANDYSIDE HOME IMPROVEMENT LTD.
BALANCE SHEET
(Prepared by management)
As at Sept. 30,
2012
As at Dec. 31,
2011
Assets
Current assets
Cash
Accounts receivable
Inventory
Prepaid expenses
$
Due from VHL
Intangible assets
Property, plant and equipment, net
12,694,447
26,826,778
426,112
39,947,337
$
5,625,000
1,956,540
10,515,888
$
58,044,765
965,124
11,653,731
22,576,894
412,060
35,607,809
11,459,631
$
47,067,440
$
15,065,192
5,149,854
20,215,046
Liabilities and shareholder’s equity
Liabilities
Current liabilities
Bank indebtedness
Accounts payable and accrued liabilities
Income tax payable
Current portion of mortgage payable
$
Mortgage payable
Shareholder loan, non–interest bearing
14,345,854
11,184,840
634,023
1,928,269
28,092,986
20,601,576
48,694,562
21,599,560
41,814,606
Shareholder’s equity
Share capital
Retained earnings
100
9,350,103
9,350,203
$
58,044,765
100
5,252,734
5,252,834
$
47,067,440
33
34
INTERIM FINANCIAL STATEMENTS
STATEMENT OF INCOME AND RETAINED EARNINGS
Revenue
$ 60,135,492
$ 38,835,962
$ 31,615,680
$ 12,915,211
48,899,937
11,235,555
25,404,732
13,431,230
20,489,687
11,125,993
1,854,702
1,219,210
1,344,621
3,267,699
1,976,952
9,663,184
2,217,151
1,457,470
1,607,390
3,906,280
2,363,292
11,551,583
1,836,616
1,207,321
1,331,510
3,235,835
1,957,674
9,568,956
1,879,647
$ 1,557,037
Cost of sales
Gross profit
Expenses1
General and
administrative
Equipment
Interest and bank charges
Occupancy
Salaries and benefits
Selling
Net income before tax
$ 1,572,371
$
$
$
143,502,345
$ 197,054,985
6,881,950
6,033,261
101,676,306
41,826,039
135,368,792
61,686,193
995,937
654,690
722,034
1,754,687
1,061,583
5,188,931
6,904,406
4,538,691
5,005,555
12,164,501
7,359,501
35,972,654
8,305,629
5,016,894
300,215
4,500,412
16,300,251
9,152,006
43,575,407
844,330
5,853,385
18,110,786
1,756,016
4,097,369
5,252,734
5,433,236
12,677,550
(10,000,000)
2,575,184
Provision for income tax — current
Net income after tax
Dividends paid
Retained earnings, beginning of period
Retained earnings, end of period
1
$
9,350,103
$
5,252,734
Expenses are allocated based on gross profit. Further information on expenses is as follows:
General and administrative expenses relate to head office.
Equipment includes the following:
o Furniture and computers leased by head office for $273,500
o Leased equipment used by the RTM division for $528,988
o Forklifts, trucks, and equipment leased by the retail divisions for $3,736,203
Due to the rent-free period offered by MRE, no amounts have been recorded for occupancy in 2012.
The Trade Contractor division comprises 8% of the square footage of the retail stores. The RTM
division accounts for 10% of overall occupancy costs.
Each division has a manager who makes an annual base salary of $120,000 plus a bonus of 0.1% of
the division’s sales. These amounts are included in salaries and benefits above. The remainder of
salaries and benefits relates to head office.
Selling costs relate to the production and distribution of a weekly flyer for retail customers.
35
ADDITIONAL FINANCIAL INFORMATION
Revenue from each retail store is uploaded nightly from the store’s point-of-sale system.
Trade contractors are given payment terms of 60 days. In addition, HandySide allows contractors to
return any unused items with no questions asked within three months of purchase. This has made
HandySide a favourite of contractors. Returns average 1% of sales, and are recognized as incurred.
Revenue from RTM is recorded upon completion of each home. Depending on the availability of
materials and the options selected, it can take anywhere from 2 to 15 months from order to delivery.
Retail inventory consists of building supplies, such as lumber, drywall, flooring, and power tools. Each
store maintains its own level of inventory, which it orders from the distribution centre (DC). The DC
warehouses approximately 60% of all inventory. The DC is necessary, especially for the smaller stores,
which do not have the space to store a large amount of inventory. It allows HandySide to buy in large
quantities and enjoy volume-based discounts.
This is especially true for drywall, for which the supplier calculates and pays a rebate based on the
volume of annual sales. HandySide typically purchases drywall for $15 per sheet. However, retail prices
average only $8 per sheet because drywall is used in promotions to bring customers into stores.
Historically, HandySide has received a rebate cheque for approximately $9 per sheet after the supplier
calculates HandySide’s annual rebate in February of the following year. (In February 2012, HandySide
received a drywall rebate cheque for $2.8 million.) However, due to a change in the volume required to
earn the rebate, HandySide will not receive the rebate for its 2012 purchases. No rebate is accrued in the
general ledger or the inventory costing system. At September 30, 2012, drywall inventory was
approximately 75,000 sheets across the DC and all retail locations. Rebates are included in cost of sales in
the financial statements when received.
The same inventory costing system used for the DC and retail stores is used for RTM. The system’s use of weighted average creates problems in the RTM cost accumulation, especially since homes are
customized. Fixed overhead production costs are allocated to each home based on the maximum capacity
of the production line.
36
ADDITIONAL FINANCIAL INFORMATION
Monthly principal payments of $625,000 plus interest at 6.5% on the loan commenced January 31, 2012,
and are paid from HandySide’s bank account. Interest is expensed. Principal is recorded in the intercompany “due from VHL” account. During 2012, HandySide took out a $23-million, 10-year, 4% fixed-rate mortgage secured by the head
office land and building. The proceeds of this mortgage were used to pay back John’s shareholder loan.
Logo project
Website project — general
Website project — e-commerce module
$
211,257
1,423,133
322,150
$
1,956,540
Logo project: HandySide paid an outside design firm to rebrand the company, complete with a new logo
and slogan.
Website project: HandySide rebuilt its website during 2012. The website includes an e-commerce module
that allows retail customers to purchase products online.
VHL OPENING BALANCE SHEET
VICTOR HOLDINGS LTD.
OPENING BALANCE SHEET
As at January 1, 2012
Assets
Current assets
Cash
Investment in HandySide
$
100
85,000,000
$
85,000,100
Liabilities and shareholder’s equity
Liabilities
Current liabilities
Current portion of long-term debt
Due to John Maarten, on demand
$
Long-term debt — CNVF
7,500,000
10,000,000
17,500,000
67,500,000
85,000,000
Share capital
100
$
85,000,100
37
38
FINANCING ALTERNATIVES FOR DISTRIBUTION CENTRE (DC) ACQUISITION
HandySide currently leases the DC from MRE under standard lease terms, which are at fair market value.
Last month, MRE was approached by a condominium developer who would like to purchase the land and
buildings for a price of $10,525,000. Under the terms of the lease, John must first offer the DC to
HandySide before selling to another party. HandySide has identified three potential financing options.
Option 1
John has offered a leasing arrangement. HandySide would lease the DC for $175,000 at the beginning of
each month for 84 months. John would retain title of the DC until all the lease payments have been made,
at which time he would sell it to HandySide for $1. If a lease payment was missed in any one month, it
could be paid in the following month, along with a $5,000 penalty. The lease would also allow for five
“payment holidays” during the term of the lease. If all five payment holiday months were chosen, the
lease would simply be extended to 89 months.
Option 2
HandySide’s bank has offered a 10-year term loan at 8%, with blended equal payments made at the end of
each month. The bank would require 25% down and a first mortgage on the DC, as well as personal
guarantees from Alex and John.
Option 3
CNVF has offered a 12% mortgage, with minimum blended repayments of $115,818 at the end of each
month. CNVF is willing to finance 95% of the purchase price, subject to a first mortgage on the DC and a
personal guarantee from Alex.
39
READY-TO-MOVE (RTM) SOFTWARE
—
Build-it 3.1 is RTM’s manufacturing system software. It began failing regularly in August of 2012. It is
an off-the-shelf package and has been extensively customized over the years by an IT consulting firm.
The IT firm does not have access to the original source code. The software manufacturer has announced it
will no longer support version 3.1 after December 31, 2012. HandySide has not kept records of the
customizations. However, the program and encrypted data are backed up nightly to the IT firm’s server. HandySide issued a request for proposal for a new system, and received two proposals.
—
Ground-Up 2012 is an end-to-end sales and manufacturing solution developed for high-end custom home
builders. Without customization, the software would present too many options to the customer and would
need to be modified to adapt to the more limited number of options offered in an RTM home.
It operates on a company’s own in-house server. Order entry can be done from any computer on the
network, allowing the customer to view the choices on screen.
Ground-Up 2012 includes a work scheduling module, although it does not schedule work days based on
labour and material availability. It simply allows work days to be entered on a shareable calendar.
Although the system does not have its own inventory costing system, the developer has offered to write
an interchange module that would automatically interface with HandySide’s existing inventory costing system.
Ground-Up 2012 costs $275,000, plus $55,000 for the modifications outlined in the proposal. Further
modifications will be charged at $100 per hour. The supplier estimates the project will take three months
to implement.
—
Virtual Pre-Fab would be custom-developed for HandySide. The system would run entirely in the “cloud”
and be accessible using a user ID and an encrypted password from any device connected to the Internet.
Although the proposing company has not worked with a manufacturing client yet, it has had extensive
experience developing an integrated system for an automobile parts wholesaler.
40
READY-TO-MOVE (RTM) SOFTWARE
The proposal includes developing a tablet-based order entry system, which would allow sales
representatives to walk around the display homes and enter customers’ choices as they are selected. Order entry would be fully integrated with the inventory system, so that as each item is chosen, the
representative would know whether the item is in stock or how long it will take to deliver. Once the
customer has made all the choices and signed off electronically on the tablet, the order would be released
to manufacturing.
The system will check for inventory shortages and automatically order any required items. Based on
estimated arrival dates, the system will automatically schedule production for an appropriate date,
accounting for labour availability and estimated delivery day. As items arrive, production personnel check
off each one on a tablet-based picking list and stage the items for production. Once production begins,
Virtual Pre-Fab’s integrated costing system would accumulate costs to each project, using specific
identification.
Virtual Pre-Fab will use a software delivery model in which software and its associated data are hosted in
an Internet cloud. The software is paid for monthly for as long as the company wishes to use it. The
monthly cost will be between $7,500 and $15,000, depending on development time. This price includes
all future upgrades. If additional features are requested, the monthly fee would be increased to reflect the
development time. The supplier estimates a total development and implementation time of 10 months.
The production supervisor would be the only HandySide employee involved in the implementation of a
new system. The production supervisor helped implement Build-it 3.1 and does not wish to change it,
preferring instead to investigate and repair the cause of the recurring system failures. The production
supervisor will be expected to maintain his current duties during the implementation since the provider of
the software chosen will perform the implementation.
The RTM division staff, many of whom are long-term employees, are very familiar with the current
system. HandySide does not employ any internal IT personnel.
41
INTERNAL AUDIT DEPARTMENT
Christine Marcotte, CA, CIA, has led the internal audit department at HandySide for the past six years as
vice-president (VP) of internal audit. Christine was previously the manager of internal audit for a large
discount retailer, and was hired by the board of directors. The VP of internal audit is required to hold CA
and Certified Internal Auditor (CIA) designations.
Staff members must be designated accountants and must begin the CIA designation program within four
weeks of completing HandySide’s internal auditor training course. Candidates with internal audit experience are given preferential consideration, although experience in external auditing is acceptable.
Staff reports to the VP, who in turn reports to the chair of the board of directors in writing at least
quarterly. The VP is also required to meet with the independent auditors at least twice a year.
Any location of HandySide may be audited, including head office. The location is required to be notified
three days in advance, and can request a postponement. All audits are conducted in accordance with
HandySide’s internal audit manual, and all work performed is reviewed by the VP.
The internal audit department visits each location at least once per year. The internal audit staff is
expected to have additional time available to fulfill requests of the board of directors and its committees.
42
ADJUSTMENT CLAUSES
The agreement with John includes a provision that would allow the $85-million purchase price to be
reduced by $21.25 million if net income before tax in either 2012 or 2013 falls below $5 million.
Net income before tax will be based on an audited set of non-consolidated annual financial statements for
HandySide, based on ASPE. However, HandySide has never had an audit performed, nor has it ever
reported under ASPE.
The agreement includes a clause requiring John to fully reimburse VHL for any additional income tax for
which HandySide may be assessed related to activities prior to January 1, 2012. VHL must notify John
prior to December 31, 2013, should it wish to use this clause of the agreement.
43
TAXATION CONSIDERATIONS
In the previous three years, HandySide claimed charitable donations of $200,000 per year. The payments
were made to International Giving of Canada, an organization that, according to its website, provides
relief from poverty to children in parts of Africa. HandySide has copies of the donation receipts, although
there is no Canadian charitable registration number on the receipts.
HandySide invested excess cash in the stock market and realized losses of $200,000 and $350,000 in
2008 and 2009 respectively.
HandySide leased a vehicle worth $123,000 for John for $1,500 per month. John used this vehicle to visit
stores, drive to meetings, and drive between his home and the head office. In total, he put about 50,000
kilometres on the vehicle annually and used it for business about 70% of the time. As part of the sale
agreement, HandySide agreed to continue paying the lease payments through the end of the lease in 2015.
John has driven the vehicle to Arizona, where he has retired with his wife.
While John was CEO, HandySide leased a small propeller plane to fly to remote HandySide locations.
John would typically spend five days working with the store manager, staying in a hotel in the town.
Often John’s wife would accompany him on these trips and they would do some fishing while there.
HandySide has been paying and deducting premiums of $2,000 per month on a life insurance policy on
John. HandySide is the beneficiary of the policy, and continues to pay the premiums at John’s request. CNVF has suggested leaving the life insurance in place until its loan is paid off.
HandySide encourages all of its managers to attend two out-of-town conventions per year, in order to
foster professional development. In the past two years, the management group attended a total of 12
different conventions in places like Las Vegas, Barcelona, and Shanghai. HandySide pays for the
manager’s flight, hotel, meals, and registration costs, but any costs for spouses are paid by the individual.
HandySide has fully deducted the convention expenses it has incurred.
44
Appendix C — Paper I — Evaluation Guide
The reader is reminded that the solutions are developed for the UFE candidates; therefore, all the
complexities of a real-life situation may not be fully reflected in the following solution. The
is not an authoritative source of GAAP.
In addition, the
sections referenced in this suggested solution are intended for learning
purposes only. While candidates are expected to apply the guidance in the
when analyzing
financial reporting and assurance issues, they are not expected to directly quote from the
Candidates who choose to quote
sections are reminded that no credit is given unless the
quotation is integrated into a meaningful analysis and applied to the relevant case facts.
To:
From:
Subject:
Alex Victor, CEO HandySide Home Improvement Ltd. (HandySide)
CA
Input on finance and audit committee agenda items associated with HandySide
As requested, I have prepared a draft report analyzing all of the agenda items associated with the finance
and audit committee meeting that will be held on October 18, 2012. My report follows.
Primary Indicator #1
The candidate identifies areas where HandySide was not reporting in accordance with ASPE,
The candidate demonstrates competence in Performance Measurement and Reporting.
Competencies
V – 2.2 Develops or evaluates accounting policies in accordance with GAAP (Level A)
V – 2.4 Accounts for the entity’s non-routine transactions (Level B)
HandySide’s opening balance sheet (December 31, 2011) was not audited and as a result there are likely
adjustments that should be made to various accounts. These accounts would include the accounts
receivable (for the trade contractor allowance), the RTM inventory (to reflect the percentage-ofcompletion method), and the retail inventory (for the rebates not accrued — see later discussion).
(Few candidates recognized these minor issues. Of those candidates who did address issues associated
with the opening balances, most appropriately dealt with the issues while discussing each of the related
balances for the current year.)
45
HandySide has several distinct revenue streams, each of which must be disclosed and accounted for
separately. We are concerned that the RTM homes and trade contractor revenue have not been accounted
for correctly.
Ready-To-Move (RTM) Homes
RTM homes are being accounted for using the completed contract method, with revenue being recognized
upon completion of the home. According to Handbook Section 3400.18, “The completed contract method would only be appropriate when performance consists of the execution of a single act or when the
enterprise cannot reasonably estimate the extent of progress toward completion.”
The homes take 2 to 15 months to build, so performance consists of more than one act. Since HandySide
has been in the home building business for several years, and since construction costs can usually be
estimated, the enterprise can reasonably estimate the extent of progress.
The percentage-of-completion method, by contrast, is appropriate when “performance consists of the execution of more than one act, and revenue would be recognized proportionately by reference to the
performance of each act” (HB 3400.19).
Since there are several steps in building a home, it would be appropriate to use the percentage-ofcompletion method. The costs-to-date method would be the most appropriate way to recognize revenue,
since it measures how complete the project is. However, given that HandySide’s costing system does not allocate costs individually to each house (see cost accumulation discussion), exact costs may be difficult
to determine. We should discuss with management what information is available. If costs cannot be
determined, an expert’s estimation of the completeness of the house would be appropriate. Delivery and installation may also form part of the contract when RTM homes are sold and should be considered as
part of the home building process.
(Most candidate’s recognized the revenue recognition issue with respect to the RTM homes. Many also clearly understood that the percentage-of-completion method would be a more appropriate method for
recording revenue. However, some candidates indicated that HandySide could choose either the
completed contract or the percentage-of-completion method, and that either would be appropriate. This
was not correct. HandySide would be required to choose the method that better reflected the substance
of the transaction, and given the case facts, this would most likely be the percentage-of-completion
method.)
Trade Contractors
We must consider the effect of the liberal return policy on revenue recognition. Since contractors are
allowed to return items with no questions asked within three months of purchase, returns could be very
significant. The contractors can over-order supplies, not pay for them, and then return what they do not
use. Further, they could buy tools, use them on a job, and then return them.
46
CICA Handbook Section 3400.21(b) states:
Revenue would not be recognized when an enterprise is subject to significant and unpredictable amounts
of goods being returned; for example, when the market for a returnable good is untested. If an enterprise
is exposed to significant and predictable amounts of goods being returned, it may be sufficient to provide
therefor.
Since it sounds like this policy has been in place long enough for HandySide to become a favourite of
contractors, returns can likely be estimated and provided for at year-end. Historically returns have
averaged 1%; therefore, this may be a good estimate of returns at year-end.
Given that trade contractors are also given 60 days to pay for their goods, HandySide should consider
including an allowance for uncollectible amounts. We would need to examine more information on
historical payments by trade contractors to determine an appropriate allowance.
(Most candidates were able to demonstrate an appropriate understanding of the revenue recognition
issue with regards to trade contractors. Some candidates went to great lengths to discuss all of the
various revenue recognition criteria contained in the
, which was not required in this
situation. The real issue was the liberal return policy, and efficient candidates were able to zero in on
this issue, analyze it using case facts, and recommend an appropriate accounting treatment.)
There is an issue with the costing of drywall. Handbook Section 3031.10 states that “Inventories shall be measured at the lower of cost and net realizable value.” Since drywall retails for $8 and yet is purchased
for an average of $15, it is being carried above its realizable value of $8. Since the rebate received in the
past was $9, the actual cost should have been $15 − $9 = $6. However, HandySide is not expecting to receive the rebate for its 2012 purchases, so we should not accrue the rebate.
ASPE requires a writedown to the lower of cost, $15, and net realizable value, $8. Therefore, we should
reduce the inventory carrying cost on the 75,000 sheets remaining in inventory by $525,000 [($15 − $8) × 75,000]. The weighted average costing system is acceptable under ASPE, as is first-in, first-out.
As well, HandySide received a $2.8-million rebate cheque in February 2012 relating to 2011 purchases.
Therefore, net income in 2012 should be reduced by $2.8 million (and net income in 2011 should be
increased by $2.8 million).
(Most candidates identified and discussed the issue relating to the NRV of the current drywall
inventory and performed an appropriate analysis. Surprisingly, few candidates discussed the issue of
the improper treatment of the 2011 rebate, even though this resulted in a very large misstatement.)
47
The RTM homes cost accumulation is problematic. Handbook Section 3031.22 states: “The cost of
inventories of items that are not ordinarily interchangeable and goods or services produced and
segregated for specific projects shall be assigned by using specific identification of their individual
costs.” Since RTM homes are all custom-built to a customer’s specifications, the use of a weighted average cost flow assumption is not acceptable. HandySide will be required to use the specific
identification method to accumulate costs to each home.
As well, overhead production costs are being allocated based on maximum capacity of the plant. Under
Handbook Section 3031.14, “The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities.” Unless the plant runs at maximum capacity
normally, we will need to calculate an overhead factor that reflects normal production. This will increase
the amount of costs assigned to each RTM home.
(Many candidates did not recognize the cost accumulation issues with the RTM homes. However, most
candidates who recognized these issues were able to appropriately discuss them and included
appropriate case facts to support their analyses.)
The CNVF term loan is not a liability of HandySide because the loan was made by CNVF to VHL;
therefore, the interest should not be expensed in HandySide. Instead, it should be expensed in VHL. This
will have a significant impact on earnings in HandySide, since the interest deducted so far has been as
follows:
Loan
1
2
3
4
5
6
7
8
9
Date
01/01/2012
31/01/2012
28/02/2012
31/03/2012
30/04/2012
31/05/2012
30/06/2012
31/07/2012
31/08/2012
30/09/2012
Payment
Interest
$ 1,031,250
1,027,865
1,024,479
1,021,094
1,017,708
1,014,323
1,010,938
1,007,552
1,004,167
$
406,250
402,865
399,479
396,094
392,708
389,323
385,938
382,552
379,167
$ 9,159,375
$ 3,534,375
Principal
$
625,000
625,000
625,000
625,000
625,000
625,000
625,000
625,000
625,000
Balance
$ 75,000,000
74,375,000
73,750,000
73,125,000
72,500,000
71,875,000
71,250,000
70,625,000
70,000,000
69,375,000
$ 5,625,000
Therefore, $3,534,375 should be credited to interest and debited to the inter-company account. HandySide
may need to pay a dividend or management fee to VHL so that VHL will have cash to make its payments
to CNVF.
(Most candidates were able to identify and discuss the inappropriate accounting treatment of the
CNVF interest. This issue may not have been as obvious as some of the other accounting issues, and
the Board was pleased to see that, despite this, most candidates were still able to identify it.)
48
HandySide has capitalized certain expenditures in 2012. Under Handbook Section 3064, in order to meet
the definition of an intangible asset, assets must meet the identifiability, control, and future economic
benefits tests.
Identifiability
Under Handbook Section 3064.12, “An asset meets the identifiability criterion in the definition of an intangible asset when it
(a)
is separable (i.e., is capable of being separated or divided from the entity and sold,
transferred, licensed, rented or exchanged, either individually or together with a related
contract, asset or liability); or
(b)
arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations.”
The logo project and website could not be separated from HandySide, since the name and site are
essential for operation. It is possible the e-commerce part of the website could be separated from
HandySide, and more information needs to be gathered to determine if this is in fact possible. For now we
will assume that the e-commerce portion can be separated.
Control
An entity controls an asset if the entity has the power to obtain the future economic benefits flowing from
the underlying resource and to restrict the access of others to those benefits. (HB 3064.13)
The logo, website, and e-commerce part of the website meet this definition, since each will have future
economic benefits (increased sales), and others outside the company cannot access them.
Future Economic Benefits
The future economic benefits flowing from an intangible asset may include revenue from the sale of
products or services, cost savings, or other benefits resulting from the use of the asset by the entity. (HB
3064.17)
The logo, website, and e-commerce part of the website meet this definition, since they all should increase
sales.
In summary, the only item that meets all three criteria of an intangible asset is the e-commerce part of the
website.
Further, Handbook Section 3064.47 specifically states: “Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognized as intangible
assets.”
49
As well, Section 3064.21 states: “An intangible asset shall be recognized if, and only if:
(a) it is probable that the expected future economic benefits that are attributable to the asset
will flow to the entity; and
(b) the cost of the asset can be measured reliably.”
Therefore, the general website and logo expenditures must be expensed. However, the amount paid for
the e-commerce module may be capitalized, since it will produce future revenue directly.
We should also consider the amortization period for the e-commerce portion of the website. Since
technology changes quickly, the amortization period for the e-commerce portion should be short —
perhaps two years.
(The accounting guidance with respect to the intangible assets (the logo project and the website) can be
quite complex, and various areas of the
could have been used appropriately to analyze these
issues. Candidates were rewarded for suitable discussions of these issues that were based on the
application of appropriate
sections. Most candidates were able to distinguish the various
costs associated with the logo project and the website and analyzed them separately, as expected.)
Currently, no amount is recorded in the financial statements for occupancy costs, since HandySide has a
rent-free period for all of 2012. However, under Handbook Section 3065.27, “Lease inducements are an inseparable part of the lease agreement and, accordingly, are accounted for as reductions of the lease
expense over the term of the lease.” Therefore, we must include lease expense on our financial
statements, calculated as follows:
Occupancy cost in 2011
Years of rent to pay
Total rent to be paid
Remaining lease term
Annual lease expense
4,500,412 (this assumes a similar amount for future years)
×
4
18,001,648
÷
5
$3,600,330
(The rent-free period was a relatively straightforward accounting issue, and most candidates were able
to identify and discuss the issue appropriately. Most candidates were also able to demonstrate their
understanding of this issue by calculating the amount that would need to be expensed in 2012.)
50
EFFECTS OF ADJUSTMENTS TO ASPE ON NET INCOME BEFORE TAX
9-month period ended September 30, 2012
Adjustment
As stated
$
Annualized × 12 ÷ 9
7,804,513
Adjustments:
RTM – % of completion – more information required
Trade contractors (return allowance) – more information required
Trade contractors (A/R allowance) – more information required
Inventory (opening) – 2011 rebate
Inventory – 2012 drywall writedown
Interest expense reallocated to VHL (extended for 12 months)
Occupancy costs
Expense logo project
Expense general website project
Amortization of e-commerce part of website, over 2 years
Adjusted net income under ASPE
Net Income
5,853,385
???
???
???
(2,800,000)
(525,000)
4,651,563
(3,600,330)
(211,257)
(1,423,133)
(161,075)
$
3,735,281
Many of the adjustments to the statements to convert to ASPE will reduce income, and will probably
reduce it below the $5-million threshold necessary to invoke the price adjustment clause. We should also
note that the above analysis assumes that HandySide earns revenue and incurs expenses evenly
throughout the year. We do not have enough information to determine the impact seasonality may have
on the above adjustments.
(Many candidates recognized the impact of the price adjustment clause and performed calculations to
determine whether it would be invoked. Several of the above adjustments were included in their
calculations.)
For Primary Indicator #1 (Performance Measurement and Reporting), the
candidate must be ranked in one of the following five categories:
51
Percent
Awarded
Not addressed — The candidate does not address this primary indicator.
0.0%
Nominal competence — The candidate does not attain the standard of reaching
competence.
13.5%
Reaching competence — The candidate identifies some of the significant
accounting issues for HandySide.
35.6%
Competent — The candidate discusses some of the significant accounting issues
for HandySide.
50.8%
Highly competent — The candidate thoroughly discusses most of the significant
accounting issues for HandySide.
0.1%
(Candidates were asked to identify areas where HandySide was not reporting in accordance with ASPE
and to provide an analysis and recommendations to correct any misstatements. This analysis was very
important due to the price adjustment clause with the previous owner of HandySide. To demonstrate
competence, candidates were expected to provide an analysis of several of the significant accounting
issues for HandySide.)
(Virtually all candidates recognized the requirement to discuss the accounting issues. They were able to
recognize a number of relevant accounting issues, and attempted to analyze the issues. In total there
were approximately eight significant accounting issues. However, none of the accounting issues were
complex or required a large amount of analysis. Therefore, candidates were expected to cover a fair
number of issues in their responses. Most candidates performed reasonable analyses of the accounting
issues and did well when applying the ASPE standards to the case facts. Some candidates struggled
with the relevant standards and discussed irrelevant issues, but overall the responses from the
candidates were as expected.)
The candidate considers whether the independent auditors can use the work of the internal
audit function, and provides specific audit procedures to substantiate net income before tax for
the price adjustment clause.
The candidate demonstrates competence in Assurance.
Competencies
VI – 2.4 Develops guidelines to set the extent of assurance work, based on the scope and expectations of
the assignment (Level A)
VI – 2.5 Designs appropriate procedures based on the assignment’s scope, risk, and materiality
guidelines (Level A)
52
Given my background in a public accounting firm in an assurance capacity, Alex has asked me to help the
internal audit department. Specifically he has asked me to comment in two areas:
1. He would like my comments on determining “what will the independent auditors consider when determining whether and to what extent they will use the work of the internal audit function”; and
2. He would like me to “suggest procedures the internal audit department procedures could perform to
substantiate the high-risk account balances in the financial statements.”
Before analyzing these two items specifically, I would like to point out some overriding issues with such
an engagement.
(Candidates had no difficulty identifying what was being asked of them in terms of this indicator.)
Conflict of Interest
You have asked me to suggest procedures the internal audit group could perform to substantiate the highrisk account balances in the financial statements. This may create a perceived conflict of interest because
I will be suggesting procedures that will be performed on the accounting transactions and balances that
are maintained by the finance and accounting department, where I am employed. However, this perceived
conflict can be mitigated if the procedures are reviewed and vetted by the internal audit group before they
perform them.
(Few candidates recognized this potential perceived conflict of interest.)
Management Bias
It should be noted that management at HandySide has a bias to reduce income below the $5-million
threshold in order to trigger the $21.25-million price adjustment clause. This should be kept in mind when
planning the audit of the high-risk accounts by the internal audit function.
(A few candidates recognized this potential bias but did not explain how it might affect the scope of the
work to be performed.)
Scope of Work
The price adjustment clause includes the following statement: “The agreement with John includes a
provision that would allow for the $85-million purchase price to be reduced by $21.25 million if net
income before tax in either 2012 or 2013 falls below $5 million.” Therefore, the results would be based
on a full year (12 months) of operations. The statements that we have been provided with are for only the
first nine months of 2012, and therefore the work that the internal audit function can perform at this point
will not be conclusive. However, it can provide an estimate of the income, based on ASPE, for the first
nine months of 2012, and this can then be projected for the full year.
53
We should also note that the price adjustment clause is based on net income before tax. While this is more
specific then the financial statements as a whole, the vast majority of the balance sheet accounts and the
income statement accounts would need to be audited to ensure that the net income before tax is not
materially misstated. As such, the procedures planned and the work performed would be very similar to
an audit of the full financial statements. The one significant difference would be that disclosures would
not be important when auditing the price adjustment clause.
(For the most part, candidates did not recognize the shortened period of nine months and did not
comment on what work would be required to substantiate the “net income before tax” amount.)
Independent Auditors’ Perspective
The independent auditors would assess the risk for the HandySide engagement at three levels: at the
engagement level, the financial statement level, and the assertion/account level (see Canadian Auditing
Standards (CAS) 315 — Identifying and Assessing the Risks of Material Misstatement through
Understanding the Entity and Its Environment). The independent auditors are also expected to incorporate
“additional elements of unpredictability in the selection of further audit procedures to be performed”
(CAS 330 A1). Therefore, the internal auditors can perform procedures similar to the independent
auditors and can “expect” that the independent auditors will use their work, but the independent auditors are under no obligation to do so. In fact, the independent auditors would likely be less willing to use the
work of the internal audit group for the high-risk account balances because they may want to perform
procedures on these themselves to substantiate the balances.
(Very few candidates explicitly recognized the fact that the independent auditors would be under no
obligation to use the work of the internal auditors.)
Communication
An important element to consider when planning the procedures of the internal audit function with respect
to the price adjustment clause is the communication element with the independent auditors. Before
beginning any work, the internal audit function should sit down with the independent auditors and discuss
such things as
risk at the financial statement level and the assertion/account level
the planned procedures to be performed
the timing and extent of those procedures, and
how the independent auditors may use the work of the internal auditors to assist them with their
external audit.
(Few candidates made this practical recommendation. Since the work would be essentially performed
for the independent auditors, it would be very important to understand what, if anything, they would
use.)
CAS 610.9, Paragraph A4, details the assessment of the internal auditors from the perspective of the
independent auditors:
54
9.
In determining whether the work of the internal auditors is likely to be adequate for purposes of the
audit, the external auditor shall evaluate:
(a) The objectivity of the internal audit function;
(b) The technical competence of the internal auditors;
(c) Whether the work of the internal auditors is likely to be carried out with due professional
care; and
(d) Whether there is likely to be effective communication between the internal auditors and the
external auditor.
Further details are provided in CAS 610, Paragraph A4. We have analyzed these specific standards in the
following table and have included our analysis of the applicability to HandySide’s internal audit function.
Objectivity
The status of the internal audit function
within the entity and the effect such
status has on the ability of the internal
auditors to be objective.
Since the VP reports directly to
the board and was hired by the
board, the objectivity of the
function is maintained.
Whether the internal audit function
reports to those charged with
governance or an officer with
appropriate authority, and whether the
internal auditors have direct access to
those charged with governance.
Further, the reports issued by
the internal audit function are
used by the board to recommend
improvements to operations.
Whether the internal auditors are free of
any conflicting responsibilities.
Whether those charged with governance
oversee employment decisions related to
the internal audit function.
Whether there are any constraints or
restrictions placed on the internal audit
function by management or those
charged with governance.
Whether, and to what extent,
management acts on the
recommendations of the internal audit
function, and how such action is
evidenced.
There do not appear to be any
conflicting responsibilities, in
fact, but there may be a
perceived conflict of interest as
noted previously.
Therefore, the objectivity
standard appears to have been
met.
Technical competence
Whether the internal auditors are
members of relevant professional
bodies.
Whether the internal auditors have
adequate technical training and
proficiency as internal auditors.
Whether there are established policies
for hiring and training internal auditors.
The VP of internal audit
previously worked at a large
discount retailer, a similar
business to HandySide, where
she was the manager of internal
audit, so she will likely have
technical competence in
auditing.
She has both CA and CIA
designations, further
demonstrating her technical
competence.
Staff hired in IA are required to
take an internal audit training
course and must pursue the CIA
designation within four weeks
of beginning employment.
Therefore, they too have
technical competence in
auditing.
Moreover, preference in hiring
is given to candidates with
internal audit experience.
Due professional care
Whether activities of the internal audit
function are properly planned,
supervised, reviewed, and documented.
Therefore, the technical
competence standard appears to
have been met.
HandySide has an audit manual,
and all staff work is reviewed
by the VP.
The existence and adequacy of audit
manuals or other similar documents,
work programs, and internal audit
documentation.
The work programs should be
reviewed with the independent
auditors to ensure that they are
adequate.
Subject to review by the
independent auditors, the due
professional care standard
appears to have been met.
55
56
Communication
Communication between the external
auditor and the internal auditors may be
most effective when the internal auditors
are free to communicate openly with the
external auditors, and
• meetings are held at appropriate
intervals throughout the period;
• the external auditor is advised of and
has access to relevant internal audit
reports and is informed of any
significant matters that come to the
attention of the internal auditors when
such matters may affect the work of
the external auditor; and
• the external auditor informs the
internal auditors of any significant
matters that may affect the internal
audit function.
The VP meets at least twice a
year with the independent
auditors, and her reports are
provided to them regularly.
As noted here, we suggest that a
meeting take place between the
independent auditors and the
internal audit function before
the internal audit function
begins its work.
Subject to the suggested
meeting noted here, the
communication standard
appears to have been met.
Further details on
communication follow.
CAS 610.10, Paragraph A5, provides further details on the information that may be communicated
between the independent auditors and the internal audit function.
10.
In determining the planned effect of the work of the internal auditors on the nature, timing or
extent of the external auditor’s procedures, the external auditor shall consider:
(a) The nature and scope of specific work performed, or to be performed, by the internal
auditors;
(b) The assessed risks of material misstatement at the assertion level for particular classes of
transactions, account balances, and disclosures; and
(c) The degree of subjectivity involved in the evaluation of the audit evidence gathered by the
internal auditors in support of the relevant assertions.
CAS 610 A5 further expands on CAS 610.10 and provides details on what may be agreed to in advance
between the external auditors and the internal audit function.
Planned Effect of the Work of the Internal Auditors on the Nature, Timing or Extent of the External
Auditor’s Procedures (Paragraph 10)
A5. Where the work of the internal auditors is to be a factor in determining the nature, timing or extent
of the external auditor’s procedures, it may be useful to agree in advance the following matters with the internal auditors:
• The timing of such work;
• The extent of audit coverage;
•
Materiality for the financial statements as a whole (and, if applicable, materiality level or
levels for particular classes of transactions, account balances or disclosures), and
performance materiality;
• Proposed methods of item selection;
• Documentation of the work performed; and
•
57
Review and reporting procedures.
Therefore, we would suggest that a meeting take place between the independent auditors and the internal
audit function so that they may discuss the items detailed here, including the specific procedures that will
be performed, which follow.
(It was not necessary for candidates to specifically identify CAS 610 in order to perform well on this
indicator. The Board was attempting to assess the broad concepts of this section and to ascertain
whether candidates understood the key criteria to consider when deciding whether independent
auditors may use the work of the internal audit function. In general, candidates were able to discuss
the concepts of objectivity and technical competence with respect to the internal audit function. Better
candidates were also able to discuss the due professional care and communication concepts. The Board
was generally pleased with the responses and the ability of candidates to apply appropriate case facts in
their responses, given that candidates may not be very familiar with the internal audit function.)
I have performed an analysis of the high-risk areas for the financial statements of HandySide at the
account level and the assertion level. I have also developed procedures that the internal audit function
may use to cover off those risks. My analysis follows.
Revenue
recognition —
RTM homes
Accuracy
Revenue is
understated (revenue
is currently not
recorded until jobs
are completed).
HandySide will need to use the percentage-ofcompletion method to record revenue for
RTM homes (see ASPE discussion).
Therefore, for any RTM homes not completed
at year-end, it is important that HandySide
determine the extent that they have been
completed.
To do this, the internal audit function could
determine what costs have been incurred to
date versus the expected total costs (by
looking at the detailed cost breakdown) to
determine the percentage complete.
Then they would review the contract with the
customer to determine the total revenue
expected and recalculate the percentage of
revenue that should be recognized.
The internal audit function could also consider
the reasonability of sales versus cost of sales,
based on the previous year’s margins.
Alternatively, HandySide could hire an
independent expert to estimate the percentage
of completion of each home at a specific date.
58
Revenue
recognition —
trade
contractors
Occurrence
Valuation (of
the related
receivables
balance)
Inventory —
drywall
Inventory —
cost
accumulation
of RTM
homes
Valuation
Valuation and
accuracy of
cost of
sales/revenue
for RTM
homes
Revenue is overstated
(or the allowance for
returned goods is
understated).
The allowance for
doubtful accounts is
understated because
trade contractors are
given 60 days to pay
with no credit checks.
Inventory is
overstated since the
drywall is purchased
above its market
value.
RTM revenue and
cost of sales are not
recorded properly.
Risk of misstatement
is high, since the
costing system does
not appropriately
accumulate costs to
each job. Since using
percentage of
completion, costs
may determine
revenue to be
recognized.
Examine returns after year-end to determine if
an allowance for returns is necessary.
Confirmations could also be sent to trade
contractors with a specific question relating to
returned goods.
Analyze bad debts in previous periods to
determine adequacy of the allowance for
doubtful accounts.
Analyze aging of accounts receivable for
contractors, to determine if any are over 90
days’ old. If there is an indication of impairment, review the specific customers’ receivable balances for subsequent payments,
their history of late payments, and their ability
to pay. Determine if the allowance for
doubtful accounts is adequate.
Compare the costs of significant inventory
items (such as drywall) to most recent selling
price (sales invoices/receipts) to determine if
they are being carried above market price.
Compare the net realizable value of inventory
with its carrying cost and determine if a
writedown of inventory is required.
Costs need to be traced to each specific home.
Trace costs per job to supporting
documentation to assess whether costs by job
are accumulating accurately and are related to
that job. This may be difficult because costs
are not accumulated to specific jobs at present.
Determine management’s procedures for estimating costs for each specific job and
assess for reasonableness.
Review breakdown of labour and parts from
home specifications and build up costs by
comparing with actual labour hours and costs
and specific parts included in the home.
Review supplier invoices to determine
accuracy of cost of parts.
Accuracy
Overhead allocations
may be inaccurate
because they are
based on maximum
production.
CNVF term
loan and
related interest
expense
Existence,
valuation, and
accuracy
Interest expense is
overstated because it
has been recorded in
HandySide but the
loan is to VHL.
Occupancy
costs
Accuracy
Occupancy costs
(rent) are understated.
Intangible
assets
Valuation
Intangible assets are
overstated.
59
Examine production levels in previous periods
to determine normal production capacity for
allocation of overhead costs.
Determine reasonableness of overhead costs
by tracing items on a test basis back to
invoices and other supporting documentation.
Recalculate overhead allocations based on
normal production and compare to amounts
recorded.
Examine loan statement and agree to amount
in general ledger.
Ensure amount recorded properly in
HandySide (it should be recorded in the intercompany account with VHL and not in the
interest expense account)
Examine lease agreement and recalculate
amount of rent to be incurred over the term of
the lease. Compare amounts with the general
ledger to determine accuracy of amounts
recorded.
Obtain a breakdown of the costs included as
intangible assets. Determine the nature of the
expenses and assess against established
criteria (i.e., HB 3064) to ensure that the
appropriate amounts have been expensed or
capitalized.
Trace costs to supporting documentation (e.g.
invoices) where appropriate.
Assess the useful life of the intangible assets
for reasonableness by comparing to similar
assets in other entities or industry standards.
(Most candidates were able to identify the high-risk areas of the audit (which flowed from their
analyses in Primary Indicator #1) and develop specific audit procedures to cover off these high-risk
areas. For example, most candidates recommended a procedure to compare the carrying cost of the
drywall to selling prices through a review of recent sales invoices to ensure that the net realizable value
of the drywall is above its carrying value. Procedures provided, such as this one, were clear, related to
a specific risk, and effective in real life. Candidates were also able to identify effective procedures for
the trade contractor revenue and the occupancy costs.)
60
(Most candidates who did not perform as well on this indicator still attempted to develop procedures,
but their procedures were often too vague and did not cover off the specific risks involved with these
areas.)
For Primary Indicator #2 (Assurance), the candidate must be ranked in one of the
following five categories:
Percent
Awarded
0.1%
competence.
9.6%
Reaching competence — The candidate attempts an analysis of the internal
audit function and identifies procedures for some of the high-risk areas OR
prepares an analysis of the internal audit function OR discusses procedures for
some of the high-risk areas.
34.7%
Competent — The candidate prepares an analysis of the internal audit function
and discusses procedures for some of the high-risk areas.
55.5%
Highly competent — The candidate thoroughly analyzes the internal audit
function and discusses procedures for most of the high-risk areas.
0.1%
(Candidates were required to consider whether the independent auditors could use the work of the
internal audit function, and to provide specific audit procedures to substantiate the high-risk areas
associated with HandySide’s financial statements. Candidates were expected to assess the internal
audit department in terms of its objectivity, technical competence, and similar criteria as set out in CAS
610. As well, candidates were expected to develop specific procedures directly related to the high-risk
areas of HandySide’s financial statements that the internal audit function could perform.)
(In general, candidates performed well on this indicator. Most candidates were able to assess the
internal audit function in terms of whether the work it had performed could be used by the independent
auditors. Candidates also supported their analyses of the internal audit function with case facts. As
well, most candidates were able to develop specific audit procedures and tie them directly to the highrisk areas of HandySide’s financial statements. Many weak candidates did not discuss the internal audit function from the perspective of the independent auditors’ reliance, or developed only very general audit procedures without tying them to the high-risk areas.)
The candidate analyzes the two replacement software systems and the associated
implementation issues.
The candidate demonstrates competence in Management Decision-Making — IT.
61
Competencies
VIII – 4.1 Analyzes, selects, and suggests IT solutions to support processes and management’s information needs (Level B)
VIII – 4.2 Evaluates alternative IT solutions (Level B)
VIII – 4.3 Identifies and evaluates acquisition or sourcing decision factors (Level B)
VIII – 4.4 Performs an analysis of the IT options (Level B)
VIII – 4.5 Improves the entity’s IT systems implementation (Level B)
Although the current system is still in operation at the RTM division, there is significant risk to its
continued use. The developer of Build-it 3.1 has stated it will stop supporting the software, on which the
system is built, after the end of this year. While this does not mean the software will stop working on that
date, it means that HandySide will no longer be able to get support for the product in the event there are
problems with it.
Further, the system has started failing regularly recently. It may be reasonable to investigate the cause of
these failures as suggested by the production manager, if only to keep the system alive until a new one is
implemented. However, this is only a short-term solution, and a long-term solution must be considered.
Therefore, we recommend that the current system be replaced.
(Candidates were not asked or expected to discuss the current system in great detail. However, it was
helpful to identify and understand that the current system was not a viable option in the long term.)
Ground-Up 2012 is a reasonable improvement over the existing system. It is an off-the-shelf package
developed for custom home builders, which is a little different than HandySide’s RTM division. We would be following the same model as with Build-it, in that we are relying on updating an existing
package and customizing it. You will note that in several instances customization is necessary to adapt the
software to RTM manufacturing. On the positive side, the version is dated 2012, which is quite recent.
HandySide would need to ensure that it keeps a complete record of all customizations so that it is not at
the mercy of another developer.
Order entry is an improvement over the current system, allowing customers to view the choices onscreen
as they are selected. Although it currently presents too many options to customers, it can be modified to
limit the options. Ground-Up 2012 is an improvement over the current scheduling system, in that it
includes an electronic, shareable calendar. However, the scheduling is still done manually by the
manager, without using inventory arrival dates or labour availability as inputs.
Perhaps the biggest issue with Ground-Up 2012 is that it does not have its own inventory and costing
system, but can only interface with HandySide’s existing inventory and costing system. As noted earlier, HandySide’s existing inventory and costing system cannot adequately handle manufacturing and only
uses average costing. This causes problems when an RTM home is extensively customized.
62
Ground-Up 2012 has the advantage of requiring only a one-time fee of $330,000 ($275,000 + $55,000),
which includes the modifications outlined. It also has the advantage of being implementable within three
months, which is still after support for Build-it 3.1 expires, but sooner than the next alternative.
(Most candidates did a reasonable job of identifying the advantages and disadvantages of the GroundUp 2012 system. Most candidates also supported their analyses with case facts and went beyond a
straight regurgitation of the simulation facts. For example, candidates stated that the implementation
timeframe of three months (a case fact) was an advantage of the Ground-Up 2012 system compared to
the Virtual Pre-Fab system. Candidates further explained that this timeframe was beyond the point in
time when Build-it 3.1 would stop being supported, and therefore recognized that HandySide would
still be required to come up with a short-term solution, regardless of the option selected.)
Virtual Pre-Fab is a custom system developed uniquely for HandySide’s RTM division. It has the
advantage of fitting exactly to HandySide’s operations, but the disadvantage is that HandySide will have
to work the bugs out of the program. Although the company has not worked with manufacturers before, it
has developed an integrated system for an automobile wholesaler. The cloud computing model is a
current trend in software development, and is acceptable as long as sufficient security measures are built
into the system. Cloud delivery has the advantage of not requiring HandySide to purchase or maintain an
in-house server, and allows for platform-independent access to the system.
Order entry in Virtual Pre-Fab appears to be superior to the other two systems, in that it allows
representatives to take customers around the display homes and enter choices as they are selected. This
would provide instant feedback to the representative and customer on inventory availability, allowing
them to choose another more available product immediately. The choices are signed off electronically and
immediately enter production, to allow for quicker manufacturing times.
Rather than the current manual method, Virtual Pre-Fab offers automatic calculation of inventory
deficiencies and produces a report for the production manager, which should result in more accurate
ordering and fewer shortages. The tablet-based item staging would also produce more accurate inventory
results at every stage of production. Virtual Pre-Fab also has a complete scheduling program that
considers labour, material, and facility availability, which would likely improve production efficiency.
One of the best reasons to choose this option is that it comes with its own inventory parts system, which
flows into its own cost accumulation system for production using specific identification as required under
ASPE. Costing is a critical weakness of the current weighted average costing system, especially for
highly customized homes. Ground-Up 2012 simply integrates with the existing cost system, offering no
solution for the costing issue.
A significant disadvantage of Virtual Pre-Fab is cost, and the fact that the costs will continue as long as
HandySide uses the software. The range of $7,500 to $15,000 is large and could vary by as much as
$90,000 per year. We recommend that you request a more solid monthly estimate based on a more
detailed scope evaluation. If we assume a mid-point price of $11,250 per month, this option becomes
more expensive after 29.3 months of use ($330,000 ÷ $11,250), ignoring the time value of money.
However, the monthly fee is an all-in cost that includes future upgrades. As well, the fee appears to be
monthly and could be discontinued at any time if a new, superior system came along, without the need to
cancel a contract.
63
Another disadvantage of Virtual Pre-Fab is the longer development time of ten months, compared with
three months for Ground-Up 2012. That will mean HandySide will face about seven months in which
Build-it 3.1 is not supported before the new system is ready. HandySide could approach the IT firm that
provided the customization to see if it will support the software in that interim period.
(Many candidates provided an appropriate analysis of the Virtual Pre-Fab system. Better candidates
were able to compare the two systems using similar criteria and were able to explain why one system
was superior to the other under each criteria. As well, strong candidates explained that the Virtual PreFab system was the only option that had its own inventory costing system and as a result could resolve
the accounting issue associated with specific cost identification noted in Primary Indicator #1. This
was an excellent display of integration skills by those candidates.)
Conclusion
Due to its costing system and superior features, we recommend HandySide implement Virtual Pre-Fab.
Given the system failures and the termination of support for Build-it 3.1 on December 31, 2012,
HandySide will need to choose a new system. Therefore, there will be implementation issues to consider.
Manager
Issue
The production manager helped implement Build-it 3.1 and does not wish to change, and would be the
only HandySide employee involved in the implementation.
Implication
The production manager may resist or delay implementing the new system.
Recommendation
Ensure that the manager on the implementation team understands the reasons for not fixing Build-it 3.1.
IT Department
Issue
HandySide does not have an IT department.
Implication
Implementation may be unsuccessful if there is no on-site IT staff to fix system problems.
Recommendation
Hire staff with IT expertise or request a secondment of staff from the chosen provider during the
implementation period. This could also be included in the negotiated contract with the chosen vendor.
64
Workload
Issue
The production manager is expected to maintain his current duties during implementation.
Implication
System implementation may be delayed, since primary production duties will take precedence.
Recommendation
The production manager should be relieved of some duties during the implementation phase.
Responsibility
Issue
The software provider is expected to implement the new system.
Implication
HandySide employees will not be involved in the implementation, and therefore it may not have the
required user functionality.
Recommendation
The implementation team should include functional employees along with employees of the software
provider.
Employees
Issue
Many HandySide RTM employees are long-time employees who are familiar with the current system.
Implication
Employees may resist the new system and may not know how to use it.
Recommendation
Ensure key employees are part of the implementation team, and that all employees receive adequate
training.
(Candidates who recognized the requirement to discuss the implementation issues were able to
highlight one or two of the relevant issues and recommend solutions, such as the need for training or
the lack of an internal IT function at HandySide. However, some candidates appeared to not recognize
this required even though it was specifically directed to in the simulation.)
For Primary Indicator #3 (Management Decision-Making — IT), the candidate
must be ranked in one of the following five categories:
65
Percent
Awarded
0.4%
competence.
10.3%
Reaching competence — The candidate discusses some of the advantages and
disadvantages of the two systems OR discusses the implementation issues.
37.3%
Competent — The candidate discusses some of the advantages and
disadvantages of the two systems, makes a recommendation, and discusses the
implementation issues.
51.9%
Highly competent — The candidate thoroughly discusses the advantages and
disadvantages of the two systems, makes a recommendation, and thoroughly
discusses the implementation issues.
0.1%
(Candidates were asked to analyze the two potential RTM replacement systems and the associated
implementation issues. The candidates were provided with an exhibit that outlined the key features of
the two systems and were also provided with some information with regards to the implementation.
Candidates were expected to use the case facts to analyze the pros and cons of each of the systems.
Candidates were also expected to identify weaknesses in the proposed implementation plan and to
provide suggested improvements.)
(Candidates performed reasonably well on this indicator. Most candidates were able to analyze the pros
and cons of each of the systems and went beyond the case facts to provide additional insight into why
each key feature was either a pro or a con. They were also able to discuss some of the important
implementation issues and suggest improvements. However, a few candidates simply regurgitated the
case facts without providing any additional insight, and as a result their analyses were of little value.
Some candidates also struggled to provide reasonable recommendations to improve the implementation
plan. Thoughts were often limited to an identification of the key weaknesses with the current
implementation plan, without suggesting reasonable improvements.)
The candidate analyzes the three options for financing the distribution centre (DC) acquisition.
The candidate demonstrates competence in Finance.
Competencies
VII – 3 Develops or analyzes investment plans, business plans, and financial proposals (Level B)
66
The distribution centre (DC) appears to be integral to the operations of HandySide’s retail division, since it allows volume discounts and provides the system to stock inventory in the retail stores. However, given
HandySide’s current cash position, it is not a good time for an acquisition costing $10,525,000. It seems,
though, that if HandySide does not buy the DC, it will be sold to a developer and torn down to put up
condominiums. So, although HandySide may not have the cash to purchase the DC, we will analyze the
present value of the cash flows of each option, and present alternatives for financing the down payment.
(While it was not essential, better candidates were able to explicitly discuss why it was necessary for
HandySide to consider acquiring the distribution centre at this point in time.)
Option 1 — Lease-to-Own
Payment per month (beginning of month)
Number of payments ×
$
175,000
84
Total payments
$ 14,700,000
Fair market value of warehouses
$ 10,525,000
Interest rate implicit in lease
10.33%
Interest rate used for PV calculation
8.0%
PV of payments
$ 11,302,723
Monthly cash flow
$
175,000
Option 2 — Bank Financing
Loan proceeds
Down payment required
75%
25%
$
7,893,750
2,631,250
$ 10,525,000
Rate
Number of periods
Monthly payment required (end of month)
$
PV of payments @ 8%
$
Down
Mortgage
8.0%
120
95,772.97
2,631,250
7,893,750
PV of payments
$ 10,525,000
Monthly cash flow
$
95,773
67
Option 3 — CNVF Financing
Loan proceeds
Down payment required
95%
5%
$
9,998,750
526,250
$ 10,525,000
Rate
Monthly payment required (end of month)
Number of periods
$
PV of payments @ 8%
$
Down
Mortgage
12%
115,818
200
526,250
12,772,998
PV of payments
$ 13,299,248
Monthly cash flow
$
115,818
(Candidates struggled to provide an appropriate quantitative analysis for the financing options. The
above analysis was one possible method of comparing the three options, but it was by no means the
only method. The key to the quantitative analysis was to put the three options on an equal footing.
Since each of the options presented was missing one key variable (Option #1 did not list the interest
rate, Option #2 excluded the monthly payment, and Option #3 left out the term of the loan), candidates
were expected to calculate one or more of these missing variables and then compare the options on a
quantitative basis. However, few candidates were able to place the options on common ground. Instead,
many candidates discounted the cash flows using different discount rates for each option and then
compared the results. Because they had used different discount rates for each option, the resulting
present values were not comparable.)
Option 1 — Lease-to-Own
The lease-to-own option provided by John has the advantage of no down payment required. Currently,
HandySide’s cash flow is tight, and having no initial cash outlay would help. Further, this option has the
advantage of being able to defer five months of principal repayments during the term of the lease. While
not included in the current quantitative analysis, this would give HandySide the flexibility to defer
payment in months with low cash flow. The penalties for a skipped payment are also not onerous, since
other institutions night call the loan under similar circumstances, but John seems willing to accept a
penalty fee, although at a high rate of interest (5,000 ÷ 175,000 × 12 = 34%).
However, it also has several disadvantages. The present value of future cash flows calculated using a
borrowing rate of 8% (8% was used so that it can be compared with the bank’s offer) is $11,227,871, which is higher than Option #2’s present value of $10,525,000. However, John’s terms seem reasonable, with an implicit rate of 10.33% over seven years. The monthly cash flow of this option is high, due to the
short loan term of seven years, at $175,000 per month.
68
Option 2 — Bank Financing
The bank financing is at a lower interest rate, 8%, than the other loans. The loan also extends over
10 years, rather than the 7 years offered by John, meaning monthly cash outflow is reduced to only
$95,773 per month.
However, this option requires a down payment of $2,631,250 (25% of $10,525,000). HandySide does not
currently have any cash with which to make a down payment. Further, this option requires unlimited
personal guarantees by Alex and John. Since John is no longer a shareholder, it is unlikely that he would
be willing to personally guarantee the debt of HandySide.
Option 3 — CNVF Financing
This option has the advantage of requiring only 5% down, or $526,250. Although HandySide does not
have the cash to make a down payment, 5% is better than 25%, as required in Option #2.
However, this option carries the highest interest rate (12%) of all three options, and it requires a personal
guarantee from Alex, although not from John, as required in Option #2. The term of the lease is over 16.6
years, so its monthly cash flow is only $115,818, which is less than that of Option #1 ($175,000).
(The qualitative analysis performed by the candidates was generally well done. Candidates discussed
the three options, and many were able to support their analyses with case facts. Many integrated the
cash flow constraint currently afflicting HandySide into their analyses as well. Weak candidates did
not or were unable to support their analyses with the simulation details.)
The option you choose depends on whether HandySide can find cash to make a down payment. Alex
should consider a personal cash injection or request the cash from John. If a down payment cannot be
made, you will have to choose Option #1.
You could also consider other options, which would include moving the distribution facility to another
location. Given that HandySide is currently leasing a desirable location (evidenced by the demand from
the condominium developer) and is leasing the DC at fair market value, HandySide may be able to lease a
cheaper or more suitable location. This option should be researched and considered.
(Few candidates discussed any options outside of those presented in the simulation.)
For Primary Indicator #4 (Finance), the candidate must be ranked in one of the
69
Percent
Awarded
0.8%
competence.
35.6%
Reaching competence — For each of the three options, the candidate attempts
a quantitative and qualitative analysis OR prepares a reasonable quantitative
analysis OR prepares a reasonable qualitative analysis.
48.7%
Competent — The candidate prepares a reasonable quantitative and qualitative
analysis for each of the three options and concludes.
14.8%
Highly competent — The candidate prepares a thorough quantitative and
qualitative analysis for each of the three options and concludes, incorporating the
current cash constraints of HandySide.
0.1%
(Candidates were provided with a schedule of three different financing options for HandySide to
consider in order to purchase the distribution centre from John Maarten. Each of the options
presented excluded one variable from a financial perspective: Option #1 omitted an interest rate,
Option #2 excluded the monthly payment amount, and Option #3 left out the term of the loan. Each of
the options also contained various non-financial elements. Candidates were expected to analyze the
three options from both a quantitative and a qualitative perspective and to provide a recommendation
on the most appropriate alternative.)
(Candidates did not perform well on this indicator. From a qualitative perspective, candidates were
able to discuss the features of the three options, and many were able to use case facts to support their
analyses. Weak candidates did not support their analyses with case facts, such as the fact that John
Maarten was no longer involved with HandySide and would not likely provide a personal guarantee or
that HandySide did not have a lot of cash on hand to fund a down payment. From a quantitative
perspective, the analysis provided by the majority of the candidates was very poor. Most candidates
struggled to compare the three financing options on an equal footing. One way to do this would have
been to compute the implicit rate in the first option and compare this rate with the remaining two
options. Another method would have been to compute the present value of the payments for the three
options using the same discount rate for each of the options and to compare the three present values.
However, many candidates discounted the payment streams using different rates for the three options,
which provided no basis for comparison. This type of analysis provided no added value to the
response.)
The candidate analyzes the profitability of the divisions and provides recommendations.
The candidate demonstrates competence in Management Decision-Making.
70
Competencies
VIII – 2.1 Prepares, analyzes, and monitors financial budgets, forecasts, or projections (Level A)
VIII – 2.3 Determines and evaluates the entity’s cost-volume-profit relationships (Level A)
Upon analysis of the divisions of HandySide, we recommend that you do not close the Trade Contractor
division. Not only is it a highly profitable division, but it also contributes significantly to cover the fixed
expenses of HandySide.
DIVISIONAL ANALYSIS
9-month period ended September 30, 2012
Retail
9%
46.7%
$ 12,915,211
6,881,950
6,033,261
42%
18.7%
$ 60,135,492
48,899,937
11,235,555
27%
34.6%
$ 38,835,962
25,404,732
13,431,230
Trade
Contractor
22%
35.2%
$ 31,615,680
20,489,687
11,125,993
528,988
2,458,797
1,277,406
-
4,265,191
270,025
1,358,485
877,320
194,418
2,700,248
90,000
12,915
901,928
90,000
60,135
4,471,665
8,439,082
90,000
38,836
2,887,836
5,171,398
90,000
31,616
316,034
360,000
143,502
7,359,501
14,828,442
8,259,832
$ 10,809,959
21.3%
$ 11,056,304
11.2%
34.2%
RTM
Revenue %
Gross profit %
Revenue
Cost of sales
Gross profit
General and
administrative (1)
Equipment (2)
Interest and
bank charges (3)
Occupancy (4)
Manager’s salary:
(5)
Base salary
(9 months)
Bonus of 0.1%
Selling costs (6)
Contribution by
division
Contribution % by
division
Total retail
$
5,131,333
39.7%
Cities
$
2,796,473
4.7%
Rural
$
Total
100%
29.1%
$ 143,502,345
101,676,306
41,826,039
$
26,997,597
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(Most candidates recognized the need to perform some form of quantitative analysis based on the
information supplied in the simulation. Many candidates performed an analysis of only the Trade
Contractor division because this was specifically requested by Alex. This was completely acceptable,
but as a result of choosing this format for their analyses, some candidates did not recognize that
certain costs would not be eliminated but rather would need to be allocated to other divisions or to the
head office. Costs that would not be eliminated (in other words, the costs referred to as “head office” in
this analysis) were not relevant to the decision at hand and were removed when calculating the
contribution by division above.)
1. General and administrative
These costs all relate to head office and therefore are assumed to be irrelevant when analyzing the
various divisions. However, if some of these costs could be eliminated as a result of closing divisions,
they would be relevant.
(Some candidates discussed this concept within the narrative parts of their responses, which was
completely acceptable. This concept of relevant and irrelevant costs was very important in displaying a
candidate’s competence on this indicator.)
2. Equipment
Total
Remove head office
equipment
$
(273,500) Not relevant — see G&A costs for analysis
4,265,191
(528,988)
Remove RTM
Remainder to allocate
4,538,691
$
3,736,203
Shared by retail divisions — allocate based on cost of sales.
Retail — cities
Retail — rural
$ 48,899,937
25,404,732
66%
34%
$
2,458,797
1,277,406
$ 74,304,669
100%
$
3,736,203
A portion could also be allocated to the Trade Contractor division since it uses retail space. With
additional information this allocation could likely be refined further.
(This was only one of the many acceptable methods for reallocating these costs.)
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3. Interest and bank charges
These costs all relate to corporate functions and therefore are assumed to be irrelevant in the analysis
of the various divisions. However, if some of these costs could be eliminated as a result of closing
divisions, they would be relevant.
(These costs are similar to the head office costs discussed above.)
4. Occupancy
Annual total
Portion to September 30,
2012 (9 months)
Allocate to RTM
Allocate to retail and TC
TC at 8%
$
Allocate based on sales:
Cities
Rural
2,700,248
(270,025)
2,430,223
(194,418)
10%
Remaining to retail
$
$
60,135,492
38,835,962
$
98,971,454
3,600,330 See accounting discussion
2,235,805
61%
39%
$
1,358,485
877,320
$ 2,235,805
We could also allocate more to the city stores since they likely cost more in rent than rural, due to
property values. The leases would need to be reviewed in detail to ensure this number is as accurate as
possible.
5. Salaries and benefits
Only the divisional managers’ salaries and bonuses have been included because the remaining salaries
all relate to head office and therefore are assumed to be irrelevant when analyzing the various
divisions. However, if some of these costs could be eliminated as a result of closing divisions, they
would be relevant.
(Most candidates reallocated the divisional managers’ salaries and benefits, but many also tried to
allocate the head office salaries using an inappropriate allocation.)
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6. Selling costs
Since the selling costs relate to flyers, they should be allocated to the retail divisions, based on the
applicable revenue percentages.
Total selling costs
$
7,359,501
Allocate based on sales:
Cities
Rural
$ 60,135,492
38,835,962
$ 98,971,454
61%
39%
$ 4,471,665
2,887,836
$ 7,359,501
Fixed costs are being allocated to the divisions based on gross profit, thereby penalizing divisions that are
more profitable. Our analysis of the contribution of each division ignores head office overhead allocations
to determine the actual contribution of each division towards fixed costs and profitability.
Based on our divisional analysis, all divisions make positive contributions. However the Retail — Cities
division has the weakest margin, at only 4.7% of revenue. It appears that the gross profit is too low and
the rent is too high in the city division. In fact, when we look at the retail division as a whole, it is the
least profitable division, with a contribution percentage of only 11.2%.
The most profitable divisions from a contribution perspective are the Trade Contactor and RTM divisions,
both of which have good gross profit margins and contribute well to fixed expenses. You likely need to
keep the retail stores open, for presence, inventory, and trade contractor purposes, but you could focus on
expanding into towns where there are no big box retailers so you will not have to compete with them on
price. When HandySide considers new locations, trade contractors should always be a consideration.
Therefore, an ideal new location would be a small town with no big box retailers and a significant number
of trade contractors.
We therefore recommend that you do not close down the Trade Contractor division, and focus more of
your efforts in the non-retail divisions, which contribute the most to overall profitability.
(Most candidates were able to interpret their quantitative analyses correctly and conclude that the
Trade Contractor division should not be closed. Many also went further to discuss the other divisions
and their profitability.)
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For Primary Indicator #5 (Management Decision-Making), the candidate must be
ranked in one of the following five categories:
Percent
Awarded
1.3%
competence.
18.7%
Reaching competence — The candidate attempts a divisional analysis.
41.3%
Competent — The candidate prepares a reasonable divisional analysis and
concludes.
38.6%
Highly competent — The candidate prepares a thorough divisional analysis and
concludes on an appropriate course of action.
0.1%
(Candidates were asked to provide an analysis of the profitability of the various divisions of
HandySide, and in particular the Trade Contractor division, since Alex mentioned he was considering
closing this division. Candidates were supplied with a detailed statement of income for HandySide that
had allocated expenses based on gross profit, plus some additional information providing further
details on the expenses. Candidates were expected to reallocate the expenses on a more appropriate
basis and analyze the results. In order to demonstrate competence, candidates were required to remove
expenses from the Trade Contractor division that were irrelevant to the decision at hand.)
(Many candidates were able to recalculate the profitability of the Trade Contractor division, based on
its contribution to the overall profitability of the company, by removing irrelevant costs. However, a
significant number of candidates simply performed reallocations of all of the expenses from the
information supplied without recognizing that certain costs were irrelevant to the analysis because they
would not be eliminated if the division were closed. As a result, their analyses were not useful to the
decision at hand.)
The candidate analyzes the tax issues for HandySide.
The candidate demonstrates competence in Taxation.
Competencies
IX – 1.1 Understands the entity’s tax profile (Level A)
IX – 2.3 Calculates taxes payable for a corporation in routine situations (Level A)
IX – 2.4 Calculates taxes payable for a corporation in non-routine situations (Level B)
75
Because of the time limitation associated with the indemnity clause in the sale agreement, it is very
important that we review the previous three years of tax returns (at least) to determine if there are
potential outstanding tax liabilities. From a review of the issues you raised, we are not confident that the
returns were prepared correctly. Returns beyond three years from the date of assessment are statutebarred, so cannot be re-examined by the Canada Revenue Agency (CRA), unless CRA can prove gross
negligence or fraud. We have also considered whether the other issues we have noted will have an impact
on taxation in 2012.
(Few candidates raised any issues with respect to the time limits involved in reviewing prior years’ tax
returns. However, due to the nature of the tax adjustment clause, this could result in some additional
exposure for Alex and HandySide.)
We are concerned about these charitable donation deductions because there is no Canadian charitable
number on the receipts, as required by CRA. It may be that International Giving of Canada is not a
registered charity, and the donations would therefore not be deductible. We should investigate the charity
further to determine if CRA considers it a registered charity by checking CRA’s listing of registered charities. This could indicate a $600,000 ($200,000 × 3) denied donation, increasing tax by approximately
$180,000 ($600,000 × 30%), plus interest and penalties. We should take this up with John. If the
expenditures were indeed not made to a charitable organization as defined by CRA, it may be possible to
reallocate the donations as marketing expenses, depending on the purpose of the expenditures.
(Most candidates recognized this issue from a taxation perspective and provided appropriate analyses.
Many also performed the calculation to estimate the tax exposure, further enhancing their responses.)
The $200,000 and $350,000 investment losses that HandySide incurred in 2008 and 2009 respectively are
capital losses. Capital losses can only be used to offset capital gains, and normally can be carried back for
three years and carried forward indefinitely.
However, there was a change in control of HandySide on January 1, 2012, when Alex acquired (through
VHL) all of the shares of HandySide from John. Capital losses expire upon a change in control, and
therefore these losses will not be available to HandySide on an ongoing basis.
An election can be filed to “bump up” the cost of capital property to use up the capital losses. For
example, HandySide may be able to bump up the undepreciated capital cost of the head office building to
use up these losses. It would need to do so for the year ended December 31, 2011 (prior to the change in
control) in order to use these losses. We will need to check whether HandySide made this election with its
2011 T2 corporate tax return, which would have been due by June 30, 2012. (If HandySide had no taxes
payable for the year ended December 31, 2011, the election deadline would be 90 days from the date of
the Notice of Assessment to file the appropriate election. Because HandySide was taxable in 2011, the
election was due June 30, 2012.)
76
(Many candidates recognized the change-of-control issue for HandySide and the resultant impact on
the capital loss carry-forward amounts. Few candidates discussed the possibility of a bump up to use
these losses.)
Due to the price of the vehicle leased by John, not all of the lease payments should have been deducted in
the past. The non-deductible portion is calculated as follows (ignoring GST/HST/PST):
123,000 × 85% = $104,550
Lesser of:
(a) $800 × 365 ÷ 30 = $9,733
(b) $30,000 × 18,000 ÷ 104,550 = $5,165
Therefore, HandySide has deducted $12,835 ($18,000 − $5,165) too much on an annual basis for the
leasing costs and could be reassessed for this amount.
John will also have a taxable benefit for personal kilometres driven during those years.
There is a further ongoing taxation issue. Once John has sold the company and no longer provides any
services, it is difficult to justify continuing to pay his lease payments on the vehicle, since there is no
business purpose whatsoever. This is further evidenced by the fact that he will be living in Arizona when
retired, so probably not working for the company. The lease payments would then not be at all deductible,
and he would have to take the payments into his own personal income.
The propeller plane lease is probably deductible if John used it primarily for business purposes. However,
if there are other, less expensive ways to get to the remote store locations, the deductibility of the plane
may be limited to those costs. There may also be an issue with the company paying for his wife’s travel as
well, although since the lease was already paid for, there is no additional charge for her ticket. However,
we should examine if any personal travel expenses were deducted by John or his wife.
Life insurance premiums of $24,000 per year are only deductible to the company if they are a required
condition of a loan. Since HandySide had no debt under John’s ownership, it is unlikely that it was a required condition of a loan. Therefore, the premium is not deductible. Although CNVF has
recommended that the premium be paid, they have not made it a required condition of the loan. In order
to continue to deduct the premium, the agreement would need to include a policy on John’s life.
(Many candidates discussed one or more of the taxation issues related to the CEO expenses. Most were
able to identify the non-deductible portion of the vehicle lease (although the quality of the calculations
provided varied widely), and many candidates recognized that HandySide could not deduct personal
expenses. The issue of the life insurance premiums was a bit more difficult, and as a result many
candidates avoided this taxation issue. Some candidates appeared to be guessing at the appropriate
treatment and as a result displayed their lack of competence.)
77
Under ITA 20 (10), Convention Expenses
Notwithstanding paragraph 18(1)(b), there may be deducted in computing a taxpayer’s income for a
taxation year from a business an amount paid by the taxpayer in the year as or on account of expenses
incurred by the taxpayer in attending, in connection with the business, not more than two conventions
held during the year by a business or professional organization at a location that may reasonably be
regarded as consistent with the territorial scope of that organization.
Since HandySide managers attended a total of 12 different conventions in the past two years, it is possible
it may have exceeded the conventions that can be deducted from income. IT-131R2 provides additional
clarification as to whether a corporation can deduct more than two conventions:
9. The provisions of subsection 20(10) apply to corporations as well as to individual taxpayers and,
where the rules of a particular convention allow a corporation to register at the convention quite
independently of who its officers may be, a corporation can "attend" a convention through one or more of
its agents or employees. A corporation generally will be subject to the usual limitation of two conventions
per year in connection with its business but may send more than one representative to each.
10. However, a corporation which has diversified business interests and many employees may take the
limit of two conventions per year to apply to each such interest. For example, a large integrated oil
company might be interested in conventions of personnel people, accountants, chemists, geologists, and
other groupings and the limit would be applicable separately to each.
Since HandySide’s managers attended 12 meetings in two years, they have likely exceeded the two
conventions that the company is allowed to deduct in Paragraph 9. However, there may be an argument
that HandySide has diversified business interests and would be allowed to deduct two conventions per
interest. For example, home improvement retailing may be one interest and custom built homes may be
another interest. Given that the managers have attended 12 conventions when only two per year per
interest is permitted, there will still likely be some additional taxes due on the non-deductible convention
expense. In addition, meals paid for are subject to the 50% restriction on meals and entertainment
expenses.
As well, we should ensure that the conventions were held in locations that CRA would consider
acceptable. The conventions noted were in places such as Las Vegas, Barcelona, and Shanghai. If there
were similar conventions available to the employees of HandySide at closer, less costly locations, then
CRA may disallow these “excess” convention expenses as well.
(Many candidates either avoided this issue or used the case facts incorrectly, assuming that any
additional conventions above two per year were not deductible. Most candidates also ignored the
location issue with respect to the conventions.)
78
Although HandySide is making interest and principal payments, the interest on the loan to CNVF is only
deductible in VHL, since VHL is the borrower. Interest for the first nine months of 2012 alone totals
$3,534,375. Since VHL’s only income will be dividends from HandySide, which are not taxable, VHL
will not have any income against which to deduct this large expense.
Therefore, we recommend amalgamating HandySide and VHL, to be able to deduct the interest in the
new combined company. This would have represented a potential tax saving of $1,060,313 ($3,534,375 ×
30%) for the first nine months of 2012 alone if the amalgamation had been completed on January 1, 2012.
Alternatively, reasonable management fees could be paid from HandySide to generate taxable income in
VHL to offset the interest expense.
(This taxation issue was not explicitly included in the list of tax issues in the simulation. As a result,
most candidates did not address this issue.)
Occupancy costs that are deducted under ASPE may not be deductible to HandySide, since the rent-free
period income will not be taxable to HRE because it is a non-cash item. (For reference: 1998/02/12 —
(SCC) Canderel Ltd v The Queen)
The website development will be considered part of Class 12 and deducted at 100% (50% in the first year,
due to the half-year rule). The logo costs will be expensed as advertising costs for tax purposes.
For Primary Indicator #6 (Taxation), the candidate must be ranked in one of the
Percent
Awarded
0.9%
competence.
20.5%
Reaching competence — The candidate identifies some of the tax issues.
39.8%
Competent — The candidate discusses some of the tax issues.
38.7%
Highly competent — The candidate discusses most of the tax issues and
recognizes the importance of the indemnity clause.
0.1%
79
(Candidates were provided with a schedule of taxation issues for HandySide and were asked to review
and comment on the issues presented. Candidates were expected to analyze the issues and to provide a
recommendation on the appropriate tax treatment. As there were many issues provided that could have
been discussed, candidates were expected to provide a correct analysis for several of the issues in order
to be assessed as competent.)
(Candidates were generally able to identify the issues, and many provided appropriate analyses. Many
of the issues were simple taxation issues and did not require a great deal of analysis. However, some
candidates failed to address enough issues to demonstrate competence. As well, some candidates
discussed personal tax issues for John or Alex that were not relevant to HandySide. Other candidates
displayed a lack of competence by providing incorrect discussions with respect to the issues.)
The candidate analyzes the draft terms of reference for the finance and audit committee,
identifies weaknesses, and recommends improvements.
The candidate demonstrates competence in Governance, Strategy, and Risk Management.
Competencies
IV – 1.1 Evaluates the entity’s governance structure (Level B)
IV – 1.3 Identifies and evaluates the audit committee’s role in governance (Level A)
IV – 1.4 Identifies the importance of governance activities (Level B)
It is commendable that you are establishing a finance and audit committee (the “Committee”) to support
the already existing board of directors of HandySide. However, we have identified some opportunities for
improvement in your draft terms of reference.
Purpose
The primary purpose of the Committee should be to assist the board in fulfilling its oversight of the
company’s financial affairs and to liaise with the independent auditors. The Committee should also assist in selecting the independent auditors and assessing their independence. Therefore, the purpose of the
committee, as stated, is appropriate.
(Because the purpose of the audit committee as set out in the draft terms of reference was reasonable,
few candidates commented on this area.)
Composition
The current suggested composition of the Committee includes employees of the company, who are not
independent. For example, the CEO, the vice president of internal audit, and the controller all work for
the company and are the very people the Committee should be overseeing. Therefore, they should not also
be members of the Committee. With three of the six members being employees of the company, a quorum
could be achieved by the employees of the company if one of the independent members could not attend a
meeting. We recommend that the majority of committee members be independent from the company.
80
We do not recommend including a representative of CNVF as a committee member, unless it is part of
the loan agreement. Since it is the significant lender to VHL, there is risk in including it as part of the
oversight of management because a representative may be biased to favour the fund’s interests. On the
other hand, the CNVF representative may add some significant financial and business skills to the
Committee.
We recommend that all members of the Committee have a basic knowledge of accounting and finance (as
opposed to just one member) and that at least one member of the Committee be an audit committee
financial expert, such as a Chartered Accountant. As a whole, the skill sets of the various members on the
Committee should be diverse enough to meet the needs of the organization.
In order to retain the best possible members, HandySide may need to compensate committee members. It
is unlikely that skilled individuals would be willing to sit on this Committee without any compensation.
Appointment of the Committee by the CEO is not recommended, since the Committee is expected to
oversee the management team. The CEO could simply appoint friends or colleagues who may not provide
appropriate oversight. We recommend that the members be appointed by the board of directors or a
nominating committee.
The VP of internal audit should not serve as the chairperson — as stated, we do not recommend that the
VP of internal audit be included on the Committee at all. We recommend that the chairperson be elected
by the board of directors, or internally by the committee members.
A representative of the company’s independent auditor should not be a member of the Committee. It is
unlikely they would agree to serve on the Committee since it would impede their independence. The
Committee also appoints the independent auditor, which would be a conflict of interest. The auditor
should have regular contact and consultation with the Committee, but should not be included as a voting
member.
(There were a number of issues that candidates should have discussed regarding the proposed
composition of the audit committee as set out in the draft terms of reference. Principal among these
was the lack of independence of many of the members. Most candidates recognized this problem,
discussed the implications, and suggested appropriate solutions. The Board was pleased to see that
most candidates understood this concept. Candidates generally also discussed one or two of the
additional problems with the composition of the audit committee using relevant case facts to support
their analyses.)
Meetings
The current terms of reference require only one meeting per year. An annual meeting is not sufficient to
provide appropriate oversight of the financial affairs of the company. We recommend more frequent,
mandated meetings, at least quarterly, if not monthly. Further, the CEO should not set the agenda; it
should be set by the chairperson in consultation with all members.
(Most candidates recognized this issue and provided appropriate recommendations. Because this issue
was not complicated, many candidates discussed it efficiently.)
81
Powers, Duties, and Responsibilities
It is appropriate for the Committee to review and discuss with management and the independent auditors
the company’s audited financial statements and to review the company’s annual income tax return. However, reviewing and discussing operational issues with management should not be part of what a
finance and audit committee does. If anything, that is something the CEO should review with the
management team, and something the board can review at a strategic level.
As well, finance and audit committees should not design and implement the company’s systems for internal control. Designing and implementing controls should be done by management. The Committee
should review and monitor the controls and reports from the auditor on their compliance. Also, while
reviewing fees of the independent auditor is important, negotiating these fees should not be a primary
function of the Committee.
Likewise, the Committee should not prepare the operating budget for HandySide. This is a responsibility
of management and should be completed by all levels of management. The finance and audit committee
could assume the role of reviewing and approving the operating budget at a high level.
It is also not appropriate for the Committee to negotiate the compensation packages for the divisional
managers. This is clearly a responsibility that senior management should assume. However, it may be
appropriate for this Committee to review and approve the compensation package for the CEO.
Alternatively, a compensation committee (which would likely be a subgroup of the board of directors)
could be created to perform this function.
It is appropriate for the Committee to highlight business risks associated with its strategic direction, but it
should also take a broader responsibility for risk oversight in the company.
(Some candidates struggled with the division of responsibilities between management and an audit
committee or any committee of the board of directors. Some candidates assumed that this was an
operational committee and therefore felt that these responsibilities were reasonable and prudent.
However, board committees in general are oversight committees and would not normally get involved
in the day-to-day activities of organizations at the level outlined in the draft terms of reference. Strong
candidates recognized this issue and made appropriate recommendations to improve the terms of
reference.)
Independent Auditors
It is appropriate that the Committee sign the engagement letter, since it should be responsible for
appointing the auditors and should generally manage the relationship with them. However, management
of the company should also sign the representation letter, since management is the group providing
information during the year-end audit.
The Committee should also be responsible for assessing the independence of the auditor.
(Most candidates understood the relationship between management, the independent auditors, and the
audit committee and clearly communicated this knowledge in their responses.)
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Additional Responsibilities
In addition to the items mentioned, we suggest that the finance and audit committee also be responsible
for additional activities, such as the following:
Reviewing and approving HandySide’s capital budget at a high level, in addition to its operating
budget as discussed above.
Reviewing HandySide’s internal financial statements periodically and obtaining explanations for any significant variances between the actual results and the budgeted results.
Assessing, at a high level, HandySide’s financial risks, including its use of debt (leverage).
Assuming a greater responsibility for assessing HandySide’s overall risk profile and reporting the results to the board of directors.
(Few candidates suggested additional activities that the finance and audit committee could or should
carry out. Many of these responsibilities concentrated on the finance side of the organization since
these seemed to be missing from the draft terms of reference as presented. Note that these
recommendations should still be at an oversight level and would not be work that the financial
management of the organization would normally perform.)
For Primary Indicator #7 (Governance, Strategy, and Risk Management), the
Percent
Awarded
1.5%
competence.
13.1%
Reaching competence — The candidate identifies some issues with the terms of
reference.
30.3%
Competent — The candidate discusses some issues with the terms of reference.
54.7%
Highly competent — The candidate thoroughly discusses most of the issues with
the terms of reference and recommends improvements.
0.4%
(Candidates were asked to analyze the draft terms of reference for the newly formed finance and audit
committee, identify weaknesses, and recommend improvements. In order to achieve competence,
candidates were required to identify, discuss, and suggest improvements for the various aspects of the
terms of reference.)
(Most candidates performed well on this indicator. They were able to identify a number of weaknesses
in the draft terms of reference as presented, discuss the implications of these weaknesses, and then
suggest improvements. Overall, candidates appeared to understand the purpose of an audit committee
and its function. However, some candidates clearly did not understand the functions of an effective
audit committee. They focused on creating several committees instead of identifying issues with the
current terms of reference. As well, some candidates assumed that the internal audit function and the
finance and audit committee were one and the same, and were not able to appropriately articulate their
competence with respect to the audit committee.)
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The candidate understands the significant financial constraints faced by HandySide, the flaws in
the strategic direction contemplated by Alex, and the importance of the price adjustment clause.
The candidate is demonstrating competence in Pervasive Qualities and Skills.
Competencies (lists the Pervasive Qualities and Skills for the entire simulation):
I – 3 Carries out work with a desire to exercise due care (Level A)
II – 4 Strives to add value in an innovative manner (Level A)
III – 1.1 Gathers or develops information and ideas (Level A)
III – 1.2 Develops an understanding of the operating environment (Level A)
III – 1.3 Identifies the needs of internal and external clients and develops a plan to meet those needs
(Level A)
III – 2.1 Analyzes information or ideas (Level A)
III – 2.2 Performs computations (Level A)
III – 2.3 Verifies and validates information (Level A)
III – 2.4 Evaluates information and ideas (Level A)
III – 2.5 Integrates ideas and information from various sources (Level A)
III – 2.6 Draws conclusions/forms opinions (Level A)
III – 3.1 Identifies and diagnoses problems and/or issues (Level A)
III – 3.2 Develops solutions (Level A)
III – 3.3 Decides/recommends/provides advice (Level A)
III – 4.2 Documents in written and graphic form (Level A)
III – 4.3 Presents information effectively (Level A)
HandySide will face several issues in the near future. As a result, it does not have the financial capacity to
implement some of its planned courses of action.
The acquisition of HandySide by Alex has put the company in a much weaker financial position than it
was prior to the purchase.
HandySide repaid John his shareholder loan totalling $26.6 million, converting non-interest bearing,
equity-like financing into an interest-bearing mortgage with regular repayment terms, further reducing
HandySide’s cash flow. In addition, VHL borrowed $75.0 million from CNVF to purchase the shares of
HandySide, and VHL has no assets or cash flow with which to repay the debt. Therefore, the cash will
likely have to come from HandySide. This amount totals $7.5 million per year plus interest. Also,
HandySide now has $14.3 million in current bank financing, whereas it previously had no bank financing
whatsoever.
Therefore, in total, HandySide (including VHL) has well over $100 million of debt and needs to service
this debt out of the operations of HandySide. This is a substantial burden, and this increased leverage adds
to the financial risk of HandySide.
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HandySide also must undertake at least two acquisitions in order to continue its operations — the DC
purchase and the RTM manufacturing software replacement. However, it has no cash with which to
undertake either project. Not purchasing the DC could mean that it will be sold and HandySide will have
no place to store its inventory. Not replacing the software could bring RTM production to a halt.
Finally, it should be noted that the loan from John to VHL ($10 million) is due on demand. Should John
request this amount, it would put HandySide in a very difficult position. It is not clear where VHL would
get this amount of cash in a short period of time, although invoking the price adjustment clause (as noted
further on in this report) is one option.
(Few candidates explicitly recognized the substantial increase in financial risk that HandySide is now
carrying as a result of the acquisition from John Maarten. Fewer still integrated the fact that the debts
of VHL and HandySide were effectively all debts of Alex and the overall organization, and that this
level of leverage was quite alarming. Some candidates did recognize that the cash position of
HandySide had deteriorated, but few tied this to the bigger picture or the seriousness of the issue.)
Although Alex seems convinced that competing directly with big box retailers is the correct strategy to
pursue, we do not recommend this course of action.
While analyzing the profitability of the divisions, we noted that the retail division overall provides the
lowest contribution to fixed costs. In addition, the city-based stores have an even lower gross profit, and
this is where other big box retailers would be located.
We suggest that Alex rethink this strategy and consider concentrating on the current operations of
HandySide before further expansion. Retail locations should be analyzed individually, and locations that
do not contribute to the profitability of HandySide should be eliminated on a systematic basis after
considering all of the quantitative and qualitative factors.
(Some candidates recognized that competing with big box stores was likely not the best course of action
for HandySide. They were able to incorporate into their discussions of this issue the quantitative
analyses they had performed when analyzing the Trade Contractor division and as a result understood
that the strategic direction proposed by Alex may be flawed.)
HandySide has entered into preliminary discussions with a chain of home improvement retail stores in
Atlantic Canada. We suggest that no further time or effort be spent in these discussions for the following
reasons:
HandySide’s operating performance and profitability have deteriorated significantly in 2012.
HandySide needs to focus its attention on improving its own results before entertaining substantial
expansion plans.
HandySide (and VHL) has incurred a significant amount of debt over the past year and is now highly
leveraged. It does not have a significant amount of equity and is not in a financial position for a
substantial expansion at this time.
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Significant debt repayments will be made to CNVF over the next 10 years ($7.5 million per year plus
interest) and HandySide/VHL needs to pay down this debt as its first priority before entertaining
expansion plans.
(Few candidates recognized the absurdity of the plans for national expansion at this point in time. The
financial situation of HandySide and its current operations need to be the focus for Alex right now. As
a result, any discussions about expansion must be delayed for quite some time.)
The purpose of the price adjustment clause included in the agreement with John was to protect HandySide
and Alex “from any deterioration in profitability.” While we believe that this clause protects HandySide from some unforeseen negative events, it does not provide for total protection. As stated in the next
section, $21.25 million is a significant amount of money and will certainly help HandySide through some
rough times, but it does not “fix” operational issues associated with HandySide, nor does it solve the
related financial constraints on an ongoing basis. In order to survive and thrive, it must find a way to
reverse its fortunes and increase its profitability. This is the only way that HandySide can survive over the
long term.
(Very few candidates recognized the issue of the price adjustment clause.)
While the deal has already been completed, it appears Alex may have overpaid for the shares in
HandySide. No business valuation was prepared, and it may be that most of the value related to
HandySide was in the real estate, which is still held by John Maarten in HRE.
In order for VHL) to receive the reduction in purchase price, we must show that net income before tax
under ASPE falls below $5 million in either 2012 or 2013. Based on our analysis of the ASPE accounting
issues, we believe net income will fall below that threshold. The importance of receiving this amount
cannot be overstated. $21.25 million is a great deal of money, and as we have noted previously,
HandySide’s financial position has deteriorated over the last year. It also needs to make some significant investments and does not have the financial capacity to incur additional debt.
HandySide’s position will greatly improve if the price adjustment clause is successfully invoked. It will
result in a cash infusion of at least $11.25 million ($21.25 million less the $10-million demand loan owed
to John), which would at least allow HandySide to purchase the DC for $10.25 million without additional
financing. It would also allow HandySide to invest in new RTM software (although the software option
we recommend does not require a significant upfront cash outflow, so this might be possible without the
additional cash).
HandySide should request back the entire $21.25 million from John Maarten as soon as possible after
year-end (assuming net income does indeed fall below $5 million), and request he continue to carry his
$10 million loan. In addition, HandySide will receive some cash back from the tax-related indemnity
clause, which will provide more financing for operations.
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With this injection of cash into HandySide, its financial position and future prospects will be greatly
improved.
(Some candidates recognized that HandySide may be able to invoke the price adjustment clause, and
that if it was invoked, then it may free up some cash to purchase the distribution centre and replace the
RTM software. However, few recognized how important triggering the clause was and how it would be
able to assist HandySide. While invoking the price adjustment clause was certainly not the only answer
to solving HandySide’s substantial issues, it would help, and would buy Alex some time to get things
under control.)
For Primary Indicator #8 (Pervasive Qualities and Skills), the candidate must be
Percent
Awarded
0.0%
competence.
51.5%
Reaching competence — The candidate discusses one of the following items:
• The significant financial constraints faced by HandySide
• The flaws in the strategic direction contemplated by Alex
• The protection/importance of the price adjustment clause
36.8%
Competent — The candidate discusses two of the following items:
11.7%
Highly competent — The candidate discusses all three of the following items:
0.0%
(Candidates were not directly asked for an analysis for this indicator. The purpose of this indicator was
to reward those candidates who could properly identify and assess the big-picture issues facing
HandySide. There were many hints throughout the simulation that may have indicated to the
candidates that these issues were important. These hints included discussions about the price
adjustment clause, the facts supplied for the big-box-store strategy, and the national expansion plans,
as well as the financials, which indicated a significant increase in HandySide’s debt level year over year. Candidates were expected to identify these big-picture issues and analyze them from HandySide’s perspective.)
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(Candidates performed very poorly on this indicator. Candidates had great difficulty seeing any of the
broad issues in this scenario. While this is not unusual, candidates are encouraged to always step back
and perform an overall analysis of any simulation or business situation they encounter. These bigpicture issues included the fact that
1. HandySide (and VHL) had taken on a large amount of debt as a result of the purchase of
HandySide’s shares by Alex, and the company was now very highly leveraged;
2. while the price adjustment clause provided some protection for Alex in terms of recovering amounts
from the previous owner, the amount was limited and it would not fix the ongoing operational
issues of HandySide;
3. the strategy of focusing on expanding stores into areas where existing big box stores were located
was likely flawed based on the divisional analysis; and
4. the national expansion plan was extremely aggressive and should not be considered in the near
future or at least until HandySide sorts out its other significant issues.)
(Few candidates addressed any of these issues, and as a result did not meet the expectations of the
Board in this area. These pervasive qualities and skills are critical for well-rounded Chartered
Accountants at all levels of their careers.)
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Secondary Indicator #1
The candidate analyzes the financing options related to the national expansion plans for
HandySide.
Competencies
VII – 2.4 Identifies and evaluates sources of funds (Level B)
VII – 5 Analyzes the purchase, expansion, or sale of a business (Level B)
HandySide has entered into preliminary discussions with a home improvement retail chain in Atlantic
Canada. The chain has 65 stores and over $225 million in annual revenue, which makes it larger than
HandySide (HandySide has 28 stores and approximately $190 million in annual revenue). Therefore, this
would be a sizable acquisition. The acquisition of the chain by HandySide would not take place for
approximately five years. We have analyzed each of the proposed financing options below.
(Few candidates analyzed this issue, although some candidates did recognize that the timing of such an
acquisition and its sheer size made any analysis at this point less relevant.)
Option #1 — CNVF Term Loan
The current CNVF term loan bears interest at 6.5% and has a repayment term of 10 years. Alex borrowed
$75 million of the $85-million purchase price for HandySide from CNVF.
If CNVF were to lend HandySide (or VHL) the amount to finance the acquisition of the home
improvement chain in Atlantic Canada, it would be done with debt. Therefore, HandySide (or VHL)
would incur a significant amount of additional debt, and this would add to its financial leverage, which is
already very substantial. As well, HandySide (or VHL or Alex) would need to come up with a portion of
the purchase price (approximately 12%, assuming the same terms as the HandySide deal), and HandySide
currently has no funds for such expansion. It is possible that it could accumulate these funds over the next
five years, but in order to do so the current operations would need to improve.
On a positive note, this would not dilute Alex’s control of HandySide and he would still maintain his 100% ownership.
However, I believe that CNVF is unlikely to lend such a large amount to HandySide/VHL until the
current loan is paid off. By 2017 there will still be over four years remaining.
(Most candidates who analyzed the CNVF term loan option were able to discuss a number of the issues
described above. Principally, candidates discussed the interest rate and control issues.)
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Option #2 — Initial Public Offering
The second option noted was an initial public offering (IPO), offering HandySide shares to the public. If
an IPO is the chosen strategy, then it is a good idea to start planning for that course of action now in
anticipation of going public in five years’ time. Going public takes considerable time and effort, and this
time would be necessary to prepare HandySide’s accounts and operations for such an offering. One
example is the requirement to prepare financial statements in accordance with International Financial
Reporting Standards (IFRS).
On a positive note, going public and issuing shares to the public would increase the equity base of
HandySide and would lower its financial leverage and therefore its financial risk. Going public would
also create liquidity for HandySide’s shares, and therefore might provide Alex with an exit strategy at
some point in the future.
However, issuing shares to the public would dilute Alex’s ownership and, given the size of the
transaction, would likely require Alex to lose control of HandySide. As well, Alex’s shares in HandySide (through VHL) would likely be placed in escrow for a considerable amount of time, and therefore may
not generate the liquidity Alex may desire in the short term.
Our greater concern is that HandySide is not attractive at this point to the general public; therefore, this
may not be a viable option at all. However, if this is the preferred course of action, then HandySide
should begin to take steps now to make it attractive in five years’ time.
(Few candidates analyzed the option of going public. Candidates who did limited their analyses to one
or two minor issues, such as the IFRS requirement for publicly traded companies.)
Option #3 — Venture Capital Financing
The third option noted was issuing a 3% convertible debenture to a venture capitalist.
This option has the elements of both debt and equity, depending on the convertible feature. As such it
would have some of the same advantages and disadvantages outlined in the previous sections.
As well, venture capitalists tend to demand relatively high returns (based on their assessment of the risk
of the investment, which in this case is likely to be high). As a result, this option may be quite expensive
compared with CNVF’s 6.5% interest rate despite the stated interest rate of 3%. Venture capitalists often
have additional requirements as well, such as meaningful input in decisions at a strategic level.
On a positive note, venture capitalists often have good business and management skills that could benefit
HandySide.
(Candidates who analyzed this option were able to tie in two or three case facts with their analyses. For
example, many recognized that the convertible feature was dilutive for Alex.)
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Other Considerations
Certainly before a final decision can be made regarding the type of financing that would best fit
HandySide, additional analysis and due diligence should be performed. Paramount among this analysis
would be the suitability of this expansion given the current state of HandySide, as well as further details
on the proposed transaction.
If HandySide still wants to proceed with the expansion, then I would suggest that it also look into
additional potential sources of financing, such as
a strategic partner;
vendor take-back financing (although this may not be practical given the size of the financing likely to
be required); and
a merger with the retail chain (instead of an acquisition).
(Few candidates discussed the plan that would need to be put in place to determine the suitability of
any financing plan, and few discussed alternatives beyond those presented within the simulation.)
For Secondary Indicator #1 (Finance), the candidate must be ranked in one of the following
three categories:
Not addressed — The candidate does not address this secondary indicator.
Nominal competence — The candidate does not attain the standard of competence.
Competent — The candidate discusses the advantages and disadvantages of the three
financing options presented.
(Candidates were provided with information on HandySide’s national expansion plans. These plans included the potential purchase of a chain of 65 retail stores in Atlantic Canada. Candidates were also
provided with three options that HandySide was considering using to finance this acquisition.
Candidates who addressed this indicator were expected to analyze the three alternatives and
recommend the most suitable choice.)
(Few candidates attempted to analyze the three options. Most of those candidates who did address this
indicator were able to provide appropriate advantages and disadvantages for all of the options and
come up with a supported conclusion. Weak candidates provided a laundry list of pros and cons that
were not supported by case facts.)
(Overall, candidates performed adequately on the comprehensive simulation, with the exception of
Primary Indicator #4 (Finance) and Primary Indicator #8 (Pervasive Qualities and Skills). This
simulation required candidates to perform several calculations and discuss several issues spanning the
various competencies.)
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(Candidates who performed adequate quantitative assessments were generally able to interpret their
calculations and provide a meaningful narrative analysis. However, some candidates struggled to
perform a reasonable quantitative analysis. On Primary Indicator #4, candidates were provided with
the details of three financing options, and, although candidates understood that they were required to
compare the three options from both a qualitative and a quantitative perspective, most could not
perform a valid quantitative analysis that would have been useful in selecting between the three
alternatives.)
(As in prior years, candidates were provided with five hours to respond, while the comprehensive
simulation was developed to be a four-hour exam. There was no evidence of significant time
constraints. However, candidates clearly had difficulty seeing the big-picture issues associated with
HandySide. This may have been the result of the lack of direction provided to the candidates with
respect to Primary Indicator #8. Candidates are reminded of two very important items that relate to
Primary Indicator #8:
1. The pervasive qualities and skills, which in this case involved seeing the big picture for HandySide,
are extremely important skills for Chartered Accountants to possess at all stages of their careers.
2. Uniform Evaluations will continue to include indicators that are less directed. This does not reduce
the importance of these issues. Part of the skill set of any Chartered Accountant is to identify and
analyze underlying issues when not specifically directed to them.)
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Appendix C — Paper I — Sample Response
To: Alex Victor
From: CA
Subject: HandySide Home Improvement (HS)
Review of HS Internal Audit Group
Strengths:
Training and competence:
The members of the IA group all hold accounting designations and must be working towards their
CIA designation. They also receive inhouse training on HS internal audit procedures. The group
appears to be staffed with persons who are familiar and competent in accounting which is key to an
effective IA group.
Board Reporting:
The VP IA reports directly to the chair of the BoD at least quarterly and in writing. This provides
documentation of issues raised by the IA group and ensures that the BoD is informed in a timely
manner which can be used for decision making purposes. (e.g. to decide whether a change in policy is
required across all stores).
Extent of Audit:
The IA group audits each store at least once per year, ensuring that there is sufficient coverage of the
stores and that internal controls at stores are regularly monitored. This reduces the risk that stores
would be operating outside company policies as the store managers are aware that they will be
audited regularly.
Weaknesses:
Weakness: The internal audit group gives locations 3 days notice prior to visiting a location and the
store has the option to reschedule the visit.
Implication: By being given notice, the store could remind its staff to use standard HS internal
controls and/or change operations at its store to appear in adherence to company policies so the
operations being audited by the IA group are not representative of normal operations.
Recommendation: The IA group should not announce its intentions to audit any particular stores in
advance, they should be auditing stores without warning to be able to adequately assess whether the
store is complying with standards and internal controls during normal operations.
Procedures:
Revenue is a high risk account balance due to the number of transactions involved and the numerous
product lines. There is a possibility that revenue is misstated due to issues with the RTM cost
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accumulation system.
to ensure that RTM revenue recognition is recorded in the proper period (on completion of
home), obtain list of all constructions in progress and trace to revenue ledger to ensure that no
revenue relating to those homes has been recorded.
To ensure that the provision for returns on the contractor accounts is adequate at 1%, recalculate
the historical returns rate for the past 9 months to ensure that it is reasonable and in line with
expectations. Recalculate expected returns from contractor sales and compare to actual returns.
Inventory
Valuation and existence of inventory is a high risk due to the number of locations inventory is stored
in and the fact that inventory is subject to theft and the drywall may be sold at below cost. Inventory
should be valued at the lower of cost and net realizable value.
To ensure that inventory exists and that the inventory listing is complete, the internal auditors
should supervise the store and DC inventory counts and perform floor-to-sheet and sheet-to-floor
test counts on a sample of representative items and all key and high-risk inventory items.
To ensure that inventory is appropriately valued, IA should obtain copies of recent sales invoices
and sales prices (from flyers) and compare to the carrying value at cost to see if items are being
sold below cost. This is likely to occur with drywall which is purchased at $15/sheet and sold at
$8/sheet. IA should review the inventory listing to determine how the inventory is valued and
calculate whether a write down is required based on the recent sales prices.
Intangibles
This is the first year that HS is recording intangible assets. There is a risk that these assets do not meet
the intangible asset criteria for capitalization.
Trace costs capitalized to the invoices and verify the descriptions and amounts to ensure that the
costs are directly attributable to the logo or the website and that the amounts agree.
Review Board meeting minutes for documentation of management's intention to complete the
website and logo and that adequate resources have been allocated.
To ensure that there is an expected future benefit from these items, obtain documentation from
management such as cash flow forecasts, underlying market surveys, etc., that would support the
fact that the logo and website would result in increased economic benefit to HS that exceeds the
carrying value of the intangible.
Reliance on the Internal Audit Group by External Auditors
In determining whether and to what extent to use the work of internal auditors, the external auditors will
evaluate the following:
Adequacy of IA's work for the purpose of the external audit.
They will review whether the IA group is objective. It appears that the IA group is objective as they
report directly to the BoD chair and not the CEO or finance department. All members of the IA group
are independent of the finance division. We should ensure that the additional requests made by the
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BoD and its committees given to the IA department do not impair the group's objectivity (i.e. not
assisting in FS reporting). Met.
They will review the technical competence of the IA group. Since all the IAs are designated
accountants and working towards or have a CIA designation, it appears that our group is competent.
Met.
Whether the work of the IA is carried out with professional due care. Based on the description of the
IA group, the VP IA reviews all work. There is also an internal IA manual in place for IAs to follow.
Assuming that the work is adequately supervised and actual testing is performed with due care, this
appears to be met.
Whether there is likely to be effective communication with the IA and the external auditor. The VP
IA currently meets with the external auditors at least twice a year. There appears to be effective
communication means in place. Met.
Thus it appears that the work of the IA group is likely to be adequate for the purpose of the audit.
Need to consider the planned effect of the work of the IAs on the external auditor's procedures.
The next step, would be for the external auditors to determine the nature, scope and timing of the work
performed by the internal auditors to see whether these can be leveraged for their own procedures. They
need to review the assessed risks of material misstatement at the assertion level, and the degree of
subjectivity involved in the evaluation of the audit evidence. This means that the external auditors will
consider whether the IAs work can be leveraged into their own procedures. This is only possible if the IA
group has performed adequate procedures, assessed the risks appropriately and that the interpretation of
the audit evidence supported the assertions.
Assuming that the above is met, then the external auditors would be able to rely on our internal audit
group's work to potentially reduce audit fees. However, they cannot fully rely on the work of our IA
group and will need to perform procedures to test the adequacy of the IA group itself. They will still be
performing other audit procedures on the items tested by IA. The cost containment would likely be
realized, but maybe not to the extent that you expect.
In reviewing the draft terms of the F&AC, I have some concerns that should be addressed prior to the
meeting next week.
Conflicting Functions
Currently you plan for this F&AC committee to oversee both Finance and Audit. This is a concern
because there is a self-review issue as the committee will be responsible for the financial statements and
the audit thereof. To mitigate this, I highly recommend that we create 2 new committees: the finance
committee, whose function will be to assist the BoD in overseeing the company's financial affairs and FS,
and a separate audit committee, whose function will be to liaise with external auditors and oversight of
the internal auditors.
Composition - Technical Expertise
The current requirement is that at least one member must possess a working familiarity with finance and
accounting practices. This does not appear sufficient as there is a potential that persons with insufficient
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expertise may be providing input on finance / accounting policy matters (Finance committee), or
recommending ineffective internal controls or of insufficient competence to discuss matters with the
external auditors (Audit committee). I recommend that the requirement be that all persons on the Finance
Committee and separate Audit Committee have experience in finance and accounting.
Composition - Independence
The committee you have planned does not appear to be an independent committee. Of the 6 persons
listed, there is a potential that the one member of the BoD may potentially be independent. Otherwise, the
member of the CNVF who has a significant loan agreement with HS's parent company is not independent.
The CEO, VP-IA and controller are not independent by virtue of employment with HS. The
representative of the independent auditors would not be able to serve on a Board of HS (as their client) as
this would violate the independence requirements of an audit -- we would need to find an alternative
external audit firm.
For the audit committee, I recommend that we find 3 (primarily independent) board members to staff the
committee. These should not be individuals who have oversight over the FS (e.g. not the controller or
CFO).
For the finance committee, I recommend that we find 3 (primarily independent) board members to staff
the committee. These should not be individuals who have oversight over the internal audit function as
there would be a self-review risk here (e.g. not the VP-IA).
Meetings
Meetings are planned to be held minimum once per year. This may be an issue since the committees may
not be able to make key decisions in a timely manner or review the financial performance of HS (finance
committee) in order to make key strategic decisions. There is a risk that HS may not be able to identify
and react to problems in a timely manner. I recommend that the committees meet at minimum, every
quarter.
The quorum for the transactions of business are based on the majority of the committee. There is a risk
that due to the number of non-independent Board members who have some vested interest in the company
(e.g. CNVF member), that decisions would not be made in the best interest of HS. I recommend that
quorum require, at a minimum, the committee chair and the CEO.
Duties and Responsibilities
Budgets:
The committee will prepare the annual operating budget. This is not the most effective set up as the
Committee would not be able to evaluate the performance of management (CFO, CEO) based on their
projections and ability to meet the budget. The budget should be prepared by HS management (CFO,
CEO) and reviewed by the Committee. The Committee should review the budget to actual results and use
these in their decision making and evaluation of management.
Board Communication:
It is good that you require the committees to periodically report to the Board, however, you should
consider requiring that these reports be made in writing on a quarterly basis to ensure that the Board is
kept informed of decisions and concerns raised by the Finance committee and Audit committee.
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In reviewing the financial statements and operations for HS for the 9 months ended September 30, 2012,
there were some issues that I noted that do not appear to be in compliance with ASPE. If these are not
corrected prior to the audit, if the errors are material, the auditors may issue a qualified or adverse opinion
(if pervasive) for the GAAP departure.
Free Rent
Under the terms of the lease agreement with MRE, we are being provided with 12 months free rent for the
year 2012 as a lease inducement.
Lease inducements are an inseparable part of an operating lease agreement and should be accounted for as
reductions of the lease expense over the term of the lease under a straight-line basis or another more
representative basis.
Currently we have not recorded the 9 months in free rent on the financial statements in any form. We
should be recording rent expense for 9 months that is equal to the normal expected lease payments, less 1
year's rent amortized straight line over the 60 months of the lease. (i.e. 12 months payments / 60 total
payments: 20% reduction in rent expense than stated in the lease).
Rent expense is understated - See exhibit A.
Inventory
Inventory under ASPE is carried at the lower of cost or net realizable value. In reviewing our drywall
inventory purchases and sales, it appears that the drywall inventory may be impaired. The original cost is
$15/sheet. Retail prices are on average $8/sheet due to various discounts and promotions. Historically,
because we obtained a rebate averaging $9/sheet, the effective cost to us was $7/sheet so that the drywall
was being sold at above cost thus no write-down required.
Since we will not be earning the rebate going forwards, it appears that we are selling drywall at below
cost.
Drywall inventory's net realizable value ($8) is less than cost ($15) so a $7/sheet write-down will be
required to be in compliance with ASPE. Currently no adjustments have been made to inventory for the
loss of the rebate/impairment.
At September 30, 2012 we have 75,000 sheets of drywall in inventory. Inventory needs to be written
down by $525,000 ($7 x 75K) with a corresponding amount expensed through COGS or other expenses.
Revenue Recognition - Trade contractors
Currently revenue on the trade contractor sales appear to be recognized as the sale is made, and returns
are recognized as incurred.
Under ASPE, revenue from sales requires that all of the following criteria be met:
A - Ultimate collection is reasonably assured
B - Pervasive evidence of an arrangement exists
C - Delivery has occurred
D - Price is fixed or determinable
E - Reasonable assurance exists regarding the measurement of consideration that will be derived from the
sale and extent to which goods may be returned.
A would be met assuming that we run credit checks on all our trade accounts prior to issuing 60 day
payment terms. B exists as there is some agreement in place requiring that the persons pay within 60 days
and stating the return terms. C has occurred as the goods are transferred when the sale is made. D is met
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since prices are fixed.
E may not be met at the time of the sale -- we need to be able to obtain reasonable assurance regarding the
extent to which goods may be returned. Based on historical data that I assume to be reliable, we know that
1% of goods sold to trade contractors will be returned. We should be creating a separate provision to
reflect this uncertainty at the time that revenue is recognized and the amount of revenue recorded would
be adjusted. The 1% provision should be made at the time of sale, and not adjusted when the actual
returns are received under ASPE.
Furthermore, if the returns are unpredictable and significant because our historical data is not reliable,
then we would not be able to recognize revenue until the 3 month return period has lapsed.
Revenue from Trade Contractors is overstated.
Revenue Recognition - RTM Homes
Currently we have elected to use the completed contract method for accounting for the RTM homes.
Under ASPE, there is a policy choice whether to use the completed contract or the % completion method,
however, specific guidelines have been established in the handbook.
The completed contract method would only be appropriate where performance consists of a single act or
when progress towards completion cannot be reasonably estimated. Otherwise, the percentage of
completion method is more appropriate (i.e. multiple acts).
The construction of a house would appear to consist of multiple stages (laying foundation, framing,
plumbing, electricity, drywall & other interior work). The % completion of a house should be
determinable by the construction supervisor, or based on the completion of the stages listed above. This
would support the use of the % completion method under ASPE.
The completed contract method was likely chosen to reduce income for 2012 so that the profitability
clause of the purchase agreement for HS could be enabled to reduce the purchase price from John.
However, under ASPE, it would appear that the % completion method would be more appropriate. To
support using the completed contract method we would need to establish that it is a single act (e.g. putting
together a prefab home from premade components is a single act), or that we cannot reasonably estimate
progress towards performance (e.g. construction progress is poorly monitored due to system errors and
failures, production logs not reliable).
I think we should be using a % completion method to account for RTM homes which would increase
revenues for the RTM division in 2012.
Shareholder Loan / Interest Expense
Currently HS is recognizing interest expense on payments made to VHL to fund its CNVF loan payments.
Since the loan payments are made by VHL and not HS, HS has no legal obligation to pay interest. The
whole amount of the payment (principal & interest) should be recorded in the intercompany receivable
account.
Overall Impact
Based on estimates in Exhibit A, adjusted overall net income before tax for HS is expected to be
$2,311,981 for the 9 months ended Sept 30, 2012.
Annualized net income before tax expected to be $8M, which is above the $5M price adjustment
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threshold so no price adjustment would be seen on the Purchase deal with John.
John has received a purchase option from a third party for the DC property and you have identified 3
options to match the purchase of the property. All calculations have been prepared in Exhibit B.
Option 1 - John Lease
Qualitative Analysis
Pro: This option has the shortest commitment term of 7 years (84 months) which may be beneficial if
HS decides to changes its strategy with regards to the DC in the next few years.
Pro: There is some flexibility in the lease payments, allowing HS to take a payment holiday up to 5
times to defer lease payments if cash flow becomes an issue. This will allow HS to manage its cash
needs in case of emergencies.
Con: Penalties associated with missing lease payments are fairly high ($5,000/payment), which may
be a problem if HS cannot meet its lease obligations.
Quantitative Analysis
In Exhibit B I have determined the cost of interest on this option having a NPV of $2.3M. Relative to
other options this is a moderate cost.
Option 2 - Bank Financing
Pro: Bank has most attractive interest rate.
Con: Requires personal guarantees from Alex and John. Since John is not related to HS any more, he
would be reluctant to sign a guarantee particularly since the condo developer was offering to buy the
property with no strings attached. Also, Alex would be personally liable for any overdue amounts and
may be putting his personal assets at risk.
Con: Requires 25% down ($2.6M). Currently HS has no cash on hand and has $14M on its current
bank indebtedness. Would need to find financing or way to obtain this cash for the down payment
since the company does not appear to have any.
In Exhibit B I have determined the cost of interest on this option having an NPV of $1.6M. This is the
least expensive option.
Option 3 - CNVF Financing
Con: Requires personal guarantees from Alex. Alex would be personally liable for any overdue
amounts and may be putting his personal assets at risk.
Con: Per Exhibit B, at the stated loan terms it would take 200 payments (16.7 years) to repay the loan,
which may be longer than the expected usefulness of the building. HS may be paying for this loan
after it ceases to use the building which would impact future profitability.
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Pro: Only 5% down payment required ($526K), allowing HS to conserve its cash flows. This may be
funded by Alex personally or by selling part of interest in HS to a business partner, selling idle or
redundant store assets.
In Exhibit B I have determined the cost of interest on this option having a NPV of $6.9M. This is the most
expensive option.
Overall Recommendation
Based on the options above, I would recommend that you consider option 1 to take a leasing arrangement
with John for the DC. This option has moderate interest expense associated with it and a relatively short
repayment period. There is also repayment flexibility with regards to the payment holidays.
Despite preferable interest terms, the bank option is likely not viable due to the requirement of large down
payment and John's personal guarantee. The CNVF option has excessively high interest costs and would
take a long period to repay which would not be preferable to HS (longer repayment period drives up
interest cost and loan may outlive usefulness of building.).
However, before we decide on these options I recommend that we consider alternative DC options. It may
be possible to pay market rent for a similar building in a similar area that can hold our inventory and be
an accessible shipping hub. We currently pay market rent for the DC and the options above all appear to
result in above-market rent payment amounts being paid. I highly recommend that we look for other real
estate options before agreeing to the purchase of the DC at all.
Current System - Build 3.1
Con: The system has been failing since August 2012. This may be due to the significant
customizations that have been made to the off-the-shelf program by our hired programmers who do
not have access to the underlying source code. The modifications we have made may be conflicting
with the base program and creating these crashes.
Con: The system provides unreliable data for RTM homes since it assigns weighted average costs that
are not useful for these highly customized homes (evidenced by range of production times from 2-15
months).
Con: The software manufacturer will stop providing support for the software as of December 31,
2012 so there will not be any updates or bug fixes going forward. If we upgrade equipment the system
may not be compatible with newer hardware which may result in the system being unusable or more
crashes.
Con: Modifications by the third-party developer are not tracked. This may mean that redundant or
conflicting modifications have been made to the software. Also on software updates by the
programmer, we may have conflicting processes that interfere with our modifications. By not having
a list of modifications it may not be easy to identify the particular modification causing errors, and
whether it relates to the underlying software (developer problem) or to our edits (after-market
problem) so that we cannot easily trace errors. Recommend that going forward we track any
modifications and back up source code before and after modifications to allow easy reversion and
review of original source code.
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Pro: All the employees are familiar with the Build 3.1 software.
Pro: System allows for encrypted daily backups to the firm servers. This protects the company in case
of data loss.
Ground-Up
Pro: The company has experience in the home building business as evidenced by the fact that the
program is made for high-end custom homes and has features beyond our needs.
Con: The system has too many functions and options for our RTM consumer needs so we will need to
modify the program to limit needs. We should provide the developer with a list of desired functions
and features and those to be removed to ensure that the final product meets our needs. We should
review the product prior to implementation that it only contains items we can deliver so that our
customers do not place orders we cannot fulfill which would reduce customer satisfaction.
Pro: Orders can be entered from any computer on the network. Since each store has networked
computers, the RTM sales associate can assist the customer in picking out options to enter into the
order. We should ensure that this is not abused and that fraudulent orders are not entered by
unauthorized persons. We should request a modification to this system so that it requires a user
specific ID and password to access the order form, and that all orders will be associated with that user
ID. This would restrict access to the order form, and any orders would then be traceable to a
particular person.
Con: The work scheduling module enters days based on a shareable calendar. Although the calendar
feature is good as it can be shared with the necessary trades persons, the fact that the scheduling does
not take into account inventory levels and staffing availability means that customers may be given an
unrealistic timeline. This would result in delays in building the home if staff or items are unavailable
which may decrease overall profitability (if discounts or penalties need to be given by HS) and
customer satisfaction which would ultimately hurt market share and RTM reputation.
Con: Inventory costing function is not standard, however the developer has agreed to build an
interchange module to interface with our existing system. We know that our existing inventory
costing system is unable to adequately assign specific costs to RTM homes as it tries to apply a
weighted average system. This system link would not be effective as it would not address the
underlying problem with our costing system.
Pro: Quick implementation time. Expected to be up and running with certain modifications in 3
months which is relatively fast compared to Virtual Prefab (10+ months).
Cost: Very expensive compared to the Prefab system. The Ground-up system costs $330K excluding
additional modifications discussed and still would not be able to satisfy our needs re: inventory
costing and scheduling. This high price tag is likely due to the numerous features that high end home
builders need that are beyond the scope of RTM homes. We are paying for features we are going to
remove.
Virtual Prefab
Pro: Tablet order entry allows sales persons to show customers around the model homes to enter in
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their choices directly as they make them, reducing errors in the ordered home. To mitigate the risk
that these tablets may be misappropriated we should require that employees sign out tablets, where all
tablets are identified by a unique ID/serial number and if a tablet is not returned it should be followed
up with the person.
Con: The order system on the cloud can be connected from any device connected to the internet. If a
login ID is misappropriated, there is a risk that we could be filling orders that were not made by HS
RTM staff. To mitigate this risk we should ask the developer to limit access to the software to HS
networked machines and certain approved tablet devices (e.g. filter by MAC address for network
computers, IMEI for wireless tablets).
Con: Developer has no experience working with manufacturing client. Their experience with an auto
wholesaler may have some carry-over benefits (e.g. ability to track parts and labour), however, we
should carefully review their costing reports and outputs to ensure that inventory costing is accurate.
Pro: System will check for inventory levels and schedule production around the availability of items
on hand (or expected delivery). This will increase customer satisfaction as we will not be promising
delivery dates that we cannot reasonably deliver on. However, the system is given the power to
automatically order required items. This is risky as program errors may result in incorrect amounts
and types of inventory being ordered which could severely impact our cash flows and ability to
manage inventory. Recommend that the program, on finding an item shortage, generate a report that
the purchasing manager of RTM will review and then follow standard purchasing procedures to fulfill
(e.g. approved PO, obtain quotes, etc.).
Pro: Integrated cost system will accumulate costs to each project using specific identification. This
will help alleviate the issue with our existing inventory costing system that assigns a specific average
cost. This would also allow us to better track whether a project is expected to be profitable and the
margins on an order so that we can ensure that only profitable RTM homes are sold.
Con: Implementation time is relatively long at 10 months and may take longer due to above
recommendations, when compared to the Ground-up system.
Pro: High end expectation for the Prefab system cost is 15K * 10 month = $150,000. This is far less
than the Ground-Up System at $330K base price. Although modifications may drive up the cost, the
cost of a highly modified prefab system would still be less than the Ground-Up.
Recommendation
Between the 2 systems I recommend the Virtual Prefab system since it meets our inventory costing needs,
provides salespersons a way to interact with customers while in show homes and allows us to schedule
based on availability of persons and items. In the 10 months it takes to implement the system, I
recommend that we continue to use the Build It system. Although the developer will no longer support it
as of December, our system is so highly modified that developer support would likely not be helpful.
Our staff may not agree with changes since they are accustomed to the Build It system. To alleviate the
issues I recommend that we hire either an internal IT person to assist with troubleshooting on a day to day
basis, or discuss a consulting/maintenance contract with Virtual Prefab for them to administer our system.
This would help with the implementation as these persons would have IT experience, and could assist
with training and user troubleshooting on the new system.
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Investigating and repairing the Build 3.1 system is not recommended as the issues are likely difficult to
pinpoint due to the non-tracked customizations and numerous edits by third-party developers. Because we
don't have access to the source code, any fixes would be on a trial-and-error basis and not effectively fix
the issue (it would be a patch rather than a fix of the underlying problem).
You have contemplated closing the TC division because you do not believe it to be part of the core
business. Before deciding to close it down, you should consider the profitability of the division to see if
closing it down would have a significant impact on HS' overall operations and performance.
In Exhibit C I have recalculated divisional income. Based on that analysis, the TC division is the most
profitable division for HS on an absolute dollar basis, generating $10.4M in income before taxes. The
division also has the second highest gross margin and total profitability % of the 4 divisions.
The reason for the difference in profitability compared to the draft statement of income provided is due to
changes in cost allocations. In reviewing the cost allocations it seems that certain costs were arbitrarily
associated to divisions (e.g. selling costs divided among 4 divisions although they only impact the retail
customers). In Exhibit C I have provided a more reasonable allocation of costs and associated support for
this treatment.
Recommendation
You currently believe that sales to trade contractors are not HS' core business as a home improvement
store. However, based on the divisional performance, the success of the TC division is key in HS' overall
profitability. I highly recommend that you do not close the TC division as it is one of the most profitable
divisions that has margins far exceeding the retail divisions.
Qualitative factors for retaining the TC division include:
- High-Volume and Low-Support customers - Contractors generally purchase in high volume and do not
require sales support in making their decisions so they require less staff time per purchase and generate
large volume sales for little effort.
- Reputation - as a home building centre, your reputation with the general consumer would be impacted
by whether the public perceives professionals to shop at the store. If you end contractor sales this may be
interpreted that our products are too inferior for contractor use which would drive down market demand
and market share.
Charitable Contributions
The donations were made to International Giving of Canada of $200K/year for 3 years totaling $600K.
These were made to a non-registered Canadian charity as evidenced by the fact that no registration
number was issued on the receipts. We should look up the charity on the CRA registered charity website
to verify whether the omission was in error or intentional. Only registered charity contributions can be
deducted against taxable income. We also need to look up whether the charity is a UN agency or an
organization outside Canada to which the Federal government has made a donation in the last 12 months.
In these cases, the donation can be deducted against taxable income despite not being a registered
Canadian charity.
If the charity is indeed not registered and fails the above tests, then we need to consider whether the
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donation meets the basic deductibility criteria as a business expenditure. i.e. whether it was incurred for
the purpose of producing business income. I believe that CRA would argue that donating to this
unregistered charity would have no benefit to HS as a company as the donation was not for a sponsorship
agreement that would provide advertising to HS, and the donation does not directly help HS in selling
hardware or homes.
The deduction would be denied as a business expense on CRA audit. We are at risk for $600 x 30% =
$180,000 if CRA denies this expense.
Assuming that HS is subject to a 30% effective tax rate and that tax rate over past 3 years remains
relatively constant.
Conventions
HS recommends that managers attend 2 conferences out of town per year. In the past 2 years,
management has attended an average of 6 conventions per year in places like Las Vegas and Barcelona. It
appears that spouses were welcome to join the managers at these conventions, at personal cost.
Under the general limitation of business expenses, no deduction is allowed unless it was incurred for the
purpose of gaining or producing income from the business or property. We need to determine whether
CRA would consider these expenses reasonable. To do so we should review that these were indeed
legitimate business conventions that relate to HS' industry. CRA may take the position that because HS is
a Canadian hardware store chain, it may not have any benefit to attending conferences outside Canada
since this is outside its market. We need to obtain documentation on the conventions to see if the topics
were relevant to HS, and obtain verification of registration and attendance to ensure that managers
attended these conventions. We should review the conference expenses to verify that no spousal costs
have been included which would constitute a non-business non-deductible expense. Since the company
policy is to have 2 conferences per year, attending 4 additional ones may not be considered reasonable by
CRA (they may look to industry standards to compare). If deemed unreasonable, then they would deny
the deduction.
Potential tax exposure: 8 of 12 conference costs may be deemed unreasonable and non-deductible for tax.
Specific amount is unknown.
CEO Life Insurance Premiums
HS pays $24K annually for a life insurance policy for John of which HS is the beneficiary. In order to
deduct this cost we need to be able to defend the position that this was incurred for the purpose of
producing business income. Since CNVF has requested that we keep paying the policy. This is likely to
ensure that they will be paid in case of John's death and as a guarantee that HS will be able to make its
loan payments.
CRA would argue that because John is retired and no longer involved, the loss of John would not have an
impact to HS and HS is not in the business of profiting from insurance policies and death of former
owners. Thus CRA would consider this policy payout, if it happened, to not be in the course of business.
Similarly, it would argue that paying for the policy does not help HS in producing business income.
If CNVF formalizes its request for us to keep paying the policy as part of the loan agreement we may be
able to take the position that paying the policy is incurred for the purpose of securing the loan, which in
turn was for business purposes, and thus the amount should be deductible. This is a risky filing position.
We should consider not deducting the policy expenses.
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CEO Flights
John used to use a plane to fly to HS locations and bring his wife on fishing trips while in the area. For
business purposes, the incremental cost of flying the wife and any extended accommodations, meals and
travel costs would not be considered incurred for the purpose of earning business income and thus would
not be deductible. We should review the trip logs to determine the amounts allocated outside the 5 day
work visit (e.g. whether they fished over the weekends or stayed another week) and determine what
amount is personal. This is non-deductible
Overall Recommendation
I think that you should invoke the tax adjustment clause based on the fact that HS has made deductions
over the past years prior to January 1, 2012 that would appear to not be deductible for tax purposes. These
would result in a potential tax liability to HS of at least $180,000 plus unknown amounts. I recommend
that you discuss these issues with John and obtain a tax advisor to mediate the discussion to mitigate HS'
risk exposure to these tax issues.
In preparing this report and reviewing the information relating to HS I have some concerns to bring to
your attention.
Lack of Financial Analysis:
In purchasing HS from John and in your decision to close the TC division you have based your
decision on gut feeling rather than performing a business valuation and reviewing the divisional
profitability, respectively. This could result in you making poor business decisions as you may be
unaware of the implications of your decisions. (e.g. may have paid more for HS than it is worth;
discontinuing a profitable division). I recommend that before you make any decisions that you
consider the financial and non-financial factors in making your decisions.
With regards to the purchase of HS for $85M, at December 31, the net assets of the company were
valued at approximately $5.2M. The annual after-tax income for December 31, 2011 was $5.4M; if
we assume that earnings approximate cash flows, you paid almost 16 times annual net income for the
company -- this is unusually high. Typically earnings multipliers used in business valuation are in the
range of 3~7. Based on this quick analysis it appears that you far overpaid for HS. Although you had
protected yourself with a minimum earnings clause, this required that HS earn revenues above $5M
before tax -- for 2011 annual earnings before tax was $18M: you are only protected if HS manages to
only earn 27% of its earnings under John's control, which is highly unlikely unless the business is
failing.
Bias of Financial Statements
In reviewing the accounting policies of HS it seems that accounting policy choices were made that
make HS appear to be less profitable than it actually is. For example, payments to VHL were
recorded as interest expense, and revenue recognition on RTM homes is done on a completed contract
method which would generally defer revenues (timing issue). This may have been done intentionally
to reduce the profitability of HS to invoke the price adjustment clause. However, since some of these
choices are not in compliance with ASPE, they will be noted at the time of the audit which would
impact the results of the audit report and John may not be required to pay out the adjustment value.
Continued Viability of HS
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The financial statements for the 9 months ended 2012 show HS as being profitable, however, I have
concerns that HS may not be able to sustain its cash needs going forward. In Exhibit D I have
summarized the cash balances of HS and the payments required to lenders and to VHL to meet its
lender needs. Based on these figures, HS is in a serious cash crunch situation and will be unlikely to
meet its repayment terms and sustain sufficient working capital to keep the company afloat. HS will
need to raise an additional $19.7M to fund its loan repayments and rent payments due in 2013.
Currently HS also owes the bank $14M on the line of credit. There is a high risk that we might need
to sell stores or otherwise find methods to raise money or else potentially go bankrupt.
Governance and Future Plans
I applaud your growth plans and the establishment of committees within the Board but I recommend
that you familiarize yourself with the requirements and the functions of the Board and special
committees.
Recommendation:
I highly recommend that you consider your strategy concerning HS and the future profitability of the
company. The high debt load is generating interest that cannot be sustained by current operations and a
significant amount of working capital has been diverted to VHL to meet the CNVF loan payments. If HS
continues at this rate, the company will be unable to meet its obligations and will be on its way to
bankruptcy if no changes are made.
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109
OF CANADA
II
PAPER II
Time: 4 hours
(2) To help you budget your time during the evaluation, an estimate of the number of minutes required for
each simulation is shown at the beginning of the simulation.
**********
2012
Printed in Canada
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Appendix C — Paper II
(90 minutes)
Fire in the Sky Inc. (FSI) is a growing company known for its spectacular fireworks shows. Kevin
Gomez, the owner, is a reputable pyrotechnician who has a passion for international fireworks
competitions. FSI recently won a major competition and will represent Canada at competitions in other
countries in 2013. Each competition requires three weeks of on-site preparation. Typically, Kevin stays a
week on location after each competition to rest.
It is November 10, 2012. Until now, FSI has had compilation engagements performed for tax return
purposes. The bank has requested that the financial statements for the October 31, 2012 year-end be
subject to a review engagement. The statements, which must comply with Canadian Accounting
Standards for Private Enterprises (ASPE) for the first time, are being finalized. Kevin and FSI’s bookkeeper have summarized FSI’s operations and its significant transactions during the year (Exhibit I).
You, CA, have been asked by the partner in charge of the review engagement to do preliminary planning
for year-end. The partner has already taken care of the client acceptance matters. Based on his brief
discussions with Kevin, the partner thinks there are areas where additional work may be required. He
suggests you concentrate on describing the work required for those areas, rather than discussing every
item covered in a review engagement, as part of your preliminary planning memo.
Kevin, Ella Marchetti (who works for Kevin), and the partner hold a conference call to discuss FSI’s operations. Kevin admits he has been away from the business a lot lately at international competitions,
and has had to increasingly rely on Ella to manage FSI. He explains that competitions are expensive and
take up a lot of his time, but he believes they help build new business. He asks for help addressing Ella’s questions in Exhibit II, since he does not have the necessary expertise.
Ella has provided a copy of a press release sent by the Explosives Regulatory Division (ERD) of the
federal government (Exhibit III) that explains a new inventory tracking system requirement. She obtained
several vendor quotes, and has deemed two worthy of further consideration (Exhibit IV). Kevin asks for
comments on the two options and suggestions of anything else he or Ella should find out about the
systems.
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(continued)
NOTES ON FSI’S OPERATIONS AND SIGNIFICANT TRANSACTIONS
FOR THE YEAR ENDED OCTOBER 31, 2012
FSI has two distinct lines of business:
1) Retail fireworks
FSI purchases fireworks and sells them to retailers. Sales are generally made with standard 30-day
payment terms. Due to ERD regulations, all fireworks must be securely sealed. If a seal is broken, FSI
is required by law to take back the fireworks from the retailer and refund the purchase price.
Before significant holidays, like Canada Day, extra product is shipped to retailers. FSI bills retailers
only once the holiday product is sold. Retailers have up to six months to return the holiday product not
sold, but returns are rare because most locations sell out.
2) Fireworks shows
FSI produces public fireworks shows under contract. A contract is signed for each show, typically six
months in advance. The cost of assembling the fireworks is about 50% of the cost of a show. FSI
receives 70% of the contract price before it begins to build the fireworks for a show. The deposit is
non-refundable since each show is unique. On the day of the event, FSI receives the remaining 30%,
unless the customer has extended payment terms (FSI offers extended payment terms to some
municipalities).
FSI does not have a formal inventory tracking system. However, the tracking of resale fireworks is
straightforward because FSI simply purchases them directly from various suppliers and resells them to
retailers. Inventory costs can fluctuate significantly. The current accounting software uses weighted
average costing for inventory.
The tracking of inventory for fireworks shows is more complex. FSI purchases the components and
assembles them to produce the fireworks for a show. For large shows, the fireworks are built by
employees and subcontractors of FSI over the pre-production period, which can be up to five months
before the show. Because of the explosive nature of the materials being assembled, the work must be
supervised by a display supervisor licensed by ERD. Once assembled, the fireworks can be used only for
that specific show. If the show is not held, ERD requires that the fireworks be destroyed. At any given
time, FSI has three to five shows in pre-production.
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(continued)
NOTES ON FSI’S OPERATIONS AND SIGNIFICANT TRANSACTIONS
FOR THE YEAR ENDED OCTOBER 31, 2012
FSI constructed its building five years ago for $655,000. This year, FSI replaced the building’s heating, ventilation, and air conditioning system at a cost of $84,000. The main reason for the change was to
remove the concentration of gunpowder in the air to meet ERD safety requirements, but it also reduces
the cost of heating because it is a more efficient system. Kevin had been thinking about replacing it for a
while. ERD’s requirements provided the added incentive to do it this year.
FSI recently upgraded its firing systems, and had a commercial igniter it no longer required. Dyno Co.
offered FSI a surplus fireworks launcher in exchange for the igniter. The igniter and launcher are each
worth about $25,000. FSI agreed to the exchange because the launcher will enable it to increase the height
achieved by its fireworks by 25%, which will help the company obtain more contracts for large-scale
shows.
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(continued)
EMAIL FROM ELLA MARCHETTI
To:
From:
Subject:
Kevin Gomez
Ella Marchetti
Tax and Other Matters
Hi Kevin,
I am trying to move things along in your absence. I have some tax issues I want to discuss with you.
There are also operational matters that I need a decision on, and I don’t think we can wait until you get
back. Please let me know your availability for a conference call.
Should the people who work on the shows be on the payroll as employees or treated as subcontractors?
They are highly skilled people who have either their Display Supervisor or Display Assistant licence. My
understanding is that we employ them on an as-needed basis to complement our staff, since we have only
two display supervisors, one of whom is you. They often work for our competitors, too, although some of
them have a degree of loyalty to FSI. Some have said they haven’t worked for anyone else in the last
18 months. We pay them a flat fee per show, rather than hourly. They work in our assembly area using
our design software and firing tools, and usually work on a show from pre-production to disassembly. We
pay them half before and the other half after the show.
You know that I am always trying to reduce costs.
FSI uses sport-utility vehicles (SUVs) to transport equipment, fireworks, and workers to and from shows.
FSI paid $50,000 each for the SUVs. I have made it clear to the employees that they must keep personal
kilometres to a minimum. So far, each vehicle is driven about 2,500 kilometres per month, of which
200 kilometres are personal, based on the logs that are kept by the employees, so they seem to have
received the message.
The employees were asking about having to pay income tax on the use of the vehicles. I don’t think that applies here, but I think we should look into it.
114
(continued)
EMAIL FROM ELLA MARCHETTI
You use the company credit card for all your travel expenses. Can we deduct all your meals while you are
away, even if you are not dining with clients? Does FSI limit the daily amount you can claim for hotel
expenses, given that you stay in luxury hotels? Do we need to account for the frequent flyer points that
accrue in your name for tax purposes?
For the celebratory dinners we hold after Canada Day and New Year’s Eve to thank employees and subcontractors for their efforts, do I enter the related costs as meals and entertainment, or as advertising?
Also, how do I record the iPads we gave to everyone?
A major supplier has requested an urgent meeting to renegotiate our contract. I have prepared an analysis
of sales and margins in anticipation of the meeting. I successfully stalled the supplier once, but I don’t think I can again. I am happy to negotiate on your behalf if you want me to.
Also, I made some costing decisions that I think are necessary for us to submit a competitive proposal to a
new client. I need you to sign the proposal before I can courier it. If we don’t do it soon, we will miss the deadline.
I also have some government remittance cheques that require your signature.
When exactly are you back in town?
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(continued)
EXPLOSIVES REGULATORY DIVISION PRESS RELEASE
Control over dangerous explosives will soon require a “cradle-to-grave” inventory tracking system. All companies under ERD’s jurisdiction must have a system in place by September 30, 2013, or risk licence
revocation and fines.
The inventory system must meet the following specifications:
1) Functionality to track unique product serial numbers for at least 25 years, from supplier to end
consumer.
2) Secure, 128-bit encrypted online access, if database is available on the Internet.
3) Strict access controls to prevent unauthorized access.
4) Ability to record business identification numbers (BIN) or social insurance numbers (SIN) of
purchasers or users of individual products.
5) Ability to print bar codes to label products.
6) Functionality to reconcile perpetual inventory to inventory count, with ability to record explanations
for discrepancies.
7) Assembly tracking functions, to allow individual items used as components in another inventory item
to be tracked.
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(continued)
QUOTES RECEIVED FROM SOFTWARE VENDORS
System Description
We customize our inventory system to meet your specific needs and the ERD requirements. Our system
allows browser-based access to data anytime, anywhere, and can produce dynamic web content
commonly seen in online catalogues.
Although not guaranteed, development time is typically nine months from the beginning of the project to
final testing.
Security
Our system includes an authentication mechanism: each user is given a “token” that generates an authentication code at fixed time intervals using a built-in clock and the token’s factory-encoded random
key. This means that, in addition to a secure user ID and password, a user must enter a unique random
code, which changes every 30 to 60 seconds, to access the server. Once authenticated, data is encrypted
using standard 128-bit encryption.
Inventory Tracking
Our system allows identification of individual items, and items remain traceable for as long as the
software is updated. Because of the nature of the database we use, reports can be written to allow analysis
of any database information (product serial number, customer business number, etc.).
When you purchase inventory, you’ll enter the unique serial number of each product into the system using a hand-held scanner. If a product does not have a serial number, the system generates a bar-coded label,
with a tracking number, to be attached to it. Customer returns are also handled using scanners, easily
returning products to inventory.
Our system allows for on-demand reconciliation of perpetual inventory to inventory counts, and for
coding of discrepancies by reason, such as damage to a product. Inventory changes are programmed to
work with your accounting package, so changes are automatically integrated into your general ledger in
real time.
Asset Tracking
Tracking equipment is also important. We build a complete asset tracking system into the software,
allowing you to track your equipment and vehicles on a real-time map display using GPS. We can even
track the number of kilometres company vehicles are driven.
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(continued)
QUOTES RECEIVED FROM SOFTWARE VENDORS
Backup
Since the system is hosted on Design-IT servers, backups to our massive server hard drives are done
nightly. You will never have to worry that your data is not being backed up. There is a required
maintenance contract of $200 per month.
Pricing
We price our product competitively. The estimated fee for the system is $75,000, subject to scope
expansion or customer-related delays.
After working closely with an ammunition manufacturer to develop a complete inventory management
solution for explosives handlers, we have a functioning version of our software at our client’s site. We can now offer the software to other companies required to comply with ERD regulations.
FireTrack will reside on any server running Windows Server 2003 or higher. Users access the database
through any workstation that is linked to the server. Once authenticated through the server on the
network, FireTrack requests a second user ID and password, which allows various levels of access to the
database.
As products arrive on your premises, you’ll enter the serial numbers in the system and tag items without
serial numbers using pre-printed, pre-numbered bar-coded labels. These numbers are available for
tracking for five years after a product has been sold or used internally. After that, the numbers are printed
in a recovery log and automatically removed from the database.
You can reconcile perpetual inventory amounts against an inventory count at any time, print out count
sheets, and note discrepancies right on the sheets.
We are beta testing an assembly tracking function that will be available in the next release, scheduled for
August 2013.
FireTrack is sold by site, which allows all users to access the database at the central location. A single site
licence is $100,000. There is also a required maintenance contract of $200 per month, which covers all
updates and patches to the existing software.
118
Appendix C — Paper II — Evaluation Guide
The reader is reminded that the solutions are developed for the UFE candidate; therefore, all the
In addition, the
when analyzing
Memo to: Partner
From: CA
Subject: Planning notes for FSI review engagement under ASPE and additional information requests
You will find attached planning notes related to the FSI review engagement. These notes will be put in
the FSI file for reference later when the staff begins the actual work on the file. At this point, we do not
have draft statements; therefore, I have raised matters for consideration based solely on the information
FSI has provided to us. Once we have the actual financial statements in hand, the issues can be further
investigated and the planning finalized.
I have also attached a draft report to Kevin and Ella on the matters Kevin requested our assistance with.
First, I have addressed the tax matters. I also provided an analysis of the IT options. The decision rests
with Kevin, but I have tried to highlight the important decision factors.
There are operational issues that need to be brought to Kevin’s attention immediately. I suggest we speak
with Kevin about the need to delegate some authority to Ella. It appears that he is away more than before,
and that issues are not being addressed on a timely basis due to Ella having to wait for Kevin’s approval. However, Ella appears to be doing an excellent job. We could suggest ways for him to monitor her
activities from a distance, rather than requiring her to wait for his go-ahead.
The candidate does some preliminary planning for the year-end review engagement,
concentrating on areas requiring extra work.
The candidate is demonstrating competence in Assurance.
119
Competencies
VI – 2.3 Evaluates the implications of risks for the assignment (Level A)
VI – 2.5 Designs appropriate procedures based on the assignment’s scope, risk, and materiality guidelines (Level A)
Overall Planning for a Review Engagement
We will need to obtain and document our knowledge of FSI’s business, sufficient to assess plausibility of the financial statements. Consideration needs to be given to the fact that FSI has not been reviewed
before, that it is reporting for the first time under ASPE, that there are external users of the financial
statements now (the bank), and that Kevin is away from the business more. We will also need to become
familiar with FSI’s control environment.
(Most candidates identified these factors, recognizing that they would have an impact on the work to be
performed.)
Since we do not have financial statements at our disposal, we can only make preliminary planning notes.
We will need to review the complete financial statements, once received, for other matters requiring our
particular attention. We will have to note in the review engagement report that the prior-year
comparatives were not audited or reviewed.
Since we are doing a review engagement, we will obtain our evidence mostly through inquiry and
discussion with management. You have asked me to focus my work on the areas where I believe
additional work may be required, rather than discuss the items that would be done in all review
engagements. I have therefore focused my discussions on the areas of significance based on the
information obtained thus far. If the inquiries and discussions outlined in this memo do not satisfy us as to
the plausibility of the balances, we may need to extend our work.
(Most candidates recognized that they were dealing with a review engagement and provided relevant
comments based on that context. However, many candidates discussed some of the planning issues
from an audit perspective — most often when discussing the determination of a materiality level to
perform their work. While this might become relevant while performing the review, materiality is not
set at the planning stage in a review, unlike in an audit.)
Based on the information provided, we should focus our work on the following areas:
120
Opening Balances
FSI is moving from a notice to reader to a review engagement, and is adopting ASPE for the first time.
With respect to opening balances, we will have to be careful since no review was done on them.
However, since the nature of a review is primarily inquiry, discussion, and analytical review, there
shouldn’t be a problem in determining plausibility since there is no requirement to send out accounts
receivable confirmations or attend inventory counts. We will simply need to perform review procedures
on the opening balances.
(Many candidates recommended that audit-type procedures, such as confirmation of accounts
receivable and inventory counts, be performed. While these procedures might be appropriate if
evidence suggests the risk related to these balances is elevated or if alternative procedures cannot be
performed, most candidates who recommended these procedures did not support their
recommendations or explain why they thought these procedures were necessary. Most of the
candidates who suggested these standard audit procedures did not consider applying basic review
procedures first, jumping straight to audit procedures.)
Revenue and Accounts Receivable
There are two revenue streams, retail and fireworks shows, which require different accounting policies
(see accounting discussion). We may wish to do additional work on revenue cut-off, the completeness and
accuracy of revenue recognition, and the valuation and collectability of accounts receivable, knowing the
two streams of revenue are accounted for differently.
In order to assess the plausibility of revenue, we should perform the following procedures:
Compare revenue (resale and fireworks shows) to the previous year and obtain an explanation of
variances from management.
Compare 70% deposit amounts to total of signed contracts for fireworks show contracts.
Compare 70% deposit balance to previous year, and consider changes in volume of contracts being
signed. Obtain an understanding or explanation of reasons for changes.
Review accounts receivable listing and compare ageing of receivables to last year’s balance.
Discuss older balances (more than 90 days) with management to assess collectability.
Obtain a list of any retail refunds (due to broken seals) issued subsequent to the year-end to support
proper cut-off.
Discuss extra product shipped (on consignment) and whether all product is still sold or if any has been
returned at the end of six months (to ensure properly classified as inventory or sale).
(Most candidates provided valid procedures to address revenue and accounts receivable, adequately
considering variances and questioning management for relevant issues, including reviewing ageing
and consignment sales returns.)
121
Inventory
Management’s list of inventory should be obtained and reviewed, because no formal inventory tracking system is in place.
Inquire of management why the costs of fireworks fluctuate during the year to ascertain if there is an
impact on inventory costing.
Inquire of management regarding the jobs in progress (work-in-process inventory) at year-end;
consider the costs applied to them, including labour and overhead. Could amount to a significant
balance since there are three to five shows in pre-production at any time.
Discuss how cut-off is managed; check cut-off of components coming in from the various suppliers or
verify exchanges (if applicable).
Extra shipments to retailers (consignment) — review supporting documents to ensure recorded as sale
or as inventory; review documentation of amounts shipped and any evidence of amounts returned in
the six months or recorded as sales. Discuss with management how information is tracked around the
six-month cut-off date for returns.
Ensure that returned inventory (with broken seals) has been destroyed and discuss with management
or review documentation.
(Only a few candidates were able to provide relevant procedures for inventory. Most candidates
provided procedures that would be relevant in an audit context but did not support why they were
recommending an audit procedure instead of a review procedure. Audit procedures could be
appropriate, but candidates needed to justify why they were suggesting audit procedures to demonstrate
they understood the difference between a review and an audit.)
Heating, Ventilation, and Air Conditioning
FSI spent $84,000 on upgrades to the building’s heating, ventilation, and air conditioning system. The
building cost FSI $655,000 when it was built five years ago.
Additional work should be done on classification in light of the comments made by management about
the nature of the work performed. Procedures we should perform as part of our review include
betterment or expense: discuss with management the nature of the work done;
review of management’s estimate of the useful life and amortization period for the new system: ensure reasonable; and
existence: review the invoice (mostly for tax purposes).
(Most candidates were able to provide valid review procedures for the HVAC system, generally
recommending discussing the nature of the work undertaken with management and explaining why
the procedure was necessary.)
122
Equipment Exchange
Review capital assets records for major additions and disposals — ensure launcher added in and
igniter removed from accounting records.
Discuss valuation of both pieces of equipment and ensure accounted for properly (non-monetary
exchange).
Discuss how commercial substance is supported (in other words, how the future cash flow was
estimated).
(Many candidates were able to provide a valid review procedure for the equipment exchange; however,
most did not explain why the procedure was necessary (in other words, what risk it would address).)
Tax Provision
Ensure the tax provision is accurate in light of tax issues raised by Ella.
Inquire of management regarding their decision regarding employees versus subcontractors, and
consider whether an accrual for CPP and EI premiums is necessary.
Review tax returns and discuss with management to ensure that SUVs were recorded as a Class 10.1
asset (or Class 10 — see tax discussion) with the $30,000 limitation.
Review T4s and T4 Summary or payroll records or both. Ensure taxable benefits are recorded.
Recalculate taxable benefits for automobiles.
Depending on policy chosen under ASPE, may need to review future tax balance.
(Most candidates did not consider the impact of the tax issues on the tax provision, and as a result did
not provide a procedure for the tax provision.)
Other: ERD Regulation
Discuss status of ERD requirements with management to ensure licence to operate is always valid.
Inquire of management if any ERD regulations are not currently met and if FSI is working on meeting
them, other than the IT system for inventory tracking.
123
Percent
Awarded
0.4%
competence.
9.1%
Reaching competence — The candidate identifies some of the key planning
considerations to focus on as part of the review and attempts to develop some
review procedures to ascertain plausibility of balances in key areas.
28.5%
Competent — The candidate discusses the key planning considerations to focus
on as part of the review and develops some review procedures to ascertain
plausibility of balances in key areas.
62.0%
Highly competent — The candidate thoroughly discusses the key planning
considerations to focus on as part of the review and develops several review
procedures to ascertain plausibility of balances in key areas.
0.0%
(Candidates were required to identify and discuss the preliminary planning issues for the year-end
review engagement for Fire in the Sky Inc. (FSI). Candidates were directed to this indicator when they
were asked by the partner in charge to do preliminary planning for year-end, indicating that he
thought there were areas where additional work may be required and that CA should concentrate on
describing the work required for those areas.)
(Candidates were expected to discuss the planning of the engagement, including identifying the risk
areas and providing review procedures that would need to be performed to assess the plausibility of the
balances. Candidates generally performed well on this indicator. Most candidates were able to provide
a reasonable plan and identify some of the significant risks for the engagement, such as the fact that
this was a first-year review, FSI was using ASPE policies for the first time, and the owner was away
quite often. Candidates were also expected to provide review procedures. While most were able to
provide relevant review procedures, in particular for revenue recognition and capital assets, many
candidates provided procedures without explaining why they were necessary. Candidates should always
support their procedures by explaining the reasons and objectives for developing such procedures. In
addition, some candidates did not recognize that a review engagement consists primarily of inquiry,
analytical procedures, and discussions, and provided audit-type procedures without explaining why
they thought this level of testing was necessary. Many candidates also calculated the materiality to be
used for the engagement, not recognizing that although a materiality level could apply to the review
engagement, it should not be set at the planning stage.)
124
The candidate discusses the accounting issues that need to be addressed by FSI in order to
comply with ASPE.
The candidate is demonstrating competence in Performance Measurement and Reporting.
Competencies
Since FSI is complying with ASPE for the first time, each of FSI’s accounting treatments should be reviewed for compliance with ASPE. The information provided does not reveal how the transactions are
being accounted for presently. Therefore, the following areas will need to be discussed with Kevin, Ella,
and the accounting staff to determine if the transactions are being accounted for as described below. If
they are not, adjustments will be required to the draft financial statements that are currently being
finalized by FSI. Kevin and Ella should be made aware of the transitional measures and choices that are
available to help with the first-time adoption of ASPE.
Retail Fireworks
There are two distinct revenue streams: pre-holiday consignment sales and regular sales.
Consignment — FSI ships additional product to retailers without billing them for the product. Retailers
have up to six months to return the product if not sold. Since these additional items are shipped but not
billed (assuming they are only billed at the end) to the retailers, and because the retailers can return the
goods up to six months after shipment, these sales are essentially consignment sales.
CICA Handbook Section 3400 provides that, where a transaction involves the sale of goods,
“performance shall be regarded as having been achieved when the following conditions have been
fulfilled:
(a) the seller of the goods has transferred to the buyer the significant risks and rewards of
ownership, in that all significant acts have been completed and the seller retains no
continuing managerial involvement in, or effective control of, the goods transferred to a
degree usually associated with ownership; and
(b) reasonable assurance exists regarding the measurement of the consideration that will be
derived from the sale of goods, and the extent to which goods may be returned.
Thus, the revenue should only be recognized when there is evidence of a retail sale. The goods should be
accounted for as inventory until then. Note that if the clients advise FSI of the sales and pay for them as
they make them during the six months, then the revenue could be recognized as proof that the sale is
obtained.
125
Regular sales — Regular sales should be recorded when shipped to the retailer, as the risks and rewards
have transferred. Since packages with broken seals can be returned for a full refund, FSI should estimate
the percentage of packages that are returned and determine an allowance for such returns. Also, since
there is a 30-day payment term for retail sales, FSI will need to estimate an allowance for doubtful
accounts.
Fireworks Shows
The fireworks shows are longer term, since a contract is signed up to six months before a show and preproduction of the customized fireworks may begin up to five months before the actual show is presented.
FSI receives 70% of the contract price as a deposit before beginning to build the fireworks for the show.
The cost of the assembled fireworks is about 50% of the cost of a show. The remaining 30% is received
on the day of the event, unless the customer has extended payment terms.
CICA Handbook Section 3400, Paragraph 6 states the following:
In the case of rendering of services and long-term contracts, performance shall be determined using
either the percentage of completion method or the completed contract method, whichever relates the
revenue to the work accomplished. Such performance shall be regarded as having been achieved when
reasonable assurance exists regarding the measurement of the consideration that will be derived from
rendering the service or performing the long-term contract.
Since the time from contract signing to completion is about six months, the completed contract method
may be appropriate, especially if all contracts are completed before year-end. However, since New Year’s Eve is December 31 and FSI’s year-end is October 31, this is unlikely. FSI has indicated that at any given
time, it has three to five shows in pre-production. In addition, the contract is complete after the execution
of several acts - designing, assembling, and executing the show - so completed contract may not be the
most appropriate method.
The percentage of completion method might be more appropriate in this situation since it recognizes
revenue proportionately with the degree of completion of goods or services under a contract (see
Handbook Section 3400.17). FSI may also want to consider whether it has a multiple deliverable (product
assembly, show, and disassembly). Based on the information presented, the following accounting
treatment is suggested: The initial 70% deposit is non-refundable. If the show is cancelled, FSI does not
appear to have an obligation to refund the money. One could argue that since the deposit is nonrefundable, it is all earned once received. However, FSI has an obligation to render a service — a
fireworks show — therefore, performance has not been achieved until the service is rendered. FSI should
therefore only record revenue once it has fulfilled some of its obligations. Based on the information
provided, there are two critical acts for FSI to earn income. Since the design and assembly of the
fireworks represents 50% of the cost of the show, 50% of the revenue can be considered earned once the
fireworks are designed and assembled, and can be recognized. Once the show has been performed,
recognition of the remaining balance is appropriate.
FSI extends longer payment terms for the 30% owing to some customers — municipalities. There are
likely no issues with collectability from municipalities, since they are government bodies. Therefore,
there is likely no need to set up an allowance for doubtful accounts for them.
126
(Most candidates provided in-depth discussions of the accounting principles under ASPE for most of
the revenue recognition issues presented (retail and consignment sales and fireworks shows) and
recommended accounting policies that were appropriate and logical based on their discussions of the
case facts. However, some candidates struggled in their discussions of the consignment sales, and
seemed to confuse the return policy applicable to fireworks with broken seals with the return policy for
the unsold additional products.)
FSI changed the building’s heating, ventilation, and air conditioning (HVAC) system at a total cost of $84,000. The reason for the change was to remove the concentration of gunpowder in the air to meet ERD
safety requirements, but it will also reduce the cost of heating since it is a more efficient system than the
previous one. Kevin has been thinking of replacing it for a while. ERD provided the added incentive to do
it this year.
FSI must decide whether the upgrade is a betterment or a maintenance expense.
Handbook Section 3061 provides that “the cost incurred to enhance the service potential of an item of property, plant and equipment is a betterment,” indicating that the service potential of a particular asset is
enhanced when its associated operating costs are lowered.
It appears that the service potential of the HVAC system was improved as a result of the change, given
that it is a more efficient system and cost of heating is reduced. However, Kevin was thinking of replacing
it before, although we don’t know why he was thinking of replacing it. If it was because it needed replacement due to maintenance issues, then perhaps it is a maintenance expense. The fact that ERD
required the change for safety may also be an argument for it being maintenance. However, since the
service potential is increased, at least a portion of the cost should be considered capital.
Section 3061 requires plant and equipment to be capitalized and amortized over their useful lives. FSI
will need to add the cost or a portion of the cost of the improvements of $84,000 to the original cost of the
asset. The HVAC system could be considered a component of the building, depending on how integral it
is. See Handbook Section 3061.18 (componentization).
The asset should then be amortized in a rational and systematic manner appropriate to its nature.
(Many candidates identified the issue and provided relevant accounting discussions, recognizing the
fact that some or all of the costs for the new HVAC system should be capitalized since they represented
a betterment to the building.)
FSI recently exchanged one of its launchers for an igniter. The igniter and launcher were each worth
about $25,000. FSI agreed to the exchange because the launcher should enable it to increase the height
achieved by its fireworks by 25 percent, which will help it obtain more large-scale fireworks shows.
127
This transaction is a non-monetary exchange and should be accounted for in accordance with Handbook
Part II, Section 3831.
This transaction appears to have a commercial substance because FSI anticipates being able to increase
sales by obtaining more large-scale shows. This should translate into better cash flows for FSI through
future sales of fireworks and shows. FSI may need to quantify the impact on future cash flows to
substantiate a change in future cash flows.
FSI should record the transaction at the more reliably measurable of the fair values, either of the acquired
equipment or the equipment traded, and record a gain or loss on the disposition of the traded equipment.
(Most candidates who discussed this issue provided an in-depth discussion of the relevant criteria
applicable for non-monetary transactions and applied case facts to arrive at an appropriate accounting
treatment. Candidates who failed to provide an in-depth discussion either did not apply the appropriate
criteria or recommended an accounting treatment without providing sufficient support.)
Using weighted average costing for fireworks purchased for resale is acceptable under ASPE. However,
since inventory prices fluctuate significantly, it will be necessary to compare year-end cost to net
realizable value and perhaps write down the cost of some items. Returned items (broken seals) are not
saleable and must be destroyed, and a provision for inventory obsolescence may be necessary since these
items have no value.
For the assembly of fireworks for shows, it would not be appropriate to use a cost flow formula.
According to CICA Handbook Section 3011.22, “cost of inventories of items that are not ordinarily
interchangeable and goods or services produced and segregated for specific projects shall be assigned by
using specific identification of their individual costs.” Since, by regulation, the products become specific
to that show and cannot be used elsewhere, they are items that are not ordinarily interchangeable.
Therefore, specific cost identification must be used.
According to Handbook Section 3031.11, costs of inventory include “costs of purchase, costs of
conversion and other costs incurred in bringing the inventories to their present location and condition.” Because of the amount of time and labour spent in assembling a show, FSI is essentially building
inventory, which becomes a unique product for a show. The costs of labour and subcontracting should
therefore be added to the cost of the inventory as it is being assembled. There should also be an allocation
of fixed and variable overhead costs. This could be significant at year-end, since FSI has three to five
shows in pre-production at any one time.
For shows not yet performed before the October 31 year-end, FSI will need to value its work in process.
This would consist of the cost of inventory purchased for the show, plus wages, subcontracting, and an
appropriate allocation of overhead.
128
(Most candidates did not recognize the nature of the inventory for the shows and the cost accumulation
issue that FSI was facing (in other words, that fireworks show inventory is built to a client’s specifications and can only be used for that show), and as a result did not discuss it in the context of
inventory valuation. Generally, candidates only recognized that inventory relating to a fireworks show
that had been cancelled should be written off.)
Percent
Awarded
0.4%
competence.
10.0%
Reaching competence — The candidate discusses the accounting treatment
that is required under ASPE for a few of the areas and transactions.
34.1%
Competent — The candidate discusses the accounting treatment that is required
under ASPE for some of the areas and transactions.
55.1%
Highly competent — The candidate discusses the accounting treatment that is
required under ASPE for most of the areas and transactions.
0.4%
(Candidates were not specifically directed to this indicator. However, they were told that, for the first
time, the financial statements need to be prepared in accordance with ASPE, and were provided with a
memo describing the operations and some particular transactions that occurred during the year.)
(Most candidates performed well on this indicator and provided in-depth discussions of some of the
relevant accounting issues, such as the revenue recognition policies to apply to the production of the
fireworks shows and the consignment sales. These candidates provided appropriate recommendations
based on their analyses and discussed some of the more significant transactions. Strong candidates
were able to integrate the case facts into their analyses and provide logical recommendations that
flowed from their analyses. Weak candidates addressed the same number of issues but often provided
recommendations without supporting them with case facts or reference to the relevant ASPE standard
or both.)
The candidate provides recommendations regarding the tax issues presented.
The candidate is demonstrating competence in Taxation.
Competencies
IX – 2.1 Calculates income taxes payable for an individual in routine situations (Level A)
IX – 2.3 Calculates taxes payable for a corporation in routine situations (Level A)
129
The following report addresses the taxation issues and computer systems.
Ella has identified several important tax issues that might have consequences for both FSI and its
employees.
FSI must determine if its display supervisors and display assistants are employees or subcontractors for
tax purposes. The Canada Revenue Agency (CRA) would examine who controls the nature and extent of
the work performed by these individuals to determine their classification as employee or subcontractor.
The question is whether an employer–employee relationship exists. There is no clear definition or set of
rules in the Income Tax Act to determine this, but guidelines do exist (including CRA publication
RC4110, Employee or Self-employed).
Factors to consider include
1.
2.
3.
4.
control;
ownership of tools;
risk of profit or loss; and
integration.
To support independent contractor/subcontractor status, FSI should consider whether it has used any of
the following practices, which would help support its position when challenging an assessment from
CRA:
Were independent contractor agreements in place?
Did FSI permit the individuals to work for other businesses?
Did any of the individuals advertise their services?
To the extent possible, did the individuals cover their own overhead expenses, including phone
service, letterhead, equipment, and supplies?
Did any of the individuals submit invoices (preferably on an irregular basis)?
Were any of the individuals registered for GST?
Were any of the individuals incorporated?
There are several factors in FSI’s case that indicate the workers may in fact be subcontractors:
Display supervisors and assistants are highly skilled.
They work with little supervision, since Kevin is usually away and there is only one other display
supervisor — in fact, they supervise other employees.
They work for the competition as well, so they do not have the loyalty of employees. (There may be an
issue in certain cases since some of the individuals haven’t worked for anyone else for the last 18 months.)
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They are paid a flat fee per show, rather than hourly, which means they have a risk of profit or loss. (It
is not clear whether they submit an invoice to FSI, whether they are registered for GST, supporting
self-employment, or whether any are incorporated.)
They receive only half of their pay up front, and the other half upon successful completion of a show.
They are in charge of the entire show, from pre-production to disassembly, indicating a degree of
autonomy.
There are also some factors that indicate they may be employees:
They use FSI’s assembly area and tools.
They are invited to FSI’s events (like regular employees), which take place after Canada Day and New
Year’s Eve.
There is “loyalty” by some, which may mean that FSI is their only “client”; as mentioned above, some
haven’t worked for anyone else in the last 18 months.
From FSI’s point of view, it is less costly for the display supervisors and assistants to be considered
subcontractors, since FSI does not have to pay Canada Pension Plan (CPP) and Employment Insurance
(EI) contributions with respect to their remuneration, which can be up to $3,000 per employee, per
calendar year. There is a risk to FSI if the treatment is inadequate (there would be penalties and interest
on unremitted amounts for deductions at source such as CPP and EI contributions). FSI can request a
ruling from CRA. Since there is more certainty if these workers are put on payroll, FSI may want to
consider doing so. It might also help ensure FSI has the display supervisors and assistants it needs since
having an employee relationship might help keep them from working for the competition.
(Candidates generally performed quite well on this issue, properly analyzing case facts against most of
the criteria considered by CRA and concluding on the nature of the relationship between FSI and the
display supervisors and assistants. As well, many candidates discussed the consequences to FSI if the
display supervisors and assistants were determined to be employees, and made recommendations to
FSI as to what it could do to ensure that they would be considered subcontractors.)
FSI is using sport utility vehicles (SUVs), which are made available to its employees for personal
purposes as well as for business. This type of vehicle is considered an “automobile” (a motor vehicle that
is designed or adapted primarily to carry individuals on highways and streets and that has a seating
capacity for not more than the driver and eight passengers) in Section 248(1) of the Income Tax Act.
These vehicles are being used to transport equipment, fireworks, and workers to and from shows, but
there is also some personal usage by the employees. So far, FSI employees are driving them about 2,500
kilometres per month for each vehicle, of which 200 are for personal use. Thus, it appears that the
vehicles are driven 92% (2500 − 200 ÷ 2500 km) for business purposes, although we should verify the
nature of the kilometres driven in the year acquired to ensure that the actual use for business is accurate.
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Although the SUVs cost more than $30,000, they may not belong in Class 10.1 for tax depreciation
purposes because they may not be “passenger vehicles.” More information is required. However,
according to ITA 248(1), passenger vehicles exclude “a motor vehicle of a type commonly called a van or
pickup truck, or a similar vehicle, that has a seating capacity for not more than the driver and two
passengers and that, in the taxation year in which it is acquired or leased, is used primarily for the
transportation of goods or equipment in the course of gaining or producing income.” Since you use the
SUVs to transport equipment and supplies to your shows, depending on their seating capacity they may
not be considered passenger vehicles.
However, they likely are able to carry more than the driver and the two passengers. Until we obtain
additional information, I will assume that the vehicles are Class 10.1 assets and that FSI is restricted to
claiming capital cost allowance (CCA) on only $30,000 of the $50,000 cost.
In addition, employees must be assessed a standby charge and operating expense benefit to the extent the
SUVs are driven for personal purposes. In general, this standby charge is 2% per month of the cost of the
automobile, with reference to the number of 30-day periods in the year the automobile was made
available to the employee or to a person related to the employee. However, this standby charge may be
reduced when personal use is less than 1,667 kilometres a month and the business-use portion of the total
kilometres driven is 50% or more.
Because the number of kilometres driven for business exceeds 90% and the personal kilometres are fewer
than 1,000 kilometres per month, the employees are eligible for a reduced standby charge.
Standby charge = 2% × cost of vehicle × (days available ÷ 30)
= 2% × $50,000 × (365 ÷ 30)
= $12,167
Reduction
= 200 km × 12 months
1,667 × 12 months
= 2,400 ÷ 20,000
= 12%
Standby charge = 12% × $12,166 = $1,460
Also, each employee will have to include in their employment income an operating cost benefit, based on
the kilometres driven for personal purposes, of $624 [(200 × 12) × $0.26*].
*
Could also use 2011 rate of $0.24 from tax tables.
The applicable operating cost benefit could be reduced if the automobile is used primarily for business
purposes. An amount equal to one-half of the standby charge benefit may be used as the amount of the
operating costs benefit in lieu of the 26 cents (prescribed rate) per kilometre. However, in this case, it is
better to use the per-kilometre amount because it results in a lower amount for the operating cost benefit.
Therefore, a total of $2,084 must be added to each employee’s income.
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(Most candidates were able to identify this issue; however, many of them were not able to properly
apply the
rules as they relate to the computation of taxable benefits (both the standby
charge and the operating costs) for the personal use of a vehicle. Only a few candidates discussed the
classification of the SUV and whether it should be recorded as a Class 10 or a Class 10.1 asset for tax
depreciation purposes.)
a) Travel and Meals
The cost of meals is generally deductible only if incurred while away, for a period of at least 12 hours,
from the municipality or metropolitan area in which the employer’s establishment is located. Kevin’s meals would generally qualify as deductible, and no taxable benefit would need to be assessed.
However, the cost of these meals is only 50% deductible when computing FSI’s net income for tax purposes.
Hotel expenses are fully deductible, and there is no daily limit, except for the overall test of
reasonableness. The exception is the extra week Kevin stays to after a competition. This week is for
personal time and not for business, since it is not related to earning income, and therefore the expenses
for that week would not be deductible. Some of the expenses incurred during that extra week might be
assessed as taxable benefits.
b) Frequent Flyer Points
Frequent flyer points that accrue to an employee are generally included as taxable benefits to that
employee if the points are used for personal travel. Since it seems that Kevin mostly travels for
business, there would not be a taxable benefit to him.
c) Events and Gifts
The dinners that FSI has after significant fireworks shows would qualify for the exemption to the 50%
limit on deductible meals if they are made available to all employees. However, FSI is restricted to six
such events in a year.
If the iPads are gifts, they are deductible and not taxable to the employees if the gifts total less than $500
each. If the iPads are worth more than $500 each, there would be a taxable benefit to the employees. To
determine if the iPads are gifts, CRA considers if ownership transfers to the employees or whether FSI
retains the ownership, and whether they are principally used for business purposes. If FSI is simply
allowing the employees or subcontractors to use the iPads, then it is possible there is no transfer and they
would not be gifts.
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(Many candidates struggled in analyzing these less significant issues. Most candidates were able to
state what the general rule was for some of the issues (for example, for meals, that only 50% of the cost
is deductible, but that for events, costs are generally fully deductible). However, they would then jump
to conclusions without first tying their analyses to the case facts or without explaining the criteria
applicable for the exceptions to apply (for example, meals are deductible when incurred in certain
circumstances, such as away from the metropolitan area; costs for events are fully deductible if all
employees can attend).)
Percent
Awarded
0.2%
competence.
6.3%
Reaching competence — The candidate identifies some of the relevant tax
issues.
37.4%
Competent — The candidate discusses some of the relevant tax issues.
56.1%
Highly competent — The candidate discusses several of the relevant tax issues.
0.0%
(Candidates were asked to help address Ella’s questions from Exhibit II, since the owner did not have the necessary expertise. Most of the issues raised by Ella in that exhibit related to tax concerns.)
(Most candidates discussed the significant issue facing FSI: whether display supervisors and assistants
should be treated as employees or contractors. However, some candidates struggled to adequately
discuss some of the factors because they did not seem to understand the purpose of them. This was
particularly true of the risk of profit or loss criteria. Many candidates also discussed some of the other
less significant tax issues, such as the deductibility of meal and travel expenses or taxable benefits.
Strong candidates provided added value by recognizing the significance of the employee versus
contractor status issue from a compliance perspective, and by informing FSI that penalties and interest
could apply if the deductions at source were not done properly as a result of assuming the wrong tax
status.)
The candidate evaluates the two systems and compares them against the ERD requirements.
The candidate is demonstrating competence in Management Decision-Making — IT.
Competencies
VIII – 4.2 Evaluates alternative IT solutions (Level B)
VIII – 4.3 Identifies and evaluates acquisition or sourcing decision factors (Level B)
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It is critical to FSI’s future that a new system be implemented as soon as possible. ERD requires this
system to be implemented by September 30, 2013. It is now November 10, 2012, and no system has been
chosen yet. The company needs to ensure it has a system in place by September 30, 2013, or there could
be serious consequences for FSI, since the news release issued by ERD indicates that non-compliant
companies could face “licence revocation and fines.” One of the systems being considered requires nine months’ development time, so there isn’t much extra time to allow for delays in implementation. With the nine months in mind, FSI needs to make a decision on which system to go with by December 31, 2012.
Any information needed to make a final decision needs to be obtained as soon as possible.
FSI should consider the option of asking ERD for an extension to ensure it has the time it needs to
develop and install the most suitable system.
1. The functionality to trace unique product
serial numbers back to their source, for at
least 25 years.
Yes, inventory remains open
and traceable in the database
for the life of the software.
2. Secure, 128-bit encrypted online access, if
database is available on the Internet at all.
Yes, browser based, accessible
through any computer
attached to the Internet, while
meeting the encryption
requirements.
Yes, very secure login of
system using randompassword generation token.
Might be more than needed.
3. Strict access controls to prevent
unauthorized access.
4. Complete recording of business
identification number (BIN) or social
insurance number (SIN) of purchaser or user
of the individual product.
5. Ability to print bar codes to label all
products.
Yes, custom-designed system,
so could easily meet this
requirement — need to
confirm.
Yes, bar coding.
Yes, can trace, but will
have to be done manually
after 5 years since
removed from database.
Question whether the log
is automatically generated,
and if so, if it remains at
FireTrack’s office.
No info — not sure if on
Internet since server based
Yes, server based, access
through workstation, with
user authentication and
second user ID and
password.
No information.
Yes, pre-printed and prenumbered bar coding.
6. Reconciliation of perpetual inventory to
inventory count, with ability to record
explanations for all discrepancies.
7. Assembly tracking functions, to allow the
individual items used as components in
another inventory item to still be tracked.
Inventory adjustments
automatically posted to the
general ledger in real time,
reducing potential for keying
errors. Returns are tracked in
the system and the age of the
inventory noted, helping to
manage returns and ensure old
stock is sold first or discarded.
Use of hand-held scanners
reduces errors. All of these
features reduce errors, which
reduces discrepancies.
Assumed to be there because
it tracks inventory item by
item through system.
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Yes, perpetual inventory
can be reconciled any time.
Discrepancies can be noted
on the printed count
sheets; since paper based,
would have to retain paper
records.
Assembly function is
being beta-tested —
available only in August
2013.
Both systems will likely meet the minimum requirements, assuming assembly tracking is part of the
August 2013 release of the FireTrack software. However, there is the risk that it isn’t part of the upgrade, in which case FSI would not be in compliance with the ERD requirements for the system. The Design-IT
system seems to have other features that FSI could benefit from (GPS tracking). However, this system
will take at least nine months to develop, so the key risk with this system is whether it might not be ready
for September 2013.
Since FSI risks losing its licence if it doesn’t meet the ERD requirements, cost is not a major driver in making the decision. However, FSI may wish to consider the cost if both systems meet the ERD criteria.
(Most candidates provided very good comparisons of the two systems against the ERD requirements
and provided reasonable conclusions on which system to select based on their analyses. However,
many candidates did not identify the potential additional benefits of selecting a particular system (for
example, the GPS tracking feature offered by the Design-IT system, which would also be useful to FSI
for purposes of tracking employees’ personal mileage with the SUVs).)
We recommend obtaining additional information before making your decision.
FSI should ask Design-IT if the development time can be reduced or if the company will guarantee that
the system will be fully operational, with the bugs worked out, by September 2013. FSI should also ask
for the contract price to be fixed, rather than subject to scope expansion.
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FSI should ask FireTrack if it has other customers using its system, and get formal references, if possible.
It appears as though the company developed its system based on working with only one client, which
could be a significant limitation in terms of prior testing of the system.
FSI should confirm that the FireTrack system addresses the criteria issued by ERD that were not clearly
addressed in the proposal. Specifically, can 128-bit encryption be used if FSI connects the system to the
Internet?
Find out if an assembly tracking system exists in Design-IT. If so, FSI should confirm whether the
tracking functions are operating correctly and would satisfy the ERD criteria.
FSI should confirm that both of the systems can track business identification numbers and SINs of
customers that purchased or used the product. It will be important to find out how the system protects
private information (it needs to meet the requirements of the Privacy Act). There is no mention of backup
processes — FSI should find out what they are and if they meet the company’s requirements.
(Most candidates did not address these issues. Candidates generally spent their time discussing the
systems’ features as they compared to ERD’s requirements and did not question what additional information should be sought from both providers, only stating that some information was missing.)
For Primary Indicator #4 (Management Decision-Making — IT), the candidate
must be ranked in one of the following five categories:
Percent
Awarded
0.5%
competence.
3.9%
Reaching competence — The candidate evaluates both options against the
requirements OR discusses some of the qualitative decision factors and risks that
weigh into the decision.
41.6%
Competent — The candidate evaluates both options against the requirements
AND discusses some of the qualitative decision factors and risks that weigh into
the decision.
53.8%
Highly competent — The candidate evaluates both options and discusses the
qualitative decision factors and risks that weigh into the decision, recognizing that
more information is required before making a decision that considers the specifics
of FSI’s operations, not just the ERD requirements.
0.2%
(Candidates were directed to this indicator, since Kevin asked CA to comment on the two system
options selected by Ella and to suggest anything else they should find out about the systems.)
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(Most candidates performed well on this indicator and attempted to compare the two options to the
ERD requirements. Strong candidates were able to integrate the case facts and provide qualitative
discussions with respect to specific features of the systems that should be of interest to FSI, in addition
to the fact that both systems met, to some extent, most of ERD’s requirements. Weak candidates showed a lack of integration in their responses, often comparing only a few of the systems’ features to some of the criteria. Also, few provided qualitative discussions other than a quick reference to the
September 30, 2013, deadline, and did not seem to recognize the significance of that deadline (loss of
licence and penalties).)
The candidate identifies that FSI is not operating effectively due to Kevin’s increased absence, and presents possible solutions to address the situation.
The candidate is demonstrating competence in Pervasive Qualities and Skills.
III – 1.1 Gathers or develops information and ideas
III – 1.2 Develops an understanding of the operating environment
III – 1.3 Identifies the needs of stakeholders and develops a plan to meet those needs
III – 2.1 Analyzes information or ideas
III – 2.3 Verifies and validates information
III – 2.4 Evaluates information and ideas
III – 2.5 Integrates ideas and information from various sources
III – 2.6 Draws conclusions/forms opinions
III – 3.1 Identifies and diagnoses problems and/or issues
III – 3.2 Develops solutions
III – 3.3 Decides/recommends/provides advice
III – 4.1 Seeks and shares information, facts, and opinions through written discussion
III – 4.2 Documents in written and graphic form
III – 4.3 Presents information effectively
Partial Memo to: Partner
From: CA
(Not part of the report to the client, but a separate memo to or discussion with the partner.)
During our discussions, we noted that many of the issues mentioned by Ella are on hold because Kevin is
away from FSI. His increased absence seems to have affected the business in negative ways. For example,
a key supplier wants to renegotiate a contract but might not wait until Kevin is able to schedule a meeting
time. The situation could result in consequences for FSI’s operations.
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Ella appears to be trying to step in and run the day-to-day operations in Kevin’s absence. For example,
she took the initiative to obtain quotes from several vendors for the ERD inventory system, and narrowed
them down to two suitable quotations. She also appears to be asking valid and relevant questions about
tax compliance and seems concerned about putting the company at risk. Further, she is concerned about
the profitability of the company, as evidenced by her comment on trying to reduce costs. She appears to
take initiative, for example, by preparing the sales and margin analysis and offering to step in to work
with the supplier.
However, she appears to lack decision-making authority, and is being frustrated in her ability to complete
the necessary tasks. If Kevin is planning on being away for long periods in the future, he needs to
consider delegating some authority to her. He admits that he has had to increasingly rely on Ella.
If Kevin concurs she is doing a good job, we could recommend that Ella be given more authority in
Kevin’s absence. If Kevin provides her with some decision-making parameters, she could make some of
the management decisions — such as meeting with the supplier.
We could also suggest giving her signing authority so that she can make essential payments, like
government remittances. If Kevin is not comfortable having her sign cheques, a system could be set up
whereby Kevin provides his authorization electronically to append his electronic signature to a cheque,
and then verifies the transactions and reviews the paperwork upon his return. The key is to find a way not
to hold up essential payments. FSI could also look into automatic or pre-authorized payments where they
are possible. For example, Canada Revenue Agency now allows payments to be made electronically,
eliminating the need for a physical cheque.
If Kevin plans to increase or maintain the current level of travel, he must find a way to manage the
business from a distance. He can either stay in touch with Ella regularly and provide her with his
authorization verbally, by fax, or by email, or give her more authority and freedom to manage the
operations on his behalf.
Kevin’s absences are primarily due to his current focus on international fireworks competitions, which is
his personal passion. Kevin is the owner of a private company, and can certainly operate it anyway he
wishes to. However, Kevin did mention that these competitions are extremely expensive and take a lot of
his time. As business advisors, we might want to discuss the matter further with Kevin. The increased
participation in international competitions has resulted in a significant change in the way FSI operates.
Kevin may not have had the time to step back and assess the impact this decision has on his operations
overall.
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He mentioned that he “believes” the international competitions help build new commercial business.
Kevin may wish to substantiate his belief that participating in international competitions helps build
business. By identifying where and how a contribution is being made to FSI’s net income, Kevin can
consciously make a decision to continue to participate in these competitions either because he chooses to
personally or because it benefits FSI. If fireworks show revenue is increasing as a result of FSI’s participation in international competitions, then the competitions could in fact be considered a form of
advertising (and be accounted for in that manner).
As mentioned, Kevin can certainly run his business the way he wants, but he might want to consider the
impact of his increased absences. It could be that they are having a negative impact on FSI due to the high
cost of the competitions and his being away. They may bring recognition to FSI, but they may be
reducing FSI’s overall income. Without a long-term benefit (increased fireworks show revenue), Kevin
may want to reconsider his decision to do more international competitions, or he may want to look at
ways of managing the business in his absence, as discussed above.
Percent
Awarded
46.9%
competence.
19.6%
Reaching competence — The candidate recognizes that Kevin’s absence is affecting the management of the company in some way.
21.1%
Competent — The candidate discusses the fact that Kevin’s absence may be negatively affecting the company and suggests a way to address the issue.
12.3%
Highly competent — The candidate discusses (with full support) that Kevin’s absence may be negatively affecting the company and suggests ways to address
the issue, including giving more authority to Ella (recognizing that she is doing a
good job).
0.1%
(Candidates were expected to warn Kevin about some of the negative impacts his absence from the
office could have on the business, and to provide some recommendations to address the issues.)
(Candidates struggled with this indicator. Most of them only mentioned to Kevin that his travelling
might have an impact on the business, and failed to either identify specific concerns (such as loss of
contracts, inadequate supply contracts, or penalties from late remittance of the salary deductions at
source) or to provide recommendations (such as providing Ella with additional training or signing
authority).)
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(Strong candidates were able to identify the issue, recognize an operational impact, and provide
remedial solutions (such as delegating more tasks to Ella). Weak candidates simply restated case facts
without raising any particular concerns or explaining the impact of Kevin’s absence on the company. The Board was disappointed that so few candidates cautioned Kevin with regard to these operational
issues.)
(Overall the Board was pleased with the quality of the responses on this simulation. This was a lengthy
simulation in which candidates were asked to do many things, and most candidates performed well,
addressing the significant issues. Most candidates addressed each of the indicators, and with
reasonable depth of analysis. However, candidates seemed to have difficulty with the big-picture nondirected issues, since they struggled the most with Primary Indicator #5. The Board encourages
candidates to not just address the specific requireds, but to also critically examine the case facts and
raise any issues they feel should be brought to the client’s attention.)
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To: Partner
From: CA
Subject: Fire in the Sky Inc (FSI)
Risk of Material Misstatement
This is the first time we're reviewing FSI, so we are unfamiliar with the industry and the company
specific operations and transactions which increases risk that we do not detect material errors. There
is also a risk that opening balances may not be adequately tested given the length of time since Oct
31, 2011.
The company is in a highly regulated industry. This increases risk as management may be
manipulating figures to meet regulatory requirements.
The bank has requested reviewed financial statements for the first time. This increases the number of
users relying on the FS which increases risk, and since this is the first time they have asked for
reviewed FS this may indicate that the bank is worried about FSI's ability to meet loan payments,
which further increases risk.
The inherent nature of the business increases risk as inventory may be unexpectedly ignited, or
subject to returns or show cancellations, which, under regulations, requires that inventory be
destroyed and unsaleable. This increases risk to the inventory valuation assertion.
Risk for the review has been assessed as high.
Approach
Our approach should be to analyze information, enquire and discuss with management to determine if FS
items are plausible. We may need to perform additional substantive procedures if the results of our testing
are inconclusive or if results are outside of our expectations.
Procedures and Key Risk Areas
Revenue - Retail Fireworks
FSI purchases fireworks and sells them to retailers with 30 day payment terms, however, under ERD
regulations, all unsecured fireworks must be taken back from the retailer and fully refunded. This would
appear to be a consignment type arrangement as any broken seals are the responsibility of FSI rather than
the ultimate retailer.
ASPE revenue recognition requires that the revenue from sales of goods be recorded only when the
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Appendix C — Paper II — Sample Response
following conditions are met:
A - ultimate collection is reasonably assured
B - reasonable assurnace exists regarding the measurement of consideration and the extent to which goods
may be returned.
C - persuasive evidence of an arragement exists
D - delivery has occurred, significant risk and rewards of ownership transferred.
E - price is fixed or determinable.
In the retail sales to customers, A is presumaly met as FSI would perform credit checks prior to issuing
customer credit. B is questionable as the extent of returns depends on whether the seals are broken at the
retailer. FSI is required to take back the product whether the broken seal was installed faulty (FSI's fault),
or tampered with on the retailer's side -- thus the extent to which goods may be returned may be
undeterminable. C is met as a sales agreement is in place. D - although the goods were delivered, FSI
retains ongoing risk associated with the product as any broken seals are the responsibility of FSI and not
the retailer. This would suggest that D is only met when a product is sold to the ultimate customer, not on
sale to the retailer. E is met as price is fixed by product.
Based on the analysis above, it seems most appropriate that FSI recognize revenue only when the retailers
sell the product on to the final customer. Despite the payment terms, the return period of the fireworks is
indefinite and wholly depends on the integrity of the safety seal. Since the returns could be significant and
unpredictable (cannot predict if the store will tamper with seals), revenue recognition should occur when
the retailer sells the goods to a third party.
Review Procedures:
- Discuss with accounting staff their revenue recognition policy on retail sales. Obtain revenue GL listing,
discuss with accounting staff how returns of products are accounted for and perform analysis on average
return % to determine if provision or reduction of revenue for product returns is plausible.
- Since the revenue recognition process impacts inventory, we should enquire with management whether
the inventory at retailers is included as part of the inventory count. We should review the sales invoices
near-year end to determine how much inventory was shipped to customers and consider sending out
confirmations to determine inventory on hand at the retail stores.
- We should review the sales agreements with the retail stores to determine whether there are any clauses
in place that would impact the returns of faulty sealed products (e.g. if product seal is tampered with at
store, whose responsibility is it? ERD will dispose of the fireworks but will store or FSI bear the loss?)
Revenue - Fireworks Shows
For the fireworks shows, they are produced under contract. Collection is reasonably assured as the
customers are mostly municipalities who would have good credit. The contract is signed 6 months in
advance and the cost of assembling fireworks is known. Revenue recogition requires that performance
should be determined using either the % completion method or completed contract method. In this case,
the creation of a fireworks show involves multiple stages: design, assembly, and actual show. This would
support the use of a % completion method. About 50% of the cost of a show relates to the assembly stage.
It would not appear to be reasonable to use a completed contract method due to the steps involved.
Review procedures:
- Enquire with management the revenue recognition procedures associated with the fireworks shows.
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Review the revenue GL for shows in pre-production to determine what full 70% deposit it not recognized
and deferred. Discuss with show designers what stage of completion the preproduction shows are at
(design, assembly) and determine if revenue recorded for these shows is plausible.
- Enquire as to the contract value of the fireworks shows and discuss cost to complete shows with
production staff. Analyze to determine whether the shows are expected to be profitable and whether
losses need to be recognized immediately.
Inventory
Inventory is a high risk account as there is no formal inventory tracking system in place and the inventory
is highly susceptible to loss (explosion). There are also a number of regulations in place that require ERD
to destroy inventory - if inventory is not used in a show, if seal is broken, etc.
Review procedures:
- Obtain list of all cencelled shows and discuss with management whether all the fireworks created for
those shows have been destroyed. Obtain list of inventory for each show and analyze to determine
whether it is plausible that all the inventory on hand relates to existing shows in preproduction (3-5
shows). Discuss how destroyed inventory is accounted for in the system. If possible, obtain list of
inventory for each shows and compare this against list of inventory written off to ensure that all destroyed
inventory is written off.
- Discuss with mnagement the cost of purchasing retail fireworks for resale and whether any of the
fireworks need to be sold at severe discount or at a loss due to various factors. Obtain the average selling
price of retail fireworks and compare to the average per FS to determine whether sales are plausible given
the volume of product sold and average price.
PP&E
Exchange Transaction
During 2012 FSI traded an igniter for a launcher with Dyno Co. This is a non-monetary transaction since
no cash was involved. Under ASPE, an entity should measure the transaction at the more reliably
measurable fair value of either asset unless a) the transaction lacks commercial substance, b) the
transaction is an exchange of product held for sale in the ordinary course of business, c) neither fair value
can be reliably determined or d) the transaction involves the owner.
b) does not apply as FSI does not ordinarily sell igniters inthe orderinary course of business.
c) does not apply as the fair value of the igniter and launcher are known to be worth approx 25K.
d) does not apply as Dyno Co. is an unrelated party and not the owner.
To determine if the transaction had commercial substance (a), we need to consider whether FSI's future
cash flows are expected to change significantly.
The launcher is expected to increase the height of fireworks by 25% which in turn should help FSI obtain
more contracts for large jobs. This would suggest that the launcher would increase future cash flows. By
comparison, the igniter was a redundant asset on the upgrade of the firing system and was not expected to
be used (future cash flow = scrap value). Thus the cash flows of the asset received differs significantly.
The transaction has commercial substance.
Thus, the non-monetary transaction should be measured at the carrying value of the asset given up (after
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reduction for impairment).
The igniter would seem to have been impaired as it was no longer expected to be used in operations and
the future cash flows associated with it would have been nil. The recoverable amount would have been
undiscounted future cash flows expected from use and eventual disposition (sale/scrap value).
Accounting treatment: Write down igniter to higher of recoverable value (scrap) and fair value (25k) if
carrying amount exceeds that, and non-monetary exchange would be valued at the carrying value.
Review procedures:
Enquire with management whether any cash consideration was received as part of this deal to
determine whether the carrying value of the asset would need to be reduced as part of accounting for
the transaction.
Discuss with management the future expected cash flows associated with the new launcher to confirm
that it will help bring in new contracts and enquire what would have become of the ingiter if it was
not sold to verify that indeed the future cash flows differed significantly (that the transaction had
commercial substance).
To: Kevin, Ella
From: CA
Subject: FSI
Employee vs Contractor
The determination of employee vs contractor is significant to FSI. If the persons are employees, FSI is
required to withhold payroll remittances and pay employer portions of CPP and EI to CRA on a regular
basis. The classification as contractor would assist FSI in reducing costs as the employer portion
withholdings do not need to be paid. If CRA deems persons to be contractors then FSI would be liable to
pay penalties and interest on amounts outstanding and Kevin would be personally liable as a
director/shareholder of the company if the amounts are unpaid.
In determining whether a person is an employee or a contractor the CRA generally looks at several
factors:
Legal form of the agreement: The contract with the people currently takes the form of an employment
contract with as-needed time requirements. The legal form suggests that this is an employee
relationship.
Use of tools: The persons currently use FSI tools and design software. This would suggest that this is
an employee relationship, however, due to the specialized nature of the tools, if the use of company
tools is the norm inthe industry, this would not be significantly indicative of being an employee.
Integration with FSI: The persons have the option to work for FSI competitors if they so choose
although not all presons do so. This suggests that this is a contractor relationship as the persons are
not wholly reliant on FSI as sources on income and are not exclusive to FSI.
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Chance of Risk and Opportunity for Reward: The persons are paid on a per-job basis rather than a flat
fee. This indicates that the person bears the risk of making a lower wage per hour if they take a long
time to complete a job. Onthe flip side, if they are efficient, they may earn comparatively higher
returns. This suggests a contractor relationship.
Payment: They are paid on a per-job basis (half before, half after), and not on a regular payroll system
(every 2 weeks or other pay period). This would suggest a contractor relationship.
Based on the above analysis I think that the persons could be considered contractors. To reduce the risk of
CRA considering these persons employees I recommend that you have a stronger contractor agreement
drafted with legal counsel, you should also require that the persons bill you before and after the jobs to be
paid rather than automatically issuing payments.
Meals and Travel
Business travel expenses are generally 100% deductible, including luxury hotel expenses. Meals while on
business travel would be deductible at 50% even when not entertaining clients as the travel itself was for
buisness purposes (to run fireworks show). However, the 1 week that Kevin stays after the shows may be
considered personal time as this is not related to running fireworks shows, selling, or getting new clients.
In this case, the meals and accomodations relating to the 1 week period would not be deductible to FSI.
The employee dinners after Canada Day and New Years are 100% deductible if they are made available
to all employees of FSI and limited to 6 events per year.
The employee gifts of iPads, since the value exceeds $500, are taxable gifts to the employees. These
should be deductible to FSI as they were incurred to keep employees loyal and increase satisfaction to
raise productivity (related to earning business income), however, they will be taxable benefits to the
employees and included on the T4 slips.
Fireworks Vehicles
Since the employees are given access to the vehicles, generally there would be an employee benefit
included on their T4 for personal use of the vehicles as the standby charge and operating cost benefit. The
standby charge is based on 2% of the vehicle cost ($1000) per month the vehicle is available for the
employee's use. However, there is a reduction in place if the employee uses the vehicle primarily for
business (which they do), and the standby charge is eliminated where the employee drives fewer than
1,667km personally. Thus, the employees should not be charged a standby charge.
Design-It
Strengths:
Security is strong and the system is encryped with required 128-bit encryption.
Access controls are extremely strong, requiring a unique ID and password and a separate code issued
by a token. I have concerns regarding the token, you should enquire what the procedure is if a token is
lost (i.e. can they be replaced and old token deactivated?)
Has ability to print bar codes for products with the tracking number as required by ERD.
Has function to reconcile perpetual inventory for inventory counts as required by ERD. Any
discrepancies and adjustments are identified with a reason. However, a concern is that the inventory
changes are automatically integrated into GL -- although a good function, we need to ensure that this
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works properly and there is some review process in place to prevent errors from being inported into
GL.
Backup occurs on a daily basis to the secured servers for $200 so that in case of data loss, the data
will be accessible from their servers.
Weaknesses:
Implementation will take 9 months, approximate completion in August 2013. The requirements need
the system to be in place and functional by Sept 30, 2013. If there are any delays, FSI may not meet
ERP standards and be liable for penalties.
Tracing of products is only as long as the software is updated. The ERD requires that items be tracked
for 25 years at minimum. You should discuss with the developer how long they intend to support the
software, or what happens if the software is discontinued. There is a risk that the software would not
meet ERD standards and your fireworks license revoked.
No assembly tracking function as required by ERD.
Fire Track
Strengths:
Access is regulated by user ID and password required at 2 levels - one at the computer login level and
once at the server level to access the system. This allows you to limit access ot the system itself to
only authorized persons.
The system issues preprinted and prenumbered barcodes, this allows you to reconcile whether bar
codes have gone missing and that all items are tagged (e.g. 10 items of inventory should use 10 bar
codes, if only 9 are used, indiates something not tagged).
Hosted on a local server so the data can be retained by FSI as long as server is functional, which may
meet 25 year limit required.
Developer will create an assembly tracking function that is epxected to be avialable for Aug 2013.
This is in time for the ERD requirements of Sept 2013, but in case of delays there is a risk that FSI
would be subject to penalties.
The base software less assembly function is ready to roll out now, so that FSI can implement and test
the software leading up to the Sept 2013 deadline.
Weaknesses:
FSI will need to back up its own data to ensure security against data loss and to ensure that the data
can be accessed up to 25 years later. Recommend that the backup be stored off site in a secure,
fireproof location (not in the fireworks locker)
The inventory reconciliation process does not allow for discrepancies or notes in the system itself,
these must be printed out and noted manually on the sheets. Although the ERD doesn't require
automatic system, this increases the risk that the sheets will be lost or otherwise damaged and the
records lost. Discuss with developer whether this can be added to the system.
Tracking is only available for 5 years after the product is sold or used. You should discuss with the
developer whether this can be extended, or what happens after 5 year limit. There is a risk that the
software would not meet ERD standards and your fireworks license revoked.
Recommendation
Based on the description of the software options above, I recommend that you consider the FireTrack
system as it would appear to meet your needs and meets more of the ERD's requirements.
147
Kevin is often unavailable which interfers with operations of FSI as vendor contracts are not being
renegotiated on time and proposals are not being reviewed in a timely manner. This may result in lost
profitability to FSI as you may be missing out on clients and preferential vendor rates.
There is an issue with government remittances not being signed on time. This is concerning as
government payments such as payroll withholdings would be personally liable for Kevin as the
owner/director. If FSI does not pay, CRA may go after him personally.
I recommend that Kevin consider distributing responsibilities between himself and Ella or other
competent individuals so that these issues can be resolved on time. This may include giving FSI signing
authority to Ella or another person. However, if you do so, need to consider controls in place to ensure
that FSI assets and resources are not misused.
Could consider hiring more design supervisors to travel for the fireworks shows rather than Kevin
himself.
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(80 minutes)
Today is September 16, 2012. You, CA, work for Garcia & Garcia LLP, a medium-sized firm located in
Montreal. Jules Garcia calls you into his office. “CA, I have a very special engagement for you. A friend of mine, Louise Martin, is starting a not-for-profit organization named MMB. MMB is going to be
Quebec’s first breast milk bank. Louise was unable to breastfeed her newborn and obtained donated breast milk for the first year of her daughter’s life. She was lucky enough to live in British Columbia at the time, and had access to donated breast milk. She now lives in Montreal and hopes to give babies here
the same access to breast milk that she and her daughter had.” Jules provides you with information on breast milk banking that he received from Louise (Exhibit I).
“The Breast Milk Agency (the Agency) is a government body that regulates breast milk banks. The role
of the Agency is to eliminate the risk that a disease or contaminant is transferred in milk by ensuring
controls are established to preclude contamination. The Agency requires that MMB establish operating
controls over the collection, storage, and distribution of breast milk. MMB must submit a description of
its controls in these three areas, to be approved by the Agency, before it begins operations. Once the bank
is operating, the Agency can shut MMB down if it finds that MMB has deviated from any of the approved
controls. Louise is planning to implement processes similar to those outlined in Exhibit I, but she’s unsure what controls she’ll need to establish around these processes to meet the Agency’s requirements for quality control. Therefore, your first task is to help Louise develop the necessary controls for MMB.”
Jules continues, “To receive grants, MMB is required to prepare financial statements that follow Canadian
Accounting Standards for Not-for-Profit Organizations. Louise has limited accounting knowledge and is
feeling overwhelmed with how to account for all the different types of donations. Please help her select
appropriate accounting policies, where necessary, and draw her attention to accounting issues she might
encounter.”
Jules also notes that Louise is not quite sure what she should charge per 120-millilitre bottle of milk in
order to recover the costs. He hands you notes from his meeting with Louise (Exhibit II). “Please help her with this calculation and any other issues that you identify.”
149
(continued)
BACKGROUND ON BREAST MILK BANKS
For mothers who are unable to meet their babies’ nutritional needs with their own breast milk, pasteurized donor milk is a viable option. Donor breast milk is often used for babies who:
are born prematurely;
have medical conditions that affect their ability to be breastfed (e.g., cleft palate);
are born to mothers with medical conditions that affect their milk supply and quality (e.g., breast
cancer);
are adopted.
Women considering donating breast milk should ensure they adhere to the following guidelines:
maintain a healthy diet;
limit exposure to pesticides and other contaminants, such as lead and mercury;
limit use of prescription drugs; and
avoid use of alcohol, tobacco, and illegal substances.
As with blood donation, there is a two-stage screening process for women who want to become breast
milk donors. First, the donor answers a detailed health history questionnaire, which her doctor signs.
Once the prospective donor has completed the health history questionnaire, she is given a blood test to
test for high-risk viruses. Potential donors may be excluded for a variety of medical reasons.
The milk bank covers the cost of the screening process. Repeat donors are treated as new donors after
each pregnancy and must undergo the screening process again.
When a donor is approved, the milk bank provides her with collection kits that include sterile containers
in which to collect, store, and freeze her milk. The milk bank also provides instructions on hygiene,
including how to properly wash hands and clean breast pumps.
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(continued)
BACKGROUND ON BREAST MILK BANKS
The process for storing donated milk is as follows:
1) Donor mothers pump and immediately freeze milk in the containers provided. Once a sufficient
amount of milk has been stored, it can be shipped to the milk bank using the designated courier.
2) At the milk bank, the milk is thawed and carefully transferred from the storage containers to glass
flasks. Milk from different mothers (up to four) is batched and mixed.
3) Prior to pasteurization, the mixed milk is poured into 120-millilitre glass bottles.
4) The bottled milk undergoes pasteurization (heated at 62.5°C for 30 minutes) in an industrial-grade
pasteurizer. Pasteurization eliminates bacteria while retaining most of the milk’s beneficial components. A bacterial culture is then taken.
5) The bottled milk is again frozen while awaiting the culture results. Milk that is culture-positive for any
bacteria after pasteurization is disposed of.
Breast milk can be stored up to seven days in a refrigerator, up to two weeks in a refrigerator freezer, and
up to six months in a chest-type freezer (at a temperature below -20°C).
When the bank receives a request for breast milk, the milk is shipped frozen in the 120-millilitre glass
bottles.
151
(continued)
NOTES FROM JULES’S MEETING WITH LOUISE
The federal government has provided Louise with a one-time grant of $100,000. The grant is intended
specifically for the purchase of tangible capital assets and for other start-up costs, and must only be used
for these purposes. A local pediatrician who is very supportive of Louise’s efforts, Dr. Sandra Oldmen, has donated $75,000. These two amounts should help fund operations until MMB can provide breast milk
to mothers in need and recoup its costs. Louise has received the donation from Dr. Oldmen but is still
waiting on the grant. MMB will not be operating as a registered charity, so Louise is not expecting a
significant amount of cash funding, and therefore MMB will not provide donation receipts.
Several public hospitals are interested in purchasing milk from MMB, and their budgets allow them to
spend up to $8 per 120 millilitres. Many private clinics have indicated that they are prepared to pay up to
$20 per 120 millilitres.
Louise notes that her email inbox is inundated with requests from women all across Canada who are
willing to pay as much as $40 per 120 millilitres for donor milk to help their babies. Her goal in the first
year is to provide donor milk to 20 babies for the first 12 months of their lives. She mentions that she is
not exactly sure how she is going to decide which babies are most deserving, given her estimate that up to
500 babies in Canada each year require donor milk.
Louise expects that, after meeting her own baby’s needs, each mother can donate approximately 15,000
millilitres of milk a year, and she expects them to donate for one year. Louise is uncertain about the
number of donor mothers needed to fulfill her goal of providing donated milk to 20 babies in MMB’s first
year. She hopes to be able to double the number of recipients on an annual basis (in other words, 40
babies in the second year, 80 in the third, and so on). Considering this aggressive growth strategy, she
wonders whether she will need to financially compensate the donor mothers for their milk, and if that is
inconsistent with her not-for-profit objective. Louise has obtained the following guidelines on the
quantity of breast milk a baby requires:
0-6 months
6-12 months
720 ml
600 ml
Louise expects a significant number of volunteers to donate their time to help run MMB. If she does not
get enough volunteers, she may need to hire and pay additional staff. In addition to the volunteers, MMB
will employ a lab technician, an employee in charge of milk donors, an employee in charge of operations
and quality control, a receptionist, and Louise, the chief executive officer, with a total expected salary
cost of $275,000 per year. Louise expects to spend approximately $60,000 on the freezers, pasteurizer,
office furniture, computers, and software. She has priced some off-the-shelf inventory management
software and expects it will cost about $500 per year.
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(continued)
NOTES FROM JULES’S MEETING WITH LOUISE
Operating costs of MMB are as follows:
Rent — $2,000 per month
Office expenses — $1,250 per month
Utilities — $300 per month
Cost of each 120-millilitre bottle — 20 cents
Cost of collection kits — $15 per donor
Average total shipping cost — $10 per 25 bottles of milk
Screening fees — $95 per donor
Lab testing fees — $42 per 25 bottles of milk
153
In addition, the
when analyzing
Ensuring the proper collection, storage, and distribution of breast milk is essential to your operations. The
repercussions if an infant were to become ill because of unsafe milk would be astronomical. I have
outlined what I believe are the key controls that need to be implemented at MMB in order for you to
ensure that the milk is safe.
The candidate provides examples of the required controls to ensure the proper collection,
storage, and distribution of breast milk.
Competencies
VI-3.1 Identifies the entity’s key operations (Level B)
VI-3.3 Evaluates internal control (Level A)
Donor Selection/Health Questionnaire
The proposed screening process is good, but you must consider the need to follow up on a donor’s health. The risk is that a donor successfully passes the screening process but then contracts a virus or illness after
the fact. This would not be caught through the current screening process.
Control: MMB needs to ensure it periodically screens its donors. MMB may want to verify what the
Breast Milk Agency recommends in terms of the frequency of screenings. (For example, would annual be
sufficient, or is biannual preferable?) However, donors should be asked to update their health information
when there are any changes to their health and a new blood test should be taken.
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The health history questionnaire must be signed by a doctor before being submitted. However, because
the questionnaire is received by MMB directly from donors, there is a risk that the information provided
is not valid (for example, the donor may falsify the information).
Control: MMB needs to ensure the information provided in the health history questionnaire is accurate.
You may want to verify the credentials of the signing doctor. You may also want to request that the
doctor submit the questionnaire directly to MMB after obtaining the donor’s consent.
(Almost all candidates discussed the issue of donor screening. However, most candidates focused solely
on the need to validate a doctor’s credentials or to make sure the doctor’s signature was not falsified.
Although these discussions were valid and awarded, the Board would have liked more candidates to
recommend controls relating to the frequency of the screening process.)
Confidentiality of Donor Information
Extremely personal health information will be included in the donor questionnaires; therefore, MMB
needs to ensure that this information remains confidential.
Control: You have not indicated whether MMB plans on maintaining paper or electronic records, but
either way, controls are necessary. If the records are electronic, there must be adequate user names and
passwords to restrict access to the files. If the records are paper-based, they should be kept in a locked
filing cabinet or secure room.
(Very few candidates identified the need to provide controls around the confidentiality of donor
information, and even fewer were able to discuss it properly and provide a valid control.)
Labelling
Breast milk has a limited life before it goes bad (maximum of six months frozen). In order to properly
track the breast milk that is donated, to calculate its expiration date, and to ensure that it is not already
bad, you will need to have an accurate date of collection.
Control: You will need to properly educate the donor mothers about labelling. You can provide stickers
and labels to the donor mothers. Indicate the date format that you would like them to use when recording
dates so that there’s no confusion between date and month. All labelling should be checked when the
breast milk arrives at the bank, and the person who accepts the shipment needs to sign and date to confirm
that it was checked.
(Few candidates recognized this issue. However, most of those who did provided good discussions.
Candidates appropriately recommended labelling the bottles and explained why this was necessary: to
track the expiry date of each bottle.)
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Shipping
Presumably it will take the donor mothers about a year to pump 15,000 millilitres of milk. It is unclear
how often you expect them to ship the milk to you. You likely do not want them to accumulate the entire
15,000 millilitres before they ship it since the milk will then expire sooner and some will have already
expired. Therefore, I have assumed weekly shipments. The breast milk must be frozen immediately after
it has been pumped. The container that it is stored in must be clean, and the milk must remain frozen
while being shipped. If not, bacteria could grow and cause the milk to go bad. Because a donor’s milk will be batched with milk from up to three other mothers, you must ensure that it is not bad before it is
mixed with the other milk, otherwise it will taint the rest of the milk.
Control: You may want to institute a policy with regards to how frequently a donor should ship her milk
to the bank. As indicated above, the milk does have an expiration date, so from that perspective, the
sooner the milk is shipped, the better. But you’ll also want to minimize your shipment costs since it costs $10 to ship 25 bottles. You should determine the ideal shipping frequency (for example, donors should
ship once they have accumulated 25 bottles) and communicate this policy to the donors to ensure that the
milk is fresh and that shipping costs stay under control.
Control: For each shipment they make, donor mothers should sign off on the quantity of milk shipped to
make sure that this matches the amount delivered and recorded as received by the bank. This will ensure
that nothing gets lost in transit and will be a critical control should you choose to pay donor mothers.
Control: You must ensure that the breast milk remains frozen during transportation. To do this, you
should ensure the shipping company has the appropriate controls on its end to keep the milk frozen. When
the milk arrives, it should be checked immediately to determine if it is still frozen, and then placed into a
freezer until it is ready to be pasteurized. The recipient of the frozen milk at MMB should document the
time of the shipment, the quantity that arrived, and whether the milk was in fact frozen.
(Only a few candidates identified these issues. Most of these candidates discussed the need to have an
approved list of couriers that would ensure the milk stays frozen during shipping. Only half of the
candidates who addressed this issue provided an in-depth discussion. Some did not provide an
explanation as to why this control was necessary. In order to provide a complete discussion, it was
important to explain to Louise why each control is important for the operation of MMB.)
Training and Support
The mothers will be responsible for collecting, labelling, and shipping their own breast milk. There are
many possible mistakes that a mother could make throughout the different steps of the process.
Control: MMB should try to reduce mistakes as much as possible by providing training materials to the
mothers and having support available, such as through a helpline.
(Fewer than half of the candidates discussed this issue, but it was generally discussed well. However,
some candidates recommended making surprise visits to ensure donor mothers were adhering to the
instructions provided. The Board did not consider this control to be practical given the number of
donor mothers and the fact that they could be geographically diverse.)
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Batching
Milk will be batched, and batches will contain milk from up to four different mothers. Therefore, you
must ensure that milk from one mother is not bad before it is mixed with the other milk so that it does not
taint the rest of the milk.
Control: A bacteria culture needs to be taken from all milk that is donated to ensure that it is not bad
before it is batched with other milk. This will be another area where you will need to properly educate the
mothers to ensure that they understand how to properly store their milk. When tested breast milk comes
back positive for bacteria, the donor mother should be contacted. A discussion should be held with her to
determine whether it could have become contaminated during storage or during transportation.
(Approximately a quarter of the candidates discussed this issue. Most of these candidates recognized
the problem with testing the milk only once it was batched and were able to provide a valid control to
prevent cross-contamination. Weak candidates did not identify this risk and instead provided a control
to ensure that milk was batched from no more than four donors.)
Pasteurization
The bottled milk undergoes pasteurization (heated at 62.5°C for 30 minutes) in an industrial-grade
pasteurizer. Pasteurization eliminates bacteria while retaining most of the milk’s beneficial components.
Control: MMB needs to make sure that all of the equipment used in the processing of the milk (such as
the pasteurizer) is regularly cleaned and sterilized to ensure that none of the milk is contaminated.
(About a third of the candidates recognized and discussed this issue in sufficient depth. Most
candidates recommended that an alarm should go off once the temperature of the pasteurizer goes
below 62.5 degrees, which was considered a valid control. Whether they recommended a control related
to the temperature of the pasteurizer or the cleanliness of the equipment, most candidates who
identified this issue were able to provide a valid control and explain why the control was needed.)
Record-Keeping
You will need to keep adequate records of which mothers the donated milk in each batch has come from.
In case of any possible problems or recalls, you will need to have up-to-date information so that you can
efficiently isolate any problem batches or donors.
Control: Given the volume of information, possible donors, and shipments in and out of the milk bank, an
inventory management system would be the optimal solution to minimize human error. You may want to
also consider some sort of numbering system for the batches to make them easier to track and identify.
However, due to privacy concerns, proper safeguards such as encrypted information, passwords, and
limited access by staff to the donor records should be in place.
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Tracking of Age of Milk
Breast milk can be stored for up to six months in a separate chest-type freezer. If the donor mother can
pump an extra 41 millilitres of milk a day (15,000 millilitres every 365 days), it would take her over 10
weeks to pump enough milk to donate (120 millilitres × 25 bottles = 3,000 millilitres ÷ 41 millilitres = 73
days). Therefore, the milk from different donors will have different expiration dates.
Control: You should batch breast milk that was pumped within the same week. Otherwise, if you batch
new milk with older milk, you will significantly reduce the shelf life of the new milk. For optimal storage,
the donors should be encouraged to store the frozen breast milk in a chest-type freezer so that it keeps as
long as possible.
(Approximately a third of the candidates identified and discussed the record-keeping and tracking of
the age of milk. Most of these candidates identified the need to have an inventory system or to label
milk bottles due to the limited shelf life of milk. Candidates generally did well on these two issues,
when they were addressed.)
Ensure No One Has Tampered with the Milk
There is always a risk that a bottle could be opened and contaminated.
Control: Once pasteurized, each bottle should have a seal placed on the lid that shows if it has been
opened. Before shipping breast milk out, all seals should be checked to ensure that none have been
opened.
(Only a few candidates identified this issue. Those who did were generally able to provide a complete
discussion of the issue along with a valid control to ensure the breast milk was safe.)
Storage Temperature
For optimal storage, the freezers must remain at −20°C or colder. Therefore, the freezer temperature needs to be monitored to ensure that the temperature does not rise above this.
Control: You should have an alarm on the freezers that lets you know if the temperature rises above a
certain amount. Someone should check on a daily basis the freezer temperature and sign off that the
temperature is below −20°C. You should have a backup generator in case the power goes out.
(Only a few candidates identified this issue. Candidates were more likely to discuss the temperature
required to be maintained in the pasteurizers than the temperature of the freezers.)
Ensuring Oldest Milk Is Distributed First
Breast milk has a limited shelf life. MMB must ensure that the oldest milk goes out first.
158
Control: Before the bottles are shipped out, the inventory control list should be scanned to ensure that the
bottles being sent out are indeed the oldest. In the freezers, the bottles should be organized by date. The
bottles will be assigned numbers. Therefore, presumably the oldest will be the ones with the lowest
numbers.
Control: The transportation company should also be able to guarantee specific delivery time. Quick
delivery is important since the milk may be shipped to hospitals across the country and it does have a
shelf life.
(Very few candidates identified this issue.)
Ensure Milk Stays Frozen During Shipment
MMB will need to ensure the milk remains frozen during shipment to recipients to ensure milk does not
spoil.
Control: As with the shipment from the donor mothers to the bank, you must ensure that the breast milk
remains frozen during transportation. To do this, you should ensure the shipping company hired has the
appropriate controls on their end to keep the milk frozen.
(Again, very few candidates identified the issue related to the freezing of the milk during
transportation. As was the case with the shipment of the milk from the donor mothers to MMB, most of
the candidates discussed the need to have an approved list of couriers, but many did not explain why
this control was necessary.)
Percent
Awarded
0.2%
competence.
7.0%
Reaching competence — The candidate identifies some of the necessary
controls.
51.6%
Competent — The candidate discusses some of the necessary controls.
41.1%
Highly competent — The candidate discusses several of the necessary controls.
The candidate achieves depth by discussing controls in each of the collection,
storage, and distribution cycles.
0.1%
(Candidates were asked to help Louise develop the necessary controls for MMB. As the Board
anticipated that candidates might have a difficult time developing operational controls for such a
business, more specific direction than usual was provided to them. The simulation stated that the
agency requires MMB to establish operating controls over the collection, storage, and distribution of
breast milk, thus giving candidates a starting point.)
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(As predicted, candidates struggled with this indicator. Although most candidates were able to
recommend controls, not all provided explanations as to why these controls were necessary. Moreover,
some controls recommended were not valid or practical, such as asking donor mothers to donate at the
bank each time. Weak candidates seemed to forget their role and provided ways to audit the controls
instead of providing the controls themselves, or focused their recommendations on ensuring there was
an adequate audit trail and documentation. Strong candidates provided specific and practical controls
and explained why these were important for MMB’s operations.)
The candidate calculates the cost per 120-millilitre bottle of breast milk that MMB needs to
charge in order to cover its operating costs.
The candidate demonstrates competence in Management Decision-Making.
Competencies
VIII-2.2 Analyzes financial and other data to provide information for pricing decisions (Level A)
VIII-2.3 Determines and evaluates the entity’s cost-volume-profit relationships (Level A)
You are not quite sure what you should be charging per 120-millilitre bottle of breast milk. Since MMB is
operating as a not-for-profit, the price charged to hospitals and clinics should be the cost of the breast
milk. The government is granting MMB $100,000 to get operations started. This is a one-time cash
inflow; therefore, it has been excluded from my calculation. I have also excluded the $75,000 donation
from Dr. Oldmen, as this appears to be a one-time donation as well.
I need to allocate a portion of the overhead costs. In order to calculate the overhead costs per unit, I need
to determine how many millilitres of milk the milk bank will process in its first year. You mentioned that
you hope to provide donated milk to 20 babies for the first year of their lives.
I have calculated a cost per 120-millilitre bottle of breast milk that needs to be charged in order to recover
all costs of operations. MMB should charge at least $11.19 per 120-millilitre bottle in order to recover its
costs. This is above the $8 per bottle budgeted by the public hospitals in the area, but below the $20 per
bottle budgeted by the private clinics. You should have a discussion with the public hospitals to determine
whether there is any flexibility in their budgets. Otherwise, you will need to find alternate means to
recover costs if you wish to sell exclusively to hospitals. Alternatively, you could calculate the optimal
sales mix that will allow you to sell to both hospitals and clinics and cover your costs.
Note that as volume increases in subsequent years, the price you will be able to charge to break even will
decrease as fixed costs will be allocated to a greater number of bottles. However, there could be
significant changes in the fixed costs from one year to another because MMB is hoping to double the
number of babies helped every year. As a result, it might be necessary to hire additional staff or to buy
additional equipment. As costs change, the budget and the calculation of the cost per 120-millilitre bottle
should be adjusted for this information so that the total cost of the breast milk is recouped.
160
The following calculation has been done assuming you will be able to meet your goal of helping 20
babies. However, it is important to note that you will need to recruit 317 donors to produce enough milk
for 20 babies. This might be difficult in the first year of operations, and therefore, you will probably have
to incur additional costs to spread the word about your organization and to recruit donors. You should be
aware that if you can’t recruit enough donors, there will be an impact on the estimated cost per bottle. In
addition, you are considering paying donor mothers. This decision will have a significant impact on the
cost per bottle. Finally, you need to consider how the internal controls we’re suggesting you implement might affect the cost estimates you have made.
161
EXHIBIT I
Purpose: To calculate the cost per 120 ml bottle of breast milk
Total # babies
Objective
Year 1
Year 2
Year 3
20
40
80
Number of mls needed
Qty per
day
(ml)
180
720
180
600
# of days
2,592,000
2,160,000
5,184,000
4,320,000
10,368,000
8,640,000
Total mls
4,752,000
9,504,000
19,008,000
mls needed
mls/bottle
Total bottles
4,752,000
120
39,600 A
9,504,000
120
79,200
19,008,000
120
158,400
Total number of mls needed / 15,000 mls per donormls needed
mls / donor
Total donors
4,752,000
15,000
317 B
9,504,000
15,000
634
19,008,000
15,000
1,267
0-6 months
6-12 months
Total mls
Number of bottles needed
Total number of mls needed / 120 ml per bottle
Number of donor mothers needed
Cost incurred per bottle
Variable cost (VC) per bottle
Cost per bottle
Shipping cost ($10/25 bottles = $0.40)
Lab testing fees ($42/25 bottles = $1.68)
Total VC for total # of bottles required per year
(A*C)
Variable cost per donor Collection kits
Screening fees
$
$
$
$
$
$
$
$
0.20
0.40
1.68
2.28 C
90,288
$
180,576
$
361,152
15
95
110 D
Total VC for # of donors required per year (B*D)
$
34,870
$
69,740
$
139,370
Rent ($2,000 x 12)
Office expenses ($1,250 x 12)
Utilities ($300 x 12)
Salaries (provided)
Inventory Management system (provided)
Audit fees (Note 1)
Security monitoring (Note 1)
$24,000
$15,000
$3,600
$275,000
$500
?
?
$ 318,100 E
$
318,100
$
318,100
$ 443,258
$
568,416
$
818,622
Fixed costs
Total Cost per year & Bottle
Total cost per year (C+D+E)
Total cost per bottle (E/A)
$11.19
$7.18
Note 1 - These are necessary costs but we do not have enough information at this time to estimate an amount
$5.17
162
For Primary Indicator #2 (Management Decision-Making), the candidate must be
Percent
Awarded
0.1%
competence.
18.1%
Reaching competence — The candidate attempts to calculate the cost to be
charged per 120-millilitre bottle of breast milk.
15.3%
Competent — The candidate performs a reasonable calculation of the cost to be
charged per 120-millilitre bottle of breast milk.
66.4%
Highly competent — The candidate performs a reasonable calculation of the
cost to be charged per 120-millilitre bottle of breast milk. The candidate considers
whether the goal of helping 20 babies is feasible.
0.1%
(Candidates were specifically told that Louise was not quite sure what she should charge per 120millilitre bottle of milk in order to recover the costs. The partner asked CA to help her with this
calculation.)
(Most candidates provided reasonable calculations of the price per bottle. In general, candidates did a
good job of distinguishing between the variable costs and the fixed costs as part of their calculations.
Strong candidates went beyond calculating the cost per bottle and performed multi-year analyses,
realizing the number of bottles required each year, and therefore the number of donor mothers, would
change. These candidates also differentiated between the variable costs that fluctuated per bottle and
the variable costs that fluctuated per donor. This provided for a more precise and complete calculation,
since comparable units were used to arrive at a cost per bottle.)
(Weak candidates performed break-even or contribution margin analyses. This type of calculation did
not answer Louise’s question of how much she should charge per bottle in order to recover her costs, given her objective of helping 20 babies in MMB’s first year of operation. A common mistake was also
to confuse the units used in the calculation. Some candidates added costs per bottle to costs per donor,
which rendered their analyses less useful. A few candidates came up with a price per bottle of milk that
was unreasonable given the circumstances. Candidates could have used the information provided in
the simulation, such as the prices the hospitals and private sector were ready to pay per bottle, to
realize that the cost per bottle they had calculated was inconsistent.)
The candidate discusses appropriate accounting policies to implement at MMB.
163
Competencies
V-1.1 Analyzes financial reporting needs (Level A)
V-2.1 Identifies the appropriate basis of accounting (Level A)
V-2.2 Develops or evaluates accounting policies in accordance with GAAP (Level A)
MMB is a not-for-profit entity and must follow CICA Handbook — Part III, Accounting Standards for
Not-for-Profit Enterprises (as required by the regulatory body). I have discussed the accounting policies
for the sections that apply to MMB. You should also verify whether the Agency has any specific
reporting requirements that MMB needs to meet.
A contribution is defined as a non-reciprocal transfer to a not-for-profit organization of cash or other
assets or a non-reciprocal settlement or cancellation of its liabilities. The cash donation of $75,000
received from Dr. Sandra Oldmen would be a contribution, as well as the government funding of
$100,000, provided that nothing was provided in return for these monies.
The cash contribution of $75,000 would be considered an unrestricted contribution because Dr. Oldmen
did not stipulate how the funds were to be spent.
The government funding of $100,000 would be considered a restricted contribution because the
government has stipulated that it can only be used for the purchase of capital assets and start-up costs.
You should clarify the definition of start-up costs. For example, does it only include costs to get the
location up and running, or does it cover costs up until MMB starts to recoup its costs from hospitals?
MMB has the option of choosing to record contributions using either the deferral method or the restricted
fund method.
The deferred contribution method reports only one fund balance aggregating all contributions.
Unrestricted contributions are recognized as revenue in the period they are received. Restricted
contributions are deferred and recognized as revenue in the period in which the related expense is
incurred. If the restricted contribution is for capital assets, revenue is recognized to correspond with
amortization.
Therefore, the $75,000 could be recorded immediately because it is unrestricted. The $100,000 would
need to be deferred and amortized over the life of the capital assets (see property, plant and equipment
discussion below for amortization periods). Since only $60,000 is expected to be used, $40,000 will not
be amortized until that money is used to purchase additional capital assets. If the remaining $40,000 is
used for start-up costs and the money is all spent, then the $40,000 can be recognized this year. Any
amount not spent will need to be deferred.
164
Under the restricted fund method, the revenues of the general fund consist of unrestricted contributions
that are recognized when received ($75,000) and revenue from the sale of donated breast milk. The
general fund is normally used to finance operating activities, so expenses would include wages, rent,
supplies, amortization, et cetera. The $100,000 of funding received from the government would be
recorded as revenue of the restricted fund. The contributions of $100,000 can be recognized when
receivable and not when the related expense is incurred. The various funds are presented separately on the
financial statements.
The users of the financial statements will be you, the Agency, and the public. The Agency most likely has
lots of experience with NPOs and will be indifferent to the method selected. The general public will have
limited accounting knowledge. Therefore, the restricted fund may be easier to interpret. On the other
hand, you are not expecting many cash donations, and the government grant is a one-time grant to get
operations going. Therefore, the restricted fund method may not be very useful once the funds to purchase
capital items and start-up costs are used.
I therefore suggest that you use the deferred contribution method, since MMB will not have any restricted
funds other than the tangible capital asset fund once the government grant is used up.
(The majority of candidates attempted to discuss the restricted versus unrestricted contributions as well
as the accounting policy choice between deferral fund accounting and restricted fund accounting
methods. Most candidates followed their discussions with a recommendation to Louise as to which
accounting method MMB should use and why. However, approximately half of these candidates
struggled to apply the relevant
sections to the case facts when discussing these issues. For
example, some candidates recognized that the $100,000 grant was a restricted contribution, but did not
explain why it should be considered restricted. This was important because Louise mentioned she had
limited accounting knowledge. In other cases, candidates appropriately recognized that, under the
deferral fund accounting method, the revenue from the grant would be deferred; however, these
candidates did not provide complete discussions because they did not explain to Louise that the revenue
would be deferred and amortized over the life of the asset.)
The money generated from the sale of pasteurized breast milk is not considered a contribution. It is
considered revenue and is recognized the same as it would be for a private enterprise. Therefore, MMB
would recognize the sale of breast milk to the hospitals when the breast milk was delivered. The risk of
collection is low because the hospitals are funded by the government. However, if you decide to sell milk
to mothers directly, rather than through hospitals or clinics, collectability may become a concern and the
timing of revenue recognition may be affected.
(This was a minor issue that only a very small number of candidates identified and discussed.)
165
CICA Handbook, Accounting Part III, Section 4410, Contributions — Revenue Recognition, provides
guidance on whether revenue can be recorded relating to donated materials and services. An organization
may choose to recognize contributions of materials and services, but should do so only when a fair value
can be reasonably estimated and when the materials and services are used in the normal course of the
organization’s operations and would otherwise have been purchased. MMB is receiving donated milk and
donated services from volunteers; therefore, this section is applicable.
Donated Milk
MMB will be receiving a significant amount of donated milk from mothers. From my calculations in
Exhibit I, I determined that MMB will need to receive at least 4,752,000 millilitres of donated milk per
year to reach its goal of providing milk to 20 babies.
Receiving donated milk is in the normal course of operations since this is the mandate of the NPO. You
are considering paying donors for their breast milk, and may contemplate this even further if you are
unable to get the donations you need to help 20 babies. Therefore, there is a chance that the milk might
otherwise have been purchased.
Even if you had to purchase the milk because you were unable to get enough donors, we would need to
reasonably estimate what the fair market value of the donated breast milk would be. Private clinics have
indicated that they would pay $20 per 120 millilitres, and private buyers have offered to pay $40 per 120
millilitres. Considering the number of requests in your inbox, other mothers may be willing to pay even
more. At this point in time, it is difficult to determine the fair value.
The revenue would be offset by COGS, so there is no impact on MMB’s bottom line. Therefore, from a
presentation standpoint, it would be beneficial to record the revenue from donated breast milk because it
would provide more information to users of the financial statements. On the other hand, recognizing these
donated amounts would cause MMB’s annual revenue to exceed $500,000. When a NPO’s average
annual revenue exceeds $500,000, it can no longer opt to not capitalize its tangible and intangible assets
(sections 4431.03 and 4431.04). Therefore, MMB would need to capitalize its assets. See the discussion
below for the impact on tangible and intangible assets.
Donated Services
You have indicated that you are hoping MMB will have a significant number of volunteers.
The volunteers’ services would be considered to be in the normal course of operations because they
would be used to help run MMB. Also, if you do not get enough volunteers, you will need to hire
additional staff, and therefore this meets the criteria that the services would otherwise have been
purchased. Presumably the fair value of services can be estimated by comparing what an equivalent
employee would be paid for the tasks that the volunteers are performing. Therefore, the criteria are met
and the revenue can be recorded. However, I question the added benefit that recording this revenue would
provide. The amount does allow you to determine how much money you are saving by using volunteers
instead of paid staff, but does not get factored into your total cost per millilitre because it is not a cash
outlay. Therefore, the additional time and effort it takes to calculate the revenue from donated services
seems to outweigh the benefits. Given that MMB has the option of recording donated services as per the
Handbook, no amount should be recorded relating to the volunteers.
166
(Candidates were more likely to address the donated services than the donated milk. However, the
Board was disappointed by the candidates’ lack of familiarity with these topics. How to recognize donated goods and services is central to not-for-profit organizations and something that they definitely
should have made Louise aware of, yet few candidates did so. Most candidates who addressed either of
these issues provided adequate discussions by analyzing the respective
criteria and applying
case facts. However, some candidates did not recognize that Louise had the option of whether or not to
record the revenue associated with donated milk or services, and provided Louise with wrong or
unclear information. As well, some candidates failed to recognize that, should Louise decide to
recognize this revenue, the associated costs (such as the cost of milk) would also need to be recorded,
therefore having no impact on the bottom line.)
As MMB’s revenue is currently below $500,000, it has the option of not capitalizing the cost of the
freezers, pasteurizer, office furniture, computers, and software ($60,000). If you decide to record revenue
related to donated breast milk, your annual revenue will exceed $500,000 and you will no longer have
that option. However, this is contingent on you obtaining the donated milk you require to help 20 babies.
Given the fact that you do not have that many assets and they are still relatively easy to track, I
recommend that the costs of these assets be capitalized and amortized over their useful lives in
accordance with Section 4431.05. Then, if and when MMB’s revenue does exceed $500,000, you will not
have any problem transitioning. Whereas if MMB were to opt to expense capital assets and subsequently
meet the threshold, Section 1506 would require you to apply retrospective treatment. Capitalizing assets
will also enable you to track your assets on hand.
Therefore, the assets will be recorded at the cost to purchase them plus costs incurred to get them ready
for their intended use (for example, transportation and freight insurance), less any residual value.
Amortization should also be calculated and recorded. I suggest that depreciating the assets over their
useful lives on a straight-line basis will be the simplest option. An example of possible useful lives is as
follows; however, more information is needed to determine useful lives.
Freezers — 5 years
Pasteurizer — 20 years
Office furniture — 5 years
Computers — 2 years
Software — 2 years
(Fewer than half of the candidates identified this issue. Candidates who discussed the accounting
treatment for capital assets generally did well and were able to provide complete discussions on the
matter. However, some candidates confused the applicable criteria under Accounting Standards for
Private Enterprises (ASPE — Part II of the
), Pre-changeover Accounting Standards (Part
V of the
) and Accounting Standards for Not-for-Profit Organizations (Part III of the
). For example, some candidates mistakenly presented to Louise the invalid option of
capitalizing assets and not amortizing them.)
167
CICA Handbook — Part III, Section 3032 only applies for inventory distributed at no charge. Since the
inventory that MMB will be distributing will be at a charge, the inventories for MMB will follow CICA
Handbook — Part II, Section 3031, Inventories. Section 3031 requires the cost of inventories to include
all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their
present location and condition.
From my discussion above, I have already determined that the cost of the donated breast milk will not be
recognized. Therefore, only the direct costs and overhead incurred in the collection, manufacturing,
testing, and distribution of the pasteurized breast milk will be recognized in inventory.
Inventory has to be recorded at the lower of cost and net realizable value. If MMB is only able to recover
$8 per 120 millilitres from the hospitals, then inventory would need to be written down to this value. If,
however, the hospitals are able to get a higher budgeted amount, or you decide to provide pasteurized
breast milk to private clinics, then the inventory would not need to be written down. You would have to
use the weighted average to calculate the net realizable value so the inventory value will depend on the
percentage sold to hospitals, clinics, et cetera.
(This issue was minor. Very few candidates attempted to discuss it, and many of those who did were not
able to provide valid and complete discussions.)
Percent
Awarded
0.1%
competence.
6.4%
Reaching competence — The candidate identifies suitable accounting policies
for some of the accounting issues.
41.3%
Competent — The candidate discusses suitable accounting policies for some of
52.1%
Highly competent — The candidate discusses suitable accounting policies for
several of the accounting issues.
0.1%
(The partner had asked CA to help Louise select appropriate accounting policies where necessary.
Candidates were directed to this indicator when they were asked which policy choices had to be
considered under Canadian Accounting Standards for Not-for-Profit Organizations, since MMB was
required to prepare financial statements under these standards.)
168
(The majority of candidates attempted to discuss the treatment of the restricted and unrestricted
contributions received by MMB to date, as well as the accounting policy choice between the deferral
fund accounting method and the restricted fund accounting method. However, many candidates
struggled to apply the relevant
sections to the case facts, and therefore did not always
provide in-depth discussions of these issues. In addition, other accounting issues that are central to
not-for-profit organizations, such as how to recognize donated goods or donated services, were not
discussed by as many candidates as the Board had hoped. In general, candidates seemed to not be
familiar with the standards applicable to not-for-profit organizations.)
The candidate discusses important decisions Louise needs to make about MMB.
The candidate demonstrates competence in Pervasive Qualities and Skills.
Competencies (lists the Pervasive Qualities and Skills for the entire simulation)
I-1
Protects the public interest
III-1.1 Gathers or develops information and ideas
III-1.2 Develops an understanding of the operating environment
III-1.3 Identifies the needs of stakeholders and develops a plan to meet those needs
III-2.1 Analyzes information or ideas
III-2.2 Performs computations
III-2.3 Verifies and validates information
III-2.4 Evaluates information and ideas
III-2.5 Integrates ideas and information from various sources
III-2.6 Draws conclusions / forms opinions
III-3.1 Identifies and diagnoses problems and/or issues
III-3.2 Develops solutions
III-3.3 Decides / recommends / provides advice
III-4.1 Seeks and shares information, facts and opinions through written discussion
III-4.2 Documents in written and graphic form
III-4.3 Presents information effectively
There are several important decisions that need to be made before MMB commences operations. In order
to help you in evaluating your options, your original intentions when starting MMB will frame your
decisions.
Selling Donated Breast Milk
You have received many requests from mothers willing to pay up to $40 per 120-millilitre bottle of breast
milk. MMB could probably find enough mothers willing to pay for breast milk, considering your email
inbox is flooded with requests. As a result, MMB could sell some milk and generate significant revenue.
This revenue could then be used to help even more infants in need. On the other hand, this may not be the
fairest allocation of the donated breast milk as babies whose parents cannot afford to pay up to $40 per
bottle will not have access to this milk.
169
You may think that a baby in need should have access to the milk regardless of his or her parents’
income. If so, you may need to determine whether you’re comfortable selling to individual mothers directly, knowing that this may preclude the allocation of milk to some babies but that the additional
revenue will allow MMB to help more babies.
You mentioned that you’re not sure how you’re going to decide which babies will receive the donor milk.
You have set a goal of helping 20 babies in the upcoming year. Considering this is the first human breast
milk bank in Quebec, and assuming very few others exist across Canada, this is clearly a situation where
demand significantly exceeds supply, since approximately 500 babies every year across Canada require
donor milk.
From a strictly financial perspective, it would seem that MMB should sell donor milk only to private
clinics or individual mothers, since MMB would be able to completely recover the costs. However, basing
the decision solely on profitability may not be the fairest allocation of the donor milk.
You need to set a policy for how MMB determines which babies are going to receive donor milk. A
rational and systematic selection method needs to be formalized so that you don’t receive any complaints
that the process is unfair. It needs to be consistent and transparent. You also need to figure out what area
you would like to service: all of Canada, all of Quebec, or only Montreal. You should talk to other milk
banks that are already established to find out what process they follow to determine which babies to
provide with milk.
You need to consider whether MMB will only be responsible for choosing the organization (the hospital),
or whether you should impose requirements on the hospitals you choose in terms of how they determine
which babies to help with the breast milk received from MMB.
(Despite Louise stating that “she is not exactly sure how she is going to decide which babies are most deserving,” only about a third of the candidates attempted to address this concern of hers. Many of
those did not go beyond identification of the issue in their discussions. Unfortunately, a simple
repetition of case facts does not provide insight to the client. Candidates who performed well not only
questioned whether Louise should sell to hospitals, private clinics, or directly to mothers, but also
provided relevant criteria that could help Louise assess which babies to help.)
Buying Donated Breast Milk
From my calculations, each baby needs approximately 237,600 millilitres of breast milk in one year. This
translates to 16 donor mothers (237,600 ÷ 15,000-millilitre donation) per baby (assuming each mother
only donates once). You need at least 317 donor mothers to meet your goal. This seems like quite a large
number of donor mothers for the first year of operations. You aren’t sure whether to pay donor mothers
for their milk. Paying mothers would most likely increase the number of donor mothers and would not be
inconsistent with your not-for-profit objective. However, this may not increase the number of healthy
donors. In addition, it might encourage mothers in financial difficulty to withhold breast milk from their
babies in order to have more breast milk to sell. Paying donor mothers will also increase the cost per
millilitre of breast milk, which will force you to sell to more clinics and individual mothers in order to
break even. Therefore, this is not a decision that should be taken lightly.
170
An alternative to paying donor mothers might be for MMB to run a marketing campaign that creates
awareness about the breast milk bank. Asking the hospitals to let new mothers who are not having
problems breastfeeding know about the breast milk bank could be another way to help promote awareness
and to recruit new donors.
Again, candidates were led to this issue by Louise herself: “She wonders whether she will need to
financially compensate the donor mothers for their milk, and if that is inconsistent with her not-forprofit objective. Therefore, it was disappointing that fewer than half of the candidates appropriately
identified this issue. Many of those who did attempted to directly answer Louise’s question of whether
paying mothers would be inconsistent with the objectives of an NPO. These candidates usually did not
go a step further to consider the potential negative implications that could come as a result of paying
donor mothers. In addition, some candidates considered the concept of paying donor mothers as part
of their quantitative analysis only (Primary Indicator #2), without providing any additional advice to
Louise.)
Other Sources of Revenue
Even if you decide that you aren’t comfortable selling milk to individual mothers or paying donor
mothers, you may wish to consider other methods of generating additional revenue for MMB, such as
fundraising or accepting cash donations. This would require MMB to register as a charity and obtain
charitable status. MMB would then be able to issue donation receipts for cash donations. MMB should
also consider having a fundraising event or securing a line of credit to generate additional funds since it
may be a while before it starts to recover some of its initial costs.
(A few candidates provided other valid discussions or recommendations to Louise on the overall
operation of MMB. Most of these candidates recommended that Louise register MMB as a charity.
However, most of these candidates did not explain why this was important. Registering MMB as a
charity could lead to more contributions because donors would receive tax credits.)
Percent
Awarded
25.5%
competence.
20.4%
Reaching competence — The candidate identifies some of the important
decisions Louise needs to make about MMB.
40.0%
Competent — The candidate discusses some of the important decisions Louise
needs to make about MMB.
14.1%
Highly competent — The candidate discusses in depth some of the important
decisions Louise needs to make about MMB.
0.0%
171
(Although this is a pervasive indicator, and therefore there was no specific required asking CA to
address these issues, they were hinted at in the simulation. According to the notes the partner, Jules,
made of his meeting with Louise, she mentioned that she was not exactly sure how to decide which
babies were most deserving of donor milk. She also wondered whether she would need to financially
compensate donor mothers and if it would be inconsistent with her not-for-profit objective.)
(Candidates struggled with this indicator. Fewer than half of the candidates attempted to address
Louise’s concern with regards to paying donor mothers. The majority of those discussed whether it
was inconsistent with her not-for-profit objective. Therefore, most candidates did not identify that this
decision should not be taken lightly since it could attract the wrong types of donors. Candidates could
have also discussed other alternatives for attracting donor mothers, such as running a marketing
campaign, but few did so.)
(Moreover, only a third of the candidates attempted to address Louise’s concern about which babies to help. Candidates’ discussions of this issue typically focused on whether, from a financial point of
view, Louise should consider selling to hospitals, given that the price she could charge to individuals
was higher than the selling price to hospitals. Strong candidates provided criteria for Louise to
consider when assessing which babies she should help.)
(Candidates performed reasonably well on some aspects of this simulation but struggled on others.
Candidates performed best on Primary Indicator #2, where they generally did a good job of
calculating the price per bottle to charge to recover costs. Candidates performed reasonably well when
it came to providing Louise with advice on the accounting policies MMB should implement, but there
is room for improvement in this area. The Board was also disappointed that candidates did not
address the issues specific to not-for-profit organizations, such as how to recognize donated milk or
donated services, as often as expected. Similarly, most candidates were able to provide Louise with
some valid operating controls, but with the long list of controls they could have discussed, candidates’ coverage of the issues could have been stronger. Where candidates really struggled was on the
pervasive indicator. Candidates had a difficult time providing Louise with valuable insight in terms of
which babies she should help and whether she should be compensating donor mothers. Most
candidates either avoided addressing these issues altogether or only identified the issue, without
providing a complete discussion.)
172
To: Louise Martin
From: CA
Subject: MMB
In order to obtain Agency approval, MMB will need to submit a list of internal controls for approval and
adhere to these to continue to be approved as a milk bank. Thus it is imperative that these controls be
implemented and adhered to ensure that MMB is not shut down.
Collection Controls
To ensure that the health history questionnaire was signed off by a valid medical doctor, MMB should
verify that the doctor is in good standing with the provincial college of physicians.
To ensure that mothers are appropriately screened prior to donating, the screening process as outlined
should be required on an annual basis. It is expected that donors produce milk for 12 month periods,
and barring additional pregnancies, there is a high risk that the donor lifestyles may change and no
longer be in compliance with the health and drug requirements. Having the doctor sign off on the
questionnaire would reduce the risk that donors are misrepresenting answers and hiding potential
additional pregnancies.
To ensure that donors are given sterile collection kits, the lab technician should perform microbial
swabs and testing on random sample of kits from each production/autoclave batch. Only kits from
clean batches should be sent out.
To ensure that mothers are adequately trained on hygiene and cleaning methods, in addition to the
paper instructions, I would highly recommend in-person training sessions, however, the cost of this
might be prohibitive for the NPO.
Storage Controls
To ensure that milk remains at acceptable temperatures in transit and during collection by the donor
(since milk at room temperature or warmer is susceptible to bacterial growth), consider including a
temperature sensitive sticker to the collection vessels. This indicator should permanently change
colour when the temperature of a vessel is increased beyond 10C. This way MMB will know when
milk has been exposed to unsafe temperatures. All questionable milk should be thrown out.
To verify that the pasteurizer is working as intended, the temperature and time of the cycle should be
tested on a daily or weekly basis by the lab tech using tempreature probes and timers to ensure that
the asset is sterilizing milk properly. The results of the tests should be logged in a log book and
reviewed regularly to ensure that the equipment is not damaged.
173
To properly identify contaminated milk, since milk contamination is likely due to donor error, MMB
would ideally not batch milk from different donors if possible. If this cannot be avoided, each 120ml
bottle should be uniquely identified with a bottle #, and each of the 4 donor IDs. The bacterial
cultures should be identified with the bottle ID number so that the contaminated bottle can be located.
All bottles from those donors should be retested to ensure that the other bottles did not test as false
negatives (as milk was pooled, chance that bottle from one mother would contaminate multiple
bottles).
To ensure that the milk storage limits are adhered to, the bottles should be dated with the date of
pasteurization. The fridge should be reviewed every day to remove expired bottles; the freezer should
be reviewed every week, and the chest freezer every month. This will reduce the risk that expired
bottles of milk will be sent to recipients.
Distribution Controls
To ensure that non-expired milk is sent out, prior to distribution the bottle dates should be reviewed
that they are still valid.
To verify that there is little chance of baterial contamination and getting receipient babies ill, the
bottles should be physically inspected for cracks, leakage and other damage to ensure that the bottles
are still sterile.
To ensure that the milk is shipped at safe temperatures, should include the temperature sensitive
stickers noted above and inform recipients that if the label is red (or whatever indicator colour), that
the milk is unsafe for use.
Methods of Accounting for Contributions
As an NPO reporting under the NPO accounting standards, there is a policy choice that can be made with
regards to accounting for contributions.
Under the restricted fund method, the financial statements are broken down by various fund types
(general, restricted, capital fund, endowment fund, etc). This results in a multi-column FS that may be
somewhat unfamiliar to you and other users, however, this generally provides users with information on
specific projects or functions that an NPO has. Since MMB intends to only have one line of operations
(breast milk), and there are no other significant projects or events, this type of presentation would not be
ideal since there would be few restricted funds or different projects that would be more useful to be
shown separately. In the restricted fund method, donation revenue is recognized immediately if there is a
restricted fund for that type of donation, or otherwise recognized in the general fund (immediately if a
current/general donation, or deferred if another type of donation that doesn't have a fund).
Under the deferral method, general contributions are recognized as expenses are incurred. Restricted
contributions are deferred and matched against the expenditures they are restricted to. This type of
reporting is generally simpler as there is only one FS category and the FS are similar to typical for-profit
statements so users tend to be more familiar.
174
Since MMB only has one type of project, and it is not expected that there will be restricted donations for
specific events or expenses, and it would not help users to present information in multiple categories, I
recommend that you adopt the deferral method of accounting for contributions.
Under the deferral method, the $75K donation from Dr. Oldmen would be recognized to the extend that
the amount is spent during the period. Any unspent amounts at the end of the period would be deferred
and recognized when actually spent.
The $100K grant from the government is a restricted donation as it limits you to purchasing capital
equipment. The grant amount should be deferred, and recognized in revenue over time, matched against
amortization expense of the related equipment. The net accounting impact of the equipment would be nil
as the revenue would offset all the amortization. Any amounts spend on the start up costs would be
recognized as revenue when the start up costs as incurred. Since you have not received the amount yet we
need to consider whether you can accrue the grant as a receivable. Since you have met the conditions for
the grant and the grant receipt is reasonably assured, you should accrue the grant as a receivable.
Capital Assets
Under NPO accounting, as long as your revenues over 2 years (this year and next year) average below
$500,000, you have a policy choice regarding capital assets. You may choose to expense capital assets in
the year acquired or capitalize them as PP&E and amortize over their useful life / period over which the
NPO expects to use it. If you exceed this threshold, the capital assets must be capitalized and amortized.
Volunteers
Generally contributions of services can only be recognized as revenue when the fair value can be
reasonably estimated, used in the normal course of business and would otherwise have been purchased.
You stated that you intend for volunteers to help run MMB. If you do not get enough volunteers you
"may" need to hire additional staff. If you are certain that you will hire staff if you have sufficient
volunteers, then it may be reasonable to record the volunteer work as revenue. Measuring the fair value of
the services may be difficult as well, but you may be able to determine the amount that you would be
willing to pay a paid employee and assign that value to the services. Please note that generally, volunteer
revenue is not recognized since the NPO would not otherwise pay for the services and the time value is
difficult to determine.
Please refer to Exhibit A for the calculation of minimum milk price required. I have assumed that you will
require the sales of the milk to cover all of MMB's operating costs since you do not expect significant
donations (due to lack of registered charity status). The government grant is expected to cover the cost of
equipment so has been excluded from the annual costs for MMB.
Average cost to produce a bottle based on current production costs is $11.24 per bottle.
These costs will vary depending on the rate of contamination and whether additional staff need to be hired
in lieu of volunteers.
Sales Avenues
The hospitals are willing to pay $8/bottle, which is below cost so MMB would not be sustainable. The
hospitals may also require larger volumes of milk than you can currently provide which would increase
risk that you cannot meet their needs. However, the hospitals would be a steady customer as there are
175
always complicated births in hospitals and premature babies that would require additional milk so it
would be a steady customer.
The private clinics are willing to pay $20/bottle. This allows you to generate a 'profit' of $8.76 per bottle.
This would be useful in case you do need to pay additional employees in lieu of volunteers and may allow
you to pay donors on a per bottle basis as incentive to join the program. You should discuss withthe
private clinics what their needs are as far as # bottles per year or number of babies, and determine whether
these would be a sustainable customer (e.g. do they regularly deal with babies who need more milk, or is
it on an unpredictable as-needed basis?).
The private individuals who are willing to purchase bottles for $40 would also be a factor. There is a risk
that selling to persons directly would not be permitted under the Agency regulations and your license
would be revoked. Before you consider this option I recommend that you review the regulations carefully.
There is additional risk here that due to shipping all over Canada, that the bottles may be broken in transit
or subjected to unsafe temperatures. The increased profit would allow you to hire more staff and pay
donors to increase your donor base for expansion.
Recommendation
While you start out I recommend that you sell milk to the local private clinics first as this will allow you
to recover costs as $20 exceeds the cost to produce at $11.25. I recommend that you price your milk at
minimum $15/bottle to recover costs and potentially cover unforeseen costs such as having to pay donors
and volnteers. Due to the increased risk associated with selling to individuals (they may default on
payment, transit issues), I recommend that you shelve this idea and contemplate it in the future when
MMB expands.
Growth
You currently are expecting that growth will double every year from the year you start. I think that this
plan is very aggressive and may not be sustainable. Based on an expectation of 20 babies per year, MMB
needs 337 donors. Since the bank is just starting up, it may be difficult to obtain just those donors alone,
let alone double the figures every year.
You also need to consider whether your operations can sustain the growth, whether you need to move to a
larger space, aquire more equipment and freezer space, etc.
Since you are new to the operations and MMB has just started up, I recommend that you wait and see
how many donors can be found in the first year. Then, once those donors are sustainable, you can then
consider growth potential. The risk is that a donor in one year would not be a donor for the following year
as milk production dries up. You would need to increase donor finding efforts every year to be able to
retain your donor base. It may be possible to attract more donors by offering payment to the donors,
however, again, I recommend that you wait until after the end of the first year of operations to see how
much excess cash can be paid for the milk if you wish to offer an incentive.
176
Choosing Recipients
Since the amount of milk expected to be received is limited and demand is high, you will need to
implement some kind of screening process to choose target donors. I recommend that you create a
standard application form for interested parties that indicates why the mother is unable to produce the
milk and the conditions affecting the babies that require additional milk. You would then be able to
prioritize which babies are in high need of the milk (e.g. premature babies, medical conditions affecting
the mother) and determine a screening process for recipients. Since you are a non-profit organization, I
presume that you would like to provide milk to those mothers in need, not those who are merely too busy
to breastfeed. Such a screening process would allow you to select individuals in line with MMB's goals.
177
178
(70 minutes)
Digital Future Technologies (DFT) is a public technology company. It has a September 30 th year-end, and
last year it adopted International Financial Reporting Standards (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, 2012. DFT’s previous auditor retired. Kin met with the CFO, Anne Rather, to gather
information on the business, and has completed the client acceptance procedures and initial audit planning.
It is now September 12, 2012. You, CA, work for Hi & Lo. Last week, Kin provided you with the notes that
he took in his initial meeting with Anne (Exhibit I). 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 II. Anne gave you updated projected results for September 30, 2012 (Exhibit III).
Kin asks you to prepare a memo summarizing the accounting issues of significance, and to discuss their
impact on the year-end audit planning and the procedures to be performed. 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.
179
(continued)
NOTES FROM KIN’S INITIAL MEETING WITH ANNE — JULY 2012
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 relevant 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
bandwidth 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.
A new bonus program was instituted at the beginning of fiscal 2012 with the objective of motivating
management to contribute to profitability by being innovative and developing new products.
Materiality is currently estimated to be $434,000, based on 5% of preliminary net income before tax of
$8,681,000.
Most revenue relates to product sales. Revenue is recognized once the products are shipped,
assuming collection is reasonably assured. DFT targets an average margin of 40%.
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 recognized as soon as the work for the specific component is complete. DFT targets a margin of
60%.
180
(continued)
NOTES FROM CA’S MEETING WITH ANNE — SEPTEMBER 10, 2012
A number of events have occurred since July that gave rise to revisions to the projected results for the year
ending September 30, 2012.
DFT had been negotiating since early in 2012 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
warehouse 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.
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 2013 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, 2012 deadline.
181
(continued)
NOTES FROM CA’S MEETING WITH ANNE — SEPTEMBER 10, 2012
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.
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 pursued government funding for research and development. The funds received from the grants,
totalling $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.
A GST/HST audit was finally completed in late August 2012. 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.
182
(continued)
PROJECTED NET INCOME FOR THE YEAR ENDING SEPTEMBER 30, 2012
(in thousands of Canadian dollars)
Sept. 30, 2012
Original Projection
(prepared on
July 8, 2012)
Revenue
Cost of sales
Gross margin
$
Operating expenses:
Research & development
Sales and marketing
General & administrative
Interest
Total operating expenses
Income before taxes
Income taxes (30%)
Net income
Note
55,374
31,942
23,432
1
2
3,991
2,622
7,824
314
14,751
3
DFT
Adjustments
$
6,077
EBITDA (for bonus calculation)
3,850
1,930
1,920
–
–
100
–
100
4
8,681
2,604
$
Note
1,820
546
$
1,274
5
5
Sept. 30, 2012
Adjusted Projection
(prepared on
Sept. 10, 2012)
$
59,224
33,872
25,352
3,991
2,622
7,924
314
14,851
6
10,501
3,150
7
$
7,351
to be determined
(also in thousands of Canadian dollars)
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 development costs.
4) General and administrative expenses include projected amortization of $2,995 related to capital assets.
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 2013.
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.
183
In addition, the
when analyzing
Kin Lo, Partner
CA
Memo regarding DFT
Attached is my memo describing the accounting issues relevant to Digital Future Technologies (DFT). I
have also identified the impact of these issues on our audit and our planned procedures. You indicated
that you were concerned about the impact of any accounting issues on income due to the new
management compensation plan that is based on EBITDA. A number of the issues I have discussed have
an impact on interest, taxes, depreciation and amortization, or elements included in earnings before tax.
As a result, I have explained the impact of these issues on EBITDA as applied in the bonus calculation.
I believe you will need to speak with Anne as soon as she is available with respect to the bonus. In my
conversation with her, she explained that she was confident management would be getting its bonus and
planned to accrue an estimated amount. Based on my revised projected income, management may not
meet the threshold amount, and therefore would not obtain a bonus. I have also provided some additional
comments and considerations with respect to the new bonus plan.
The candidate provides appropriate analysis of the accounting issues.
Competencies
V-2.2 Develops or evaluates accounting policies in accordance with GAAP (Level A)
V-2.3 Accounts for the entity’s routine transactions (Level A)
As a Canadian public company, DFT is subject to reporting under IFRS, which it adopted previously. I
have identified a number of accounting issues, many of which will significantly affect the projected
results for the year, which in turn will directly affect the bonus amount, and could also lead to material
misstatement of the financial statements.
184
Non-recurring engineering (NRE)
NRE represents a significant revenue stream. DFT has booked a total of $2.5 million in NRE revenue.
The first $1.5 million in NRE revenue, which appeared to have no further obligations beyond the initial
engineering work, was appropriate to recognize under IAS 18, Revenue, as it had been fully earned.
However, the latest arrangement differs from previous NRE revenue. DFT obtained NRE work in July for
$1 million. The difference is that the customer only agreed to the normal price on the NRE portion
because DFT agreed to provide a $225,000 discount, on product that usually sells for $750,000,
on sales in the 2013 fiscal year. The NRE revenue would not have occurred without this
concession by DFT. Therefore, the NRE revenue is linked to the future sales of product. Under
IAS 18, Paragraph 13, the transactions are considered linked and should be looked at as a whole:
[I]n certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable
components of a single transaction in order to reflect the substance of the transaction. For example, when
the selling price of a product includes an identifiable amount for subsequent servicing, that amount is
deferred and recognised as revenue over the period during which the service is performed. Conversely,
the recognition criteria are applied to two or more transactions together when they are linked in such a
way that the commercial effect cannot be understood without reference to the series of transactions as
a whole. For example, an entity may sell goods and, at the same time, enter into a separate agreement to
repurchase the goods at a later date, thus negating the substantive effect of the transaction; in such a
case, the two transactions are dealt with together.
The NRE revenue should have a portion of the discount applied to it, since the amount being charged is
determined in conjunction with the pricing of other elements (the product sales) of the transaction. The
total gross sales value is $1.75 million ($1 million NRE plus $750,000 product). Since DFT provided a
discount of $225,000 on the product sale in order to get the entire contract, a portion of the discount
should be attributed to the NRE revenue. As a result, a portion of the $1 million NRE revenue that would
otherwise be recognized must be deferred.
The percentage of the contract performed before year-end, based on revenues $1 million divided by $1.75
million, is 57%. DFT should therefore allocate 57% of the discount to the NRE part of the contract by
deferring 57% of the discount amount of $225,000 ($128,571).
The reduction in revenue is significant, although not material on its own, in terms of the financial
statements audit (see recalculation of materiality). The net reduction will have a direct impact on the
bonus calculation.
(Most candidates did not recognize that the discount was linked to future product sales and should
have been considered as part of the transaction that included the NRE $1 million revenue. Instead,
they focused on the fact that the discount had not been recorded and that it should be reflected in the
financial statements of the current year. Strong candidates recognized the underlying substance of the
arrangement and understood that the two sales transactions should be looked at as a whole, and
applied case facts to support their technical understanding. Those candidates properly allocated the
discount over a rational basis between 2012 and 2013.)
185
Indo-Tech (Indo)
The arrangement with Indo is structured in such a way that revenue is earned either when Indo takes
possession of the inventory or when 60 days have elapsed from receipt at the third-party warehouse. As a
result of the agreement in place, all of the $1.50 million related to inventory shipped by June 30 could be
recognized by September 30, even if Indo had not taken the inventory on August 2. It is appropriate to
recognize the revenue under IAS 18.
However, the remaining $1.85 million of revenue related to the inventory shipped to the third-party
warehouse cannot be recognized as revenue unless Indo takes the inventory by September 30, since
60 days will not have passed since its arrival at the warehouse (we don’t know the exact shipping and arrival dates, but if we assume it was shipped on August 3, it is about 57 days at September 30). The only
revenue that should be recognized by September 30 is the sales value of the items taken by Indo by
September 30. The remainder of the items should be recorded in inventory at cost until the 60 days in the
warehouse have passed.
The agreement with Indo is an unusual one in that it passes title to Indo after 60 days for goods sitting in a
warehouse. It seems unlikely that Indo would pay for goods it hasn’t taken from the warehouse. If the goods sit in the warehouse and are not paid for, there may be issues of collectability (see IAS 18.14(d)).
(Many candidates addressed this issue, and most were able to apply simulation facts to their
discussions. However, some candidates failed to recognize the significance of the 60 days in inventory
at Safe Storage, and considered only the transfer of risks and rewards in their discussions. As a result,
they concluded that since Indo had not taken the inventory, the sale should not have been recorded.)
Grant
The government grant revenue has been inappropriately recognized in full upon receipt. Paragraph 17 of
IAS 20, Accounting for Government Grants and Disclosure of Government Assistance, states:
In most cases the periods over which an entity recognises the costs or expenses related to a government
grant are readily ascertainable. Thus grants in recognition of specific expenses are recognised in profit
or loss in the same period as the relevant expenses. Similarly, grants related to depreciable assets are
usually recognised in profit or loss over the periods and in the proportions in which depreciation
expense on those assets is recognised.
Therefore, DFT’s government grant of $800,000 would be related to depreciable assets, and therefore
should be recognized in income over the period, and in the same proportion in which the depreciation
expense on those assets is recognized (or it could be used to reduce expenses). Since 75%, or $600,000, of
the related costs remain in deferred development costs (in the information from Anne), only $200,000 of
the grant revenue should be recognized in income. The remaining $600,000 should be deferred and
recognized in income as the related costs are amortized. Currently, DFT has recorded all the grant monies
in revenue (note, therefore, that there is a classification error).
186
Therefore, revenue needs to be reduced by the full $800,000. Since $600,000 should be deferred, the
remaining $200,000 is reallocated to research and development. Amortization expense will also be
adjusted. DFT’s policy is to amortize over a period of up to three years;; therefore, the adjustment would be to amortize the grant over the same period of three years, resulting in an estimated amortization of
$200,000 per year (note that the yearly amount then needs to be pro-rated for the portion of the year that
applies).
Note: Some of the grant received is likely for research rather than development. There would be
immediate recognition of the grant income when the research costs were recognized, and the amortization
amount would be adjusted accordingly.
(Most candidates addressed this issue. When addressed, it was generally well done. Candidates applied
case facts to their technical knowledge and concluded on an appropriate treatment that was consistent
with their analysis.)
Zeus was expected to be developed by mid-August. The delayed development, and the subsequent entry
into the market of a competing product before Zeus, may raise concerns about the valuation of the Zeus
inventory (just beginning to be produced). Under IAS 2, Inventories, a writedown would be required if
the net realizable value of inventory is below the recorded cost. Given that DFT’s products generally have a 40% gross margin, a decrease in the planned selling price, while reducing DFT’s margins, would likely not result in a net realizable value that is below cost, and therefore, no writedown would likely be
required as of September 30.
Since production just began, there is the risk of there being potential quality assurance issues, which could
lead to the need to set up a warranty provision for potential claims. This risk is increased when
considering management’s bias to increase sales in order to achieve a higher bonus.
(Candidates sometimes considered whether the valuation of the Zeus inventory was still appropriate,
and used case facts to support their concern (for example, the fact that the competitor’s product was
out to market before Zeus). Those candidates recognized that net realizable value needed to be
compared to cost and frequently linked their discussions to the audit work that would be required in
this area before a decision could be made as to whether a writedown was required.)
Zeus
Unanticipated technical difficulties have caused delays in the development of Zeus. DFT plans on having
sales and producing inventory by the end of the year, but it has just begun production (it is now two
weeks before year-end). Based on the nature of DFT’s business, in which it is important to stay ahead of the competition and produce new technology, and considering that the plan for Zeus was to tap into a
growth market, the value of the Zeus product may be questionable, now that a competitor has beaten it to
the market. DFT thinks it will need to sell at a lower price. We may need to assess the likelihood of
bringing Zeus to market (in other words, assess whether the terms for deferment are still being met).
187
(Few candidates addressed this issue, perhaps due to the fact it was not clearly directed in the
simulation. Some mention was made as to the development of the new product (Zeus) but little
additional information was provided. Most candidates who did question whether the development costs
would continue to satisfy the criteria for deferment were able to apply the relevant case facts in their
discussions of the technical considerations for deferral.)
Ares
The abandoned development of the Ares product would normally indicate the need for a writedown.
Under IAS 38, Intangible Assets, the conditions for recognizing an intangible asset include the technical
feasibility of and intention to complete the intangible asset so that it will be available for use or sale, and
the probability it will generate future economic benefits. These conditions must be met at a point in time,
such as when evaluating the project. Although the related development may be at least partially
transferable to the new product, Hades, DFT clearly has no intention of continuing with Ares. At some
point in time there would need to be an assessment of Hades to determine whether the conditions of IAS
38 are met. It would not be possible to link the Ares costs to the Hades project, unless some of the costs
had been identified as applying to both projects when first initiated. As a result, the related development
costs of $450,000 should be written off.
The write-off results in an increase in expenses of $450,000.
(Most candidates who addressed this issue did so briefly, concluding that the costs should be written off
because the development of Ares had been abandoned. Their discussions did not consider
management’s position that the costs may be transferrable to Hades, which made it difficult for them to
demonstrate depth in their responses.)
The reassessment of $125,000 related to GST/HST has already been paid, and there is no guarantee that
the courts will allow the money to be returned, even though DFT believes there has been an error. As a
result, it is a contingent asset, which IAS 37, Provisions, Contingent Liabilities and Contingent Assets,
defines as “a possible asset that arises from past events and whose existence will only be confirmed by the
occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the
entity.” IAS 37, Paragraph 33, states: “Contingent assets are not recognised in financial statements since
this may result in the recognition of income that may never be realised. However, when the realisation of
income is virtually certain, then the related asset is not a contingent asset and its recognition is
appropriate.” Because DFT cannot be certain that the courts will allow the money to be returned, virtual
certainty does not exist, and therefore no asset should be recorded.
Contingent assets are not recognized under IAS 37, but can be disclosed in the notes to the financial
statements when an inflow of economic benefits is probable. It appears to be too early to determine
whether the amount will be realized or not. As a result, the amount should not be recorded as a prepaid
asset, nor should it be disclosed in the financial statements. Rather, DFT should examine the source of the
reassessment — was it due to not charging GST/HST when it should have, or to claiming an ITC when it
was not eligible? Instead of booking as a prepaid, the amount should be posted where the reassessment
indicated the errors were. Either way, expenses will be increased.
188
The $125,000 is treated as an increase in general and administrative expenses for now.
(Few candidates recognized that the $125,000 represented a contingent asset. Candidates’ discussions
of this issue were very brief, and most concluded that the prepaid item had been erroneously recorded
and should have been expensed instead.)
The impairment loss of $100,000, related to obsolete production equipment, should not be included in
amortization of capital assets (adjusted general and administrative), but in cost of sales.
IAS 16, Property, Plant and Equipment, defines depreciation as the systematic allocation of the
depreciable amount of an asset over its useful life, whereas impairment is a valuation assessment not part
of the normal allocation process. It could be included as a separate charge.
Practically speaking, since amortization of production-related assets is included in cost of sales, it could
be argued that the impairment charge should also be included in cost of sales since it is related to the
production equipment. In addition, it should be disclosed separately from amortization in the notes to the
financial statements, rather than grouped into one amount to ensure full disclosure, depending on how
material the amount is (see IAS 1.85 and 1.86 regarding separate line items).
As a result of this writedown, management may also need to question the amortization periods.
Consideration should be given to the impact on the bonus calculation. Since the bonus is based on
EBITDA, including the impairment loss in amortization means it is excluded as an expense in the
calculation. If, however, it is separately disclosed, it could be argued that it is part of cost of sales and
should be included in EBITDA.
The $100,000 impairment adjustment should be moved from general and administrative expenses to cost
of sales, and should not be considered amortization.
(Only about a third of the candidates discussed the impairment issue. Most candidates who addressed it
were able to provide appropriate discussions, noting that the impairment loss should not be included
with amortization and should be presented elsewhere in the financial statements.)
DFT has a new bonus plan this year. The $300,000 about to be accrued by Anne for the management
bonuses cannot be booked until certain requirements are satisfied. It is contingent on achieving the set
amount of EBITDA.
In this case, the issue is whether the entity has a present legal obligation or a constructive obligation.
Based on IAS 19.17 to 20 and IAS 37, there does not appear to be a legal obligation yet because the terms
of the bonus have not been met. The question is whether the bonus might be considered a constructive
obligation. Because this bonus plan was not in place in the past, it does not look like there is a
constructive obligation either. The bonus might be considered a provision. However, there is no guarantee
that the minimum EBITDA will be met; therefore, no accrual should be made at this point. If the
conditions are met at September 30, then a provision can be booked.
189
(Very few candidates considered whether the management bonus represented a legal obligation or a
constructive obligation. More candidates concluded on whether the bonus threshold would be met,
usually as a result of their recalculation of the adjusted net income and the EBITDA calculation.)
Adjusted Net Income for the Year Ended September 30, 2012 (in thousands)
Revenue
Cost of sales
Gross margin
DFT adjusted Accounting
projection adjustments
$
59,224
(2,779)
33,872
(1,010)
25,352
(1,769)
Operating expenses
Research and development
Sales and marketing
General and administrative
Interest
Total operating expenses
3,991
2,622
7,924
314
14,851
Income before taxes
Income taxes
Net income
10,501
3,150
7,351
250
25
275
(2,044)
(613)
(1,431)
Note
A1
A1, A4
A2, A1
A3, A4
A5
Revised
projection
$ 56,445
$ 32,862
$ 23,583
$
$
$
$
4,241
2,622
7,949
314
15,126
$
$
8,457
2,537
Note A1
Sales have been reduced by $129,000 for 57% of the NRE discount of $225,000.
Sales have been reduced by $800,000 for government grants since they cannot be accounted for as
revenue. Along with the related deferred development costs, $600,000 should be deferred. The
remaining balance of $200,000 has been moved to R&D expenses. (Amortization would need to be
adjusted too — if amortized over three years, then there would be $200,000 ($600,000 ÷ 3) more in
amortization, which would then also be pro-rated for the portion of the year.)
Sales have been reduced by $1.85 million not yet earned for the Indo shipment. Cost of sales has also
been adjusted by $1.11 million based on the 40% product margin (assumed same margin).
Note A2
Research and development expenses have been increased by $450,000 for deferred development costs
related to the Ares product (write-off of deferred R&D). They have also been decreased by $200,000
for the grants reallocated from revenue.
190
Note A3
General and administrative expenses have been increased by $125,000 for the GST/HST reassessment
(reclassified from prepaid expense).
Note A4
DFT recorded $100,000 for impairment of assets. This can be included in cost of sales, not general and
administrative expenses, and should not be considered amortization. Therefore, move $100,000 from
general and administrative to cost of sales.
Note A5
Using an estimated tax rate of 30%, there should be a reduction of $613,000 for the accounting
adjustments ($2,044,000 × 30%).
Earnings before interest, taxes, depreciation and amortization (EBITDA)
based on revised projected net income
Income before taxes
Add back:
Interest
Amortization of production-related assets
Amortization of deferred development costs
After
Per DFT July Adjusted DFT accounting
projection
projection
adjustments COMMENTS
$
8,681 $
10,501 $
8,457 (as adjusted-- see previous worksheet)
314
430
1,620
314
430
1,620
Adjustment to amor of def dev costs (note 1)
Adjustment to amor of def dev costs (note 1)
Amortization of capital assets
EBITDA for bonus calculation
$
2,995
14,040 $
3,095
15,960 $
Gross margin of 40% on $1850 Indo Shipment (if happens before Sept 30)
314
430
1,620
related to deferral of government grant portion
(200) (600K/3yrs estimated)
related to abandonment of Ares project (450K/3yrs
150 estimated)
2,995
13,766 Min to get bonus is $14million
If Indo takes delivery before Sept 30, bonus could be
740 achieved
14,506 Management would get bonus again
Note: Need EBITDA of $14 million for management to get bonus
Further adjustments may be required - additional info is necessary in order to
Zeus - Consideration of value of project (i.e., Is there any? Is any writedown of
inventory required?)
Unknown
Note 1 - Development costs amortized over estimated life of product,
generally 3 years or less
Assume 3 years are remaining on project for which government grant was
received and on Ares
Need more information to determine
191
Percent
Awarded
0.0%
competence.
1.5%
accounting issues for DFT when applying IFRS.
36.7%
for DFT when applying IFRS and considers the impact of the issues on the
projected financial statements or the bonus calculation.
61.5%
Highly competent — The candidate discusses several of the significant
accounting issues for DFT when applying IFRS and considers the impact of the
issues on the projected financial statements and on the bonus calculation.
0.3%
(Candidates were asked to provide appropriate analysis of the accounting issues. To achieve
competence, they were expected to discuss some of the significant issues for DFT when applying IFRS
and to consider the impact of the issues on the projected financial statements or the bonus calculation.
Candidates were clearly directed to this indicator, since the partner asked for a memo summarizing the
accounting issues of significance.)
(Candidates performed reasonably well on this indicator. Most were able to apply simulation facts to
their technical knowledge in their discussions. Most candidates made recommendations regarding
appropriate accounting treatments that were consistent with the analysis provided. In terms of the
issues addressed, most candidates discussed one aspect of revenue recognition, which was often the
early recognition of the Indo sales, as well as the grant and the Zeus inventory. Many candidates also
considered the impact on the projected financial statements or the bonus, or both, at the end of their
accounting issue discussions.)
(Strong candidates provided responses that were well organized and that substantially covered the
issues. Their responses were also strong from both a technical perspective and an application
perspective. Weak candidates did not demonstrate sufficient IFRS knowledge, did not apply case facts
in their discussions, or neglected to do either. Many of their discussions of an issue were general in
nature and had no specificity to this simulation.)
The candidate identifies the impact of the accounting issues on the planning of the audit and
suggests procedures to be performed.
192
Competencies
VI-2.3 Evaluates the implications of risks for the assignment (Level A)
VI-2.4 Develops guidelines to set the extent of assurance work, based on the scope and expectations of the
assignment (Level A)
VI-2.5 Designs appropriate procedures based on the assignment’s scope, risk, and materiality guidelines (Level A)
VI-2.9 Draws conclusions and communicates results (Level A)
We have been newly appointed as auditors (done in July 2012), and we are preparing for the year-end
financial statement audit. Based on a review of the accounting, there are a number of issues related to
DFT that must be taken into account in the planning and performance of our audit.
First, we need to determine if our preliminary calculation of materiality of $434,000 is still appropriate.
Based on the revised forecast that includes the accounting adjustments, I believe an adjustment will be
necessary. Materiality was initially estimated in July to be $434,000 based on 5% of preliminary net
income before tax of $8,681,000 (using CAS 320 A4 and A7). My revised estimate, calculated on the
same basis but taking into account the accounting adjustments noted (5% of $8,457,000) is $422,850.
Based on these calculations, overall materiality should be decreased.
Preliminary materiality for the financial statements as a whole was calculated during our initial
audit planning, but it is not clear whether we also calculated a performance materiality.
In addition, it may be well advised to set a separate materiality (at a lesser amount) on those areas
affecting EBITDA directly, as well as considering a performance materiality for those areas of concern,
due to the increased user reliance from management for purposes of the bonus calculation.
As the results become more definitive after year-end, and as we accumulate audit adjustments, we should
revisit materiality to ensure we have done sufficient, appropriate audit work to support our opinion. As we
encounter unadjusted errors like those noted earlier, we should request that management adjust them.
(Some candidates were able to integrate their analyses of the accounting issues with the impact of these
issues on the initial audit planning that had been done, and recognized that materiality would have to
be revised. Strong candidates performed calculations to determine a new materiality level, in light of
the accounting changes recommended. Some of those candidates also considered the need for a
performance materiality or a materiality for areas affecting EBITDA directly, or for both. Weak
responses did not address this aspect of the initial audit planning at all, despite the information in the
simulation from the July 2012 meeting stating that materiality was currently estimated to be $434,000.)
In addition to revisiting materiality, we should revisit our risk assessment. The auditor is required to
document an assessment of the risk of material misstatement at the financial statement level (Ref: CAS
315.25, A105 to A108) and at the assertion level (Ref: CAS 315.32).
193
Financial statement level Regarding the nature of the business and DFT’s operating environment, we
know that DFT is a technology company whose quarterly sales can be quite variable based on inconsistent
demand. We also know that the company relies heavily on research and development to ensure its
products remain relevant (product life is generally three years). DFT has had some changes occur over the
year that resulted in new types of revenue contracts (Indo and the unique NRE contract), a new
arrangement with a third-party warehouse located overseas, new government grants for research and
development, and production delays on its new product, Zeus. These issues need to be considered when
planning our procedures.
We do not have much information on DFT’s control environment and will need to spend some time documenting systems to gain a full understanding.
The following financial statement level risks need to be considered. First, the existence of a bonus plan
based on EBITDA increases the risk of error, since management may be biased to make decisions, or
override controls, to increase EBITDA. This risk will need to be taken into account when examining the
transactions and account balances. Second, the GST/HST reassessment raises a question as to the quality
of the accounting and record-keeping.
(Few candidates considered the impact on risk of the new information that was provided subsequent to
the July 2012 initial meeting with Anne.)
Only once we have examined the control environment will we be able to determine if we can rely on the
system and take a control-based approach to the audit. In addition, we may wish to perform additional
procedures in areas that have been identified to be of concern in our previous accounting discussion (for
example, revenue recognition relating to Indo transactions and NRE revenue).
I presume that the initial audit planning has already contemplated the work that will need to be done to
gain assurance over the opening balances, since we did not do the audit of the prior year’s financial statements (as per CAS 510).
NRE —
revenue
($1,000,000
engineering
and $750,000
product sales)
Occurrence,
accuracy, cutoff, and
classification
Risk that conditions
for revenue
recognition are not
met.
Obtain a copy of the latest contract (the
unique one) and review the conditions
related to earning the revenue to gain an
understanding of when and how much
revenue can be recognized in 2012.
Consider evidence that supports the need to
defer any revenue (i.e., a link to product
sales).
Verify the completion date for the NRE
portion (Sept. 15) and the margins achieved
by agreeing to the contract, and verify that
the financial statements reflect the
substance of the transaction (defer a portion
194
of discount of $225,000 on normal sales of
$750,000).
Indo-Tech —
revenue
Indo-Tech —
inventory
($1,850,000 or
$0 depending
on
circumstance)
Government
funding (grant
of $800,000
received for
encouraging
technical
research and
development)
Occurrence,
classification
Occurrence,
completeness,
classification
Occurrence,
completeness,
classification
Risk that inventory is
recorded prematurely
as being sold (since
goods get shipped to a
third-party warehouse)
— consider
management’s bias to inflate earnings;
contract has a 60-day
clause that could affect
recognition/cut-off.
Need to track shipment
dates from DFT to
know when to
recognize revenue.
As stated, risk that
goods should be
recorded as inventory,
not a sale; risk that offsite inventory doesn’t actually exist (falsified
inventory).
Risk that terms and
conditions of the grant
are not met and funds
should be returned to
government; risk that
split between deferred
amount is not correct;
risk of amount being
deferred over an
incorrect period of
time.
Review the calculations of the revenue to
ensure they have been recorded in the
proper period and at the right amount to
ensure proper cut-off.
Ensure that the proper amount of revenue is
recorded related to Indo sales by reviewing
compliance with contract terms.
Agree the shipments from DFT to the thirdparty warehouse to shipping
documents/proof of shipment to Indo from
warehouse.
We should attempt to confirm the existing
inventory sitting at the third-party
warehouse at year-end — we will need to
communicate with Safe Storage as soon as
possible to ensure the amount can be
confirmed at Sept. 30. We should also
confirm with Indo-Tech what it believes the
amount in the warehouse is, if it has not all
been taken by them.
We may wish to visit the warehouse site
ourselves to determine if there is inventory
there (i.e., Indo does not take out any of the
$1,850,000 in inventory that was shipped
by DFT).
We should check the documentation and
agreements related to government funding
to ensure the terms and conditions are met
and that monies have been received prior to
year-end (event occurred after July
projection).
195
Ensure grants are not recognized until the
conditions of the grant are met. Verify the
portion deferred (and being amortized) as
part of development costs — DFT claims
75% of related development costs remain in
deferred costs. Ensure any research monies
received as part of grant were not deferred.
In addition, obtain an understanding of the
products to which the funding relates and
trace these to the products in deferred
development costs, to ensure the
appropriate amount is deferred, and the
appropriate classification - either expense
or capital.
Verify amortization calculations (policy is
to defer development costs over a
maximum of 3 years); ensure grant is being
amortized over same period and is properly
adjusted for a partial year.
R&D — Ares
(abandoned
R&D project
of $450,000;
costs
continued to
be deferred for
new product
Hades)
R&D (amount
unknown) —
Zeus (delays
in bringing to
market;
competitor has
entered
market)
Accuracy and
classification
Accuracy and
classification
Risk that deferred
balance cannot be used
for Hades and should
be written off; risk that
some of Ares costs are
still being deferred.
Risk that unanticipated
technical problems
cannot be solved and
that Zeus cannot be
brought to market and
that costs can no
longer be deferred.
Gain an understanding of the costs related
to Ares versus Hades, likely by discussing
with engineering staff, to ensure that costs
that have been deferred appropriately relate
to products still in development. Ensure a
“point in time” assessment was done to determine whether the costs can be
deferred.
Ensure none of the costs that were directly
related to Ares are still being deferred; we
should obtain evidence from management
of the costs that were written off and
calculate the amount to be written
off/expensed.
Discuss with management the likelihood of
bringing Zeus to market.
DFT plans on selling $200,000 worth of
Zeus by year-end, but has only just begun
production. Not likely to sell that much —
inventory balance might be higher. Also
risk of lower margin since it likely needs to
lower the sales price — see inventory
discussion.
196
Zeus —
inventory
(estimated to
be $400,000 at
year-end)
GST/HST
audit (recorded
$125,000 as a
prepaid on
basis of
reassessment
being wrong)
Valuation
Risk that inventory is
overvalued and needs
to be written down.
We should attempt to obtain information on
the revised pricing planned for the product.
The lower price DFT might offer should be
compared to the recorded cost in inventory
of these units to ensure they are recorded at
the lower of cost or net realizable value. If
cost is actually higher, we should calculate
the amount of any required impairment.
Consider that the planned sales may not
occur and that the inventory balance might
be higher than the planned $400,000.
Occurrence,
completeness,
accuracy, and
classification
Impairment
Occurrence,
adjustment of completeness,
$100,000
accuracy, and
(obsolete
classification
production
equipment)
Risk that amount is not
a prepaid/DFT will
lose reassessment and
amount is an expense.
Need to know what the
reassessment relates to
in order to verify
classification.
Risk that there is no
impairment, or that the
amount is greater than
the $100,000 booked;
risk that other pieces
of equipment require a
writedown.
Discuss with management issues related to
possible warranty claims and the need to set
up a provision due to a high rate of product
return, since it is a new product.
Examine all documentation available
related to the GST/HST audit, including the
reassessment, and ensure that the
appropriate, and complete, amount has been
recorded.
Since it cannot be recorded as prepaid, this
will require reviewing what proportion
management relates to expenses and the
proportion related to items such as capital
assets.
Discuss with management the basis of the
impairment loss on the production
equipment, examine the equipment, and
discuss its use with production personnel to
corroborate the need for recording an
impairment loss.
Ensure other adjustments are not required
for other related pieces of equipment;
discuss with management.
We should ensure there is adequate
disclosure of the impairment amount,
separate from amortization expense (if
material to the financial statements as a
whole).
197
(Candidates were generally able to provide clear and valid procedures to address the risks. To a lesser
extent, some were also able to explain why the procedures were required. While the quantity of
procedures addressed amongst candidates was comparable, strong responses included a more thorough
discussion of the procedures and a concise explanation as to why they would be required. Many weak
responses included vague or incomplete procedures or procedures that failed to address the problem
identified (for example, vouching to journal entries, or inquiring of management but with no specifics
as to what to inquire about).)
Percent
Awarded
0.2%
competence.
8.4%
Reaching competence — The candidate identifies some of the audit planning
issues (materiality, risk, etc.) and attempts to develop audit procedures to address
them, OR discusses the audit planning issues, OR discusses some of the audit
procedures.
43.0%
Competent — The candidate discusses some of the audit planning issues and
some of the audit procedures.
48.3%
Highly competent — The candidate discusses several of the audit planning
issues and several audit procedures.
0.1%
(Candidates were asked to identify the impact of the accounting issues on the planning of the audit and
to suggest procedures to be performed. To demonstrate competence, candidates were expected to
discuss some of the audit planning issues as well as some of the audit procedures. The simulation
stated that the initial audit planning had been completed. Candidates were directed to this indicator
since the partner had requested a memo discussing the impact of the accounting issues of significance
on the year-end audit planning and the procedures to be performed.)
(Candidates performed below expectations on this indicator, particularly in the area of year-end audit
planning. Many candidates failed to consider the various aspects of the audit plan and instead focused
solely on the materiality calculation, since the initial level of materiality had been provided in the
simulation. What most candidates were missing was a discussion of how the audit risk might be
affected by the events that had occurred since the initial planning was performed. Most candidates
were able to provide adequate audit procedures to be performed relating to the accounting issues, but
many were not able to explain why those procedures were required (in other words, what risk they were
addressing).)
198
(Better candidate responses often contained stronger planning discussions, considering both the
impact of the accounting issues as well as the impact of new developments within the client situation,
subsequent to the July meeting, on the various components of the audit plan. These candidates also
provided more thorough audit procedures for the accounting issues, containing strong discussions of
what was required and explanations of the reasons. Weak candidates provided vague, generic, or
incomplete procedures with no explanations as to why they would be required.)
The candidate discusses the potential for management bias towards a higher EBITDA due to
the bonus.
I had calculated the EBITDA based on an updated forecast from management, adjusted for accounting
changes related to the transactions that occurred between July and September.
The projected results showed an EBITDA of close to $16 million. As a result, management is likely
expecting to be well above the threshold of $14 million required for the bonus, and that appears to be why
Anne has indicated she will accrue a $300,000 bonus.
However, based on the recommended accounting adjustments, adjusted EBITDA would be approximately
$13,766,000, which is under the $14-million threshold. As a result, management will be very sensitive to
any adjustments that are proposed since the bonus threshold is no longer met. We should make them
aware of these adjustments as soon as possible.
Since management has the potential to earn additional compensation based on EBITDA, the members
may have been biased to make decisions that increase EBITDA. In particular, they may have had a bias to
recognize revenue sooner, buy versus rent equipment, capitalize expense items, and classify expenses into
categories that get added back to the calculation, such as interest, taxes, or amortization. A number of the
errors I have identified for adjustment have this impact.
199
Examples include the following:
Recognizing revenue sooner — Recognizing the Indo shipment even though Indo has not taken out the
inventory yet, recognizing NRE margin that is partially connected to future product sales, and recognizing
government grants when received although related to products still in development.
Capitalizing expenses — Continuing to defer development costs related to a specific product no longer
under development, and recording the GST reassessment as a prepaid expense.
Classifying expenses into categories added back for EBITDA — Including impairment related to
production equipment in capital assets amortization expense.
All of the above accounting decisions worked in management’s favour, and it seems that management has
done whatever it can to manipulate the financial statements (in other words, it has used its bias in the
selection of accounting policies when there were choices amongst alternatives or when decisions had to
be made). This has been done in order to meet the EBITDA threshold and therefore obtain the bonus. We
should question management’s integrity and bring this to the attention of the board of directors.
Ironically, it may not be the decisions of management that result in a bonus being paid or not. It may well
be the decision of Indo to take out inventory prior to September 30 that determines if management gets a
bonus. If Indo takes the entire inventory shipment worth $1.85 million prior to year-end, DFT will be able
to record $1.85 million of sales and $1.11 million of cost of sales (based on 40% gross margin), resulting
in an increase of $740,000 to EBITDA, which will put it over the $14-million threshold. This type of item
affecting the bonus may not have been anticipated when the plan was set up.
Percent
Awarded
10.1%
competence.
20.9%
Reaching competence — The candidate recognizes the potential for
management bias towards a higher EBITDA due to the bonus.
16.0%
Competent — The candidate discusses the potential for management bias
towards a higher EBITDA due to the bonus.
52.9%
Highly competent — The candidate discusses the potential for management
bias towards a higher EBITDA due to the bonus, and comments on the elements
that are driving the bonus (Indo-Tech transaction).
0.1%
(Candidates were asked to discuss the impact of the adjustments and errors in EBITDA on the management
bonus. To achieve competence, candidates were expected to discuss the potential for management bias
towards a higher EBITDA due to the bonus. Candidates were not clearly directed to this indicator, although
the partner did indicate his particular concern with issues that affect earnings because of the expectation of
a more profitable year and the new management bonus program based on EBITDA.)
200
(Candidates performed as expected on this indicator. Many recognized that the bonus caused a bias on the
part of management, and that the way transactions had been recorded was favourable to management. They
were able to identify some of the inappropriate issues, such as revenue being recognized too early, and most
were able to sufficiently explain the impact on the bonus calculation (early revenue recognition skews
earnings in management’s favour;; therefore, earnings meet the bonus threshold and management receives a larger bonus). However, some candidates focused their discussions purely on the impact of management’s bias on the extent of the audit work rather than linking that bias to the bonus.)
(Strong candidates were able to explain why management’s accounting decisions were a concern (often after their discussion of the individual accounting issue) and then recognized the potential impact on DFT
as a whole. These responses were clear, concise, and often summarized in one succinct section of the
responses. Weak candidate responses merely repeated case facts without additional comments or
recognition of the bias or the impact of the accounting choices on EBITDA or the bonus. Most did not
recognize the potential for management manipulation at all.)
(This was a fairly traditional audit and accounting simulation, and candidates seemed to be comfortable
responding to this type of scenario. Candidates performed well on Primary Indicators #1 and #3. Most
candidates appeared to be familiar with IFRS and were able to discuss the appropriate accounting
treatments for the relevant issues in that context. They were also generally able to recognize the impact the
management bonus program had on the recording of certain transactions (in other words, that the most
favourable result to management had been reported) and explained the effect on the bonus calculation.
Where candidates seemed to have more difficulty was on Primary Indicator #2. The main struggle for them
was in recognizing the need to revisit various aspects of the initial audit plan, given the additional
information that had been gathered subsequent to its preparation in July 2012.)
201
The candidate discusses the structure of DFT’s new bonus plan.
Competencies
IV-2.4 Identifies key elements of the entity’s value system (Level B)
IV-4.1 Evaluates decision-making and accountability processes (Level B)
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. It was instituted at the beginning of fiscal 2012 with the objective of “motivating management to
contribute to profitability by being innovative and developing new product ideas.”
The board and management may want to consider whether a bonus plan, based on EBITDA, will motivate
DFT’s management the way it intended. Currently, management is being rewarded in a manner that is
highly dependent on the decisions of a customer (Indo) rather than as a result of management’s direct efforts developing a new product. An additional consideration is that the bonus calculation is affected by
non-controllable factors such as the impairment of equipment and prior-period adjustments. (Using EBIT
or a return on capital employed would eliminate the impact of some of the uncontrollable factors — PPE
would be a cost no matter what.)
It appears that management was attempting to inflate earnings to achieve a higher bonus payout. Basing
your bonus on EBITDA may be causing unintended results.
Bonus plans, structured properly, can be motivating. They can align management’s efforts with the
company’s objectives. DFT needs to determine what it should reward that is linked most directly to its
objective — in this case, “being innovative and developing new product ideas that contribute to profit.” Using EBITDA may not tie the bonus closely enough to the objective for it to accomplish what you had
hoped.
You may wish to consider a process that is more closely linked to specific measurement objectives, using
the following general approach:
1. Corporate scorecard — You will want management to share the success (or failure) of the company.
This is a good incentive to remain loyal and work towards the company’s success. The scorecard
should be a mix of long-term success planning metrics, short-term success planning metrics, and
employees’ satisfaction surveys. Assign weights to the components (adding up to 100%) and measure
them against the expectations for the year. For example, you may wish to reward new product ideas
that were developed that contributed a higher-than-set-minimum contribution margin.
202
Then, if the company reaches expectations (scores exactly 100%), 10% of net income would be put
aside for the bonus pool. If it exceeds expectations (scores 150%, for example), 15% of net income
would be put aside, and so on.
2. Individual scorecard — You will want your top performers to receive a higher bonus than others.
Consider tagging performance (for example, with Excellent, Good, Satisfactory, and Below
Expectations) and associate a percent of the bonus pool to each tag (such as 150%, 110%, 90%, and
60%). By doing this, you make sure that two people in the same position will get different bonuses if
their performance differs. Again, performance can be tied to the aspects that best contribute to the
success of the company — for example, creativity, innovation, customer relations, identify trends in
the industry, share price, et cetera.
Also, test the bonus structure before fully implementing it. Consider how can it be twisted and altered so
people gain the bonus with minimum effort. You will likely understand the importance of this step
already, as it appears that management may have attempted to manipulate the accounting to inflate
earnings this year, knowing that a higher EBITDA would increase the bonus.
You may want to consider a broader compensation plan, not just a bonus. Since DFT is a public company,
you could use stock options or shares and tie their issuance or vesting to reaching set targets, if you
believe it could help achieve the set objective. Since innovation can translate into long-term financial
results, this might be a suitable incentive.
For Secondary Indicator #1 (Governance, Strategy, and Risk Management), the candidate
must be ranked in one of the following three categories:
Not addressed — The candidate does not address this indicator.
Nominal competence — The candidate does not attain the standard of competence.
Competent — The candidate discusses the structure of DFT’s new bonus plan.
(Candidates were asked to discuss the structure of DFT’s new bonus plan. To achieve competence, candidates were expected to discuss the structure and recognize that a bonus based on EBITDA may
not motivate management to be innovative and develop new product ideas. Candidates were also
expected to suggest an alternative basis for determination of a bonus for management. Candidates were not
directed to this indicator, although previous analysis of accounting issues and a recognition that the bonus
caused a bias on the part of management may have led them to comment on the structure of the bonus
plan.)
(Most candidates did not address this secondary indicator. They either did not address the bonus structure
at all or merely stated that EBITDA was not an appropriate basis for calculating the bonus, without further
explanation as to why it was not appropriate for a company like DFT.)
(Strong candidates were able to explain why the current structure of the management bonus was not
beneficial to the company as a whole (for example, potentially sacrificing product development for inflation
of revenue), and then suggest another basis for determination of the bonus, a management compensation
plan, or both.)
203
To: Kin Lo
From: CA
Subject: DFT 2012 Audit
Revenue Recognition - NRE Contracts
Accounting Issue
NRE revenue is earned by DFT providing engineering services for customers to design add-on
components. DFT currently recognizes revenue on the completion of the work on specific components.
This treatment under IFRS is incorrect as revenue recognition on the rendering of services must occur
using a % completion method and completed contract method is not allowed.
Revenue shall be recognized when all of the following conditions are satisfied:
A - amount of revenue can be measured reliably - met since contractually determined
B - probable economic benefits will flow to DFT - met since DFT is paid for engineering work
C - stage of completon can be measured reliably - currently DFT does not measure stage of completion on
DFT work.
D - costs incurred and required to complete can be measured reliably.
For any NRE contracts in progress at year end, DFT will need to determine the % of completion, such as
via discussion with the R&D/engineering staff and progress reports, and only recognize revenue to the
extent that the production is complete. The production staff will also need to estimate the costs to
complete, so that any contracts on which losses are expected are recognized immediately in the current
period
Impact on FS: indeterminable. Income and revenue understated for projects in progress at year end.
Audit Impact and Procedures
Since we know that DFT is incorrectly recognizing revenue on NRE contracts by using a completed
contract method, the cut-off of NRE revenues is high risk.
We should obtain a list of all NRE contracts in progress from management and compare these to the
research logs to ensure that our list is complete. We should discuss with the project manager the
expected state of completion of the component and obtain a breakdown of costs incurred to date and
future costs expected. We should recalculate the anticipated gross margin from the jobs to verify that
losses are appropriately recognized.
204
For all NRE projects completed subsequent to year-end, we should review the contract and the
progress reports from R&D staff to verify whether these were worked on before Sept 30 and thus
should have been at least partially recognized in 2012.
Revenue Recognition - IndoTech
Accounting Issue
The new deal with Indo is such that DFT delivers items to a shared warehouse on a fixed production
schedule. DFT retains title to the goods at the warehouse until either 60 days pass or Indo picks up the
goods. To date, DFT has delivered $1.5m of goods to the warehouse where Indo has picked up the goods,
and expects to ship another $1.85M goods that has not yet been picked up. DFT is confident that the
goods will be picked up and has recorded the revenue.
Revenue recognition criteria on the sale of goods:
A - Significant risks and rewards of ownership transferred. Since DFT retains legal title to the goods
while still in the warehouse, the $1.85M goods are still in DFT's name. Not met.
B - Entity retains neither continuing managerial involvement or effective control over goods - DFT has
legal title and access to the warehouse, so has continuing involvement and control. Not met.
C - Amount of revenue can be measured reliably - Met since purchase contract in place.
D - Probably economic benefits will flow to DFT - Met since selling goods at 40% margin.
E - Costs incurred can be measured reliably - Met since all production costs of those goods have been
incurred as of Sept 30.
Based on the above analysis, it is not reasonable for DFT to recognize $1.85M in revenue on the goods
placed in the warehouse. Management believes that the title may be constructively transferred to Indo
because of the nature of the arrangement and since Indo picked up the previous order, however, this is
insufficient to meet the title transfer requirement since the goods have not been in the warehouse for 60
days (whereby the auto title transfer clause is triggered per contract).
Impact on FS: Revenue is overstated by $1.85M, COGS is overstated by 1.11M.
This is a key audit risk area since the transaction is new, unusual and we are aware of accounting issues
with regards to revenue recognition.
We need to verify the terms of the agreement between DFT and Indo to verify when title transfer
occurs (i.e. when leaving the warehouse or on 60 days.) to determine when the appropriate revenue
recognition time is.
To verify that this inventory has been included in the inventory count, we should send staff to
supervise the count at the warehouse as well as the standard DFT location(s). We should review that
inventory in the warehouse that has been there for more than 60 days is appropriately segregated
(however, since per management, no inventory has been shipped in 60 days there should be none).
To verify that all inventory shipped to the warehouse is indeed still in the warehouse (i.e. that Indo
has not picked up amounts that the warehouse has not reported), we should obtain shipping
documentation for shipments made to the warehouse and reconcile these to the warehouse inventory
count.
205
Revenue Recognition - Special NRE Contract
Accounting Issue
In this agreement, DFT was granted a $1M NRE contract on the condition that it provided a $225K
discount on a $750K purchase to be completed in 2013.
To determine the appropriate accounting for this transaction as it may be dealt with as 2 independent
transactions or 1 single transaction. Revenue recognition criteria needs to be applied separately to each
transaction.
The transactions are considered as one when they are linked in such a way that the commercial effect
cannot be separated from each component. In this case, DFT has indicated that the customer "only
accepted" the price on the NRE because of the discount. This would support the treatment of this
transaction as a single transaction. There is little support for treating it as a separate NRE transaction and
a sales transaction because the customer indicated that they would not have entered into the NRE
otherwise.
Currently, DFT has treated this as a two separate transactions and recognized revenue on the NRE
component as the NRE development was completed Sept 15.
If we treat this transaction as a single transaction a sale of goods of both intellectual rights and discounted
products, revenue recognition does not appear to be met as title to the discounted goods has not yet been
transferred (risks and rewards not transferred), DFT has control over the discounted goods. Despite
revenue being measurable, costs being measurable and probable economic benefits flowing to DFT,
revenue should not have been recognized.
FS Impact: NRE revenue overstated by $1M and COGS by 400k.
Due to the complex nature of this transaction this is a high risk assertion/balance.
To verify the terms of the agreements, we should review the sales contract with this customer for
terms relating to the NRE and discount.
Zeus
Accounting Issue
Under IFRS, inventory is measured at the lower of cost and net realizable value. Anne has indicated that
$400,000 in Zeus inventory is expected at year end. There is concern by management that because a
competitor placed a similar product on the market first that DFT will not be able to sell Zeus at its
planned price. If the selling price of Zeus is below cost, then a write-down of inventory is required to the
lower NRV. Currently we have insufficient information to determine whether Zeus can be sold above cost
(so that no write down is required), or if expected sales price is below cost (requiring writedown).
There is a further concern that because DFT would have capitalized the cost of developing Zeus, the R&D
asset relating to zeus is impaired and needs to be written down as well. (Competitor issuing similar
product is factor that suggests impairment). The carrying value of the intangible should be determined as
206
the higher of the fair value less cost to see and value in use (future cash flows). Since fair value if
intangible asset may not be readily determinable, we need to consider the value in use to determine if a
writedown is required.
Since we know that there are factors that suggest that the sales price and NRV of Zeus are impaired, this
increases the risk that this inventory is incorrectly valued.
To determine the NRV of Zeus, we should discuss with management their anticipated adjusted sales
price of the product and compare these to the carrying value of inventory to see if the inventory needs
to be written down.
To further support the carrying value of the zeus inventory we should obtain sales invoices for the
product at year end and subsequent to year end to verify the selling price of the product. This can be
used to substantiate management's anticipated selling price that we determine before year end.
To determine whether the Zeus R&D asset needs to be written down we need to determine the value
in use (future cash flows).We should review any adjusted cash flow forecasts prepared by DFT on
anticipated Zeus sales and assess whether the assumptions used are reasonable (e.g. compare expected
sales for 2013 to the sales to date in 2012 for reasonableness). If no future cash flow analysis has been
prepared by DFT we should request one or recalculate one based on reasonable assumptions and data
available.
Overall Impact on FS
In Exhibit A I have recalculated adjusted net earnings before tax as $9,161K. Adjusted EBITDA is
$14,420K. When we compare the adjusted EBITDA to the original expectation of $15,860K it appears
that the accounting issues noted above generally resulted in overstating earnings for DFT.
Based on reduced EBITDA, Anne's accrual of the bonus will need to be revised.
Revised Materiality
Based on the adjusted projections and issues described above, I have recalculated materiality in Exhibit B
as $458,000. We need to further adjust materiality once we can quantify the outstanding issues above that
would impact the FS (impairment of Zeus, cutoff issues, etc.)
In addition to revising materiality we need to determine a lower threshold of performance materiality to
reduce the risk that undetected and uncorrected errors in aggregate are material. We should also use a
reduced materiality level for high-risk assertions to reduce the risk that uncorrected errors are material.
Bonus Program Impact - Potential Management Manipulation
As discussed above, due to various accounting policy choices and errors noted in the 2012 FS,
preliminary EBITDA as determined by the client was higher than our recalculated amount.
The errors in accounting generally resulted in premature revenue recognition for significant items (Indo,
major NRE contract). There was an error in using a completed contract method for general NRE contracts
207
that would have resulted in a deferral of revenue to the following period, however the amount may not be
significant.
The significant accounting errors may be indicative of management manipulating earnings to increase
their bonus. However, the fact that some of the errors would have decreaesd their bonus (by deferring
revenue to following period) may be indicative that the bias was not intentional. I think we have reason to
believe that earnings may be overstated and should revise our audit plan as described above.
The bonus program overall is not effective in its goal to motivate management to become innovative and
develop new products as it only focuses on the profitability of the company. We should consider
discussing with the Board (or include in management letter) that alternative performance measures should
be used for the bonus (such as # new products issued per year, # new patents) since relying on EBITDA
alone provides incentive for earnings manipulation.
208
209
OF CANADA
PAPER III
Time: 4 hours
(2) To help you budget your time during the evaluation, an estimate of the number of minutes required for
each simulation is shown at the beginning of the simulation.
**********
2012
Printed in Canada
III
210
Appendix C — Paper III
(90 minutes)
It is April 1, 2012, and you, CA, have just taken a controller position with Chinook Trailers Limited
(Chinook). For the past 10 years, Chinook has been designing and manufacturing large-capacity trailers
for the trucking industry, which is regulated by the National Trucking Association. Chinook has become
successful producing exceptionally high-quality trailers.
Chinook’s board of directors decided that it wanted to increase the company’s market share and ensure its long-term presence in the industry. In 2009, Chinook came up with the idea for a new trailer, made from
aluminum, so that it would be lighter than any other trailer in the industry and would allow for faster
unloading. Chinook called this new trailer the “Yukon,” and was awarded patents for its design and mechanics in the fall of 2010. To speed up the development process, Chinook loaned its new trailers to
one of its major clients as a way of testing the design.
On your first day on the job, you meet with Steve Clarke, a shareholder and the chief executive officer
(CEO) of Chinook. Steve says, “It is great to have you aboard. The timing couldn’t be better! Our controller quit to pursue his lifelong dream of becoming a drummer, and things have been very busy.
When we developed our first trailer, the “Traditional,” we spent a lot of time testing it before we took it to
market. Sales were built up slowly, allowing us to work out any issues before they affected too many
units. Since this method worked well for us and fit with our objective of producing only high-quality
trailers, we adopted it as our standard policy. But with the Yukon, the high demand was there right away,
so we rushed it to the marketplace without first considering whether we’d need a specialized workforce to manufacture these new high-tech trailers. In hindsight, we realize we didn’t stick to our strategy of moving slowly to ensure quality, and as a result, we ran into problems. We expect to introduce another
new trailer to the market next year and would like to avoid the pitfalls we encountered when launching
the Yukon. Therefore, I would like you to draft a plan to manage the risks related to the introduction of a
new trailer, from its design, through the manufacturing stages, all the way to its launch in the
marketplace.
“The problems we encountered with the Yukon resulted in us having a bad year. As you will see from our
draft schedule of expenses before allocation to cost of goods sold (Exhibit I), we incurred significant
rework costs, which resulted in us recording a net loss before tax of $675,000 for the year ended
December 31, 2011. The good news is that our chief operating officer (COO), Mary Irving, has assured
me that we have fixed the problems and that all of the required rework is now complete. I have had Mary
prepare a memo explaining our production process and the problems we encountered (Exhibit II). We are
now back on track, but these setbacks have cost us a lot of time and money.
“Despite all of this, the Yukon has generated such interest in the industry that we recently received an offer from a competitor, Super Trucking (Super), for the purchase of a portion of Chinook. Andrew
Gallant, Super’s CEO, presented an offer to acquire 49% of the outstanding common shares of Chinook. We are considering the sale as a way to fund future growth. Andrew originally wanted Super to control
Chinook, but I was able to negotiate the percentage ownership down to 49%. However, Andrew wants
Super to have the option of obtaining an additional 5% interest in Chinook if we are unable to achieve the
28% gross margin target we expect by December 31, 2012. The purchase price will be determined based
on five times our normalized earnings before interest, taxes, depreciation, and amortization (EBITDA) for
2011. Any normalization adjustments will have to be approved by both sides. I’d like you to calculate what you believe the purchase price should be. I have included an article I found while doing some
background research on Super (Exhibit III). Turns out we are not the only company they have considered
investing in recently!
211
(continued)
“I know this is a lot of information to digest, but there is one more thing I need you to look into immediately. Our external auditors are still waiting on two items to be able to complete their audit of the
December 31, 2011 statements. They need to know the amount of our warranty provision and the value of
work-in-process inventory. Therefore, I need you to calculate these amounts. Our financial statements are
prepared in accordance with Canadian Accounting Standards for Private Enterprises (ASPE).”
212
(continued)
DRAFT SCHEDULE OF EXPENSES
CHINOOK TRAILERS LIMITED
SCHEDULE OF EXPENSES
(before allocation of overhead to cost of goods sold)
For the years ended December 31
(in thousands of dollars)
2011
(unaudited)
2010
(unaudited)
Advertising
Amortization
Bad debt
Insurance
Interest on long-term debt
Management and administrative compensation (Note 1)
Meals and entertainment
Professional fees
Repairs and maintenance
Supplies
Rework expenses
Travel
Utilities
Warranty expense
$
380
175
12
68
189
477
23
75
48
68
450
13
550
–
$
245
185
23
65
122
367
16
72
46
45
–
14
534
300
Total expenses
$
2,528
$
2,034
Bonuses
COO salary
Other management and administrative salaries
$
100
150
227
$
25
130
212
$
477
$
367
2011
2010
213
(continued)
MEMO FROM CHIEF OPERATING OFFICER
Chinook manufactures two trailers: the Traditional, which we have been producing since incorporation,
and the new Yukon, a superior light-weight trailer that we have produced since January 2011.
The facility has a normal annual capacity of 17,000 labour hours, and the average labour rate is $15 per
hour. This level of capacity allows Chinook to produce 100 to 150 trailers per year, depending on the
model of trailer.
In 2010, we produced and sold 130 units of the Traditional, a record for us. In 2011 we adjusted our
production schedule to produce both Yukon and Traditional trailers. We should have been able to produce
more units than we did in 2010, but our employees had problems manufacturing the Yukon. They had
difficulty incorporating some of the innovative features, which meant it took additional time. Then some
reworking was required, so we did not meet our goal. We managed to produce 70 units of the Yukon and
40 units of the Traditional, for a total of 110 units.
The manufacturing of the trailers happens in four consecutive stages. Below are the average labour hours
and materials used within each stage. These average labour hours and materials are incurred evenly within
each stage.
Stage 1 - Frame construction
Stage 2 - Frame electrical
Stage 3 - Superstructure assembly
Stage 4 - Finishing
6
24
40
30
$
$
$
$
8,000
18,000
17,500
33,000
8
36
60
46
$
$
$
$
10,000
20,000
22,000
42,000
100
$
76,500
150
$
94,000
214
(continued)
Introduction of the Yukon in January 2011 led to a record quarterly sales volume. We were so excited, we
paid bonuses to each of the five managers for a total of $100,000. In hindsight, we shouldn’t have. Of the first 30 Yukons sold, we saw almost 60% come back into the shop the next quarter for reworking. There
was a design flaw: when the trailer was at capacity, it would not unload properly, and the pressure of the
load led to structural damage. In one case it caused a trailer to roll, injuring the driver and another person.
Thankfully they were okay, but we had to pay out $80,000 in compensation to them and $15,000 in legal
fees. We recalled all of the Yukons we had sold and did the necessary reworking. We then altered the
manufacturing of the trailer to ensure that these problems would not happen on future trailers, and
launched a $125,000 advertising campaign to try and recapture lost sales. Since then we have had no
further problems, and our gross margin is moving towards our originally expected margin of 28%.
The following is a summary of our gross margin percentage over the last five fiscal quarters (dollar
amounts are in thousands):
1st Quarter
2011
Trailers produced and sold
(units)
Revenue
Cost of goods sold
Gross margin
Gross margin (%)
52
$ 5,416
4,774
$ 642
12%
2nd Quarter
2011
$
$
8
864
855
9
1%
3rd Quarter
2011
12
$ 1,346
1,257
$
89
7%
4th Quarter
2011
1st Quarter
2012
38
$ 4,254
3,899
$ 355
8%
50
$ 5,400
4,320
$ 1,080
20%
Overall gross margin for 2010 was 21%.
We take quality very seriously. Each of our trailers is backed by a two-year warranty. On the Traditional,
we have relatively low warranty rates of 10% in year 1 and 5% in year 2, with our average cost of
warranty being $15,000 per trailer. Our estimates were right on last year: the warranty work required on
our Traditional trailers in 2011 exactly equalled the amount we had accrued for 2011 work at December
31, 2010. With the Yukon, we have been working with our engineers to determine a realistic estimate of
the warranty costs. Our engineers have indicated that the rework costs incurred in the current year are not
likely to occur in the future because the manufacturing process has been changed. Based on the testing
they have done, our engineers expect 5% of Yukons will require warranty work in year 1 of the warranty
period and 2% in year 2. They have estimated that the cost of warranty work for the Yukon is twice as
much per unit as for the Traditional in each year.
215
(continued)
Approximately 25% of my time last year was spent on work not related to production.
Last year, 85% of utility costs were attributable to the manufacturing process.
In 2011, $10,000 in repairs were made on trucks used by the sales staff. The remainder of the repair
and maintenance expenses were directly related to manufacturing.
Last year, 80% of the property and equipment was used in the manufacturing process.
The following is a list of trailers in production as of December 31, 2011. Each trailer is halfway
through the stage indicated:
o Trailer #384 — Yukon — Stage 1
o Trailer #382 — Traditional — Stage 2
216
(continued)
ARTICLE ON SUPER TRUCKING
Sunday, November 27, 2011
ESTEVAN FREE PRESS
SUPER CLOSES LOCAL FACTORY
With the current poor economic
climate, most wouldn’t expect a transportation company to be
making bold moves and taking
chances. However, most haven’t met Andrew Gallant of Super
Trucking.
Previously a venture capitalist,
Gallant has been Super’s CEO for the past five years. This was a
change in direction for Super, as it
had been a family-run business
since incorporation in 1988.
Early in the year, Super acquired a
local manufacturer, employing 35
people, that had developed a new
braking system to allow trucks to
brake in half the time of traditional
trucks.
While
the
braking
system
considerably improves the safety
of these trucks, sales of the system
took a significant drop and
remained flat after it failed on a
truck early this year. Super has
made the decision to discontinue
production, and has closed the
factory that manufactured the
system.
The general manager of the factory
had the following comments: “We were surprised with the closure. We
knew that the system failure was a
setback, but we had isolated the
problem in the production process
that caused the error and felt that
sales would have recovered. They
obviously didn’t agree.”
Gallant had a much different take
on the situation: “Super is a company that has achieved its
growth and success through the
acquisition of new products that are
ready for the market. In order to be
successful, we need to operate fast
and make tough decisions. Their
product had stumbled and the sales
had dropped off. In my opinion, the
problem was too severe to
overcome, so we needed to move on
and begin to look for the latest
innovative product.”
217
In addition, the
when analyzing
To: Steve Clarke
From: CA, Controller
You have asked me to do several things. First, I have provided the calculations required for the
completion of the audit by our external auditors. I have provided an estimate of the purchase price for a
portion of the company based on the proposed agreement with Super Trucking (Super). I have also made
some recommendations with regards to Chinook’s risk management strategy.
The candidate calculates the value of the WIP inventory and the warranty provision, as required
for the completion of the audit.
Competencies
V-2.3 Accounts for entity’s routine transactions (Level A)
Labour and Materials
Work-in-process inventory is based on the number of trailers in production but not completed at the end
of the year. As per Chinook’s accounting policy, the cost of labour and material for each stage is attributed to each trailer. As per CICA Handbook, Part II, Section 3031, the cost of inventories shall
comprise all costs of bringing the inventories to their present location. This would be all materials and
labour that have been incurred to date in the manufacture of a trailer.
This is the information Mary provided, as well as the fact that each trailer was halfway through their
respective stage:
Trailer # 384 — Yukon — Stage 1
Trailer # 382 — Traditional — Stage 2
218
Appendix C — Paper III — Evaluation Guide
Stage 1
Stage 2
Stage 3
Stage 4
50%
Labour hours
Materials
6
8,000
Trailer #382
Trailer #380
Trailer #378
Stage 2
Stage 3
Stage 4
Hours
Average labour rate $
Labour cost $
Labour hours
Materials
Trailer #384
Trailer #383
Trailer #381
Trailer #379
8
10,000
24
18,000
40
17,500
18
50
85
17,000
34,750
60,000
153
15
2,295 $
36
20,000
Stage 1
4
Stage 2
26
Stage 3
74
Stage 4
127
Hours
231
Average labour rate
15
Labour cost $
3,465 $
30
33,000
111,750
60
22,000
$ 114,045
46
42,000
5,000
20,000
41,000
73,000
139,000
$ 142,465
Total labour and materials in WIP $ 256,510
(Most candidates recognized that the labour and materials component of work-in-process (WIP) was
needed by the external auditors in order to complete their audit work, and attempted to calculate this
amount. Most candidates who took the time to gather the relevant information from the simulation and
to plan their calculations were more successful in the performance of their calculations. Common
errors and omissions included mixing up the two different types of trailers and not recognizing that
trailers were only 50% through their in-process stage of production, and therefore mistakenly included
100% of the costs for that stage. These were considered minor errors. More significant errors included
inconsistently calculating the WIP when applying the stages to the two trailers, as well as the failure to
roll costs up from the previous stages (for example, forgetting to include stage 1 and 2 costs for trailers
in stage 3).)
219
Overhead
We also need to determine the amount of overhead that can be attributed to the goods being produced.
This allocation is based on the normal capacity of the facility. In this operation, the best determination of
the items in production at the end of the year is labour hours. Therefore, any costs determined to be
directly linked to production will be allocated based on the amount of labour in work in process.
Based on my review, the following costs should be allocated to overhead:
a) Management Salary
Included in management’s salary is the cost of the chief operating officer’s salary, although 75% of her time was directly attributable to the production of the trailers.
b) Utilities
With a manufacturing facility of this nature, very little of the utility cost would be associated with the
head office. Currently 85% of the utility expense would be considered part of manufacturing;
therefore, this proportion of the expense should be considered part of overhead costs.
c) Repairs and Maintenance
Based on the information provided, any repairs and maintenance completed for the current year would
be directly attributable to equipment used in the manufacturing of the trailers, excluding the $10,000
spent on the sales staff trucks. Since this equipment directly contributes to the goods produced, the
amounts for repairs and maintenance (less $10,000) should be included in the calculation of overhead.
d) Amortization
Based on the information provided, 80% of the property and equipment was used in the manufacturing
process last year. Therefore, 80% of amortization should be included in the calculation of overhead.
(Most candidates recognized that overhead (OH) should be calculated and included in WIP. However,
nearly half of the candidates who addressed the overhead issue were not able to provide adequate, wellsupported calculations. Many candidates were able to identify some of the components that should be
included in the determination of OH, but did not explain the reasons for their inclusion or exclusion of
certain amounts.)
220
Percentage of time in WIP
Hours in WIP
Normal shop hours
% of total hours in WIP
Total overhead costs
Management salary
Utilities
Repairs & maintenance
Amortization
384
17,000
2.26%
Gross
$
150,000
550,000
48,000
175,000
Adjustment for non manufacturing
components
$
37,500
82,500
10,000
35,000
Amount related to
manufacturing
$
112,500
$
467,500
$
38,000
$
140,000
Total overhead adjustment
$
758,000
17,122
(Many candidates accumulated the total OH costs and charged the full 100% to WIP without
recognizing the need for a reasonable, proportionate allocation of those costs to WIP. As a result, WIP
was overstated by an amount far in excess of the calculated labour and materials component.
Candidates did not step back to assess the reasonableness of this amount. Other candidates
remembered to pro-rate the overhead costs over some basis, recognizing that only a portion should be
allocated to the costs in WIP. Although the most appropriate basis was to use normal labour hours at
capacity, candidates also allocated on other reasonable bases, such as actual labour hours or the
number of trailers produced during the year.)
Total value of work-in-process inventory: ($256,510 + $17,122) = $273,632
By offering a warranty on our trailers, we are subjecting the company to a potential future liability for the
cost of the repairs incurred. In order to reasonably estimate the cost of the liability, we need to use
historical data. This is possible for the Traditional trailer. However, for the Yukon there is no historical
data, therefore we have performed our calculation using management’s (the engineers’) assumptions about the likelihood of the trailers incurring warranty expense. It is interesting to note that the engineers
have estimated that fewer Yukons than Traditionals will require warranty work. Therefore, there is a risk
that they have underestimated the amount of warranty work required, since there is no history available to
support this amount and, since problems have occurred, one would expect the estimate to be higher.
(Some candidates misunderstood the required and performed a calculation of the warranty expense for
the year rather than a calculation of the warranty provision (a balance sheet item) needed at the end of
the year. Consequently, these candidates based their calculations on the 2011 sales only and omitted
the liability remaining related to the 2010 sales.)
221
Based on the information provided by the chief operating officer, the adjustment for the warranty
provision is as follows:
Sold in 2010
Estimated warranty %
# of trailers subject to warranty
130
10%
13
Sold in 2011
130
5%
7
40
10%
4
40
5%
2
11
$15,000
$165,000
2
$15,000
$30,000
Sold in 2011
Cost per trailer
Warranty provision needed
70
5%
4
$30,000
$120,000
70
2%
2
$30,000
$60,000
Total warranty provision for 2011
$375,000
Total # of trailers subject to warranty
Cost per trailer
Warranty provision needed
13
$15,000
$195,000
(The majority of candidates attempted to calculate a warranty amount, be it the liability or the expense.
Candidates who took the time to understand the case facts provided in this area seemed to perform
better, with fewer calculation errors (for example, they were less likely to mix up the warranty
percentages or quantities between the two trailers). Many candidates did not include the second year of
the warranty for the 2011 sales in their calculations (whether determining the provision or the
expense), which was considered a significant omission.)
222
Percent
Awarded
0.1%
competence.
6.1%
Reaching competence — The candidate attempts to perform a calculation of
both the value of the WIP inventory and the warranty provision.
39.9%
Competent — The candidate performs a reasonable calculation of both the value
of the WIP inventory and the warranty provision.
50.2%
Highly competent — The candidate performs an in-depth calculation of both the
value of the WIP inventory and the warranty provision.
3.7%
(Candidates were asked to calculate the value of the work-in-process (WIP) inventory and the amount
that should be set up as the warranty provision. To achieve competence, candidates were expected to
perform a reasonable calculation of both the value of the WIP inventory and the warranty provision.
Candidates were clearly directed to this indicator, since the CEO noted these were the two items
outstanding in order for the external auditors to be able to complete their 2011 year-end audit.)
(Candidates performed below expectations on this indicator. Most candidates were able to perform a
reasonable calculation of the labour and materials that should be included in WIP, with only minor
errors. However, they struggled with the calculation of the overhead (O/H) that should be included in
WIP. Many candidates excluded components without justification, and forgot to pro-rate the O/H
allocation (in other words, they included 100% of O/H expenses in WIP). As for the warranty
provision, many candidates kept their calculations simple, using appropriate case facts without making
unnecessary assumptions or incorrectly including or excluding items. The most common error in the
warranty calculation was the omission of the second year of warranty on the 2011 sales.)
(Strong candidates provided good calculations of both components of WIP (labour and materials,
O/H), with few calculation errors or inconsistencies. Most candidates allocated O/H to WIP using a
reasonable basis, and included the second year in the warranty provision. Weak candidates generally
attempted to calculate both the WIP and warranty amounts, but made numerous and significant errors,
both in the mechanics of their calculations and in the integration of simulation facts. Many of these
candidates ended up calculating implausible amounts, but failed to step back and assess the
reasonableness of their final calculated figures (for example, by not realizing that a warranty provision
in the millions was not a reasonable amount given the case facts).)
The candidate normalizes earnings in order to estimate the purchase price of Chinook.
223
Competencies
VII-4.2 Estimates the value of the business (Level B)
Based on the calculation I have included after this section, a reasonable price for a 49% share in Chinook
would be approximately $5,929,000. To arrive at the purchase price, I made the adjustments that follow.
It is noted in the agreement that Super must agree to all normalization adjustments.
To determine the normalized EBITA, an adjustment to the gross margin for 2011 is required. Due to the
increased time it takes to produce the Yukon, there has been a significant decrease in the gross margin. As
indicated through the discussions with the COO, the gross margin percentage should be adjusted to a
more reasonable amount since the decline was directly attributable to the problems with the design of the
Yukon. The COO mentioned that they expect to be back on track to achieving a gross margin of 28%.
Therefore, I recommend a normalization of the margin to 28%. Super may not agree with using 28%,
though, since there is no history to back up the amount, and may argue for a margin of 21% (2010
margin).
(Many candidates recognized that the 2011 gross margin (GM) was not at previous levels as a result of
the Yukon problems. However, they discussed it only in the context of the additional 5% ownership that
could be acquired by Super if the 28% GM threshold was not achieved in time, rather than connecting
it to the determination of the purchase price. As a result, few candidates normalized the GM as part of
their purchase price calculations.)
The costs incurred to repair the trailers should be adjusted out, since they represent a one-time expense
and will not be incurred in the future. Super should not have any issues with this adjustment.
Similar to the rework costs, the $125,000 advertising campaign specifically relates to the design flaw
Chinook encountered with the Yukon. The sole purpose of the advertising campaign was to try and
recapture sales lost as a result of the problems with the Yukon. Chinook has adjusted its manufacturing
process for the Yukon to ensure that a similar problem does not reoccur. Therefore, this should be
considered a one-time expense.
The cost of management salaries is considered excessive because it includes $100,000 in bonuses this
year. The payment of bonuses at such a level is not normal practice for this company, and therefore the
amount should be adjusted out.
224
In the current year, the company was involved in a lawsuit that required it to pay the victims $80,000 in
compensation. They also paid $15,000 in legal fees for the same issue. These payments would be
considered one-time payments because they are not expected to be incurred annually, and therefore
should be added back.
(Most candidates recognized some of the unusual costs related to the Yukon that had been incurred
during the year, and included them in their normalization of earnings for the determination of the
purchase price. Candidates were usually able to explain why these amounts were being adjusted by
using relevant simulation facts.)
Warranty Adjustment
The current year earnings do not include an amount for warranty expense. The warranty expense for 2011
should relate to setting up a provision for any trailers sold in 2011. Based on our earlier calculation, the
amount of warranty expense charged in 2011 should total $270,000 ($180,000 for the Yukons sold and
$90,000 for the Traditionals sold). We know that the amount of warranty work required on the
Traditionals in 2011 exactly equaled the amount accrued. We do not know the same for the Yukons;
therefore, this amount may need to be adjusted slightly if we determine that we over- or under-accrued for
the year. For now, we will use $270,000 in our calculation.
(Most candidates attempted to integrate the results of the warranty calculation they performed for
Primary Indicator #1 into their calculation of earnings. The absence of a warranty expense for 2011
was clear in the Schedule of Expenses provided in the simulation. Despite this, some candidates who
had properly calculated the warranty provision to assist the auditors did not adjust their earnings
figures accordingly.)
WIP Adjustment
An adjustment is required for WIP, but cannot be estimated right now. We have calculated the ending
WIP ($256,510 + 17,122), but without knowing the beginning WIP, we cannot determine the amount of
the entry that needs to be made.
Net income before taxes $
Warranty expense $
WIP adjustment
Adjusted income $
Interest on long-term debt
Amortization
EBITDA
Gross margin adjustment
Lawsuit
Advertising
Rework costs
Management bonuses
Normalized EBITDA
Multiplier
Total value of business
ST share
49% $
225
in ’000
(675)
(270)
?
(945)
189
175
(581)
2,231 [$11,880 x 28% = 3,326; $3,326 - 1,095 = $2,231]
95
125
450
100
2,420
5
12,100
5,929
(Few candidates attempted to integrate their WIP calculations into the determination of the normalized
earnings to be used in determining the purchase price. Most of those who did included the ending WIP
amount without considering that the opening value of WIP was unknown and that, therefore, they did
not have sufficient information to calculate the impact on earnings.)
Chinook should consider whether EBITDA is the right measure to use to value the company. Is this the
standard measure use for the industry? In addition, is the multiplier of five times EBITDA reflective of
the earnings potential of Chinook? It is unclear whether there is room for negotiation here, but if Chinook
continues to pursue this offer, we should determine whether we can negotiate and ensure the deal is fair.
Percent
Awarded
0.2%
competence.
3.5%
Reaching competence — The candidate attempts to normalize earnings in order
to estimate the purchase price of Chinook.
29.1%
Competent — The candidate normalizes earnings in order to estimate the
purchase price of Chinook.
64.4%
Highly competent — The candidate normalizes earnings, including the
accounting adjustments, in order to estimate the purchase price of Chinook.
2.8%
226
(Candidates were asked to calculate the purchase price for Chinook. To achieve competence,
candidates were expected to normalize earnings to estimate the purchase price for the company.
Candidates were directed to this indicator through the CEO’s request that CA calculate the purchase price, and were told the purchase price would be determined based on a formula using normalized
EBITDA for 2011.)
(Candidates performed well on this indicator. Many were able to calculate a purchase price for the
company that normalized 2011 earnings, incorporating a number of non-recurring items as noted in
the simulation. Some candidates also integrated the results of their Primary Indicator#1 discussions by
adjusting earnings for their outstanding accounting entries (usually the inclusion of warranty
expense). Many candidates identified the decline in gross margin (GM), but didn’t seem to recognize
that 2011 wasn’t a typical year for Chinook. As a result, they did not normalize earnings for the lower GM when establishing a value for the company.)
(Strong candidates included most of the normalizing items. They also recognized that the 2011 GM was
not indicative of a normal year and made a reasonable attempt to adjust it to an expected level in their
purchase price analyses. Those candidates also supported their adjustments with qualitative
discussions as to why the adjustment was necessary and how they came up with the amount. Many
weak candidates made only the necessary adjustments to earnings to arrive at an EBITDA amount (for
example, amortization and interest) and included some of the clearly directed normalizing items. Many
weak candidates included other expense items in their calculations (such as insurance), with no
support for the inclusions. As a result of committing several errors in their calculations, many of these
candidates arrived at a negative EBITDA amount but continued to use this amount as a basis for
calculating a purchase price.)
The candidate helps establish a risk management plan for Chinook.
Competencies
IV-3.2 Evaluates the entity’s risk management program (Level B)
IV-3.4 Identifies courses of action to help manage risks (Level B)
IV-2.4 Identifies key elements of the entity’s value system (Level B)
With the Traditional trailer, Chinook took its time in developing the product. Chinook adopted that
method as its strategy, although it admittedly did not follow that strategy very well with the Yukon. If the
goal of Chinook is to continue to focus on quality, the shareholders need to step back and assess how they
will ensure their products are of the highest quality in the future, should they introduce another new
trailer.
To help identify the risks related to the introduction of any new trailer, from its design to its launch in the
marketplace, Chinook has asked for assistance in developing a risk management strategy for the company
to follow. Having such a formalized process in place will help ensure that the financial loss that was
incurred with the introduction of the Yukon won’t occur again. Uniform Evaluation Report — 2012
—
—
227
—
There could be a significant design flaw in the The problem with the Yukon suggests that
new trailer that causes it to malfunction, similar Chinook’s current testing of new trailers is not thorough enough. This problem could have been
to what occurred with the Yukon.
prevented had the Yukon been tested at capacity.
The problem with the Yukon was that when the Any new trailer should have to undergo testing
trailer was at capacity, it would not unload under a comprehensive list of different conditions,
properly, and the pressure of the load led to including but not limited to:
- Hot and cold climates
structural damage.
- Empty and at capacity
The design flaw with the Yukon resulted in a - Containing different types of materials
trailer rolling and injuring the driver and another
person.
Chinook
incurred
$80,000
in Therefore, Chinook needs to ensure that it selects
the right clients to test out its new products. The
compensation and $15,000 in legal fees.
clients selected should be representative of most
of the company’s clients and allow it to test the new trailers under different conditions, as
mentioned above.
To prevent the company from rushing a new
product to market, Chinook may want to set a
minimum time period between the design and
product-launch steps to allow for adequate testing.
Chinook should also ensure that the right people
are involved in testing the new trailer. Make sure
that all the relevant areas of expertise are covered
(mechanical, electrical, structural, etc.).
Another way to potentially prevent this type of
problem may be to add some steps to the design
process and ensure that the right people are
involved at the design phase. A structural
engineer might have been able to identify the
potential flaw even before it was tested, just based
on reviewing the designs.
Accidents can be both very dangerous and costly
to the company, and therefore they should be
prevented whenever possible. Some of the
228
—
—
recommendations already made will help to
reduce the occurrence of accidents (such as
improving the design and testing process). But the
company should also have the necessary
processes in place to deal with accidents when
they occur. For example, have the employees
been trained in first aid and CPR? Does the
company have a plan outlined in the case of an
emergency? Does it have up-to-date emergency
contact numbers for its employees? In addition,
Chinook should also have a comprehensive
insurance plan that is in line with the risks it’s exposed to.
First, Chinook should have a process to ensure it
is up-to-date on all the safety standards its trailers
While there is no specific mention of Chinook must adhere to.
encountering issues with safety standards, given
that it manufactures large transport trailers, I am Second, a process needs to be developed to ensure
assuming that it is subject to specific safety that any new trailer meets all of these standards.
standards, the breach of which would have Chinook could develop a checklist process
significant negative repercussions (fines, whereby all the standards are included on a list,
lawsuits, damage to reputation, etc.). The and the appropriate employee must sign off that a
National Trucking Association, as regulator of new trailer has met each standard as it moves
the trucking industry, may have certain standards through the development process.
and provisions that Chinook needs to follow.
Steve, you mentioned that the company did not
—
take the time to consider whether it would need a
Chinook employees seem to have a hard time specialized workforce to manufacture the Yukon.
manufacturing some of the more innovative
aspects of the Yukon. This could result in the When a new trailer is developed, Chinook should
trailers being manufactured incorrectly or in consider the differences between the new trailer
fewer trailers being produced due to the and its existing trailers and try to anticipate any
additional time required, as was the case in 2011. areas where its current workforce may lack the
necessary skills. Then management can either
Chinook should also consider whether its ensure the workforce receives training, or they
workforce has difficulties because the assembly can hire new employees to fill any gaps.
line hasn’t been adjusted properly for the manufacture of the Yukon.
The assembly line should also be adjusted for any
necessary changes in the manufacturing process.
Chinook should implement guidelines with
—
regards to paying out bonuses. The guidelines
When the Yukon was introduced, it led to should include such things as a minimum waiting
Chinook’s best quarter ever. As a result, the period after the launch of a new trailer before the
company paid out $100,000 in bonuses. company is able to pay out bonuses (for example,
However, shortly thereafter, the design flaw was bonus will be based on success of the product
discovered and most of the trailers were returned. after the first full year). This type of guideline
In hindsight, the company would not have paid would have prevented the premature bonuses that
the bonuses. Therefore, the risk here is that the were awarded with the Yukon.
—
company pays out bonuses prematurely.
—
229
—
In addition, Chinook may want to consider basing
the bonus program on measures other than sales
or gross margin of the product. For example, if
the company wants to encourage its employees to
focus on quality, the bonus could be based on a
low percentage of reworks or a similar measure.
Chinook should ensure that it performs adequate
market research before launching a new product.
It should also assess the current state of the
industry and the economy in general to ensure
that the timing is right. This might result in the
company deciding to delay the launch of a
product.
While the Yukon seems to be doing well, the
current economic state is poor, as confirmed by
the recent article in the Estevan Free Press. New
products should not be launched when the
economy is suffering because customers will be
unlikely to take a chance on a new and more
At the very least, if Chinook decides to launch a
expensive product.
product regardless of the economic state,
management should ensure that there are
sufficient funds to successfully launch and
support the product because there will likely be
hidden costs. Also, if demand isn’t there right away, Chinook might run into a cash shortfall.
(Many candidates attempted to address the three areas raised by Steve (design, manufacturing, and
launch) and discussed the more obvious concerns (such as customers testing trailers, and the need for
a specialized workforce). Some candidates took additional time to consider the type of business and the
specific problems that had occurred with the Yukon already, and provided insightful and relevant
solutions that would successfully mitigate the specific risks. Weak candidates provided general
solutions (such as an overall strategy to proceed slowly).)
For Primary Indicator #3 (Governance, Strategy, and Risk Management), the
Percent
Awarded
1.2%
competence.
7.7%
Reaching competence — The candidate discusses some of the necessary
components of a risk management plan for Chinook.
35.7%
Competent — The candidate discusses several of the necessary components of
a risk management plan for Chinook.
54.2%
Highly competent — The candidate thoroughly discusses several of the
necessary components of a risk management plan for Chinook.
1.2%
230
(Candidates were asked to establish a risk management plan for Chinook. Candidates were expected to
discuss some of the risks faced in the introduction of a new product and to propose methods for
mitigating those risks. To achieve competence, candidates were expected to discuss some of the
necessary components of a risk management plan for the company. Candidates were clearly directed to
this indicator by the CEO’s request to draft a plan to manage the risks related to the introduction of a new trailer from its design, through the manufacturing stages, all the way to its launch in the
marketplace.)
(Candidates performed well on this indicator. Most were able to recognize some of the relevant risks
and suggest ways to mitigate them. Many candidates discussed the specific problems encountered in
the past that were mentioned in the simulation, such as design flaws and the need for a specialized
workforce, but did not try to envision other potential risk concerns.)
(Strong candidates provided well-organized, concise responses that identified risks in several areas
(development, manufacturing, and launch) and provided valid solutions. Their proposals were
thoughtful and useful to the company. They addressed obvious risks raised by case facts, as well as
others that required them to be more creative and thoughtful. All aspects of their discussions were
useful and relevant to a risk management plan. Weak candidates provided only one real
recommendation (generally, the need for testing) and repeated that same recommendation for each of
the risks. Some weak candidates also provided vague or incomplete methods for mitigating risks, or
repeated case facts without providing additional insight or analysis.)
The candidate raises issues with the sale that Chinook may not have considered.
Despite the fact that I was not specifically asked for my opinion on whether Chinook should accept the
purchase offer from Super, I felt it was necessary to raise some issues with the offer that came to light in
my review of the material provided to me.
231
(Most candidates addressed this indicator, and the majority of them did so as the qualitative portion of
their quantitative analysis estimating the purchase price of Chinook.)
Assessing the Fit with Super
Super appears to be a much different company, with a focus on growth through a business acquisition
strategy rather than Chinook’s approach of internal product development. Super seems to use an aggressive strategy. It appears it has little tolerance for allowing a product to develop in the marketplace
(which seems to be your strategy, as evidenced by the rollout of the Yukon trailer), instead expecting to
see immediate results. This is evident since it has grown through acquiring operations with new products,
rather than developing its own.
It is interesting to note that the company recently discontinued the braking system in Estevan after it
experienced difficulties. The company’s attitude was evident from the CEO’s quote in the media about
the issue in Estevan: “In order to be successful, we need to operate fast and make tough decisions. Their product had stumbled and the sales had dropped off. In my opinion, the problem was too severe to
overcome, so we needed to move on and begin to look for the latest innovative product.” This raises some concerns, particularly in light of the recent problems with the Yukon (rework costs; the design flaw which
caused the trailer to roll and resulted in injury payouts) since Super may not be tolerant of Chinook’s past approach with respect to product development and rollout in the marketplace. Super is out for the “quick profit” and high growth. This does not seem to fit well with your strategy of proceeding slowly and producing only the highest quality products.
(Some candidates commented on the different management styles of Chinook and Super, but not all
supported their discussions with examples or illustrations of those differences from the simulation
facts. As a result, their comments were unsupported. Other candidates who did try to incorporate case
facts into their responses merely repeated them, without providing additional analysis or insight.)
Option for Additional 5% (Potential Loss of Control)
There is an issue you need to consider with respect to retaining control of the corporation. Although you
have negotiated Super’s offer to less than a controlling percentage, the company is taking steps to acquire control of Chinook. With the clause that it will acquire an additional 5% if Chinook does not achieve its
expected gross margin of 28%, this will likely see you lose control. Chinook may not be able to achieve
this goal, given the problems encountered with the new trailer. While Chinook seems to have corrected
the issues with the Yukon and brought its gross margin back in line, it still has not been able to hit the
28% gross margin target (for the first quarter of 2012, it was 20%). In addition, it is not clear whether
Chinook has ever had a gross margin of 28%, since it was 21% in 2010 and only 9% ($1,095 ÷ $11,880)
in 2011.
(Most candidates recognized that previous history seems to indicate that the 28% gross margin
threshold would not be achieved (and thereby control could be lost), and incorporated relevant
simulation facts into their discussions. Some candidates simply commented that control would be lost
upon the sale to Super, although the initial purchase proposal provided for a 49% sale only.)
If Super were to obtain control, then you would have no way of ensuring that your objective of quality
products is maintained. With the added 5%, Super can effectively make the strategic decisions it wants
and could choose to close Chinook, as it did with the brake manufacturer, if Chinook were to run into
difficulties with one of its trailers again.
232
(Some candidates recognized and explained how control of Chinook could be lost, but failed to
comment on the implications such a loss of control could have on the company and operations.)
I understand that Chinook is hoping to grow and increase its market share, but it may not be worth taking
on the additional risks related to this deal. At the very least, I would recommend that you either discuss
the offer with Super and attempt to remove the option for the additional 5% or see whether Chinook could
obtain financing through alternate means.
Percent
Awarded
0.8%
competence.
3.1%
Reaching competence — The candidate identifies some of the issues with the
sale that Chinook may not have considered.
38.7%
Competent — The candidate discusses some of the issues with the sale that
Chinook may not have considered.
56.4%
Highly competent — The candidate provides a thorough discussion of some of
the issues with the sale that Chinook may not have considered.
1.1%
(Candidates were expected to raise issues with the sale of Chinook that the owners may not have
considered. Candidates were not directed to this indicator; however, they were aware that Chinook had
received a purchase offer from a competitor and were provided with an exhibit containing an article
about the competitor.)
(Candidates performed adequately on this indicator, given its non-directed nature. Most candidates
were able to discuss the potential for loss of control in their analyses, incorporating case facts into
their discussions (specifically, the option for Super to purchase an additional 5% ownership if the GM
target is not achieved). Some candidates considered the fit between the two companies and applied case
facts to their discussions, but were not always thorough enough in showing the contrast between
Chinook and Super (for example, they mentioned a clash of culture between the two companies but
without reference to the newspaper article or any other case facts).)
(Strong candidates discussed both the loss of control and the lack of fit with Super, provided several
case-specific examples of contrasts between the two companies, and then commented on the
implications of that comparison. Their responses were well written and concise and provided thorough
discussions of the issues. Weak candidates did not address either the loss of control or the fit with
Super in their responses. When they discussed Super, their discussions were often general in nature
(for example, identifying how the management styles are not in sync), without using case facts to
support their discussions or compare the two companies. When they addressed the loss of control issue,
they merely identified that it could occur without explaining how (that Chinook is unlikely to meet the
28% GM target, so the 5% option would be exercised) or elaborating on statements made.)
233
(Overall, candidates’ performance on this simulation was mixed. Two indicators on this simulation were quite unique, Primary Indicator #1 and #3. The results on those two indicators were somewhat
disappointing. On Primary Indicator #1, candidates were expected to demonstrate their accounting
knowledge by calculating specific balances using relevant information from the simulation. Candidates
struggled with this type of analysis, and their calculations commonly had errors and omissions, both in
terms of the WIP inventory and the warranty provision. On Primary Indicator #3, candidates were
asked to develop a risk management plan for the introduction of a new product. This was a scenario
that was different from the norm, although risk management is frequently encountered in practice.
While many candidates were able to identify some of the relevant risks, their recommendations of ways
to mitigate them were not always specific enough. In addition, candidates had a difficult time coming
up with risks that weren’t directed to in the simulation, which required critical thinking.)
(In contrast, candidates performed as expected on both Primary Indicator #2 and #4. They were able to
normalize earnings in order to estimate the purchase price of the company, and most discussed some of
the issues with the sale that Chinook may not have considered.)
234
Appendix C — Paper III — Sample Response
To: Steve Clarke
From: CA
Subject: Chinook Trailers Ltd (CTL)
We need to accrue a warranty provision since the costs meet the definition of a liability. We have a duty
under the sales agreement to repair defects with the trailers for 2 years, we cannot avoid this obligation
and the sale of the trailers has already occurred.
The amount of warranty provision to be recognized (established by expensing a corresponding warranty
expense) is equal to our best estimate of the warranty work required. In Exhibit B I have estimated the
warranty provision as $262,500. Net income before tax will decrease by the same amount.
Please note that because this is the first year of the Yukon trailer being produced, we need to be able to
substantiate the engineer's claims that a 5% return rate is reasonable. If there is no documentation to
support this claim we may need to revise the estimate to a 10% return comparable to the Traditional
trailer or an even higher claim to ensure that our provision is sufficient.
The cost of WIP inventory should include the cost of purchase, costs of conversion and other direct costs
incurred to bring the inventories to their present location and condition. In order to value the inventory I
have calculated the value of labour and materials used in the 7 WIP trailers at year end, and made a
reasonale allocation of overhead costs based on the direct labour hours used by the trucks. Based on this
calculation in Exhibit C, WIP inventory has been determined as 276,648.
Only overhead costs directly attributable to manufacturing were allocated, such as the COO time on the
plant floor, repairs for plant equipment and utilities used in manufacturing.
There may be alternative ways to allocate overhead costs such as amortization based on the % equipment
used by each truck type, however, based on the information provided such a detailed allocation was not
possible.
235
Design Stage
To ensure that the design is structurally sound, all designs should be created and reviewed by certified
mechanical engineers. This would reduce the risk that the design does not meet National Trucking
Association (NTA) standards for safety which would result in significant time wasted in having to
redesign the product.
To ensure that the design is technically feasible and does not require specialized equipment or labour,
prior to entering into commercial production, a prototype trailer should be manufactured on the
existing CTL equipment by CTL staff so that specialization issues (whether equipment or training)
can be identified. This would reduce the risk that we find out during commercial production that staff
cannot manufacture the equipment according to plan.
The prototype trailer should be inspected by a registered NTA inspector to ensure that the prototype
meets all specifications required. This is to mitigate the risk that we produce a trailer design that
ultimately cannot be sold if it does not meet NTA requirements.
The prototype trailer should be tested for function. The trailer should be loaded with the expected
weight capacity per design specs and reviewed that there is no structural damage or issues with
normal function. This would have identified the issues with the Yukon trailer not being able to open
when fully loaded.
The prototype trailer should be stress tested. The trailer should be loaded with a normal amount of
equipment and tested in conditions at the limits of normal use (e.g. very steep hills, high speeds, steep
banks) to ensure that the trailer does not roll, flip, or otherwise break. The trailer should be loaded
with as much weight as possible to determine when structural breakage occurs so that we know that
the stated capacity is below max capacity. This is to ensure that our trailer can perform as we claim it
can, to avoid injuries and issues that were noted with the Yukon.
Manufacturing
To ensure that commercial production of the trailer does not exceed demand, we should obtain market
studies to verify that there is a market for our product prior to producing large batches.
To ensure that equipment produced is up to standards, each trailer should be carefully inspected prior
to being issued to the sales floor. The trailer should be filled to stated capacity and functions tested to
ensure that the quality standards are high and that we can deliver product that lives up to its claims.
This would have identified issues with the trailers sold not functioning as expected.
Prior to entering into full scale production, staff scheduled to work on new products should receive
specific training for the changes they will encounter from old models (e.g. how to install new parts).
This will reduce the risk of manufacturing delays due to staff being unable to incorporate new
features.
Sales
To ensure that the product is not rushed to market and that design/manufacturing flaws only affect a
small number of product, sales of new products should be limited at first. Consider issuing only 20
new trailers of a new model type in the first year as a test batch. This will allow us to gauge the
consumer reaction and product quality without putting the entire operations at risk if sales are poor.
236
To ensure that the product is high quality and satisfies customers, we should consider sending out
customer surveys to individuals who purchased new trailers asking for feedback on new features and
whether they are working as intended. This will allow us to identify problems with the trucks before
they may be completely failing, and provide improvements for future models.
In Exhibit A I have calculated that a reasonable purchase offer from Super for 49% of CTL would be
$2.3M.
Advantages:
CTL currently has a damaged reputation due to issues with the Yukon product launch. Associating
with Super, if they have a good reputation may help customer confidence in the CTL products again.
Disadvantages:
The Board is interested in increasing market share. By providing Super with 49% control over CTL,
Andrew will have access to our Board meetings, review our strategic plans and otherwise gain access
to our proprietary information which he can then use to position Super to better compete with CTL to
drive down our market share and competitiveness.
In 2010 we had a 21% average gross margin. For 2011, the current average gross margin is
approximately 9%. The potential clause in the agreement allows Andrew to purchase an additional
5% stake in CTL for total 54% ownership if the gross margin at the end of 2012 is below 28%. Based
on our historical performance, although our GM% is increasing in 2012, it is unlikely that over the
next 3 quarters that our gross margin would well exceed 28% to bring the average to more than 28%.
(i.e. we are at 20% now, would need >28% GM to end year at 28%).
In this case, Andrew would gain control over CTL.
Andrew works for Super, which is a competitor of CTL. Based on the recent news article, Super
gained control of another of its competitors and shut the plant down using isolated equipment failures
as the reasoning. There is a large risk that if Andrew gains control of the company due to the 5%
additional purchase clause, that Andrew would use his control to shut down CTL in order to reduce
competition in the marketplace for Super.
Andrew could also use R&D efforts from CTL to benefit the Super products to further improve that
company's performance.
Recommendation
I recommend that we do not proceed with Andrew's purchase offer. The risk that Super would gain
control and ultimately shut down CTL is high as the company has done so with other trailer
manufacturers it has bought out before. Associating with a competitor to allow them access to our records
and information would also provide them with a competitive advantage which would not help our Board
in its goals to increase market share.
237
Deviation from Strategy
Historically CTL has taken a gradual growth strategy, focusing on builing high quality trailers. These
were developed slowly with lots of testing at every stage of product design and manufacturing to ensure
that customers are satisfied. This would be key in CTL being able to maintain and grow its market share
as this would be its competitive edge in the market. However,with the Yukon product, CTL deviated from
its plan and rushed a new product to market that ended up failing. This has significant impacts on the
company's profitability, but more importantly, it has damaged the company's reputation for producing
high quality products. Consumer confidence would be lower, which in turn would be reflected as a loss in
market share. I recommend that CTL management reconsider its strategy in the market and whether it
wants to proceed as a high-quality manufacturer or change strategy to produce high volume lower quality
products. If you wish to maintain producing high quality products, the controls described above should be
implemented at the design, manufacturing and distribution stages.
238
To: Steve Clarke
From: CA
Subject: Chinook Trailers Ltd (CTL)
We need to accrue a warranty provision since the costs meet the definition of a liability. We
have a duty under the sales agreement to repair defects with the trailers for 2 years, we cannot
avoid this obligation and the sale of the trailers has already occurred.
The amount of warranty provision to be recognized (established by expensing a corresponding
warranty expense) is equal to our best estimate of the warranty work required. In Exhibit B I
have estimated the warranty provision as $262,500. Net income before tax will decrease by the
same amount.
Please note that because this is the first year of the Yukon trailer being produced, we need to be
able to substantiate the engineer's claims that a 5% return rate is reasonable. If there is no
documentation to support this claim we may need to revise the estimate to a 10% return
comparable to the Traditional trailer or an even higher claim to ensure that our provision is
sufficient.
The cost of WIP inventory should include the cost of purchase, costs of conversion and other
direct costs incurred to bring the inventories to their present location and condition. In order to
value the inventory I have calculated the value of labour and materials used in the 7 WIP
trailers at year end, and made a reasonale allocation of overhead costs based on the direct
labour hours used by the trucks. Based on this calculation in Exhibit C, WIP inventory has
been determined as 276,648.
Only overhead costs directly attributable to manufacturing were allocated, such as the COO
time on the plant floor, repairs for plant equipment and utilities used in manufacturing.
There may be alternative ways to allocate overhead costs such as amortization based on the %
equipment used by each truck type, however, based on the information provided such a
detailed allocation was not possible.
Design Stage
To ensure that the design is structurally sound, all designs should be created and reviewed
by certified mechanical engineers. This would reduce the risk that the design does not meet
National Trucking Association (NTA) standards for safety which would result in
significant time wasted in having to redesign the product.
To ensure that the design is technically feasible and does not require specialized equipment
or labour, prior to entering into commercial production, a prototype trailer should be
manufactured on the existing CTL equipment by CTL staff so that specialization issues
(whether equipment or training) can be identified. This would reduce the risk that we find
out during commercial production that staff cannot manufacture the equipment according
239
240
241
242
243
(70 minutes)
Razor’s Edge Laser Cutting Inc. (Razor) is a private company that specializes in metal fabrication. Razor is located in Winnipeg, Manitoba, and reports under International Financial Reporting Standards (IFRS).
The company uses sophisticated computer-operated laser cutting machines to provide precise metal
fabrication to a number of significant customers, particularly the farm equipment manufacturing industry
and both Canadian and US military suppliers. Approximately 40% of its sales are to US customers. Razor
has a June 30 year-end and has been a client of the accounting firm Dion & Garrett (D&G) for a number
of years.
It is now August 20, 2012, and after a series of delays, Razor is now ready for D&G to perform the annual
audit. The chief financial officer, Kris Munroe, wants to proceed quickly because the bank, which
normally requires audited financial statements within 90 days of year-end, has asked if it would be
possible for D&G to complete the audit sooner. Unfortunately, due to the delays, the timing of the audit
now conflicts with the vacation of the staff member in charge of the engagement. As a result, the partner
on the engagement, Lionel Majors, has asked you, CA, to lead the audit. Lionel has provided you with the
notes from his meeting last week with Kris (Exhibit I). He has also provided you with the draft balance
sheet he received from Kris (Exhibit II) and some planning notes that the original staff member in charge
had made (Exhibit III). Finally, he has provided you with excerpts from the banking agreement
(Exhibit IV).
Lionel would like you to discuss the key audit risk areas and the procedures that should be performed in
light of the events of the current year. He would like you to prepare a memo describing any issues,
accounting or otherwise, that would have an impact on the audit. Kris acknowledges that it has been a
very difficult year, but is optimistic about the future and is prepared to provide us with whatever
documentation we require to support her point of view.
244
(continued)
NOTES FROM LIONEL’S MEETING WITH KRIS
Kris: “It has been a difficult year for Razor. Because a high proportion of our sales are in the US, we have suffered along with the US economy. In addition, customers have been slow to pay. Our accounts
receivable greater than 90 days are higher than in the past. One customer in particular, Manley Mann
Farm Equipment (Manley Mann), has caused us difficulties. Manley Mann is one of our key customers
and provides us with steady business. This year, it has begun paying us based on the most recent price of
steel that it has in its system, rather than the price indicated on our invoice. As a result, it has short-paid
our invoices, and we have spent a lot of time tracking the difference. Those small amounts add up, and we
now have $225,000 in the over-180-days category related to Manley Mann.
“You’ll recall that last year, despite a small net loss of $340,000, we supported the recoverable amount of our patent, which has protected our state-of-the-art technology, with a 5-year forecast of profits. We
bought the patent last year for $4 million and have been amortizing it over its 20-year useful life.
However, in recognition of the weak financial results this year, we have recorded a 5% impairment on the
patent of $200,000.
“As a result of new competing technology on the market, we have heard of at least one key customer that has purchased a laser machine and is planning to move its metal fabrication in-house. Our business with
that customer has slowly declined over the year.
“Amidst the departure of both the production supervisor and the inventory manager, we had some issues in June with the laser cutting machines. The machines were off in their cuts by 5 millimetres, which
caused an inordinate amount of accumulated scrap at year-end. The 1,200 tonnes of scrap are in a pile
behind our manufacturing facility and have been recorded in inventory at $800,000. We should be able to
cut down our scrap output significantly when we purchase a new laser cutter in the fall.
“We were offside on our primary financial covenant, that of meeting the minimum current ratio, in the second and third quarter of 2012, but we managed to get back onside for year-end. Taking into account
the anticipated financial performance of the company over the next 12 months, we expect that Razor will
be relatively profitable. We want to ensure the bank gets the financial statements on a timely basis so they
can see the improvement. Timely statements are also important because two of our major suppliers have
expressed an interest in receiving copies of our audited financial statements. These are all important
relationships that we can’t afford to ignore.”
(continued)
DRAFT BALANCE SHEET FOR THE YEAR ENDED JUNE 30, 2012
RAZOR’S EDGE LASER CUTTING INC.
DRAFT BALANCE SHEET
As at June 30
(in thousands of Canadian dollars)
2012
(unaudited)
2011
(audited)
Assets
Current assets
Accounts receivable
Income taxes recoverable
Inventories
Prepaid expenses
$
4,975
425
3,776
200
9,376
4,784
3,400
$
3,565
213
2,766
255
6,799
5,080
3,800
$
17,560
$
15,679
$
432
3,865
3,365
1,585
9,247
4,548
13,795
$
165
2,784
1,730
1,950
6,629
5,219
11,848
Property and equipment
Intangible asset — patent
Liabilities
Current liabilities
Bank overdraft
Trade payables and accrued liabilities
Bank loan
Current portion of long-term debt
Long-term debt
Share capital
Common shares
Preferred shares
Retained earnings (deficit)
Total equity
3,000
2,000
(1,235)
3,765
$
17,560
3,000
–
831
3,831
$
15,679
245
246
(continued)
PLANNING NOTES FROM THE ORIGINAL STAFF MEMBER
IN CHARGE OF THE ENGAGEMENT
Based on planning points from last year’s file, we will not count scrap inventory at year-end because it
represents a relatively insignificant portion of inventory.
We will not bother confirming accounts receivable with Manley Mann this year. We’re assuming it will be impossible to reconcile the confirmation with the client’s records due to the short payment issue.
In preparation for the upcoming audit, I looked up prices for steel and scrap metal and noticed the
following volatility:
Steel
Scrap
Apr
$1,125
$ 560
Price (per tonne)
May
June
$1,050
$980
$ 525
$490
July
$914
$450
Received bank confirmation — interest rate on confirmation is 2% higher than indicated in the banking
agreement. Ask the bank to correct the confirmation.
Kris realized that the US conversion rate had not been updated in Razor’s system for half of the year, and as a result, the company recorded US sales at the same rate throughout that period. Therefore, the
variations in foreign exchange gains/losses may be more significant than last year.
Per Kris, sales this year were $16.4 million, down from $17.2 million in the prior year. She indicated that
Razor’s parent company, Doyle Enterprises, injected $2 million into the company late in the fiscal year. The parent company has indicated that it will not do this again because it wants Razor to be
self-sufficient, and it wants Razor to pay back the $2 million in the next few years. Kris couldn’t seem to find any legal or board documentation on the matter, but decided to record the investment as preferred
shares.
247
(continued)
EXCERPTS FROM THE BANKING AGREEMENT
The Lender shall make available to the Borrower the following forms of financing, up to a combined
maximum of $12 million:
Line of credit — up to $750,000
Demand bank loan — up to $4.25 million
Long-term debt — up to $7 million
The Borrower shall provide to the Lender quarterly internal financial statements and state whether the
loan covenant is met. Audited financial statements shall be provided within 90 days of the year-end.
The Borrower shall maintain a current ratio of 1:1 during the term of this agreement. If the current ratio
falls below this for two successive quarters, the Borrower agrees to not make any major capital purchases
for a minimum of 180 days, unless permission has been obtained from the Lender. If during the term of
this agreement the Borrower fails to meet this covenant for three successive quarters, all debt shall be
payable on demand.
248
In addition, the
when analyzing
Partner
CA
Memo regarding Razor’s Edge (Razor)
Attached is my memo outlining the issues related to Razor. Of primary concern is the fact that Razor
seems to have numerous indicators of a going concern issue. This not only increases our risk for this
audit, but also has implications for our auditor’s report. There are a number of accounting issues present, some directly related to the going concern issue. I have recommended audit procedures that should help
us determine the significance of the going concern issue.
The candidate discusses the potential going concern issue and its impact on the auditor’s report.
Competencies
VI-2.3 – Evaluates the implications of key risks and business issues for the assignment (Level A)
VI-2.5 – Designs appropriate procedures based on the assignment’s scope, risk, and materiality guidelines (Level A)
VI-2.9 – Draws conclusions and drafts a report (Level A)
The information we have provides evidence of a potential going concern issue. Many of these indicators
have come up since our planning but before the year-end work. I think there are enough indicators to
question the validity of the going concern assumption, even before we do any testing. CAS 570 lists a
number of potential indicators of a going concern issue that appear to be applicable to Razor:
1
2
3
4
Net current liability position during the year (and
potentially at year-end after adjustments discussed
below)
Potential withdrawal of support from lender (made
possible by the terms of the banking agreement, but
the bank also seems more anxious than normal to
receive audited financial statements; in addition, based
on the draft financial statements, Razor will shortly be
reaching its maximum borrowing capacity in each
category)
Adverse key financial ratios:
Accounts receivable has increased $1.4 million, or
almost 40%, which is not proportionate to the
4.65% decrease in sales for the year. This
indicates that receivables are becoming more
difficult to collect as indicated by the CFO.
Inventory has increased over $1 million, or almost
37%, from the prior year, indicating an
accumulation of inventory that is not moving (for
example, the increased amount of scrap and work
in progress at year-end).
Bank indebtedness and bank loan have both
increased from the prior year, indicating an
increased reliance on short-term borrowing.
Substantial operating losses (recurring losses for two
years) or significant deterioration in the value of
assets used to generate cash flows (discussed below,
but includes production equipment and patent)
249
We need to review and evaluate
management’s forecast of Razor’s results
We need to see evidence that Razor will
not lose its financing; therefore,
evidence that Razor has
obtained a waiver from the bank;
renegotiated the payment terms
with the bank;
gone to tender on the bank; or
found new investors.
We need to see evidence that Razor has
created an action plan to recover the
receivables; and sold the
accumulated scrap.
Management must prepare a forecast of
Razor’s results, which we will review
and evaluate. The forecast should
include a cost-cutting program, with an
explanation of the assumptions made.
Inquire with management as to whether
they are having difficulty paying their
creditors. Why are the suppliers
interested in seeing their financial
statements?
We need to see evidence that Razor has
obtained a waiver from the bank;
renegotiated the payment terms
with the bank;
gone to tender on the bank;
found new investors; or
prepared a forecast that includes a
plan for passing the ratio in future.
5
Possible inability to pay creditors on due dates
(indicated by increased accounts payable and interest
by two creditors in receiving audited financial
statements)
6
Inability to comply with the terms of loan agreements
(current ratio not met for two consecutive quarters and
likely will not be met in the third quarter)
7
Inability to obtain financing for essential investments We need to see evidence that Razor has
(planning to purchase new equipment, but banking obtained permission from the bank to
250
8
9
10
agreement may prevent Razor from doing so, which upgrade the equipment and software or
could cause it to lose additional customers)
that it has obtained alternative financing
for the equipment.
Loss of certain key management members (production We need to discuss with management
supervisor and inventory manager — it’s not indicated their plan to replace the key employees.
whether they have been replaced yet)
Loss of a key customer (now planning to perform We need to ask whether Razor has a
laser cutting in-house)
plan to find new customers or new
markets to replace old ones.
Parent company has indicated that it will not continue We need to see evidence that the parent
to invest in Razor on a go-forward basis
company has reconsidered and is
willing to invest more. We also need to
assess the parent company’s ability to provide the additional support.
The above indicators strongly suggest a going concern issue. However, if Razor is able to show us
evidence of some of the mitigating factors, then we may be able to conclude that it remains a going
concern.
We should not assess the going concern issue in isolation. We should ask management to perform its own
assessment of the going concern assumption. They may already have done so, considering the bank’s request. Their assessment should extend to at least 12 months from the date of the financial statements, if
it doesn’t already. We should then evaluate and test the assumptions inherent in management’s assessment, and determine if they are reasonable and whether there are mitigating factors. We should also
request representations from management regarding their future plans.
(Most candidates were able to identify the indicators of a potential going concern issue. However,
fewer than half of the candidates explained the implications of these indicators on Razor’s operations
and the going concern assumption. Candidates also struggled to provide procedures that could be
performed to mitigate the going concern issue. Weak candidates zeroed in on only the bank covenant,
recalculating it, identifying that it had been breached, and concluding that the loan would be on
demand. These candidates did not step back to see the bigger picture. They did not perceive this breach
as an indicator of a potential going concern issue, nor did they pick up on the other case facts pointing
to other potential indicators.)
(The Board was disappointed to see that candidates did not address the potential going concern issue in
greater depth. This simulation was specifically designed to include many case facts that should have
raised concerns as to the likelihood of Razor continuing to be a going concern. Sufficient information
was given for the candidates to not only raise these concerns, but also discuss why they might call into
question the going concern assumption and what they, as Razor’s auditor, would need to do and see in order to be able to issue a clean opinion. While most candidates identified a few of the indicators, they
were usually not able to elaborate on the consequences on either the audit or the business itself. Strong
candidates were better able to explain why a particular event or occurrence was a potential indicator of
a going concern issue, but they still struggled to identify what needed to be done from an audit
perspective in order to mitigate the going concern issue.)
251
A going concern issue would have significant implications for the nature of our auditor’s report. If we conclude that the use of the going concern assumption is appropriate, but there is material uncertainty, we
should assess whether the financial statement disclosure adequately describes the contributing factors to
the material uncertainty (for example, the recurring losses, current year deficit, lack of compliance with
bank covenants, et cetera). If we are comfortable that the disclosure is adequate, we can still issue an
unmodified opinion. However, we must add an Emphasis of Matter paragraph to highlight the material
uncertainty and reference the appropriate note disclosure.
If, however, we conclude that the going concern assumption is not appropriate, we might still be able to
express an unmodified opinion on the financial statements. If the financial statements are prepared on an
alternative basis (for example, liquidation basis), and we determine this is an acceptable financial
reporting framework in the circumstances, plus we are able to perform an audit on those financial
statements, we would be able to express an unmodified opinion.
Finally, if we conclude that the going concern assumption is not appropriate and management refuses to
prepare the financial statements using an alternative basis, we must issue an adverse opinion. As noted
above, we will have to obtain management’s assessment and perform specific testing to determine if this
type of report is necessary. We do not have a lot of time to do so, given the bank’s request for earlier statements; therefore, this testing should be a priority.
(Only a few candidates provided an in-depth discussion of the impact of the going concern issue on the
auditor’s report. Some candidates seemed to lack technical knowledge in this area. For example, a few
candidates jumped to the conclusion that a qualified opinion would be necessary or that the balance
sheet must be presented at liquidation value given the uncertainty of the going concern assumption. In
addition, most of the candidates who did address the impact on the auditor’s report only mentioned what they thought the impact would be, without explaining it further or providing different courses of
action, depending on the situation. For example, the impact on the report would be different if there
was a going concern issue and material uncertainty.)
Percent
Awarded
9.4%
competence.
11.4%
Reaching competence — The candidate identifies the potential going concern
issue.
46.8%
Competent — The candidate discusses the potential going concern issue.
31.6%
Highly competent — The candidate thoroughly discusses the going concern
issue.
0.8%
252
(Candidates were not directed to this indicator; however, several hints were provided in the simulation.
First, CA was asked by the partner to “prepare a memo describing any issues, accounting or otherwise, that would have an impact on the audit.” Second, the CFO said that she “acknowledges that it has been a very difficult year, but is optimistic about the future and is prepared to provide us with whatever
documentation we require to support her point of view.” Moreover, Exhibit II of the simulation pointed
to a retained deficit in the draft balance sheet, and a breach of the debt covenant should have been
obvious as a result of the need to make various accounting adjustments. Candidates were expected to
take a step back and understand the audit implications of the threatened going concern assumption.)
(Most candidates successfully identified some of the indicators that showed Razor may no longer be a
going concern. However, most typically jumped straight to a conclusion as to whether or not Razor was
a going concern, without first discussing why these were indicators or what the impact of the indicators
would be on the audit report. Moreover, candidates struggled to provide mitigating steps that the client
could take to support the going concern assumption. The CFO’s comment quoted above should have alerted candidates to the fact that she did not believe Razor had a going concern issue and was
prepared to support her position. There were many steps that candidates could have provided, such as
asking management to provide a forecast of Razor’s results or obtaining a waiver from the bank. Overall, the Board was disappointed with candidates’ performance on this indicator.)
The candidate provides appropriate analysis of the accounting issues.
Competencies
V-2.2 – Develops or evaluates accounting policies in accordance with GAAP (Level A)
V-2.3 – Accounts for the entity’s routine transactions (Level A)
Razor is subject to reporting under IFRS. There are a number of accounting issues, some of which are
indicators of a going concern issue and some of which would be affected by the identification of a going
concern issue. I will start with a discussion of the general accounting issues, then indicate the impact of
the going concern issue on the accounting.
Accounts receivable may be overstated. IAS 39, Paragraph 58, requires an entity to assess at the end of
each reporting period whether there is any objective evidence that a financial asset or group of financial
assets is impaired. There is evidence of impairment given that Manley Mann has started short-paying its
invoices and that, as a result, $225,000 remains on the books for more than 180 days, casting doubt as to
the collectability of the amount. According to Paragraph 63, for assets recorded at amortized cost, the
amount of the impairment loss is measured as the difference between the asset’s carrying amount and the
present value of estimated future cash flows discounted at the financial asset’s original effective interest.
Manley Mann appears to be a key customer, and therefore Razor may not want to risk losing its business
by insisting it pay these short payments. If that’s the case, and Razor has no intention of recovering these
amounts, then accounts receivable are impaired and the Manley Mann balance should be written down by
the full $225,000. If, however, Razor does plan to recover some of this amount, it should estimate the
percentage that it will be able to recover from Manley Mann and record an impairment for the remainder.
253
(Most candidates discussed the collectability of the accounts receivable. However, about half of the
candidates did not provide a complete discussion. These candidates either did not provide case facts to
support their conclusions or did not refer to relevant
guidance. For example, some
candidates concluded the account receivable from Manley Mann should be provisioned for as it was
over 180 days; however, these candidates did not refer to any relevant
guidance or use any
case facts to support their conclusions. Candidates could have referenced the fact that Manley Mann is
short-paying the invoices or that it may be a significant customer and Razor might not want to risk
damaging the relationship by pursuing the matter.)
There are concerns about the valuation of the scrap inventory. Firstly, the amount of scrap inventory is
more significant than in the past (1,200 tonnes at year-end). However, given that it is scrap, an assessment
should be done of the net realizable value in its current form. If Razor cannot realize on the recorded
price, it should be written down to net realizable value according to IAS 2. According to research
previously done, the price for a tonne of scrap steel at year-end was $490. As a result, the total scrap has a
value $588,000 (1,200 tonnes × $490). The scrap was recorded at $800,000 and, therefore, inventory
needs to be written down by $212,000.
Secondly, it is important to note that due to the volatility in the commodity prices, Razor is exposed to
valuation risk with regards to inventory. For example, while the year-end price of scrap metal was $490 a
ton, the price in July had dropped to $450 a ton, which would cause the value of scrap to decrease to
$540,000 if it was still on hand at that point.
(Most candidates identified this accounting issue and provided an in-depth discussion. Typically,
candidates stated that according to IFRS, inventory should be recorded at the lower of cost and net
realizable value, and calculated the writedown required based on the June steel prices. This issue was
generally handled well by candidates.)
It appears that there may be impairment of certain of Razor’s property and equipment and intangible assets. Under IAS 36, management should be considering the laser-cutting machines for impairment,
given the issues Razor has had with offcuts. In addition, the planned purchase of a new laser cutter also
suggests that there is the need for a writedown on current equipment, if there is still an unamortized
balance.
Under IAS 36, the intangible asset related to the patent is likely impaired. The patent is likely impaired
since competition is offering similar technology and Razor has started to lose customers as a result. In
addition, the patented technology is now several years’ old, which may indicate some degree of obsolescence. Therefore, while it was appropriate for management to consider a writedown of the patent,
it appears their evaluation may not have been sufficiently robust. A significant writedown may be
required. After the recognition of an impairment loss, Razor should also reassess the useful life of the
patent.
254
(Approximately half of the candidates identified this issue and provided a good discussion. Weak
candidates who identified this issue did not always use case facts to support their analyses, such as
providing examples of indicators of impairment (for example, the competition starting to offer a similar
technology, the loss of customers, et cetera). Some candidates also appeared to confuse the estimated
useful life of the patent of 20 years with the 5-year forecast of profit provided by management. These
candidates thought that the patent’s useful life was only 5 years. This did not affect most candidates’ responses because they could still provide valid discussions on the concepts the Board was looking for,
but candidates should be aware that a misinterpretation of case facts could, in certain circumstances,
have a negative impact on their response.)
The sales revenue related to US amounts has not been properly recorded. Razor converted the US sales at
the fixed amount recorded in the system. According to IAS 21, the sales should have been recorded at the
exchange rate on the transaction date. While there is no bottom line impact, there will need to be an
adjustment between sales and foreign exchange gain/loss. This may also have an impact on any accounts
receivable at year-end for US customers, which will likely affect the current ratio. Depending on the
volatility of foreign currency, this may or may not be a material adjustment.
(Only a few candidates provided an in-depth discussion of this issue. Some candidates appeared to lack
technical knowledge in this area and, as a result, did not identify the correct issue. For example, some
candidates incorrectly provided a discussion regarding functional currency or foreign operations.)
The capital injection from Razor’s parent company has been recorded as preferred shares, but this is likely not the appropriate treatment. According to IAS 37, Paragraph 10, a liability is a present obligation
of the entity arising from past events, the settlement of which is expected to result in an outflow of
resources embodying economic benefits. Also, according to IAS 32, Paragraph 16, one of the conditions a
financial instrument needs to meet in order to be considered an equity instrument is that the instrument
includes no contractual obligation to deliver cash or another financial asset to an entity. We do not know
whether there is any formal documentation, but we do know that the parent company wants to be repaid
in the next few years. Therefore, there does appear to be an obligation involved with the funds. As a
result, the capital injection should likely be recorded as a liability. Even if documentation for the
transaction is found and it supports the treatment of the capital injection as preferred shares, these would
likely be considered retractable preferred shares given the circumstances, which are classified as a
liability, and therefore the accounting presentation would be the same. If we do conclude that the capital
injection should indeed be recorded as a liability, we need to determine whether a portion should be
shown as current, which would make the current ratio worse.
(Many candidates discussed this issue; however, most of them did not provide complete discussions.
Candidates typically concluded that since the amount will have to be paid back, it should be reclassified
as a liability. However, these candidates did not explain why the preferred shares should be reclassified
because they did not refer to any
guidance to support their conclusions. Candidates are
reminded to always support their discussions and conclusions with the appropriate technical guidance
as well as case facts.)
255
The banking agreement indicates that if Razor is offside on covenants for three consecutive quarters, all
debt becomes current. Since Razor is barely meeting the 1:1 current ratio based on the draft balance sheet,
some of the accounting adjustments discussed above would be enough to put it offside again (see
calculation below). Since Razor has already been offside for two quarters in a row, this would be
sufficient to cause the loans to be demand. As a result, all of the debt would be shown as current, putting
the company further offside and causing further concerns about its ability to continue, assuming Razor did
not receive a waiver by year-end, which is likely. The bank’s request to receive the financial statements earlier may be an indicator of its concern. In addition, the higher interest rate on the bank confirmation
may actually be correct, as an indicator of the additional risk the bank sees. Nonetheless, the breach of
covenants during the year (and at year-end, after adjustments) must be disclosed in the financial
statements in accordance with IFRS 7, paragraphs 18 and 19.
Current assets (as stated)
Less: Scrap writedown
Manley Mann A/R writedown
Current portion of pref shares
9,376
(212)
?
?
9,164
Current liabilities (as stated)
Revised current ratio
9,247
0.99
Most candidates recalculated the debt covenant and concluded it was breached and that, therefore, the
bank loan would need to be reclassified as current.)
In addition to the above specific accounting issues, there is a potential comprehensive impact on
accounting that is dependent on our assessment of the going concern assumption. Overall, if we conclude
that the going concern issues are so significant that the short-term continuation of operations is in
jeopardy, there would be significant implications for the accounting. The current financial statements
were prepared based on the going concern assumption. If we conclude that Razor is no longer a going
concern, we will need to consider whether a different basis of accounting, such as liquidation value, is
more appropriate. The valuation of all assets would need to be reconsidered since the company may not
be able to realize on the anticipated future economic benefits of the assets. Significant writedowns could
be necessary as a result. Liabilities would also have to be reconsidered to determine the appropriate
amounts to record, as well as whether any other unrecorded obligations should be recorded based on the
cessation of operations (for example, site cleanup). The impact on recorded amounts would be significant.
We do not have enough information yet to conclude whether the issues are that significant, but must
determine that relatively quickly, given the implications for recorded amounts.
256
(Most candidates did not address this topic. Candidates who did identify the issue typically discussed it
within their going concern discussion. Most concluded that, should the going concern assumption no
longer hold, the balance sheet would need to be restated at liquidation value.)
Percent
Awarded
0.0%
competence.
6.9%
accounting issues for Razor under IFRS.
34.8%
for Razor under IFRS.
56.9%
Highly competent — The candidate discusses several of the significant
accounting issues for Razor under IFRS.
1.4%
(Candidates were required to identify and discuss accounting issues that would have an impact on the
audit. Candidates were told in the simulation that Razor reports under International Financial
Reporting Standards (IFRS). There were several accounting issues candidates could have discussed.
Most of these accounting issues were relatively non-complex in nature.)
(Most candidates attempted to discuss a sufficient number of accounting issues. Candidates generally
discussed the collectability of accounts receivable, the valuation of scrap inventory, the classification of
the preferred shares, and the potential asset impairment. Most candidates did a good job of discussing
the valuation of inventory. Candidates typically stated that, according to IFRS, inventory should be
recorded at the lower of cost and net realizable value, and noted that, based on recent steel prices, it
appeared that the scrap inventory was overvalued. They then concluded that a writedown was required,
and calculated the amount of the adjustment required. These candidates explained the appropriate
accounting treatment under IFRS and used case facts to support their conclusions. However,
approximately half of the candidates did not provide complete or in-depth discussions on the remaining
accounting issues, and either wrongly concluded or did not provide sufficient support for their
conclusions in the form of case facts or
guidance or both. For example, regarding accounts
receivable, some candidates concluded that the account receivable from Manley Mann should be
provided for since it is over 180 days; however, these candidates did not refer to any relevant
guidance or use any case facts to support their conclusions. Candidates could have
supported their discussions using a variety of case facts. For example, candidates could have referred
to the fact that Manley Mann was short-paying invoices, or that Razor might not want to dispute the
amounts because Manley Mann is a significant customer. Candidates are reminded to always support
the accounting treatments they conclude on with both relevant
guidance and case facts.)
257
The candidate identifies the impact of the accounting issues on the planning and performance of
the audit and suggests additional procedures.
Competencies
VI-2.3 – Evaluates the implications of key risks and business issues for the assignment (Level A)
VI-2.4 – Develops guidelines to set the extent of assurance work, based on the scope and expectations of
the assignment (Level A)
VI-2.5 – Designs appropriate procedures based on the assignment’s scope, risk, and materiality guidelines (Level A)
VI-2.6 – Executes the work plan (Level A)
VI-2.8 – Evaluates the evidence and the results of analysis (Level A)
Given the going concern issues discussed above, the risk of our audit increases substantially, and we
should increase our professional skepticism in performing the audit. The planning for this engagement
has already been done, since I have the planning notes from the previous staff member in charge of the
engagement from June and July, and Razor’s year-end was June 30. It’s now August 20 and you just met
with the CFO last week. We need to wrap up our testing by September 28 (90 days after year-end) if we
are to meet the deadline.
Given the significant loss of $2.066 million (before any audit adjustments) in the current year, we will
need to decide on an appropriate base for materiality other than net income. Revenue may be an
appropriate basis, as it seems more stable from year to year. For example, if we chose to use 1% of
current year revenue of $16.4 million, we could select $164,000 as a basis for materiality. However, given
the use of the financial statements by the bank and the suppliers, we may want to select a more
conservative amount.
There are a number of specific areas that will require some additional testing.
Accounts
receivable
Valuation
Manley Mann
A/R balance
may be
overstated
Given the difficulties in confirming accounts receivable
with Manley Mann (MM), it may be legitimate and more
efficient not to confirm with them. However, we must
then perform alternate procedures, such as agreeing a
sample of the recorded amounts to sales invoices. We
should test outstanding short payments on the MM
account by reviewing old amounts and determining if any
subsequent receipts can validate that the amounts are
ultimately collected, even after 180 days. If there are still
no subsequent payments related to the short payments,
this is indicative of impairment on the amounts. We
should also inquire with management as to their
intentions with regards to the short payments (i.e., do they
intend on pursuing MM or letting them go?).
258
Scrap
inventory
Valuation
Total A/R
balance may be
impaired
Valuation
Foreign A/R
balances may be
incorrect
Scrap balance
may be
overstated
Existence
Valuation
Scrap balance
may be
overstated
Property
and
equipment
Valuation
Equipment may
be impaired
Intangible
assets —
patent
Valuation
Patent may be
impaired
Foreign
exchange
Accuracy
US sales may
be incorrect
Preferred
shares
Classification
Cash injection
from parent
company may
not be recorded
With the significant increase in receivables, we should
examine the aging of accounts receivable and consider
older accounts, looking at subsequent receipts to
determine if they have since been paid and discussing the
accounts with management and possibly obtaining their
analysis, to assess the collectability of these accounts and
whether there is impairment.
We should also determine the impact of the incorrect US
exchange rate used in the second half of the year on the
year-end accounts receivable balances.
Given that the scrap inventory was much higher at yearend than anticipated, we should perform a count of the
scrap, even though it is after year-end. It is likely that
either the scrap has not moved much, or the difference
can be reconciled back to year-end by looking at amounts
sold and shipped subsequent to year-end. In this way, we
can still gain assurance on the quantity of scrap.
To test the valuation, we should try to validate the
recorded value either by considering subsequent sales
amounts, or by agreeing the value to an outside source.
It’s possible that both the counting and the valuation of scrap may require the use of a specialist.
We need to inquire with management as to the reason for
the offcuts. Has the problem been fixed? What are the
chances of it happening again? The offcuts issue is an
indicator of impairment, but we’ll need to gather additional information before concluding on whether
there is a valuation issue.
We should ask management to provide us with their
analysis supporting the valuation of the patent and we
should assess the reasonableness of the primary
assumptions. We may need to engage a valuation
specialist to assist with this. Otherwise, we should
examine the prior year’s 5-year cash flow and compare it
to actual results for the current year. We should then
evaluate whether any recorded impairment is sufficient —
at present, there appears to be a need for a significant
writedown of the patent.
We should ask for a list of all the sales denominated in
US dollars that occurred in the second half of the year.
We should determine the impact of using an improper
exchange rate for these sales and recalculate the amount
of the adjustment. We should also ensure that the issue
was isolated to US sales, since it may have had an impact
on other US-denominated transactions, such as purchases.
We should examine legal correspondence and board
minutes to determine if the preferred shares were properly
issued and documented, or whether a reclassification to
contributed surplus is necessary. If the preferred shares
correctly
Bank
covenants
Disclosure
Bank covenants
are breached
and bank
decides to call
loan
Interest rate
Disclosure
Other —
estimates
(accounts
receivable,
inventory,
and
intangibles)
Valuation
Interest rate
disclosed in
notes may be
incorrect
Some of the
balances for
which
significant
estimates were
made could be
misstated
Subsequent
events
Existence and Significant
disclosure
subsequent
events have
occurred that
have not been
properly been
captured in the
F/S
259
were properly issued, we should examine the features of
the preferred shares to determine the appropriate
classification as liability or equity.
Once we have determined all the required adjustments,
we should recalculate bank covenants, such as the current
ratio, to determine whether they are offside again. If so,
we should ensure the financial disclosure is adequate in
describing the covenant breaches, and ensure that longterm debt is properly presented in accordance with its
nature. We should contact the bank to see if it can
confirm its intentions with regard to calling the debt.
We should clarify the proper interest rate, due to the bank
confirmation discrepancy, and ensure the note disclosure
describes the appropriate interest rate.
CAS 540 requires us to identify all of the areas where
Razor has used significant estimates, to ensure that our
procedures were sufficient. The most significant area that
comes to mind is the estimates management will have to
make in terms of the valuation of Razor’s significant assets: A/R, inventory, and intangible assets. Therefore,
we will need to ensure our procedures on these balances
are sufficient.
We are also required to understand the processes,
including relevant internal controls, used by management
to make accounting estimates. For example, how does
management identify the need for accounting estimates to
be recognized, and how does management calculate
accounting estimates? We also need to determine the
degree of estimation uncertainty associated with each
estimate; that is, the inherent lack of precision in an
estimate’s measurement based on factors such as the extent of judgment involved, the sensitivity to changes in
assumptions, the availability of reliable data, etc. The
greater the degree of estimation uncertainty, the more
room there is for management bias, and as a result, the
greater the risk of material misstatement.
We will also have to determine whether any significant
subsequent events have occurred after year-end that
would require adjustment of or disclosure in the year-end
financial statements. For example, has there been any
communication with the bank? Has the bank provided a
waiver or called the loan? Has Razor been able to
upgrade its equipment and software?
260
(Most candidates were able to discuss the most significant risk areas, those being the collectability of
the accounts receivable from Manley Mann and the existence and valuation of inventory. Strong
candidates consistently provided valid procedures and explained the objectives these procedures would
address. Weak candidates suggested generic or invalid procedures. For example, for accounts
receivable, some candidates suggested calling Manley Mann. This procedure was considered weak
since Razor was already aware that Manly Mann was short-paying it based on the most recent steel
prices. Therefore, calling Manley Mann would not provide any additional information with regards to
the collectability or validity of its accounts receivable balance. Another example of a somewhat weak
procedure candidates suggested was performing an inventory count to test the existence of inventory.
While an inventory count in this case was an appropriate procedure, some candidates failed to
recognize that a rollback would be necessary since it was after year-end.)
(Most candidates identified the risk relating to the valuation of the intangible assets. Candidates
typically recommended obtaining management’s forecast of future cash flows and reviewing management’s assessment and assumptions. Weak candidates recommended comparing the value of
the patent to other patents on the market in a similar industry.)
(Most candidates provided good discussions about preferred shares. These candidates understood the
importance of reviewing the terms of the loan to determine the appropriate classification of the
preferred shares. Weak candidates provided vague procedures, such as discussing the issue with
management or with Razor’s parent company, which would not have covered the risk as well.)
(Most candidates identified the risk associated with the accuracy of the foreign exchange rate used.
However, some of these candidates provided generic procedures, such as selecting a sample of
transactions and verifying the rate used with that of the Bank of Canada. We were already told in the
simulation that the incorrect rate was used; therefore, this procedure did not provide any additional
value.)
(The Board would like to highlight the fact that some candidates did not take into consideration that
part of the audit had already been completed. Although some parts of the audit would have to be
revisited in light of recent events, candidates were not asked to perform the audit planning again from
scratch. Candidates should have focused on the parts of the planning that would be affected by the
changes discussed in the meeting.)
261
Percent
Awarded
0.0%
competence.
3.2%
Reaching competence — The candidate identifies some of the significant audit
issues and attempts to suggest audit procedures to address them.
35.1%
Competent — The candidate discusses some of the significant audit issues and
suggests audit procedures to address them.
60.0%
Highly competent — The candidate discusses several of the significant audit
issues and suggests audit procedures to address them.
1.7%
(In this simulation, candidates were required to discuss key audit risk areas. They were also specifically
asked to provide procedures that should be performed in light of the events of the current year. To
achieve competence, candidates were required to discuss some of the significant audit issues and
suggest audit procedures to address them.)
(Candidates performed well on this indicator. Most were able to discuss the key risk areas and provide
procedures to address them. Most candidates discussed the collectability of accounts receivable, the
existence and valuation of inventory, the classification of the preferred shares, and the valuation of the
intangible assets. Some weak candidates provided procedures that were either generic or vague, such
as “discuss with management” or “obtain support/document.” This seemed to happen most frequently with the asset impairment and preferred shares issues. Strong candidates provided well-thought-out
procedures that addressed the risk related to the significant accounting issues, and clearly explained
why these procedures were necessary. These candidates generally combined this indicator with the
performance and measurement indicator (Primary Indicator #2) by discussing an accounting issue and
then providing procedures to address it. While not necessary, this seemed to help candidates focus on
the key risks.)
III-2.6 Draws conclusion /forms opinions
III-3.3 Decides/recommends/provides advice
III-4.1 Seeks and shares information, facts, and opinions through written discussion
262
(With the exception of the first indicator, candidates performed reasonably well on this simulation.
Most candidates were able to discuss in depth a sufficient number of the IFRS accounting issues.
These candidates used case facts to support their analyses and conclusions. Candidates also did a good
job of identifying the key risk areas and providing valid procedures to mitigate these risks.)
(Where the Board was disappointed was in candidates’ performance on the first indicator. The Board recognizes that this was a different type of indicator, but had hoped candidates would rise to the
occasion. Instead of hiding the going concern issue and having candidates merely identify it, the goal
was to make the going concern issue obvious, given the numerous indicators presented in the case, and
have the candidates discuss the specific indicators and try to explain to the client the next steps (in
other words, what they could do to support the going concern assumption and what the impact may be
on the audit report given the different scenarios). Despite the different approach taken by the Board in
the design of this simulation, some candidates appeared to answer the simulation in a fashion similar
to previous simulations that had a going concern issue; in other words, they did not go beyond
identifying the potential going concern issue. Candidates are reminded to critically analyze the specific
case facts they are given and are cautioned against assuming there is a pattern to all simulations.)
263
To: Lionel Majors
From: CA
Subject: Razor 2012 Audit File
"Preferred Shares"
During 2012, Razor's parent company injected $2m into Razor and indicated that it will not do this again
and it wants Razor to pay back the amount in the next few years. Razor has currently recorded this
amount as preferred shares due to lack of documentation on the cash injection.
This presentation is incorrect as the amount arose from a previous event, it obligates Razor to repay the
parent company at some point in the future and Razor seemingly cannot avoid this obligation (the parent
company intends for Razor to be completely self-sufficient). Thus the amount should be classified as a
liability. Since Razor does not have to repay the debt in the next 12 months, it should have been classified
as a long-term liability.
Impact: Long-term liabilities are understated, equity is overstated.
Scrap Inventory
Currently Razor has 1,200 tonnes of scrap metal on hand. Under IFRS, inventory is measured at the lower
of cost and net realizable value. Currently scrap appears to be recorded at cost.
The year-end scrap metal price at June 30, 2012 was $490/tonne, or $588,000 for the 1,200 tonnes on
hand. The inventory is currently recorded as $800,000. A write-down of inventory needs to be recorded
for the difference in the current period, for $212,000.
Impact: Current assets are overstated.
Foreign Exchange Rates
Due to an error in the system, US sales for half the year were recorded at the wrong exchange rate. The
foreign currency transaction should have been recorded on initial recognition by applying the spot rate on
the date of the transaction. Since 40% of Razor's transactions are with US customers, the foreign
exchange exposure is likely material.
Adjustments may be required to the income statement for foreign currency transactions for the half of the
year where the FX rate was unchanged.
Monetary items at year-end are translated at the year-end spot rate, this would include AR and AP in USD
or other foreign currencies. It is currently unknown whether AP and AR have been properly translated.
264
Impact: Undeterminable.
Bank Loans
When an entity breaches a bank covenant on or before the end of the reporting period so that the loan is
callable, it should be classified as a current liability even if the bank waives the right to call the loan.
Based on the adjustments stated above, Razor would be offside on the 1:1 current ratio requirement for
year-end (Exhibit A). Since this is a breach of the covenant for 3 consecutive quarters, by virtue of the
loan agreement the loans are immediately callable. The long-term debt should be reclassified as a current
liability for the 2012 YE statements.
Even if the company obtains a waiver, because the waiver was obtained after year-end, at year-end, the
covenant was in breach.
Impact on FS: Reclass 4,548K long-term debt as current liability.
Overall Impact
The issues noted above exceed materiality (discussed below). If Razor does not make the requested
changes we would be required to issue a qualified audit opinion for the IFRS departures. The issues
appear to be isloated and do not render the statements useless so I do not believe that there is grounds to
issue an adverse opinion if the changes are not made.
Materiality
In reviewing the planning notes it does not appear that materiality was calculated. In Exhibit B I have
calculated materiality as $15,500 based on 1% adjusted net assets. Although the FS users, the bank,
shareholders and suppliers are interested in Razor's ability to make payments and stay afloat, because
Razor has been in a loss position for 2 years, materiality cannot be determined based on net income
before tax.
We also need to determine a lower threshold of performance materiality to reduce the risk that
uncorrected and undetected errors are not in aggregate, material. This lower threshold should also be used
in our testing of high risk assertions because we believe these to contain more possible
errors/misstatements.
Key Risk Area - AR
This is a key risk area for Razor because AR makes up 53% of total unadjusted current assets, and we
know that due to the US economy issues Razor is having difficulty collecting on its receivables
(significant increase in +90 day and +180 day outstanding receivables).
The previous audit lead noted that it was not worthwhile to confirm the AR amount with Manley
Mann. This customer has had issues with paying invoices as they have paid based on their system
value of metals rather than the invoice amounts. It is not valid to assume that the amount cannot be
reconciled.
We should send an AR confirmation to the customer for the amounts due to Razor.
If there are discrepancies noted between the customer stated amounts and the amounts on Razors
books, we should obtain the invoices sent ot Manley Mann to determine the total AR incurred
265
during the year, and reduce this by the amount of actual payments received from MM based on
the cancelled cheques and/or bank statements. This would allow us to gain comfort over the
amount of AR outstanding.
Due to the general increase in AR, we should send out confirmations to all major/key customers and a
representative sample of other customers to ensure that AR exists.
To verify that AR is appropriately valued, which is an issue due to the significant outstanding and late
payments as a result of customer financial difficulties, we should review subsequent receipts since
year end and determine whether the amounts have been received after-year end. For amounts still
outstanding, we should discuss with Razor whether they believe these amounts are collectible to
assess whether their provision for bad debts is reasonable.
Key Risk Area - Inventory
Inventory is a key risk area because it makes up 39% of unadjusted current assets and the value of steel
and scrap metal is highly volatile. There is a large amount of inventory on hand (thousands of tonnes)
which increases the risk that inventory is misstated due to the volume of product to account for.
Scrap metal at year end was not counted. This was an error by the previous audit lead as they believed
the value of the scrap metal to be insignificant. Based on the amounts originally booked by the client,
scrap metal made up 21% of total inventory, which is significant. The value of inventory is also
material ($588 adjusted, $800 unadjusted, vs $15.5 materiality). Since the scrap metal was not
counted we need to perform an inventory count ASAP and perform roll-back procedures to verify the
amount on hand at year end (trace sales to sales invoices and additions to the scrap pile from
production logs).
The price of metals is highly volatile. Since inventory should be carried at the lower of cost and net
realizable value, we need to compare the NRV at year-end, based on the price of steel and scrap to
cost. To gain comfort over NRV, we should review the sales invoices for steel near year-end to verify
that the steel was sold at above cost. For scrap metals, we should review the sales invoices to scrap
dealers to determine what the NRV of scrap metal would have been. Alternatively we could obtain
third-party market price information from reputable sources.
Key Risk Area - Doyle $2M Injection
The parent company gave Razor $2M to help fund operations. This is a key risk area because it is an
intercompany transaction which lacks supporting legal documentation and it is an unusual, material
transaction.
Since legal and board documentation on the funding is unavailable from Razor, we should contact
Doyle to request documentation of the transaction from their side.
We should verify that the amount received was in fact $2m by tracing the payment receipt in the
Razor bank accounts.
Key Risk - Patent
Razor relies on its patent to protect its state of the art technology on laser cutting processes. This item is
key to their ongoing success. The fact that their customers are now learning to cut metal on their own is
an indication that the patent may be impaired. We need to determine whether a further write-down of the
patent is necessary and that the patent is appropriately valued. The patent should be valued at the lower of
266
fair value less cost to sell and the value in use (future cash flows)
We should obtain Razor's forecast of profits relating to the patent and determine whether the
assumptions therein are reasonable. We should compare the discount rates to Razor's market
borrowing rates for reasonableness. We should discuss with management whether the projections
have been adjusted for losses of sales to key customer who is now cutting their own metals.
Bank Loan & Going Concern
We should advise Razor to contact their bank to discuss being offside on the covenant for 3 consecutive
quarters and to try to obtain a waiver against the bank calling the loan. If the loan is called, Razor does
not have sufficient liquid assets to repay all bank loans. They do not have any cash on hand, a significant
amount of current assets are tied up in potentially uncollectible AR and in inventory that may not be
saleable in a fast enough period of time.
If the bank calls the loan, there is a high risk that Razor will no longer be a going concern.
Since we believe that there is a risk that Razor has a going concern uncertainty we need to discuss the
matter with management and assess whether they have prepared an assessment of Razor's ability to
continue as a going concern. The CEO indiacted that she believes the company to be profitable going
forwards, but we don't know whether this is based on a proper financial analysis.
If an analysis has been performed, we need to determine whether certain events have caused Razor to no
longer be a going concern (e.g. Manley Mann debt unpaid, loss of key customer, US customers unable to
pay), and if so, their plans to address them.
If no analysis has been performed we need to discuss the factors that may have caused the uncertainty
with management.
We would need to perform additional audit procedures:
review the going concern assessment prepared by management including the assumptions built
therein.
evaluate management's plan for future actions and determine whether the plans are feasible,
reasonable and likely to improve the going concern analysis.
obtain written representation of management and the Board regarding their plans for future action and
feasibility of the plans.
If, based on our audit procedures we believe that Razor's going concern uncertainty is material, we would
need to determine whether the FS are fairly stated (e.g. liquidation approach vs. ongoing operations), and
need to include this in the emphasis of matter paragraph.
The bank and 2 suppliers requesting audited financial statements in a shorter timeframe is further support
that these external presons believe that Razor may not be a going concern.
The fact that key customers are learning to produce their own laser cut metals is also an indication that the
market is declining.
267
268
(80 minutes)
It is September 15, 2012, and you, CA, are entering a meeting with your long-time tax client Ron Funky.
Ron has brought along Paul Van Bakel for a meeting about the future of Funky Town Tire Ltd. (Funky
Tire).
Ron tells you, “I have owned and operated Funky Tire for close to 30 years. I have decided that it is time to retire and sell the business to Paul. As you know, CA, I sold Paul some common shares of Funky Tire a
few years back.” Paul: “I went online this weekend and read a little bit about acquiring and selling a business. I took some notes (Exhibit I), but to be honest I don’t really understand it all, so it would be helpful if you could address the points I’ve raised. Ron and I each consulted our own legal advisors on the option of transferring assets, and we agreed not to pursue it. Our advisors confirmed that selling assets would result
in a large tax liability for Funky Tire, so we are only interested in your thoughts on selling or redeeming
shares.”
Ron: “Paul has been a long-time employee, and is almost like a son to me. I’m interested in maximizing my after-tax return on investment, but I want to make sure I am being fair to Paul. I’m ready to start enjoying life.
“Here are excerpts from the valuation report (Exhibit II) that we had done for the purposes of the buyout. We have agreed to use the financial statements and valuation report as of June 30, 2012. I brought along
the internal financial statements from last year so you know what is behind the valuation report, as well as
some notes from my wife, Sharon, our bookkeeper, that she thought might be useful (Exhibit III). Paul
and I would like you to outline our alternatives for the buyout, while assessing Paul’s ability to finance the buyout and considering the tax consequences.
“It isn’t essential, but if there is a way to gift or sell shares to Sharon so that she can report some of the
income from the sale, I think it would be beneficial to us as a family from a tax point of view.”
Paul: “In my case, my wife, Wanda, is not earning much money. I plan to pay her a salary, but is there anything else I can do from a tax perspective? I also have two children aged 14 and 15. Like Ron, I don’t think this is a priority, but if you have suggestions, great.
“Can I ask you for one last thing, CA? As you know, Sharon has been doing the bookkeeping for years, and has decided to leave when Ron does. I would like Funky Tire’s accounting to be in accordance with Canadian Accounting Standards for Private Enterprises (ASPE) when I become the owner. Can you
please provide your views on any accounting policies that I would need to adjust or implement?”
You agree to help Ron and Paul, and to get back to them with a discussion of any engagement issues,
including possible conflicts of interest and how you will manage them, and to provide suggestions for
additional services that would be useful to Ron and Paul.
269
(continued)
PAUL’S NOTES ON BUYING AND SELLING BUSINESSES
For a buyer:
A business is generally financed through debt and equity. The total of your debt and equity equals the
assets you are buying. Too much debt can bankrupt your business.
Interest and salaries are deductible for tax purposes.
Some buyers take advantage of acquiring a business through a “holding company.”
For a seller:
Sellers want to get their cash as quickly as possible.
They can get special tax treatment on capital gains (all the time?).
These are my personal thoughts:
I have about $150,000 in savings from investments. Since the company is valued at $1 million, I will need
to borrow the rest. My home is worth about $450,000, on which I currently have a mortgage of $250,000,
and I have another $275,000 in my RRSP. Maybe I can use some of that? I read that banks can lend up to
75% of the appraised value of real estate used in a business and 95% of the appraised value of a home.
Could I borrow some of what I need from the company itself?
I gather that I can pay the vendor (Ron) directly or invest in a holding company that pays the vendor, and
that sometimes the vendor is paid from the cash flow of the company, either from the holding company or
the operating company. I think that is called “vendor take-back” financing. Could we explore something like that?
270
(continued)
EXCERPTS FROM VALUATION REPORT
JUNE 30, 2012
Funky Tire is a tire shop located near the downtown core of a city with a population of approximately
150,000. Funky Tire sells, installs, inspects, and repairs tires. Funky Tire sold 37,548 tires in its most
recent fiscal year. It has two tow trucks for providing off-site service. The garage is in good condition,
with no structural defects, and the location is well suited for the business. Funky Tire has operated in the
same location for decades, and the business has a good reputation.
Ron Funky owns 75 issued and outstanding common voting shares. Ron originally inherited 100 shares
from his father, Rick Funky, when Rick passed away in 1982. At the time, the common shares had
nominal value. Ron later sold 25 of his 100 shares to Paul.
Paul Van Bakel owns 25 issued and outstanding common shares. He purchased those shares in 2004 from
Ron for $50,000. Ron used his capital gains exemption on the sale.
The common shares have a paid-up capital of $100 in aggregate.
The value of Funky Tire’s equity is $1 million. It is the midpoint in the range of values that we considered
appropriate in our valuation work.
The working capital is, in our view, close to the norm for this type of business.
271
(continued)
NOTES FROM SHARON’S FINANCIAL STATEMENT FILE
Revenue
Cost of sales
Gross margin
Expenses
Salaries and wages (1)
Amortization
Other operating costs (2)
Income before tax
Income tax
Net income
$
3,492
2,400
1,092
534
95
182
$
281
71
210
(1) Management salaries: $150,000 per year paid to Ron Funky; $100,000 per year paid to Paul Van
Bakel.
(2) Includes interest expense of $14,000 annually.
The fair market value of the assets and liabilities of Funky Tire at June 30 (excerpts from the valuator’s report):
$
Accounts receivable
28,369
Inventory
133,815
Tools and equipment
176,200
Land and building
485,000
Bank overdraft
Accounts payable
Long-term debt (mortgage)
63,816
15,321
200,000
The bank overdraft has an interest rate of 7% and is secured by a general security agreement over the
assets of the company and a shareholder guarantee from Ron Funky. The maximum amount that can be
overdrawn is $100,000. There are 15 years of payments remaining on the mortgage, and the interest rate
is 4%.
272
(continued)
NOTES FROM SHARON’S FINANCIAL STATEMENT FILE
When Funky Tire removes old tires and installs new ones, it charges an “environmental handling” fee of $3 per tire. We remit this fee quarterly — on the last day of the months of January, April, July, and
October — to the provincial government, which uses the fees to recycle tires. When we receive the fee
from the customer, I book it to revenue. Then, when I pay the fee to the government each quarter, I charge
the payment to cost of sales.
One of our contracts with a courier company has a take-or-pay provision. This provision requires the
courier company to purchase a minimum number of tires each year to cover our risk of carrying excess
inventory. Each year on January 1, I set up a sale and an account receivable for the contract amount, and I
draw down the receivable during the year as they pay us. They usually use the minimum number of tires
by the end of October, so for the rest of the year I just invoice them as they purchase tires. As of June 30,
they are still drawing on the account receivable that I set up on January 1, 2012.
Traditionally, when we rotate tires or install new tires, we balance them using a machine that spins the tire
after it has been installed on the rim. The process requires the technician to install small pieces of metal
on the rim if the tire is not balanced properly. We just bought two new machines that make the old
process less efficient. We’ll only use the old machines when we are busy and can justify the extra time it will take.
We purchased our old machines back in 2003, and they had an estimated useful life of 15 years. They will
still last for another 5 years, I figure, so we can keep them on the books at their current book value.
Paul is going to sign a deal allowing Funky Tire to sell old tires for $5 each to a company that uses tires to
produce synthetic turf products for use in soccer and football fields. I told Paul he should set all the old
tires up as inventory, but Paul says that because we didn’t pay for them, there is no cost to account for. Any used tires with remaining tread life are resaleable and therefore have some value. The remainder are
worthless to us.
Paul is going to offer storage services. We have extra space in our garage where we can store customers’ winter and summer tires during the off-seasons. He is thinking of charging $20 per month for storage.
Customers who use the storage services will receive their tire changes for free.
273
In addition, the
when analyzing
.
To: Ron and Paul
From: CA
Subject: Various requests for assistance
Gentlemen,
First, I will address the engagement issues related to the work you have both requested, highlight the
possible conflicts of interest, and suggest how the conflicts of interest can best be handled. Then,
presuming you will accept the proposed terms of engagement for the share purchase work, I will address
the details of the share purchase itself, outline the possible financing options, and discuss the tax
implications. In addition, I have addressed Paul’s request with respect to ASPE compliance. I have also addressed your questions about splitting income with your wives, recognizing that it isn’t a key concern for either of you.
The candidate discusses engagement issues related to the work being requested, including
potential conflicts of interest, and suggests ways to manage them, while considering useful
additional services that could be provided to Ron and Paul.
Competencies
VI – 2.1 Considers issues related to accepting an assignment (Level A)
I agreed to get back to you both with a discussion of any engagement issues, including possible conflicts
of interest and how I propose to manage them, and to provide suggestions for additional assurance
services that would be useful to both of you.
274
First, let me explain that I see two distinct engagements.
I propose treating the accounting policies request (compliance with Accounting Standards for Private
Enterprise (ASPE) for the opening financial statements following the share purchase) as a separate
engagement since it is not related to the advice being sought with respect to the share purchase. This
engagement is with Paul only since the request is for Funky Town Tire’s (Funky Tire’s) accounting after the share purchase is completed. I will require a signed engagement letter from you, Paul, to
confirm the work to be performed. I am not expressing an audit opinion or other conclusion conveying
assurance. I am simply providing my view on where Funky Tire’s current policies and proposed treatments align with the requirements of ASPE.
(Note: Paul, if you decide you want a higher level of comfort regarding whether the application of a
specific ASPE accounting policy used by Funky Tire is consistent with the requirements of ASPE, the
engagement would likely fall in the category of being an assurance engagement, and I would follow
the requirements and guidance set out in Section 5025, Standards for Assurance Engagements.)
(Even though most candidates discussed the application of ASPE to Funky Tire’s current and future operations and plans, most candidates did not consider whether it was a separate engagement and as a
result did not even raise the issue with Ron and Paul.)
The second engagement is directly related to the purchase agreement and is with both of you. There is
a potential conflict in trying to serve both of your needs (see below). You need to consider this
potential conflict and how I propose to manage it. I will only proceed with the work if you accept
these terms. An engagement letter will clearly state that I am not providing any form of assurance
related to the suggested financing and tax planning.
Buyout Potential Conflict
Together, you have requested an outline of the options for the buyout of Ron’s shares in Funky Tire. In preparing this report, I will be acting for both sides of the transaction (the buyer and seller), which
could create a conflict of interest for me. There is a conflict because some suggestions I make in the
report may benefit Paul without benefitting Ron, such as deferring some of the proceeds on the sale.
Each of you appears to accept that I am acting on behalf of both of you, since the request was jointly
made. My suggestions are prepared on the basis of providing a fair result to both of you. To the extent
possible, I will choose options that are mutually beneficial. Where there may be competing interests, I
will attempt to balance the interests to remain fair. If this isn’t possible, the advantage created for whichever party is affected will be fully disclosed to both of you.
275
Additional steps can be taken to protect against the potential conflict, should you wish. You are both
free to seek independent advice on the transactions I am proposing (and I will encourage you to do so)
to ensure that I have acted in a “fair” manner, as I have been instructed to do.
I will also seek a written acknowledgement from both of you that states that you have engaged me to
do this work with full knowledge of the potential conflict of interest.
(Most candidates discussed this issue in sufficient depth and provided a valid recommendation to
mitigate the conflict. However, some candidates recognized the conflicting objectives of Ron and Paul
with regards to the share purchase transaction and discussed their conflict without recognizing its
impact on CA.)
Preparation of the Financial Statements Used in the Valuation
Paul, you should know that a potential bias could exist in the financial statements. Ron’s wife, Sharon, prepared the financial statements that were used for the valuation performed in June. It is possible that
she accounted for transactions in a way that would benefit Ron.
Paul, you may wish to include a clause in the purchase agreement that allows for the June 30 financial
statements that were used for the valuation to be audited, as well as for an adjustment to be applied to
the purchase price should there be differences identified. Having the financial statements audited
might provide some assurance over the book value of the business’s assets and liabilities, and may identify possible contingencies. Arrangements can be made for our firm to complete the audit;
however, I will need to ensure the staff doing the work is independent from those of us providing you
with tax and other advisory services. You may not think that a full audit is necessary since you are
already a shareholder who is involved in the operations, and would therefore be aware of the financial
assets, liabilities, and general risks. However, the audit may provide additional comfort to you before
you take over the business. You should be aware of the fact that there would be some limitations to
doing an audit because some of the opening balances, like inventory, could not be verified.
Another option is to perform due diligence procedures related to the purchase of the shares and based
on the terms of the shareholder agreement. Again, independent staff would be used for this work,
which would entail performing a list of specific procedures that focus on the risk areas when buying
100% of the shares of a company. In the case of Funky Tire, work would likely be done on
environmental liability risk, for example, since the business likely handles grease and other
environmental contaminants.
(Many candidates identified that due diligence procedures could be performed on the June 30 financial
statements. However, most of them did not discuss this matter further. Most candidates only stated the
need for due diligence procedures without any explanation of the objective of such procedures or how
the purchase price could be affected as a result of the work. In addition, only a few candidates
identified the potential conflict that existed as a result of Ron’s wife preparing the financial statements used to value the shares of Funky Tire.)
276
Third-Party Reliance and Impact of ASPE Adjustment on Valuation
I have relied on the valuation report for the values used in my discussion of the buyout alternatives.
Since I was not engaged to value Funky Tire, I have not attempted to do so in my work.
After determining the magnitude of the adjustments with respect to the ASPE engagement, you both
may wish to communicate with the valuator to allow him or her to determine if the valuation would
change given the new information.
(Even though most candidates provided in-depth analyses of the impact of adopting the ASPE
standards on Funky Tire’s financial statements (Primary Indicator #4), only a few candidates demonstrated integration within their response by raising concerns that the valuation could be affected
by the accounting adjustments they had recommended.)
Percent
Awarded
14.8%
competence.
33.1%
Reaching competence — The candidate attempts to describe one of the
potential conflicts of interest or addresses the need for two separate
engagements.
30.0%
Competent — The candidate discusses some of the engagement issues related
to the work being requested, clearly describes the potential conflict of interest
related to the purchase agreement, and provides suggestions to address one of
the conflicts discussed.
22.1%
Highly competent — The candidate thoroughly discusses the engagement
issues related to the work being requested, clearly describes the potential conflict
of interest related to the purchase agreement, and provides suggestions for useful
additional services to address the conflict.
0.0%
(Candidates were directed to this indicator since the simulation stated that CA agreed to discuss “any engagement issues, including possible conflicts of interest and how you will manage them.” As well, candidates were asked to provide suggestions for additional services that would be useful given the
circumstances.)
277
(Candidates were expected to discuss the conflicts that could result from providing advice on the
purchase and sale transaction to both Ron and Paul, or the requirement to provide services under two
separate engagements (ASPE for Funky Tire, and advice for Paul and Ron on purchase and sale of
Funky). Most candidates did not recognize that two separate engagements should be conducted.
Candidates also struggled to identify the conflict resulting from the fact that they were asked to provide
advice to both the purchaser and the vendor, and struggled to recommend ways to resolve that conflict.
Many candidates provided guidance on the additional services that could be provided with respect to
the transaction, such as special audit or due diligence services. Strong candidates were able to not only
identify CA’s conflict, but also provide a recommendation to solve it. Weak candidates either did not recognize the nature of the conflict or were unable to provide a valid mitigating resolution. Many did
not see the big picture — they recognized that there was a conflict between Ron’s objectives and Paul’s objectives, but did not realize that their differing objectives created a conflict for CA.)
The candidate determines the amount of financing needed and discusses the potential sources
of financing for the proposed transaction.
Competencies
VII – 1.3 Identifies ways in which ownership can change (Level B)
VII – 2.1 Monitors cash flow (Level A)
VII – 2.3 Identifies the role of short-term, medium-term, long-term, and project financing (Level B)
VII – 2.4 Identifies and evaluates sources of funds (Level B)
VII – 3 Develops or analyzes business plans and financial proposals (Level B)
The value of the equity in Funky Tire is $1.0 million based on the valuation report. Since Ron owns
75 common shares (which is 75% of all the common shares), he will receive $750,000 from the sale of his
shares (75% × $1,000,000). The total amount that must be paid to Ron is, therefore, $750,000.
Personal Funds
Paul, you have identified some potential sources of funds for the purchase of the shares. You have
$150,000 of cash savings available to make the purchase. You also have equity in your home. If you
remortgage your home, based on the fact that the financial institutions are prepared to lend up to 95% of
its appraised value, $427,500 would be available (95% × $450,000). Since you currently have a mortgage
of $250,000, you could borrow an additional $177,500 against your home.
278
You also have an RRSP worth $275,000. If you withdraw the funds from the RRSP, you will incur a large
tax liability (approximately 40% of the value, or $110,000). Therefore, I would suggest not using your
RRSP to fund the purchase of Funky Tire.
(Most candidates provided a reasonable analysis of these personal sources of funds. However, many
candidates did not recognize that Paul’s house was already mortgaged or that income taxes would be payable upon the withdrawal of the RRSP investments, thereby resulting in them overestimating the
true amount of funds available from those sources. Candidates should ensure that they consider the
impact of current borrowings and income tax costs when including an asset in their analysis.)
Corporate Funds
Funky Tire has some financing room available to it. The bank overdraft has additional room of $36,184
($100,000 less the $63,816 that is currently drawn). However, using the full line of credit to fund the
purchase of Ron’s shares does not seem like a great idea. The funds are supposed to be available as working capital for the business. The valuator’s report indicates that, at the current draw of $63,816, the
working capital is within industry norms. Therefore, I would not suggest using the line of credit to fund
the buyout.
Also, there is additional room to borrow against the land and building owned by Funky Tire. It can be
financed up to 75% of its value, or $363,750 (75% × $485,000). The current mortgage is $200,000 on the
asset. Thus, additional mortgage financing of $163,750 can be drawn.
(Most candidates included the financing available through the corporate assets into their analyses.
However, many of those candidates did not take into account the current borrowings that encumbered
these assets or did not consider that this additional borrowing could put some strain on the company’s financial performance.)
Total Funds Available
Total funds available to Paul are $327,500 ($150,000 savings + $177,500 on house) of personal funds and
$163,750 (additional mortgage) of corporate funds. For purposes of this discussion, I will round that total
to $490,000. That means that an additional $260,000 ($750,000 less $490,000) must be raised.
(Most candidates calculated the financing shortfall, whether it was within their narrative discussion or
in a separate spreadsheet analysis. However, candidates who performed a separate spreadsheet
calculation generally had a more complete analysis because they were more likely to consider the
current borrowings encumbering the assets and the income tax costs of withdrawing funds from an
RRSP.)
279
Term (for Vendor Take Back)
Paul raised the potential of vendor take-back financing. This seems like a good compromise as a way to
raise the additional required funds. Ron would receive $490,000 up front and finance the remaining
$260,000. To be fair, Ron should be compensated for this financing through, for example, a reasonable
interest payment.
Income (from f/s)
$211,000
Add back: Amortization
95,000
Operating cash flows from business
306,000
Ron salary of $150,000 — assume replaced by someone else at lower salary
Assume $50,000 less (i.e., same as Paul’s old salary of $100,000)
50,000
Capital replacement (assumed about half of amortization)
(50,000)
Incremental debt servicing costs on extra mortgage of $163,750 @ 4%
(6,550)
($550 per month in additional interest)
Paul needs $15,000 to pay his additional mortgage payments
(25,000)
(on amount borrowed to purchase shares) — before-tax amount is
$25,000
Estimated cash flows after financing costs
A three-year payout on amount owed to Ron of $260,000
Plus interest (need to determine rate with Ron)
Overall leaves free cash in business of approximately $190,000
$274,450
(86,667)
?
$187,783
You both should ensure that Ron’s personal guarantee on Funky Tire’s debt is removed.
(Most candidates did not provide an adjusted cash flow analysis using the excerpt from Funky Tire’s June 30 income statement. Candidates generally jumped from the discussion of the financing shortfall
to identifying a source of financing without considering cash flows generated by Paul and Funky
Tire.)
280
Percent
Awarded
0.8%
competence.
21.6%
Reaching competence — The candidate attempts to calculate the financing
shortfall and identifies a potential source of financing.
37.2%
Competent — The candidate calculates the amount of the financing shortfall and
discusses a potential source of financing.
40.3%
Highly competent — The candidate calculates the amount of the financing
shortfall and determines a potential source of financing and the terms of a
potential vendor take-back with Ron.
0.1%
(Candidates were expected to provide Ron and Paul with alternatives for structuring the buyout, as
well as assess Paul’s ability to finance the buyout (for which information on Paul’s personal assets was provided).)
(Most candidates were able to compute the financial shortfall that Paul would experience as a result of
acquiring Ron’s shares once he had used all of his personal financial resources. However, many candidates struggled with the structure that Paul and Ron should use to proceed with the actual
buyout. The majority of candidates were not able to provide reasonable discussions of the vendor takeback option specifically mentioned in the case, or at least recognize that Funky Tire’s cash flows could be used to service the balance of sale. Instead, many candidates mentioned only that Paul should
consider borrowing from the bank, not recognizing that the available personal and corporate
guarantees to proceed that way might be insufficient. Strong candidates attempted reasonable
calculations of the shortfall and provided qualitative discussions with respect to the reasons for either
not withdrawing from the RRSP (substantial tax liability) or not re-mortgaging the house (increased
risk of losing personal assets).)
The candidate discusses the significant taxation issues associated with the proposed
transaction.
Competencies
IX – 3.2 Identifies, analyzes, and advises on specific tax-planning opportunities for shareholders of
closely held corporations (Level B)
IX – 3.5 Identifies, analyzes, and advises on tax consequences or planning opportunities associated with
certain corporate transactions (Level B)
281
Both of you have requested advice on taxation and the structure of the deal. There are several options, and
they very much depend on the method of financing chosen. The tax implications flow from the option
chosen.
If you, Paul, borrow the funds directly from Funky Tire, you will ultimately be taxed on the funds
received, either as a dividend or salary, both of which create a significant tax liability. Such a loan would
generally be considered as a loan provided as a result of being a shareholder of Funky Tire (not as an
employee), and as such would have to be reimbursed before the end of the taxation year following the
year during which the loan was granted. The exception from treasury shares would not apply because the
shares are acquired from another shareholder. As well, interest would have to be paid on the loan,
otherwise deemed interest would be included in your income for the period the loan was outstanding.
Currently, the deemed interest is computed as 1% of the amount outstanding. However, this deemed
interest should be deductible pursuant to Section 20(1)(c) of the Income Tax Act (ITA) in computing your
taxable income because it is incurred for the purposes of earning income.
If you, Paul, were able to borrow funds personally from a financial institution, you would be allowed to
deduct the interest when computing your taxable income on your personal tax return. As with the interest
incurred on funds borrowed from Funky Tire, as mentioned above, this deduction is in accordance with
ITA Section 20(1)(c) since the funds would be borrowed for the purposes of earning income.
For the portion of the purchase of the shares that you are unable to fund, Funky could redeem Ron’s shares equivalent to that amount. If the amount paid for such shares is greater than the paid-up capital of
the shares, the redemption of such shares (see ITA Section 84(3)) would generate a deemed dividend to
Ron. He will want to avoid this situation because he can otherwise use the unused portion of his lifetime
capital gains deduction upon a direct sale of his shares and substantially reduce his income tax liability.
Through the use of a holding company (Holdco), Ron’s shares can be acquired with minimal personal tax impact for both of you. Paul would establish a Holdco and subscribe to common shares at a nominal
value. Paul would then lend personal funds to Holdco to acquire the shares from Ron. The money he
would need to borrow from Funky could then either be paid to Holdco via a tax-free inter-company
dividend or be lent on an interest-free basis. Unlike the loans from a company to an individual
shareholder, loans to a corporate shareholder are generally not subject under the ITA to any repayment
requirement or deemed interest.
282
(Even though most candidates were able to identify at least one valid source of financing (such as bank
financing or a vendor take-back), they generally struggled when it came to discussing the tax
implications of the purchase structure for either Ron or Paul. Most often, candidates commented on
the deductibility of interest incurred to earn income, but did not tie that comment into any specific
simulation facts or to their recommendations. Strong candidates were able to recognize the benefits of
setting up a Holdco and appropriately discussed such benefits (Funky Tire’s current borrowing
capacity and future cash flows could be used to finance the acquisition).)
Tax Implications for Ron (Selling Shares)
Regardless of the combination or permutation, there are a limited number of possible tax consequences to
consider for you, Ron, since you do not have any significant ACB in your common shares. From the
financial information provided with the valuation report, it appears as though more than 90% of the fair
market value of Funky Tire’s assets are used in an active business in Canada. If, throughout the
immediately preceding 24 months, more than 50% of the FMV of its assets were used in an active
business in Canada, and if Ron has held those shares throughout that period of time, they should qualify
for the lifetime capital gains exemption when sold.
(Most candidates demonstrated that they had a good understanding of the Qualified Small Business
shares rules and provided an appropriate conclusion to their analysis.)
If Funky Tire redeems the common shares from Ron, this will generate a deemed dividend for tax
purposes, which would result in a significant income tax liability. So, Ron, as discussed below, you will
want to sell them to Paul or Holdco.
If the shares are sold, Paul or Holdco will pay Ron the initial $490,000 instalment (the rounded amount)
on the sale. For the remaining $260,000, Ron, you could take a note payable from the ultimate purchaser.
By taking a note, you will be able to defer the capital gain on the share sale until the time the proceeds are
due on the note (bear in mind the requirement to take into income a minimum of one fifth per year). Ron,
you need to consider that you already used some of your lifetime capital gains exemption in 2004 when
you sold 25 common shares to Paul for $50,000. Therefore, you should have $700,000 in capital gains
exemption available. This will allow you to shelter most of the taxable capital gain that would be realized
upon the sale of your shares. Ron, you should consider taking security on the note receivable from
Holdco, likely in common shares of Funky Tire, so that if you are not repaid you can take back the shares.
(Most candidates discussed only how Ron could use the unused portion of his lifetime capital gains
deduction upon the sale of shares, and did not consider other ways for Ron to dispose of his shares.
While the use of the lifetime capital gains deduction might be the better tax plan, candidates should
remember that they should consider all valid alternatives before ultimately concluding on the best
approach for the client.)
283
Tax Implications for Paul
Paul, you indicated you will have available $327,500 of personal financing to purchase Ron’s shares. Funky Tire has $163,750 that will also be immediately available to purchase Ron’s shares. However, if Funky Tire pays that amount directly to Ron, he will get a deemed dividend treatment, which he wants to
avoid since it is generally taxed at a slightly higher income tax rate compared to a capital gain.
Alternatively, if it is paid to Paul who then pays Ron, Paul, you will either receive a dividend or a
shareholder loan, both of which will have negative tax implications. The solution is for Paul to
incorporate Holdco. Holdco would be the acquirer of Ron’s shares. This would give Ron the tax result that he wants (in other words, outright sale of shares).
To get the personal funds into Holdco, Paul, you can subscribe for fully paid shares of Holdco with your
$327,500 or loan the funds to Holdco. Either way, you will be able to withdraw the $327,500 tax free
when Holdco has enough funds (paid from Funky Tire) to pay you — likely through the payout of intercompany dividends.
Note that if Paul is the one who borrows some of the funds personally to lend them to Holdco, the interest
would be tax deductible since it is being incurred to generate investment income.
Tax Implications for Holdco
To get the Funky Tire funds into Holdco, Funky Tire can either lend the funds to Holdco or pay a
dividend to Holdco. Because Funky Tire and Holdco would be connected corporations (Holdco would
own more than 10% of Funky Tire’s voting shares) at the time the dividend is paid, the dividend would be deductible from Holdco’s income as an inter-company dividend and Holdco would receive it tax free.
Ron and Paul will want to consult with their financial institution before paying any dividends out of
Funky Tire, since a dividend would reduce the corporation’s retained earnings and assets, resulting in reduced value and reduced security for the bank’s loans.
After the above transactions, Holdco would own 75% of the common shares of Funky Tire. Paul already
owns the other 25% of the common shares. Also, there is a way of getting 100% of the shares in Holdco
by doing a Section 85 rollover of the shares owned by Paul. The interest, if any, paid on the note payable
to Ron would be deductible in computing Holdco’s income, but Holdco would have no taxable income because the business would continue to be in Funky Tire. To match the interest deduction with taxable
income, Holdco and Funky Tire could be merged on a tax-free basis through an amalgamation under
Section 87 of the ITA.
Tax Implications for Funky Tire
The acquisition of Funky Tire by Paul’s Holdco will represent an acquisition of control for tax purposes. This will result in a deemed tax year-end for Funky Tire. In addition, if the amalgamation mentioned
above is completed, another tax year-end will result. It may be beneficial to time the transactions to occur
on the same day and also for the transactions to occur on a month-end date to ease the preparation of the
tax return for the period from July 1 to the closing date of the acquisition. The acquisition of control rules
will have no other material impact on Funky Tire since it does not have losses or other items that are
affected by those rules.
284
(Many candidates discussed the creation of a Holdco in the context of buying out Ron’s shares, but most of them did not provide the mechanics for Paul to fund the Holdco (for example, subscribe to
shares or loan funds, and also pay dividends from Funky Tire) and the tax implications of these
various transactions and operations.)
Percent
Awarded
0.1%
competence.
41.0%
Reaching competence — The candidate discusses some of the tax issues
associated with the proposed transaction (such as capital gain deferral, interest
deductibility, and taxation of withdrawals).
30.2%
Competent — The candidate discusses the deemed dividend or the usefulness
of a holding corporation.
28.0%
Highly competent — The candidate discusses the deemed dividend and the
usefulness of a holding corporation, and makes a recommendation (understands
the mechanics of the Holdco option).
0.7%
(Candidates were asked to consider the tax consequences that would apply to both Paul and Ron as a
result of the buyout.)
(Most candidates were able to discuss the generic tax implications of the transaction, namely that Ron
would realize a capital gain if he sold his shares and that he could use his lifetime capital gains
deduction (LCGD) to shelter part of that gain. As well, most candidates recognized that Paul would be
able to deduct interest that would be incurred to earn income, but did not necessarily tie their
discussions to the specific case facts. However, most candidates were not able to discuss some of the
more significant tax issues, such as the impact of having Ron’s shares redeemed by Funky Tire (deemed dividend) or the use of a holding company to proceed with the transaction. Strong candidates
were able to discuss these more complex issues as well as recognize the tax impact of withdrawing
funds from the RRSP and the deductibility of the interest in the context of the acquisition of Ron’s shares. Some also recognized that Ron could defer the taxation of his capital gain if he received his
proceeds over time. Weak candidates simply mentioned that RRSP withdrawals are taxable, and
typically committed errors in computing the capital gain or the available LCGD.)
The candidate discusses some of the accounting policies that would be required for the Funky
Tire financial statements to be in accordance with ASPE.
285
Competencies
V – 2.4 Accounts for the entity’s non-routine transactions (Level B)
Paul, you asked me to let you know of any accounting policy adjustments that would be required to
ensure that Funky Tire’s opening financial statements, following your acquisition of Ron’s shares, would be in accordance with Canadian Accounting Standards for Private Enterprises (ASPE).
I have looked over the June 2012 financial statements prepared by Sharon, along with the additional notes
and information she provided. I’ve noted that the following items are potentially not in compliance with ASPE. Further work or information is required in some cases to make a firm conclusion.
Government Fee on Tires
An environmental handling fee of $3 is charged per tire and is remitted on a quarterly basis (last day of
the month) to the provincial government. This fee should be shown as a liability until it is remitted, since
the funds do not belong to Funky Tire but rather are held on behalf of the provincial government. It
should not be booked as revenue/cost of sales, as Sharon currently has it. This is a gross vs net issue as
the handling fee really looks to be a pass-through-type cost that should not have an impact on the income
statement in any way.
Rather than booking the “revenue” when received, you should book this as a deferred liability account on the balance sheet. The account should then be decreased when the funds are remitted to the government.
Note that the current way of doing the accounting is causing a timing and cut-off issue with revenue and
net income, and this could potentially affect the financial results. It might not be a big impact because of
the rolling nature of the items, but it is something that should be considered by the valuator.
(Most candidates provided an in-depth discussion of this issue, and presented a valid and supported
recommendation for the accounting of the fee as a deferred liability.)
Take-or-Pay Contract
Sharon recognizes the value of the entire calendar year’s sales up front for the take-or-pay contract by
recording the expected sales and an account receivable for the full amount of the contract. She draws it
down as the client pays. The accounts receivable and revenue numbers in the year-end financial
statements would therefore have amounts for tire sales that occurred after year-end. Even though those
sales are guaranteed through the take-or-pay contract, Funky Tire cannot account for the receivable until
the tires are actually sold. Also, if only the receivable and revenue were booked, there could be a
mismatch of the income and expenses. Sharon might not have booked the corresponding cost of sales
amount. However, if the accounts receivable entry is reversed as at year-end for tires delivered after that
date, the error will be corrected. If the corresponding cost of sales was also recorded, that entry will need
to be reversed as well. (Note: This error would have occurred every year, but the adjustments to the
opening and closing balances would mostly offset each other, so the error does not likely affect the
valuation materially.)
286
(Most candidates were able to identify that the accounting for the take-or-pay contract was inadequate.
However, many candidates did not provide a full discussion of the issue, and as a result did not identify
that the June 30 financial statements could be misleading and that the balance in accounts receivable
should be adjusted.)
Equipment
a) Value in use of old tire equipment
The change in technology presents a potential valuation issue for the old equipment. There are about
five or six years left in the amortization of the old equipment, but the equipment could actually be
obsolete if it won’t be used at all in the future. Funky Tire does not plan to use the equipment unless
necessary. As a result, the value of the equipment could be overstated on the financial statements. The
value of a capital asset must be adjusted if the net cash flow from its use and ultimate sale does not
equal or exceed the current book value. Hence, the old equipment would be set up at its net
recoverable amount, which is its estimated future net cash flow from use together with its residual
value. Funky Tire will have to estimate the cash flows to be generated by the machines. If the total of
the cash flows and the ultimate selling price (if they can sell the used equipment) are below their net
book value, then the value of the equipment will have to be written down on the financial statements to
an amount that is supported.
b) Useful life
The original estimate of the useful life of the old equipment appears to have been off by a substantial
amount. The initial estimate was 15 years, and now that Funky Tire has owned the equipment for
several years, there are still 5 years left in the useful life. It is debatable whether Funky Tire can
actually get another 5 years’ use from the machines. It is possible that the estimated useful life should have been adjusted or was incorrectly estimated. Funky Tire may want to try to come up with a better
estimate of the useful life for the new equipment.
(Most candidates provided an in-depth discussion of the impairment of the equipment and a valid
recommendation as to how to account for it under ASPE. However, many candidates did not address
the issue with the remaining useful life of the assets, and as a result offered no comments with respect
to this issue.)
Selling of old tires
Paul, you are planning to sign a deal in which Funky Tire can sell old tires for $5 each to a company that
turns tires into synthetic turf products. Sharon suggested setting up all the old tires as inventory. Paul says
that because Funky Tire didn’t pay for them, there is no cost to set up. CICA Handbook, Section 3031 —
Inventory, Paragraph 10 requires that inventory be “measured at the lower of cost and net realizable
value.” Paragraph 11 says, “the cost of inventories shall comprise all costs of purchase, costs of
conversion and other costs incurred in bringing the inventories to their present location and condition.”
287
Essentially, Funky Tire will now have two markets for its used tires:
1. Tires with remaining tread that are resaleable. These tires can be recorded in inventory at the cost of
conversion. This cost will need to be determined — it likely includes the cost of storing them and
could include the labour cost associated with taking them off the car when changing tires, as well as
fixed overhead costs like a portion of the depreciation on the garage used for storage.
2. Tires that cannot be resold and are not held in inventory. There may be a small labour cost to account
for the removal of the tires, but that cost is likely small, so their cost is likely zero.
This raises a question about the environmental handling fee and whether it would continue to apply if this
new deal is signed. Paul, you should check with the government to answer this question.
(Many candidates identified that there was an issue to be addressed. However, most candidates only
recognized that the old tires that would be sold should be set up as inventory, and did not discuss how
they would be accounted for in inventory (in other words, the costs that should be added to inventory).)
Storage services
Paul, you are thinking of offering new storage services. Funky Tire has extra space in the garage where
customers’ winter or summer tires can be stored during the off-season. Paul is thinking of charging $20
per month for storage. Customers using the storage services receive their tire installation for free.
This is a multiple deliverable, and Funky Tire will need to account for the transactions separately. CICA
Handbook Section 3400, Paragraph 11 provides the following:
[I]n certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable
components of a single transaction in order to reflect the substance of the transaction. A single sales
transaction may involve the delivery or performance of multiple products, services, or rights to use
assets, and performance may occur at different points in time or over different periods of time. In some
cases, the arrangements include initial installation, initiation, or activation services and involve
consideration in the form or a fixed fee or a fixed fee coupled with a continuing payment stream. For
example, when the selling price of a product includes an identifiable amount for subsequent servicing,
that amount is deferred and recognized as revenue over the period during which the service is
performed. [emphasis added]
Therefore, Funky Tire will have to allocate a portion of the $20 storage revenue to tire installation. The
standard price of an installation should be used to determine the portion that should be allocated to the tire
installation income.
(Less than half of the candidates discussed this issue. However, most candidates who did discuss it
provided both an in-depth discussion of the ASPE guidance in this area and a valid recommendation
as to how to account for the storage service revenue.)
288
Percent
Awarded
0.6%
competence.
16.8%
Reaching competence — The candidate identifies some of the accounting
policies that would be required for the Funky Tire financial statements to be in
33.7%
Competent — The candidate discusses some of the accounting policies that
would be required for the Funky Tire financial statements to be in accordance with
ASPE.
48.5%
Highly competent — The candidate discusses several of the material accounting
policies that would be required for the Funky Tire financial statements to be in
0.4%
(The new owner of Funky Tire has decided to use ASPE for the financial statements that will be
prepared after the buyout, and specifically asked that CA provide his or her views on any accounting
treatments that would need to be adjusted (versus current accounting policies) or implemented (to
record new products or services).)
(Most candidates attempted to discuss some of the accounting policies currently in place that would
need to be adjusted under ASPE, or how ASPE would apply to Paul’s new projects. However, most were not able to provide in-depth discussions for a sufficient number of the accounting issues, and
made some errors either in their analyses of the policies or in the recommendations provided. Weak
candidates committed multiple errors either in trying to understand the issue or in trying to apply the
appropriate ASPE standard, frequently providing a recommendation without adequate support.)
III – 1.1 Gathers or develops information and ideas
III – 1.2 Develops an understanding of the operating environment
III – 1.3 Identifies the needs of stakeholders and develops a plan to meet those needs
III – 2.1 Analyzes information or ideas
III – 2.2 Performs computations
III – 2.3 Verifies and validates information
III – 2.4 Evaluates information and ideas
III – 2.5 Integrates ideas and information from various sources
III – 2.6 Draws conclusions/forms opinions
III – 3.1 Identifies and diagnoses problems and/or issues
III – 3.2 Develops solutions
III – 3.3 Decides/recommends/provides advice
III – 4.1 Seeks and shares information, facts, and opinions through written discussion
III – 4.2 Documents in written and graphic form
III – 4.3 Presents information effectively
289
The candidate discusses how to split income, considering attribution rules.
Competencies
IX – 3.1 Identifies, analyzes, and advises on specific tax-planning opportunities for individuals (Level B)
Ron, you asked if there was a planning opportunity for splitting income with your wife, Sharon. You
asked whether, prior to the sale of your shares to Paul, you could sell or gift some of your Funky Tire
common shares to Sharon. Sharon would then sell them to Paul, with the idea that Sharon could report
some of the capital gain and perhaps some of the interest income and other investment income that will be
earned on the proceeds of disposition.
Usually, if this is done, the capital gain on the sale of Funky Tire shares and the investment income
earned on the subsequent investments made with the proceeds would be subject to the so-called
attribution rules in the Income Tax Act. These rules would require you, Ron, to report the capital gain and
investment income in your income even though the investment is in Sharon’s name. The attribution rules are designed to prevent this type of income splitting.
There is one exception to the attribution rules. If you sell your shares to Sharon at their current fair market
value and take back a note payable with an interest rate equal to or exceeding the rate currently prescribed
in the Income Tax Regulations, and if you file a special election with your 2012 personal income tax
return, Sharon can report the subsequent investment income as her income. She will be required to pay
the interest to you each year. You will be required to report the interest paid by Sharon in your income.
As long as Sharon invests the funds, she can deduct the interest paid to you against her income each year.
Since the current prescribed rate is 1%, as long as Sharon’s investment earnings exceed 1%, you will accomplish your income-splitting objective. Unfortunately, in this case Sharon would not report a capital
gain as she will be buying the shares at fair value from you and then selling them to Paul at the same
amount.
Paul, you plan to pay Wanda a salary, but are wondering if there is anything else you can do from a tax
point of view. You also have two children aged 14 and 15.
290
As you suggested, you could pay Wanda a salary from Funky Tire. To ensure that the salary expense is
deductible for tax purposes, Wanda would need to do some work to earn the salary. You could do the
same for the kids (for example, they could clean the office).
If you set up a Holdco, you could consider making Wanda and the children shareholders in the new
corporation to split income among the family members. Properly structured, a corporation’s shareholders can include family members, who can receive dividends. While dividends distributed to family members
under the age of 18 are subject to the top rate of tax, dividends distributed to family members over the age
of 18 are taxed at their marginal tax rates. A corporation could therefore be set up with Wanda and the
kids as shareholders. Dividends could be distributed to Wanda initially, and then to the kids once they
reach the age of 18. The dividends would be taxed in their hands.
(Candidates were asked to discuss personal tax issues (for example, splitting income with spouses and
children). However, a discussion of these issues was not considered critical.)
(Despite comments from Paul that these issues were “not essential” and not a “priority” for him, many candidates discussed these issues in their responses. Most candidates who addressed this indicator
struggled when applying the income-splitting concepts, and also failed to recognize the anti-avoidance
rules that are in place to counter some of the tax planning, namely the transfer and subsequent sale of
shares by a spouse.)
For Secondary Indicator #1 (Taxation), the candidate must be ranked in one of the following
three categories:
Not addressed — The candidate does not address this indicator.
Nominal competence — The candidate does not meet the standards of competence.
Competent — The candidate discusses income splitting and the attribution rules as they
relate to Ron and Sharon and to Paul and Wanda and their kids.
(Overall, the Board was somewhat disappointed with the quality of the responses provided on this
simulation. While most candidates demonstrated an appropriate level of understanding on Primary
Indicators #2 and #4, candidates often fell short on the assurance and tax indicators (Primary
Indicators #1 and #3). Many candidates failed to demonstrate their competence on these indicators
because they did not provide in-depth discussions of the issues. For many candidates, this was due to
them not sufficiently digesting and integrating case facts into their responses, thus resulting in them
concluding on a particular issue without providing adequate support.)
291
To: Paul Van Bakel
From: CA
Subject: Funky Tires (FT)
In our discussion you mentioned that you wish for FT to prepare financial statements in accordance with
ASPE when you acquire the company. Based on the bookkeeper's notes, certain proposed treatments are
not in accordance with ASPE and would need to be changed.
Revenue Recognition - Environmental Handling Fee
The environmental handling fee (EHF) is collected on behalf of the government from customers and
remitted on a regular basis. Amounts collected on behalf of third parties do not result in economic benefit
to the company, and thus do not increase equity and must be excluded from revenue. In the FS ended June
30, 2012, revenue and COGS are overstated by $112,644 (37,548 x 3).
The EHF fees collected should be recorded on the books as a liability to FT as the company has an
obligation to remit the amounts ($3/tire), the obligation cannot be avoided, and it arises on the sale of a
tire.
Revenue Recognition - Take or Pay Provision
In the agreement with the courier company, the company is committed to buying a minimum number of
tires and they generally do so in 10 months. Currently Sharon recognizes revenue on the entire agreement
at Jan 1 and reduces the receivable when FT is paid. This is not in accordance with revenue recognition
under ASPE.
ASPE requires that in the sale of goods, revenue is recognized when all of the following criteria are met:
A - ultimate collection is reasonably assured
B - Reasonable assurance exists regarding measurement of consideration and extent of returns
C - persuasive evidence of an arrangement exists
D - Delivery has occurred
E - Price is fixed or determinable
A is met as the courier company is in good credit standing and has historically made its payments on this
contract. B is met as the number of tires and sales price is known and the extent of returns is likely
determinable. C is met as there is a contract in place. D is only met as the courier company actually picks
up the tires. E the price is contractually fixed.
292
Based on this analysis, it would appear that revenue recognition for these tires can only occur as the tires
are shipped to the customer. Thus revenue should be recognized proportionately to the number of tires
sold and the minimum required by the contract (e.g. if 25% of the minimum number shipped, then 25%
revenue recognized). Revenue for 2012 is overstated as there are at least 3 months worth of tires that are
yet to be sold to the courier company.
Inventory - Turf Tires
Paul intends to sell old tires to a company that produces turf products for $5 each. These tires are acquired
at no cost to FT. Under ASPE, these tires would appear ot be classified as inventory as they are held for
sale in the ordinary course of business (FT would make it part of their business to deal with this turf co),
inthe process of such sale or raw materials. Thus is seems that the tires qualify as inventory.
Inventories are measured at the lower of cost and net realizable value. Since the inventories are acquired
for free (i.e. customers leave them here), then the cost of the inventory would be the cost of purchase ($0)
plus the cost of conversion and other costs incurred in bringing inventories to present location and
condition. If FT needs to pay to transport the inventories to the warehouse or otherwise modify them, then
these can be included in the cost figure.
The fact that the tires have some value $5 or other residual value if they have some tread is only a factor if
the cost is non-zero. In which case, you need to determine whether the net realizable value is below cost,
in which case a writedown would need to be taken.
Equipment - Old Machines
The replacement of the machines and the fact that technicians will preferentially use the new machines is
an indication that the old machines may be impaired. An impairment loss needs to be recognized when
the carrying amount is not recoverable and exceeds fair value.
The recoverability would be determined as the future cash flows associated with these machines based on
their expected lower amount of use, and the eventual salvage value. The fair value of the assets would be
the fair market value of the goods as they are today. If both of these amounts are below the current
carrying value, these machines would need to be written down as they are impaired. This would impact
net income for the period.
Equipment - Amortization
The old machines were purchased in 2003 with an expected useful life of 15 years (to 2018). At the end
of 2012 it is determined that they will last another 5 years (to 2018) so there has not been a change in the
estimated useful life of the assets.
The bookkeeper intends to keep the assets on the books at the current carrying value. This is not
acceptable under ASPE as all items of PP&E should be recognized in a systematic manner over the useful
life of the asset. Since the assets intend to be used in a limited capacity, they should still continue to be
amortized.
293
Paul's notes contain some uncertainties which I wish to clarify.
"Salaries are deductible for tax purposes"
Although generally true, CRA limits the deduction of salaries to the extent that they are legitimate
and reasonable. If your wife, children or other persons are hired in the company and are paid
unreasonably high amounts for the amount of work performed, CRA will deny the deduction.
"special tax treatment on capital gains"
There is a personal tax exemption available on a lifetime maximum of $750,000 in capital gains
(lifetime capital gains exemption or LCGE). That is, a person selling qualified small business
corporation (QSBC) shares may reduce their taxable capital gain inclusion in income by a maximum
of $375,000 during their lifetime (capital gains are 50% taxable). This amount does not replenish.
In the case of the sale of FT, Ron's shares are likely QSBC shares as they meet the requirements. a) he
or a person related to him has held the shares for a consecutive period of 24 months prior to the sale
(Ron has held them for 30+ years), b) more than 90% of the assets in the company are used to derive
active business income (based on the valuation report, all the assets appear to be used in the active
business), c) in the 24 months prior to the sale, more than 50% of the assets value used in the active
business (assume operations in prior 2 years approximately equal to assets as appraised, so met) and
d) the corporation is a CCPC (FT is a privately owned, canadian-resident controlled corporation, so
met). Based onthis, Ron is selling QSBC shares and capital gains may be reduced by the LCGE.
If Paul eventually sells the shares, as long as above criteria are met, then he would be able to claim
the LCGE as well.
The amountof LCGE claimed against capital gains is limited to the maximum limit ($750K), the
annual gains limit and the cumulative gains limit.
Using RRSP to fund purchase of FT
Money in an RRSP cannot be pulled out without being penalized unless the withdrawal qualifies for
the lifetime learning plan or the homebuyer's plan. In this case, taking out funds to purchase a
company would not qualify. If you withdraw the money, the money will be taxable as income to you
when withdrawn and additional penalties will be levied on your RRSP.
Holding Company
Holding companies are useful as they allow you to defer personal tax payable if you choose to sell an
investment down the road.
294
In order to raise the $750,000 required to buy out Ron as per the valuation report, you have several
options. You currently have $150,000 in investments than you are willing to liquidate which means that
you will have an additional $600,000 to raise.
Additional Bank Loan
You noted that banks generally lend up to 90% of the appraised value of a personal home. Your home is
worth $450K and is currently mortgaged for $250K. You could approach your bank for a second
mortgage on your home, up to $155,000 (450K*95% - 250K).
Currently mortgage rates are 4% according to Sharon, which is relatively low compared to general bank
interest rates for corporations (7%).
You could use your increased salary or shareholder loans from FT to make the additional mortgage
payments.
Withdrawing from RRSP
As mentioned above, I do not recommend withdrawing from your RRSP due to the additional penalties
imposed, and the amount withdrawn is taxable to you. Based on withdrawing $275K at 43% tax rates
(highest marginal tax rate on highest bracket), you would receive $158,750 after tax before penalties.
However, this would impair your ability to save for retirement which could have serious implications for
your future retirement ability - investing your retirement funds into FT may be more risk than you and
your wife are willing to take on.
Financing through FT
Currently FT has a mortgage on its land and building for $200K and they are worth $485K. Banks
generally are willing to lend up to 75% of business real estate. FT could potentially borrow an additional
$163,750 from the bank and then loan this money to you. To avoid being deemed to have received a
taxable shareholder benefit by having a below market interest loan, you should be paying 1% interest on
the loan (or else CRA will deem you to have incurred this as a benefit and you would be taxed as if you
had received it).
Recommendation:
Based on the above calculations, you need an additional $600K and could raise this by remortgaging your
home ($155K), obtaining a loan through remortgaging FT assets ($164K), which would leave you with
$281K still to raise. Your RRSP would be insuffucient to cover this deficit. You do not have enough
money to buy FT from Ron.
However, I present to you some alternatives:
Deferral of Payments
You should consider discussing with Ron the option to pay a smaller amount up front, say $300,000
which could be raised by remortgaging your home and liquidating your investments, and to pay him the
remainder over the next 3 years. This would allow you to fund the investment using FT's cash flows. Ron
would be able to defer tax on the capital gains by claiming a capital gains reserve over the 4 year period
so he is not disadvantaged by the tax treatment (i.e. doesn't get hit with the full tax bill up front).
295
Alternatively, you could set up the remaining payments as a function of FT's cash flow, e.g. 10% cash
flows. Though this means that a variable amount is being paid to Ron, if business improves, there is a
benefit to him as he would receive more cash for the company than it is currently worth. However, you
need to determine whether you are willing to pay him potentially more than the value of the company
today.
Downsize Home
Your home is worth $450K. If you sell your home you can claim the principal residency exemption so
that capital gains are not taxed, which would leave you with more cash ($450K) to pay for the shares in
RT and purchase a smaller home.
296
To: Ron Funky, Paul Van Bakel
From: CA
Subject: Funky Tires (FT) Engagement Options
You two have come to me requesting assistance with the potential sale and purchase of FT between each
other. There are certain issues with such an arrangement.
Conflict of Interest
As the seller, Ron is motivated to obtain the best price for his ownership in FT (high after-tax cash). As
the buyer, Paul is motivated to pay the lowest possible price for those shares. There is a conflict here as
certain recommendations I may make would benefit one party over the other.
To mitigate this risk, I recommend that one of you find an alternative accounting advisor to avoid creating
conflicts based on the nature of the advice. I would recommend finding someone outside my firm if
possible, however, we would be able to set up a "chinese wall" for independence between myself and the
other advisor if we are in the same firm to protect our objectivity.
Future Reporting Options
Paul has requested that I assist in reviewing and proposing accounting policy choices for FT for him to
use going forward. If Paul wishes for the company to be reviewed or audited in the future, this may create
an indepencence issue as it would be perceived as a self-review risk. To mitigate this risk, I recommend
that Paul hire a competent controller at FT and that all accounting policy choices be ultimately made by
FT management. All adjustments proposed should be reviewed and approved by management.
To ensure that the FS prepared going forwards are in compliance with ASPE as requested, I recommend
that the FS be audited or reviewed. An audit would provide high assurance that the FS are not misstated
under ASPE, although at a relatively high cost due to the nature and extent of testing required. A review
engagement would be less costly, but provides negative assurance (moderate assurance) regarding
compliance with ASPE that the FS are plausible. Whether you opt for one of the other would depend on
the level of comfort required and the needs of FS users (e.g. a bank may require an audit as part of a loan
agreement, for example).
However, since the company is a long-time tax client of ours, I would not be able to perform the
audit/review myself due to the perceived impairment of objectivity. Another partner at my firm would be
able to perform the assurance engagement to mitigate the risk of self-review particularly on the tax
matters and on the perceived independence issue regarding our long-term business relationship.
Tax Advice
Since you are both requesting personal tax advice, I could be engaged to assist you in preparing your
2012 personal tax returns in 2013.
To: Ron
From: CA
Subject: Sale of FT in 2012
In Exhibit A, I have calculated that if you receive $750,000 from Paul for your shares in FT as a lump
sum, then you can expect to receive $739,272 in after-tax cash to fund your retirement.
297
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15
16
17
18
19
20
21
22
23
24
25
Periods
Hence 2%
0.54
0.52
0.51
0.49
0.48
0.62
0.61
0.59
0.57
0.55
0.72
0.70
0.68
0.66
0.64
0.84
0.81
0.79
0.77
0.74
0.97
0.94
0.92
0.89
0.86
3%
0.44
0.42
0.41
0.39
0.38
0.53
0.51
0.49
0.47
0.46
0.65
0.62
0.60
0.58
0.56
0.79
0.76
0.73
0.70
0.68
0.96
0.92
0.89
0.85
0.82
4%
0.36
0.34
0.33
0.31
0.30
0.46
0.44
0.42
0.40
0.38
0.58
0.56
0.53
0.51
0.48
0.75
0.71
0.68
0.64
0.61
0.95
0.91
0.86
0.82
0.78
5%
0.29
0.28
0.26
0.25
0.23
0.39
0.37
0.35
0.33
0.31
0.53
0.50
0.47
0.44
0.42
0.70
0.67
0.63
0.59
0.56
0.94
0.89
0.84
0.79
0.75
6%
0.24
0.23
0.21
0.20
0.18
0.34
0.32
0.30
0.28
0.26
0.48
0.44
0.41
0.39
0.36
0.67
0.62
0.58
0.54
0.51
0.93
0.87
0.82
0.76
0.71
7%
0.20
0.18
0.17
0.16
0.15
0.29
0.27
0.25
0.23
0.21
0.43
0.40
0.37
0.34
0.32
0.63
0.58
0.54
0.50
0.46
0.93
0.86
0.79
0.74
0.68
8%
0.16
0.15
0.14
0.13
0.12
0.25
0.23
0.21
0.19
0.18
0.39
0.36
0.33
0.30
0.27
0.60
0.55
0.50
0.46
0.42
0.92
0.84
0.77
0.71
0.65
9%
0.14
0.12
0.11
0.10
0.09
0.22
0.20
0.18
0.16
0.15
0.35
0.32
0.29
0.26
0.24
0.56
0.51
0.47
0.42
0.39
0.91
0.83
0.75
0.68
0.62
10%
0.11
0.10
0.09
0.08
0.07
0.19
0.17
0.15
0.14
0.12
0.32
0.29
0.26
0.23
0.21
0.53
0.48
0.43
0.39
0.35
0.90
0.81
0.73
0.66
0.59
11%
0.09
0.08
0.07
0.07
0.06
0.16
0.15
0.13
0.12
0.10
0.29
0.26
0.23
0.20
0.18
0.51
0.45
0.40
0.36
0.32
0.89
0.80
0.71
0.64
0.57
12%
0.08
0.07
0.06
0.05
0.05
0.14
0.13
0.11
0.10
0.09
0.26
0.23
0.20
0.18
0.16
0.48
0.43
0.38
0.33
0.29
0.88
0.78
0.69
0.61
0.54
13%
0.06
0.06
0.05
0.04
0.04
0.12
0.11
0.09
0.08
0.07
0.24
0.21
0.18
0.16
0.14
0.46
0.40
0.35
0.31
0.27
0.88
0.77
0.67
0.59
0.52
14%
0.05
0.05
0.04
0.03
0.03
0.11
0.09
0.08
0.07
0.06
0.21
0.19
0.16
0.14
0.12
0.43
0.38
0.33
0.28
0.25
0.87
0.76
0.66
0.57
0.50
15%
0.04
0.04
0.03
0.03
0.02
0.09
0.08
0.07
0.06
0.05
0.20
0.17
0.15
0.13
0.11
0.41
0.35
0.31
0.26
0.23
0.86
0.74
0.64
0.55
0.48
16%
0.04
0.03
0.03
0.02
0.02
0.08
0.07
0.06
0.05
0.04
0.18
0.15
0.13
0.11
0.09
0.39
0.33
0.28
0.24
0.21
0.85
0.73
0.62
0.53
0.46
17%
0.03
0.03
0.02
0.02
0.02
0.07
0.06
0.05
0.04
0.04
0.16
0.14
0.12
0.10
0.08
0.37
0.31
0.27
0.23
0.19
0.85
0.72
0.61
0.52
0.44
18%
0.03
0.02
0.02
0.02
0.01
0.06
0.05
0.04
0.04
0.03
0.15
0.12
0.10
0.09
0.07
0.35
0.30
0.25
0.21
0.18
0.84
0.71
0.59
0.50
0.42
19%
0.02
0.02
0.02
0.01
0.01
0.05
0.05
0.04
0.03
0.03
0.13
0.11
0.09
0.08
0.06
0.33
0.28
0.23
0.19
0.16
0.83
0.69
0.58
0.48
0.40
20%
299
15.42
15.94
16.44
16.94
17.41
12.56
13.17
13.75
14.32
14.88
14.03
14.45
14.86
15.25
15.62
11.65
12.17
12.66
13.13
13.59
12.82
13.16
13.49
13.80
14.09
10.84
11.27
11.69
12.09
12.46
17.01
17.66
18.29
18.91
19.52
5.08
5.79
6.46
7.11
7.72
21
22
23
24
25
5.24
6.00
6.73
7.44
8.11
0.95
1.86
2.72
3.55
4.33
13.58
14.29
14.99
15.68
16.35
5.42
6.23
7.02
7.79
8.53
0.96
1.89
2.78
3.63
4.45
5%
16
17
18
19
20
5.60
6.47
7.33
8.16
8.98
6
7
8
9
10
0.97
1.91
2.83
3.72
4.58
4%
9.79 9.25 8.76 8.31
10.58 9.95 9.39 8.86
11.35 10.63 9.99 9.39
12.11 11.30 10.56 9.90
12.85 11.94 11.12 10.38
0.98
1.94
2.88
3.81
4.71
1
2
3
4
5
3%
11
12
13
14
15
2%
Periods
Received
7.50
7.94
8.36
8.75
9.11
4.77
5.39
5.97
6.52
7.02
0.93
1.81
2.62
3.39
4.10
7%
11.76
12.04
12.30
12.55
12.78
10.84
11.06
11.27
11.47
11.65
10.11 9.45
10.48 9.76
10.83 10.06
11.16 10.34
11.47 10.59
7.89
8.38
8.85
9.29
9.71
4.92
5.58
6.21
6.80
7.36
0.94
1.83
2.67
3.47
4.21
6%
10.02
10.20
10.37
10.53
10.68
8.85
9.12
9.37
9.60
9.82
7.14
7.54
7.90
8.24
8.56
4.62
5.21
5.75
6.25
6.71
0.93
1.78
2.58
3.31
3.99
8%
9.29
9.44
9.58
9.71
9.82
8.31
8.54
8.76
8.95
9.13
6.81
7.16
7.49
7.79
8.06
4.49
5.03
5.53
6.00
6.42
0.92
1.76
2.53
3.24
3.89
9%
8.65
8.77
8.88
8.99
9.08
7.82
8.02
8.20
8.36
8.51
6.50
6.81
7.10
7.37
7.61
4.36
4.87
5.33
5.76
6.14
0.91
1.74
2.49
3.17
3.79
10%
8.08
8.18
8.27
8.35
8.42
7.38
7.55
7.70
7.84
7.96
6.21
6.49
6.75
6.98
7.19
4.23
4.71
5.15
5.54
5.89
0.90
1.71
2.44
3.10
3.70
11%
7.56
7.65
7.72
7.78
7.84
6.97
7.12
7.25
7.37
7.47
5.94
6.19
6.42
6.63
6.81
4.11
4.56
4.97
5.33
5.65
0.89
1.69
2.40
3.04
3.60
12%
7.10
7.17
7.23
7.28
7.33
6.60
6.73
6.84
6.94
7.02
5.69
5.92
6.12
6.30
6.46
4.00
4.42
4.80
5.13
5.43
0.88
1.67
2.36
2.97
3.52
13%
6.69
6.74
6.79
6.84
6.87
6.27
6.37
6.47
6.55
6.62
5.45
5.66
5.84
6.00
6.14
3.89
4.29
4.64
4.95
5.22
0.88
1.65
2.32
2.91
3.43
14%
6.31
6.36
6.40
6.43
6.46
5.95
6.05
6.13
6.20
6.26
5.23
5.42
5.58
5.72
5.85
3.78
4.16
4.49
4.77
5.02
0.87
1.63
2.28
2.85
3.35
15%
5.97
6.01
6.04
6.07
6.10
5.67
5.75
5.82
5.88
5.93
5.03
5.20
5.34
5.47
5.58
3.68
4.04
4.34
4.61
4.83
0.86
1.61
2.25
2.80
3.27
16%
5.67
5.70
5.72
5.75
5.77
5.41
5.47
5.53
5.58
5.63
4.84
4.99
5.12
5.23
5.32
3.59
3.92
4.21
4.45
4.66
0.85
1.59
2.21
2.74
3.20
17%
5.38
5.41
5.43
5.45
5.47
5.16
5.22
5.27
5.32
5.35
4.66
4.79
4.91
5.01
5.09
3.50
3.81
4.08
4.30
4.49
0.85
1.57
2.17
2.69
3.13
18%
5.13
5.15
5.17
5.18
5.20
4.94
4.99
5.03
5.07
5.10
4.49
4.61
4.71
4.80
4.88
3.41
3.71
3.95
4.16
4.34
0.84
1.55
2.14
2.64
3.06
19%
4.89
4.91
4.93
4.94
4.95
4.73
4.77
4.81
4.84
4.87
4.33
4.44
4.53
4.61
4.68
3.33
3.60
3.84
4.03
4.19
0.83
1.53
2.11
2.59
2.99
20%
300
Investment
Cost
Rate of
Return
×
Marginal
Rate of
Income Tax
+
×
Rate of
Capital Cost
Allowance
Rate of Capital
Cost Allowance
×
1+
Rate of Return
2
×
1+
Rate of Return
Class 1 ...................................................... 4%
Class 8 ...................................................... 20%
Class 10 .................................................... 30%
Class 10.1 ................................................. 30%
Class 12 .................................................... 100%
Class 13 .................................................... Original lease period plus one
renewal period (minimum 5 years
and maximum 40 years)
Class 14 .................................................... Length of life of property
Class 17 .................................................... 8%
Class 29................................................ .... 50% straight-line
Class 43 .................................................... 30%
Class 44 .................................................... 25%
Class 50 .................................................... 55%
Class 52 .................................................... 100%
Maximum depreciable cost — Class 10.1
$30,000 + GST or HST
Maximum monthly deductible lease cost
$800 + GST or HST
Maximum monthly deductible interest cost
$300
Operating cost benefit — employee
24¢ per kilometre of personal use
Non-taxable car allowance benefit limits
- first 5,000 kilometres
52¢ per kilometre
- balance
46¢ per kilometre
301
302
Evaluation Booklet Tables
Taxable Income
Tax Rate
$41,544 or less
$41,545 to $83,088
$83,089 to $128,800
$128,801 or more
15%
$6,232 + 22% on next $41,544
$15,371 + 26% on next $45,712
$27,256 + 29% on remainder
*
2012 rates increase by an indexing of 2.8%.
The
tax credits are 15% of the following amounts:
Basic personal amount
Spouse or common-law partner amount
Net income threshold for spouse or common-law partner amount
Child
Age 65 or over in the year
Canada employment amount
Disability amount
Infirm dependants who reach 18 in the year
Net income threshold for infirm dependants 18 and over
Basic amount for:
Age credit and GST credit
Child tax benefit
Children’s fitness credit
$10,527
10,527
NIL
2,131
6,537
up to $1,065
7,341
4,282
6,076
32,961
41,544
up to $500
The tax payable by a corporation on its taxable income under Part I of the Income Tax Act is 38%
before any additions and/or deductions.
Year
Jan. 1 - Mar. 31
Apr. 1 - June 30
July 1 - Sep. 30
Oct. 1 - Dec. 31
2012
2011
2010
2009
2008
1
1
1
2
4
1
1
1
1
4
1
1
1
1
3
1
1
1
3
This is the rate used for taxable benefits for employees and shareholders, low-interest loans, and other
related-party transactions. The rate is 4 percentage points higher for late or deficient income tax payments
and unremitted withholdings. The rate is 2 percentage points higher for tax refunds to taxpayers with the
exception of corporations, for which the base rate is used.
***********
277 Wellington Street West, Toronto ON M5V 3H2
Tel (416) 977-3222 Fax (416) 204-3423 www.cica.ca
For more information
The CA qualification process prepares future CAs to meet the challenges that await them.
For more information on the qualification process, the uniform evaluation, and your province’s
specific education requirements, contact your regional education director.
Regional Education Directors
Atlantic Canada and Bermuda:
Dan Trainor, FCA
Ontario:
Jacqui Mulligan, CPA, CA
Québec:
Diane Messier, FCPA, FCA
Western Canada
and the Territories:
Dr. Sheila Elworthy, CA
Atlantic School of Chartered Accountancy
Cogswell Tower, Suite 500
Scotia Square, P.O. Box 489
Halifax, Nova Scotia B3J 2R7
Tel:
(902) 425-7974
Fax:
(902) 423-9784
Web site: www.asca.ns.ca
E-mail:
[email protected]
Vice-President, Qualification
Ordre des comptables
professionnels agréés du Québec
680, rue Sherbrooke Ouest, 18th floor
Montréal, Québec H3A 2S3
Tel :
(514) 288-3256 ext. 2227
1 800 363-4688 ext. 2227
Fax :
(514) 843-8375
Web site : cpa-quebec.com
E-mail : [email protected]
The Institute of Chartered
Accountants of Ontario
69 Bloor Street East
Toronto, Ontario M4W 1B3
Tel:
(416) 962-1841 ext. 296
Fax:
(416) 962-8900
Web site: www.icao.on.ca
E-mail:
[email protected]
CA School of Business
500 – One Bentall Centre
505 Burrard Street
Vancouver, British Columbia V7X 1M4
Tel:
1 866 420-2350
Fax:
(604) 681-1523
Web site: www.casb.com
E-mail:
[email protected]
Provincial Institutes/Ordre
Accountants of Bermuda
48 Church Street
Sofia House, 1st Floor
Hamilton, Bermuda HM 12
(441) 292-7479
www.icab.bm
Accountants of Nova Scotia
5151 George Street, Suite 502
Halifax, Nova Scotia B3J 1M5
(902) 425-3291
www.icans.ns.ca
The New Brunswick Institute
of Chartered Accountants
55 Union Street, Suite 250
Mercantile Centre
Saint John, New Brunswick E2L 5B7
(506) 634-1588
www.nbica.org
Accountants
of Prince Edward Island
97 Queen Street, Suite 600
Dominion Building
Charlottetown, PEI C1A 4A9
(902) 894-4290
www.icapei.com
Accountants of Newfoundland
and Labrador
95 Bonaventure Avenue, Suite 501
St. John’s, Newfoundland A1B 2X5
(709) 753-7566
www.icanl.ca
Ordre des comptables
professionnels agréés du Québec
Accountants of Saskatchewan
3621 Pasqua Street
Regina, Saskatchewan S4S 6W8
(306) 359-1010
www.icas.sk.ca
Accountants of Alberta
680, rue Sherbrooke Ouest, 18e étage
Montréal, Québec H3A 2S3
(514) 288-3256 1 800 363-4688
cpa-quebec.com
580 Manulife Place, 10180 – 101 Street
Edmonton, Alberta T5J 4R2
(780) 424-7391 1 800 232-9406
(for Alberta, outside Edmonton)
www.icaa.ab.ca
Accountants of Ontario
Accountants of British Columbia
69 Bloor Street East
Toronto, Ontario M4W 1B3
(416) 962-1841 1 800 387-0735
www.icao.on.ca
Accountants of Manitoba
700 – One Lombard Place
Winnipeg, Manitoba R3B 0X3
(204) 942-8248 1 888 942-8248
www.icam.mb.ca
Suite 500, One Bentall Centre
505 Burrard Street, Box 22
Vancouver, British Columbia V7X 1M4
(604) 681-3264 1 800 663-2677
www.ica.bc.ca
If you are in the Yukon, please contact
the Institute of Chartered Accountants
of British Columbia.
If you are in the Northwest Territories
or Nunavut, please contact the Institute
of Chartered Accountants of Alberta.

2012 UFE Report

Transcription

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