CPA Final Common Exam - Day 3 Example Page 1 On Day 3, all candidates assume the same roles when answering a series of shorter cases. Day 3 will be completed in four hours and will be made up of three to four cases. It will provide candidates with the opportunity to demonstrate their competence in all of the breadth areas and provide additional opportunities to demonstrate depth in Financial Reporting or Management Accounting—the common elements. The degree of complexity of the case facts and the level of critical thinking expected can be higher than at the end of Core 1 and Core 2, since candidates’ skill level will have increased significantly over the two year professional education program. This is a second example for Day 3. A Full Day 3 is NOT provided here. Question 1 (of 3 or 4) (Suggested Time: 70 minutes) (Coverage: Core 2: strategy and governance, Core 1: internal controls and taxation) It is June 13, 2011. You, CPA, have known Jane Smith for many years. She has asked you to meet with her parents to discuss the latest development at Boy and Girl Toys Inc. (BGT) — what Jane has described as an amazing turn of events. Sally and Orland, Jane’s parents, are in their mid-fifties and have jointly owned BGT since they took over the business from Sally’s father several years ago. At the meeting, Sally describes the opportunity that BGT is contemplating. “World Entertainment Ltd. (WEL) is an international toy distribution and retail business. It is a publicly traded company with its head office in Canada. WEL noticed the success we have been having locally with our newest product, NanoPets. They approached us with a non-negotiable proposal to expand our business by injecting some equity. WEL has made investments of this type before to help capitalize on sales trends in the retail market. Here is a copy of WEL’s proposal (Appendix I). As you know, I am the fourth-generation owner of BGT. We are proud of our achievements, but this proposal could take us to a whole new level of business success.” You inquire, “Do you have some idea of the amount of growth this opportunity entails?” Sally provides a summary of the financial and production data agreed to as part of WEL’s proposed investment in BGT (Appendix II). She comments, “We never thought we would run a business that produces five million toys annually. That’s ten times what we produce now! It’s incredibly exciting. We want to go ahead, but first we want to understand the tax implications of bringing in a new shareholder. We’ve provided you with some summary tax information on BGT (Appendix III). Orland and I each own 12,500 common voting shares that we purchased from my father. At $60 per share, we would each receive $750,000 tax-free when we eventually sell and claim the capital gains exemption, like Dad did, but I’m sure there are other tax considerations.” CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 2 You ask what concerns, if any, they have with WEL’s offer and proposed expansion. Sally answers, “Well, when the representative from WEL was here, he asked some questions about internal controls and budgeting and variance analysis. Currently, Jane does all the bookkeeping and handles all payments to suppliers and employees. She has never paid anyone late or had any trouble with suppliers. The external accountant comes in every year for two weeks and prepares BGT’s financial statements and the tax returns. We’ve never had a problem. We’ve always run our business on handshakes and trust, so we were a little taken aback by the WEL representative’s questions. We are sure that once WEL’s management sees us in action they’ll be fine with what we do and how we do it. Then again, BGT is not a multinational company like WEL, so maybe their questions are valid. Could you recommend the internal controls we’ll need if we accept the proposal? We will have to hire some new employees, as you can see from the proposal, and we may not be able to monitor everything. Jane has already mentioned that she will need some help in the office too. She has prepared some notes on our current situation and how she thinks it might change (Appendix IV). “We would also like your observations, a kind of sober second thought, on the proposed business expansion, with an emphasis on any risks you see that we may not have identified or fully explored.” After the meeting, Jane walks you out. She comments, “I think Mom really wants to do this deal. I guess it could be a big opportunity and could make us rich. But I’m not sure this is the way Grandpa would have wanted it to go. BGT has been in the family forever. I was hoping Mom would realize that I have worked hard and stayed here through everything thinking I would be next in line. Anyway, I hope it all works out.” CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 3 APPENDIX I PROPOSAL MADE BY WORLD ENTERTAINMENT LIMITED TO BOY AND GIRL TOYS INC. WEL’s non-negotiable proposal includes investing up to $9 million over a two-year period to fund expansion of the NanoPets line of toys. The initial investment of $1.8 million will be for 30,000 newly issued common voting shares of BGT at a price of $60 per share. WEL will have an option to purchase an additional 120,000 shares, at $60 per share, for $7.2 million. WEL will be authorized to appoint at least three seats on the board of directors of BGT, and the board of directors will have no more than five members in total. BGT will produce quarterly financial statements for WEL’s internal management purposes. Sally and Orland will be guaranteed their current positions and salaries at BGT for a period of one year from the initial investment by WEL. BGT agrees to hire a marketing vice-president within three months of accepting the proposal to handle customer relationships and marketing functions. BGT agrees to hire a distribution manager within three months of accepting the proposal to assist in distribution to customers. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 4 APPENDIX II BOY AND GIRL TOYS INC. FINANCIAL AND PRODUCTION DATA BGT’s current production capacity is 500,000 toys annually. BGT started producing NanoPets in early March 2011, and has produced and sold 40,000 NanoPets in three months. With a $3 million expansion, BGT could increase production to two million toys annually. The expansion would be funded with $1.5 million from WEL and $1.5 million from BGT’s bank. WEL guarantees a minimum purchase of 50,000 NanoPets in calendar 2011 to sell in its corporate-owned retail stores. WEL is planning to expand the number of stores it owns in 2012, at which point the minimum guaranteed purchase amount will be increased. The purchase price to be paid by WEL will be at a discount of 5% from the lowest price offered by BGT to any competing customer. The first phase of expansion would be complete in September 2011, with NanoPets production gradually increasing by the end of September in time for the Christmas shopping season. If the 2011 sales are strong, additional expansion will occur beginning in January 2012, such that production capacity reaches five million toys by June 2012. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 5 APPENDIX III BOY AND GIRL TOYS INC. TAX INFORMATION December 31, 2010 Fiscal Year End Taxable income $ 450,000 Taxes payable before credits (11%) 49,500 Scientific research and experimental development: Investment tax credit for developing NanoPet technology ($200,000 × 35%) 70,000 Net federal tax refund 20,500 December 31, 2010 retained earnings 1,100,000 Dividend paid 2010 150,000 Capital loss carry-forward 30,000 May 31, 2011 (Five-Month Period) Estimated taxable income Estimated scientific research and experimental development: Investment tax credit ($100,000 × 35%) Estimated May 31, 2011 retained earnings Anticipated dividend $ 250,000 35,000 1,335,000 70,000 CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 6 APPENDIX IV NOTES ON PROCESSES AND PROCEDURES (PREPARED BY JANE) My mom is BGT’s president, and handles all the relationships with customers. My dad is the vice-president of production and is in charge of research, production, distribution, and employee and supplier relationships. I handle administrative duties, including performing basic bookkeeping functions and working with BGT’s external accountant, who produces BGT’s financial statements under a compilation engagement and prepares BGT’s tax return. All pricing decisions are made by my mom in consultation with my dad. My dad estimates the production costs based on his experience, and then my mom decides what a reasonable margin is based on her knowledge of the market and what customers are willing to pay. Most customer contracts are verbal. We have never had collection problems with any customer. The new marketing vice-president will take over pricing for all customers, including ensuring compliance with the agreement to provide a 5% price discount to WEL. The WEL representative wants the new marketing person to focus on maximizing our sales to use up our new production capacity. We pay our suppliers on receipt of invoice. My dad handles the negotiations with all major suppliers for production machinery and raw materials, and takes care of distribution to customers. We spend small amounts on office supplies and other overheads like insurance. We own our facilities. The new distribution manager will take on the function of shipping the toys to our customers. He or she will also be in charge of related functions, including receiving returns of damaged or unsold goods, processing change orders from customers, and leasing a new warehouse as we expand our markets. All hiring is currently done by my dad because he knows what skills are needed for production and research. He was Grandpa’s right-hand man before Grandpa passed the business on to my parents. He tells me when a new employee has been hired, and I make sure I collect the information needed for payroll, like Social Insurance Number, home address, etc. My dad determines pay rates based on experience and the market. If I give up some of the office duties, he may have to communicate with the new office staff on payroll matters. I think the new marketing vice-president and distribution manager will determine pay rates and hours of work for the employees working in their areas. The people at WEL want these two positions to be filled quickly because they think we need to move fast to take full advantage of the trendy product we have developed. My parents and I have signing authority over the bank accounts, so it only makes sense that the new hires would have that authority as well. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 7 APPENDIX IV (continued) NOTES ON PROCESSES AND PROCEDURES (PREPARED BY JANE) Every year, after the external accountant has prepared the draft financial statements and tax returns, my mom and I meet to determine the amounts of wages and dividends we can afford to pay based on our financial results. My dad doesn’t attend the meetings where we go over the detailed financial data because he knows the numbers through his experience and personal involvement on the costing side. He prefers to spend his time on the factory floor. We have had several applications for administrative jobs, so I should have no problem finding someone to help in the office. I’m not sure we will need a full-time person, but it would be nice to be able to hand off some of the more routine tasks like invoicing, adding suppliers, making deposits, and writing cheques. I would then be able to focus on getting a better handle on how to use our software to produce and print reports like the ones the WEL representative was talking about. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 8 MARKING GUIDE BOY AND GIRL TOYS INC. (BGT) Memorandum to: From: Re: Sally and Orland Smith CPA Proposal from WEL to invest in Boy and Girl Toys Inc. (BGT) You have asked me for advice with respect to the proposal from WEL to invest in BGT. In particular, you want to understand the tax implications of bringing in a new shareholder, and you have asked me to provide recommendations of internal controls that you would need if you go forward with the proposal from WEL. I have provided the information you requested below. In addition, you also asked for my comments, a kind of sober second thought, on the proposed business expansion, with an emphasis on any risks I see that you may not have identified or fully explored. I have included my thoughts on the proposed WEL investment and expanded operations of BGT. However, it is ultimately your decision whether to proceed. I have tried to highlight the most important considerations so that you can make an informed decision about this non-negotiable deal. Regards, CPA Assessment Opportunity #1 The candidate discusses the taxation issues related to the acquisition of control and change in status. The candidate is demonstrating competence in Core 1-Taxation competency area. CPA Map: 6.1.1 Assesses a corporate entity’s general tax issues (Core- Level B) 6.1.4 Advises on tax consequences or specific tax-planning opportunities for shareholders and their closely held corporations (Core Level C) 6.1.5 Analyzes the tax consequences or planning opportunities for complex corporate transactions (Core- Level C) Also touches 2.3.2 evaluates the entity’s internal and external environment and its impact on strategy development (CoreLevel B) Acquisition of Control The transaction as proposed will result in WEL acquiring 30,000 shares, and BGT will have 55,000 shares outstanding at that point in time. WEL will control BGT because it will have more than 50% of the voting shares. Because of this, the acquisition of control rules will apply. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 9 Deemed Year End The consequences of an acquisition of control are that BGT will have a deemed year end, for tax purposes, on the day preceding the date of the acquisition of control. This will cause a short year for income tax purposes, requiring a pro-ration of certain amounts based on the number of days in the year. One impact will be on the small business deduction (SBD) limit. BGT gets a reduction in its tax rate from 16.5% to 11.0% on earnings under the business limit. The business limit is pro-rated for short tax years, so, for example, if the transaction closes on June 30, the business limit will be about $250,000 (half of the usual $500,000 allowed). Note: candidates are expected to demonstrate Level C- they are expected to explain an dapply the basic knowledge in a routine, non-complex situation, which BGT is. The following paragraph would be beyond the expectations: Since BGT has earned $250,000 to date this year (based on your May 31 estimate), it looks like this will mean that some of its income will be taxed at the high corporate rate. Capital cost allowance (CCA) claims are also pro-rated for the short taxation year, so if BGT’s taxable income estimate claimed full CCA, that will need to be adjusted. Capital Losses There are capital losses of $30,000 noted as carried-forward in the December 2010 tax information. Since they are capital in nature, they would be lost on WEL’s acquisition of control. The company can make an election on capital property to trigger capital gains that may have accrued in order to use the capital losses before they are lost. Because the company owns its own facilities, it is possible that the value of the land has increased over its original purchase price and unrealized capital gains exist. Other Matters Immediately before an acquisition of control, capital property, depreciable property, and eligible capital property with inherent losses must be written down to their fair market value. Realizing losses on the depreciable property and eligible capital property will create non-capital losses to the extent that there isn’t sufficient income to offset the losses. Losses on the capital property will increase the capital loss carryforward, which will be added to the existing $30,000 balance and will be lost on the acquisition of control. Non-capital losses (if they arise under the above revaluation) can be carried forward, provided BGT is carrying on the same or similar business, which it will be. The losses would be affected by the deemed year end. One year would be lost on the carry-forward period for the non-capital losses. BGT should review its other assets (including assessing the fair market value of accounts receivable) to see whether there are losses that will be triggered as part of the transaction and to consider if there are any capital gains that it could trigger in order to use up the losses before they are lost. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 10 Change in Status CCPC versus Public Corporation Since WEL is a public corporation, BGT will no longer qualify as a Canadian-controlled private corporation (CCPC) for tax purposes after the shares are issued to WEL and it acquires control. Being a non-CCPC will mean that BGT will not be allowed to claim a small business deduction after the date of the transaction and its tax payable will increase. We noted that BGT claims investment tax credits for scientific research and experimental development (SR&ED). Since it will no longer be a CCPC, it will have a different rate (20% versus 35%) applied to its qualifying spending for SR&ED purposes, and the credit will no longer be refundable to the extent that it eliminates the federal income tax payable. So, for example, the refund of tax received for 2010 would not be refundable, and the SR&ED credit exceeding the $49,500 of income tax would have been carried forward to offset future years’ taxes payable. In addition, the company will now have to pay its outstanding corporation income tax balance one month earlier (in other words, two months after year end rather than the threemonth period that is available to CCPCs). Prior to the change in status, and to the extent that it may be applicable, BGT should clear its capital dividend account and its refundable dividend tax on hand, because only private corporations can pay capital dividends or receive dividend refunds. These accounts will be affected by any capital gains that may be triggered as part of the plan to use capital losses that will otherwise expire (see the previous discussion on losses). Dividends We noticed that you pay substantial dividends on a regular basis. You should be aware of the fact that the nature of the dividends may change if you go from being a CCPC to a non-CCPC (the reference is Section 89(1) of ITA). There are separate sets of rules to follow for dividends, depending on whether the payer is a CCPC or not. Beyond expectation: The rules for CCPCs involve an annual calculation of the general rate income pool (GRIP). The GRIP is determined by a formula, but essentially consists of the company’s after-tax active business income that did not benefit from the small business deduction. A CCPC that pays any dividend can designate it as an eligible dividend, and that dividend would reduce the GRIP balance. Eligible dividends are subject to a lower personal effective tax rate than those not paid out of the GRIP. Beyond expectation: When the corporation is no longer a CCPC, it will be required to compute a low-rate income pool account (LRIP). Future dividends are considered to be paid out of the LRIP account until the account is fully depleted. Then, dividends can be paid as eligible dividends with the same tax effect as noted under GRIP. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 11 In terms of the proposed deal, it sounds like you are guaranteed the salary you currently make for one year. There is no indication of whether you will still receive dividends. You should be aware of the fact that the receipt of dividends has a more preferential tax treatment for an individual than employment income does (see the discussion of alternatives later in this report). Capital Gains Exemption The matter of greatest concern to you is that your shares will no longer qualify for the capital gains exemption (CGE), since you seem to believe they will. (This observation is based on your comment that the value of the shares would be $750,000 each, and that you could receive that value tax-free when you finally sell out and claim the CGE, as your dad did). The current value of $1.5 million based on the price (assumed to be the fair value) of $60 per share, less what you paid, would usually qualify for an exemption from tax. However, the rules for the exemption require that the corporation be a CCPC at the time of the disposition. Since you would be selling your shares after BGT is no longer a CCPC, the shares would no longer meet the requirements for a qualifying small business corporation, so you would be able to claim the CGE. Prior to the acquisition by WEL, you should take steps to crystallize your CGE to retain the taxfree status on the first $1.5 million of the gain on those shares prior to losing eligibility. For example, the shareholders can file an election as described under Section 48.1 of the Income Tax Act or undertake a corporate restructuring (such as a Section 85(1) rollover) in order to crystallize the gain. Other: Non-arm’s Length Transactions The future sales of 50,000 NanoPets to WEL (at a 5% discount from the lowest price offered by BGT to any competing customer) will have to be revalued to fair market for tax purposes since the two companies are not dealing at arm’s length with each other. Assessment Opportunity #2 The candidate discusses improvements to the control environment considering WEL’s proposal. The candidate is demonstrating competence in Core 1-Assurance competency area (controls). CPA Mapping: 4.1.1 Assesses the entity’s risk assessment processes (Core- Level A) 4.1.2 Evaluates the information system, including the related processes (Core- Level B) CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 12 WEL is a publicly traded company. It must therefore meet certain reporting requirements, one of which includes a sign-off on the satisfactory functioning of the internal controls regarding the production of financial statement information. WEL’s concern over internal controls is therefore valid. We don’t know the relative size and importance of BGT to WEL’s overall operations. If significant, what BGT does will influence WEL’s reporting. This may explain why the representative from WEL was asking questions about your controls. However, even without this reason, you need to consider the impact of introducing “outsiders” to your family-owned–and-operated business. The purpose of having adequate and appropriate internal controls is to ensure that you have safeguard your assets (cash, capital assets, inventory, etc.), that your payments are made to vendors and employees who actually provided value to your company, and that you invoice your customers appropriately and collect payment. One of the purposes of internal controls is to protect against fraud and error, and another is to protect you from loss due to damage and accident. Each process in your company should be reviewed to make sure that you have adequate controls in place. This will be somewhat time-consuming. BGT will not need to have controls as robust as those of a multinational business, since the company is small, but you do need to take adequate steps to protect against various risks, some of which will be new risks to BGT. BGT will no longer be a small family business, where you have the ability to fully trust all those who have access to bank accounts, financial records, and other valuable assets. You must consider how best to protect BGT’s assets. Review and Follow-up As you grow, your attention to budgeting and variance analysis will need to increase. Your business will no longer be small enough that Orland will be able to instinctively determine production costs and product margins. As you can understand, if you are producing ten times as many toys as you currently produce, a small change in margin due to increased production costs or raw material price changes will have a much larger impact than it has today, so there is greater risk of financial difficulties being created by short-term problems. Part of the agreement includes guaranteeing WEL a price that is 5% lower than that offered to anyone else. You will need to monitor the impact of this discount on your margins, because you still want the reduced sales price to cover your costs of production and marketing, as well as contribute towards covering other business costs. Since you will hire new employees to market and distribute the product, you will not have firsthand knowledge of the pricing and costs, the way you do today. You will want to generate reports frequently from your accounting system to be able to monitor costs, pricing, and margins so that you can ensure that BGT continues to make a profit. You will want something to compare the costs to as a benchmark, so you should prepare a budget, watch for when the costs vary from budget, and then follow up on variances to get explanations to ensure that they are appropriate. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 13 WEL requires quarterly financial statements be prepared for internal purposes. I recommend that a rolling quarterly and annual budget be prepared. These budgets should reflect the expectations of capacity increases, new or lost business, market conditions, new capital expenditures, and production. Each quarter, these budgets should be compared to actual results. Significant variances or unusual patterns should be investigated by the appropriate person. You will need to make sure your accounting software and reporting package can generate the financial and management reports you need. Jane mentioned wanting time to get to know what reports the accounting system is able to produce. This is a good idea. It will be important to know whether the current accounting system is able to produce the reports you will need. If not, you may need to buy a new accounting system. You mention that BGT currently pays all suppliers on receipt of an invoice. You may want to reevaluate this decision and only pay immediately those suppliers that provide a discount for early payment. Your accounting system should be able to schedule the payments on the most efficient or beneficial schedule, since you will likely now be in a position to want to manage your cash to ensure your loan payments are not jeopardized in any way. Many people will likely be ordering products and materials, and information about the orders should be recorded on a bill of order or request for product, kept in the office, and then reconciled against deliveries when they are made to the warehouse. This way there can be a reconciliation of products ordered and received. The amounts should also be reconciled with accounts payable. Similarly, a formal process should be put in place for accounts receivable since Sally and the marketing vice-president will be sharing duties. All sales, returns, and order changes will be handled by that team and then passed along to the shipping department. The records of shipments out of the department could then be reconciled with the back office invoices and orders to ensure completeness and occurrence of sales and that only authorized transactions are processed. Segregation of Duties The assistant that will be hired to help Jane in the office should be adequately trained and supervised. His or her work should be reviewed for accuracy. For example, if vendor invoices are input and cheques generated for payment by this person, someone else should review the cheques and ensure they match the invoices prior to signing. The person who inputs vendor invoices should not have the ability to add new vendors. These are examples of internal “segregation of duty” controls. The same concept would apply to invoicing your customers and paying your employees. The duties of receiving and deposit cash should be separate from billing, and of the duty of preparing the payroll should be separate from signing payroll cheques and adding new employees. As you grow, this will become increasingly important because you will get to the point where you may not personally know all your employees or be able to sign each cheque personally. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 14 On the shipping, receiving, and warehousing side, you should ensure that the duties of shipping are separate from the duties of receiving damaged or returned goods. Otherwise, it is possible for someone to make an error or commit fraud on the shipping documents to hide what are made to look like returns without the goods actually being returned. Now that you will no longer be in charge of all customer and supplier relationships, the risk of this type of behaviour increases. Authorization Limits You mention giving signing authority to both the new vice-president and the new manager. You should consider whether signing authority should be granted at the manager level. You may wish to restrict the granting of this privilege to the most senior level employees, likely vicepresident and higher. You should ensure that there are limits to the amount of authority anyone with signing authority has, since they are committing the corporation to financial transactions and agreements. If managers are granted signing authority, it should be for relatively small amounts at first; perhaps just a corporate credit card with a small limit to cover travel and entertainment expenses. You should establish policies and procedures regarding pricing that take into account not only volume considerations, but also ensure that you maintain adequate margins (so that costs of production and marketing are covered, as well as contributing to other business expenses). Floor pricing should be set for each product and should be tied to the size of the customer’s potential and the size of the order. These types of limits would apply at all levels, to anyone with signing authority. You noted that the new vice-president and manager will hire their own employees and set their wage rates. Once again, you should consider whether the manager level should have this much authority or whether it should be restricted to the vice-president level or higher. You should set some parameters for the wage ranges they would be allowed to use when hiring, as well as the range for wage increases, to ensure the wages are reasonable compared to the marketplace. Proper Documentation and Approval Processes If you proceed with the proposal from WEL, you will want to put processes in place to have formally signed contracts with your suppliers and customers. Handshakes work when you have a limited number of relationships that you can be personally involved in. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 15 Now that you are hiring people (such as the marketing vice-president and the distribution manager) to develop new relationships and take over functions that you currently undertake, you will want to ensure that the discussions and agreements that they enter into are adequately documented in a written agreement. For example, verbal contracts with past customers (despite no collection problems) will now have to be formalized and in written format, so that in the event of disputes, the terms and conditions are supportable by signed agreements. In addition, BGT should have a credit approval process in place to limit credit risks from customers, as well as a developed pricing policy. Also, you will want to have some sort of approval process in place so that your employees cannot enter into bad deals that put you at risk of loss. You mention that the new vice-president and manager will hire their own employees; however, you should consider whether the manager level should have this level of authority or whether it should be restricted to the vice-president level or higher. You should have an approval process in place for the hiring of employees — perhaps all proposed new hires need to be reviewed and approved at a senior level before the job offer is made to ensure that responsible persons with the appropriate job capabilities are selected for each position. Similar review and oversight processes might also apply to letting employees go. Since WEL will have significant representation on the board of directors, maintaining the minutes of board meetings is important, so that business decisions are documented. Access Controls You will want to set up other access controls; specifically, you will want to have the appropriate people in appropriate work places, and keep doors that should be locked actually locked. As the value of your inventory grows, your potential loss from theft will be greater. You will also need access controls over your IT systems. You will want to have passwords for access to accounting records so that unauthorized persons cannot go in and change the numbers to hide errors or theft. You will especially want to restrict access to banking and loan records and to any online banking information. Access controls should be in place so that shippers cannot access inventory reconciliation records or goods return records, nor should they be able to adjust invoices. Fixed Asset Controls As you hire more employees, you will also likely be buying office equipment, furniture, computers, and peripherals for them. You will likely want to keep control of these assets — to know who has them and where they are — more so than when it was just family members who used these types of assets. Since they are easily stolen, you will want to put controls in place to ensure you can track these assets. You may want to use a fixed asset ledger system and assign asset numbers to all of BGT’s fixed assets. This makes tracking the cost of acquisitions and disposals much easier. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 16 Assessment Opportunity #3 The candidate discusses the risks related to WEL’s proposal. The candidate is demonstrating competence in Core 2- Performance Management CPA Mapping: 2.1.1 Evaluates the entity’s governance structure (policies, processes, codes) (Core- Level B) 2.2.1 Assesses whether management decisions align with the entity’s mission, vision, and values (Core- Level B) 2.3.3 Evaluates strategic alternatives (Core- Level B) 2.4.1 Analyzes the key operational issues and alignment with strategy (Core- Level B) It appears that you have identified most of the potential benefits of the deal. You have asked me to comment on the risks of the business expansion that you may not have identified. We would like to highlight the following risks that you may not have considered. Loss of Control First, you have alluded to, but may not have fully considered, the implications of the loss of control. Currently, Sally and Orland are the only two shareholders of BGT. You can currently set policy; determine whom to hire, fire, and do business with; and make any decision that is related to the business. If you conclude the transaction with WEL, you will no longer have complete control. In fact, with a majority of the shares and a majority of the members of the board of directors, WEL will control BGT. Through its control, WEL will have the final say in all the policy and business decisions that you now currently control. WEL is a public company and likely has different pressures put on it by its shareholders, which could have an impact on the decisions it makes at BGT, depending on the significance of BGT to WEL’s overall operations. Culture WEL’s involvement in the business will likely change the culture of the company completely. It can determine the way the business is run, through its voting power, and veto any “family” decisions. Decisions that affect the policies and strategy-setting will no longer be discussed around the kitchen table. With the addition of WEL personnel on your board, the board meetings will likely become more frequent and formal, requiring proper motions, minutes, agendas, and notices of meeting dates, for instance. Your management structure is also going to change. The new vice-president and manager being hired will have influence over decision-making since they are in management roles. Sally, you will continue to be the president of the corporation, but you will not be able to operate the corporation without consultation and compromise. Currently, you and Orland work together to make decisions, and have a strong working relationship with your suppliers and customers based on the fact that you often do business on a hand-shake. There may be a significant impact on the operating culture, which could directly affect the employees of BGT. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 17 You also need to consider the next generation of your family — preserving the history of the family-owned business into its fourth generation. It appears that Jane wanted the corporation to become hers some day. I understand that she has worked hard for you. She might have to consider finding something else to do to replace the type of income and capital growth that she was expecting from BGT, depending on her role in the future of BGT. Job Security The agreement also does not include a commitment to you personally, beyond guaranteeing a job and your current salary for one year. Having only one year of guaranteed employment is a risk to you since WEL will have the power to vote in new management if they believe you are not successful after one year. In addition, the fact that a marketing vice-president and distribution manager will be hired within the next three months (and presumably trained by the two of you) may be a cause for concern, since you are essentially hiring (and potentially training) staff who could replace you. You should ensure that you obtain an idea of what WEL expects in terms of results from BGT so that you can determine if the expectations are reasonable. You can then determine the exact risk of the loss of your jobs. Assuming you keep your jobs, there is no guarantee that you will be able to draw the current dividends of $150,000 per year (from 2010 info), so while your salary might be maintained, you will not have the same cash flow that you are currently drawing from BGT. Since you will no longer have the majority of share ownership or control over the board of directors, you will have little ability to influence the dividend decision. The terms should be discussed and formalized. You should also discuss with WEL the terms of your compensation arrangements, so that you may have an opportunity to share in profit through a profit-sharing plan, in addition to your share ownership. Financial Considerations The potential dilution of your ownership interest is to 25,000 of a total of 175,000 shares, or approximately 14%. You are currently making $450,000 profit annually, based on 2010 results, plus the salaries that you are drawing for family members. Your share of BGT is arguably worth $1.5 million ($60 × 25,000 shares currently outstanding) as it stands, based on the price offered by WEL. However, you will need to assess whether the $60-per-share price offered by WEL represents fair value. For the purposes of our discussion, we will use $60. You should assess whether $60 is a fair price. (Our firm could assist you in this matter.) Let us say that you are successful in growing tenfold. You will arguably have profit of $4.5 million, but you will own 14%, rather than 100%, of the company. If your share of the company, with a profit of $450,000 per year, is worth $1.5 million, then perhaps the company will grow tenfold to be worth $15.0 million. At 14%, your share could have a value of $2.1 million. Your value will have increased $600,000. The question you need to ask is if that is worth the risk. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 18 Assuming the price per share seems fair, the equity valuation of $1.5 million is $165,000 above the book value of your equity today. However, you are taking on more debt and the company is more highly leveraged; therefore, the general risk related to holding debt goes up with this deal. We noted a couple of things in the documents you provided to us that we thought we should bring to your attention. WEL’s commitment to purchasing NanoPets is fairly limited, with only 50,000 units committed to this year, out of a production capacity of 2 million. While it appears that WEL intends to purchase a larger number of units once it expands, it has made a relatively small commitment, which will result in a stranded investment if you do not sell enough toys to make up for the substantial increase in volume (you currently produce only 40,000 units). You should consider how financially strong the backing from WEL actually is —perhaps review its financial position — to ensure that it will fulfill its commitments. WEL is committing $1.5 million of the equity investment required. With the additional $1.5 million of funding coming from the bank, if your expansion is not successful and you fall back to your traditional volume and profitability, your ability to pay off that large of a bank loan may be affected. Also, there is no guarantee on the value of your shares. While they are notionally worth $60 per share, because that is the purchase price for WEL, you are not cashing out, and if the business does not grow as you expect, your shares will be worthless. That is the risk, which should be balanced against the reward of significant growth that would possibly result in increased share value if you are successful in selling at capacity. You need to consider the market risks (discussed below), in conjunction with this point. Another factor to consider is the absence of an exit strategy for you in the current proposal. In effect, you are giving up a significant portion of your business with no immediate benefit to you (in other words, no cash in your pocket at the current time) and with no ability to control the future of the business. Part of the agreement includes guaranteeing WEL a unit price that is 5% lower than that paid by anyone else. Your margins could be eroded by the discount. The impact might depend on whether your production costs decline with the increased volumes being produced. Market Risks Further to the risks affecting product sales, there is some risk that the popularity of NanoPets may be fleeting. The WEL representative referred to the product as “trendy.” If it is in fact a fad toy, you will want to develop another product to replace it, and it will need to be a product that can attract the same type of popularity as NanoPets seems to be currently enjoying if you are going to get a return on your large capital investment. There is some risk that the financial and growth projections are too aggressive. There will be logistical issues to producing, distributing, and selling the volumes given that the average sales of NanoPets are only 13,000 per month. There is a chance that this will become a world-wide phenomenon, but at the same time there is some risk it will not take off. Not only would the investment be stranded, but the company could be bankrupted, with a total loss to you. To the extent possible, when projecting sales volumes, you should ensure that there is strong support for the volumes to be produced. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 19 Size and Rate of Expansion of Building and Operations You will be ramping up the business very quickly. Are you sure you will be able to handle the large increase in volume of business, in terms of your operations and back-office support? The addition of new employees will help, but you need to consider the large amount of growth you are suggesting and plan for it properly before proceeding. In addition, the deadline to complete the first phase of the expansion (September 2011) is tight. You need to consider the fact that BGT is obtaining bank financing for its share of the capital expansion required. There is no mention in the agreement of the type of support WEL will provide should there be any delays in construction, increase in costs of equipment, and similar expenses. It is not uncommon for there to be delays that often result in increased construction costs. Is BGT expected to bear any additional costs that may be incurred? You may wish to clarify what WEL’s commitment will be should there be any delays or increased costs, to ensure that BGT isn’t solely on the hook. Another type of risk mitigation that you are likely already employing is the use of adequate and appropriate insurance for your assets and operations for protection from the risk of theft, loss, or damage. Since you are growing, your insurance coverage (both for physical assets and business interruption) should likely be expanded. We are not trying to indicate that we think the WEL proposal is unfair in any way. These are just additional considerations we believe you should take into account when considering the offer. Alternatives Although the agreement itself is non-negotiable, perhaps WEL would be open to a partial cashout for you. Maybe it would purchase half of your current shareholdings so that you at least have some cash not at risk if the business does not expand as desired. This limits your upside potential, but also your downside risk, and would be prudent if your assets outside your investment in BGT are not enough to fund your retirement. Another alternative is to enter into a distributor agreement with WEL and grow slowly into the NanoPets market, rather than ramping up as quickly as they have suggested. This would allow you to retain control of your company while still perhaps taking advantage of WEL’s international market reach, and its experienced and professional management with connections in the international business community. There are some risks in the current agreement (for example, your salaries are only guaranteed for one year, and you are limited to two seats on the board) that could perhaps be addressed through a separate shareholders’ agreement. Having a formal shareholders’ agreement in place would help protect you from being “pushed out” by WEL. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved. CPA Final Common Exam - Day 3 Example Page 20 We have one final suggestion for your consideration. Rather than entering into an agreement with WEL at all, you may want to consider how you could go about expanding BGT in other ways. You appear to have run your business quite successfully. Perhaps a growth strategy, with the assistance of bank financing, is a feasible alternative. If any of the above alternatives appeal to you, we can discuss them further. CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved.