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JUNE 2002

The Canadian Institute of Chartered Accountants


277 Wellington Street West,Toronto ON M5V 3H2 E D U C A T I O N
Tel (416) 977-3222 Fax (416) 204-3423 www.cica.ca

For more information


The new CA qualification process will prepare future CAs to meet the challenges that await them.
For more information on the new qualification process, the new uniform evaluation, and your province’s specific
education requirements, contact your regional education director or your local Provincial Institute/Ordre.

Regional Education Directors


Atlantic Canada and Bermuda: Ontario:
Dan Trainor, FCA Brian Leader, CA
Atlantic School of Chartered The Institute of Chartered Accountants
Accountancy of Ontario
Cogswell Tower, Suite 706 69 Bloor Street East

Preparing for the 2003 UFE


Scotia Square, P.O. Box 489 Toronto, Ontario M4W 1B3
Halifax, Nova Scotia B3J 2R7 Tel: (416) 962-1841 extn. 273
Tel: (902) 425-7974 Fax: (416) 962-8900
Fax: (902) 423-9784 Web site: www.icao.on.ca
Web site: www.asca.ns.ca E-mail: bleader@icao.on.ca
E-mail: theschool@asca.ns.ca
Western Canada and the
Quebec: Territories:
Diane Messier-Marcotte, CA John Brennan, FCA or
Ordre des comptables agrées du Don Carter, FCA
Québec C A School of Business
680, Sherbrooke Ouest, 18e étage 582 Manulife Place
Montréal, Québec H3A 2S3 10180-101 Street
Tel: (514) 982-4601 Edmonton, Alberta T5J 3S4
Fax: (514) 843-8375 Tel: 1 866 420-2350
Web site: www.ocaq.qc.ca Fax: (780) 424-8041
E-mail: d.messier Web site: www.casb.com
marcotte@ocaq.qc.ca E-mail: j.brennan@icaa.ab.ca
or carter@ica.bc.ca

Understanding the Evaluation Methodology


Provincial Institutes/Ordre
The Institute of Chartered The Institute of Chartered The Institute of Chartered
Preparing for the 2003 UFE
Accountants of Bermuda Accountants of Newfoundland Accountants of Saskatchewan
Box HM 1625 95 Bonaventure Avenue, 5th Floor 1801 Hamilton Street, Suite 830
Hamilton 5, Bermuda
(441) 292-7479
www.icab.bm
P.O. Box 21130
St. John’s, Newfoundland A1A 5B2
Regina, Saskatchewan S4P 4B4
(306) 359-1010 Understanding the Evaluation
(709) 753-7566 www.icas.sk.ca
The Institute of Chartered www.ican.nfld.net
The Institute of Chartered
Methodology
Accountants of Nova Scotia Ordre des comptables agréés du Accountants of Alberta
1791 Barrington Street, Suite 1101 Québec 580 Manulife Place, 10180-101 Street
Halifax, Nova Scotia B3J 3L1 680, rue Sherbrooke Ouest, 18e étage Edmonton, Alberta T5J 4R2
(902) 425-3291 Montréal, Québec, H3A 2S3 (780) 424-7391 1 800 232-9406 (for
www.icans.ns.ca (514) 288-3256 1 800 363-4688 Alberta, outside Edmonton)
The New Brunswick Institute of www.ocaq.qc.ca www.icaa.ab.ca
Chartered Accountants The Institute of Chartered The Institute of Chartered
93 Prince William Street, 4thFloor Accountants of Ontario Accountants of British Columbia
Saint John, New Brunswick E2L 2B2 69 Bloor Street East 1133 Melville Street, 6th Floor
(506) 634-1588 Toronto, Ontario M4W 1B3 Vancouver, British Columbia V6E 4E5
www.nbica.org (416) 962-1841 1 800 387-0735 (604) 681 3264 1 800 663-2677 JUNE 2002
The Institute of Chartered www.icao.on.ca www.ica.bc.ca
Accountants of Prince Edward The Institute of Chartered If you are in the Yukon, please contact
Island Accountants of Manitoba the Institute of Chartered Accountants
P.O. Box 301 – 129 Kent Street, 500 – 161 Portage Avenue East of British Columbia.
Suite 203 Winnipeg, Manitoba R3B 0Y4
Charlottetown, PEI , CIA 7K7 If you are in the Northwest Territories
(204) 942-8248 1 888 942-8248
(902) 894-4290 or Nunavut, please contact the Institute
www.icam.mb.ca
of Chartered Accountants of Alberta.
TABLE OF CONTENTS

I INTRODUCTION ...............................................................................................................2

II THE MOCK MARKING CENTRE ....................................................................................4

III THE BOTTOM LINE: PASS/FAIL ...................................................................................8

IV BOE CONCLUSIONS ON THE METHODOLOGY.......................................................14

V COMMENTARY ON CANDIDATE PERFORMANCE .................................................15

APPENDIX A MOCK MARKING CENTRE SIMULATIONS AND EVALUATION


GUIDES...........................................................................................................19

APPENDIX B CANDIDATE PERFORMANCE ON PRIMARY INDICATORS BY


COMPETENCY AREA.................................................................................156

APPENDIX C CANDIDATE PERFORMANCE ON PRIMARY AND SECONDARY


INDICATORS BY SIMULATION...............................................................159

Copyright  2002
The Canadian Institute of Chartered Accountants
277 Wellington Street West, Toronto, Canada M5V 3H2
Printed and bound in Canada

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I INTRODUCTION

Overview
In March 2002 the CICA published “Preparing for the 2003 UFE: An Introduction to the New
Uniform Evaluation Process.” That publication explains the change in the CA professional
education to focus on competence. It also briefly describes the new Uniform Evaluation process
that will be used to assess whether candidates possess the level of competence expected of entry-
level CAs.

The Board of Evaluators (BOE) was charged with the responsibility of developing a
methodology for evaluating competence. Given the nature and magnitude of the changes, the
BOE decided to test the new methodology before using it for the 2003 Uniform Evaluation. In
February 2002 the BOE set up a Mock Marking Centre using selected 2001 UFE questions and a
representative sample of candidate responses. Experienced markers applied the new
methodology using the new tools created by the BOE.

To provide candidates with a better understanding of how the new evaluation process works, this
report explains the methodology in some detail, describes how it was applied at the Mock
Marking Centre, and sets out some important lessons learned  lessons that the BOE believes
will be of benefit to candidates. The information regarding the new methodology and its
implications applies to the Uniform Evaluation to be written by CA candidates in 2003.

Background

Evaluation geared to the Vision CA

The CICA Board of Directors concluded in the late 1990s that the Canadian CA profession faced
changes of such magnitude that it needed to articulate a vision to guide the profession in the 21st
century. The resulting Vision Report set out the following Mission and Vision statements
describing the profession’s purpose and direction:

Mission: Our mission is to enhance decision-making and improve


organizational performance through financial management, assurance and
other specialized services. We act with integrity, objectivity and a
commitment to excellence and the public interest.

Vision: We will be the leaders in creating, validating and interpreting


information that measures and enhances organizational performance, and be
the obvious choice for financial management, assurance and other specialized
services.

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The Board of Directors subsequently approved the adoption of a competency-based approach to


CA qualification as a key element in fulfilling the Mission and achieving the Vision. This
approach specifies expectations in terms of learning outcomes, or what an individual can do or
accomplish.

The Competency Map and its impact on evaluation

What a CA should be able to do or accomplish at the time of entry into the profession is set out
in the “The Canadian CA Competency Map,” published in September 2001.

The profession’s adoption of a competency-based approach and the new ground rules set out in
the Competency Map created an entirely new context in which CA candidates would have to be
evaluated. Among the significant changes introduced by the Competency Map are the expanded
competency areas of Information Technology, Finance, and Organizational Effectiveness. The
Competency Map makes room for these expanded competencies and limits the complexity
resulting from expanding the competencies, by requiring that competencies be evaluated under
“normal circumstances.” Further, the Competency Map requires the pervasive and specific
competencies be evaluated in an integrated manner.

The adoption of the Competency Map by the profession necessitated a complete re-thinking of
the evaluation process by the BOE, resulting in a new methodology and the creation of new tools
to implement it.

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II THE MOCK MARKING CENTRE


In February 2002 the BOE convened a Mock Marking Centre to test the methodology it had
developed. A sample of 2001 UFE papers was selected and marked using the new methodology.
The objectives in conducting the Mock Marking Centre, the process it followed, and the various
components are described in more detail below.

Objectives
The BOE set up the Mock Marking Centre (the Centre) because it wanted to test:

• whether individual candidate responses could be evaluated using the BOE’s new
competency-referenced evaluation methodology, and

• whether a valid, composite view of the candidate’s competence could be obtained for
purposes of making a pass/fail decision.
In the course of performing this test, the BOE anticipated that it would be able to:

• identify “lessons learned” that would be useful to the BOE, to educators, and to future
candidates;

• obtain information that would be helpful in charting the BOE’s course for the 2003 UFE;

• explore any concerns about the methodology; and

• gather more information on how candidate excellence can be identified for recognition.

The Centre was not expected to answer all of the questions that either the BOE or educators
might have about the new process due to the following limitations:

• The Centre was (and is) not a “perfect tool.” That is, not all competency areas were well
covered. The candidate responses used were written by candidates who had prepared for a
traditional UFE, not for a competency-referenced evaluation.

• The Centre’s set of questions differed from the 2001 UFE. It excluded one single-subject
question, one multi-subject question, and the multiple-choice questions. In addition, the
comprehensive question contributed only 25% of a candidate’s mark on the 2001 UFE
whereas it represented 33% of a candidate’s evaluation at the Centre.

Therefore, the BOE’s analysis of the Centre’s results focused on the application of the new
evaluation methodology to individual candidates. Did those candidates who displayed
competence pass; conversely, did those candidates who did not display competence fail?

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Mock Marking Centre process


To conduct the mock marking exercise, it was necessary to use simulations (business cases
representative of the kinds of challenges entry-level CAs face). The simulations used at the
Centre were selected from 2001 UFE questions that were deemed appropriate. An evaluation
guide that incorporated the new methods was developed for each of the 2001 UFE questions
selected. Markers were trained in the new methods, and consistency was achieved before “live”
marking of the sample responses began. Each of these steps in the process is described below.

The BOE developed a “passing profile” and made pass/fail decisions. These components of the
process are discussed in the next chapter of this report.

2001 UFE questions were selected for use as simulations

In selecting which 2001 UFE questions to include in the mock marking exercise, the BOE was
guided by the Competency Map. It specifies the knowledge, skills, and attitudes expected of all
CAs at the point of qualification. It also specifies:

• the “normal circumstances” in which all entry-level CAs are expected to demonstrate the
required competencies; and

• the level of proficiency that all entry-level CAs are expected to demonstrate with regard to
each competency.

The Board reviewed the 2001 UFE to determine which questions were appropriate for the Mock
Marking Centre. First, the multiple-choice questions were eliminated. Then, Paper II question 3
was not considered appropriate because it was a single-subject tax question and because the
knowledge tested in the question was considered to be beyond the level of competence described
by the Competency Map. Finally, Paper III question 3, a multi-subject question, was not
considered appropriate because the scenario (a large public company) and the cumulative
complexity of the accounting issues covered represent a situation no longer (i.e., under the new
methodology) considered appropriate for entry-level CAs.

All other questions were considered appropriate for use at the Mock Marking Centre.

Evaluation guides were developed

The BOE developed evaluation guides for each of the 2001 UFE questions included in the mock
marking exercise. Evaluation guides were prepared for primary and for secondary indicators of
competence.

Primary indicators of competence answer the question: “What would a competent CA do in these
circumstances?” Secondary indicators of competence answer the question: “What other issues
could a CA raise?”

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The difference between primary and secondary indicators is that, in the circumstances given, the
primary indicators are more “mission critical” than the secondary indicators. In other words, if
the issues identified in primary indicators are not addressed, the CA could, in real life, be placed
in professional jeopardy or could place the client in jeopardy. Secondary indicators pertain to
issues that, while relevant, are not absolutely essential to address. Each indicator of competence
given in the evaluation guides is followed by a description of the issues that could be raised or
discussed to demonstrate competence.

Finally, the evaluation guides include carefully defined performance levels to assist markers in
evaluating a candidate’s competence relative to the indicators. Five categories of performance on
each primary indicator are given. 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 secondary indicator, the candidate’s performance must be ranked in one of four
categories:

• Not addressed
• Nominal competence
• Competent
• Highly competent

(“Reaching competence” is not relevant at the stage where the BOE considers the candidates’
performance on secondary indicators. This stage is explained in The Pass/Fail Decision
Framework, Level 3, below.)

The simulations and evaluation guides used at the Mock Marking Centre are included as
Appendix A of this report.

2001 UFE papers selected for the Mock Marking Centre

A representative sample of 203 candidate papers was selected for the mock marking exercise
using the 2001 UFE grade as a proxy for performance. The BOE wanted to ensure that the
sample covered the full spectrum of candidate performance. In addition, the sample included the
same proportion of French and English language papers as existed for the 2001 UFE.

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Orientation of markers/startup/consistency

The mock marking exercise was held in February 2002, immediately following the 2001 UFE
Appeal Centre. Senior markers who attended the Appeal Centre also participated in the Mock
Marking Centre.

A one-day training session was held with each team of markers (each team was responsible for
one question on the 2001 UFE). The training consisted of familiarizing the markers with the
evaluation guides that had been prepared for each question, and then reading and test marking
photocopied candidate papers.

Before “live” marking began, agreement was reached as to precisely what it was that would
distinguish the achievement of one performance level from another (i.e., what elements had to be
present in a response for that candidate to be considered, “competent” as opposed to “reaching
competence”). In addition, consistency was sought and achieved (i.e., senior markers and board
staff all reached the same opinion as to the performance level demonstrated by a candidate).

The marking teams were instructed to maintain consistency by discussing candidate responses
that required a great deal of judgment to rank or candidate responses that did not follow the
normal pattern. In addition, marking teams were encouraged to mark a paper together every few
hours to ensure that the team’s judgment remained consistent.

The BOE analyzed results

Once live marking was completed, the incoming BOE Chair, the current BOE Chair, and the
BOE staff spent three days analyzing the candidates’ results produced by the mock marking
exercise. The BOE subsequently met for two days to review the results and the analyses.

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III THE BOTTOM LINE: PASS/FAIL


After the live marking was completed at the Mock Marking Centre, the BOE reviewed each
candidate’s performance on the simulations considered as a whole in order to evaluate whether a
candidate passed or failed. This decision was based on a comparison of the candidate’s
performance against a “passing profile.” The BOE developed a passing profile for the mock
marking exercise. It will do so for the Uniform Evaluation each year.

The principles guiding the construction of a passing profile are outlined below. A decision
framework for applying the passing profile and thus reaching the final pass/fail decision also
had to be developed and is also described below.

The concept of a “passing profile”


The current UFE fair pass decision-making process begins with assessing candidates on the basis
of each piece of knowledge or skill that they demonstrate. Every possible valid piece of
knowledge or skill is noted on the marking key, and markers are asked to make hundreds of
discrete yes/no decisions. Did the candidate demonstrate that piece of knowledge or skill? The
BOE then assigns each of these pieces a weighting based on the importance of the knowledge or
skill to the scenario. The weightings are aggregated, and a candidate receives a score that ranks
his or her performance relative to all candidates.

Evaluating competence and the Passing Profile

The new competency-referenced evaluation shifts the focus away from many individual
assessments to an assessment of whether the candidate’s response to the Uniform Evaluation
(i.e., his/her responses to all the simulations considered as a whole) conforms to a set of
characteristics, or a passing profile, that the BOE has determined constitutes competence. In
short, does the candidate’s performance meet the passing profile? If it does, the candidate passes;
if not, the candidate fails. Thus, the decision is an overall pass or fail: the candidate’s
performance is found either to be competent or not. No ranking relative to other candidates is
provided.

Developing a passing profile to determine competence is a considerable challenge. The BOE has
to consider multiple elements. It must take into account not only whether the candidate has
covered all the specific competence areas adequately but also the way in which the responses are
framed (the pervasive qualities). At the same time it must recognize that varying combinations
of relative strengths and weaknesses can demonstrate adequate competence and appropriately
lead to a “pass.”

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The requirement specified for any one element of the profile must not be set too high, since
candidates must meet the requirements set by the BOE for every single element of the passing
profile. These elements are described below. Thus, although meeting the requirement for any
single element on its own might seem a relatively easy task, the fact that all requirements must
be met without exception means that candidates face a larger challenge.

The Elements of the Passing Profile


In defining the profile of a “competent” candidate  that is, in defining a passing profile  the
BOE looked to the Vision CA requirements and the Competency Map.

The three elements and the Pass/Fail decision framework

To meet the passing profile, a candidate’s response must comply with the following elements:

1. The response must be sufficient, i.e., the candidate must demonstrate competence on the
primary indicators a sufficient number of times to be considered competent.

2. The response must demonstrate depth in the areas of performance measurement and
assurance.

3. The response must demonstrate breadth across all areas of competency.

Each candidate’s performance is assessed against these three elements using measures designed
by the BOE. Each of the three elements represents a “level” or decision point in the framework
that the BOE uses to determine pass/fail for each candidate.

Only if the candidate meets the first level is he or she assessed against the second level; only if
he or she meets the second level is he or she assessed against the third level. (The decision
framework is further explained below.)

In addition to the elements of a passing profile outlined above, the candidate’s response must
also demonstrate competence consistently. That is, a candidate cannot rely on superior abilities
in, for example, information technology to compensate for poor performance in, say, taxation.
Neither could a candidate rely on superior performance on one primary indicator in, for example,
assurance to compensate for poor performance on other primary indicators in assurance.

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Determining the Passing Profile

Each year the BOE will design measures to assess each of the three elements that constitute the
passing profile for that year. These measures will, of course, vary, depending on what
competencies are tested in the Uniform Evaluation for that year. But the underlying elements
will remain the same from year to year. The BOE’s approach to determining the passing profile
is further explained below.

1. Candidates must demonstrate sufficient competence on the issues that are critical to the
analysis.

The candidate must demonstrate competence as measured by all primary indicators


considered as a whole. The standard for sufficiency is set at as modest a level as possible to
allow the majority of candidates to be assessed at the subsequent levels. As is the current
practice, the BOE will continue to adjust this standard to account for the difficulty of the
simulations, etc.

To measure sufficiency, a numerical value will be assigned to the “reaching competence” and
“competent” levels of performance associated with each primary indicator.

At the Mock Marking Centre, the “reaching competence” and “competent” levels associated
with the comprehensive question’s primary indicators were assigned a value of 4 points and 8
points respectively. For the non-comprehensive simulations, the corresponding values were 2
points for “reaching competence” and 4 points for “competent.” Note that a standing of
highly competent is awarded the same points as a standing of competent. This point
weighting reinforces the importance of consistency in a candidate’s performance across all
primary indicators.

2. Candidates must demonstrate depth on the key issues in the areas of Performance
Measurement and Assurance.

This requirement is supported by the heavier weighting assigned to these areas and is
justified on the grounds that these areas are still the hallmarks of the CA profession.

Candidates must demonstrate competence in Performance Measurement and Assurance by


analyzing issues, ranking issues, and providing practical advice on issues. “How much”
constitutes depth is a matter for the BOE to judge. A decision will be made each year based
on the number, quality, and difficulty of the primary indicators in Performance Measurement
and Assurance.

The measure used to assess depth will not rely on an assigned numerical value; rather, it will
be the number of times a candidate demonstrates competence on the Assurance and
Performance Measurement primary indicators.

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3. Candidates must demonstrate breadth, on the premise that a new CA must display some level
of competence in all the required specific areas. Breadth requires evidence of competence on
more indicators but at a lower level of performance than is required for depth. “How much”
constitutes sufficient breadth is a BOE judgment that will be made each year based on the
number of primary and secondary indicators on which candidates may demonstrate
competence in each of these specific areas.

The BOE will assign a numeric value to assess breadth for each specific area. If candidates
do not demonstrate breadth based on the primary indicators, they will be given another
opportunity through a consideration of their performance on the secondary indicators.

The evaluation guides will ensure that passing candidates consistently demonstrate competence.
This outcome is achieved through the weighting/scoring assigned to the various levels of
performance associated with each indicator. “Competent” and “highly competent” are assigned
the same number of marks. This weighting contrasts with the approach used in past UFEs,
where a candidate could gain enough marks by doing very well in one area to offset poor
performance in another. Under the new framework, the ability to achieve beyond the level of
“competent” on one performance indicator will not offset poor performance on another
performance indicator. Competence must be consistently demonstrated to achieve a pass.

Overriding Principle

The BOE will continue to use its judgment in determining the passing profile to ensure that
candidates are treated fairly.

The Pass/Fail Decision Framework

The pass/fail decision framework is designed as follows.

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Our Decision Framework 12

Was the aggregate competency


F NO demonstrated sufficient?
Level 1
YES P
A NO Were the PM and A competencies
demonstrated deep enough?
Level 2
YES A
I Primary
indicators Was the competency demonstrated
broad enough? YES
only
Level 3
S
NO
L Review additional information
from secondary indicators to
enhance the ability to assess
S
NO breadth – 2nd assessment of “Was YES
the competency demonstrated
broad enough?”
Secondaries

QUALITY CONTROL

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Level 1 – The first test is that of sufficiency. On the primary indicators does the candidate
demonstrate sufficient aggregate competence? This will be a numerical test. The BOE will not
look at the pattern of how the numeric value was accumulated but rather whether a minimum
standard that demonstrates sufficiency has been achieved. If the candidate meets this
requirement, he or she will move on to the Level 2 test. If the candidate does not meet this
requirement, he or she will be assessed as a fail.

Level 2 – The second test is that of depth. On the primary indicators does the candidate
demonstrate competence a sufficient number of times in the areas of Assurance and Performance
Measurement? If the candidate meets this requirement, he or she will move on to the Level 3
test. If the candidate does not meet this requirement, he or she will be assessed as a fail.

Level 3 – The third test is that of breadth. First, the BOE will consider performance on the
primary indicators only. Has the candidate demonstrated some minimum level of competence in
each of the specific areas, or has the candidate consistently avoided a specific area on the
simulations as a whole?

If breadth is not evident from the candidate’s performance on the primary indicators, then the
BOE will consider performance on the secondary indicators to assess breadth of coverage. If the
candidate demonstrates breadth, he or she will be assessed as having passed. Otherwise the
candidate will be assessed as a fail.

Appendix B contains a table showing the results produced by the Mock Marking Centre. This
table summarizes candidate performance on the primary indicators analyzed by competency area.

Appendix C contains a table summarizing candidate performance on both primary and


secondary indicators, analyzed by simulation.

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IV BOE CONCLUSIONS ON THE METHODOLOGY

The BOE’s overall conclusions are presented below.


The mock marking exercise provided the BOE with the assurance it required to ascertain that the
new evaluation methodology does produce valid results. This was determined by reading the
papers of candidates who passed and failed based on the new methodology. In each case the
BOE was satisfied that the candidates were assigned the appropriate pass/fail standing.

The new evaluation methodology is practical. The examination can be developed and marked
with integrity and consistency.

BOE board members, staff, markers, and members of the Qualifications Committee were
uniformly enthusiastic about the new method.

Next steps
The next challenge to the BOE will be ensuring that the “architecture” of the overall 2003
Uniform Evaluation is such that there are sufficient primary and secondary indicators to assess
sufficiency, breadth, and depth.

For the 2002 examination, the BOE will not publish the traditional UFE Report. Instead, it will
publish the 2002 UFE with accompanying competency-referenced evaluation guides for each
question.

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V COMMENTARY ON CANDIDATE PERFORMANCE


The following comments are intended to help candidates, academics, and others understand the
implications of the new evaluation methodology. To attain a pass standing, candidates must
demonstrate sufficient competence in all areas, as well as appropriate depth and breadth in
their responses.

General comments
• The importance of a well-rounded response, addressing all elements of the profile, cannot
be overstated. As is evident from the comments in “Detractors from performance” below,
the methodology isolates deficiencies in meeting the passing profile requirements.

• The comprehensive question gains in importance, commencing in 2002, when it will


account for 1/3 of the total evaluation instead of 1/4 of the evaluation (which it has been in
the past).

• Consistent satisfactory performance across all areas is critical. Doing very well in one area
will no longer offset poor performance elsewhere. Consistently avoiding an area will not
result in a pass standing.

• The pervasive qualities are integrated into virtually all the indicators of performance.
Therefore specific knowledge on its own will not suffice: how that specific knowledge is
applied is important. Contradictory, unethical, and otherwise inappropriate comments will
detract from good performance. Absence of intellectual integrity in the response as a whole
will affect the assessment of both the pervasive and the specific competencies. In short,
any such comments will reduce the likelihood of achieving a pass standing.

• Technical accuracy is important as it is built into all levels of performance.

• “Weak but awarded” is no longer possible. Today, UFE markers could award a mark even
though, in their opinion, the candidate is weak on the point. In a competency-based
evaluation there is no such measure as “weak.” A candidate either displays competence or
does not.

Detractors from performance

The BOE analyzed the candidates who failed at each level of the decision framework to
determine if there were common performance characteristics which could be noted. The
following is a summary of these detractors from performance.

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At Level 1 of the decision framework:

The comprehensive question is a key component of a candidate’s demonstration of competence.


Because the comprehensive question provides a relatively high proportion (1/3) of the
opportunities to demonstrate competence, poor performance on this question is very difficult to
overcome. Compared to other questions the comprehensive question requires candidates to
process more information, integrate a larger body of data, and adopt a broader perspective in
formulating responses. These are key skills in the new world. Poor performance on the
comprehensive question is a signal of potential difficulties in 2003.

Candidates who in the past did well on some UFE questions by scoring point marks on
peripheral issues (e.g., audit checklists, GAAP recitation) and making boilerplate comments did
not display competence as required in the new evaluation methodology. Candidates who respond
to the primary indicators in this manner will not be evaluated as competent on the new Uniform
Evaluation: they will fail at Level 1.

Candidates who on many of the questions did not meet the BOE’s expectations on the 2001 UFE
did not do well at Level 1 of the mock simulations.

At Level 2 of the decision framework:

Assurance

Candidates whose coverage of assurance focused on audit procedures were not assessed as
competent on the primary indicators in the mock simulations. The evaluation guides developed
for the Mock Marking Centre required candidates to demonstrate an understanding of the audit
issues, develop audit strategies, and display a sound appreciation of the audit risks in order to be
assessed as competent on any primary assurance indicator. Without a demonstration of these
skills, the candidate has not displayed depth in assurance.

For example, primary indicator # 1 in Paper II, Question 1 required candidates to identify the
important changes that had occurred during the year and to discuss the consequences for the
audit. In order to be assessed as competent, candidates had to identify the audit issues and
convey their significance by discussing the associated audit risk and the impact on the covenant.
Secondary indicator # 1, on the other hand, required candidates to discuss the detailed audit
procedures relevant to one of the risk areas identified. Candidates who jumped right into the
discussion of the detailed audit procedures without clearly explaining why an issue was
important and its impact on risk and the covenants missed a critical part of the question.

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Candidates whose Assurance discussions focused on an evaluation of the GAAP considerations


of an issue without addressing the audit implications, or the challenges of what constitutes
appropriate evidence or assurance results were not assessed as competent on Assurance
indicators. For example, in Paper IV, Question 2, primary indicator # 2 required candidates to
identify the engagement planning issues, procedures, and reporting issues. To be assessed as
competent, candidates were required not only to identify the issues related to revenue
completeness and the reporting options but also to discuss some of the challenges of gathering
audit evidence. Without the discussion of the challenges, candidates were assessed as “reaching
competence.”
Performance measurement

On some 2001 UFE questions (and earlier UFE questions), candidates could employ a strategy of
broadly addressing all the performance measurement issues identified, and could expect to score
some marks on each issue. In the new Uniform Evaluation, however, merely touching on an
issue is no longer sufficient because it fails to demonstrate the depth of analysis or ranking
required for an evaluation as competent.

Candidates should note that only discussions of key issues (primary indicators) are considered
when assessing competence at Level 2. Candidates who were unsuccessful at Level 2 because of
performance measurement tended to treat all the accounting issues identified as being equally
important. This approach detracted from their performance because competence was
demonstrated in part by evidence of their understanding of the issues and of their ability to rank
them based on their importance.

For example, in Paper III, Question 1 there were two Performance Measurement indicators: one
primary and the other secondary. Both indicators required candidates to analyze the accounting
issues. The difference between those accounting issues considered in the primary indicator
versus those considered in the secondary indicator was the materiality of the amount to the
analysis. Candidates who spent more of their time analyzing accounting issues that had no
material impact on the statement of claim would not have been evaluated as competent under the
new methodology. Candidates were required to provide an analysis of the material issues in
order to demonstrate competence in performance measurement on this question.

Another example is provided in the comprehensive question. Primary indicator #3 relates to


Performance Measurement. Candidates’ competence in this area was evaluated on the basis of
their discussion of major accounting problems (i.e., the acquisition of Sam’s equipment, the
acquisition of the vines, and the pre-operating costs). A candidate whose discussion focused on
the minor issues, (renovations, barrels, etc.) achieved no more than the level of “nominal
competence.” To attain the “competent” level, candidates had to discuss, in depth, at least one
major issue and analyze different alternatives, or consider both sides of the transaction.
“Competent” means being able to identify the important issues and discuss them in appropriate
depth.

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Candidates who assume there is only “one right answer” and therefore do not articulate the
analysis upon which their conclusion is based jeopardize their chances of success. For example,
in Paper II, Question 1, primary indicator # 2, candidates were required to discuss the accounting
treatment of warranty costs. In order to demonstrate depth, candidates were required to discuss
various warranty estimates. Simply assuming that any one amount was correct was not
considered sufficient depth.

Another example is provided in Paper III, Question 2. On primary indicator # 2, candidates were
required to discuss alternative accounting treatments. Assuming that one treatment was
appropriate without a discussion of the alternatives would not be sufficient to display
competence on this indicator.

On some UFE questions in the past, candidates could do well by summarizing their
understanding of a situation in an “overview” description section and then doing a separate
quantitative analysis that did not link back to the situation in any way. On the new Uniform
Evaluation, without the broader discussion (i.e., context, alternatives, bias, lack of definitive
guidance) it would be difficult to reach “competent.”

Again, on some past UFE questions, if a correct statement was made it had to be awarded the
mark on the marking key, even if that statement was subsequently contradicted. On the new
Uniform Evaluation, assessment of competence on any given indicator takes the candidate’s
response into account in its entirety. The absence of intellectual integrity in the response
considered as a whole makes “competent” difficult to award.

At Level 3 of the decision framework:

There were two groups of candidates who failed at Level 3:

• The first group consisted of strong candidates who demonstrated sufficient competence
overall and demonstrated depth in the areas of performance measurement and assurance.
However, on further analysis of the other specific competency areas, the candidates were
found to have consistently avoided at least one area. There were two primary indicators in
finance on the mock centre simulations. Both indicators required candidates to perform a
cash flow analysis. One candidate that failed at Level 3 did not even attempt the cash flow
analysis in either instance. In both instances these were central requirements in the
simulations.

Under the new Uniform Evaluation candidates must display some competence in all
competency areas. Consistently avoiding an area will not result in a pass standing.

• The second group consisted of candidates whose assessment at both Level 1 and Level 2 was
marginal. Those candidates failed the Level 3 test if they did not demonstrate any breadth in
Assurance or Performance Measurement, the key competency areas. These candidates
overall demonstrated inadequate breadth and inadequate depth.

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APPENDIX A

MOCK MARKING CENTRE


SIMULATIONS AND EVALUATION GUIDES

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PAPER I

Heart Wines Limited (HWL) was incorporated as a private company in 2000 with a year-end of
December 31. HWL is the result of a life-long dream of one of the four owners, Pierre Heart. The other
owners are his wife and two children. Pierre grew up on a vineyard in the Burgundy district of France.
He is the fourth generation of Hearts in the wine industry. When Pierre was 25 years old, his father died
and left the family operation in France to the eldest son, Michel. Pierre and Michel continued to manage
the wine operation together.

Pierre and his brother had different goals and objectives concerning the winery. Michel believed in
tradition and keeping operations the same as in the past. Pierre was an entrepreneur who wanted to
experiment with new methods and modernize operations. After a year of attempting to work together, the
brothers agreed to go their separate ways.

Pierre found it impossible to purchase land to start a new vineyard in France, since all of the premium
land was owned by families who passed it on from one generation to the next. Pierre decided to relocate
to the Niagara region in Ontario because its climate is similar to that of the best vineyards of France. In
1978, Pierre, his wife, and their two children immigrated to Canada.

With his inheritance of $200,000, Pierre purchased a farm with 220 cultivated acres and an old
farmhouse and barn. Pierre lives in a nearby community with his family. Although Pierre has not
incurred any debt operating the farm and it has provided a comfortable living for him and his family, he
had not been able to save enough or obtain sufficient financing to purchase the vines, equipment, and
buildings necessary to start a winery. Pierre accumulated $300,000 in his RRSP but had little surplus
cash or investments beyond that. In the meantime, Pierre continued to dream and plan. Background
information on the wine industry and Pierre’s plans for HWL are included in Exhibit I.

In 2000 two events occurred that made Pierre’s plans for a winery more than just a dream. The first event
was an agreement to sell 20 acres of the farm that fronted a major highway leading into town. As a result
of recent industrial expansion in the area, Pierre was able to sell the 20 acre parcel of land for after-tax
proceeds of $510,000. The sale closed in late 2000. In early 2001, Pierre transferred the proceeds of the
sale, the remaining land, and the property to HWL using a tax free roll-over.

Also in 2000, Sam St. Laurent, the owner of a nearby winery, reached the age of 70 and decided to retire.
Having no heirs to take over the business, Sam entered into an agreement with ABC Inc. (ABC), a major
wine maker in the area. Sam agreed to grow the grapes for ABC, and ABC agreed to complete the harvest
at the end of the year. The agreement further provided for ownership of the vineyard to be transferred to
ABC upon Sam’s death.

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Although Sam’s equipment and machinery had a useful life of at least another 20 years, ABC was not
interested in purchasing it. Sam agreed to sell the equipment and machinery to Pierre. Sam believed that
the machinery and equipment was worth $2.5 million. Since he had no immediate cash requirements and
knowing that Pierre was short of capital, Sam entered into an agreement with HWL, outlined in Exhibit
II. Through this agreement Sam hoped to get at least a reasonable rate of return.

To help his brother achieve his dream, Michel agreed to enter into a barter arrangement with Pierre.
Under the barter, Pierre is to receive two shipments of vines from Michel in exchange for 20% of HWL’s
bottled wine production for the next 10 years. Michel believes there is a market for Canadian wine in
France.

Pierre’s two children completed their university degrees in 2000 and joined the family business. Pierre’s
son Dominique completed a degree in agriculture, and his daughter Suzanne completed a business degree
specializing in marketing. Other than seasonal labour, the family will be the only employees of HWL.

In January 2001 Pierre finalized a $1.5 million loan with the local bank by granting a first mortgage
against the farm property. The loan bears interest at 9% and has no principal repayments for three years.
Thereafter principal repayments of $250,000 annually are required. Pierre expected that the loan would
cover the renovations and installation of equipment, which he estimated at $1 million. The remaining
$500,000 was intended to finance other start-up costs.

It is now October 1, 2001. You, CA, are a staff accountant at Nelson McKinley, Chartered Accountants.
Pierre has approached your firm to assist with the start-up of HWL and to perform the audit that will be
required by the bank. You and the senior partner, Toni Dann, met with Pierre who related the
developments to date (see Exhibit III).

At the meeting Pierre went on to say, “This project has turned out to be a greater financial burden than I
expected. With cost overruns I’m not sure I’ll have the capital I need to fund operations until HWL
begins to show a profit. Because of the high risk of a start-up venture, there are few sources of capital.
My neighbour is an executive with Ventura Capital Inc. (Ventura). He thinks his firm may be able to
provide up to $1 million under the right circumstances. An extract from a draft proposal from Ventura is
shown in Exhibit IV. The proposal is typical of the deals that Ventura normally offers companies
seeking financing.

“I will need to make a formal presentation to Ventura’s investment committee in two weeks. I need your
assistance in preparing for this presentation. I don’t know exactly what will be required, but my
neighbour mentioned an assessment of HWL’s viability, tax implications, and pertinent industry and
corporate information. You should have all the necessary information, but if you have questions I am
available to answer them.”

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Later, you and Toni meet to discuss your assistance with the presentation to Ventura. Toni tells you:
“In addition to helping with the presentation, we need to address the start-up issues, the accounting
policies, that sort of thing. Please draft a memorandum for next week so that I will be prepared for the
meeting with Pierre.

“By the way, we’ve undertaken to assist HWL in setting up an information system for the business.
Pierre’s already bought a computer. We need to help him make effective use of it. I would like a
separate memo that includes your suggestions on this matter and your comments on any audit
engagement issues we should consider.”

Required:

Prepare the two memoranda to your partner.

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INDEX TO EXHIBITS

EXHIBIT Page

I Background Information on the Wine Industry and Plans for HWL..............................24

II Extracts from the Equipment & Machinery Purchase and Sale Agreement
Between HWL and Sam St. Laurent .............................................................................26

III Developments in 2001 ....................................................................................................27

IV Extracts from the Ventura Capital Inc. Draft Proposal ..................................................29

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EXHIBIT I

BACKGROUND INFORMATION ON THE WINE INDUSTRY


AND PLANS FOR HWL

Background on the farm and vineyards

The 200-acre farm has soil and climate conditions similar to those of the southern end of the Burgundy
district in France. In that area of France, each vine generally yields 66 kilograms of high quality grapes
each year.

Industry practice is to plant rows approximately 90 cm apart allowing for 100 vines to be planted per
acre. A trellis is attached to help support the vine. In the spring, the vines are pruned to stimulate growth.
Pesticides and fertilizers are used as required. The costs of pesticides, fertilizers, and trellises average
$10 per vine per year. New vines normally produce 40% and 60% of a full commercial crop in the first
and second years respectively. Usually by the third year vines are producing 100% of a full commercial
crop. If the vines are properly maintained, they will live indefinitely.

The grapes are harvested in October before the temperatures start to fall and damage the grapes. For ice
wine, the grapes are left on the vines and protected from being eaten by the birds by means of netting.
The grapes are picked by hand during the night in their frozen state. The temperature must be between -
10 to -13 degrees Celsius for harvesting ice wine grapes. Ice wine production results in increased
revenues and increases certain direct costs. An industry “rule of thumb” has been developed to estimate
the net impact of both the revenue and expense increases when grapes are used for ice wine production.
The estimate is that there is an increase in profits equal to 50% of the revenue that would have been
generated if the grapes had gone into regular wine production.

The harvested grapes are pressed to separate the juice from the by-products (stems, seeds, and pulp). The
by-products are returned to the fields to act as a natural fertilizer. The juice is stored in huge tanks for
fermentation. After fermentation, depending on the type of wine, the wine is aged or filtered
immediately. On average, 4 kilograms of grapes are required to produce each litre of wine. After
filtration the wine is bottled and shipped. Each year’s production is normally sold in the following year.

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EXHIBIT I (continued)

BACKGROUND INFORMATION ON THE WINE INDUSTRY


AND PLANS FOR HWL

Background on the wine industry

Success in the wine industry is based on high quality, varied products, and low costs, which are mainly
affected by the quality and yield of the vines. The total of all the direct costs of harvesting, fermentation,
filtration, bottling, and shipping is $2.50 per litre. The premium wine market has been steadily growing
in Canada over the last five years. Consumers often judge quality by the number of awards a winery has
won and the Vintners’ Quality Alliance (VQA) designation on the label.

The total annual volume of wine sales in Canada is currently between 200 and 250 million litres. White
wine constitutes 45% of this market, red wine 25%, and other varieties the remaining 30%. The largest
growth has been achieved in the red wine market. Prices have been rising steadily, with VQA designated
wines selling for an average of $12 per litre at the wholesale level. Non-VQA wines sell at a
considerable discount.

Plans for HWL

HWL will focus on premium wines only. In this market it is important to receive the VQA seal of
approval. To obtain the VQA designation, HWL will have to send its wines every year for testing by an
expert panel for compliance with regulations and standards. When approval is received, HWL will be
able to include the VQA seal on its labels. Estimated VQA fees are a single annual charge of $2,000 for
the winery plus $0.05 per litre of VQA wine produced. An aggressive marketing program will be
developed to reinforce the quality of the HWL label. Marketing expenses are expected to be at least 20%
of the wholesale value of the wines.

Initially, two types of wine will be produced: white wines made from the Riesling and Chardonnay
variety of grapes, and red wines from Pinot Noir and Cabernet Sauvignon grapes. By the 2003 season,
HWL plans to shift 50% of its production to the higher-margin ice wines.

Any grapes that are not of suitable quality for premium wines will be sold to ABC Inc. ABC has a
standing agreement to purchase any excess harvest from local vineyards for $0.75 per kilogram.
Currently, there is a world-wide shortage of grapes for wine production.

Initially, the wine will be distributed mainly to liquor and wine stores at wholesale prices. Suzanne is
investigating the possibility of home deliveries and orders through the Internet.

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EXHIBIT II

EXTRACTS FROM THE EQUIPMENT & MACHINERY


PURCHASE AND SALE AGREEMENT BETWEEN HWL AND SAM ST. LAURENT

Clause 1 The agreement is effective on January 1, 2001.

Clause 2 On this date, Sam will transfer the ownership of the machinery and equipment to HWL.

Clause 3 Sam guarantees that the machinery and equipment is in good working order. In the event
that any repairs are required immediately following the transfer, Sam is responsible for
them.

Clause 4 HWL will assume responsibility for moving the machinery and equipment and installing it.

Clause 5 HWL will pay Sam 50% of net income before income tax for each of the next 15 years. At
the end of 15 years, Sam will have no further rights under this agreement.

Clause 6 In the event of Sam’s death, HWL will make no further payments to Sam’s estate.

Clause 7 Sam has the right of full access to the accounting records of HWL and can appoint an
arbitrator in the event of any disagreement over the accounting policies used in the
determination of net income.

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EXHIBIT III

DEVELOPMENTS IN 2001

The first harvest begins in the fall of 2001. The first vines planted are expected to reach their full
production capacity in the year 2003.

The following steps have been taken in 2001:

1. Pierre applied for a winery licence for HWL. This licence was granted in February, after the
appropriate documents of HWL had been provided to the government.

2. On January 1, title to the machinery and equipment was transferred to HWL from Sam. If this
machinery and equipment had been purchased new, it would have cost $30 million. The carrying
value of the machinery and equipment in Sam’s financial statements was $10 million. Sam’s
financial statements were prepared solely for tax purposes.

3. In the spring, an underground facility was built below the barn to house the filtration process, the oak
barrels for aging, and bottles for storage. The existing barn walls and doors were modified to ensure
that a constant temperature is maintainable. Renovations were completed on the existing farmhouse
for an on-site store, office, tasting room, and tourist facilities. All renovations were completed in
August of 2001 at a cost of $1.2 million.

4. Also, in the spring, 100 acres of the 200-acre farmland were prepared for the arrival of the vines from
France.

5. On May 1, the first lot of vines arrived from France and was immediately planted. The vines were
spaced 90 cm apart and will produce Riesling, Chardonnay, Pinot Noir, and Cabernet Sauvignon
grapes. HWL was responsible for the $200,000 cost of shipping the vines.

6. The remaining 100 acres continue to be used as farmland to provide additional cash flow from
operations. They will be planted with vines from France in 2002.

7. In August the machinery and equipment was installed in the new facilities, after the building
renovations had been completed. Although there was no cash outlay for the machinery and
equipment, there were costs of $100,000 to install and test the equipment. During testing, one of the
bottling machines did not function properly. HWL paid $200,000 for replacement parts ordered from
Italy.

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EXHIBIT III (continued)

DEVELOPMENTS IN 2001

8. On September 1, 2001, Pierre signed an agreement with an oak barrel manufacturer in France to
purchase 200 barrels a year, at a cost of $200 each, for the next five years beginning in 2001. The oak
barrels, used for aging, have a lifespan of four years, after which they can be used for storage only.
Sam used to replace one quarter of his barrels every year.

9. A computer was purchased for use in the office. It is equipped with the current version of Windows
and is capable of accessing the Internet. No other software has been purchased to date. Pierre and
Suzanne have not had an opportunity yet to sit down and determine their information needs.

10. In addition to the initial installation costs and other direct costs, the following costs have been
incurred to September 30, 2001.

Incorporation costs $ 3,000


Tanks for fermentation 25,000
Salaries 300,000
Administration 75,000

$403,000

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EXHIBIT IV
EXTRACTS FROM THE VENTURA CAPITAL INC. DRAFT PROPOSAL

1. HWL will issue common shares for a cash consideration of $200,000. Subsequent to this
transaction, Ventura will own 25% of the common shares.

2. Ventura will also provide a loan of up to $800,000 secured by a second charge on all of the
assets of HWL.

3. The loan will bear interest at 10% plus 5% of HWL’s net income before tax, payable within 90
days of year end.

4. The loan will be repayable at the end of seven years.

5. If the loan is in default for a period of more than 30 days, the loan can be converted into common
shares representing an additional 50% of the outstanding common equity.

6. Upon repayment of the loan, Ventura can require HWL to repurchase the common shares held by
Ventura. At the end of the seven years, the repurchase amount will be $500,000. If the loan is
repaid early, the repurchase amount increases by $50,000 for each year less than the full seven-
year term. (For example, if the loan is repaid two years early, the repurchase amount will be
$600,000.)

7. Ventura would have the right to appoint members to the board of directors in proportion to its
common-share equity interest.

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EVALUATION GUIDE
COMPREHENSIVE QUESTION 2001
PRIMARY INDICATORS OF COMPETENCE

Primary Indicator # 1:

The candidate understands the nature of the risks and opportunities facing the company
and analyzes the potential impact of these risks and opportunities on the company’s ability
to succeed in the future.

The candidate demonstrates competence in Pervasive Skills.

RISKS
• Possible loss of control
• Lack of cash
• VQA designation
• Quality of the vines
• Yield of the vines
• Weather

OPPORTUNITIES
• Innovative financing
• Payment on machinery could cease
• Premium wine market growing
• Price for wine growing
• Pierre’s experience and expertise
• Future on site/Internet sales
• Low cost operation

The results could be better than those shown in Appendix I, since this analysis does not include any
revenue from the farm for 2001 and 2002 or from the sale of lower grade grapes. We have also assumed
that HWL will obtain the VQA designation and will therefore be able to command higher prices for its
wine. If HWL does not obtain this designation, the results will be quite different. We did not take into
account potential sales through home deliveries and the Internet, since we do not know whether this is
legally feasible.

Ventura will have a 25% interest in HWL at the outset, but this interest could increase to more than 50%
if HWL is in default and the loan is converted. Pierre would then lose control over appointments to the
Board, destroying his life-long dream of owning and operating a winery. However, our projections for
2005 show that, when fully operational, the business can generate sufficient cash to accumulate the
amount required to reimburse the loan and buy back the shares in 2007.

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The price set for the repurchase of the common shares is high. Ventura wants $500,000 for shares for
which it will have paid $200,000, which means a $300,000 premium over seven years, i.e.,, $43,000 per
year. However, it would be very difficult to find other, less expensive sources of capital. As the
agreement is still at the drafting stage, it may be possible to negotiate better terms. In addition, the
agreement should state whether GAAP is to be followed in determining net income before income taxes.

The presentation to Ventura should highlight the strong points of the business and the industry and
present solutions for any weaknesses. It should be emphasized that the price of wine is on a consistent
upward trend, that there is a higher profit potential on home delivery and Internet sales, and that our
forecasts do not take this factor into account. The market for high quality wine has been growing for the
past five years, and HWL wants to penetrate that market. It is therefore important that it obtain the VQA
designation. The presentation should also emphasize the experience and expertise of Pierre in
winemaking, as well as the fact that, since the business is a family affair, it is not costly to operate. Pierre
has managed to find creative financing methods through agreements with his brother and Sam, which
have resulted in minimizing cash outflows in the start-up phase. Ice wine, on which Pierre plans to focus,
generates higher margins. There are, however, uncertainties relating to the Canadian climate and the
yields to be obtained from the French vines.

For Primary Indicator #1, the candidates must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate recognizes that there are risks and opportunities
facing HWL but does not provide any context.

Reaching competence – The candidate identifies some risks and opportunities and
discusses their possible impact on the future viability of HWL.

Competent – The candidate identifies some of the major risks and opportunities facing HWL
and discusses their impact on the future viability of HWL. The candidate incorporates the
risks and opportunities into his/her quantitative analysis or advises the client that the risks
and opportunities should be presented to Ventura.

Highly competent – The candidate identifies some of the major risks and opportunities and
discusses their impact on the future viability of HWL. The candidate incorporates the risks
and opportunities into his/her quantitative analysis and advises the client that the risks and
opportunities should be presented to Ventura.

Primary Indicator #2:

The candidate performs a cash flow in order to assess the future viability of the Company.

The candidate demonstrates competence in Finance.

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We have calculated HWL’s cash flows for the next five years, which is the best way to assess HWL’s
long-term viability (see Appendix I). A five-year period was chosen since the business requires five years
to reach full operational capacity. This calculation also gives an indication of what the future financing
needs of the business will be. In addition, we have calculated the net income before income taxes in order
to determine the payments to be made to Sam and Ventura (see Appendix II). These payments are
included in the cash flow calculation. The net income calculation takes into account the
recommendations made with respect to the accounting policies to be applied.

Our calculations are based on the assumption that the salaries and administrative costs will remain at the
same level and that the sales prices and costs will remain stable during the five-year period.

Based on the calculations in Appendix I, when HWL is fully operational in 2005, net cash flows will
total $561,918, which suggests robust viability. However, from 2002 to 2004, cumulative cash flows are
negative and other, temporary sources of financing will have to be found. One source could be Pierre’s
RRSP, currently valued at $300,000, but this amount would be taxed immediately, resulting in a lower
available amount. HWL could reduce salaries or defer payments to Michel. HWL could also try to get an
additional bank loan which would increase its financing costs. It would be useful to calculate monthly
cash flows in order to assess when, during the year, financial needs will be greatest.

For Primary Indicator #2, the candidates must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate performs a single-year projection or assumes full


production in every year of a multiple-year cash flow.

Reaching competence – The candidate performs a multiple-year projection but the overall
analysis lacks depth or contains fundamental errors.

Competent – The candidate performs and interprets a multiple-year cash flow, that moves
up to full production, recognizes timing difference between revenues and expenses, and
attempts to quantify payments made to Sam/Ventura (CF approach). The candidate
recognizes that there will be a cash deficiency in the first few years.

Highly competent – The candidate performs and interprets a multiple-year cash flow that
moves up to full production, recognizes timing differences between revenues and expenses,
and attempts to quantify payments made to Sam/Ventura based on net income (IS and CF
approach). The candidate suggests alternative financing for the cash deficiencies in the first
few years.

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Primary Indicator #3

The candidate discusses the major accounting policies.

The candidate demonstrates competence in Performance Measurement.

MAJOR ISSUES
• Acquisition of Sam’s equipment and machinery
• Acquisition of the vines
• Pre-operating costs

Acquisition of Sam’s equipment and machinery

According to the agreement between HWL and Sam, HWL acquired the equipment and machinery in
exchange for a payment equal to 50% of net income before income taxes for each of the next 15 years.
This consideration is difficult to assess today, and we must decide how this transaction should be
recorded. For purposes of measuring the asset, the acquisition cost of this equipment and machinery
needs to be determined. A high acquisition cost will allow for a high amortization and therefore will
reduce Sam and Ventura’s payments.

There are several possible alternatives at which to record the machinery and equipment: Sam’s carrying
value of $10 million, the $30 million replacement cost, and the fair market value of $2.5 million
(according to Sam). The replacement cost reflects the value of new assets, but the equipment and
machinery acquired are used. The carrying value comes from Sam’s unaudited financial statements, and
we do not know how this value was determined. Those two alternatives are therefore not appropriate.
The CICA Handbook recommends recording non-monetary transactions at their fair market value (FMV).
In this case, the FMV of the equipment and machinery received is much easier to determine than the
value of the consideration. Thus, we should use the $2.5 million FMV as the equipment and machinery
acquisition cost and add to that cost the installation cost of $100,000. (This assumes that Sam’s estimate
of FMV is accurate.)

We also need to determine the amortization period and amortization method to be used. A shorter
amortization period would best serve Pierre’s needs. It appears that the useful life of this equipment and
machinery is 20 years, and I would recommend using this period.

The liability to Sam will be difficult to record as the exact amount cannot be determined at this time
because it is based on the income to be earned by HWL and on Sam’s lifespan. We could record it at the
best estimate of the amount to be paid to Sam over the next 15 years. If a liability is recorded, payments
made to Sam will be applied against this liability and not against income. Alternatively, a contributed
surplus could be recorded if the machinery is believed to be worth more than the payments that Sam will
likely receive. Also, we could choose not to record any asset or liability on the balance sheet if the
likelihood of payments being made is low. Payments could then be expensed when made, but the
contingent payments should be disclosed in a note to the financial statements.

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I recommend recording an asset and a liability at a $2.5 million market value. If Sam dies before the
entire liability is paid off, we should record a gain in the same year. If payments exceed the liability, we
should then expense those excess payments in the year they are paid.

Acquisition of vines

Pierre will be receiving two shipments of vines from his brother Michel in exchange for 20% of HWL’s
bottled wine production for the next 10 years. We need to establish the acquisition cost for those vines.
They could be accounted for at their fair market value based on two approaches. The first would be the
net present value of future payments. A calculation is presented in Appendix I showing an FMV of
$4,687,452. This calculation is based on the actual wholesale value of the bottles shipped. It could also
have been made using future prices or the cost to produce the bottles shipped. The FMV could also be
determined using the cost of purchasing vines from an independent vendor. In any event, transportation
costs should be included in the acquisition cost. Future payments are uncertain since they are linked to
the production level of wine, and these may be difficult to estimate. We could record nothing on the
balance sheet, and disclose in a note the future payments contingency and the related party situation. My
recommendation would be to record the vines at a cost of $4,687,452. This figure is higher than that
obtained using production cost and therefore allows a higher amortization.

Vines last virtually forever; it could be argued that the asset need not be amortized. Alternatively, the
vines could be amortized over a maximum period of 40 years. Amortization would help Pierre reduce
income. I recommend amortizing over 40 years on a straight-line basis. This amortization will reduce net
income and therefore reduce payments to Sam and Ventura.

Is Michel’s contribution a liability or contributed surplus? The amount owed to Michel can easily be
estimated but may vary depending on the level of production or the type of wine produced. I recommend
recording a liability.

Start-up costs

The treatment of costs incurred in the years prior to the start of commercial operations, such as salaries
and administrative costs, needs to be considered. These costs should be expensed if their recovery at a
later date is uncertain. They could also be deferred, but then the pre-operating period would need to be
defined. If the costs are deferred, an amortization period and basis should be determined.

The CICA Handbook provides guidance in EIC-27. An expenditure can be deferred if it is related directly
to placing the new business into service, if it is incremental in nature, and if it is probable that it is
recoverable from the future operations of the new business. In the case at hand, no sale will be made in
the first year, i.e., 2001, and the production of grapes in the first few years is not sufficient to support
commercial viability. The cash budget in Appendix I clearly indicates that commercial viability will
begin, at the earliest, in year 4.

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A pre-operating period can be defined on the basis of a number of factors, such as the passage of time or
a given activity level, and it precedes the moment when the new business becomes capable of
consistently providing its intended product or service. HWL will not be operating at full capacity until
2004 and will not be profitable before 2005. It could be argued that until HWL starts operating at 100%
of its capacity, it will be in its pre-operating period. Revenues and costs should therefore be deferred
until full production is attained. These deferred costs should be amortized over a period not exceeding
five years. Deferring the costs would be beneficial to HWL because their amortization would help reduce
future net income. Consequently, start-up costs should be deferred until HWL reaches full operating
capacity, i.e., in 2004.

Repair of bottling machine

HWL had to pay $200,000 in August to repair one of the bottling machines it purchased from Sam. The
sales agreement between Sam and HWL, signed in January, guaranteed that the equipment and
machinery were in good working condition. Should Sam reimburse HWL even if eight months has
elapsed since the signing of the contract? If HWL bears the cost of the repair, should this cost be
expensed or capitalized? It could be argued that the repairs are already reflected in the recorded cost and
that the fair market value used is based on the assumption that the equipment and machinery are in good
working order.

Inventory of wine

The wine produced in the fall of one year is sold in the next year. The production costs of the wine
should therefore be included in the December 31 year-end inventory balance. These costs include direct
costs such as fermentation and bottling, fertilizers, pesticides and trellises. Additional relevant overhead
costs could also be capitalized. Capitalizing all of these costs will increase HWL’s borrowing capacity.

Other issues

When the loan is reimbursed, Ventura may require that HWL repurchase its common shares. These
shares can therefore be treated as a liability. The repurchase amount provided for is $500,000, whereas
their cost is $200,000. The difference could be recorded as a deferred financing expense, which would
reduce future net income.

The barrels will have to be capitalized and amortized over four years or, if the amounts are not material,
they could be expensed in the year in which they are purchased.

The land transferred by Pierre to HWL should be recorded on the balance sheet at its market value.

Future income tax assets and liabilities will also have to be recorded.

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For Primary Indicator #3, the candidates must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate discusses minor GAAP issues (barrels, renovations,
repairs) and does not identify the major issues.

Reaching competence – The candidate identifies at least one major issue. The candidate
discusses major issues superficially.

Competent – The candidate discusses at least one major issue in depth and analyzes
different alternatives or considers both sides of the transaction.

Highly competent – The candidate discusses at least one major issue in depth, analyzes
different alternatives and both sides of the transaction, or discusses two or more issues in
depth including an analysis of alternatives.

Primary Indicator #4:

The candidate integrates the accounting policies with the cash flow issue and understands
that his/her policy recommendations will affect the net income and therefore the 5% to
Ventura or 50% to Sam. The candidate understands that this impact is significant and that
these policy choices may be challenged by Sam and/or Ventura.

The candidate demonstrates competence in Pervasive Skills.

Since the business is in its start-up phase, we will need to determine the accounting policies to be used
for preparing the financial statements. However, the users of the financial statements have conflicting
objectives. Pierre will want policies that minimize net income before income taxes in order to reduce
payments to Sam and Ventura, while Sam and Ventura will want policies that maximize net income
before taxes. The choice of accounting policies is therefore very important, as it will have a direct impact
on the users’ objectives and more importantly a direct impact on cash flows. It would be useful to review
the policies usually applied in the wine industry, especially in view of the fact that several transactions
are unusual and choosing the appropriate accounting policy may prove difficult. Pierre should be
reminded that the final decision as to the choice of accounting policies is his. However, the agreement
with Sam allows for the appointment of an arbitrator in the event of any disagreement over the
accounting policies used in the determination of net income. Therefore, the accounting policy choice
must be defensible.

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The agreements with Sam and Ventura do not refer to the use of GAAP in the determination of net
income before taxes. However, as the bank wants audited financial statements, they will likely have to be
consistent with GAAP. Several transactions are unusual and will require estimates. We need to determine
the accounting policies before assessing the viability of HWL since they will have a major impact on
income calculation and, consequently, on the payments to be made to Sam and Ventura.

For Primary Indicator #4, the candidates must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate performs an analysis of accounting policies and


future projections. The candidate incorporates into his/her calculation some effect of his/her
accounting discussion but does not take into account the users’ needs, the impact on the
cash flow, or the different accounting choices possible.

Reaching competence – The candidate understands that the choice of accounting policies
affects the future cash flows but does not consider this impact when selecting accounting
policies.

Competent – The candidate chooses the accounting policies with the users’ needs in mind,
and acknowledges the impact of these choices on future cash flow in his/her discussion but
does not incorporate that impact in his/her income calculations.

Highly competent – The candidate understands that the choice of accounting policies is
linked to the users’ objectives, chooses the policies that will benefit Pierre, and incorporates
the impact of these choices on the future cash flow.

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EVALUATION GUIDE
COMPREHENSIVE QUESTION 2001
SECONDARY INDICATORS OF COMPETENCE

Secondary Indicator # 1:

The candidate discusses income tax issues related to the start-up transactions of the
company and advises the client adequately.

The candidate demonstrates competence in Taxation.

TAX ISSUES

• Land rollover in the Company


• Deemed year end if loan is converted

UNUSUAL TRANSACTIONS
• Acquisition of vines — barter with brother
• Acquisition of Sam’s equipment and machinery
• Share repurchase payment
• Bonus interest on Ventura’s loan

USEFUL RECOMMENDATIONS
• Reduce CCA claim to use loss-carryforward
• Suggests alternatives to salary
• Do not charge GST on export sales
• Could use cash basis for tax

Pierre transferred to HWL the land, the buildings, and $510,000 using a tax-free rollover. We should
make sure that the land is transferred at its fair market value for tax purposes. This transfer could result
in a potential benefit being conferred on Pierre’s spouse who is a shareholder, but since these assets are
being used in a small business corporation, there will be no attribution. Nor will there be any attribution
to the children (who are shareholders) because they are over 18 years old.

Since the equipment and machinery are operating, HWL could amortize them for income tax purposes. It
remains to be seen whether the tax authorities would accept the accounting treatment recommended. In
general, the tax treatment is consistent with GAAP, but the tax authorities will not allow a deduction that
exceeds the amount that was paid. The tax authorities might check the value at which Sam reported the
disposition and cap HWL’s deduction at that amount.

From an income tax point of view, the vines must be valued at their fair market value and amortization is
optional. However, the cost of transportation of the vines should be added to their capital cost. The wine
shipped to Michel will have to be included in taxable revenue at its fair market value.

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The 10% interest on the loan is clearly deductible for tax purposes, but we need to monitor how the tax
authorities deal with the deduction of additional interest based on net income. From a tax point of view,
the repurchase of Ventura’s common shares would be treated as a deemed dividend.

As HWL is a new corporation, whose business may be considered a farm operation, the cash basis should
be used for income tax purposes. Based on our calculations, the business will be losing money for at least
the first three years and, by the end of five years, will have unused loss-carry forwards of $3,221,439. In
order to be able to use these losses within the prescribed time frame, we should consider not claiming any
CCA. The business could also reduce management’s salaries, but this would reduce the level of
contributions to their RRSPs. Management could be compensated through dividends.

For Secondary Indicator #1, the candidates must be ranked in one of the following
four categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate addresses minor or irrelevant tax issues.

Competent – The candidate discusses the tax treatment of one or more unusual transactions
or makes useful recommendations to the client.

Highly competent – The candidate discusses the tax treatment of some of the unusual
transactions and makes useful recommendations to the client.

Secondary Indicator #2:

The candidate addresses the partner’s request to look at an information system and
recommends solutions that meet the specific needs of the company and the particular
characteristics of the industry.

The candidate demonstrates competence in Information and Information Technology.

HWL purchased a computer equipped with the current version of Windows and capable of accessing the
Internet. The shortage of cash in the first few years will influence the choice of the information system.
We should nevertheless consider whether the system would be able to grow with the business.

At a minimum, a generic accounting software package should be purchased. It should not be too
complicated to operate, as the family will do the bookkeeping and the operations are straightforward.
This system should be able to segregate revenues by type of wine and track results from the marketing
program, as well as maintaining and aging receivable records. For inventories, a cost system should be
implemented that will capture production costs and allocate them to the main processes. Also, the system
should be able to ensure compliance with sales tax rules.

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We will have to make sure that the system can be used for budget estimates and for easy actual-to-budget
comparisons.

In addition to the basic accounting system, HWL needs to be able to access key information. Monitoring
cash flows is essential, especially during the first few years when negative cash flows are expected. HWL
must have the capacity to monitor and schedule production inputs, fertilizing schedules, etc. It must also
be able to monitor the quality of the wine since the VQA label depends on it. The business must be able
to track the aging of the wine batches.

A website will need to be developed to sell wine on the Internet, with the security controls required for
receiving orders and payments through the Internet.

For Secondary Indicator #2, the candidates must be ranked in one of the following
four categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate recommends solutions for an accounting system


without linking those recommendations to the specifics of the wine industry, the lack of cash
flow, or the size of the business.

Competent – The candidate recommends solutions adapted to the industry, the lack of cash
flow, or the size of the business.

Highly competent – The candidate recommends solutions adapted to the industry, the lack
of cash flow, the needs of the client or the size of the business and advises on key
information needs (i.e., the candidate’s response is more strategic in nature).

Secondary Indicator #3:

The candidate addresses the audit issues in his audit memo to the partner.

The candidate demonstrates competence in Assurance.

Our firm faces a potential conflict of interest as we have been asked to recommend accounting policies
for HWL and also to audit them. Since Pierre Heart is our client, we should select the accounting policies
that are in the best interests of HWL, but as auditors, we are accountable to all other financial statement
users, including Sam St. Laurent and Ventura. In addition, we have been asked to act as advisors to HWL
in helping it to obtain financing from Ventura. We need to consider the appropriateness of accepting all
these engagements. At a minimum, we should ask an independent accountant to review the accounting
policies selected.

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We should obtain an engagement letter to clarify our different mandates. We will be performing the
audit, but we will also be associated with the presentation to Ventura. This presentation will include cash
flow and earnings forecasts. These forecasts will not be audited, and we will not be providing any
assurance on them. However, we still need to ensure that the presentation does not include any
information that we know, or should know, is misleading.

The audit risk is high for the following reasons: several users, including the bank, Ventura, and the
shareholders, will be relying on the financial statements. Also, because the business is new and the yield
from the vines has not yet been demonstrated, the business risks are high. This is a first audit engagement
and we will have to rely on Pierre, since internal control is non-existent. Several transactions, such as the
purchase of the vines and of Sam’s equipment and machinery, will require accounting estimates. We
could use specialists to determine the fair market value of these items. We should also make sure that we
have sufficient knowledge of the wine industry.

A substantive approach will most likely be needed, since there is no internal control at HWL.

Based on my calculations, the business will be incurring losses in the first few years, available financial
resources are very limited and we have no information on HWL’s past performance. Disclosure as to
whether HWL is a going concern may be required, but such disclosure could affect Ventura’s decision to
invest in HWL. The company’s viability depends in part on its obtaining the VQA designation.
Therefore, we must verify that HWL has obtained the designation and that the wine that is being made is
quality wine. Evaluation of inventory is essential; we will also need to attend the inventory count.

Since the business is in its first year of operation, there will be no specific first audit issues, e.g., there are
no opening balances. We need to look at the contracts with Sam and Ventura and find out whether HWL
has adequate insurance (including crop insurance).

For Secondary Indicator #3, the candidates must be ranked in one of the following
four categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate discusses general and irrelevant audit issues.

Competent –The candidate recognizes that the audit engagement is high risk and explains
why. The candidate identifies one of the conflicts or discusses the going-concern evaluation
or discusses audit procedures focused on risk areas (unusual transactions)

Highly competent – The candidate recognizes that the audit engagement is high risk and
explains why. The candidate identifies one of the conflicts and discusses the going-concern
evaluation.

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APPENDIX I

Cash Flow Calculation

2001 2002 2003 2004 2005


40% 60% 100% 100%
Production Production Production Production
First 100 acres
(66 kg x 100 vines x 100 acres) – 264,000 396,000 660,000 660,000
Second 100 acres – – 264,000 396,000 660,000

Production in kilograms – 264,000 660,000 1,056,000 1,320,000


Number of litres (4 kg/litre) – 66,000 165,000 264,000 330,000
Value of production ($12 per litre) $ – $ 792,000 $ 1,980,000 $ 3,168,000 $ 3,960,000
Incremental ice wine value
(50% more per litre) – – – 792,000 990,000

Total revenues – 792,000 1,980,000 3,960,000 4,950,000

Vine payment (20%) – 158,400 396,000 792,000 990,000

Net revenues – 633,600 1,584,000 3,168,000 3,960,000


Operating costs
VQA ($0.05 per litre) – 3,300 8,250 13,200 16,500
VQA fixed – 2,000 2,000 2,000 2,000
Marketing (20%) – 126,720 316,800 633,600 792,000
Fermentation and bottling ($2.50/litre) 165,000 412,500 660,000 825,000 825,000
Barrels (200 x 200) 40,000 40,000 40,000 40,000 40,000
Fertilizers, pesticides, trellises 100,000 200,000 200,000 200,000 200,000
($10 per vine x 200 acres
x 100 vines/acre)
(305,000 ) (150,920 ) 356,950 1,454,200 2,084,500

Salaries (4/3) 400,000 400,000 400,000 400,000 400,000


Administration (4/3) 100,000 100,000 100,000 100,000 100,000
Incorporation 3,000

Bank interest (9%) 67,500 135,000 135,000 135,000 112,500


Ventura loan interest (10% x 800,000) – 80,000 80,000 80,000 80,000

Net cash from operations $(875,500 ) $ (865,920 ) $ (358,050 ) $ 739,200 $ 1,392,000

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APPENDIX I (continued)

Cash Flow Calculation

2001 2002 2003 2004 2005


40% 60% 100% 100%
Production Production Production Production

Net cash from operations $(875,500 ) $ (865,920 ) $ (358,050 ) $ 739,200 $1,392,000

Capital costs
Shipping vines 200,000 200,000 – – –
Renovations 1,200,000 – – – –
Replacement parts
(200,000 collected) – – – – –
Equipment installation 100,000 – – – –
Fermentation tanks 25,000 – – – –
Debt payments
Bank loan – – – 250,000 250,000

(2,400,500) (1,065,920 ) (358,050 ) 489,200 1,142,000

Sources of financing
Land sale 510,000
Bank loan 1,500,000
Ventura capital 1,000,000
Equipment payment – – – (87,855 ) (527,347 )
Ventura capital payment – – – (8,785 ) (52,735 )

Cash surplus (requirements) $ 609,500 $ (1,065,920 ) $ (358,050 ) $ 392,560 $ 561,918

Cumulative $ 609,500 $ (456,420 ) $ (814,470 ) $ (421,910 ) $ 140,008

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APPENDIX I (continued)

Vine Payment

Year 1 $ 158,400
Year 2 396,000
Year 3 792,000
Year 4 990,000
Year 5 990,000
Year 6 990,000
Year 7 990,000
Year 8 990,000
Year 9 990,000
Year 10 990,000

Capitalization rate 10%

Net present value $4,687,452

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APPENDIX II

Calculation of Net Income

2001 2002 2003 2004 2005

Net cash from operations $(875,500) $(865,920) $(358,050) $ 739,200 $1,392,000

Treatment of vine acquisition


costs
Cost at 10% NPV of
cash flow 4,687,452
Cost of shipping 400,000
5,087,452
Amortize over 37 (40-3) years (137,499) (137,499)
Reverse payment (of liability) – 158,400 396,000 792,000 990,000
Calculate financing cost
($4,687,452 x 10%) (468,745) (499,780) (510,158) (481,973)

Amortize renovations, straight-line basis:


$1.2 million over 23 years (52,174) (52,174)

Amortize equipment over


17 (20-3) years
Original cost 2,500,000
Repairs (depending
on treatment) –
Installation 100,000
2,600,000 (152,941) (152,941)

Net income (loss) before adjustments (875,500) (1,176,265) (461,830) 678,429 1,557,413

Adjustments
Capitalize start-up losses 875,500 1,176,265 461,830
Amortize over 5 years (502,719) (502,719)

Net income before equipment payment $ – $ – $ – $ 175,710 $1,054,694

Payment to Sam $ – $ – $ – $ 87,855 $ 527,347

Ventura capital payment $ – $ – $ – $ 8,785 $ 52,735

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APPENDIX II (continued)

Calculation of Net Income

2001 2002 2003 2004 2005

Income taxes

Net cash from operations $(875,500) $(865,920) $(358,050) $ 739,200 $ 1,392,000

Adjustments
VQA - deductible per 20 (1) cc – – – – –
Interest - deductible per 20 (1) c – – – – –
Incorporation 3,000
Cumulative eligible capital (75% x 7%) (158) (146) (136) (127) (118)
Salaries and admin - period costs – – – – –

Shipping of vines (200,000) (200,000) – – –

Renovations - first use in 2001 1,200,000


- assume Class 6 @ 10% x ½ year (60,000) (114,000) (102,600) (92,340) (83,106)

Equipment - first use in 2001 2,600,000


- assume Class 8 @ 20% x ½ year (310,000) (558,000) (446,400) (357,120) (285,696)

Payment to Sam – – – (87,855) (527,347)


Ventura capital payment – – – (8,785) (52,735)

Loss-carryforward (192,973) (442,999)

Taxable income (loss) $(1,442,658) $(1,738,066) $ (907,186) $ – $ –

Cumulative loss-carryfoward $(1,442,658) $(3,180,724) $(4,087,910) $(3,894,937) $ (3,451,939)

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PAPER II, QUESTION 1

Warmth Home Comfort Limited (WHCL) is a Canadian manufacturer of furnaces and air-conditioning
units. The company was acquired by a group of 15 investors in the early 1990s. Three of the investors are
senior managers with the company, including Jacob Kovacs, who is president and chief executive officer.

Over the years WHCL had been quite successful, but it has struggled in the face of increased competition
from overseas competitors. The owners believe that three years from now WHCL will be poised to be a
major player in the Canadian and the US heating and cooling markets. Summary financial statements are
provided in Exhibit I. Kovacs points out that the company’s financial performance seems to be
improving, given the smaller loss in 2000 and the increasing revenues after two years of falling sales.

Your firm has been auditor of WHCL since its first audit in 1993. It is now January 2001. This is the first
year you are in charge of the audit. Yesterday, you visited WHCL and met with key personnel to discuss
the forthcoming audit engagement. You obtained the following information.

1. In early fiscal 2000, the company increased its debt load significantly by borrowing $300,000 from
Colo Investors Ltd. Excerpts from the loan agreement are as follows:

Warmth Home Comfort Limited (the borrower) covenants that:

a. A current ratio of 1.2 or higher will be maintained, and


b. the debt-to-equity ratio will not exceed 2:1. Debt is defined as all liabilities of the company.

2. In 1994, WHCL introduced a new model of gas furnace that was popular with consumers because
its reduced gas consumption resulted in lower heating bills. The furnace design has remained
virtually unchanged since it was introduced. The furnaces are sold with ten-year warranties on parts
and labour. Historically, claims have been minimal.

In the summer of 2000, several warranty claims were made against WHCL. Routine inspections by
gas-company employees revealed cracked heat exchangers, which could leak gases that might cause
health problems when mixed with warm air in a home. Thirty claims were made, and WHCL paid
for repairs. The cost of repairing each furnace was $150, which was expensed by WHCL.

Jacob Kovacs believes that the furnaces were damaged because of poor installation by contractors.
He cannot see more than an additional 40 or 50 units being damaged. The 30 repaired furnaces were
manufactured in 1998 and 1999. Over 10,000 units of this model have been sold over the past five
years.

Later, in a discussion with the chief engineer, you learn that she had examined the heat exchanger
used in the gas-furnace model in question and saw no evidence of a design flaw. However, she
expressed concern that the problem might be due to heavy use of the furnace. She noted that the 30
reported problems were in northern locations where the demands on the equipment are considerable.
Between 1,500 and 2,000 furnaces were installed in homes in those locations.

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PAPER II, QUESTION 1 (continued)

3. WHCL has been working on a new technology for heating office buildings. Expenditures on the
new technology are summarized in Note 1 of Exhibit I. The project began in early 1999.

According to management, the project is nearing the end of development, and it is now only a
matter of time before it is successfully brought to market. Jacob Kovacs does not think that it will be
possible to bring the project to market in the coming fiscal year without additional financing. He is
optimistic that negotiations with a private investor will be successful, allowing the project to go
forward. Kovacs estimates that an additional $150,000 to $200,000 is needed to bring the product to
market.

4. In January 2000, WHCL bid on and won a $1.05 million contract to supply heating and air
conditioning equipment for a large commercial and residential project. Construction on the project
began in March 2000.

The fixed-price contract calls for WHCL to start delivering and installing the equipment in early
September 2000. In addition, WHCL has agreed to pay a penalty if the project is delayed because
WHCL is unable to meet the agreed-to timetable. A brief strike by its factory employees has caused
production and delivery to lag about two weeks behind schedule, so WHCL is shipping units as
soon as they are produced. According to the agreement, half of the equipment has to be shipped and
installed at the project site by the end of February 2001. Jacob Kovacs is confident that WHCL will
be able to catch up to the promised timetable.

In 2000, WHCL recognized $350,000 of revenue based on the number of units shipped to year end.
WHCL has received $50,000 for the units that have been installed by year end.

5. Starting in February 2001, WHCL will begin offering customers the option of paying a monthly fee
for the use of a furnace. At the end of a certain number of years, the customer can purchase the unit
for a nominal amount or ask for a replacement furnace and continue with the monthly payments.
WHCL will do all maintenance at no cost until a customer purchases the unit. This scheme is
intended to help WHCL remain competitive. The terms for such arrangements have not been
finalized, but Jacob Kovacs is confident that they will increase sales revenue. Jacob has asked for
advice on how to account for them.

6. Economy and Efficiency Limited (EEL) is hired by corporations to find ways to minimize expenses.
EEL is paid 75% of the first year’s savings and 50% of the second year’s savings. In addition to
property tax and insurance fees, EEL investigates heating costs.

In early 2000, WHCL won a bidding competition to become EEL’s consultants on heating matters
by claiming that it could, on average, lower heating costs by 20%. WHCL spent over $20,000
preparing and presenting its bid.

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PAPER II, QUESTION 1 (continued)

The arrangements under the agreement are as follows. WHCL sends an employee to the site of each
EEL client to estimate the savings that can be made if one of WHCL’s heating systems is installed.
Provided that the client considers the projected savings worthwhile, WHCL then installs the system.
WHCL sells the heating system at cost and is paid directly by the client. EEL is responsible for
monitoring the client’s actual savings, and EEL pays WHCL 50% of the amount it collects for
savings related to heating expenses. EEL remits the amount to WHCL after collecting the full
amount from its client. However, if savings are less than 10%, EEL remits nothing to WHCL.

WHCL investigated some clients during 2000 and predicted savings of 15 to 25%. WHCL has
accrued its share of the savings that it believes will be generated at the sites it investigated during
the year. The feedback from EEL to date is that actual savings are not as good as predicted by
WHCL and have ranged from nil to 15%.

Your partner asks you to prepare a memo for him outlining the accounting and auditing issues that came
to your attention as a result of your visit.

Required:

Prepare the memo.

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PAPER II, QUESTION 1 (continued)

EXHIBIT I

WARMTH HOME COMFORT LIMITED


EXTRACTS FROM THE DRAFT FINANCIAL STATEMENTS
BALANCE SHEET
As at December 31
(in thousands of dollars)

2000 1999
(Unaudited) (Audited)
Assets

Current
Cash $ 15 $ 100
Accounts receivable 875 587
Inventory 500 540
Other current assets 56 120
1,446 1,347

Capital assets 2,026 2,026


Accumulated amortization (1,071 ) (926 )
955 1,100
Product development – net (Note 1) 580 230

$ 2,981 $ 2,677

Liabilities

Current
Bank indebtedness $ 450 $ 400
Accounts payable 581 395
Other current liabilities 118 100
1,149 895

Long-term debt 825 525


1,974 1,420

Shareholders’ equity

Share capital 100 100


Retained earnings 907 1,157
1,007 1,257

$ 2,981 $ 2,677

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PAPER II, QUESTION 1 (continued)

EXHIBIT I (continued)

WARMTH HOME COMFORT LIMITED


EXTRACTS FROM THE DRAFT FINANCIAL STATEMENTS
INCOME STATEMENT
For the years ended December 31
(in thousands of dollars)

2000 1999
(Unaudited) (Audited)

Sales $ 7,900 $ 7,800


Cost of goods sold 6,478 6,400
Gross margin 1,422 1,400
Expenses
Selling, general and administrative 1,155 1,290
Amortization of capital assets 120 146
Amortization of product development 50 20
Interest 140 88
Other 147 160
1,612 1,704

Net loss (190 ) (304 )


Retained earnings, beginning of period 1,157 1,561
Dividends (60 ) (100 )

Retained earnings, end of period $ 907 $ 1,157

Note 1:

Expenditures relating to the project to develop new technology for heating office buildings that were
made and capitalized:

2000 1999

Product development – opening balance $ 230 $ 0

Costs incurred during the period


Materials 150 93
Salaries and wages 125 78
Allocation of overhead 80 50
Amortization of capital assets 25 16
Interest 20 13

Total 630 250

Less amortization (50 ) (20 )

Product development – ending balance $ 580 $ 230

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EVALUATION GUIDE
PAPER II, QUESTION 1
PRIMARY INDICATORS OF COMPETENCE

Primary Indicator #1

The candidate identifies the important changes that have occurred during the year and
discusses the consequences for the audit.

The candidate demonstrates competence in Assurance.

SIGNIFICANT CHANGES
1. The new loan has covenants attached to it. If WHCL breaches the covenants, the bank may call the
loan, which would impact the financial statement opinion.
2. The warranty claims have increased. The increase may impact warranty expense and accrual.
3. There are delays in the delivery of equipment for a new contract. Not meeting the timeline may
impact revenue recognition.
4. For the new program with EEL, we must assess the revenue recognition policy since this is new
revenue stream.
5. For research and development, we must assess whether costs are to be capitalized or expensed, as
the treatment impacts reported income.

This year the WHCL engagement poses a number of issues that are of particular concern. Management
believes the company can be a major player in the heating and cooling markets, and steps have been
taken to achieve this goal. In particular, the company has increased its debt significantly in the last year
and the new debt has covenants specifying a minimum current ratio and a maximum debt-to-equity ratio.
Violating these covenants may result in renegotiation of the terms of the loan or even a demand for
immediate repayment. The financial statements will undoubtedly be used by the lenders to monitor
WHCL’s adherence to the loan covenants.

The preliminary financial statements are very close to violation of the debt-to-equity ratio restriction and
violation of the current ratio covenant. Because of the risks associated with violating the covenants, the
company has an incentive to choose accounting policies that improve or at least do not worsen the ratios.
The choices that WHCL must make for a number of controversial accounting issues present WHCL with
the opportunity to use “aggressive” accounting methods to increase equity and current assets, and to
avoid increases in liabilities. As a result, the covenants present audit risks to our firm. It will therefore be
necessary to increase testing and reduce reliance on management and controls because of management’s
incentives to avoid violation of the covenants. Any such violation of the covenants will have to be
disclosed in the financial statements.

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As an example, WCHL will want R&D costs to be capitalized. If they are expensed in 2000, the company
will be in violation of the debt-to-equity covenant. As a result, management has an incentive to overstate
the likelihood of obtaining the needed financing. Another example is the EEL agreement. As a result of
accruing all the savings, accounts receivable and revenue may be overstated, and as a result, the debt-to-
equity and current ratios will be favourably affected.

The debt-to-equity ratio on December 31, 2000, calculated using the preliminary financial statements, is
1.96 and the current ratio is 1.26. The ratios have worsened since 1999, when the debt-to-equity ratio was
1.50 and the current ratio was 1.25. The ratios still meet the conditions of the loan, but some accounting
issues need to be addressed, and their resolution may have a negative impact on these ratios.

As a result, the lender may call WHCL’s loan, which raises the question of whether WHCL is a going
concern. The situation facing the company should be disclosed in the notes to the financial statements.
We may have to qualify our opinion unless some assurances can be obtained from the lender or the loan
can be satisfactorily renegotiated. WHCL should be encouraged to try to work out an arrangement with
the lender as soon as possible.

For Primary Indicator #1, the candidate must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate identifies the introduction of debt covenants as a


significant change, but fails to discuss how this change affects the audit risk.

Reaching competence – The candidate identifies some of the significant audit issues
(covenants and changes in circumstances around warranties), and explains their impact on
audit risk. The candidate recognizes that a breach of the covenants will likely result in a going
concern note/qualified opinion.

Competent – The candidate identifies most of the significant audit issues (covenants,
warranty changes, fixed priced contract or R&D or EEL) and explains the relevance of the
issue to the audit in terms of audit risk. And, the candidate recognizes the link between the
accounting policy choices and the impact on the covenants and how this increases audit risk.

Highly competent – The candidate identifies all the significant issues and clearly explains
why they are considered major issues in terms of the audit. (i.e., links impact on financial
statements and covenants to audit risk).

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Primary Indicator #2

The candidate discusses the accounting treatment of the material transactions.

The candidate demonstrates competence in Performance Measurement.

Warranty

Probably the most serious business and accounting problem facing WHCL is the potential warranty
liability. Problems have arisen with a product that the company has sold since 1994 raising the prospect
of large out-of-pocket costs for the company. The reporting issue is how much, if any, of these costs
should be accrued and expensed in the 2000 financial statements. The $4,500 actually spent in 2000 on
warranty service was expensed in fiscal 2000.

A variety of estimates could be made. WHCL obviously wants to minimize the charge to the current
period whereas fair reporting might require a larger accrual. The information we currently have does not
provide us with a sufficient basis for making an estimate. If we accept a low estimate, our firm faces
litigation if the lenders suffer losses because the actual costs prove to be higher than the accrual. On the
other hand, if we demand a higher accrual, the company may be driven into financial distress. We
therefore face risks regardless of how we proceed.

The estimate suggested by Mr. Kovacs is between $6,000 and $7,000. He argues that the problems are
due to poor installation by contractors, which would limit the extent of the problem. However, Mr.
Kovacs’ incentive to minimize expenses makes his position less reliable. At the other extreme, if all the
furnaces require repair the cost will be $1.5 million (10,000 x $150). This cost is not as improbable as it
may seem since the government could decide that there is a significant health risk and require the
company to repair all the furnaces. Accruing repair costs for all the furnaces is very conservative—
perhaps too conservative.

The chief engineer has suggested that the damage may be due to heavy usage, which occurs in more
northerly communities. Since 1,500 to 2,000 furnaces were sold in the north, warranty costs ranging from
$225,000 to $300,000 (1,500 x $150 – 2,000 x $150) could arise. The chief engineer has expertise in the
field, but she too is speculating as to the actual cause of the problem.

Yet another basis is the year of manufacture. All of the furnaces repaired so far were made in 1998 or
1999. If the problem is associated with those furnaces only, the accrual would be about $600,000,
assuming an equal number of furnaces were made in each year (2,000 per year x 2 years x $150).
Combining the year of manufacture with the number sold in northern communities results in an estimate
of about $120,000 (2,000 sold in northern climates x 40% (two years out of five) x $150).

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All of these estimates, except Mr. Kovacs’, put WHCL in violation of the covenants. As explained
earlier, we face risks irrespective of how we proceed. At this point the estimate of the chief engineer
combined with the year of manufacture presents a credible and supportable amount. However, I cannot
say I have more confidence in that estimate than in any other. I think that we should wait as long as
possible to make the final determination and, if necessary, call in experts to help determine the source of
the problem. The accrual made should be the amount less the $4,500 actually expended in the current
period.

There are also potential additional liabilities from the health hazards associated with the damaged units.
It is virtually impossible to estimate the potential cost of these liabilities since no claims have been made
to date and we are not even sure of the number of furnaces affected. As a result, it is not necessary to
accrue this liability. We should consult independent experts to report on the potential health hazards
caused by the damaged furnaces.

Research and development

WHCL has been developing a new technology for heating office buildings. Management believes that the
technology is ready for market—all that is needed is additional financing of between $150,000 and
$200,000. That financing is not yet in hand and negotiations are ongoing. One of the conditions for
capitalizing development costs is that adequate financial resources must be available to complete the
project. WHCL is clearly in need of funds, which suggests that the development costs should not be
capitalized. However, there is a potential lender and negotiations with the lender, according to
management, have a good chance of being successful, which supports capitalization.

We will have to examine documents related to the negotiations to determine whether the funding is
likely. It is possible that the issue will be resolved before we have to sign off on the statements.
Otherwise a determination of the likelihood of the availability the funds will be required. We will also
need to make sure that the other criteria for capitalizing the development costs are met. We will have to
check whether a market actually exists for the product—examining any marketing studies will help in
this regard. We will need to examine a cost analysis to determine whether the product is economically
viable once the additional costs are considered.

Fixed price contract

In January 2000 WHCL won a fixed price contract to supply heating and air conditioning for a large
project. WHCL is recognizing the revenue from the contract on a percentage-of-completion basis, which
is acceptable. The completed contract method would also be allowed if uncertainty about costs or
collectibility exists. WHCL should accrue any penalty expected for delaying the project. A penalty is
possible because of the strike by WHCL’s factory workers that put production behind schedule.

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We should determine how similar sales are accounted for to ensure that similar contracts, if any, are
treated consistently. Of course, if the terms of this contract are different, different accounting would be
acceptable. We need to evaluate the revenues and expenses allocated to 2000. WHCL has incentives to
overstate revenue and understate expenses because of the covenants. We need to determine how
management estimated the total costs of the contract and the costs attributed to 2000. We should assess
the reasonableness of the method WHCL used to determine the amount of revenue to be recognized in
2000. The percentage-of-completion method could be applied in different ways. The percentage could be
determined based on costs incurred, furnaces produced, or furnaces delivered. Of potential concern is the
amount owed by the contractor. The percentage-of-completion method does not require that any money
be collected, but collectibility is required. As a result, we need to satisfy ourselves that the contractor will
be able to pay.

For Primary Indicator #2, the candidate must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate’s discussion of the accounting issues is technically


incorrect or very weak. Or the candidate addresses only the less significant accounting
issues (e.g., the penalty in the fixed price contract, the EEL agreement, bid costs of $20,000,
or the lease).

Reaching competence – The candidate addresses one of the significant accounting issues.
The accounting discussion may contain minor technical weaknesses. Typically, the
candidate does not see that there are alternatives in the treatment or amounts being
accounted for (warranty, R&D and/or fixed price contract).

Competent – The candidate discusses two or more of the significant accounting issues in
sufficient depth to demonstrate an understanding of the decision variables. The discussion is
technically correct.

Highly competent – The candidate discusses the three significant accounting issues in
depth, demonstrating a clear understanding of the decision variables and considers the
impact of each issue on the covenant.

Primary Indicator #3

The candidate recalculates the debt covenant ratios based on findings and assesses the
possible outcomes.

The candidate demonstrates competence in Pervasive Skills.

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WHCL is in difficulty. It appears likely that the debt-to-equity covenant will be violated given the accrual
required for the warranty costs and the reduction in income necessitated by the aggressive accounting for
the EEL arrangement. A reduction of income of more than $20,000 would make the debt-to-equity ratio
greater than 2. A warranty accrual of more than $13,333 will put the debt-to-equity ratio over 2. It seems
improbable that the future warranty costs will be less than this amount. In addition, given how close the
company is to violating the covenants, efforts to obtain additional funds to finance the new technology
are less likely to succeed. If the development costs have to be expensed, the problem of meeting the
covenants is exacerbated. As a result, the lender may call WHCL’s loan, which raises the question of
whether WHCL is a going concern. The situation facing the company should be disclosed in the notes to
the financial statements. We may have to qualify our opinion unless some assurances can be obtained
from the lender or the loan can be satisfactorily renegotiated. WHCL should be encouraged to try to work
out an arrangement with the lender as soon as possible.

For Primary Indicator #3, the candidate must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate concludes that the covenants are breached without
providing detailed support. There is no recalculated amount to support the position taken and
the candidate’s explanation as to why the covenant is breached is weak.

Reaching competence – The candidate recalculates the ratios based on a single


accounting adjustment, thus ignoring the possibility that other adjustments might go in the
opposite direction.

Competent – The candidate accurately recalculates the ratios, takes into account most of
his/her accounting adjustments (i.e., integrated the discussion of the ratios into his/her
accounting discussion) and concludes that the covenants are in breach. The candidate
discusses how the breach may impact WHCL’s future.

Highly competent – The candidate accurately recalculates the ratios taking into account all
of the accounting adjustments, and concludes that the covenants are breached. The
candidate discusses how the breach impacts WHCL’s future and the audit. The candidate
understands that the client has some choices to make within the policy recommendations that
may result in the ratios being better than they would be with other choices.

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EVALUATION GUIDE
PAPER II, QUESTION 1
SECONDARY INDICATORS OF COMPETENCE

Secondary Indicator # 1

The candidate discusses detailed audit procedures.

The candidate demonstrates competence in Assurance.

Because of the increase in audit risk caused by the existence of the loan covenants and the proximity to
violation, it will be necessary to increase testing and reduce reliance on management and controls
because of management’s incentives to avoid violation of the covenants. Any violation of the covenants
will have to be disclosed in the financial statements.

Warranty

A number of audit steps can be taken to improve our ability to assess the reasonableness of any estimate
of the liability. All of the estimates should be thoroughly discussed with management. We could
investigate Mr. Kovacs’s estimate by finding out whether all of the furnaces repaired to date were
installed by the same person. We could also confirm whether all the repaired furnaces were in the north
to assess the reasonableness of the chief engineer’s estimate. In addition, we should assess the objectivity
of the chief engineer because our ability to rely on her depends on her credibility. Since she is as an
employee of WHCL we should, of course, view her position with at least some skepticism. We should
also examine the warranty document itself to determine the extent of WHCL’s liability for this problem.
We should also examine any legal letters and ensure that we receive a response to the legal inquiry letter.

Financial statements presentation

The warranty liability could have current and non-current elements, depending on the length of time that
the repairs will have to be made. WHCL would prefer to have more of the amount classified as a long-
term liability to minimize the impact on the current ratio. The effect on the debt-to-equity ratio is the
same regardless of the classification as current or non-current. If the company plans to fix units over the
next few months, then the liability should be classified as current. We should examine the company’s
action plan to determine how it is planning to proceed.

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Research and development

We also need to ensure that the costs included in the development costs are properly classified.
Management could try to “hide” unrelated costs among the development costs to reduce expenses. We
need to determine how costs were segregated from the ordinary operating costs of the business and
whether the basis for charging costs to the project is reasonable. Similarly, how were allocated costs such
as amortization charged to the project? Amortizable assets used exclusively on the project are not a
problem, but the costs for assets that are used only in part for the project need to be examined carefully.
We also need to determine whether the interest charged to the project is for funds specifically borrowed
for the project, in which case the charge is appropriate, or whether the interest is an allocation of interest,
in which case we need to assess the reasonableness of the basis of allocation.

EEL

Auditing this arrangement will be challenging. There is no past experience for us to rely on, and WHCL
employees are making the estimates of the savings. Further, EEL is responsible for collecting from the
client and for auditing the savings. Auditing savings can be difficult since many factors contribute to the
cost of heating over and above the equipment being used (weather, for example). In the end, the only way
to recognize revenue might be on collection because only EEL will know the credit worthiness of the
clients. There is also some question as to whether WHCL bears the credit risk or whether EEL is
responsible for paying WHCL regardless of whether EEL gets paid. Ultimately, we will have to
determine how accurate the estimates of savings being made by WHCL are. If the estimates are good, it
will be possible to recognize revenue at the time of installation of the furnace. For this year, it will not be
possible to tell the accuracy of the estimates since it is the middle of the first full winter. As a result it
will not be possible to rely on projections of the savings and, therefore, the profit projections. For the
current year, I do not think that any revenues or profits derived from the relationship with EEL should be
recognized because of the uncertainty about the amount that will be earned.

For Secondary Indicator #1, the candidate must be ranked in one of the following four
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate discusses audit procedures at random or discusses


standard audit procedures without specifically linking them to the case facts or the
procedures are not valid.

Competent – The candidate discusses detailed audit procedures for one of the more
significant risk areas, i.e., attempts to address the specific risks identified through relevant
procedures.

Highly competent – The candidate discusses detailed audit procedures for all major risk
areas (warranty, fixed price contract, R&D, EEL).

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Secondary Indicator #2

The candidate discusses the minor accounting issues.

The candidate demonstrates competence in Performance Measurement.

Fixed price contract penalty

We need to determine if the penalty clause is likely to take effect. At present, even a small penalty could
put WHCL in violation of its debt-to-equity covenant. We have to be concerned about whether WHCL
will be able to meet the required timetable. We should determine whether WHCL is able to catch up and
meet the terms of the contract and whether management plans to do so. In either case, if the answer is no,
then a penalty cost should be accrued.

EEL (revenue recognition)

WHCL has an arrangement with EEL to provide consulting services and installation services. The
arrangement entitles WHCL to share in savings on heating achieved by customers who follow its
recommendations. WHCL appears to be aggressive in recognizing the savings because it is accruing
savings for all sites inspected regardless of whether there is any indication that the recommendations will
be accepted or that the savings estimates are reasonable.

WHCL sells the heating equipment to the clients at cost. Any profit that is earned comes later, from the
saving achieved by the client. The revenue could be recognized in different ways. One approach is to
recognize it at the time of installation. Under this approach it is not apparent what the profit will be
because the profit depends on what the client saves. This approach defers the revenue until the savings
are known. It addresses the uncertainty issue, but it delays recognition of revenue, which WHCL would
find disadvantageous. Alternatively, the arrangement with EEL could be looked at as an integral part of
the furnace sale since the furnace is being sold at cost, which WHCL would not normally do. Using this
approach, the normal revenue is accrued at the time of the furnace installation. A third approach is to
assess each contract individually. A contract that does not appear profitable would be written off
immediately. In any case, the arrangement with EEL will not produce losses because the furnaces are
sold at cost, so most of WHCL’s costs will be recovered.

The $20,000 spent preparing the bid could be capitalized or expensed. WHCL would prefer to capitalize
it because doing so decreases expenses and thus lowers the debt-to-equity ratio. If the arrangement is
profitable, then capitalization is legitimate because the costs were incurred to earn income. However, if it
appears that the arrangement is not profitable, then the $20,000 should be expensed because the outlay
produces no future benefit.

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For Secondary Indicator #2, the candidate must be ranked into one of the following
four categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate’s discussion of the issues (penalty in the fixed price
contract, EEL, bid costs $20,000) is technically incorrect or very weak or the candidate
discusses a single issue.

Competent – The candidate discusses most of the issues in sufficient depth to demonstrate
an understanding of the decision on variables. The discussion is technically correct.

Highly competent – The candidate discusses all the issues and clearly explains the decision
variables, and considers the impact of each issue on the covenant.

Secondary Indicator #3

The candidate advises on how to account for the new furnace payment options.

The candidate demonstrates competence in Performance Measurement.

Monthly fees/lease

The furnace rental plan is a new source of revenue for WHCL, and we need to advise the company on
how to account for it. The choice is whether to treat this arrangement as an operating lease or as a sales-
type lease. WHCL would prefer the sales-type lease because it would allow the revenue from the sale of
the furnaces to be recognized immediately, thereby increasing revenue and net income and lowering the
debt-to-equity ratio. The sales-type lease classification would also improve the current ratio because
there would be a current receivable. Given what we know at this point, it is not certain whether the
criteria for a sales-type lease are met, but it appears that they are. Transfer of ownership would likely
occur because the price is nominal. Whether the lease covers 75% of the life of the furnace or recovers
90% of the investment is not clear. The term of the lease seems to be fairly long, so the credit risk may be
higher than normal, in which case classification as an operating lease would be appropriate. To classify
the lease as a sales-type lease, the customers must be able to pay.

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The maintenance costs should be accrued and matched against the revenue from the lease. WHCL is
responsible for maintenance of the equipment. If the maintenance costs cannot be reasonably estimated, it
may be appropriate to classify the lease as an operating lease because the risks associated with the asset
are not transferred. Since WHCL has been in the heating business for many years, it is reasonable to
assume that the company will be able to estimate the costs.

Accordingly, it is reasonable to classify the lease as a sales-type lease.

For Secondary Indicator #3, the candidate must be ranked in one of the following
four categories:

Not addressed – The candidate does not address this secondary indicator or does not
attain the standard of nominal competence.

Nominal competence – The candidate recognizes that the new payment options
described are in fact a lease. The candidate identifies only one treatment option (i.e., one
of operating or capital).

Competent – The candidate identifies the accounting treatment options (operating vs.
sales-type lease) and does one of the following:

1. provides advice on which method to choose based on Jacob’s objectives.

2. recognizes there are many factors in determining the classification and that additional
information is needed.

Highly competent – The candidate discusses the accounting treatment options (operating
vs sales-type lease) and provides advice on which method to choose based on Jacob’s
objectives. The candidate recognizes that there are many factors in determining the
classification and that additional information is needed.

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PAPER II, QUESTION 2

Dan McKinley, a long-time friend, has come to you, CA, seeking some advice. The following
conversation takes place on Wednesday morning:

Dan: “I’m thinking of retiring. In fact, my wife, Pam, and I are looking for a small business that we
can manage and from which we can earn $50,000 per year to live comfortably. But we don’t
have much experience with this type of thing, and we are hoping you can help us out.”

CA: “I’ll try, Dan. Is there anything specific that I can help you with?”

Dan: “Yes, there is. We have been approached by Steve Doty, who wants to sell his business and
was wondering if we were interested. It looks like a good little business for my wife and me
and something that we could earn a living from until we retire for good in about ten years’
time. We just want the business to generate enough money so that we can live comfortably and
still maintain the retirement nest egg that we have built up in the past. Steve has prepared an
information package for us regarding the history of the business and its potential in the future
(Exhibit I). Can you please let us know if you think it is a good business and, if so, give us
your opinion on whether we should buy it?”

CA: “Sure, Dan. How soon do you need an answer?”

Dan: “Steve wants an oral commitment and a small deposit by this Friday. I know that’s not a lot of
time, but I don’t need anything fancy – just a report letting us know what you think. After that
point he says that we could review his records and contracts in more detail and have a closer
look at the business and then finalize the terms of the deal.”

CA: “No problem, Dan. We’ll see you on Friday morning.”

Required:

Prepare the report for Dan McKinley.

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PAPER II, QUESTION 2 (continued)

EXHIBIT I

INFORMATION PACKAGE SUPPLIED BY STEVE DOTY


REGARDING THE PROPOSED BUSINESS ACQUISITION

September 10, 2001

Mr. Dan McKinley


2500 Devil’s Advocate Way, Unit 007
Scout Town, Canada
T0L 1M0

Dear Dan:

I have attached an information package for you regarding the investment opportunity that we discussed
on the phone earlier.

I am eager to make a deal as quickly as possible. If you are interested, I would be happy to hold the deal
for you with a deposit of $10,000. As I told you, I have also sent the package to several other parties. If
you are interested and provide me with the deposit as noted above, I will assume that we have a deal in
principle. We can then work out the details over the next few weeks.

I look forward to hearing from you soon.

Regards,

Steve Doty

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PAPER II, QUESTION 2 (continued)

EXHIBIT I (continued)

INFORMATION PACKAGE SUPPLIED BY STEVE DOTY


REGARDING THE PROPOSED BUSINESS ACQUISITION

Proposal

Sale of 100% of the shares owned by Steve Doty in “Licensing and Registrations Inc.” (LRI). The sale
price for the shares will be four times net income before taxes based on the fiscal July 31, 2001 unaudited
financial statements. The proposed closing date is October 1, 2001.

Company background

In February 1991, the provincial government privatized the services that are now offered by LRI. The
government believes that the private sector can distribute the products now offered by LRI more
efficiently and with enhanced service to the public at large.

LRI was incorporated in November 1996 by Tom Jones. LRI acts as an agency for the provincial
government and distributes drivers’ licences, lottery licences, birth certificates and vehicle registrations
for the provincial government. Essentially, LRI collects fees from the general public and remits the
amounts that it collects to the provincial government. For these services, LRI earns income from the
government based on the number of transactions that it performs.

The services that LRI is allowed to perform are governed by an agency agreement signed with the
provincial government. The agreement gives LRI non-exclusive rights to distribute drivers’ licences,
lottery licences, and birth certificates as well as to register vehicles in the small town in which LRI is
located. The agreement specifies where these services can be offered and specifies the fees that may be
charged for these services.

In September 1999, the provincial government temporarily revoked the agency agreement with LRI,
citing irregularities by Tom Jones and objecting to his management practices. The business was closed,
and Tom Jones was given 60 days to sell the business or the provincial agency agreement would be
permanently revoked. Tom Jones sold the shares of LRI to Steve Doty on November 1, 1999, for
$50,000. In addition to the amount paid to Tom Jones, Steve Doty paid a licensing fee of $40,000 to the
provincial government for the right to sell the government products. LRI reopened for business on
December 1, 1999.

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PAPER II, QUESTION 2 (continued)

EXHIBIT I (continued)

INFORMATION PACKAGE SUPPLIED BY STEVE DOTY


REGARDING THE PROPOSED BUSINESS ACQUISITION

Competition

In the small town where LRI operates, no other businesses are currently allowed to distribute any of the
products being offered by LRI.

Expansion opportunities

LRI began to register and incorporate businesses for the provincial government in September 2000.
These corporate services have been very successful to date. Under the agency agreement, LRI may offer
private services in addition to the government services that it provides. Other businesses similar to LRI
elsewhere in the province offer additional services in the following areas:

• Automobile insurance
• Foreign currency exchange
• Cheque cashing services

The additional services are subject to the approval of the provincial government. Currently, LRI does not
offer any of these services to the public. However, these services generate annual gross revenues of
$30,000 to $60,000 in towns of similar size.

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PAPER II, QUESTION 2 (continued)

EXHIBIT I (continued)

INFORMATION PACKAGE SUPPLIED BY STEVE DOTY


REGARDING THE PROPOSED BUSINESS ACQUISITION

INCOME STATEMENT
For the years ended July 31
(unaudited)

2001 2000 1999 1998 1997


(Note 2) (Note 1)

Revenues
Drivers’ licences $ 50,000 $ 44,000 $ 64,000 $ 63,000 $ 44,000
Vehicle registrations 96,000 70,000 108,000 105,000 76,000
Lottery licences (Note 4) 36,000 20,000 50,000 54,000 36,000
Birth certificates 13,000 8,000 16,000 17,000 12,000
Corporate services 44,000 − − − −
239,000 142,000 238,000 239,000 168,000

Operating expenses
Advertising 5,000 6,000 7,000 5,000 8,000
Rent (Note 5) 40,000 52,000 52,000 52,000 52,000
Wages and benefits (Note 6) 68,000 55,500 64,000 63,000 66,000
Supplies 10,000 12,000 13,000 13,400 11,200
Amortization 24,000 25,000 26,000 27,000 28,000
Meals and entertainment 3,000 3,200 23,000 26,000 21,500
Interest expense 4,000 4,500 5,000 6,000 9,000
154,000 158,200 190,000 192,400 195,700

Income (loss) before taxes 85,000 (16,200 ) 48,000 46,600 (27,700 )


Income taxes 20,200 (4,050 ) 11,600 7,200 −

Net income (loss) $ 64,800 $ (12,150 ) $ 36,400 $ 39,400 $ (27,700 )

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PAPER II, QUESTION 2 (continued)

EXHIBIT I (continued)

INFORMATION PACKAGE SUPPLIED BY STEVE DOTY


REGARDING THE PROPOSED BUSINESS ACQUISITION

BALANCE SHEET
As at July 31
(unaudited)

2001 2000 1999 1998 1997

Assets

Cash $ 83,000 $ 96,000 $ 93,000 $ 69,000 $ 76,000


Miscellaneous receivables 2,400 1,600 1,000 2,400 1,400
Prepaid expenses 7,000 6,400 5,600 6,000 5,000
Capital assets (Note 7) 116,450 68,050 90,600 83,400 90,000
Licensing fee 40,000 40,000 − − −

$248,850 $212,050 $190,200 $160,800 $172,400

Liabilities and equity

Accounts payable $ 55,000 $ 6,000 $ 7,000 $ 5,000 $ 8,000


Government payables (Note 3) 95,000 144,000 81,000 72,000 72,000
Long-term bank debt 48,000 56,000 64,000 72,000 120,000
Share capital 100 100 100 100 100
Retained earnings (deficit) 50,750 5,950 38,100 11,700 (27,700 )

$248,850 $212,050 $190,200 $160,800 $172,400

Dividends paid
1997 $0
1998 $0
1999 $10,000
2000 $20,000
2001 $20,000

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PAPER II, QUESTION 2 (continued)

EXHIBIT I (continued)

INFORMATION PACKAGE SUPPLIED BY STEVE DOTY


REGARDING THE PROPOSED BUSINESS ACQUISITION

Notes:

1. LRI opened for business on January 1, 1997.

2. LRI was closed from September 15, 1999, through November 30, 1999, due to the provincial
government’s decision to temporarily revoke the agency agreement with Tom Jones, the former
owner of LRI.

3. Customers who want to purchase driver’s licences, birth certificates and vehicle registrations must
visit LRI and present the required forms and documentation. LRI then issues the documents
requested by the customers. Customers make their payments (cash, cheque or debit card) directly to
LRI. LRI then remits the money, net of its fee, to the government.

4. Lottery licences are issued for $500 per licence. LRI sells these licences through its web site only.
The customers provide required information on-line and use their credit card to pay for their lottery
licence on-line. LRI records the revenue when cash is received. The customers must then visit LRI
in person (usually months after they have paid for their licence) to sign documents and receive their
lottery licence. The delay in receiving the licence is because the government must do a background
check before the licence can be issued.

5. During fiscal 2000 LRI moved from its old location to a new, comparable location with lower rent.
LRI sub-leased its old location for the same amount that it was paying, and therefore the net rent is
zero for the old location. The lease for the old location expires in 2006. The new long-term lease in
effect at the new location expires on July 31, 2011.

6. Wages and benefits include only amounts for the staff at LRI. No salary has ever been received by
Tom Jones or Steve Doty.

7. At July 31, 2001, the capital assets, at cost, on the balance sheet consist of the following:

Digital imaging system $ 30,000


Computer equipment 44,000
Furniture and equipment 20,000
Leasehold improvements – old location 65,000
Leasehold improvements – new location 38,000
Total capital assets – costs 197,000
Less: accumulated amortization (80,550 )

Total capital assets – net $116,450

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EVALUATION GUIDE
PAPER II, QUESTION 2
PRIMARY INDICATORS OF COMPETENCE

Primary Indicator #1

The candidate performs a quantitative analysis to support the recommendation/advice


provided to the client. The candidate explains the methodology chosen.

The candidate is demonstrating competence in Finance.

Financial assessment

A business can be valued in several ways. The proposal to multiply income before taxes by an earnings
multiple is one method, and is relatively simplistic since it ignores any non-recurring events that may be
included in income. The effect may be particularly problematic because only a single year is being used
as the basis of the multiple. Another approach is to look at cash generated by the business. Future cash
flows that LRI will be generating should be estimated because that is what you will be earning. A good
place to start this analysis is to look at cash generated in recent years. Cash from operations is the cash an
entity generates from its normal business operations. The entire statement of cash flow gives some
insights into cash flows for all purposes by the entity.

LRI’s cash flow statement for 2001 is as follows:

2001 2000 1999

Net income $ 64,800 $ (12,150 ) $36,400


Add: amortization 24,000 25,000 26,000
Less: increase in miscellaneous receivables (800 ) (600 ) 1,400
Less: increase in prepaids (600 ) (800 ) 400
Add: increase in accounts payable 49,000 (1,000 ) 2,000
Less: decrease in government payables (49,000 ) 63,000 9,000
Cash from operations $ 87,400 $ 73,450 $75,200

Financing activities
Dividends (20,000 )
Repayment of long-term bank debt (8,000 )

Investing activity
Purchase of capital assets (72,400 ) (116,450 - 68,050 + 24,000)

Net change in cash $(13,000)

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Cash generated by operations on the surface appears quite reasonable and exceeds your requirements of
$50,000 per year. However, this amount does not include a charge for Mr. Doty. If he actually worked in
the store for free, the attractiveness of the cash flow diminishes. If, on the other hand, Mr. Doty did not
work in the business, then you and Pam can take the income earned by employees and still have the cash
flow from operations on top of that.

Expenses incurred by LRI seem to have been relatively stable over the years, which provides some
confidence that costs are reasonably predictable. LRI does seem to be continually tight on cash
(remember to net out the cash on hand against the government payable). Current assets have been
consistently and significantly lower than current liabilities, which suggests liquidity problems. The cash
owed to the government provides a buffer for meeting obligations, but this could cause problems if the
government pushes for more rapid payment of liabilities. Also, the continual cash crunch makes it more
difficult to pay cash out to owners. On the other hand, LRI has been able gradually to lower its bank loan
over the years. With respect to the bank loan, we need to determine the repayment terms. What is the
amount and timing of repayments? Is a large repayment due in the near future?

Revenues in 2001 increased over 2000 (which was a partial year), but they have not recovered to their
1999 levels. Can recovery be expected or was some business lost permanently? It is hard to figure out
exactly why a full recovery did not occur. Could it be that people found alternatives to LRI and have not
gone back to it? It would seem that as the only show in town, people would return to LRI as a matter of
convenience. The decline could reflect the demographics of the community. If a full recovery can be
expected, the attractiveness of the business increases.

Projecting into the future, if it is assumed that revenues for existing businesses will return to 1999 levels,
and corporate services will increase at 10% per year while expenses remain stable in 2002 and increase
by 5% in 2003, estimated cash from operations for 2002 and 2003 would be:

2002—projected 2003—projected
Revenues (assume all in cash)
Government documents $238,000 $238,000
Corporate services 48,400 53,240
Expenses (excluding amortization) (130,000 ) (136,500 )

Cash from operations (before tax) $156,400 $154,740

The cash from operations increases in 2002 and then declines a bit in 2003 as a result of increased costs.
Of course, the outcome of this analysis is sensitive to the assumptions and it would pay to dig deeper into
the numbers as we get new information.

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Some additional points of concern are the following:

• The amortization expense decreases even though the amount of capital assets increases. The reason
for this needs to be determined.
• Are any capital investments required in the near future? LRI has invested a fair bit of money in
recent years and if these investments continue, cash will be consumed. The issue is important for
determining the cash that you will get each year.
• There has been a large increase in accounts payable since the last year end and an identically large
decrease in government payables. There may be a good explanation for this, or it might be an
accounting error or it might suggest a reliability problem with the financial statements. In any case,
this matter needs to be investigated.
• Will significant capital investments be required for the new lines of business?
• Why have meals and entertainment declined so much over the last two years? Is this an indication of
significant problems or more prudent management of resources?

In examining the balance sheet, you should not be misled by the large amount of cash on hand. This cash
belongs to the government and is required to pay off the large government payable.

Notwithstanding the concerns and uncertainties, the cash flow generated by operations seems quite
satisfactory. If we deduct a further $25,000 per year for capital expenditures and as a contingency fund,
the business generates enough cash to satisfy your cash needs of $50,000 per year. This analysis is based
on the assumption that you and Pam will operate the business and will not have to pay someone to do so.
If you do have to pay someone else, the analysis will differ. The present value of annual cash flows of
$75,000 ($100,000 per year from the above table less $25,000 for capital expenditures) discounted at
15% over 10 years is about $376,000. Discounted at 20% the present value is about $315,000. Based on
this analysis alone, the price being asked by Steve is within an acceptable range.

One other issue to consider is how you will finance the purchase. Since you do not want to use your
retirement savings, you will need to seek out financing. This process should probably begin at the bank to
see how much and under what terms it will provide financing. You might also look at any resources
outside of your retirement nest egg that you could invest.

Other matters

Revenue recognition

The change in revenue recognition timing (in how LRI recognizes its revenue) would reduce revenue in
2001. The amount of the impact on income in 2001 depends on the lag between the time a customer pays
the fee and picks up his or her licence. If the lag is three months and assuming the licences are issued
evenly throughout the year, revenue in 2001 would be reduced by:

$36,000/12 x 3 - $20,000/12 x 3 = $4,000

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The first term is the income currently recognized in 2001 that is now deferred until 2002. The second
term is the income that was recognized in 2000 and now should be recognized in 2001. The effect on the
selling price using the proposed formula is $16,000 ($4,000 x 4).

Leasehold improvements

If the amounts are written off in fiscal 2001 the purchase price will decrease. However, if the amount
had been written off in fiscal 2000, when the actual move occurred, then the only effect on the fiscal
2001 financial statements would be reduced amortization, which would actually increase the purchase
price based on the formula.

In reality, the leasehold improvements are irrelevant for your evaluation of LRI. They have no
consequences for the future performance of LRI and should not be included in the analysis.

Initiation fee

Like the leasehold improvements, the amortization of the initial fee has no economic impact on the
performance of LRI (assuming that it does not have to be paid again). It will have no effect on the future
cash flow of LRI as it represents a one-time expenditure.

Proposed deal

The proposal states that the selling price of LRI will be four times net income before taxes based on the
fiscal July 31, 2001 unaudited financial statements. Since the financial statements are not audited, it is
not clear what basis they have been, or should be, prepared on. GAAP might be an appropriate basis for
the statements, though GAAP does allow for considerable choice and judgement, which can work for and
against you. The unaudited financial statements pose a problem and risk because there is no way of
knowing whether the numbers in the statements are reliable and representative of LRI’s economic
activity. The price for LRI, even if you were to accept the terms of the proposal, should not be final
because changes to the financial statements may be necessary, which will change the price.

In addition, we must assess the appropriateness of the earnings multiple selected. Is an earnings multiple
of four too high for a business that has lost money two years in five? As well, earnings in fiscal 2000
represents the highest that the company has ever had by far and the company does not have a record of
sustainable earnings. Perhaps a more logical method would be to base the price on an average of the five
years’ earnings. On the other hand, cash from operations, the cash flow an entity generates from its
normal business activities, has been reasonable over the last few years. Discounting estimated cash flow
might be a better way to value the business than using an earnings multiple.

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For Primary Indicator #1, the candidate must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence –The candidate assesses current cash flow from operations and
makes several errors or incorrect assumptions. The candidate does not understand why a
future cash flow assessment is helpful in addressing the client’s questions.

Reaching competence – The candidate attempts to estimate either the future cash flows or
normalized net income from operations, adjusting for some non-recurring items. In the case
of a cash flow analysis, the candidate adds back, for example, CCA, license fee, and
leasehold improvements. In neither case does the candidate attempt to adjust for changes in
current operating items (e.g., new line of business, capital requirements). The analysis may
contain some errors but, for the most part, is valid. The type of analysis performed by the
candidate is the appropriate one to support the advice provided to the client. For example, a
cash flow analysis will answer the question of whether the business can generate $50,000 to
live on. A normalized net income will not. At this level of competence, however, the candidate
does not have to explicitly state the rationale for the type of analysis.

Competent – The candidate answers both questions (i.e., Is cash flow sufficient? What is
the value of the company?) The candidate estimates future cash flows or normalizes net
income from operations adjusting for non-recurring items and for changes in current
operating items (e.g., financial accounting adjustments, new business income). All inclusions
are supported, and the analysis contains very few errors. The candidate explains the link
between the type of analysis performed and the advice provided to Dan. For example, “My
cash flow analysis indicates that your need for $50,000 a year can be met.” or “Normalized
net income supports a value for the company of $ …, which justifies a purchase price of $ …
for the shares”.

Highly competent – The candidate estimates future cash flows in an attempt to address
both of Dan’s questions (cash flow needs and value of company). The candidate
understands that there are many ways to value the company and uses two methods to
assess the range of possible “values”(e.g., future cash flows and normalized net income).
The candidate builds in both financial accounting adjustments and future activity assumptions
into analysis, e.g., Increase in sales due to new products, capital reinvestment. The
calculations are complete, accurate, and well supported. The candidate clearly understands
and makes the link between the net income adjustments and the cash flow forecast.

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Primary Indicator #2

The candidate identifies and discusses the factors affecting the decision to purchase the
business. The candidate’s recommendations to the client take these factors into account.

The candidate demonstrates competence in Organizational Effectiveness, Control and Risk


Management.

The first factor to be considered by Dan should be the price. There are however other factors to consider
as they affect the value of the business.

A number of qualitative factors must be considered when evaluating the attractiveness of LRI. These
factors could decrease the value of the business or increase the chance that the business will not perform
well in the future. These qualitative factors include the following:

1. The agreement between LRI and the provincial government is non-exclusive. The government could
allow a similar business to open up across the street from LRI that would carry the same products.
2. The business is controlled or regulated by the provincial government. The government could shut
down the business or change its operations considerably for arbitrary or politically motivated
reasons. We have already seen evidence that they may do this from the experience of Tom Jones in
1999.
3. The business is relatively new and does not have a proven track record. As well, the corporate
revenues product line is only one year old and may not continue or may not grow. The lack of
history leads to uncertainty with respect to future operations.
4. The business operates in a small town and as a result there may be limited growth potential or even
a decreasing market if the population of the town is declining.

There are also qualitative factors that may increase the value of the business or increase the future
prospects of the business. These include the following:

1. There are additional product lines that the company could offer to increase its revenue in the future.
These potential revenues need to be assessed to determine their feasibility.
2. The corporate services area appears to have been very successful in its first year of operations.
Further opportunities may exist to expand this product line in the future.
3. There is no direct competition for the business within the town where LRI operates, so customers
who need this service have a limited choice as to where they obtain the service. The barriers to
entry are high as well, given that the government is unlikely willing to support a second similar
business within the town.
4. The financial history of the company is fairly stable if we remove the first year of operations (since
it was not a complete year) and we remove the 1999 fiscal year (because the operation was shut
down for two and one half months).
5. Economies of scale are available because LRI has exclusivity on the government services that can
form the financial base for providing services that are not exclusive.

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Miscellaneous concerns regarding the deal

There are a number of additional points that you should consider while evaluating the offer and
negotiating the final terms if you choose to go ahead with the deal:

• If you purchase the shares of LRI, you should include a clause in the agreement that allows you to
recover from Mr. Doty any amounts that LRI must pay with respect to liabilities that were unknown
at the transaction date that relate to the period before the transaction date.
• You should include in the agreement a non-competition clause so that Mr. Doty will not set up
business in direct competition with LRI.
• We also need to determine whether another $40,000 initiation fee will be required if you acquire
LRI.
• We will need to review the sub-lease and the original lease at the old location to determine if there
are any contingent liabilities for LRI related to the old location.
• The agency agreement with the government must be reviewed carefully.
• If you choose to proceed with the purchase, you should find out whether the deposit is refundable
should circumstances change and you are unable or unwilling to close the deal. Also, the deposit
should be held in escrow until the deal is finalized.
• We should also inquire as to why the government suspended the agency agreement in 1998 and the
likelihood of this situation arising in the future.
• You should determine whether Mr. Doty or members of his family have been working at LRI. If so, it
weakens the performance of LRI because they have been working for free—which could happen to
you and Pam as well. We should attempt to determine the value of any services provided by Mr. Doty
and his family and factor them into the value of the company as a whole. This factor could
significantly affect the attractiveness of the business.
• You should determine why Mr. Doty is selling LRI after such a short period of ownership. There may
be a good explanation for his decision, but he may also be bailing out of a bad situation.
• The proposed selling price seems very high compared with the $50,000 Steve Doty paid less than two
years ago. What has occurred to justify this large change in the value?

Operating a small business offers challenges that are very different from being an employee. If you do
purchase a small business to manage after you retire, it has to be the right business—choosing the wrong
business could be costly, frustrating, and discouraging.

We have to consider Pam’s and your tolerance for risk. Businesses are risky, and you have to be aware of
and understand the risks you are taking. We also have to consider that you do not have any experience
running a small retail business. Many small businesses fail, and experience can reduce the likelihood of
that happening.

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For Primary Indicator #2, the candidate must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate identifies only the price as a decision factor or the
candidate states that financial statements are biased because they are unaudited and
decides that he/she therefore cannot provide advice.

Reaching competence – The candidate discusses the price and either some of the
downside risk factors (e.g., age and tolerance for risk) or some of the upside factors and their
effect on Dan’s decision to purchase. The points raised are valid in the context of the
information provided. Overall, the candidate’s coverage is poor or one sided or does not
identify or discuss implications.

Competent – The candidate discusses the price and the more significant downside and
upside risk factors that impact Dan’s decision (e.g., age, government involvement, financial
position of company, share vs. assets, deadline/unaudited). The candidate’s discussion may
be overly conservative or optimistic (i.e., may tend to go one way). The candidate provides
reasonable coverage of different factors or considers both the up and down sides or
considers implications.

Highly competent – The candidate discusses most of the factors and takes them into
account when making a recommendation. The discussion is well balanced. The candidate
understands that the government’s role creates both advantages and disadvantages.

Primary Indicator #3

The candidate considers both the quantitative and qualitative factors in making an overall
assessment of the situation and recommending a course of action.

The candidate demonstrates competence in Pervasive Skills.

Overall conclusion

The cash flows for LRI look good and, if they prove to be as good as they look, buying this business
might suit your needs. You can negotiate with Mr. Doty, who should be flexible, if as he suggests, he is a
motivated seller. But, and this is a big but, proceeding with the purchase of the business requires good
answers to the many issues raised in this report. If you do not get good answers or are suspicious, I
recommend that you not pursue the deal. Before signing anything, I suggest we get together and review
the additional information you gathered. Alternatively, I would be happy to work with you in filling the
missing pieces. And definitely, do not rush into anything. If Mr. Doty is pressuring you to sign a deal,
that is probably a warning signal.

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For Primary Indicator #3, the candidate must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence –The candidate recommends a course of action based on qualitative


factors only, supported by inadequate or no explanation or the candidate chooses not to
recommend a course of action on the grounds that the deadline is too tight or the statements
are too biased.

Reaching competence – The candidate recommends a course of action considering either


the quantitative or the qualitative factors.

Competent – The candidate recommends a course of action based on both the quantitative
and the qualitative analysis he/she has performed. The candidate ignores the fact that much
of the information needed to make a final decision is missing. The candidate may have
addressed only one of the two needs (cash flow and value).

Highly competent – The candidate clearly understands that a final decision depends on the
outcome of additional research but makes a recommendation to the client supported by a
balanced quantitative and qualitative analysis. The candidate addresses both needs, i.e., the
cash flow sufficiency and the value of the company.

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EVALUATION GUIDE
PAPER II, QUESTION 2
SECONDARY INDICATORS OF COMPETENCE

Secondary Indicator #1

The candidate discusses the financial statement issues, recognizing that the statements are
the basis for the purchase price calculation.

The candidate demonstrates competence in Performance Measurement.

The financial statement issues are discussed below in relation to the fiscal 2000 unaudited financial
statements since they form the basis for the purchase price.

Revenue recognition

Currently LRI recognizes revenue on lottery licences when the cash is received for lottery licences (i.e.,
as soon as the customers pay with their credit cards). This approach may be appropriate given that:

• the money has already been collected from the customers and so collection is assured
• the critical event is cash collection and the gathering of the required information.

An alternative would be to recognize the revenue when the customers receive their lottery licence. This
may be appropriate given that the critical event is the performance of the service (the signing of the
documents) and the issuance of the licence, which does not occur until the customers visit in person at
LRI.

Recognition when cash is collected is too early because none of the effort for processing the licence has
been done. There is no indication of what happens if the application is rejected (is the $500 refunded) or
whether customers can change their minds and request their money back. I think that recognition when
the license is approved (picked up by the customer) makes more sense.

Leasehold improvements

From the information supplied it appears that the leasehold improvements from the old location (prior to
the move in 2000) remain on the books at the end of fiscal 2001. These leasehold improvements should
have been written off at the time of the move because they are not providing LRI with any benefits at its
new location.

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Mr. Doty might argue that the old lease is still in the name of LRI, and if LRI ever assumed the lease
again for the old location then the improvements might be of some benefit. Mr. Doty could also argue
that the rent that it is receiving for the old location could be partially due to the leasehold improvements.
Other than avoiding the write-off in 2000 and thereby inflating income for that year, Mr. Doty’s
arguments do not make sense and do not really serve his interests. For purposes of the formula, you could
simply take the benefit from the slightly lower income caused by amortization of the improvements. I do
not think an argument could be made to write off the leasehold improvements in 2001, which would be
most beneficial to you with regard to the four-times multiple.

Licensing fee

The initiation fee that Mr. Doty paid to the provincial government when he purchased LRI in fiscal 1999
is not being amortized. An argument could be made that the initiation fee does not require any
depreciation/amortization because the agency agreement has an unlimited life and does not decrease in
value.

A second alternative would be to amortize the initiation fee on a systematic and rational basis over the
estimated useful life of the benefits of the agreement. The problem is this: what is a reasonable period
for amortizing the fee? If 20 years was chosen, the annual amortization would be $2,000 per year. The
shorter the amortization period chosen, the more the selling price is lowered using Mr. Doty’s formula.
Using a 20-year amortization period would lower the selling price by $8,000 ($2,000 x 4), and a 10-year
amortization period would lower the selling by $16,000. In reality, the choice of amortization period is
arbitrary as long as it falls within a reasonable range.

I recommend that the initiation fee be amortized. The fee represents an economic cost to the entity and
should be reflected in the financial statements. As the choice of amortization period is arbitrary, I would
argue for a shorter period to begin and be prepared to settle on, say, a maximum of 20 years.

For Secondary Indicator #1, the candidate must be ranked in one of the following four
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate discusses one accounting policy issue.

Competent – The candidate recommends two or three accounting policy changes. The
candidate presents only one side of the issue. The candidate explains the impact of the
policy change on income and on the purchase price. The candidate does not necessarily try
to choose policies that benefit the purchaser.

Highly competent – The candidate discusses two or three accounting policy changes in
depth (i.e., both sides of an issue are presented.) The candidate clearly understands that
because the statements are currently unaudited, an opportunity exists to reduce the income
figure by adjusting the policies to suit the purchaser’s needs. The candidate understands that
GAAP is not a requirement since the statements are unaudited and likely recommends
following GAAP in determining the accounting adjustments needed.

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Secondary Indicator #2

The candidate discusses the tax impacts of the proposed transaction.

The candidate demonstrates competence in Taxation.

The change in ownership will be a change in control, which will trigger a yearend for tax purposes. This
will affect the loss-carry-forward, if any.

An alternative for you would be to purchase the assets of the business instead of the shares. Purchasing
the assets has tax advantages to you that lower the effective cost of the business. The tax benefit would
be that purchasing the assets would increase the tax values of the assets and therefore increase the capital
cost allowance (CCA) in future years. Another benefit of purchasing the assets for you is that you would
not assume any contingent liabilities that are unknown at the time of the purchase.

Mr. Doty, on the other hand, benefits from the sale of shares because he could take advantage of the
lifetime Capital Gains Exemption (CGE). However, if he sells his shares before October 1, 2001, he will
not have waited the mandatory two-year holding period so he would not be eligible for the CGE. I
suggest that if you go ahead with the purchase, you should delay the closing by one month so that Mr.
Doty can benefit from the CGE. This may benefit us by allowing us to negotiate a lower purchase price
while allowing Mr. Doty to obtain the same amount of after-tax dollars on the sale.

With a new business there are a lot of issues that need to be addressed that can result in reducing the net
cost overall of the acquisition and operations. These issues include how you and Pam will get money out
of the business—by salary or dividend. There are also questions regarding the financing of the business
and the tax treatment of the financing charges. We can consider these later.

For Secondary Indicator #2, the candidate must be ranked in one of the following four
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate discusses the filing requirements associated with a
share transaction or discusses paying salary versus dividends.

Competent – The candidate discusses the risks associated with the purchase of shares and
either: salary versus dividends or the filing requirements.

Highly competent – The candidate discusses the risks associated with the purchase of
shares, salary versus dividends, and filing requirements. The candidate looks closely at the
alternative of purchasing assets from a tax perspective. The candidate also recognizes that
the tax position of the seller can be improved by delaying the purchase for another month.

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PAPER II, QUESTION 4

Your assurance partner, Susan Lafleche, has just met with Charles Brangman, CEO of Heliparts Canada
Inc. (Heliparts), a new assurance client. Heliparts, a distributor of helicopter parts, has recently been
taken over by Universal Airframe Supplies Inc. (UASI). The new parent company will require an annual
audit of Heliparts.

While talking with Charles, Susan learned that Heliparts has an advanced information technology (IT)
system. Heliparts has an electronic link with an Irish manufacturing plant, Rolland Corp (Rolland), that
allows Heliparts to automatically ship parts to Rolland without having to wait for manual orders to be
processed.

Heliparts’ year-end is December 31. Susan would like to gain a detailed understanding of the client’s IT
environment and determine the related implications for the assurance work to be performed.

To help with the planning of this new assignment, Susan asks you, CA, to visit Heliparts’ premises and
meet with the IT Director, Henry Chan.

The following day you travel to Heliparts’ office, located on the perimeter of the airport. After a brief
introduction by Charles Brangman, you sit down to talk with the IT Director. Henry Chan is very proud
of the company’s new systems. He talks at some length about Heliparts’ participation in a new trading
exchange, Airparts.com, and how Heliparts’ parts distribution system has been integrated with the
Airparts.com web site to permit fast responses to orders and bids. He maintains it will be a great new
sales channel, but at the same time he is concerned it will increase market competitiveness. Heliparts
also processes orders directly through its own web site.

You return to the office to review your notes (see Exhibit I) and to check the web sites for UASI,
Rolland, and Heliparts to gain more background information. You receive an e-mail from Susan asking
for a memo to the audit planning file that identifies the significant IT processes and describes the audit
approach you will take with respect to the general IT environment and the specific applications.

Required:

Prepare the memo for Susan.

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PAPER 2, QUESTION 4 (continued)

EXHIBIT I

EXTRACTS FROM NOTES TAKEN DURING THE VISIT

1. Heliparts is the main supplier of spare parts for Rolland, a major helicopter manufacturer in Ireland.

2. An inventory of commonly used parts is kept in the warehouse facility next to Heliparts’ offices at
the airport.

3. Heliparts orders new parts periodically from the US using a traditional EDI link and a US-based
value added network, International Data Services (IDS). The company relies on IDS’s “store and
forward” capability to send purchase orders and to receive, in response, acknowledgements and
advance shipping notices from the US suppliers.

4. Heliparts’ inventory management system is tied directly into its web-based sales system to ensure
that parts needed by customers can be obtained immediately. Often, they are shipped directly from
Heliparts’ supplier to the customer.

5. Heliparts’ Canadian customers can order their parts through an on-line catalogue on Heliparts’ web
site.

6. A more recent additional sales channel is the industry trading exchange set up at the web site
Airparts.com. Customers place their orders on the exchange, and suppliers like Heliparts bid on the
order. The supplier that offers the best price and delivery time wins the order. Airparts.com
forwards the order to the successful bidder through its web-based sales system.

7. Heliparts’ inventory management system maintains the company’s customer order file for web-
originated sales. If items are in stock, an acknowledgement is e-mailed to the customer and shipment
of the order is initiated. If the item is not in stock and is available via IDS, the order is transferred to
IDS. As soon as an acknowledgement has been received from the US supplier, the web site order
file is automatically updated with the change in status.

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PAPER 2, QUESTION 4 (continued)

EXHIBIT I (continued)

EXTRACTS FROM NOTES TAKEN DURING THE VISIT

8. Customers can monitor the progress of their orders through a tracking facility that accesses the
status field on the original order on the web site database. For items shipped by courier, customers
can cut and paste the waybill number into the courier’s web site tracking page and check up on the
status of their order.

9. Heliparts has a client-server-configured local area network (LAN): individual servers are dedicated
specifically to each application, namely, the financial accounting system, inventory management
system (incorporating the EDI link), e-mail, the Heliparts web site, and a firewall.

10. Each of the 82 staff and management of Heliparts has a workstation with access to the LAN.

11. The Heliparts web site was developed and is maintained by a local consulting firm, B2B InterLink
Services Inc.

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EVALUATION GUIDE
PAPER II, QUESTION 4
PRIMARY INDICATORS OF COMPETENCE

Primary Indicator #1:

The candidate is able to identify the significant IT processes and to explain why they are
significant.

The candidate demonstrates competence in Information and Information Technology.

Identification of the significant IT processes

Heliparts conducts business using various sales methods and related sales systems. Some sales are
processed through a direct electronic link while others are processed through the Internet—either through
a trading exchange site or through Heliparts’ own web page. Each of these sales systems appears to be
directly linked to the inventory management system. The inventory management system itself uses EDI
to place orders with US suppliers through IDS, a value added network.

The electronic link with the Irish manufacturing plant is the first identifiable sales subsystem. In this
subsystem, sales orders are received from Ireland electronically rather than on paper. This stream seems
to have been in existence for a while since Heliparts is Rolland’s main supplier. Although we do not
know the dollar volume of transactions processed, it is likely that many of Heliparts’ transactions flow
through this subsystem.

The Airparts.com link is a new subsystem for Heliparts. Because the order taking and parts distribution
system have been integrated with the Airparts.com web site, the web site is essentially part of Heliparts
systems. The controls associated with this system will be critical to ensuring the security of Heliparts
other systems and data.

Heliparts’ own web-based sales catalogue and order system, used by its Canadian customers, is also an
important subsystem as the web site opens up contact with the outside world on the Internet and exposes
Heliparts to Internet related risks. The tracking of waybill numbers with the courier is another contact
point with the outside world.

Another very important subsystem is the inventory management system because it is directly linked to the
sales systems identified above and to the IDS (EDI) ordering system.

An important link between the various sales systems and the inventory management system is the LAN
(local area network). It is the piece that integrates the various applications. The fact that there are
numerous users of the LAN further increases its importance.

The financial accounting subsystem is also significant, as it collects and summarizes the information
generated by the other subsystems. The completeness and accuracy of the financial information
generated is critical because management makes its business decisions based on this information.

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For Primary Indicator #1, the candidates must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate’s description of the IT processes is muddled and the
significant processes are not identifiable or the candidate incorrectly ranks the systems, i.e.,
it is evident that the candidate does not see that some systems are more important than
others. (e.g., e-mail system is discussed first, etc.)

Reaching competence – The candidate is able to separate the sales and the inventory
systems (and perhaps the LAN) or the candidate identifies the processes but does not
explain their significance.

Competent – The candidate is able to identify three of the four significant processes and
explain the significance of one or two of the processes identified.

Highly competent – The candidate is able to identify the significant subsystems and explain
why they are significant. (The accounting system and the e-mail system are not considered
significant.)

Primary Indicator #2:

The candidate is able to describe the audit approach that should be used to audit Heliparts.
The candidate supports the discussion with a description of the audit risks associated with
the IT processes identified.

The candidate demonstrates competence in Assurance.

General comments

Overall, Heliparts’ business processes rely heavily on technology, creating a business risk. This risk is
even higher as a result of using communication tools such as the Internet. However, the opportunity to
increase sales through greater exposure to the market and the ability to speed up the order process is a
benefit to Heliparts, as long as the proper controls are in place to ensure that business is not interrupted
by technological breakdowns. The successful implementation of the Airparts.com trading exchange, for
example, could have a significant impact on the sales levels and future profitability of the company. We
should find out what percentage of Heliparts business is being conducted over the Internet to help assess
the relative importance of this subsystem to the audit.

From an audit perspective, the increased use of the Internet relative to prior years and the fact that many
different subsystems are used adds complexity to the systems and increases overall audit risk.

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The suggested IT audit approach includes an assessment of the controls in place in each of the
subsystems and an assessment of the general environmental controls in place, i.e., security measures
currently used by Heliparts. In order to assess the controls properly, we may need the assistance of our IT
specialists. The lack of a paper trail in many of the subsystems will compel us to rely on systems-based
testing. We will therefore be using CAATs to test many of the subsystems.

Since this is our first audit of Heliparts, the opening balances will need to be audited. Inventory in
particular appears to be a significant asset of the business and will require close attention.

Airparts.com

Since the Airparts.com and Heliparts systems are linked, Airparts.com is essentially part of Heliparts
systems and must be audited as such. The adequacy of the controls in place must be assessed. A section
5900 report (Opinions on Control Procedures at a Service Organization) from Airparts.com’s auditor
might be the best way to gain assurance over the reliability of Airparts.com controls.

The Airparts.com web site should be looked at. I have not yet looked at it. The site may provide us with
some insight as to how Airparts.com operates. We should also gain some assurance as to how the
bidding process works. Heliparts’ success depends on the bidding system working fairly. We should
confirm that the bidder with the best price is in fact the one who gets the order. We also need to know
what the return and cancellation policies are when dealing with customers through the trading exchange.

We should clearly document how the order information is transferred from Airparts.com to the Heliparts
system. We need to understand how the information flows in order to assess the security of the transfer
of information and the accuracy of the actual data flowing into Heliparts system. The speed of the
information transfer should also be assessed, as Heliparts will be relying on a timely exchange of
information.

Electronic Link with Rolland Corp and IDS system

Heliparts has not provided us with much information on the electronic link with Rolland. We must find
out how the electronic order “automatically” generates a shipment of parts to Rolland.

It will be important to find out how back orders, over and under shipments, and returns are handled in
this paperless subsystem. We will need to identify and test any built-in limits and reasonableness checks
that are part of the system to ensure that they are functioning.

The handling of the foreign exchange components right through to the financial accounting system will
also have to be tested.

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The most efficient way to audit these transaction streams might be with audit software. The controls can
easily be tested through the processing of fake transactions in the system.

The reliability of IDS’s “store and forward” capabilities should be checked. Again, a section 5900 report
could be used to assess the company’s controls. The formal operating agreement with IDS should be
reviewed to gain an understanding of the technology and business risks being assumed with such an
arrangement.

The actual audit trail for direct shipments from suppliers to customers needs to be ascertained and
verified, as the cut off around these transactions may be inaccurate if they are not tracked properly.

Heliparts web site

Since the web-based sales system is in direct contact with the outside world, it is important to find out
how the web-based sales system links up with the internal order-entry system and the inventory
management system. This information will help determine whether there is a risk of internal data being
corrupted by outside viruses or being accessed by hackers. The entire sales system should be tested for
completeness and accuracy of transactions. The web site order file should be secure and the transfer to
the internal sales records accurate. Also, it would be useful to know how often the catalogue is updated
and by whom, how the transactions are approved (i.e., credit risk), and how the order confirmation is
generated and sent to the customer by e-mail. The link with the courier (by waybill number) should also
be documented and tested to ensure that it is secure.

The web site is being maintained by B2B, a local consulting firm. We must assess whether the firm can
be relied upon to develop a good system with good controls. (B2B may be responsible for the design of
the web page only, in which case we must find out who is responsible for the web related controls.)

Inventory management system

All the sales orders information flows into the inventory management system. The system must
determine whether the goods are in stock, and if not, place an order directly with a supplier or with IDS.
Shipments to customers are initiated through the system as well.

The functioning of the system must be tested. For example, the flow of restocking orders to IDS should
be tested to ensure that all orders flow through. The e-mailing of order acknowledgments to customers
appears to be an automated function and should be tested to ensure that the right orders are processed and
that all the orders are being acknowledged.

In some cases the orders are delivered directly from the supplier to the customer. Cut-off testing of these
transactions will be important at year end. The acknowledgement process will be documented and tested.

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We should find out from Heliparts whether it will be doing a book to physical adjustment for its
inventory based on an inventory count at year end or whether it will be relying on its inventory
management system to generate a year end inventory figure. We should arrange to attend the inventory
count and test the system for valuation of inventory to ensure that costs in the system are accurate.

LAN

Heliparts has a client-server configured local area network. The network is the component that allows all
the subsystems to be connected and to communicate with each other. The management of the network
plays an important part in the security and accuracy of the information processed.

The actual system configuration details should be obtained from the system administrator and
documented. The network security administration routines such as how passwords are set, changed, and
deleted when employees are hired or dismissed should be documented.

Since all 82 employees can access the network, operating details—such as time-outs on inactive
workstations, what physical controls there are over the servers, and who is responsible for the network
maintenance, etc.—should all be documented. This documentation will allow us to assess the
effectiveness of the security controls in place.

For Primary Indicator #2, the candidate must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate discusses a general audit strategy (versus an IT


audit strategy). The candidate’s description of audit risks is too general or is unsupported. It
is not specific to the case/processes identified, e.g., there are security risks. Or the candidate
simply recognizes the need to rely on the controls vs. taking a substantive approach.

Reaching competence – The candidate discusses the general IT audit approach without
identifying two specific audit risks, but provides a good supported discussion. For example,
shows an understanding of the need to test controls without necessarily stating it explicitly, or
discusses the need to use CAATS and explains why. Or the candidate identifies two specific
IT related audit risks without discussing the general IT audit approach.

Competent – The candidate recognizes the need to test controls. The candidate identifies
some of the audit risks for two of the more significant processes and discusses a valid,
related IT audit approach/procedures. The candidate may or may not have addressed the
general IT audit approach.

Highly competent – The candidate recognizes Heliparts’ dependence on technology and


reflects this in a discussion of both the general IT environment and of each system’s specific
audit approach. The candidate includes a thorough discussion of the audit risks.

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EVALUATION GUIDE
PAPER II, QUESTION 4
SECONDARY INDICATORS OF COMPETENCE

Secondary Indicator #1:

The candidate demonstrates an understanding of the importance of the various subsystems


to the success of the business.

The candidate demonstrates competence in Organizational Effectiveness, Control and Risk


Management.

The considerable variation in sales methods being used by Heliparts adds complexity to the business and
increases the risk of control breakdowns.

Management of inventory levels is critical to managing the cash flow of the business and relies heavily
on the accurate reporting of inventory levels.

The security of each of these subsystems is important to ensuring data integrity and continued business
operation for Heliparts.

The accurate functioning of this subsystem is critical to the success of Heliparts’ business. Without
proper inventory management, Heliparts’ customers may turn to other suppliers to meet their needs.

For Secondary Indicator #1, the candidates must be ranked in one of the following
four categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate makes one insightful comment on how the business
risk is higher due to technology.

Competent – The candidate is able to rank the IT processes by reference to the business
processes and their importance to the business. The candidate may not make a clear
statement of the relationship, e.g., sees inventory management is important to the business.

Highly competent – The candidate discusses the importance of the process working well to
the success of the business on several occasions, e.g., Web-links. The candidate
understands the importance of the inventory management system working properly to the
cash flow position of the business. It is apparent in the answer that the candidate has insight
into the business processes.

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Secondary Indicator #2:

The candidate discusses the general IT environment controls as one of the IT systems.

The candidate demonstrates competence in Information and Information Technology.

General IT environment/controls

In order to assess the general IT controls, there are some general questions that need to be posed to the
client. For example, we should find out whether Heliparts has a disaster recovery plan in place and then
assess its effectiveness.

We should find out:

• what technology platforms are being used and determine what security features are available and
being used. The effectiveness of the firewall should be assessed.

• who administers the overall security for Heliparts and what types of security measures are in place.
For example, are passwords used for all employees? Is data encryption used when sending data
electronically?

• what backup procedures are in place, and ensure they are functioning properly.

All of these things are particularly important in light of Heliparts’ reliance on technology.

It is not clear whether Heliparts does any of its own programming or whether it relies on an outside
developer or uses purchased software. This matter should be investigated, and if development is done in-
house, the controls over development should be tested.

For Secondary Indicator #2, the candidates must be ranked in one of the following
four categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate recognizes the significance of the general IT


environment to the success of Heliparts but does not discuss the particular general controls
that exist in Heliparts’ system or discusses them in very non-case specific terms, e.g.,
“should have anti-virus.”

Competent – The candidate recognizes the significance of the general IT environment to the
success of Heliparts and identifies the more significant general controls in Heliparts’ system.

Highly competent – The candidate recognizes the significance of the general IT


environment to the success of Heliparts, identifies the significant general controls and
discusses why they are considered significant.

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PAPER III, QUESTION 1

ReadQ Inc. is a small book publishing company in Hazleton, a university town. It was founded in 1979
by Mr. Peters and is still owned by the Peters family. ReadQ operates as a publisher and printer. It
originally focused on academic books, but in recent years it has changed its focus to general interest
books – specializing in history and biographies. It has been moderately successful and has grown slowly
over the years; currently it has 76 titles in print. It generally adds 10 to 15 new titles per year. This year,
for the first time, one of its new titles has won a major literary prize, the Huntington Award. Such
awards usually result in an increase in sales ranging from 25 to 50% for the prize winning book.

On September 2, there was a fire at the company’s premises. The fire started at night when no employees
were in the building. The company’s premises include office space, a production facility, and a
warehouse. The building needed some repairs but was not destroyed. Some of the company’s printing
equipment and warehouse fixtures were destroyed. In addition, a large quantity of inventory was
destroyed. The office sustained smoke and water damage.

Mackenzie & Co., Chartered Accountants, has been ReadQ’s auditor since the company’s inception. The
company’s year end is April 30, and the current year’s financial statements were issued with an
unqualified opinion.

Mr. Abigail, the engagement partner, received a call yesterday (October 9) from Ms. Black, ReadQ’s
controller, requesting Mackenzie & Co.’s assistance in getting the insurance claim processed. The claim
must be certified by the company’s auditor. The partner sent you, CA, to meet with Ms. Black to find out
more.

When you met with Ms. Black, she provided you with a copy of the insurance policy, excerpts of which
are included in Exhibit I, a copy of the Statement of Claim (Exhibit II) she has prepared, and her working
papers with detailed calculations and other support (Exhibit III).

Ms. Black is anxious to have the claim completed and settled as quickly as possible. She would like your
firm to review the claim and suggest any changes you believe may be warranted. She also wants to be in
a position to defend ReadQ’s claim if the insurance company wants to make unfavourable changes.
Although the company is successful, cash flow is tight at this time of the year, and Ms. Black has
requested that your firm work on a contingent fee basis for this engagement. She says that she does not
expect it to take you long to complete your work, as Mackenzie & Co. has always audited the company’s
books and has never had any problems. If the insurance company takes longer than 30 days to process the
claim, ReadQ is considering approaching the bank with the statement of claim to obtain interim
financing.

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PAPER III, QUESTION 1 (continued)

In preparation for the next meeting with the client, Mr. Abigail has requested that you draft a memo to
him discussing the details of the engagement, including an outline of the work to be done and a
preliminary analysis of the statement of claim. Your preliminary analysis should cover the
appropriateness and completeness of the claim prepared by the client. He would like you to identify any
additional information that you need from the client and any related matters you think should be brought
to the client’s attention.

In addition to the information obtained from the client, you have reviewed last year’s audit file and have
made extracts (Exhibit IV).

Required:

Prepare the memo.

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PAPER III, QUESTION 1 (continued)

EXHIBIT I

EXCERPTS FROM INSURANCE POLICY

Requirements after loss

10. (1) Upon the incurrence of any loss of or damage to the insured property, the insured shall, if
such loss or damage is covered by the contract:
a. forthwith give notice thereof in writing to the insurer;
b. deliver as soon as practicable to the insurer a statement of claim, certified by an
independent accountant:
i. giving a complete inventory of the damaged and/or destroyed property and showing
in detail: quantities, costs, actual cash value, and particulars of the amount of loss
claimed;
ii. showing the amount of other insurance policies and the names of other insurers; and
iii. showing the interest of the insured and of all others in the property, with particulars
of all liens, encumbrances, and other charges on the property.

When loss payable

12. The loss shall be payable within thirty days after approval by the insurer of the statement of claim.

Basis for settlement

15. Capital assets – The loss or damage shall be ascertained based on replacement cost and shall in no
event exceed what it would cost to repair or replace the same material of like kind and quantity.

16. Inventory – The insurer shall not be liable beyond the lower of net realizable value and replacement
cost of the inventory at the time any loss or damage occurs.

17. Work performed by insured – Repair work is normally contracted to independent third parties.
Where work is performed by the insured, labour costs will be reimbursed at cost less 50%. No
payment will be made for overhead or profit. The insurer reserves the right to limit payment to an
estimate of the value of the work reduced by overhead, profit, and 50% of labor costs.

18. Business interruption – The loss or damage shall be ascertained based on unavoidable costs and lost
profits caused by the insured event.

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PAPER III, QUESTION 1 (continued)

EXHIBIT II

STATEMENT OF CLAIM PREPARED BY READQ

Claim

1. Building repairs and cleaning $ 53,067


2. Printing equipment 485,000
3. Warehouse fixtures 134,000
4. Inventory – books 512,850
5. Inventory – materials 115,985
6. Display books 15,000
7. Promotional costs 7,500
8. Profit on lost sales 512,850
9. Interest 36,725

$1,872,977

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PAPER III, QUESTION 1 (continued)

EXHIBIT III

STATEMENT OF CLAIM PREPARED BY READQ


SUPPORTING CALCULATIONS

1. Actual cost of building repairs and cleaning

Materials $23,435
Labour (Note 1) 25,317
Supplies 2,500
GST 1,815

$53,067

Note 1:

Labour
Basic $11,502
Overtime 7,200
Employee benefits 3,740
Foreman 2,875

$25,317

The work was done by the company’s own staff. In order to have the clean-up done as quickly as
possible, staff worked overtime. Labour includes employee benefits at 20%. Also included is an
allocation of the foreman’s time at 25% of the basic labour cost. Employee benefits are calculated
as ($11,502 + $7,200) x 20%.

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PAPER III, QUESTION 1 (continued)

EXHIBIT III (continued)

STATEMENT OF CLAIM PREPARED BY READQ


SUPPORTING CALCULATIONS

2. Printing equipment

The company could not purchase the same printing equipment, XT100, as it lost in the fire because
it is no longer available. It was purchased five years ago and had an expected life of 10 years. The
XT100 cost $450,000 and had a net book value of $208,000. The comparable printing equipment
available is:

i. the XP550, which has enhanced features not present on ReadQ’s previous equipment that
enable it to produce a wider range of print styles. The XP550 costs $475,000.
ii. the XP750, which has the same features as the XP550 but is faster, increasing the capacity
available and reducing operating costs by approximately 10%. The XP750 costs $485,000.

The company chose to purchase the XP750.

Included in the costs of the printing equipment is a special “rush” delivery charge of $1,000 and
training session on the new equipment costing $2,500. The training must be provided by the
manufacturer or the warranty is void.

3. Warehouse fixtures

Original cost $125,000


Accumulated amortization $ 55,000
Cost of replacement fixtures purchased $134,000

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PAPER III, QUESTION 1 (continued)

EXHIBIT III (continued)

STATEMENT OF CLAIM PREPARED BY READQ


SUPPORTING CALCULATIONS

4. Inventory – books

The company performed an inventory count of undamaged books shortly after the fire, and the
difference between the count and the perpetual records is claimed. The claim is based on a detailed
listing of titles and is summarized below:

Number
Year printed of books Average cost Total cost

Current year 26,827 $7.50 $201,200


1 year prior 5,329 7.60 40,500
2 years prior 16,350 7.75 126,710
3 or more years prior 18,284 7.90 144,440

Total 66,790 $7.68 $512,850

5. Inventory – materials (at cost):

Paper $ 72,700
Inks 34,040
Other 9,245

$115,985

Market prices for paper costs have decreased approximately 5% in the last six weeks.

6. Display books

The company keeps one copy of the first edition of each book it publishes in a display area in its
offices. These books were damaged by smoke from the fire. As it is not possible to replace first
editions, Book Restore Inc. was hired to clean the books. The cost of cleaning the 150 books was
$15,000.

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PAPER III, QUESTION 1 (continued)

EXHIBIT III (continued)

STATEMENT OF CLAIM PREPARED BY READQ


SUPPORTING CALCULATIONS

7. Promotional costs

ReadQ spent $15,000 promoting its new books for the upcoming season. Because of the fire, it
anticipates not being able to produce enough copies of some titles to meet demand and has included
50% of this promotional cost in the insurance claim.

8. Profit on lost sales

The normal markup on books is 100% of cost. Profit on lost sales was calculated as equal to the
cost of the inventory lost. Before the fire, the company expected to be operating at full capacity
until early January.

9. Interest on outstanding claim receivable

Total claim $1,836,252


Interest rate 12% per annum

The interest rate is based on the company’s overdraft rate. It is assumed that the insurance claim
will be processed and funds from the claim received on October 31.

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PAPER III, QUESTION 1 (continued)

EXHIBIT IV

EXCERPTS FROM LAST YEAR’S AUDIT FILE

1. Inventory

a. Quantities – attended physical count at year end. There was no reliance on quantities in the
perpetual inventory system. Inventory counts have always been well organized and properly
conducted. There have never been material errors in the counts.

b. Cost – the company’s cost system has been tested and relied on for inventory valuation
purposes.

c. Valuation – as is common in the publishing industry, there are titles that do not sell and have to
be written down. The allowance provided in last year’s inventory was as follows:

Year printed Allowance

Current year 5%
1 year prior 10%
2 years prior 15%
3 or more years prior 25%

2. Purchases/payable/payment system

a. Rebates are received annually from the paper supplier based on the volume of paper purchased.
The rate increases as the volume increases.

b. Payment discounts are credited to a separate general ledger account.

3. The company’s business is seasonal. Approximately 75% of the company’s sales occur in the fall
when bookstores are stocking up on inventory for the Christmas season. Because of the seasonal
nature of the business, cash flow is tight in the fall of the year. Our previous experience with the
company shows, however, that it has a good cash budgeting system and a strong relationship with its
bank. Overall, it is in strong financial health.

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EVALUATION GUIDE
PAPER III, QUESTION 1
PRIMARY INDICATORS OF COMPETENCE

Primary Indicator #1

The candidate discusses the engagement issues.

The candidate demonstrates competence in Assurance.

We have been engaged by ReadQ to assist the company in preparing a statement of claim for its
insurance company because of a fire on September 2. We have also been asked to certify the claim for
the insurance company, which the insurance company will use in its evaluation of ReadQ’s claim.

A number of engagement issues need to be sorted out as we proceed with this engagement. It is not clear
who the client is for the certification. Are we preparing the certification on behalf of ReadQ or on behalf
of the insurance company? We are seeking to help a long-time client maximize their claim within the
parameters of the insurance policy. The insurance company is looking for an objective interpretation of
the losses suffered by ReadQ. If we accept this engagement, we must be especially careful to approach
the work with an independent frame of mind.

In addition to the insurance company, ReadQ’s bank may also be a user of the statement of claim if the
insurance company does not pay within 30 days. We need to consider whether there are any implications
associated with the bank using the statement of claim. We could restrict distribution of the statement of
claim to the insurance company, or we could perform procedures that would be appropriate for the
bank’s purpose.

ReadQ has asked that we do this engagement on a contingent fee basis. I do not think that this request is
appropriate because this is an assurance engagement and there is a need for objectivity on our part. A
contingent fee would, at a minimum, lend the appearance of bias in our approach to the engagement since
our economic incentive would be to maximize the amount received by ReadQ.

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For Primary Indicator #1, the candidate must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate identifies one of the engagement issues (bank,
independence, conflict, contingent fees) but does not demonstrate the pervasive skills
pertaining to Ethical Behavior and Professionalism.

Reaching competence – The candidate recognizes the conflict between the insurance
company and ReadQ or recognizes the conflict between preparing and certifying the claim.
The candidate recognizes that the contingent fee is inappropriate.

Competent – The candidate recognizes the conflict between the insurance company and
ReadQ or the conflict between preparing and certifying the claim and discusses one of these
conflicts in depth. The candidate recognizes that the contingent fee is inappropriate.

Highly competent – The candidate recognizes the conflict between the insurance company
and ReadQ and the conflict between preparing and certifying the claim and discusses both of
these in depth. The candidate recognizes that the contingent fee is inappropriate.

Primary Indicator #2

The candidate discusses the type of report needed by the insurance company and discusses
alternatives.

The candidate demonstrates competence in Assurance.

The insurance policy requires that an independent accountant certify the statement of claim. It seems that
some form of assurance is required, but it is not clear what is required for certification or whether we can
provide the assurance that the insurance company requires. If the insurance company requires a
conclusion that the claim is in accordance with the terms of the insurance policy, then it will be an
assurance engagement. From the information I have gathered, it does seem that the insurance company
wants assurance regarding the contents of the claim.

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There are a couple of choices for the type of report we can provide to the insurance company. One
possibility is an audit report on compliance with agreements, statutes, and regulations (S.5815). This
report will allow us to audit all the elements of the claim and provide assurance on them. Alternatively,
we could discuss the specific requirements with the insurance company and perform the specific
procedures it requires (S.9100). If we are not able to obtain sufficient appropriate audit evidence to
evaluate one or more aspects of the claim, we may not be able to provide the assurance required for
certification. It is possible that we may have to qualify our report because of scope limitations. For
example, it is not yet clear whether the accounting records and invoices were destroyed in the fire. If they
were, there may be scope problems.

ReadQ wants the claim to be processed quickly, which limits the amount of time we have in which to do
our work. We need to discuss this matter with the client and agree on a reasonable timetable.

For Primary Indicator #2, the candidate must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate assumes an audit is required or identifies the wrong
type of report.

Reaching competence – The candidate recognizes that the engagement type has not been
defined and identifies an appropriate report. (Handbook 5815 or 9100.)

Competent – The candidate recognizes that the engagement type has not been defined and
discusses valid alternative reports (Handbook 5815 and 9100) that can be provided.

Highly competent – The candidate attempts to meet the client’s need by recommending an
appropriate engagement (Handbook 5815) and discusses the impact of insufficient audit
evidence on the report.

Primary Indicator #3

The candidate analyzes major components of the statement of claim and suggests changes
to or supports Read Q’s position for the insurance claim.

The candidate demonstrates competence in Performance Measurement.

Major components of the statement of claim: printing equipment, books inventory, and profit on lost
sales.

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Printing equipment

The insurance policy does not make clear what is meant by “replacement cost.” Replacement cost could
mean the cost of replacing the destroyed assets with brand new ones or it could mean replacement cost
after taking into consideration the age and condition of the destroyed assets. This matter has a definite
answer. We must determine what the policy provides for by contacting the insurance company.

The situation is a bit tricky because ReadQ did not acquire equipment identical to that destroyed, as the
particular model was no longer available. The model ReadQ did purchase has some features that go
beyond what could be considered a reasonable substitute for the destroyed equipment. The insurance
company’s obligation is to provide ReadQ with equipment that makes it no worse off than it was before
the fire.

At a minimum, ReadQ is entitled to equipment with the same features. The XP550 is the closest in
features to the destroyed printer, so that should be what the insurance company should compensate
ReadQ for. As a result, the insurance company is unlikely to pay the extra $10,000 for the XP 750. The
insurance company could contend that the XP 550 offers more than the destroyed equipment and so the
compensation for the loss should be reduced. However, if the XP 550 is the option closest to the
destroyed equipment without leaving ReadQ worse off, then the insurance company has an obligation to
pay the full amount for the XP 550.

The rush delivery charges should be covered because getting the new equipment in place as quickly as
possible should reduce the amount of lost sales, especially in view of the seasonality of the business and
the time of year. The insurance company could attempt to argue that rush delivery is not covered.
Training costs should be covered, since employees must know how to operate the new equipment and the
need for training is a direct result of the fire. The training is also necessary to validate the warranty and
so is an integral cost of the equipment. If the training cost for the XP 550 differs from that for the XP
750, the insurance company could argue that the incremental amount should not be covered.

If replacement cost means the cost of replacing the lost equipment with new equipment, then ReadQ
should receive $475,000. If replacement cost means depreciated replacement cost, then ReadQ should
receive an amount in the neighbourhood of $257,000 (the proportion of the destroyed equipment that had
not been amortized ($475,000 x $242,000/$450,000)). I assume that delivery and training are
recoverable. The maximum that ReadQ can expect to receive is the full cost of the XP 750. The worst-
case scenario is that ReadQ receives $257,000.

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Inventory—Books

The amount that ReadQ has included in its initial claim represents 100% of the cost of the books with no
allowance for a decline in value. However, industry norms indicate that the saleability of at least some
books declines with time, and inventory is written down based on the age of the books on hand. The
policy allows ReadQ to recover no more than the lower of net realizable value (NRV) and replacement
cost. If NRV falls below cost, then according to the policy NRV should be the amount that ReadQ is
compensated. The rationale is that the insured should not be better off as a result of the fire. If ReadQ is
reimbursed for the cost of the books when NRV is less than cost, then ReadQ will be better off since it
will receive more from the insurance company than it would have from sale of the books. An important
question is whether the allowances traditionally used by ReadQ are reasonable estimates of the decline in
value. Assuming the allowances noted are appropriate, the amount claimed should be as follows:

Year printed Allowance Total cost Cost after allowance taken

Current year 5% $201,200 $191,140


1 year prior 10% 40,500 36,450
2 years prior 15% 126,710 107,704
3 or more years prior 25% 144,440 108,330

$512,850 $443,624

The new printing equipment is supposed to be 10% more efficient than the equipment it replaced, which
reduces the cost of replacing the destroyed books. In principle, this should reduce further the amount that
ReadQ should recover from the insurance company. If the equipment improves efficiency as claimed,
ReadQ will be able to reap the benefits immediately and the replacement costs should be reduced by
10%—ReadQ should receive $461,565 (90% of $512,850) or $399,262 (90% of $443,624), depending on
whether the full cost or the cost after taking the allowance is claimed.

Before the payout is determined, however, the claim of a 10% improvement in efficiency needs closer
scrutiny. Where does this 10% come from? Has ReadQ found that it enjoys a benefit of this magnitude?
Or is this 10% improvement a marketing claim that applies only under ideal conditions? Will ReadQ
benefit immediately, or will it take time before the efficiencies are achieved? It is not at all clear that
ReadQ will benefit from these efficiencies, and I do not think that the payout to ReadQ can justifiably be
based on a possible gain. If the 10% saving is not borne out, ReadQ is significantly out of pocket. I
recommend that the 10% increase in efficiency not be factored into the claim. It may be prudent not to
emphasize the benefits of these efficiencies when justifying the purchase of the XP750 since the
insurance company may use the justification to argue for a reduction in the payment for inventory
replacement.

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Quantities reported are based on a comparison of physical count to perpetual inventory. We have not
tested or relied on the perpetual system in our audits, so there is some question as to the reliability of the
information. Our experience has shown no problems in the past. The impact will depend on the type of
engagement we do—it may limit the assurance we can give.

Profit on lost sales

ReadQ is entitled to recover lost profits caused by the insured event. As a result, profits from
permanently lost sales can be recovered. The insurance company may respond that if the inventory is
replaced quickly, no sales can be considered lost because ReadQ will be in a position to sell the entire
inventory. This interpretation is valid if sales are merely delayed and not lost. In that case there is no loss
of profit.

ReadQ’s claim assumes that the profit has been lost on all the inventory that was destroyed or damaged
in the fire. This is not a realistic assertion since ReadQ will be able to replace and sell at least some of
the books. Making matters worse is the assumption that items that have been in inventory for a long time
will suddenly be sold. We will have to determine the amount of time ReadQ is not operating so that we
can come up with an estimate of the lost sales. Because some items remain in inventory for some time,
ReadQ will be able to replace the inventory and ultimately sell the items.

To estimate the loss we must consider the following:

• the amount of sales permanently lost because the fire will not allow the company to produce all the
books it requires to meet demand for the busy Christmas season;
• the impact of the award-winning book;
• the permanent loss of sales because some books will become less marketable or unsaleable—for
example, seasonal book sales are lost;
• consideration for old stock—similar to the valuation adjustments made for inventory. Some items
will sell at reduced margins or not at all; and
• the requirement to minimize losses through the timely replacement of inventory.

The estimate of a loss of profits is very difficult. Clearly, the ReadQ’s estimate overstates the loss, for the
reasons explained above. More information is necessary to make a reasonable estimate.

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For Primary Indicator #3, the candidate must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate addresses one of the major claim components
(discussion is weak).

Reaching competence – The candidate addresses two of the major claim components. The
quality of the discussion of one issue is reasonable, i.e., is supported.

Competent – The candidate addresses three major claim components. The quality of
discussion of two of the issues is reasonable and covers both sides. The candidate attempts
a calculation for two issues or makes an overall calculation.

Highly competent – The candidate addresses all of the major items, discusses both sides of
the issue in depth and attempts an overall calculation.

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EVALUATION GUIDE
PAPER III, QUESTION 1
SECONDARY INDICATORS OF COMPETENCE

Secondary Indicator # 1

The candidate discusses the tax treatment of the insurance claim components.

The candidate demonstrates competence in Taxation.

TAX ISSUES
• Replacement property rules for capital assets—tax consequences can be avoided;
• Reimbursement of costs is taxable (interest, other out of pocket costs);
• Lost profit is taxable;
• Lost inventory is deductible but the proceeds for replacing it are taxable

For Secondary Indicator #1, the candidate must be ranked in one of the following four
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate recognizes the tax consequences of the insurance
proceeds.

Competent –The candidate discusses the tax treatment of one component (GST, ITC;
replacement property rules).

Highly competent – The candidate discusses the tax treatment for more than one of the
claim components.

Secondary Indicator #2

The candidate recommends a strategy to the client to help address the short-term cash flow
crunch.

The candidate demonstrates competence is Finance.

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The client has noted its tight cash flow at this time of the year. Discussions should be held with the bank
immediately to ensure that interim financing is available until the insurance company pays the claim.
Discussions with suppliers should also be held so that they are aware of the situation and will continue to
offer credit to ReadQ in the event of payment delays. ReadQ could use the money used to replace the
equipment for operating purposes and finance the replacement equipment on a long-term basis.

ReadQ has indicated a concern about its cash flow, at least until it receives payment from the insurance
company. We should advise the client that there may be some delay in receiving the lost profits portion
of the claim because the insurance company will want to wait until they receive the final results for the
year before determining the amount they will pay. We may be able to assist ReadQ by providing them
with payment terms that suit their cash flow situation.

For Secondary Indicator #2, the candidate must be ranked in one of the following four
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate recognizes the cash flow shortage but does not offer
any valid advice to help address the problem.

Competent – The candidate recognizes the cash flow shortage and suggests at least one
step that could help the situation.

Highly competent – The candidate recognizes the cash flow shortage and suggests more
than one possible step.

Secondary Indicator #3

The candidate does a preliminary identification of the specific audit procedures that need to
be performed.

The candidate demonstrates competence in Assurance.

Below is a preliminary list of work that needs to be done on the engagement:

1. Review of insurance policy

Do we require help with interpreting the policy or help with the forensic accounting work? The insurance
company will probably hire an expert to assist it in interpreting the claim. The policy must be read to
ensure that we understand its terms so that we can calculate the claim properly.

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2. Building repairs and cleaning

Materials—examine invoices—ensure the materials used in repair and cleaning were related to fire
damage. Labour—examine time sheets and verify payroll burden rate, overtime premium; determine
how supervision costs and benefits were arrived at (were they overhead or actual costs?).

3. Printing equipment

Examine invoices, inspect equipment, and review specifications of equipment. We may have to perform
work to ensure there was no alternative to purchasing the upgraded equipment.

4. Inventory – books

Did the insurance company do an inspection at time of fire? If so, we should examine the inspection
report.

The quantities in the insurance claim are based on a comparison of the physical inventory count to the
perpetual records. However, we have not tested or relied on the perpetual system. Can we reconcile
changes since the year-end physical count from shipping and production records (inventory roll
forward)? We could also vouch purchases of materials and estimate sales since the physical count. We
should also inspect the remains of the inventory after the fire to determine its condition and whether any
of what remains is salvageable and saleable.

The fact that we did not rely on the perpetual inventory system may create problems with regard to
providing assurance on the inventory since it may be difficult to determine the amount of inventory that
was on hand at the time of the fire.

5. Inventory – materials

It may be difficult to verify quantities because likely difficult to estimate usage. Vouch purchases;
estimate usage since the physical count.

6. Display books

Verifying costs is not a problem—vouch to invoice—provided that the invoices are available and not
destroyed in the fire. It may be difficult to determine appropriate coverage.

7. Promotional costs

Verifying costs is not a problem—vouch to invoice—it may be difficult to determine appropriate


coverage.

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8. Other costs

Interest costs - Verifying the calculations is straightforward. We need to determine whether an overdraft
was created by these payments or whether interest was actually incurred.

For Secondary Indicator #3, the candidate must be ranked in one of the following four
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Reaching competence – The candidate identifies audit procedures but provides no support.

Competent – The candidate identifies appropriate audit procedures to validate the claim
amounts (at least two audit procedures are supported).

Highly competent –The candidate identifies appropriate audit procedures to validate the
claim amount and recognizes that difficulties in obtaining audit evidence are likely due to the
fact that the records were destroyed in the fire.

Secondary Indicator #4

The candidate suggests changes to or supports Read Q’s position for the insurance claim on
the minor issues.

The candidate demonstrates competence in Performance Measurement.

Building repairs and cleaning

Materials and supplies used in the repair and cleaning of the building are allowable under the insurance
policy. However, the policy permits only 50% of the cost of work done by ReadQ’s employees to be
claimed. This means that only $12,658.50 ($25,317 x 50%) of the cost of employee labour can be
recovered from the insurance policy. Nor does the policy allow for the recovery of overhead costs. The
way in which ReadQ has calculated the cost of supervision by foremen as a percentage of labour costs
suggests that it is an overhead allocation rather than the actual cost of the foremen. To recover the cost of
the foremen, ReadQ will have to show the actual cost of the work they performed. It is also necessary to
show that the cost of benefits, which is charged at 20% of the cost of labour, represents the actual cost of
the benefits. ReadQ can charge the actual cost of benefits but not overhead costs, so it will be up to
ReadQ to support the charge (with our help, if need be).

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The insurance policy allows the insurance company to limit payment to “an estimate of the value of
work…” On this basis, the insurance company may object to the overtime charge since a third-party
provider would not have charged overtime. ReadQ can try to support the overtime charge by arguing that
the costs are justifiable because the overtime enabled the company to get operating again as quickly as
possible, which served to minimize its losses. With respect to the overtime charges and for all costs
incurred, ReadQ’s case will be more supportable if it can show that the in-house charges are comparable
to those a third party would have charged.

GST should not be included in the claim because of the availability of the input tax credit.

Based on the terms of the insurance policy, ReadQ’s claim will be reduced by at least 50% of the cost of
labour. The worst-case scenario is that the insurance company will also try to exclude the overtime
charges, benefit costs, and the cost of the foremen. The revised claim for building repairs and cleaning is:

Best case Worst case

Materials $23,435 $23,435


Labour
Basic 5,751 5,751
Overtime 3,600 0
Benefits 1,870 0
Foreman 1,437 0
Supplies 2,500 2,500
GST 0 0

Total $38,593 $31,686

Warehouse fixtures

The insurance company should be willing to pay for the destroyed warehouse fixtures since they appear
to be explicitly covered by the policy. The question is how much should be paid. As was the case with
printing equipment, we need clarification on the definition of replacement cost—is it new or depreciated?
If it is replacement cost new, ReadQ will receive $134,000. Otherwise, it will receive $75,040, which is
56% of the replacement cost new, the proportion of the fixtures that is unamortized (155,000/125,000).
The information gathered from ReadQ makes no mention of the cost of installing the new fixtures. This
amount may be included in the replacement cost or may have been ignored. ReadQ should be entitled to
100% reimbursement of these costs regardless of the definition of replacement cost.

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Inventory—materials

Paper costs have declined 5%; therefore, replacement cost will be $3,635 ($72,700 x 0.05) less than
reported in the inventory listing. ReadQ also receives a volume discount at the end of the year from its
supplier. Whether the insurance company is entitled to the discount is debatable. It could be argued that
the insurance company is entitled to the volume discount only to the extent that the replacement paper
itself exceeds the volume required. Alternatively, it could be argued that the discount should be averaged
over all purchases during the year. I suggest we use the former approach since it is beneficial to ReadQ
and is defensible. I think the worst case is that the discount would have to be shared proportionately. The
claim for inventory materials should be $112,350.

Display books

If the display books are considered inventory, ReadQ is unlikely to recover the $15,000 cost of cleaning
the books unless it had special insurance coverage for them. If there is no special insurance, the insurance
coverage is limited to the lower of replacement cost and net realizable value. The average cost of
producing books in the current year according to the information provided is $7.50 per book. To replace
the 150 damaged books would cost $1,125 ($7.50 x 150).

As an alternative, it might be possible to argue that the display books are capital assets, not inventory.
The display books are not available for sale and therefore should not be classified as inventory. The
books are used in ReadQ’s offices, much as art or furniture would be. Art and furniture would be
classified as capital assets. If the display books are considered capital assets, then the repair costs would
be allowable.

In my view it is not very likely that the insurance company will allow the books to be classified as capital
assets, but it is certainly worth the try.

Cost recovery promotion

The issue appears to be that ReadQ anticipates that it will lose sales as a result of not being able to
produce enough books to meet demand—the lost sales being the result of a successful promotion where
demand goes unfulfilled. If the insurance company is willing to compensate ReadQ for lost sales and
profits, then compensation for the promotion costs is not appropriate. The company is not entitled to the
benefits from the lost sales and from the promotion costs since the outcome would make ReadQ better
off as a result of the fire, which is not acceptable. I think that ReadQ would be better off recovering lost
profits on sales than the lost promotion cost.

The problem is that the effectiveness of the promotion may be hard to substantiate unless there is some
precedent that demonstrates its effectiveness. It would be necessary to base the loss on forecasted sales
rather than on historical patterns (although the insurance company may find this comparison
unacceptable). Certainly the award that one of ReadQ’s books received would enhance the effectiveness
of the program.

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Other costs

ReadQ has included a charge for interest in its statement of claim. We have to determine whether interest
is covered by the policy. If interest is allowed by the policy, the interest claim should be the actual out-
of-pocket cost incurred. The amount that ReadQ has included in the statement of claim for interest is
based on the total amount of the claim from the date of the fire on September 2. This figure is not
realistic since many costs were incurred after that date. To calculate the appropriate amount of interest
we will have to determine when actual payments were made, such as the cost of repairing the building,
etc. It does not appear appropriate to charge interest on certain costs because they do not represent out-
of-pocket expenditures. These include the inventory replacement cost and lost profit.

A first cut at this estimate would be to include the following costs for a period of one month: building
repairs and cleaning, printing equipment, fixtures, inventory material, and display books. This would
make the interest cost $7,711 ($771,068 x 1%). An exact calculation will require that we look at the
actual dates of payments.

We should also determine whether our fees can be included as part of the claim.

For Secondary Indicator #4, the candidate must be ranked in one of the following four
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Reaching competence – The candidate attempts discussion of one of the six minor issues
(discussion is weak).

Competent – The candidate attempts discussion of three of the six minor issues. The
quality of the discussion of the building or two of the other issues is reasonable (support is
provided). The candidate addresses both sides of one minor issue. The candidate attempts
a calculation for at least two issues or makes an overall calculation.

Highly competent – The candidate identifies three of the minor items. The quality of the
discussion of the building plus one of the other issues or three of the other issues is
reasonable (both sides of each issue are discussed in depth), and the candidate attempts an
overall calculation.

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PAPER III, QUESTION 2

Aquatic Biotechnology Inc. (ABI) is a medium-sized, public company operating an aquaculture business
in eastern Canada. The company has been in operation since the mid-1980s, and during the latter half of
the 1990s it grew at a rapid pace through both increased sales and the acquisition of minor competitors.

ABI has an October 31 year end. It is now November 15, 2001 and you, CA, are working on the 2001
audit. Your firm, Linkletter & Cormier Chartered Accountants, has conducted the audit of ABI for
several years and has always considered it to be a routine audit engagement. The audit senior on the
engagement recently resigned from the firm, and you have been asked to act as senior on the audit. All
October 31 inventory counts and routine confirmations have been dealt with, and you have been provided
with the audit planning files. These files are summarized in Exhibit I.

The corporate structure of ABI is based on management’s philosophy that vertical integration will allow
this growth-oriented business to achieve its objectives. ABI controls nearly all aspects of the supply
chain, from growth of the product to processing and delivery to the customer. ABI operates the hatchery,
where each of the three major products (salmon, trout, scallops) are hatched, the fish farms where growth
takes place, and the processing plant where smoking and packaging occur. ABI also owns Marine Tech
Limited (MTL), a supplier of boats, nets, and gear to the Canadian market. MTL provides nearly all
supplies, repairs, and maintenance for the corporate group.

Scallop farming is a relatively new area of aquaculture, in which ABI has invested a substantial amount
of capital for research and development. Scallops are grown in a “cage” which sits on the ocean floor in
an area that does not experience problems such as strong tides and bacteria which could destroy the crop.
As with many other aquaculture products, scallops can take from 24 to 30 months to reach a marketable
size. ABI has yet to earn any revenue from scallop farming, but it is confident that its new system will be
successful.

ABI has been working on scallop farming technologies for about five years. Previous years’ audit files
indicate that the costs related to scallop farming had been expensed, as the company lost much of its
stock during the winter months. ABI is confident that its new cage style, developed in 2000, will result
in a tremendous crop ready for harvest in 2002. At year end, the scallop stocks were checked by the
company and by an aquaculture expert hired by your firm, and it was determined that the stock is at 75%
of its marketable size. However, the aquaculture expert would not comment on the likelihood that the
stock would reach full maturity. At maturity, it is estimated that the crop will be 500,000 kilograms.
Costs to date related to the 2002 harvest have been $1.425 million, of which $1.2 million has been
incurred in fiscal 2001.

Salmon and trout farming are major divisions of ABI. Both have been successful for a number of years,
although the selling price of salmon decreased slightly in 2001. The salmon division has provided
substantial cash flow to the company, due to the perfected method of growth and the low marketing costs
associated with the product. Trout farming is a relatively new division of the company and has been
moderately successful for the past two years.

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PAPER III, QUESTION 2 (continued)

Despite the positive cash flows generated by the salmon division, ABI has had difficulty in managing its
cash flows due to its substantial investments in scallop farming. In August 2001, ABI decided to
refinance much of its debt to consolidate loans. The Business Development Bank, a federal government
agency, agreed to consolidate most of ABI’s debt and loaned ABI an additional $5 million for five years,
with the first year to be interest-free. The bank further agreed to extend the interest-free period for each
fiscal year that ABI is able to maintain net income at $1 million or more. A loan arrangement fee of
$500,000 was paid in order to cover the bank’s costs to consolidate the debt. The bank requires ABI to
maintain a current ratio above 1, given the current level of debt. The new debt structure has allowed ABI
to improve its cash situation.

You have just reviewed the working paper files and have met with ABI’s controller, Jim Gibbins, to
gather information related to the audit (Exhibit II) and a set of draft financial statements (Exhibit III).
The engagement partner has asked you to prepare a memo summarizing the relevant accounting and audit
planning issues in preparation for her meeting with ABI to discuss the ongoing audit.

Required:

Prepare the memo.

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PAPER III, QUESTION 2 (continued)

EXHIBIT I

EXTRACTS FROM ABI AUDIT PLANNING FILES

1. Materiality has been set at $1.4 million since ABI is a continuing client and has always had low
business risk and strong controls.

2. Preliminary tests of controls were performed in August during the audit planning, and no
weaknesses were noted.

3. Bank confirmations have been sent to the appropriate financial institutions.

4. A signed engagement letter for the audit has been obtained from ABI.

5. Computer assisted audit techniques have not been carried out in previous years due to difficulties in
extracting data from ABI’s database system. Therefore, additional tests of controls and analytical
procedures are necessary.

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PAPER III, QUESTION 2 (continued)

EXHIBIT II

INFORMATION OBTAINED FROM JIM GIBBINS

1. During the year ABI acquired Bay Mussels Limited (BML), a large mussel grower in the area, to
diversify its product lines. ABI paid $4.75 million to acquire 100% of the outstanding shares of
BML. BML’s net tangible assets were valued as follows on the date of acquisition:

Book value Market value

Current assets $ 1,986,773 $ 1,986,773


Non-current assets 14,686,934 16,437,593
Current liabilities 2,089,657 2,089,657
Non-current liabilities 10,768,540 11,239,415

2. During September ABI began the phase-in of its new information system. It is a resource planning
software package for medium-scale enterprises which allows integration of all aspects of business,
from production to sales to financial accounting. As of October 31 the financial accounting
modules were fully implemented, and ABI was conducting its own testing while running the system
in parallel with the old database system. During testing Jim Gibbins uncovered a number of
unauthorized transactions in the old database. Since their dollar amounts were insignificant, they
have not been adjusted for. Jim believes the new system will allow ABI to better establish strategic
direction and evaluate its profitability by product line.

3. Jim has not yet recorded revenue for the scallop production, but would like to record as much
revenue as possible in 2001, since the product is 75% of its marketable size and orders for the
coming year are already being received. The price per kilogram can be reasonably estimated at
approximately $20.00, although supply may affect the market price.

4. Since early November ABI has been holding discussions with a major competitor to sell its trout
division. ABI believes that, although the division has been relatively successful, scallop farming is
much more attractive in the long run. The buyer has made a preliminary offer of $2.8 million for
the trout division, and ABI management expects that the cash flow will assist the company in
getting through the winter until scallop sales begin. The buyer’s offer expires on November 30, but
the buyer may be open to further negotiations.

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PAPER III, QUESTION 2 (continued)

EXHIBIT III

AQUATIC BIOTECHNOLOGY INC.


EXTRACTS FROM CONSOLIDATED BALANCE SHEET
As at October 31
(in thousands of dollars)

2001 2000
(unaudited) (audited)
Assets

Current
Cash $ 115 $ 283
Accounts receivable, net 1,650 1,030
Inventory – salmon and other 4,568 4,396
Inventory – scallops 1,425 −
Prepaid expenses 543 555
8,301 6,264

Property and equipment, net 67,913 64,423


Deferred costs – scallop cages 3,007 500
Other 2,684 3,774

$81,905 $74,961

Liabilities

Current
Bank indebtedness $ 2,103 $ 1,131
Accounts payable and accruals 2,804 2,332
Current portion of long-term debt 3,145 2,365
8,052 5,828

Long-term debt 61,500 58,243


Future income taxes 1,345 1,297

Shareholders’ equity

Share capital 10 10
Retained earnings 10,998 9,583
11,008 9,593

$81,905 $74,961

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PAPER III, QUESTION 2 (continued)

EXHIBIT III (continued)

AQUATIC BIOTECHNOLOGY INC.


EXTRACTS FROM CONSOLIDATED INCOME STATEMENT
For the years ending October 31
(in thousands of dollars)

2001 2000 1999


(unaudited) (audited) (audited)

Revenue
Salmon $27,345 $29,879 $26,567
Trout 13,588 10,673 9,453
Mussels 1,647 − −
Fishing gear and other 32,486 30,788 29,765
75,066 71,340 65,785

Cost of goods sold


Salmon 15,714 15,917 13,359
Trout 6,280 5,140 7,860
Mussels 1,400 − −
Scallops − 1,310 1,260
Fishing gear and other 22,962 21,899 20,324
46,356 44,266 42,803

Gross margin 28,710 27,074 22,982

Expenses
Salaries and benefits 12,879 10,547 9,643
Selling and advertising 5,225 3,426 2,784
General, administrative, and other 3,423 2,879 1,866
Interest on long-term debt 4,288 4,562 4,848
Research – scallop cages − 5,250 3,078
Loan arrangement fee 500 − −
Total expenses 26,315 26,664 22,219

Income from operations 2,395 410 763


Gain on acquisition of BML 345 − −
Net income before income taxes 2,740 410 763
Income taxes 1,325 156 298

Net income $ 1,415 $ 254 $ 465

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EVALUATION GUIDE
PAPER III, QUESTION 2
PRIMARY INDICATORS OF COMPETENCE

Primary Indicator #1

The candidate assesses the audit planning that has been done to date and adjusts the audit
plan for the upcoming engagement.

The candidate demonstrates competence in Assurance.

Assessment of audit risk

A number of important issues have arisen that will necessitate changes to the audit procedures planned
for the current year. The preliminary assessment of audit risk appears inappropriate. The audit risk
appears to be higher than in previous years for the following reasons:

• Bank refinancing has been obtained to soften the cash flow difficulties. The bank has placed
covenants on the refinancing loan and will be relying on our audited figures for determination of net
income and the current ratio.

• There is an incentive for management to maximize income and assets, or minimize liabilities, in
order to retain ABI’s favorable financing arrangements.

• The client reported discovering unauthorized transactions in the old database during installation of
the new information system. Despite the small dollar amounts, we will have to complete additional
tests of controls in order to rely on the old system.

• The high levels of debt may indicate a going concern problem.

Based on the above risk factors and the motivation of management to maximize assets and income to
comply with the debt covenants, audit risk should be set at a higher level this year.

Materiality

The materiality level for the audit was set in the planning files based on a low audit risk level. This
preliminary assessment of $1.4 million needs to be revised and set at a lower amount, particularly in light
of the fact that small adjustments may cause a violation of the bank covenants. The previous level was
approximately 2% of revenue; a much lower estimate of 10% of net income ($150,000) may be more
appropriate.

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Audit plan

We should revise the audit planning files to reflect revisions to audit risk and materiality and carry out
sufficient additional tests of controls to gain comfort from the results. A lower materiality level may
require additional procedures. Changes in circumstances, such as the additional loan and the purchase of
BML, also suggest that additional audit work is required.

We also need to assess the impact on the audit plan of errors found by the client. We may be able to
isolate the control deviations by investigating the errors found by the client, which would reduce the
amount of additional work necessary.

For Primary Indicator #1, the candidate must be ranked in one of the five following
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate ignores the planning done to date and begins
planning from scratch.

Reaching competence – The candidate recognizes that the risk is higher and materiality is
lower. The candidate does not comment on the inappropriateness of the planning done.

Competent – The candidate recognizes that the planning needs to be revised and explains
why by identifying a number of factors that affect the change in assessment (in sufficient
detail). The candidate suggests changes to the planning, e.g., recommends a different
materiality level.

Highly competent – The candidate states that the planning needs to be revised and
provides strong support as to why the changes are necessary. The candidate suggests valid
changes to the plan. The candidate clearly demonstrates an understanding of the
importance of the bank covenants to the audit.

Primary Indicator #2

The candidate demonstrates an understanding of the significant performance measurement


issues by providing a discussion of the issues including a recommended treatment.

The candidate demonstrates competence in Performance Measurement.

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Revenue recognition

Jim Gibbins would like to recognize revenue associated with scallops that are being grown using new
methods but have not yet been harvested. We need to ensure that we are comfortable with the revenue
recognition methods chosen for the scallop production and that all the conditions for the recording of
revenue have been fulfilled. Several factors suggest the adoption of a conservative approach to revenue
recognition:

• There is a history of inventory losses. ABI has tried unsuccessfully in the past to grow scallops with
prototype systems, and there is no firm basis to support the likelihood of success in this endeavor.

• Strong tides and bacteria have destroyed crops in the past. Although the stock is currently at 75%
maturity, a repetition of the same conditions could destroy the crop.

• The aquaculture expert has provided no assurance that the crop will reach full maturity.

• There is no certainty that the sales orders will translate into actual sales, as there is no firm
commitment on the part of the purchaser.

• Although the current market price is $20 per kilogram, the price may fluctuate significantly before
harvest and processing.

The client may attempt to argue that the long growth cycle of the aquaculture industry justifies the use of
the percentage-of-completion method of revenue recognition. However, this method of revenue
recognition may be difficult to support for ABI because the costs of the crop are difficult to estimate (due
to the lack of experience with the current production process) and the revenue is difficult to measure (due
to market instability). We may also argue that ultimate collection is questionable, despite a ready market,
since the inventory could easily be lost before reaching a 100% completion stage.

The client is strongly motivated to recognize revenue early due to the BDC loan covenants. However, in
view of the lack of history of success with the current method, the lack of assurance from the aquaculture
specialist as to the likelihood of success, as well as a history of losses with previous methods, I
recommend a conservative approach: revenue should be recognized at the date of harvest if there are
sales orders to support recognition. If there are no sales orders, I recommend that revenue be recognized
at the date of sale.

Scallop inventory

The scallop inventory should be recorded at the lower of cost and net realizable value.

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The unaudited 2001 statements include Inventory – scallops at $1.425 million, which are the costs to date
of the current crop on hand. Of the $1.425 million, only $1.2 million was incurred in fiscal 2001. Our
2000-year end audited financial statements assigned no inventory value to scallops. Recording the entire
$1.425 million as an inventory asset has likely resulted in an overstatement of income for 2001 by
reversing costs that had previously been expensed. It would appear that ABI has changed its accounting
policy with regard to inventory valuation due to the incentive to maximize current assets.

We must determine the net realizable value of the scallop inventory. The history of losses with previous
methods, as well as the lack of comfort provided by the aquaculture specialist, point to the need for a
conservative policy. On the other hand, we must also consider the new process and the fact that the
scallops have achieved 75% maturity, indicating that some value may be appropriate. Caution would
suggest a conservative approach, however, and I recommend that we record an inventory value of $0
because a net realizable value above zero has yet to be demonstrated with any certainty.

Research and development

ABI has capitalized over $3 million in costs related to the development of the scallop cages. To meet the
requirements of GAAP for capitalization, these costs must be development costs that can be expected to
provide future value in the form of increased revenues, and not research costs. Although the
marketability of the product is not an issue here (there is clearly a market for scallops), it may not be
appropriate to capitalize these costs, for the following reasons:

• The technical feasibility of the process has not been clearly established.

• Given the current liquidity problems, the company may not have the funds to complete the project, if
this year’s stock fails or if the bank calls its loan.

The adoption of an aggressive accounting policy again demonstrates management bias to maximize assets
and net income. Although the cost of the cages was capitalized in prior years, I recommend expensing
the cost of the cages until the technical feasibility of the new method is more clearly established.

Acquisition of Bay Mussels Limited

The acquisition of Bay Mussels Limited (BML) and ABI’s accounting for the transaction also raise some
issues that need to be addressed. The purchase price for the BML acquisition resulted in negative
goodwill of $345,000 ($4.750 million - $5.095 million), which has been recorded as a gain on the
financial statements. Negative goodwill should not be reported as a gain; instead, this purchase price
discrepancy should be recorded as a reduction of non-monetary assets. The client’s recording of this
adjustment of goodwill demonstrates its bias to increase net income.

The acquisition will also need to be detailed in the notes to the consolidated statements for the upcoming
year. The difference between the tax treatment and the accounting treatment of the negative goodwill
will have an impact on future income taxes.

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We need to determine whether BML was audited at the date of acquisition to confirm opening balances.
If it was not audited, we may need to qualify our report since the acquisition is material to the financial
statements. We also need to review the purchase agreement to ensure there are no contingencies or
additional details that require disclosure. Finally, we need to obtain evidence as to the adequacy of the
values provided for BML at the date of acquisition and the allocation of the purchase price.

For Primary Indicator #2, the candidate must be ranked in one of the five following
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate does not discuss the major issues or the points
raised are technically incorrect or the discussion of the issues lacks depth.

Reaching competence – The candidate’s discussion addresses a number of issues but the
discussion lacks depth, or recommendations as to the correct treatment are not made. The
candidate may recognize the management bias, but likely does so in a general or overview
statement.

Competent – The candidate identifies most of the four issues and discusses at least two of
the issues in sufficient depth by considering both sides of the issue. The candidate also
identifies specific cases of management bias to overstate income for each of the issues
discussed. The candidate’s discussion concludes with a recommended treatment.

Highly competent – The candidate identifies and discusses all of the performance
measurement issues to some degree. The response reveals an understanding of the
subjectivity, and uncertainty associated with these issues and the need to take a conservative
approach to valuation given the history of the company and its current financial position.

Primary Indicator #3

The candidate discusses the impact of the accounting issues on the debt covenant. The
candidate recognizes that the debt covenant breach may result in cash flow difficulties that
could create going concern issues.

The candidate demonstrates competence in Pervasive Skills.

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Based on the preliminary analysis of the financial statements of ABI, a number of accounting
adjustments appear to be necessary to more fairly reflect the operations of ABI. I have attached as
Appendix I a revised income statement based on the primary adjustments identified in this report,
resulting in a net loss of $1.137 million. The profitability of ABI is drastically overstated for the year
ended 2001, and the interest-free requirement of maintaining a net income at $1 million or more is not
met. This situation may have a significant impact on the cash flows of ABI.

In addition to the adjustments to net income, current assets would be adjusted from $8.301 million to
$6.876 million. The potential reduction to inventory would cause the debt covenant to be violated
(current ratio = $6.876/$8.052 = 0.85), and therefore the client is at risk of having its debt recalled.
There appears to be some risk that ABI may have a going concern problem. ABI is already in a weak
cash flow position, and any further demands on cash will cause substantial difficulties. It may be
appropriate for ABI to meet with the bank to renegotiate the debt covenants or terms of the loan. ABI
should seek to obtain a letter from the bank indicating that it will not call the loan. In the longer term,
ABI’s cash flow will have to become even stronger as the repayments on the $5 million loan commence.

The current cash flow difficulties of ABI may be only short term in nature if the scallop crop matures and
is successfully harvested in the upcoming year. However, the history of failure during the winter months
suggests that the next few months of the winter are the highest risk period. If the loss of the scallop crop
would cause ABI to fail, then we must consider disclosing this significant risk in the financial statements.
In general, the uncertainties associated with ABI place it in a highly risky position, but the risk will be
alleviated if the scallops reach maturity and are harvested. At a minimum, there will have to be
disclosure of a going concern issue based on the levels of risk identified.

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APPENDIX I

Recast Income Statement


For the year ended October 31, 2001
(unaudited)

Net income per unaudited financial statements $ 1,415,000

Adjustments:
Inventory – scallops (1,425,000 )
Deferred costs – scallop cages (2,507,000 )
Gain on BML acquisition ($345,000 )
Loan arrangement fee 400,000
Estimated reduction in income taxes 1,325,000

Adjusted net loss $(1,137,000)

For Primary Indicator #3, the candidate must be ranked in one of the following five
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate attempts to recast the financial statements (one
adjustment is sufficient) but does not make a link to the covenants.

Reaching competence – The candidate attempts to recast the financial statements and
sees that the covenants might be breached but does not properly assess the effects of the
breach on cash flows and the future of the company.

Competent – The candidate recasts the financial statements and understands the precarious
situation that the company is in vis-à-vis the breach of the covenants. Candidate suggests a
possible course of action to help the situation or discusses the implications for the audit
report.

Highly competent – The candidate recasts the financial statements and understands the
precarious situation that the company is in vis-à-vis the breach of the covenants, suggests
courses of action, and discusses the implications for the audit report.

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EVALUATION GUIDE
PAPER III, QUESTION 2
SECONDARY INDICATORS OF COMPETENCE

Secondary Indicator #1

The candidate discusses issues associated with the sale of the trout division, questioning the
decision to sell it.

The candidate demonstrates competence in Finance.

The (potential) sale of the trout division may be an additional source of cash, alleviating ABI’s
immediate cash flow problem. However, the sale of the trout division should be discussed with
management since it may affect the profitability and the potential for the firm in the future. ABI’s
strategy of vertical integration and diversification within the aquaculture industry suggest that the sale
might be a desperate move to raise cash in the short run. The sale increases ABI’s reliance on the
successful harvest of the scallop stocks and therefore increases the risk faced by ABI. If the client is
looking to sell in order to generate cash flow, we should suggest alternative methods of generating cash
flow such as additional financing or the sale of non-essential equipment as opposed to selling a profitable
division. As well, the $2.8 million selling price seems low compared to the profitability of the division.
We might suggest to the client that the trout division is likely worth more than $2.8 million.

For Secondary Indicator #1, the candidate must be ranked in one of the following four
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate addresses the sale of the trout division and identifies
the sale as a possible source of cash or the candidate recognizes that the company is selling
the most profitable division. The candidate does not advise management on the wisdom of
the sale or does not suggest alternatives to selling the division.

Competent – The candidate discusses the sale of the trout division. The candidate
addresses the increased reliance on a riskier operation (scallop farming) or questions why
the division is being sold.

Highly competent – The candidate addresses the reliance on a riskier operation and
questions the selling price of the division.

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Secondary Indicator # 2

The candidate recognizes that the new management information system does not affect this
year’s audit.

The candidate demonstrates competence in Assurance.

Management information system

The implementation of a new system raises a number of issues for the current and upcoming audits. The
system has been implemented over the last quarter of the fiscal year and run in parallel with the existing
system. It would therefore seem logical to audit the changeover during the current audit so that next
year’s audit can rely on the opening figures. We would need, however, to rely on the old system for the
current year’s audit. In addition, the new system needs to be tested for internal controls so we may rely
on the general controls of the system in future audits. We should determine whether the client requires a
conversion audit and at a minimum ensure that backup procedures and disaster recovery plans are in
place.

In the past we have been unable to carry out computer assisted audit techniques (CAATs). The new
system presents an opportunity to change our audit procedures and perform CAATs throughout the
upcoming year. We should evaluate the capabilities of our audit software to extract data from the new
system and should carry out appropriate procedures during the year that may reduce testing in upcoming
audits.

For Secondary Indicator #2, the candidate must be ranked in one the four following
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate discusses the impact of the system changes as
though they affect the current year’s audit.

Competent – The candidate recognizes that the system changes do not affect the current
year’s audit and understands the need to rely on the old system for the audit.

Highly competent – The candidate recognizes that the system changes do not affect the
current year’s audit but do affect the planning for the next year and discusses planning
points.

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PAPER IV, QUESTION 1

LeisureCorp Canada Limited (LCL) was incorporated six years ago by five wealthy golfing friends who
decided to turn their passion into a business. They pooled their resources and began buying a series of
historically unsuccessful golf courses. Their approach was originally to invest in upgrading the course
and clubhouse and then to convert the course to a private, member-only facility.

As the business grew, LCL began acquiring strategically located land and building new courses from
scratch. This approach allowed the company to expand its inventory of courses and acquire adjoining
land for luxury residential development.

Up until last year, the business was financed by the personal investments of the owners and the cash
generated from initiation fees and annual dues, clubhouse and pro shop sales, and daily green fees
charged for members’ guests. However, as LCL continued its aggressive expansion strategy, the owners
found it impossible to fund acquisitions independently. Early in 2000, LCL secured a $20 million
operating line of credit and a $175 million term loan. The owners are contemplating a public offering in
the near future to finance additional acquisitions and developments.

Although all five owners are active members of the board of directors, the president and CEO, James
Duggan, is the driving force behind LCL’s aggressive growth strategy. James is a visionary and a risk
taker who has a reputation for turning his dreams into reality.

LCL recently held a strategic planning retreat for its management and ownership group. Three primary
objectives were identified for the business: achieve 30% annual growth in revenues in each of the next
five years; maintain a minimum 15% return on capital invested; and be perceived as the provider of the
highest quality golf facilities in Canada.

You are a CA with Michaels and Andrews, Chartered Accountants (M&A), and your firm has been the
auditors of LCL since its inception. At a board meeting on March 31, 2001, the engagement partner was
told that, although the board endorses the strategic plan for the business, the board members are
concerned that they do not have a deep enough understanding of the significant risks facing the business.

The partner is currently preparing a presentation for the next LCL board meeting. He has requested that
you prepare a memo to him identifying LCL’s business risks and discussing how these business risks
may affect the achievement of the company’s objectives.

You gathered the information contained in Exhibits I and II.

Required:

Prepare the memo requested by the partner.

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PAPER IV, QUESTION 1 (continued)

EXHIBIT I

INFORMATION GATHERED FROM THE CLIENT

1. LCL currently owns and operates 25 private golf courses, primarily in the Vancouver, Calgary and
Edmonton areas. It is actively working on expansion into the Toronto market, but is finding that it
will have to buy or develop new courses a minimum of 50 km from the downtown core due to the
high number of quality courses in the Greater Toronto Area.

2. LCL aims to attract members who are business professionals between 30 and 60 years of age, with
annual incomes exceeding $100,000, and whose employers will pay for the memberships. Such
people are looking for top quality courses that are immaculately maintained, high quality clubhouse
facilities for entertainment, and low membership numbers (keeping on-course delays to a minimum).

3. James believes that the targeted market is prepared to pay “top dollar” for premium memberships.
He has acted on this belief: non-refundable initiation fees (now averaging $25,000) and annual dues
(now averaging $3,000) were increased by 25% last year, and further increases are budgeted.

4. A key long-term component of LCL’s strategy is the development of residential and resort properties
on lands adjacent to its golf courses. In most cases, the land is commercial or agricultural and
therefore must be re-zoned before development can commence. James claims that LCL has a lot of
experience in dealing with the government on such issues, and he does not see the re-zoning as a
major concern.

5. In order to maintain the desired level of growth, in December 2000 LCL entered into a commitment
to purchase two well-established ski resorts in British Columbia and property for development into a
third ski resort outside Calgary. James is very excited about this new venture and plans to use the
same strategies as for LCL’s golf investments.

6. LCL finances all operating equipment through capital leases, the majority of which have five-year
terms.

7. James has stated that, although acquisitions to date have been very successful, two or three properties
are not performing to expectations:

• One is about 60 km outside Calgary and is experiencing low membership numbers due to its
location.
• The other two are recent acquisitions in the Edmonton area. They are also experiencing low
membership, but the cause appears to be the poor quality of the courses and facilities. LCL plans
to upgrade both properties, but making this investment would mean using financing capacity that
is earmarked for the acquisition of two premium courses in the Greater Toronto Area.

8. LCL spends significant amounts on advertising and promotional programs to market its facilities to
potential members. LCL sees its competitive advantage as its size, expertise and reputation. James
says, “When new members join the LCL family, they know they will enjoy the service and prestige
associated with belonging to the very best.”

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PAPER IV, QUESTION 1 (continued)

EXHIBIT II

INDUSTRY OVERVIEW

1. Golf has experienced tremendous growth over the past few years. According to an authoritative
study in 1996, the golfing population in Canada has increased by 36.7% since 1991. This growth
has been fuelled largely by the increase in the participation of women, as well as growth in the
number of younger golfers. Continued growth is expected during the next 10-15 years but the
demographic mix will become skewed, as the number of retired baby boomers will increase
significantly.

2. One of the trends in the golfing industry has been towards the development of high quality, private
courses with fewer members. There are concerns that the average player is being priced out of the
private club market. Public courses are attempting to compete through creative semi-private
arrangements, partnering with other courses to provide reciprocal golfing privileges, etc.

3. The golfing industry faces constant challenges from environmentalists regarding the use of
pesticides, and the environmental impact of golf course development on the local vegetation. These
lobbying groups are becoming increasingly powerful and are gaining the attention of local,
provincial, and federal governments which are beginning to look more closely at regulating the
industry.

4. The golfing industry is going through a period of consolidation, with Canadian and US companies
developing significant property holdings over the past several years. The market is very
competitive, and premium prices have been paid for many of these purchases. Prices have far
exceeded those that would have been paid under normal methods of valuation.

5. The industry practice of acquiring golf courses within a certain geographic region (known as
“clustering”) is driven by the cost-reducing synergies that can be obtained in management,
purchasing, and labour. Further, clustering allows the group of courses to act as a market leader on
green fee pricing. Characteristically, the cluster organization can drive fees up and the competition
is likely to follow. On average, green fees have risen 10 to 15% over the last year.

6. Tastes in golf are changing and will continue to do so as baby boomers continue to mature. Private
club members are less attracted by extravagant clubhouses and dining facilities than in the past.
New golfers are more concerned with the condition of the course and the availability of tee times.

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EVALUATION GUIDE
PAPER IV, QUESTION 1
PRIMARY INDICATORS OF COMPETENCE

Primary Indicator #1

The candidate identifies and discusses the business risks facing the company.

The candidate demonstrates competence in Organizational Effectiveness, Control, and Risk


Management.

Industry trends and the changing golf population

Increased competition and a changing target audience compel a company to be vigilant and to forecast
future trends correctly. Both factors are business risks.

There is much evidence that the competition may force LCL to adapt its business model. LCL’s policy
of charging “top dollar” for premium memberships may no longer be the most appropriate approach in
today’s golfing marketplace. The market for premium-priced memberships may be shrinking, with many
public and private courses offering alternative arrangements. Public courses, for example, are
introducing creative semi-private arrangements that may seriously erode into LCL’s target market.
Undue reliance on premium-priced memberships may mean that LCL will be adversely affected in the
event of an economic downturn. Golfers may also be increasingly reluctant to invest high, non-
refundable initiation fees in a non-equity membership. Many courses now offer equity participation, and
therefore a chance, at a minimum, to recover the initial capital investment.

The golfing industry is also becoming more and more competitive, and LCL may get caught in a
marketplace that is saturated. The competition for limited land is driving up the prices of new courses,
rendering new courses less profitable than their predecessors.

Changing tastes are also challenging LCL’s business model. Many golfers are shunning extravagant
clubhouses and dining facilities in favour of excellent courses. Although the golfing population has
grown by more than one-third since 1991, future growth is far from assured. As well, the predicted
future growth pattern does not seem to match LCL’s business model. The growth is predicted to be
fuelled largely by women and younger golfers; neither group matches LCL’s target market. Aging baby
boomers may also fall out of LCL’s target market in the coming years.

In order for LCL to be able to attract new members, trends in the ever-changing golfing population need
to be closely examined and forecasted. LCL will need to have the flexibility to adapt to new options.

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Expansion of golf courses into new markets

The desire to continue to acquire golf courses in new markets may be a business risk in itself. Increased
competition for prime locations has reduced the availability of viable options, making it difficult for LCL
to buy attractive courses in new market areas. The Toronto and Calgary courses, for example, are well
outside the usual target area for LCL. These new courses will likely not be as profitable as existing
courses, due to the remoteness of their locations. As well, LCL will likely have to pay a hefty premium
for any courses in the Toronto area, making the courses less profitable. Re-zoning may be required to
build new courses, resulting in delays and additional costs.

Toronto is a prime example of an area where LCL faces a significant number of competitors, many of
whom have been established in the Toronto area for many years. These competitors benefit from a
clustering advantage, which LCL will not be able to achieve in this city. As a result, LCL is likely to
become a price follower in the Toronto area, and not a price leader.

LCL has limited funds with which to pay for both the acquisition of new courses and the improvement of
existing courses. LCL may need to choose, for example, between acquiring the Toronto area course and
upgrading the Edmonton courses. A careful analysis of the profitability to be derived from these courses
should be undertaken before a decision is reached.

LCL should reassess its desire to enter the Toronto market in light of the risks identified above. It may
be more prudent for LCL to deal with the problems in Edmonton and Calgary before acquiring another
golf course.

Acquisition of poorly performing golf courses

James Duggan, the CEO of LCL, identified a few properties that have not been performing to
expectations. They present a risk as substantial funding may be needed to turn them around—especially
the Edmonton area courses, which require significant upgrades. LCL may have limited funds to invest in
these courses, particularly since a public offering may or may not yield a significant inflow of funds.
This use of funds detracts from other, possibly more lucrative, investments.

These “poor performer” courses, particularly those that do not meet LCL’s high standards of quality, may
also hurt the company’s reputation. LCL’s business strategy relies heavily on providing top quality
courses in return for premium membership fees. This strategy will be compromised by the existence of
courses that are of poor quality or are badly located.

Development of ski resort facilities

The development of ski resorts represents another area in which LCL lacks experience and is therefore a
business risk. LCL has not previously operated in this industry.

Profitability would be difficult to forecast and variable, with the industry’s short seasons and
unpredictable weather.

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James has stated that he plans to use the same strategies as for LCL’s golf investments. The existing
business model may not apply to an industry that may be very different. Skiers may focus on the quality
of the lifts and runs, and not on the facilities. The pricing strategy for skiers may be different from that
for golfers.

Once again, LCL may face the difficulty of having only limited funds to develop the ski resorts and
expand its golf business. It may need to choose between acquiring golf courses and ski resorts. The
development and maintenance of ski facilities typically require a high level of investment (the industry is
very capital intensive).

A mitigating risk may be the fact that the golf season and the ski season are complementary, enabling
LCL to operate year round.

Development of residential and resort properties

The decision to develop residential and resort properties is risky, as it is not clear that LCL has
experience in the development of such properties. Although James does not foresee problems with the
re-zoning of commercial or agricultural land, government delays or environmental lobbying are always
possibilities. LCL bears the market risk of carrying these properties prior to development and during the
long development time. Significant downturns in the market may result in a substantial loss of funds or
significantly reduced profit.

Environmental lobbyists

The impact of environmental lobbying on the operations of LCL is unpredictable and is clearly another
business risk. Increasingly powerful environmental lobby groups can delay or block projects. Lobby
groups may force companies to reconfigure their plans to take into account local endangered flora and
fauna, sometimes increasing costs substantially. The need to change maintenance plans to take into
account the concerns of environmental lobbyists may also affect the quality of the courses. Finally,
environmental lobbyists sometimes seek to discredit a company if they believe that the corporation is not
acting in a socially responsible manner.

All of these concerns apply to different aspects of LCL’s business, including the development of courses
in new areas, the maintenance of existing courses, the development of residential properties adjacent to
the courses, and the development of ski resorts in new areas.

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High investment in focused advertising and promotion

LCL spends heavily on advertising and promotional programs based on LCL’s perceived competitive
advantages of size, expertise, and reputation. This highly focused advertising poses some risk. The
company may be perceived as “elitist,” limiting the size of its potential market. Clients may also be
disappointed if they join some of the poorer quality courses that have yet to be upgraded, such as the two
in the Edmonton area. LCL may suffer from a loss of reputation if its courses do not live up to the
advertising promises.

The funds poured into advertising also limit LCL’s ability to expand into new areas or improve its
existing courses.

For Primary Indicator #1, the candidates must be ranked in one of the five following
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate identifies one or more business risks without
explaining why they are significant or the candidate identifies and discusses one business
risk.

Reaching competence – The candidate identifies most of the significant business risks and
offers a few valid points of support, but overall the discussion lacks depth, i.e., logic is not
apparent and case facts are not considered.

Competent – The candidate identifies and discusses most of the significant business risks
(industry trend, expansion into new market, acquisition of poor performance, ski resorts), in
sufficient depth.

Highly competent – The candidate identifies and discusses all the significant business risks,
providing an in depth analysis of most risks.

Primary Indicator #2

The candidate assesses the impact of the business risks on the stated objectives.

The candidate demonstrates competence in Organizational Effectiveness, Control, and Risk


Management.

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Industry trends and the changing golf population

Impact on LCL’s objectives

The business risk posed by changing industry trends could adversely affect all three of LCL’s objectives,
primarily the revenue target. Inaccurately anticipating changing golfing tastes could result in a decrease
in revenue, or certainly less growth than the aggressive 30% target. Reduced revenue would, in turn,
adversely affect the return on investment desired by LCL. Finally, courses that more accurately meet
golfers’ demands may be perceived far more favourably than LCL’s courses, pushing LCL out of the
“number one” spot.

The premium-priced membership policy may preclude the achievement of a 30% annual growth in
revenues. Should the membership prices drive out existing members, or fail to attract new members,
such an aggressive growth objective will be difficult to meet. A loss of clients or a failure to attract new
clients will also put pressure on the bottom line, making the 15% return difficult to achieve.

Expansion of golf courses into new markets

Impact on LCL’s objectives

The expansion of golf courses into new areas, if not handled carefully, could adversely affect
achievement of all three of the company’s objectives. Acquiring poor quality or badly located courses
with limited funds could result in decreased membership and lost opportunities elsewhere (making the
objective of 30% revenue growth unachievable), increased costs to purchase or develop courses, as well
as increased costs to turn courses around and to maintain them (15% return on investment unachievable),
and loss of reputation (no longer perceived as the provider of first rate courses).

Acquisition of poorly performing golf courses

Impact on LCL’s objectives

This business risk affects all three of the corporation’s objectives.

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The company has already noted that the Calgary and Edmonton courses are experiencing low
membership numbers. Traditionally, LCL’s growth has depended on acquiring and developing top
quality courses. The acquisition of poor courses, with their low membership clearly jeopardizes
achieving the objective of a 30% annual growth in revenues over the next five years. The extra
investment required to turn these courses around also jeopardizes achieving the 15% return on capital
invested. Finally, poor courses may lead to a loss of reputation, jeopardizing the objective of being
perceived as the supplier of top quality courses in Canada.

Development of ski resort facilities

Impact on LCL’s objectives

The development of ski resorts mainly affects the two financial objectives of LCL. Given LCL’s lack of
experience in this sector, the company will need to pay careful attention to its forecasted sales and costs.
As well, the sector is subject to many ups and downs, making it difficult to meet financial targets
consistently. Costs could easily get out of control, seriously jeopardizing the return on equity objective.

Development of residential and resort properties

Impact on LCL’s objectives

The costs and the market risks associated with developing the residential properties may adversely
impact achievement of the objective of a 15% return on equity. Cost overruns, re-zoning difficulties, or a
downturn in the market are all factors that would affect the return on investment. Delays in the
development of the properties may also mean that the 30% revenue growth target is not met.

Environmental lobbyists

Impact on LCL’s objectives

Environmental lobbyists could have an adverse impact on costs to develop and to maintain the courses
(and therefore the objective to achieve a 15% return on investment). They could also harm the
company’s reputation (and therefore the objective to be perceived as the provider of top quality courses).
Once again, the possible impact of environmental lobbying will need to be carefully monitored. LCL
may wish to plan for the renovation and upkeep of the properties in the most environmentally friendly
manner possible, in order to accurately forecast return on investment and maintain its good reputation.

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High investment in focused advertising and promotion

Impact on LCL’s objectives

LCL’s targeted and expensive advertising policy may make achievement of the 15% return on capital
invested difficult. If the campaign is unsuccessful, the high cost of advertising may drive down profit
margins. An unsuccessful campaign may also mean that the 30% revenue growth rate will not be
achieved.

For Primary Indicator #2, the candidates must be ranked in one of the five following
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate rarely considers the impact of the risks on the
business objectives or assesses the impact of the business risks in a superficial manner.

Reaching competence – The candidate sometimes considers the impact of the risks on the
business objectives.

Competent – The candidate consistently discusses the impact of the risks on the business
objectives.

Highly competent – For all the risks that the candidate identifies, he/she assesses the
impact on several objectives.

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EVALUATION GUIDE
PAPER IV, QUESTION 1
SECONDARY INDICATORS OF COMPETENCE

Secondary Indicator # 1

The candidate questions the reasonableness/achievability of the objectives set.

The candidate demonstrates competence in Organizational Effectiveness, Control and Risk


Management.

Considering the changes occurring in the market place re: land availability, price and changing consumer
profiles, the Board should perhaps evaluate whether the stated objectives need to be revised. In
particular, the growth rate of 30% in revenues may need to be reevaluated. 30% growth may no longer
be achievable with greater competition now in the industry.

The 15% return on capital may be impacted by the increased use of debt to finance the expansions. The
third objective of being perceived as the provider of the highest quality facilities may not be the best
strategy in light of current economic conditions and changing consumer demands. Each of the objectives
needs to be monitored on a regular basis to ensure that each one remains relevant and is appropriate in
helping the company remain profitable.

Other issues

LCL is very dependent on James Duggan for its success. If James decided to leave the company, LCL’s
future would be seriously compromised under the current structure. A succession plan should be put into
place.

The primary objectives of the business are extremely aggressive and may be leading the company into
more aggressive actions than are prudent. The objectives seem to be fueling the rapid expansion of the
company into new markets, which also seems to be affecting the quality of the product offered by LCL.
The objectives themselves should be reassessed in light of the risks identified above.

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For Secondary Indicator #1, the candidate must be ranked in one of the four following
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate indirectly questions the achievability of one of the
objectives through the discussion of the impact of the business risks.

Competent – The candidate discusses the reasonableness of the objectives in light of the
analysis performed (can be one in depth).

Highly competent – The candidate discusses the reasonableness of the objectives in light of
the analysis performed (three in depth).

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PAPER IV, QUESTION 2

Safety Net (SN) is a not-for-profit organization operating in Big Town, Canada. SN runs a shelter for the
homeless, operates a soup kitchen, and provides counselling services to runaway teenagers and street
kids. The demand for SN’s services and its operating budget have expanded rapidly over the last few
years. Exhibit I details SN’s operations.

SN’s operations have changed substantially in the last year (Exhibit II). Fund-raising has been much
more aggressive, two government grants have been obtained, and the “bequest on death” campaign begun
several years ago has yielded one large bequest during the year. In dealing with these changes, the board
of directors of SN realized that they need financial advice. Accordingly, they recently approached your
firm, Fortin & Larose, Chartered Accountants, to advise them on the reporting requests they should be
making of management to ensure the board is making informed business decisions based on relevant
information. Where appropriate, the board would like advice on the selection of accounting policies and
on financial statement disclosure and any other matters of importance. In the past, SN has recorded
revenue and expenses on a cash basis.

The Board has also asked your firm to perform an audit to meet the requirements of one of the
government grants and to provide the certified documentation for both grants, for the year ended March
31, 2001 (see Exhibit II).

It is now January 22, 2001. The senior partner of Fortin & Larose, has asked you, CA, to draft a report to
the board of directors of SN providing them with the requested information. The partner has also
requested a memo highlighting the various engagement issues. He believes that there are additional
service opportunities, and he wants you to note in the memo the services that the firm could perform for
SN.

Required:

Prepare the report and the memo.

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PAPER IV, QUESTION 1 (continued)

EXHIBIT I

DESCRIPTION OF SAFETY NET’S OPERATIONS

SN has three core operations: a shelter for the homeless, a soup kitchen for the needy, and a drop-in
counselling service for runaways and street kids. There are also administrative and fundraising activities.

Shelter for the homeless

The shelter operates out of a former university residence. The residence was donated to SN several years
ago when the university was closed as part of the provincial government’s plan to rationalize higher
education. No amount was recorded on SN’s books for the donated residence.

The shelter is run with a minimum number of paid staff.

Soup kitchen

The soup kitchen operates out of leased facilities: a former church in a rundown part of town. The
signing of a 20-year lease on this property resulted in the dismissal of the previous executive director of
SN. He was dismissed after the board discovered that the lease costs exceeded the fair market value rent
for similar properties and that the remaining useful life of the church, at the time of signing the lease, was
only 15 years.

Paid staff and volunteers prepare two meals a day. Volunteers include chefs from local restaurants,
university food-service providers, and students from a local university’s food sciences program.

Donated food supplies are a major component of operations, and the level of donations remains relatively
constant. Corporations make donations throughout the year, and individuals donate large volumes of
fresh produce in the summer and fall months. None of these donated goods or services are currently
recorded.

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PAPER IV, QUESTION 1 (continued)

EXHIBIT I (continued)

DESCRIPTION OF SAFETY NET’S OPERATIONS

Counselling services for runaways and street kids

The drop-in centre has two paid counsellors. The counsellors work closely with the kids and provide
referrals to other programs such as drug rehabilitation.

The centre has entered into several innovative arrangements to provide assistance to runaways needing
transportation back home. A major airline has begun a frequent-flyer grant program whereby the
members of its frequent-flyer program are asked to donate some or all of their frequent-flyer points to the
drop-in centre. The centre can then use the donated points to acquire a plane ticket. Counsellors attempt
to identify the kids most likely to benefit from free transportation home.

Administration

The administrative staff consists of the executive director, a full-time fund-raiser, managers for the three
operating areas, a bookkeeper, and an accounting clerk/receptionist. There are a relatively large number
of volunteer fund-raisers. In the past, fund-raising consisted mainly of a door-to-door campaign by
volunteers seeking donations and selling “I care” SN memberships. In SN’s financial statements, the
costs of the campaign are netted against total funds raised to present a single door-to-door fundraising
total.

The bookkeeper handles all accounting and banking duties except for verifying accounts payable invoices
for accuracy and filing documents. These two tasks are handled by the receptionist. The bookkeeper has
a microcomputer system and uses an off-the-shelf accounting package.

The executive director verbally promised the full-time fund-raiser a bonus of 10% of funds raised in
excess of $500,000.

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PAPER IV, QUESTION 1 (continued)

EXHIBIT II

CHANGES TO SAFETY NET’S OPERATIONS

Fund-raising

The full-time fund-raiser aggressively pursued fund-raising opportunities. Among the new fund-raising
efforts was a SN charity golf tournament put on by a local golf club. The net proceeds of the tournament
received from the golf club were recorded on SN’s books.

SN’s annual telethon was held on the local cable television station during December 2000. Its success
was greatly enhanced when a country music superstar, in town for a series of concerts, saw the broadcast
and volunteered to do a one hour personal appearance as soon as five companies pledged $20,000 each.
Five local car dealers responded by making pledges, although payment has yet to be received. News of
this commitment increased the number of personal pledges by viewers. Even though the number of
personal pledges increased, only a small percentage of them have been honoured to date. As a result, the
bookkeeper is not sure how to record the pledges.

The “bequest on death” program began several years ago. There was one large bequest during the year,
which left SN with a cash fund to be used for capital acquisitions only. During the year some of the
money from the fund was used to acquire furniture for the shelter, at a cost substantially below fair
market value.

Two grants were negotiated with the government during the year. The first provides for the recovery of
50% of operating costs for the shelter and soup kitchen and 30% of other operating costs.

The second government grant was a lump sum contribution of $200,000 to assist with the capital costs
related to the shelter for the next five years. SN must provide a minimum number of beds at the shelter
during that period and create at least one new full-time position or 33% of the grant becomes repayable.

Both grants included a clause that states “SN will provide certified documentation annually to support its
claim of government funds.” The second grant also requires annual audited financial statements to be
submitted to the government.

During the year, SN began a campaign to raise funds to build a new shelter for runaway kids. The shelter
is expected to begin operations in three years. Thus far, $2 million in pledges has been raised, and the
construction of the building is scheduled to begin sometime in July 2001. SN plans to apply most of the
$200,000 grant from the government to the capital costs of the new shelter. The funds have therefore
been put aside for this use.

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EVALUATION GUIDE
PAPER IV, QUESTION 2
PRIMARY INDICATORS OF COMPETENCE

Primary Indicator #1

The candidate recommends accounting policies that are appropriate to this particular not-for-
profit organization.

The candidate demonstrates competence in Performance Measurement.

This will be a high-risk engagement due to a number of factors:

• SN is a new client and we are not familiar with their systems;


• SN has never been audited;
• The accounting systems may be questionable, since revenue and expenses are currently recorded on a
cash basis;
• Duties in the accounting department do not appear to be segregated;
• There have been significant changes in SN’s operations during the year; and
• The government department responsible for administering the grants may scrutinize the operations.

A major user of the financial reports will be the Board of Directors of SN. It is assumed that the Board’s
primary objective is to maximize the funds available for charitable operations. A government grant is
available that provides for cost recovery of 50% of operating costs for the shelter and soup kitchen and
30% of other operating costs. The government will therefore be interested in reviewing the financial
information in order to administer the grant and monitor fulfillment of the grant requirements. Other
donors may also be interested in SN’s reports in order to monitor stewardship of restricted donations.
Another user will be the fundraiser who appears to have a bonus based on 10% of funds in excess of
$500,000.

Donated university residence

Donated capital assets should be recorded at their fair market value. Organizations having average
annual revenues for the current and preceding fiscal period of less than $500,000 have the option of not
recording capital assets. These organizations must disclose the policy followed in accounting for capital
assets, and must provide information as to the nature of capital assets donated, if expensed or not
recorded. The government grant may cover the amortization amount charged to operations related to the
university residence if it is capitalized. Alternative amortization methods are available and management
should choose an amortization method, such as the declining balance method, that maximizes the
amortization charge in early years, as there is no guarantee the grant will be available indefinitely.

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The residence is not currently recorded on the books. It will be necessary to establish the value of the
donated asset and its useful life.

Donated goods and services

The basic rules for recognizing donated goods and services are that the fair value can be reasonably
estimated, that SN uses the donated goods and services in the normal course of operations, and that it
would have otherwise purchased the good or service.

Soup kitchen staff appear to meet the criteria, as food preparation staff are an integral component of any
food service operation. The chefs’ time could be valued based on normal wage levels for chefs in that
area. It could be argued that a soup kitchen would likely hire short order cooks instead of chefs and their
wage levels would be more appropriate. It will be necessary to establish the number of hours worked to
calculate the cost. Management should initiate some sign-in sheet or log book to provide a record of
hours.

University food-service providers and food sciences students should be recorded at minimum wage.
There is no other verifiable wage level to utilize. This approach will allow for some cost to be recorded.
As with the chefs, it will be necessary to track hours volunteered to calculate the expense.

Donated food is an integral part of the soup kitchen operation. It is likely that food products would have
to be purchased if they were not donated. It should be relatively easy to establish a cost for the donations
by corporations. These goods could be recorded at wholesale cost, or retail cost. Wholesale cost would
be the easiest to establish, but retail cost will meet SN’s objective of maximizing the operating costs. It
will be necessary to establish a means to track the nature and volume of fresh produce donated by
individuals. This may not be worth the effort. We can help management assess whether the cost of
implementing this system would outweigh the benefits derived.

The donated frequent flyer points would also appear to meet the criteria, as a stated goal of the
organization is to help runaways and street kids get back home. The organization would certainly have to
purchase tickets in order to return kids to their families. The frequent flyer points could be valued by
reference to the fair market value of tickets that would otherwise have had to be purchased, although this
valuation may be somewhat high. It is difficult to say whether the organization would purchase plane
tickets if they were not able to use frequent flyer points. Kids would perhaps be returned home by bus or
by some other less expensive method of transportation. Donated but unused points would be difficult to
value at year end and are likely to be immaterial from year to year. I recommend that recording only the
donated points that have been used.

If the donated goods and services are not recorded because they do not meet the criteria, the nature of the
donated goods and services should be disclosed in the notes to the financial statements.

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Donated goods and services should be recorded as both a contribution and an offsetting operating cost.
The fund-raiser will argue that recognizing the contribution for accounting purposes means these
amounts should be included in the bonus calculation. It would be beneficial for SN to record these
amounts, as the bonus is 10% and the minimum grant amount is 30%.

Fund raising

Revenue from the door-to-door campaign is currently being recognized net of costs. The gross proceeds
of the campaign should be recorded separately from the offsetting costs. This method of recording the
fundraising efforts would help maximize the government grant by increasing operating costs. It will also
increase the bonus to the fundraiser, since the gross revenue recorded will be higher than the net amount
currently recorded. By contrast only the net proceeds should be recorded for the charity golf tournament,
as the fundraising costs do not relate to SN’s operations.

Pledges

Pledges are recognized as revenue only if there is reasonable expectation of collection and the amount
can be reasonably estimated. It is likely that the pledges by the car dealers will be honoured and before
year end, since there is still over two months to collect these pledges. Accrual at the pledge date or
recording when received will not affect the year-end financial statements. The number of personal
pledges increased substantially this year. SN has no history of such a large number of pledges, and it may
therefore be impossible to reasonably estimate the amount that will be collected from individual pledges.
Industry statistics on similar telethons could be reviewed to derive a reasonable estimate of the
percentage that will ultimately be collected. Not recording these pledges will minimize the bonus this
year.

Restricted contributions

Both the large bequest received this year and the second government grant restrict the use of the funds
received. The bequest is to be used for capital acquisitions only, and the government grant is to be used
for capital costs related to the shelter. The revenue from these restricted contributions can be recognized
under either the deferral method or the restricted fund method. Under the deferral method, the revenue
would be recognized on the same basis as the amortization expense of the capital assets acquired with the
contributions. The deferral of revenue would not affect the amount of the government grant since it is
based on operating expenses.

Under the restricted fund method, the contribution would be recognized as revenue in a separate
restricted fund when it is receivable or received. In the future, the amortization expense would be
recorded in the restricted fund. This method of accounting may affect the amount of the grant, as the
grant may not take into account the amortization expense recorded in the restricted fund. Recognition of
the contribution in the restricted fund may result in a higher bonus to the fund-raiser, as revenue is
recognized sooner.

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The furniture acquired with the funds from the bequest should be recorded at fair market value, with the
difference between cost and fair market value recognized as a contribution to SN. The resulting higher
amortization may increase the value of the government grant in the future.

The use of the funds for the second government grant must be closely monitored. If the terms of the
grant are not followed, an accrual for possible repayment of the grant may be required.

Other

The lease of the former church meets the criteria of a capital lease. The leased asset should be recorded
at no more than fair market value, and it should be amortized over the remaining 15-year life. The
interest amounts inherent in the lease payment and the amortization expense should be included in
operating costs and as a result will increase the grant amount. The recording of the lease as a capital lease
instead of an operating lease may affect the timing of the grant, as the expenses are not recorded in the
same period.

For Primary Indicator #1, the candidate must be ranked in one of the five following
categories:

Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate recognizes that financial statements have to be


prepared in accordance with GAAP but does not address the specific requirements of a not-
for-profit organization, or the answer is technically very weak. Candidate does not address
valuation issues.

Reaching competence – The candidate recognizes that the financial statements have to be
prepared in accordance with GAAP and recommends some appropriate policies (e.g.,
donated goods, university residence, pledges, fund raising). The candidate addresses the
valuation issues, but not in sufficient depth.

Competent – The candidate recognizes that the financial statements have to be prepared in
accordance with GAAP and recommends appropriate accounting policies for most issues
raised in the case, including restricted contributions. The candidate recommends a policy and
addresses the valuation issues for most of the issues raised. The candidate may attempt to
tie the accounting policy choice back to the financial statement users.

Highly competent – The candidate does as stated in “competent” and supports the choice
of policies with a discussion of the type of government grant to be received (i.e., recognizes a
bias to flow expenses through certain programs; tries to maximize the funding).

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Primary Indicator #2

The candidate identifies engagement planning issues, procedures, and reporting issues
related to this engagement.

The candidate demonstrates competence in Assurance.

Audit issues

A major component of the audit work will involve valuation of donated goods and services. The value of
donated services by chefs and food science students can be established by reference to normal pay levels.
It may be difficult to establish the number of hours, as it is unlikely that hours worked are being tracked
at this time. The value of donated food supplies can be established by reference to wholesale or retail
prices. The corporations probably required a donation receipt, so there may be documentation to support
those numbers. It will likely be nearly impossible this year to establish the quantities and values of fresh
produce donated by individuals. The value of the donated frequent flyer points can be established by
confirming with the airline the number of points donated and then valuing those by reference to likely
flight usage.

We can confirm the net proceeds of the golf tournament fund-raiser. We could also confirm significant
pledges (in particular, the car dealer pledges) and assess the collectibility of the pledges. It is likely that
the car dealer pledges will be honoured by year-end and will be a non-issue. The viewer pledges present
a more interesting challenge. The presence of the superstar may also positively or negatively affect
pledge redemption rates. We should obtain industry statistics to assess the reasonableness of recorded
amounts.

We will need to pay particular attention to the allocation of costs, as the allocation will affect the cost
recovery grant. We will need to determine the definition of qualifying costs for the government grant. In
addition, we must check the accrual for this cost recovery on the year end financial statements. We will
need to ensure that the terms of the second government grant are being met. We should ensure that
proper accruals are made if the terms of the grant are violated.

We must ensure that the bonus, if valid, is properly accrued at year-end. This will be difficult as the
agreement is verbal and very vague. We will need to clarify the basis of the calculation.

Reporting issue

The strategy for this engagement will be primarily substantive. There are no control systems to support
reliance. It is highly unlikely that we will be able to substantiate opening balances so we should inform
the client that there would be a qualification on the initial financial statements to establish a starting point
for future audits. It will also be necessary to establish a reasonable system of internal control to obtain
unqualified audit reports in the future.

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It will probably not be possible to give an unqualified audit report, as part of the fund raising involves
canvassing by volunteers and it is impossible to establish the completeness of revenue. It should be
explained to the client that most not-for-profit entities are faced with this situation.

Certified documentation for government grants

The Board has asked us to perform an audit to meet a condition of one of the government grants and to
provide the certified documentation for both grants, for the year ended March 31, 2001.

The government will want information that allows officials to assess the proper level of funds to disburse
under the operating cost grant. They will undoubtedly also want information on the nature of costs
included as operating costs. SN will need to provide information to facilitate that calculation. Possible
alternatives would include reporting results by program (shelter/soup kitchen/other) within the operating
fund or providing a special report to the government that states that the operating costs as defined under
the agreement are a certain amount and provides the calculated amount of the reimbursement. We could
offer to provide such a report.

The government will also want assurance that the terms of the lump sum contribution grant are being
met. We can provide a report that attests to whether the terms of the contractual agreement are being met
(section 5815 report on compliance with the contractual agreement). We may suggest trying to negotiate
with the government to permit a report other than audited financial statements.

Other

There are a number of additional ways in which we could assist SN. Its most pressing concern is the
absence of a reasonable internal control system. In addition to detailing internal control weaknesses in a
management letter, we should suggest an engagement to review and suggest improvements to create an
effective internal control system.

The bonus calculation is likely to become a contentious issue. There may be a need for a section
5805/section 9100 combination report (audit reports on financial information other than financial
statement and reports on the results of applying specified auditing procedures to financial information
other than financial statement). We should also suggest to the client that the bonus arrangement be
formalized and put in writing because the bonus amount, depending on interpretation, could turn out to
be very material. We could help SN define the terms of the bonus arrangement and formalize the
agreement.

We should also work with management on developing reports to the Board of Directors, such as those
reports suggested in my report to the Board.

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For Primary Indicator #2, the candidate must be ranked in one of the five following
categories:
Not addressed – The candidate does not address this primary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate addresses audit issues without tying these issues to
case facts. The candidate identifies one of the reporting needs related to the government
grants.

Reaching competence – The candidate addresses the audit issues related to revenue
completeness and identifies the reporting options for one of the grants.

Competent – The candidate does as stated in “reaching competence” and discusses some
of the challenges of gathering audit evidence.

Highly competent – The candidate does as stated in “competent”, recognizes the


importance of cost allocation to the government grants and discusses the reporting options
for both government grants.

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EVALUATION GUIDE
PAPER IV, QUESTION 2
SECONDARY INDICATORS OF COMPETENCE

Secondary Indicator #1

The candidate discusses the principles of not-for-profit accounting in general terms.

The candidate demonstrates competence in Performance Measurement.

Basis of accounting
The shelter must operate under generally accepted accounting principles, since the second government
grant requires audited financial statements. Accrual accounting will provide more accurate information to
the Board of Directors.

Not-for-profit organizations generally use fund accounting to record the results of their operations. Fund
accounting consists of a self-balancing set of accounts for each fund. This method of accounting enables
the organization to review the operation of each fund separately. Typical funds may include an operating
fund, for the day-to-day operating activities, a capital acquisition fund, an endowment fund, and so on.
Different operating activities (such as the shelter and the soup kitchen) may be reported in separate
funds. In your case, financial statement users will require reporting by major activity, either by way of a
separate fund or by special report. It may be best to report the operations of the shelter and soup kitchen
separately from the general operating fund, in order to simplify the calculation of the grant. The
government grants will be maximized by ensuring all costs related to the shelter and soup kitchen are
recorded as such (of which 50% is reimbursed by the government).

There are two basic approaches to recording contributions to a not-for-profit organization: the deferral
method and the restricted fund method. Under the deferral method of accounting for contributions,
restricted contributions related to expenses of future periods are deferred and recognized as revenue in
the period in which the related expenses are incurred. Under the restricted fund method of accounting for
contributions, restricted contributions are recognized as revenue in a separate restricted fund. The
purpose of a restricted fund is to record the receipt and use of resources that are subject to restrictions
separately.

The restricted fund method may be the best method in your situation, as you have received restricted
donations. The restricted fund method will, however, recognize endowment funds and restricted
contributions in the current period, which may be used by the fund-raiser as a basis for arguing for a
bonus. The choice of methods will not affect the amount of the government grant, which is based on
operating expenses and not on revenue recorded.

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For Secondary Indicator #1, the candidate must be ranked in one of the following four
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – The candidate describes fund accounting or restricted versus


deferral but is technically incorrect, or does not discuss the subject in sufficient depth.

Competent – The candidate discusses not-for-profit accounting in terms of both fund


accounting and restricted versus deferral, covering both topics in sufficient depth.

Highly competent – The candidate discusses not-for-profit accounting in terms of both fund
accounting and the methods to record contributions in sufficient depth, and suggests
appropriate methods for Safety Net’s operations.

Secondary Indicator #2

The candidate suggests appropriate information for the Board of Directors to request of
management.

The candidate demonstrates competence in Performance Measurement.

Reporting requests of management

In order to properly assess the operation of Safety Net (SN) as well as the performance of management,
we suggest that you make the following requests of management:

• A monthly financial information package, including statement of financial position, operations, and
changes in cash flows. The financial information should be tracked against an approved budget.
This package will enable the Board of Directors to assess the financial health of the organization,
foresee any cash flow difficulties, and evaluate management’s effectiveness in running the
organization while respecting the annual budget.

• The financial information package should include reporting by major activity, such as the costs of the
soup kitchen or of the shelter for the homeless. This breakdown will enable the Board of Directors to
better track the costs that are covered by the government grant, as well as assess the net result of each
activity independently.

• Benchmarks such as the number of families sheltered, meals served, individuals receiving
counseling, and runaways transported back to their homes should be maintained. Once again, these
statistics should be measured against an approved target. This package will enable the Board of
Directors to evaluate the effectiveness of the organization in meeting the needs of the community, as
well as management’s effectiveness in running the organization.

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• The status of the government grants, including likelihood of repayment and measures to obtain grants
in the future. Continued funding by the government may be key to the survival of SN, and the status
of the grants, as well as constant exploration of new possibilities, should be followed up on an
ongoing basis.

For Secondary Indicator #2, the candidate must be ranked in one of the following four
categories:

Not addressed – The candidate does not address this secondary indicator or does not attain
the standard of nominal competence.

Nominal competence – Candidate identifies only the financial statement component of the
information request.

Competent – The candidate identifies financial measurement tools (cash flows, budget,
financial statements) or non-financial statement measures for the Board to request.

Highly competent – The candidate does as stated in “competent” and links the information
to the grant requirements.

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APPENDIX B

CANDIDATE PERFORMANCE ON PRIMARY INDICATORS


BY COMPETENCY AREA

Not Nominal Reaching Competent Highly


addressed competence competence competent
% % % % %

PERVASIVE QUALITIES
I Comprehensive HWL Primary Indicator #1 – The 1% 8% 40% 44% 7%
candidate understands the nature of the risks and
opportunities facing the company and analyzes the potential
impact of these risks and opportunities on the company’s
ability to succeed in the future.

I Comprehensive HWL Primary Indicator #4 – The 15% 13% 20% 37% 15%
candidate integrates the accounting policies with the cash
flow issue and understands that his/her policy
recommendations will affect the net income and therefore
the 5% to Ventura or 50% to Sam. The candidate
understands that this impact is significant and that these
choices may be challenged by Sam and/or Ventura.

II-1 Warmth Homes Primary Indicator #3 – The 15% 22% 36% 26% 1%
candidate recalculates the debt covenant ratios based on
findings and assesses the possible outcome.

II-2 McKinley Primary Indicator #3 – The candidate 1% 8% 57% 34% 0%


considers both the quantitative and qualitative factors in
making an overall assessment of the situation and
recommending a course of action.

III-2 Aquatic Primary Indicator #3 – The candidate 22% 9% 18% 39% 12%
discusses the impact of the accounting issues on the debt
covenant. The candidate recognizes that the debt covenant
breach may result in cash flow difficulties that could create
going concern issues.

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Not Nominal Reaching Competent Highly


addressed competence competence competent
% % % % %

ASSURANCE

II-1 Warmth Homes Primary Indicator #1 – The 1% 64% 28% 6% 1%


candidate identifies the important changes that have
occurred during the year and discusses the consequences to
the audit.
.
II-4 Heliparts Primary Indicator #2 – The candidate is 0% 35% 33% 29% 3%
able to describe the audit approach that should be used to
audit Heliparts. The candidate supports the discussion with
a description of the audit risks associated with the IT
processes identified.

III-1 Read Q Primary Indicator #1 – The candidate 0% 33% 28% 36% 3%


discusses the engagement issues.

III-1 Read Q Primary Indicator #2 – The candidate 6% 46% 33% 14% 1%


discusses the type of report needed by the insurance
company and discusses alternatives.

III-2 Aquatic Primary Indicator #1 – The candidate 1% 2% 18% 30% 49%


assesses the audit planning that has been done to date and
adjusts the audit plan for the upcoming engagement.

IV-2 Safety Net Primary Indicator #2 – The candidate 22% 35% 25% 15% 3%
identifies engagement planning issues, procedures and
reporting issues related to this engagement.

PERFORMANCE MEASUREMENT

I Comprehensive HWL Primary Indicator #3 – The 0% 5% 46% 40% 9%


candidate discusses the major accounting policies.

II-1 Warmth Homes Primary Indicator #2 – The 1% 10% 51% 35% 3%


candidate discusses the accounting treatment of the
material transactions.

III-1 Read Q Primary Indicator #3 – The candidate 0% 5% 60% 32% 3%


analyzes major components of the statement of claim and
suggests changes to or supports Read Q’s position for the
insurance claim.

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Not Nominal Reaching Competent Highly


addressed competence competence competent
% % % % %
III-2 Aquatic Primary Indicator #2 – The candidate 0% 13% 43% 35% 9%
demonstrates an understanding of the significant
performance measurement issues by providing a discussion
of the issues including a recommended treatment.

IV-2 Safety Net Primary Indicator #1 – The candidate 2% 19% 62% 14% 3%
recommends accounting policies that are appropriate to this
particular not-for-profit organization.

FINANCE

I Comprehensive HWL Primary Indicator #2 – The 0% 1% 49% 36% 14%


candidate performs a cash flow in order to assess the future
viability of the Company.

II-2 McKinley Primary Indicator #1 – The candidate 3% 30% 46% 20% 1%


performs a quantitative analysis to support the
recommendation/advice provided to the client. The
candidate explains the methodology chosen.

ORGANIZATIONAL EFFECTIVENESS

II-2 McKinley Primary Indicator #2 – The candidate 0% 2% 28% 58% 12%


identifies and discusses the factors affecting the decision to
purchase the business. The candidate’s recommendations to
the client take these factors into account.

IV-1 Leisure Primary Indicator #1 – The candidate 0% 3% 45% 49% 3%


identifies and discusses the business risks facing the
company.

IV-1 Leisure Primary Indicator #2 – The candidate 2% 15% 30% 50% 3%


assesses the impact of the business risks on the stated
objectives.

INFORMATION TECHNOLOGY

II-4 Heliparts Primary Indicator #1 – The candidate is 1% 33% 31% 33% 2%


able to identify the significant IT processes and to explain
why they are significant.

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APPENDIX C

CANDIDATE PERFORMANCE
ON PRIMARY AND SECONDARY INDICATORS
BY SIMULATION

Not Nominal Reaching Competent Highly


AREA TESTED addressed competence competence competent
% % % % %

I Comprehensive HWL

Primary Indicator #1 – The candidate PERVASIVE 1% 8% 40% 44% 7%


understands the nature of the risks and QUALITIES
opportunities facing the company and
analyzes the potential impact of these
risks and opportunities on the
company’s ability to succeed in the
future.

Primary Indicator #2 – The candidate FINANCE 0% 1% 49% 36% 14%


performs a cash flow in order to assess
the future viability of the Company.

Primary Indicator #3 – The candidate PERFORMANCE 0% 5% 46% 40% 9%


discusses the major accounting policies. MEASUREMENT

Primary Indicator #4 – The candidate PERVASIVE 15% 13% 20% 37% 15%
integrates the accounting policies with QUALITIES
the cash flow issue and understands
that his/her policy recommendations
will affect the net income and therefore
the 5% to Ventura or 50% to Sam. The
candidate understands that this impact
is significant and that these choices may
be challenged by Sam and/or Ventura.

Secondary Indicator #1 – The TAXATION 16% 52% N/A 28% 4%


candidate discusses income tax issues
related to the start-up transactions of
the company and advises the client
adequately.

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Not Nominal Reaching Competent Highly


AREA TESTED addressed competence competence competent
% % % % %
Secondary Indicator #2 – The INFORMATION 4% 56% N/A 33% 7%
candidate addresses the partner’s TECHNOLOGY
request to design an information system
and recommends solutions that meet the
specific needs of the company and
consider the particular characteristics
of the industry.

Secondary Indicator #3 – The ASSURANCE 1% 48% N/A 43% 8%


candidate addresses the audit issues in
his audit memo to the partner.

II-1 Warmth Homes

Primary Indicator #1 – The candidate ASSURANCE 1% 64% 28% 6% 1%


identifies the important changes that
have occurred during the year and
discusses the consequences to the audit.

Primary Indicator #2 – The candidate PERFORMANCE 1% 10% 51% 35% 3%


discusses the accounting treatment of MEASUREMENT
the material transactions.

Primary Indicator #3 – The candidate PERVASIVE 15% 22% 36% 26% 1%


recalculates the debt covenant ratios QUALITIES
based on findings and assesses the
possible outcome.

Secondary Indicator #1 – The ASSURANCE 13% 35% N/A 48% 4%


candidate discusses detailed audit
procedures.

Secondary #2 – The candidate PERFORMANCE 7% 63% N/A 29% 1%


discusses the minor accounting issues. MEASUREMENT
Secondary Indicator #3 – The PERFORMANCE 33% 50% N/A 16% 1%
candidate advises on how to account for MEASUREMENT
the new furnace payment options.

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Not Nominal Reaching Competent Highly


AREA TESTED addressed competence competence competent
% % % % %

II-2 McKinley

Primary Indicator #1 – The candidate FINANCE 3% 30% 46% 20% 1%


performs a quantitative analysis to
support the recommendation/advice
provided to the client. The candidate
explains the methodology chosen.

Primary Indicator #2 – The candidate ORG 0% 2% 28% 58% 12%


identifies and discusses the factors EFFECTIVE-
affecting the decision to purchase the NESS
business. The candidate’s
recommendations to the client take
these factors into account.

Primary Indicator #3 – The candidate PERVASIVE 1% 8% 57% 34% 0%


considers both the quantitative and QUALITIES
qualitative factors in making an overall
assessment of the situation and
recommending a course of action.

Secondary Indicator #1 – The PERFORMANCE 11% 51% N/A 32% 6%


candidate discusses the financial MEASUREMENT
statement issues, recognizing that the
statements are the basis for the
purchase price calculation.

Secondary Indicator #2 – The TAXATION 58% 28% N/A 8% 6%


candidate discusses the tax impacts of
the proposed transaction.

II-4 Heliparts

Primary Indicator #1 – The candidate INFORMATION 1% 33% 31% 33% 2%


is able to identify the significant IT TECHNOLOGY
processes and to explain why they are
significant.

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Not Nominal Reaching Competent Highly


AREA TESTED addressed competence competence competent
% % % % %
Primary Indicator #2 – The candidate ASSURANCE 0% 35% 33% 29% 3%
is able to describe the audit approach
that should be used to audit Heliparts.
The candidate supports the discussion
with a description of the audit risks
associated with the IT processes
identified.

Secondary Indicator #1 – The ORG 46% 40% N/A 11% 3%


candidate demonstrates an EFFECTIVE-
understanding of the importance of the NESS
various sub-systems to the success of
the business.

Secondary Indicator #2 – The INFORMATION 9% 51% N/A 33% 7%


candidate discusses the general IT TECHNOLOGY
environment controls as one of the IT
systems.

III-1 Read Q

Primary Indicator #1 – The candidate ASSURANCE 0% 33% 28% 36% 3%


discusses the engagement issues.

Primary Indicator #2 – The candidate ASSURANCE 6% 46% 33% 14% 1%


discusses the type of report needed by
the insurance company and discusses
alternatives.

Primary Indicator #3 – The candidate PERFORMANCE 0% 5% 60% 32% 3%


analyzes major components of the MEASUREMENT
statement of claim and suggests
changes to or supports Read Q’s
position for the insurance claim.

Secondary Indicator #1 – The TAXATION 68% 8% N/A 21% 3%


candidate discusses the tax treatment of
the insurance claim components.

Secondary Indicator #2 – The FINANCE 33% 52% N/A 14% 1%


candidate recommends a strategy to the
client to help address the short-term
cash flow crunch.

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Not Nominal Reaching Competent Highly


AREA TESTED addressed competence competence competent
% % % % %
Secondary Indicator #3 – The ASSURANCE 13% 24% N/A 58% 5%
candidate does a preliminary
identification of the specific audit
procedures that need to be performed.

Secondary Indicator #4 – The PERFORMANCE 1% 66% N/A 23% 10%


candidate suggests changes to or MEASUREMENT
supported Read Q’s position for the
insurance claim on the minor issues.

III-2 Aquatic

Primary Indicator #1 – The candidate ASSURANCE 1% 2% 18% 30% 49%


assesses the audit planning that has
been done to date and adjusts the audit
plan for the upcoming engagement.

Primary Indicator #2 – The candidate PERFORMANCE 0% 13% 43% 35% 9%


demonstrates an understanding of the MEASUREMENT
significant performance measurement
issues by providing a discussion of the
issues including a recommended
treatment.

Primary Indicator #3 – The candidate PERVASIVE 22% 9% 18% 39% 12%


discusses the impact of the accounting QUALITIES
issues on the debt covenant. The
candidate recognizes that the debt
covenant breach may result in cash flow
difficulties that could create going
concern issues.

Secondary Indicator #1 – The FINANCE 44% 12% N/A 39% 5%


candidate discusses issues associated
with the sale of the trout division,
questioning the decision to sell it.

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Not Nominal Reaching Competent Highly


AREA TESTED addressed competence competence competent
% % % % %
Secondary Indicator #2 – The ASSURANCE 14% 73% N/A 10% 3%
candidate recognizes that the new
management information system does
not affect this year’s audit.

IV-1 Leisure

Primary Indicator #1 – The candidate ORG 0% 3% 45% 49% 3%


identifies and discusses the business EFFECTIVE-
risks facing the company. NESS

Primary Indicator #2 – The candidate ORG 2% 15% 30% 50% 3%


assesses the impact of the business risks EFFECTIVE-
on the stated objectives. NESS

Secondary Indicator #1 – The ORG 1% 66% N/A 32% 1%


candidate questions the reasonableness/ EFFECTIVE-
achievability of the objectives set. NESS

IV-2 Safety Net

Primary Indicator #1 – The candidate PERFORMANCE 2% 19% 62% 14% 3%


recommends accounting policies that MEASUREMENT
are appropriate to this particular not-
for-profit organization.

Primary Indicator #2 – The candidate ASSURANCE 22% 35% 25% 15% 3%


identifies engagement planning issues,
procedures and reporting issues related
to this engagement.

Secondary Indicator #1 – The PERFORMANCE 24% 52% N/A 10% 14%


candidate discusses the principles of MEASUREMENT
not-for-profit accounting in general
terms.

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Not Nominal Reaching Competent Highly


AREA TESTED addressed competence competence competent
% % % % %
Secondary Indicator #2 – The PERFORMANCE 44% 11% N/A 34% 11%
candidate suggests appropriate MEASUREMENT
information for the Board of Directors
to request of management.

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JUNE 2002
The Canadian Institute of Chartered Accountants
277 Wellington Street West,Toronto ON M5V 3H2 E D U C A T I O N
Tel (416) 977-3222 Fax (416) 204-3423 www.cica.ca

For more information


The new CA qualification process will prepare future CAs to meet the challenges that await them.
For more information on the new qualification process, the new uniform evaluation, and your province’s specific
education requirements, contact your regional education director or your local Provincial Institute/Ordre.

Regional Education Directors


Atlantic Canada and Bermuda: Ontario:
Dan Trainor, FCA Brian Leader, CA
Atlantic School of Chartered The Institute of Chartered Accountants
Accountancy of Ontario
Cogswell Tower, Suite 706 69 Bloor Street East

Preparing for the 2003 UFE


Scotia Square, P.O. Box 489 Toronto, Ontario M4W 1B3
Halifax, Nova Scotia B3J 2R7 Tel: (416) 962-1841 extn. 273
Tel: (902) 425-7974 Fax: (416) 962-8900
Fax: (902) 423-9784 Web site: www.icao.on.ca
Web site: www.asca.ns.ca E-mail: bleader@icao.on.ca
E-mail: theschool@asca.ns.ca
Western Canada and the
Quebec: Territories:
Diane Messier-Marcotte, CA John Brennan, FCA or
Ordre des comptables agrées du Don Carter, FCA
Québec C A School of Business
680, Sherbrooke Ouest, 18e étage 582 Manulife Place
Montréal, Québec H3A 2S3 10180-101 Street
Tel: (514) 982-4601 Edmonton, Alberta T5J 3S4
Fax: (514) 843-8375 Tel: 1 866 420-2350
Web site: www.ocaq.qc.ca Fax: (780) 424-8041
E-mail: d.messier Web site: www.casb.com
marcotte@ocaq.qc.ca E-mail: j.brennan@icaa.ab.ca
or carter@ica.bc.ca

Understanding the Evaluation Methodology


Provincial Institutes/Ordre
The Institute of Chartered The Institute of Chartered The Institute of Chartered
Preparing for the 2003 UFE
Accountants of Bermuda Accountants of Newfoundland Accountants of Saskatchewan
Box HM 1625 95 Bonaventure Avenue, 5th Floor 1801 Hamilton Street, Suite 830
Hamilton 5, Bermuda
(441) 292-7479
www.icab.bm
P.O. Box 21130
St. John’s, Newfoundland A1A 5B2
Regina, Saskatchewan S4P 4B4
(306) 359-1010 Understanding the Evaluation
(709) 753-7566 www.icas.sk.ca
The Institute of Chartered www.ican.nfld.net
The Institute of Chartered
Methodology
Accountants of Nova Scotia Ordre des comptables agréés du Accountants of Alberta
1791 Barrington Street, Suite 1101 Québec 580 Manulife Place, 10180-101 Street
Halifax, Nova Scotia B3J 3L1 680, rue Sherbrooke Ouest, 18e étage Edmonton, Alberta T5J 4R2
(902) 425-3291 Montréal, Québec, H3A 2S3 (780) 424-7391 1 800 232-9406 (for
www.icans.ns.ca (514) 288-3256 1 800 363-4688 Alberta, outside Edmonton)
The New Brunswick Institute of www.ocaq.qc.ca www.icaa.ab.ca
Chartered Accountants The Institute of Chartered The Institute of Chartered
93 Prince William Street, 4thFloor Accountants of Ontario Accountants of British Columbia
Saint John, New Brunswick E2L 2B2 69 Bloor Street East 1133 Melville Street, 6th Floor
(506) 634-1588 Toronto, Ontario M4W 1B3 Vancouver, British Columbia V6E 4E5
www.nbica.org (416) 962-1841 1 800 387-0735 (604) 681 3264 1 800 663-2677 JUNE 2002
The Institute of Chartered www.icao.on.ca www.ica.bc.ca
Accountants of Prince Edward The Institute of Chartered If you are in the Yukon, please contact
Island Accountants of Manitoba the Institute of Chartered Accountants
P.O. Box 301 – 129 Kent Street, 500 – 161 Portage Avenue East of British Columbia.
Suite 203 Winnipeg, Manitoba R3B 0Y4
Charlottetown, PEI , CIA 7K7 If you are in the Northwest Territories
(204) 942-8248 1 888 942-8248
(902) 894-4290 or Nunavut, please contact the Institute
www.icam.mb.ca
of Chartered Accountants of Alberta.