Mock Common Final Examination

Day 3
Mean Green Machines Inc.
(Booklet #1 – Case)

Examination Details
The examination consists of:

Booklet #1 – (this booklet)

Case #1 (85 minutes)
Booklet #2 – Rough notes

The case should be answered in Word and Excel. The main body of your response should be
in Word. Only supporting calculations should appear in Excel, within a single worksheet.

Answers or part answers will not be evaluated if they are recorded on anything other than
Word or Excel. Rough-note paper is available in a separate booklet. Rough notes, and
any other annotations made in the exam booklet will not be evaluated.

The CPA Canada Handbooks and the Income Tax Act, in the form of searchable PDF files, are
available on your computer during the exam if you have Securexam installed (Program Files /
Software Secure, Inc / Securexam Student / PDFDocumentViewer.exe). These PDF files
provide the standards in effect and tax laws enacted at December 31, 2017.

A tax shield formula and other relevant tax information are available at the end of this booklet.
Mock Common Final Examination Day 3 Page 2

Case #1 (Suggested time 85 minutes)

Mean Green Machines Inc. (MGM) is a Canadian manufacturer of eco-friendly lawn machines,
and is one of a few dominant players in this niche market. In an effort to create cost synergies
and also expand its market position, MGM is interested in purchasing all outstanding shares of
one of its competitors, Turbo Turf Inc. (TTI). TTI’s owners know of MGM’s interest and expect to
sell the company. Background information on the industry as well as TTI is provided in Appendix
I.

You, CPA, work for an advisory firm and have been approached by MGM’s CEO, Dale
Thompson, for advice on the acquisition, which is targeted to take place effective March 1,
2018. It is currently January 3, 2018 and Dale has invited you to his office for a meeting.

“CPA, we are very excited at the prospect of acquiring TTI. The company has a strong
reputation for quality products, and we’re hoping to leverage this to improve our overall brand
image through the take-over. The primary purpose of the acquisition would be to capitalize on
TTI’s newest product, the H2MOW hybrid. This is something the industry has never seen and
could be a game-changer. Testing just finished and TTI is planning to take it to market in March.
TTI has provided us with the expected first-year profit for this product (Appendix II). Please
verify that the calculation makes sense.

“We are also hoping to reduce our manufacturing costs through this acquisition by using one of
TTI’s patented engine parts. What level of production would be required for us to save money
by producing this part versus continuing to purchase it?

“I need you to determine a preliminary amount to offer for TTI before we present a formal offer
to TTI’s owners. A recent take-over in the industry was done using a multiple of four times
normalized pre-tax income for the most recent year-end. I believe this would be fair, and would
also be prepared to offer an additional amount equal to three times first-year profit for the
H2MOW line. TTI’s draft 2017 income statement is provided in Appendix III. Of course, we will
conduct proper due diligence after we receive the audited financial statements at the end of the
month.

“TTI outsourced its tax preparation a few years ago. Take a look at a summary of the latest filing
information (Appendix IV) and assess the accuracy. TTI’s taxes seem quite low for the past few
years, which is surprising given its profit levels. Also, please advise on any specific risks I
should be aware of in terms of structuring the deal through a purchase of shares, using
examples from the information you gather. Please ignore any acquisition of control concerns
you may have from a tax perspective.

“Finally, please advise as to how we would account for the acquisition at March 1 under IFRS,
including any relevant calculations. Acquisition costs of $225,000 are expected to be incurred.”

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APPENDIX I
BACKGROUND INFORMATION

Industry Highlights

 New product offerings typically sell an average of 2,500 units per month in the first year,
with warranty costs averaging 6.5% of sales.

 Gross margins are stable for mature products, averaging 55%. For new products, it is
not uncommon to have a gross margin in excess of 60% in the first year.

 Advertising costs are typically 10% of sales, but can be higher during product launches.

 Annual insurance costs for new products are approximately $50,000.

Information on TTI

 Shareholders’ equity balance of $10,249,500 at December 31, 2017.

 The book value of all assets and liabilities approximate fair market value except for the
following:

Account Book Value Fair Market Value Difference

Building $3,319,400 $4,094,400 $775,000
Patents $125,000 $2,220,000 $2,095,000
Bond liability $392,800 $220,800 $172,000

 TTI has not recorded an accrual for a potential liability relating to a personal injury
lawsuit filed last month. The amount and likelihood of payment are both undeterminable
at this point per the company’s lawyers.

 Since TTI expects a take-over bid, management decided not to accrue and pay out
bonuses to senior management for 2017, which has upset many employees. In each of
the past five years, TTI paid out 2.5% of sales as bonuses.

 With the exception of the H2MOW and patented engine part, the majority of TTI’s
products and processes are very similar to MGM’s and may cause some redundancies.

 MGM has excess capacity at its building because of a recent facility expansion and
could easily house TTI’s operations with minimal re-configurations.

 H2MOW is the first new product to be released by TTI in the past five years.

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APPENDIX II
H2MOW PROFIT CALCULATION AND ENGINE PART INFORMATION

H2MOW Projected Profit in Year One

Projected sales [1] $19,500,000

Variable costs:
Parts [2] 5,280,000
Labour [3] 1,560,000
6,840,000
Fixed costs:
Full-time production supervisor [4] -
Advertising 100,000
100,000

Projected profit $12,560,000

Notes:

[1] 5,000 units per month x $325 selling price

[2] 5,000 units per month x $88 per unit

[3] 5,000 units per month x $26 per unit

[4] Excluded from calculation since salaried cost of $75,000

Engine Part – Produce versus Purchase

TTI is currently the only North American company that supplies a required engine part for
certain machine models. The price is $28 per unit, which represents a mark-up of 55% over its
variable cost of production.

Rather than purchase from TTI, MGM sources a similar product from an Australian company.
The cost is $10,000 per order of 500 units, plus an additional 5% shipping cost, which is waived
as long as at least $100,000 of product are purchased annually. To get this deal, a three-year
contract was signed last year that includes a $50,000 penalty if MGM ceases purchases during
that time. Typically, the Australian dollar and Canadian dollar trade at par with one another.

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APPENDIX III
DRAFT TTI INCOME STATEMENT INFORMATION

For the year ended December 31, 2017

Revenue [1] $16,578,000

Cost of goods sold [2] 4,647,310
Gross margin 11,930,690

Expenses:
Salaries and wages 2,428,000
Depreciation 1,027,500
Advertising 453,200
Insurance 250,000
Bad debt accrual [3] 231,870
Interest [4] 221,800
Utilities [5] 218,550
General and administrative 146,200
Total expenses 4,977,120

Pre-tax income $6,953,570

Notes:

[1] Includes $1,120,000 order shipped to Grass ‘R Us (GRU), a major retail chain, on
December 31. The order was initiated just one day before, which is unusual both in
terms of the speed of delivery and also the order size since very few machines are sold
in the winter months. GRU issued a certified cheque on delivery and agreed to a no-
return policy. Dale thinks revenue might be over-stated since MGM has had issues
collecting receivables from GRU in the past. He wants to know if this revenue should be
recognized under IFRS since MGM has early adopted IFRS 15, Revenue from Contracts
with Customers. The cost of the goods sold was $288,000.

[2] During the year, TTI was able to lower its cost of production significantly by entering into
a one-year contract with a new, lesser-known part supplier. Previously, TTI’s main
supplier was a reputable and high-quality source.

[3] This general provision has averaged 3% of credit sales annually since inception but was
adjusted to 1.5% (excludes the GRU order) by management for 2017. There were no
specifically identifiable uncollectible accounts at year-end for either 2016 or 2017. The
allowance for doubtful accounts was $330,650 at the end of 2017 and $405,650 at the
end of 2016.

[4] Includes $110,000 of fees incurred for mortgage refinancing, which is required every
three years.

[5] Each unit produced uses utilities of approximately $1.75.

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APPENDIX IV
2017 YEAR-END TTI TAX FILING SUMMARY

Pre-tax income $6,953,570

Add:
Depreciation 1,027,500
Meals and entertainment [1] 20,850

Deduct:
Capital cost allowance [2] 1,843,700

Net income for tax purposes 6,158,220

Deduct:
Net capital loss carry-forward 3,236,580

Taxable income $2,921,640

Notes:

[1] Calculated as 50% of total expense of $41,700, which includes staff Christmas party
($9,750), employee appreciation barbecue ($7,250), golf membership for senior staff
($1,500), and business luncheons at the golf course ($23,200).

[2] Includes claim for new manufacturing machinery purchased in 2017 with a cost of
$835,000 placed into Class 53, calculated as 50% x $835,000 = $417,500.

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END OF EXAM

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CPA COMMON FINAL EXAMINATION REFERENCE SCHEDULE

1. PRESENT VALUE OF TAX SHIELD FOR AMORTIZABLE ASSETS

a) Present Value of Total Tax Shield from CCA for a New Asset
= CTd 2 + k = CdT 1 + 0.5k
(d + k) 2(1 + k) (d + k) 1 + k

Notation for above formula:

C = net initial investment
T = corporate tax rate
k = discount rate or time value of money
d = maximum rate of capital cost allowance

2. SELECTED PRESCRIBED AUTOMOBILE AMOUNTS

2017 2018
Maximum depreciable cost — Class 10.1 $30,000 + sales tax $30,000 + sales tax
Maximum monthly deductible lease cost $800 + sales tax $800 + sales tax
Maximum monthly deductible interest cost $300 $300
Operating cost benefit — employee 25¢ per km of 26¢ per km of
personal use personal use
Non-taxable automobile allowance rates
- first 5,000 kilometres 54¢ per km 55¢ per km
- balance 48¢ per km 49¢ per km

3. INDIVIDUAL FEDERAL INCOME TAX RATES

For 2017

If taxable income is between Tax on base amount Tax on excess

$0 and $45,916 $0 15%
$45,917 and $91,831 $6,887 20.5%
$91,832 and $142,353 $16,300 26%
$142,354 and $202,800 $29,436 29%
$202,801 and any amount $46,966 33%

For 2018

If taxable income is between Tax on base amount Tax on excess

$0 and $46,605 $0 15%
$46,606 and $93,208 $6,991 20.5%
$93,209 and $144,489 $16,544 26%
$144,490 and $205,842 $29,877 29%
$205,843 and any amount $47,670 33%

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4. SELECTED INDEXED AMOUNTS FOR PURPOSES OF COMPUTING INCOME TAX

Personal tax credits are a maximum of 15% of the following amounts:

2017 2018
Basic personal amount $11,635 $11,809
Spouse, common-law partner, or eligible dependant 11,635 11,809
amount
Age amount if 65 or over in the year 7,225 7,333
Net income threshold for age amount 36,430 36,976
Canada employment amount 1,178 1,195
Disability amount 8,113 8,235
Canada caregiver amount if infirm dependants 18 & over 6,883 6,986
Net income threshold for caregiver amount 16,163 16,405
Adoption expense credit 15,670 15,905

Other indexed amounts are as follows:

2017 2018
Medical expense tax credit – 3% of net income $2,268 $2,302
ceiling
Annual TFSA dollar limit 5,500 5,500
RRSP dollar limit 26,010 26,230
Lifetime capital gains exemption on qualified small
business shares 835,716 848,252

5. PRESCRIBED INTEREST RATES (base rates)

Year Jan 1. - Mar. Apr. 1 - June 30 July 1 - Sep. Oct. 1 - Dec. 31

31 30

2018 1 2
2017 1 1 1 1
2016 1 1 1 1
2015 1 1 1 1

This is the rate used for taxable benefits for employees and shareholders, low-interest
loans, and other related-party transactions. The rate is 4 percentage points higher for late
or deficient income tax payments and unremitted withholdings. The rate is 2 percentage
points higher for tax refunds to taxpayers, with the exception of corporations, for which the
base rate is used.

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6. MAXIMUM CAPITAL COST ALLOWANCE RATES FOR SELECTED CLASSES

Class 1 ...................................... 4% for all buildings except those below

Class 1 ...................................... 6% for non-residential buildings acquired for first
use after March 18, 2007
Class 1 ...................................... 10% for manufacturing and processing buildings
acquired for first use after March 18, 2007
Class 8 ...................................... 20%
Class 10 .................................... 30%
Class 10.1 ................................. 30%
Class 12 .................................... 100%
Class 13 .................................... Original lease period plus one renewal period
(minimum
5 years and maximum 40 years)
Class 14 .................................... Length of life of property
Class 14.1................................. 5% for property acquired after December 31, 2016
Class 17 .................................... 8%
Class 29 .................................... 50% Straight-line
Class 43 .................................... 30%
Class 44 .................................... 25%
Class 50 .................................... 55%
Class 53 ................................... 50%

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