80 Appendix C — Paper II — Evaluation Guide

EVALUATION GUIDE
II-1 SECURITY PLUS
PRIMARY INDICATORS OF COMPETENCE

The reader is reminded that the solutions are developed for the UFE candidate and that therefore all
the complexities of a real life situation may not be fully reflected in the following solution. The UFE
Report is not an authoritative source of GAAP.

Primary Indicator #1

The candidate discusses the appropriate financial accounting treatment under GAAP for the
issues identified.

The candidate demonstrates competence in Performance Measurement.

DRAFT NOTES FOR DISCUSSION WITH OTHER COMMITTEE MEMBERS

Compliance with GAAP

Security Plus’s (SP) financial statements have been prepared by a friend of Joe’s. We do not know what
background she has in accounting, but there are areas where the policies/presentation may not be in
accordance with Generally Accepted Accounting Principles (GAAP). This poses a problem, as EEDC
requires the financial statements to be in accordance with GAAP. GAAP statements will also provide
better information for evaluating the financial results and position of SP.

From a GAAP perspective, there are several areas of concern.

1. Treatment of the system and monitoring revenue

SP runs a promotion in which new customers who sign a 36-month contract receive a “free”
monitoring system. The same monthly fee is charged by SP regardless of whether customers sign up
for 36 months or for a shorter term. However, if SP were to sell the system separately from the
contract, they would charge the customer $495. The system costs SP $230. The monthly rental fee is
$33. This arrangement therefore involves the delivery and performance of multiple products and
services at different points in time. The system is delivered at the beginning of the contract, but the
monitoring service is not physically delivered at that time. Instead, it will be provided over the next 36
months. According to EIC-142, “a vendor should evaluate all deliverables in an arrangement to
determine whether they represent separate units of accounting.”
 Uniform Evaluation Report — 2006 81

In determining whether the delivered item should be accounted for as a separate unit of accounting,
EIC-142 has established criteria that must be met. A delivered item should be considered a separate
unit of accounting if all of the following criteria are met:

A) “The delivered item has value to the customer on a stand-alone basis. That item has value on a
stand-alone basis if it is sold separately by any vendor.”

The system represents the delivered item in the arrangement. The system has value on a stand-alone
basis because it is offered separately by SP. According to Joe, without entering into a contract, he
would charge $495 for a new system. Also, it appears that the system could be purchased from SP,
while the monitoring service could be obtained from another vendor. Therefore, the first condition
for separation is met.

B) “There is objective and reliable evidence of the fair value of the undelivered item.”

The monitoring service represents the undelivered item in the arrangement. Objective and reliable
evidence of fair value exists for the monitoring service. Joe has indicated that he would charge the
same monthly monitoring fee regardless of whether the customer signs up for a 36-month contract.
He has also indicated that the $33 monthly fee is in line with competitors’ pricing. Therefore the
monthly monitoring fee being charged appears reasonable. As a result, the second condition for
separation is also met.

C) “If the arrangement includes a general right of return relative to the delivered item, is performance
of the undelivered item considered probable and substantially in the control of the vendor?”

We are not given any specific information about whether or not SP would refund a customer if the
customer wished to return a system. However, it is unlikely that SP would allow a customer to do so
given that they have signed a contract for a three-year period. With regard to the undelivered item
(the monitoring service), the delivery of the service appears to be both probable and substantially
under the control of SP. Again, the customer has signed up to receive the service for a three-year
period, and SP (through Gargantuan) has complete control of who receives the service. Therefore,
the third condition likely is satisfied.

Accordingly, the system and the monitoring service should be accounted for as separate units of
accounting.

The next step in the process is to assign a value to the separate units of accounting. “If there is objective
and reliable evidence of fair value for all units of accounting in an arrangement, the arrangement
consideration should be allocated to the separate units of accounting based on their relative fair values.
The best evidence of fair value is the price of a deliverable when it is regularly sold on a stand-alone
basis.”
82 Appendix C — Paper II — Evaluation Guide

Joe has provided us with the sales price for the system if sold separately ($495). However, we know that
no customers have purchased a system for $495 if they were also signing up for the monitoring service. Of
course, we are also told that SP also sells security products (without service packages). There is a chance
that SP has sold a system for $495 in the past. At this point, we do not have enough evidence to determine
whether $495 is representative of the fair value on a stand-alone basis. We would have to obtain more
information to confirm the fair value. We might have to seek third-party evidence of fair value by
comparing SP’s quoted price to that of a competitor.

If we determine that there is no objective and reliable evidence of the fair value of the system, then the
residual method should be used. Under the residual method, the amount of consideration allocated to the
delivered item equals the total arrangement consideration less the fair value of the undelivered item.

In addition, we should also consider whether the installation of the system acquired with a contract should
be considered as a separate accounting unit. Joe has not provided us with sufficient information to make
that determination at this time. To determine whether installations meet the conditions listed above, we
would have to know the following:

- whether SP regularly provides installations on a stand-alone basis

- what amount SP charges for installation only

Once we establish the amount of revenue that should be recognized up front and over the life of the
contract, we can determine whether SP should be recording a deferred revenue balance. Customers are
billed in advance and can choose to be billed monthly, quarterly or annually. As a result, the timing of the
billing will likely differ from that for recognizing revenue.

(Many candidates had difficulty recognizing that multiple deliverables existed within the contract and
were unfamiliar with the GAAP treatment of these components when they were properly identified. As
a result, their discussion generally lacked sufficient depth.)

(Some candidates spent time discussing the need to match costs (of the initial system and installation)
to revenues over the three-year contract term and focused on cost deferral and amortization rather
than approaching the issue from a revenue-recognition perspective.)

2. Presentation of the sales and cost of sales amounts for the sale of security products

The issue is whether the sale of security products should be recorded as sales revenue or whether the
gross profit is really just commission. Either way, net income will not be affected. However, the
presentation will affect the gross revenue reported. When assessing whether revenue should be
reported at gross or net, we should consider the following:

a. Whether SP acts as principal in the transaction. Generally the sales contract will outline
whether SP or the supplier is responsible for fulfilling the product order. Factors that might
indicate that SP is the principal include whether it is SP who sets the sales price; whether SP is
able to select the supplier it deals with, and works with more than one supplier, etc.
 Uniform Evaluation Report — 2006 83

b. Whether SP takes title to the products. It appears that SP does not take title to the products.
Products are shipped directly from the supplier to the customer.

c. Whether SP bears the risks and rewards of ownership, such as risk of loss for collection,
delivery, or returns. The fact that SP does not carry security products for resale in inventory
supports the argument for presenting the revenue at net. However, it appears that SP is still
responsible for billing and collecting from these customers. As a result, it is still exposed to
collection risk. We are not provided with any information as to returns. Therefore we would need
to determine whether returns can be sent back to the supplier for a refund or whether SP would
bear the cost.

In order to make a final recommendation in this area, we need more information. Overall, it would depend
on the amount of control SP has over the sales and the level of risk it assumes. Product sales are currently
not a major concern, since they accounted for only 11% of revenue in 2006. However, this was an increase
of 3% over 2005, so these sales may become more important in the future. It would be advisable to
establish a policy upfront rather than possibly having an adjustment in the future. The method of reporting
will also have implications for the GST threshold in 2005 see tax discussion.

A similar discussion can be had about whether the monitoring revenue should be presented at gross or
net. SP uses Gargantuan to provide the monitoring services for its customers. While we do not have many
details concerning SP’s relationship with Gargantuan, it appears that SP should continue to record the
monitoring revenue at gross for the following reasons:

SP appears to be the principal in the transaction. It has contracted Gargantuan to provide the
monitoring service for its customers. However, SP does not have a long-term contract with
Gargantuan, so SP could change service providers at any time.

SP is the primary obligor in the arrangement. The customers obtain the system and sign up for the
service through SP and probably do not know about Gargantuan’s involvement in the service.
Therefore, if customers experience service difficulties, they will pursue SP to resolve them.

(Many candidates were able to recognize the revenue recognition issue of “gross versus net,” and
applied their GAAP knowledge to the simulation facts in their discussion of how SP should report these
revenue items.)
84 Appendix C — Paper II — Evaluation Guide

3. Other statement items

Other items on the financial statements that need to be dealt with are as follows.

1. No allowance for doubtful accounts is recorded on the balance sheet. SP should consider whether
collection of some of its accounts receivable may be in doubt and should include those doubtful
accounts in its allowance. An analysis of the accounts receivable balance indicates that approximately
2.7 months of fees are outstanding ($123,750 / 12 = $10,313; $27,883 /$10,313), as receivables have
increased to $27,883 at the end of 2006. This may indicate possible collection problems. The aging of
receivables should be reviewed to determine what an appropriate provision might be.

2. No physical inventory count was performed. The inventory balance at year end is just an estimate. The
balance at the end of 2006 has not changed from the previous year despite an increase in the sales
volume. Inventory should be counted and measured at the lower of cost and market value to ensure
that the balance is accurate.

3. SP should consider taking a provision related to maintenance costs that may be necessary over the
three-year life of the customer contracts. However, SP probably lacks the historical data needed to
estimate a reasonable provision.

4. Classification/presentation issues:

- The current portion of the EEDC loan ($10,000 due in 2007) should be disclosed separately from
the long-term portion.
- Deferred revenue should be recorded for those customers who have been billed in advance. While
there is no deferred revenue on the balance sheet, SP might have recorded this as a credit balance
in accounts receivable. We will need more information in this area to determine the amount to
record.
- The income statement format could be improved to show cost of goods sold (including system
material, alarm monitoring, installer fees, and cost of product sold) and gross margin, before
other operating expenses are deducted. Clearer presentation may help Joe to better interpret his
financial information, and help him make better business decisions regarding revenues and costs.
- Interest on long-term debt is required to be disclosed separately.
- We should ensure that the vehicle lease is an operating lease.

Although Joe may be correct in thinking that SP will reach profitability this year, he would benefit from
improved presentation of the financial information. The current format of the income statement does not
make it easy to understand how the business is doing.
 Uniform Evaluation Report — 2006 85

The important point to get across to Joe is that the current financial statements are not in accordance with
GAAP. We will need to obtain more information before we can properly advise him on the specific
adjustments that are required to the income statement and balance sheet.

(Candidates addressed some of the deficiencies within the financial statements, often to the detriment
of their discussion of the more significant revenue recognition issues.)

(The board considered the revenue recognition discussions to be the key accounting issues on this
simulation. Candidates could not achieve competent by addressing only the items pertaining to
financial statement presentation. A surprising number of candidates provided no discussion on the
two revenue recognition areas, solely touching upon the presentation issues.)

(The board was somewhat surprised by the number of candidates who did not see the multiple
deliverables issue at all, considering that many of the accounting cases in the news in recent years
have dealt with multiple deliverables. The board encourages candidates to stay abreast of cases in the
news. By becoming aware of where GAAP is being misapplied or misinterpreted, candidates gain a
better understanding of such issues.)

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

Not addressed – The candidate does not address this primary indicator. 6.0%

Nominal competence – The candidate does not attain the standard of reaching
27.0%
competence.

Reaching competence – The candidate discusses the appropriate financial

14.5%
accounting treatment for some of the accounting issues.

Competent – The candidate discusses, in sufficient depth, the appropriate

51.8%
financial accounting treatment for one key accounting issue.

Highly competent – The candidate discusses, in sufficient depth, the appropriate

0.7%
financial accounting treatment for most of the accounting issues.

Primary Indicator #2

The candidate performs a quantitative or qualitative analysis of the monitoring service, the
proposed Health Alert service, or the offer from Gargantuan.

The candidate demonstrates competence in Performance Measurement.

86 Appendix C — Paper II — Evaluation Guide

SP’s performance

The areas that I would like to discuss with Joe are the profitability of SP’s current goods and services,
the pricing of the proposed new service (Health Alert), and the offer made by Gargantuan.

Profitability of the current business

An important tool to use in evaluating profitability is contribution analysis. See Appendix 1 for this
analysis. It shows that in total for the 36-month contract, the contribution margin is $620 per system. (On
existing systems this will be reduced by 7% (or 6% if used instead of 7%) of revenue for the Goods and
Services Tax (GST) see tax discussion). Of course, the contribution margin of this service has also been
reduced in 2006 by the increase in the monitoring cost, from 15% to 20%. Also note that the actual
contribution margin earned is higher in cases where Joe performs the installation himself and is able to
save on the installation cost.

On average, SP will earn a profit of $620 for every new system Joe sells. This profit will not be earned
evenly over the 36-month contract. In the first year, because of upfront costs for the equipment and
installation, SP will actually lose $13 for every new system. By contrast, in years two and three SP will
earn $317 in profit per system. It is this difference in the timing of revenue and expenses related to these
three-year contracts that has resulted in a net loss for SP in 2005 and 2006 and has contributed to the
current cash flow shortages that are concerning Joe.

(Few candidates saw the timing issue.)

Analyzing the services SP provides on a contribution margin (CM) basis will help Joe in making decisions
on pricing and related issues, including the offer from Gargantuan. However, Joe should also ensure that
his contribution margin is high enough, given the current demand, to cover his fixed costs. Fixed costs
amounted to approximately $75,000 in 2006. Therefore, with a unit contribution margin of $620, SP
needs to sell 122 units to break even. It should do so easily if Joe’s assumption that he will sell 425
systems in 2007 is realistic.

Gargantuan’s offer

Gargantuan has offered to provide SP with customers for an upfront payment of $50 per customer. There
are several factors to consider in evaluating this offer. Assuming the customers sign up for the 36-month
contract, the payment would reduce the contribution margin by $50 (or approximately 4%) over the life of
a 36-month contract. In evaluating this offer, SP would have to consider if this approach would bring in
more customers than it would otherwise obtain or if it would just cannibalize SP’s own sales efforts.
Would it reduce advertising costs? Is there any provision that the customers would have to be maintained
for a certain amount of time? In addition, this cost would add to the burden of one-time costs incurred in
the first year. These issues need to be considered before a decision can be made.

(Few candidates addressed the Gargantuan offer, focusing instead on the existing monitoring service
and the new Health Alert Service.)
 Uniform Evaluation Report — 2006 87

Health Alert: add-on and standalone

Appendix 1 also shows a contribution analysis for the proposed new service, Health Alert. I have prepared
this analysis to give Joe some idea of how to price the service. I have assumed that Joe wishes to maintain
the same contribution margin percentage (rather than contribution margin dollars) for both systems. He
will have to decide on the price and consider factors other than cost (e.g., competitors' prices). For existing
customers, assuming a 36-month contract for this service, he will have to charge $27.46 per month in
order to achieve a contribution similar to the security monitoring service. Some administrative economies
will be achieved in providing an additional service to existing customers (for example, there will only be
one account receivable per customer). In addition, the upfront costs of the Health Alert service are
minimal because they do not include the system cost. For these reasons, Joe may be satisfied with a lower
contribution margin. While 52% may be appropriate for the security service, other factors should be
considered when setting a rate for Health Alert.

Pricing for the Health Alert service for customers who do not have the security service (standalone) are
also presented in Appendix 1. To achieve a 52% contribution, a price of $46.56 per month would be
required. Also keep in mind that as an “add-on” service, we have assumed that the customer will sign on
for a period of three years. If a customer acquires the Health Alert service as a standalone product, we
cannot guarantee that he or she will sign a three-year contract. Therefore, if SP still wants to make a 52%
margin but the length of the contract is shorter than three years, the price will have to increase
accordingly. As with the “add-on service,” this and other factors should be considered in setting the price.

The standalone price could be used in conjunction with the monthly security price to advertise the “value”
of the combined services and show the “savings” to the customer of having both. For example, based on
the 52% contribution, the “value” of the combined services would be $80 ($33 + $47), but they could be
bundled and offered at $60 ($33 + $27) to encourage customers to subscribe to both services. It is
important for Joe to keep in mind that the Health Alert monthly revenue will help to cover his one-time
costs in the first year because only one system is needed for both services.

We will need to discuss doing this type of analysis with Joe and show him how he can use it as part of his
decision-making process, bearing in mind that non-financial issues must also be considered.

(Many candidates recognized the need to analyze the existing monitoring services provided, and
attempted a margin calculation on those services, as a starting point for their analysis of the Health
Alert service. Some candidates appeared unfamiliar with calculating a contribution margin, which uses
specific product revenues and costs, and instead performed a gross margin analysis, incorporating
various revenues and costs from the income statement provided.)

(Most candidates were able to include some of the relevant elements in their margin calculation and
apply the results to the relevant Health Alert costs to determine a pricing strategy for Joe to use.
However, the contribution margin calculations generally contained errors, and support for the
calculations used in the analysis was not always provided.)
88 Appendix C — Paper II — Evaluation Guide

(The board expected candidates to perform either a quantitative or a qualitative analysis of two of the
service areas, addressing the service combinations requested by the client. Although the calculations
did not have to be perfect, they had to be reasonably well done, as the board was looking for evidence
that candidates understood how to perform and interpret a contribution margin analysis. Those
candidates choosing to attempt a qualitative analysis had to clearly demonstrate the same level of
understanding.)

(The majority of candidates performed a quantitative rather than a qualitative analysis. Better
responses considered qualitative factors in addition to their quantitative analysis.)

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

Not addressed – The candidate does not address this primary indicator. 4.7%

Nominal competence – The candidate does not attain the standard of reaching
16.0%
competence.

Reaching competence – The candidate attempts either a quantitative or a

qualitative analysis of the monitoring service, the proposed Health Alert service, 38.9%
or the offer from Gargantuan.

Competent –The candidate performs either a quantitative or qualitative

analysis in two areas: the monitoring service, the proposed Health Alert 40.2%
service, or the offer from Gargantuan.

Highly competent – The candidate performs either a quantitative or qualitative

analysis of the monitoring service, the proposed Health Alert service, and the 0.2%
offer from Gargantuan.

Primary indicator #3

The candidate prepares a cash flow statement and discusses the current working capital
issues.

The candidate demonstrates competence in Finance.

 Uniform Evaluation Report — 2006 89

Cash flow

SP has some immediate cash flow issues, but if it manages its receivables well SP should be able to turn
the situation around this year. Joe initially invested $70,000 and has even more than that invested at the
end of the 2006 year due to SP’s loss position. SP has a loan and bank debt of approximately $22,000 and
its current ratio is 0.28:1 [($30,183-$2,300) / ($110,361-$10,000)]. SP’s receivables and payables have
increased substantially over the previous year.

The amount of cash SP will require depends on the number of new customers. However, success in
attracting new business may actually create cash flow problems. This is in part because SP has to bear the
cost of the new systems upfront in year one, while ongoing revenue streams in years two and three of the
contract are relatively cost free (with the exception of the alarm monitoring services cost provided by
Gargantuan). It will take approximately 13 months of monitoring services to recoup the initial system cost
and installation fees. However, once that point has been reached, ongoing revenues net of monitoring costs
are approximately $317 annually for the remainder of the contract term.

It is important for SP to prepare a budget so it can deal with this issue in a proactive way. The current
presentation of the income statement, although not appropriate for measuring profitability, is a reasonable
approximation of cash flow. I have prepared a cash budget based on this information for 2007 in Appendix
2. I have assumed that SP will be able to acquire 425 new customers, as Joe indicated an increase of this
amount is likely. I have also assumed that installers will be used for 75% of the installations, as Joe has
indicated that he will need to hire more help in this area. Some adjustments still need to be made for the
Health Alert project, anticipated increases in receivables, inventory and payables as well as any anticipated
repayments to the owner.

The cash flow statement that I have prepared shows positive cash flow of $17,412. Once the $10,000
repayment due on the EEDC loan is taken into account, the cash flow is reduced to $7,412. When the
statement is adjusted for the outstanding Health Alert items noted above, it is likely that SP will need to
obtain additional external financing. This cash flow does not include a salary for Joe. Although Joe has
indicated that he has additional sources of income, we do not know how long he may be able to live off
these other sources.

(Many candidates addressed Joe’s cash flow concern and some prepared a cash flow projection to
indicate what 2007 would be like. Candidates did not always comment on the results of their cash flow
projection and explain what the results meant for Joe. Candidates must remember that the explanation
of the results is an integral part of the analysis.)

(Some candidates performed a cash flow analysis for 2006. However, an analysis of 2006 was not
useful to Joe, as he had already expressed his concern regarding a shortage of cash.)
90 Appendix C — Paper II — Evaluation Guide

To improve its cash flow, SP should concentrate on collecting its outstanding receivables and
implementing other initiatives to help offset the one-time upfront costs, such as requiring customer
deposits on new systems. If Joe does not need the dividend income for personal income purposes, he may
wish to postpone payment of dividends until such time as the cash flow situation in SP improves. Based
on the profitability analysis performed earlier, there is no reason why SP should not be profitable if it
properly manages its cash flow and working capital.

(Most candidates provided suggestions on ways to improve the situation in the coming year.)

(The board expected candidates to assess Joe’s concerns with respect to cash being short. To do so,
candidates could either perform a cash flow projection and comment on it, or qualitatively assess the
situation by discussing the timing issues around collection of revenue and the cost of goods and services
being provided.)

(Most candidates took the approach of doing a cash flow projection. However, some candidates
immediately recognized the timing issue, and clearly explained its impact on SP. The board was pleased
that these candidates took the time to step back and understand what was causing the problem. )

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

Not addressed – The candidate does not address this primary indicator. 6.9%

Nominal competence – The candidate does not attain the standard of reaching
18.7%
competence.

Reaching competence – The candidate discusses the cash flow situation. 43.8%

Competent – The candidate qualitatively discusses the cash flow situation, and
either prepares a cash flow projection for 2007 or recognizes that the situation 30.5%
should improve in the coming year.

Highly competent – The candidate qualitatively discusses the cash flow situation,
prepares a cash flow projection for 2007, and recognizes that the situation should 0.1%
improve in the coming year.

Primary Indicator #4

The candidate discusses the income tax areas that are of concern to SP and its owner.

The candidate demonstrates competence in Taxation.

 Uniform Evaluation Report — 2006 91

There are several tax issues that we should discuss with Joe in relation to SP.

Contractor or employee

Anna currently pays the installers as independent contractors, but is not sure this is the correct treatment.

It is important to ensure that treating the installers as independent contractors is the correct treatment. The
question is whether an employer-employee relationship exists. There is no clear definition or set of rules
to determine this, but guidelines do exist (CRA publication "Employee Or Self-Employed" (RC4110)).
Factors to consider include:

1. Control
2. Ownership of tools
3. Risk of profit or loss
4. Integration

It is important to have the correct classification. If the installers are treated as independent contractors but
CRA deems them to be employees, SP could be held responsible for unpaid source deductions (employer
and employee contributions of Employment Insurance and Canada Pension Plan) and various penalties
and interest associated with those under-remitted items. To support independent contractor status, SP
should consider the following:

Have a lawyer prepare an independent contractor agreement.

Permit the individual to work for other businesses.
Have the individual advertise his services.
To the extent possible, have the individual cover his or her own overhead, including phone service,
letterhead, equipment, and supplies.
Have the individual prepare periodic invoices, preferably on an irregular basis.
Have the individual register for the GST.
If feasible, having the individual incorporate.

However, if Joe wants to eliminate the uncertainty and know without a doubt how SP will be taxed, he
could always seek a ruling from the government on this matter.

(Candidates who addressed Anna’s concern were generally able to identify the factors to consider
when assessing whether an individual is an independent contractor or an employee and discussed
the implications for SP of improper treatment (i.e., need to issue a T-4 if an employee.)

(Better candidates applied simulation facts to the factors identified, presented a discussion of the issue,
and tried to help the client to meet the independent contractor criteria for his installers.)
92 Appendix C — Paper II — Evaluation Guide

GST

SP did not register for the GST until December 1, 2005. Registration is required when annual revenue
exceeds $30,000. SP may have to file for the previous year depending on when it hit the $30,000
threshold. If the “product sales” are treated as income, the threshold would have been exceeded in late
fiscal 2005, and returns may have to be filed for that period. This will require retroactive adjustment in
SP’s accounting records.

With respect to the GST, SP should be made aware of the following items:

SP will have to remit GST on its revenue; however, it will receive an input tax credit (ITC) for its
expenses. It is important to note that not all expenses have ITCs attached to them, as not all providers
of goods and/or services are registered for GST.
There is a $3,000 GST payable balance on the 2006 balance sheet. However, no GST is likely to be
payable in 2006, given that SP had a large loss in both 2005 and 2006.
Penalties and interest will be assessed for late filing if the net amount is an amount payable rather
than an amount receivable.
Before the pricing for Health Alert is finalized, it will have to be determined whether the service is
GST taxable. Incorrect treatment can result in a significant financial cost to SP.

(Many candidates did not address the GST issues. Those who did often recognized that there was a
difference between the date of registration for GST and the revenue reported on the 2005 financial
statements and discussed the implications for SP.)

Corporate tax considerations

The following items should be brought to Joe’s attention with regard to the corporate tax return.

1. It is important for SP to file a corporate tax return as the company has experienced losses for the past
two years that can be carried forward and applied against future income.

2. An allowance for doubtful accounts should be claimed if required.

3. Vehicle lease payments are deductible subject to restrictions as long as the vehicle is being used for
business purposes.

4. Meals and entertainment expenses are only 50% deductible for tax purposes.

5. There is a need to consider whether the revenue recognized under EIC-142 for accounting purposes
will be different from the revenue that should be recorded for tax purposes.

6. Bad debts must be identified on a specific account basis in order to be deductible for tax.

7. Since the company has had losses for the past two years, SP may want to postpone claiming the CCA
(tax depreciation) on capital assets in order to preserve balances for claiming in profitable years.
 Uniform Evaluation Report — 2006 93

8. Dividends paid out of negative retained earnings may have a legal consequence. We need to obtain
further information in this regard. However, it is important to note that if the corporation borrowed
funds to pay out dividends, the interest on the loan would not be deductible.

9. If Joe decides to pay a salary to his wife for the administrative work that she performs for the
company, it must be a reasonable amount in order to be deductible for SP.

(Most candidates were able to discuss some of the specific issues affecting the corporate income tax
return, and understood the tax treatment for meals and entertainment and the need for a reasonable
salary for Joe’s wife. Better responses recognized that losses could be carried forward and recognized
that the CCA claim could be deferred.)

Personal tax

There are other tax issues related to Joe’s involvement with SP that should be discussed with him,
generally on a personal income tax basis.

I have assumed that no salary was paid to Joe in 2005 or 2006. I have assumed this because the annual
salary expense for those years was $3,000 and Joe said that SP pays a small salary to Anna Sharp for the
accounting. While it appears that no salary was paid, dividends of $10,000 were paid in 2006. There was
an amount of $10,000 due from shareholder in 2005 and $19,000 payable to shareholder in 2006. In order
to minimize taxes on a combined corporate and personal basis and maximize his pension potential (RSP
and CPP), Joe needs to have a plan for investing and withdrawing money from SP. Joe should be told that
dividends do not create RSP room, and we should determine his optimal mix of salary versus dividends.
Alternatively, Joe may not want to pay CPP in the early years of the business and opt to receive dividends
only.

We are told that Joe’s wife often helps out with the administrative work. It appears that SP has not been
paying her a salary. Joe should consider paying his wife a reasonable salary for the work that she
performs, as it will be deductible to the company and it will present them with personal income-splitting
opportunities (as Joe’s other sources of income may put him into a higher income tax bracket than his
wife). In the future, when SP becomes profitable (it appears that it will be very profitable in the near
future), there may be more opportunities for tax splitting (e.g., have some shares owned by spouse).

The initial investment in SP came from a personal loan that Joe obtained. The interest on the loan
obtained personally by Joe is deductible because it was invested to earn investment income.

It appears that Joe will have to record a taxable benefit for the vehicle lease. SP is paying for the vehicle
expenses (lease, fuel, repairs). As a result, Joe will likely have to include an amount in his personal return
for his personal use of the vehicle and may be eligible for the standby charge reduction.
94 Appendix C — Paper II — Evaluation Guide

With regard to the home office expense, if the amount received from SP is a reimbursement of his
expenses, then the amount will not be taxable. If, however, the amount being charged to SP is classified
as rent, then it will be taxable to Joe, and he will be able to deduct a pro-rata share of various home
expenses against this rental income.

The shareholder loan of $10,000 in 2005 will create a taxable benefit to Joe equal to the prescribed interest
rate multiplied by $10,000.

(Many candidates were able to adequately address various personal income tax issues that impacted
Joe, specifically those relating to salary versus dividends, income splitting, and deductibility of interest
on the loan used for investment purposes. Most discussions in this area provided useful information to
Joe.)

(There were many taxation topics that candidates could address on this indicator. The board expected
candidates to discuss two tax areas in sufficient depth, (e.g., contractor or employee, income splitting,
GST, etc.) with one of the areas generally being contractor or employee. The board viewed the topic of
employee versus contractor as an important one to address as Anna specifically asked that it be looked
at. However, candidates’ discussion of other topics was also considered competent if they addressed
many of the smaller personal tax issues in great depth.)

(In general, candidates performed very well on this indicator. Their discussions demonstrated
knowledge in tax and were useful to Joe as a small business owner.)

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

Not addressed – The candidate does not address this primary indicator or
1.0%
does not attain the standard of nominal competence.

Nominal competence – The candidate does not attain the standard of reaching
2.6%
competence.

Reaching competence – The candidate has a reasonable discussion of one

31.7%
income tax area or identifies several income tax areas.

Competent – The candidate has a reasonable discussion of two income tax

64.4%
areas.

Highly competent – The candidate has a reasonable discussion of three

0.3%
income tax areas.
 Uniform Evaluation Report — 2006 95

EVALUATION GUIDE
SECURITY PLUS
SECONDARY INDICATOR OF COMPETENCE

Secondary Indicator #1

The candidate discusses operational issues and decisions that SP faces in the coming year.

The candidate demonstrates competence in Organizational Effectiveness, Control and Risk

Management.

The following operational issues should be discussed with Joe.

SP’s customers have signed up for a 36-month contract. Joe needs to consider what happens from a
business risk perspective if the customer backs out of the contract. In theory, it seems that he would
charge for the equipment ($495). Given that the individual will no longer be a customer, collection of this
fee may be difficult. Joe needs to consider whether SP can get the equipment back, what costs would be
involved, and whether the equipment can be reused if it is returned.

When SP started, the rate charged by Gargantuan for alarm monitoring was 15%. It has already increased
to 20%. The rate SP charges its customers is fixed for 36 months. This will reduce the contribution/profit
margin significantly. Joe should consider whether it is possible to get a longer-term rate from Gargantuan,
or whether SP can obtain a guarantee of service from Gargantuan. He should also assess the impact on
his business if Gargantuan stopped offering the monitoring service, by determining what other companies
are available to take over and what the cost would be. To address these issues, SP should obtain a long-
term contract with Gargantuan.

Joe needs to determine how long the monitoring systems will last. If they last beyond the 36-month period
and the customers continue service, the contribution margin will increase as the one-time cost of the
equipment and installation will not recur. Technological changes may make the systems obsolete, and
they may need to be replaced. Joe should also determine whether repairs to the systems will be necessary
after SP has been in operation for a few years.

SP uses contractors to do 50% of installations and expects to use them more in the future. Given the
current number of installations (325 systems in 2006), SP could not keep a full-time installer occupied.
However, at some point in the future, if sales volumes continue to increase, SP should consider whether it
would be beneficial to hire someone to do the installing. Having an employee would give SP more control
over timing of service and perhaps better quality control, and might reduce cost. Advantages of
contracting out include not having to pay for EI, CPP, holiday pay, and other payroll taxes (can be 7% to
10%), as well as avoiding idle time. These advantages are offset to some extent by higher hourly rates and
less control over how and when the work is done.
96 Appendix C — Paper II — Evaluation Guide

SP needs to consider the impact of the GST on their pricing in the future. It will likely have to absorb the
GST on its existing contracts with customers, but could raise rates on new contracts to include the GST.
This will allow SP to maintain the same return on its sales.

We need to clarify whether SP has adequate insurance coverage. SP is having cash flow difficulties; in
addition, we are not sure whether SP has a service guarantee with Gargantuan. SP could be exposed to
additional business risk.

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

Not addressed – The candidate does not address this primary indicator.

Nominal competence – The candidate does not attain the standard of competent.

Competent – The candidate discusses some of the operational issues in reasonable depth.

(Most candidates did not address this indicator. Those who did typically discussed business issues
associated with Gargantuan as SP’s sole supplier of monitoring services and the related business issues
of monitoring service contracts and systems.)

(In this simulation candidates were provided with a very broadly worded required, i.e., “You are
responsible for advising on the accounting, tax, and finance aspects of the business.” There was some
evidence of candidates struggling to figure out what to address, e.g., some focused on the financial
statement disclosure. However, most candidates were able to identify the issues of significant concern
to Joe.)

(The board was disappointed with the performance on Primary Indicator #2. Although candidates
attempted a contribution analysis, the number of errors in logic was surprising. In addition, the board
was disappointed that a large number of candidates did not analyze both pricing options, even though
Joe asked for a standalone and an add-on price. Candidates should ensure that they read the required
closely and that they respond to all of the client’s requests when preparing the report. Answering half
a question does not provide the client with very useful information.)
 Uniform Evaluation Report — 2006 97

APPENDIX 1

CONTRIBUTION MARGIN ANALYSIS

Security systems
Monthly CM per unit Year 1 Year 2 Year 3
Selling Price ($33 x 36) $1,188.00 $396.00 $396.00 $396.00
Less: Unit variable costs (20%)
(Monitoring) 237.60 79.20 79.20 79.20
Monthly CM per unit $950.40

Less: One-time upfront costs

Equipment 230.00 230.00
Installation 100.00 100.00
CM per Unit $620.40 => (13.20) 316.80 316.80
CM % 52%

Break-even analysis = $75,469.00 = $121.65 (122 systems)

$620.40

Health Alert as an “add-on” (assumes that customers sign up for a three year contract)
Monthly CM per Unit
Selling Price $988.54 /36 months = $27.46 /month
Less: Unit variable costs
(Monitoring) 432.00
Monthly CM per Unit $556.54

Less: One-time upfront costs

Equipment 30.00
Installation 12.50
CM per Unit $514.04
CM % (same as for security
systems) 52%

Health Alert as a (assumes that customers sign up for a three year contract)
“standalone” service
Monthly CM per Unit
Selling Price $1, 676.07 /36 months = $46.56 /month
Less: Unit variable costs
(Monitoring) 432.00
Monthly CM per Unit $1 244.07

Less: One-time upfront costs

Equipment 260.00
Installation 112.50
CM per Unit $871.57
CM % 52%
98 Appendix C — Paper II — Evaluation Guide

APPENDIX 2

Security Plus Inc.

Projected cash flow from June 1, 2006 to May 31,2007

Number of new systems (sales occurring evenly throughout the year) 425
Monthly rate $ 33
System material cost* $ 235
Monitoring rate - Gargantuan 20%
Cash inflows:
Monitoring services ($59,400 + 128,700 + 84,150)
(2005=150*$33*12, 2006=325*$33*12, 2007=425*$33*12*50% assumes
new systems sold evenly throughout the year) $ 272,250
Product sales 15,700
287,950
Cash outflows:
System material cost (425 x $235) 99,875
Alarm monitoring expense ($272,250 x 20%) 54,450
Installer fees (425 x $100 x 75%) 31,875
Licenses and bonds 15,560
Cost of product sold 10,990
Vehicle lease 8,000
Advertising 6,450
Miscellaneous 6,018
Meals and entertainment 5,590
Vehicle fuel 4,500
Communication 4,450
Supplies 4,200
Office 3,340
Insurance 3,300
Interest and bank charges 3,120
Salaries 3,000
Vehicle repairs 2,500
Bad debts 1,820
Home office 1,500
Total outflows 270,538
Net cash inflow 17,412
Less: EECC loan payment due (10,000)
Net Projected Cash Flow $ 7,412

*Assume an increase of 2% similar to the increase experienced in 2006

Other outflows assumed to be comparable to 2006 – additional information would change these
amounts.