CPA Case Analysis 1: Quality Contracts Inc.Instructions

Instructions and Submission

• Weight 8% of the final grade
• Due no later than 11:00 p.m. on Sunday ofUnit 5

Description

In all accounting specialization courses, the case method is used to enable you to apply concepts, share ideas, and improve communication skills. Through case work students are able to discover for themselves the usefulness of concepts, how to apply them in practice and their benefit to organizational decision-makers. The expectation is to complete the required cases during specific units. All cases in this course are integrative, meaning concepts from prior accounting specialization courses have been included in each case study, however the heaviest weighting of the case is from the current course content. Effective analysis consists of quantitative and qualitative analysis in order to provide a well-rounded solution.

In order to complete your case analysis successfully, you should

• identify the role you are playing,
• assess the financial reporting landscape, considering the user needs, constraints, and business environment,
• identify the issues,
• analyze the issues (qualitatively and quantitatively), and
• provide a recommendation and conclusion

CPA Case Analysis 1: Quality Contracts Inc.

Brief Description

Students will complete the case "Quality Contracts Inc." published by the Chartered Professional Accountants (CPA) of Ontario (the Institute of Chartered Accountants of Ontario).

The purpose of this case is to provide a multi-subject simulation that requires application of technical knowledge in assessing and critiquing accounting policies and application decisions.

The primary learning objectives of this case include:

1. Analyze a variety of accounting issues
2. Provide advice and guidance on a business decision: a proposed acquisition

Submission Instructions

Professional accountants continue to be recognized for their strong technical knowledge. A strong technical background is still a foundational trait for professional accountants in protecting the public interest. Professional accounting bodies across the globe are recognizing the increased importance of higher-order cognitive skills such as critical thinking, problem solving, and analytical ability. Case analysis is an important tool for developing these higher-order skills for financial reporting.

Once the case is solved, upload your solution to the dedicated space on Brightspace in Word format.

Please complete the Unit 5 component of the Case Analysis Work-Sheet.Respond in a single Word doc (or comparable text editor).

Evaluation and Feedback

The overall grading will be out of 100. Below is a breakdown of the grade; note that simply meeting expectations garners an average grade. The rubric will be manually graded by your Professor.

Please only discuss the issues listed in the rubric for this case. There are additional issues in the case, however, they are out of scope for the evaluation of this case study. Only issues 1-6 in the rubric will be assessed. Ignore any issues related to Auditing.

Activity/Competencies Demonstrated	% of Final Grade
Identification and Analysis of Issues (80%)
Intermediate Accounting I & II
Issue 1: Sales Orders	/10
Issue 2: Inventory	/10
Issue 3: Asset Retirement Obligation	/10
Issue 4: Error Correction	/10
Corporate Finance
Issue 5: Potential Selling Price of QCI	/20
Issue 6: Cash Flow from Web-Based Operations	/20
Recommendation (10%)
a. Provides appropriate recommendations given the case facts and analysis completed	/10
Attention to Detail (10%)
a. Spelling, grammar, and APA 7th edition formatting	/10
Total	/100

Question 3 (90 minutes) Dr. Mateo Case is an optometrist and the sole shareholder of Quality Contacts Inc. (QCI), an optical company that sells prescription disposable contact lenses and eye glasses out of its location in Cabbagetown, a neighbourhood in Toronto. QCI is managed by Mateo and has a May 31 year end. You, CA, are a manager with Lark & Bell LLP (L&B). Yesterday, you and Tony Bell, the engagement partner, met with Mateo at QCI. Mateo asked for this meeting to discuss the future of QCIs operations. L&B has performed review engagements for QCI for the past three years. Mateo began, "I have decided to live year round at my cottage in northern Ontario and have therefore been considering two options regarding the future of QCI. I believe I could sell QCI and live off the proceeds or I could oversee the operations of QCI from my cottage, as a web based company selling contact lenses only. I would like your help in determining the best alternative for me. "I will require an audit of QCI for 2010, as I believe a buyer would require audited statements. I need your assistance in determining a reasonable selling price for the shares of QCI. I have brought you a draft income statement for the 2010 year end. I believe the last three months of sales are the best indicator of future sales potential so I have included information for that period as well (Exhibit I). I have also included some background information on QCI which may be useful to you (Exhibit II). "I have notes on how the web-based operations would work (Exhibit III) and would like to know how much cash I would be able to generate if I were to pursue this option. I am only concerned with my cash flows for the next four years, until I am eligible to access my pension income in 2014. I estimate I will need between $300,000 and $400,000 to cover my expenses until 2014. "I met with a web consultant who provided me with information on a system that could be used if I were to operate QCI as a web-based company (Exhibit IV). I am concerned about the security with this kind of operation and would like you to identify the significant risks that the web-based company would be exposed to as well as any practical recommendations to mitigate these risks." After the meeting you reviewed some of the accounting records and further discussed the business with Mateo. A summary of some of the issues that you discovered while out at QCI are in Exhibit V. It is now June 4, 2010 and you are meeting with Tony to discuss the QCI engagement. Tony asks that you prepare a memo to him addressing the issues raised by Mateo in the meeting and asks that you discuss the accounting issues you discovered while at QCI and identify the related audit procedures that should be performed. For now, he would like you to ignore the personal income tax implications of the sale of QCI and any first time audit considerations. Copyright 2010 ICAO School of Accountancy 12 13 Copyright 2010 ICAO School of Accountancy EXHIBIT I QCI EXCERPTS FROM FINANCIAL STATEMENTS* FOR THE PERIODS ENDED 3 months to 12 months to 12 months to May 31, 2010 May 31, 2010 May 31, 2009 (Draft) (Draft) (Reviewed)** Revenues: Contact lenses $228,764 $805,306 $720,678 Glasses and frames 63,892 356,970 365,094 Other 10,200 38,000 35,100 302,856 1,200,276 1,120,872 Cost of goods sold 90,689 420,770 412,593 Gross profit 212,167 779,506 708,279 Operating expenses: Selling 21,479 99,660 97,720 General and administration 98,236 455,055 446,024 Depreciation 3,000 12,000 12,000 Lease 9,000 36,000 36,000 Interest 2,000 4,000 131,715 604,715 595,744 Income before taxes 80,452 174,791 112,535 Income taxes 13,275 28,841 18,568 Net income $ 67,177 $ 145,950 $ 93,967 * Other than inventory, the balance sheet has no significant assets or liabilities. ** The financial statements of QCI follow CICA HB- Accounting- Part V, XFI, without differential reporting options. EXHIBIT II BACKGROUND INFORMATION PROVIDED BY MATEO QCI has a regular customer base which I anticipate will make it an attractive acquisition for another business in the same industry. I have been in communication with the owners of two other optical stores which operate in similar markets and learned that on average they made about a 10% after tax return on their investments. I believe that any purchaser would have their existing staff place all orders. This would eliminate the salary currently being paid to QCIs order clerk of $60,000. In recent years QCI has not invested much in advertising as its current customer base consists of mostly repeat customers. Other optical stores spend around $85,000 annually to attract new customers. The current store location is leased at a rate of $3,000 per month. It is located within walking distance from several apartments and businesses making it convenient for customers to access. QCI had a bank loan which they entered into in 2008 with a fixed interest rate of 5% that was secured by a personal guarantee I provided. This loan was repaid in full in January 2010. Copyright 2010 ICAO School of Accountancy 14 EXHIBIT III NOTES ON OPERATING QCI AS A WEB-BASED COMPANY Ordering The store location is only necessary for the glasses portion of the business as customers typically want to try on frames before committing to a purchase. Since the sale of contact lenses could all be made via internet orders, I could oversee the operations from my cottage. QCI would order the contact lenses from our suppliers as soon as the customer places their order. We would have the contact lenses delivered from our supplier directly to the customer within two days so there is no need to maintain an inventory of contact lenses on hand. QCI would accept credit cards as the only form of payment from customers and would have a no return policy as the lenses are for each customers specific prescription. Customers To retain existing customers, QCI would send a mass mailing explaining the changes to the business and providing the new contact information, etc. Such a campaign is estimated to cost around $12,000. As a result of the mailing QCI should be able to retain approximately 75% of existing contact lens customers. There are currently approximately 1,000 existing customers who purchase an average of 30 pairs of disposable contact lenses each month. Although it varies by brand, the average retail price per pair of lenses is $2. The remaining contact lens customers may leave either because they do not trust the security behind making online payments or because they would prefer to purchase both contacts and glasses from the same location. I am not interested in spending a great deal of time and effort trying to grow the web based business as the plan is to ease into semi-retirement. I estimate that sales will increase slowly so I would expect only a 2% increase in annual sales. Copyright 2010 ICAO School of Accountancy 15 EXHIBIT III (continued) NOTES ON OPERATING QCI AS A WEB-BASED COMPANY Operating Costs The cost of contact lenses will remain around 38% of their selling price. Selling expenses are expected to be around 9%. This will include payment to advertise on search engine websites. General and administration expenses are expected to be $108,000 in the first year and then increase 2% annually. These costs will now include wages for only one part time staff member to assist me in the business. Currently customers pick up their lenses at QCIs store. However under the web-based option, QCI will pay shipping charges to have the suppliers ship the lenses directly to the customer. The additional shipping charges are expected to be approximately 10% of sales. I anticipate the cost of setting up the web-based internet site will be around $30,000, with annual service and maintenance fees of $3,500. Copyright 2010 ICAO School of Accountancy 16 EXHIBIT IV NOTES FROM MATEO'S DISCUSSIONS WITH WEB CONSULTANT Ordering All customer orders will be placed via the website that will be developed and maintained by the web consultant. As all orders will be placed online, customers must pay using a major credit card. Funds will then be deposited into QCIs bank account directly from the credit card companies. When an order is placed, the customer will be asked to enter the following information onto the web page: o brand and quantity of pairs of contact lenses o prescription requirement for each eye o personal information including shipping address o credit card information All information will be entered on one page, making the order process quick and easy for the customers. If the customer fails to enter the quantity of lenses, the system will not allow them to hit "Submit". The system will prompt them with an error message and require them to enter the quantity of lenses to proceed. This is the only field that when not completed will prevent customers from placing an order. When the customer is done inputting information, they will click on "Submit" and the information will automatically transfer to QCIs sales tracking sheet and the general ledger will be updated concurrently. Once the transaction is submitted the system will produce a sales receipt which indicates the total cost of the order with details of what was purchased. Shipping Once the orders are received by the system, QCI will take the information on the sales tracking sheet and contact the suppliers to place the orders and arrange for their shipment to the address input by the customer. The part-time staff member will count the total number of orders on the sales tracking sheet and compare this to the total number of orders recorded in the general ledger for that day. Although counting the orders daily may be time consuming, this will ensure that the system is operating as it should. Copyright 2010 ICAO School of Accountancy 17 EXHIBIT IV (continued) NOTES FROM MATEO'S DISCUSSIONS WITH WEB CONSULTANT Information System The mainframe will be located in the cottage where QCIs operations will be run. The system will be setup to make automatic weekly back-ups of the sales tracking information which will be stored on a separate drive on the mainframe. There will be logins and password setup on the computer for each user. The web consultant can use an internet connection to remotely access the system to install updates and make any necessary changes to the system. The web consultant can even fix a bug or perform an upgrade to the system while it is running so there will be no downtime. Copyright 2010 ICAO School of Accountancy 18 EXHIBIT V ACCOUNTING AND OTHER ISSUES DISCOVERED WHILE AT QCI In March 2010, as part of a special "pay now and get 5% off" promotion, sales orders were placed by 140 customers for 30 pairs of contact lenses for each of the remaining nine months of 2010. QCI recorded the full amount of these sales as revenue in March as these orders had been paid for in full. The contacts, however, are typically not ordered from the suppliers until closer to the month for which the orders relate, as customers pick up their orders on a monthly basis. Mateo indicated that a significant number of frame styles are out dated with a book value of $10,000. Mateo is hopeful that the frames will come back in style however there has been no indication of this to date. The frames cannot be returned to the supplier. Mateo is planning to sell these at 50% of cost in order to move them. It is typical in the industry to have to write down a portion of inventory annually as the styles change so frequently. QCIs inventory of frames is currently valued at $50,000. QCI has 60 specialty sunglasses in inventory (separate from the frames) recorded at a cost of $200 per pair. In January, 2010 Mateo decided to reduce the selling price of the sunglasses from $250 to $150 as this is the price he believes will guarantee their sale. QCI has never had to lower the price of sunglasses before as they typically sell quickly and Mateo does not expect to have to lower the price of any other specialty frames in the future. QCI is planning to count the inventory on June 6, 2010. The current store location is leased over a five year term which commenced on June 1, 2008. I requested a copy of the lease agreement and discovered that an obligation to pay for the cost to restore the building to its original condition was built into the lease. The contractors who performed the leasehold improvements at the time estimated that cost to restore the building to its original condition would be $20,000. This obligation has not been recorded in QCIs financial statements. Copyright 2010 ICAO School of Accountancy 19