CO22101 E PC02 Case Annotated PDF

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Core 2 — Practice Case 2 Case (60 minutes) Wallace Inc. is a small, publicly traded manufacturer with three divisions: 1. Electronics (Electro) assembles electronic products for industrial users. 2. Consumer Products (Consumer) assembles electronic products for consumers. 3. Circuitry (Circuit) manufactures the electronic circuit common to the products sold by Electro and Consumer, and sells any excess Circuit output externally. Up until very recently, profits for Wallace exceeded expectations. However, increased competition and a recent downturn in demand for electronic products have caused a considerable drop in profits for the company. One of the divisions, Circuit, is losing money. Senior management believes that outsourcing the circuitry may be more cost effective than producing it internally. Management has negotiated a bulk purchase price of $28/unit with an outside supplier whose only line of business is building circuitry. At the board meeting on October 1, 2021, a proposal was presented to the board to outsource the circuitry for Wallace’s other divisions and to shut down Circuit. Information about the profitability of its divisions for the first nine months of the current fiscal year, as well as specific information on Circuit, are provided in Appendix I. The fiscal year is January 1 to December 31.

Chartered Professional Accountants of Canada, CPA Canada, CPA are trademarks and/or certification marks of the Chartered Professional Accountants of Canada. © 2021, Chartered Professional Accountants of Canada. All Rights Reserved. Les désignations « Comptables professionnels agréés du Canada », « CPA Canada » et « CPA » sont des marques de commerce ou de certification de Comptables professionnels agréés du Canada. © 2021 Comptables professionnels agréés du Canada. Tous droits réservés. 2020-11-25

Commented [CPA1]: Timing: As with all Core cases, this case is 60 minutes. Start with 15 minutes for reading, outlining, and planning (ROP), then 45 minutes for writing. Note your start and end time for the case and the ROP on your outline. This is a good habit to get into to ensure you stick to your time budgets.

Commented [CPA2]: You are told here that Wallace has three divisions and that one of the divisions, Circuit, supplies parts to the other two. You should highlight this or make a margin note because it’s likely to be important given that the author specifically listed the divisions.

Commented [CPA3]: The fact that management “believes” that outsourcing may be more cost effective is a trigger that this may not be the case. Commented [CPA4]: This information will be important considering the information already provided that Circuit supplies the other divisions at this time and management believes that it should be outsourced.

Core 2 — Practice Case 2

Case

It is now October 15, 2021. The president of Wallace, Jeff Wallace, has approached you, CPA, an analyst in the corporate office, to assist in answering the board’s requests. “After our last board meeting, some board members were surprised by our decision to outsource the circuit units and questioned whether it will truly be cost effective. Please prepare a memo for me evaluating the outsourcing of the circuitry work from a quantitative and qualitative perspective, and provide a recommendation. “As well, we are dealing with a couple of unusual financial reporting issues this year — one with regard to a lawsuit and one with regard to the costs associated with the purchase of some new robotics equipment (Appendix II). Can you recommend appropriate accounting treatments for management’s consideration?” Wallace reports under IFRS. After your conversation with Jeff, you also met with the general manager of Circuit, Edward Horton. Edward blames the transfer pricing policy for the performance of Circuit. He is also concerned about the corporate costs allocation policy and the effect that this policy has on management bonuses. While you do not have sufficient information to recast the financial statements, you decide to discuss these concerns qualitatively in your memo to start. Your notes from your meeting with Edward are summarized in Appendix III. Your response should be no longer than 1,800 words, excluding any Excel files.

Commented [CPA5]: Note the “now” date on your outline. Commented [CPA6]: Role: You are a CPA and the analyst for the corporate office.

Commented [CPA7]: This is another trigger to the fact that it may not be more cost effective to outsource the circuit units. Commented [CPA8]: Required #1 (R1) and #2 (R2): Provide a memo to the president, Jeff Wallace, on whether the circuitry work should be outsourced. Your analysis needs to have three components: quantitative analysis, qualitative analysis, and a recommendation. Details on the costs are in Appendix I.

Commented [CPA9]: Required #3 (R3): An analysis of the two accounting issues must be completed. Details are in Appendix II. Commented [CPA10]: Edward Horton will be a user of this information in addition to the board and Jeff Wallace.

Commented [CPA11]: Required #4 (R4) and #5 (R5): Edward blames the transfer pricing policy and the corporate cost allocation policy on the issues with Circuit as well as the impact on management bonuses. These are to be addressed to determine whether or not he is correct. Commented [CPA12]: Each case in PEP will include a word limit at the end of the narrative to ensure that you limit your analysis to what would be attainable in 60 minutes. On exams, you will only be given a time limit, not a word limit.

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Core 2 — Practice Case 2

Case

Appendix I Divisional financial information For the nine months ended September 30, 2021 (Unaudited) Electro Sales — external Sales — internal Cost of goods sold

$ 6,000,000 — 6,000,000 3,600,000

$

Commented [CPA13]: R1 and R2: This information provides details on the “sales” from Circuit to the two other divisions and identifies the fact that there are external sales made by Circuit.

Circuit

Consumer

Total

825,000 1,410,000 2,235,000 2,600,000

$ 7,000,000 — 7,000,000 3,500,000

$ 13,825,000 1,410,000 15,235,000 9,700,000

Gross margin Divisional costs

2,400,000 1,000,000

(365,000) 400,000

3,500,000 1,700,000

5,535,000 3,100,000

Operating income

1,400,000

(765,000)

1,800,000

2,435,000 1,500,000

Corporate cost allocation* Income (loss) before taxes Income taxes at 36% Net income

500,000

500,000

500,000

$ 900,000

$ (1,265,000)

$ 1,300,000 $

935,000 (336,600) 598,400

*Information on the corporate cost allocation can be found in Appendix II. Circuitry division Capacity of manufacturing facility Internal transfers External sales

Units per year

Units to Sept. 30, 2021

Transfer/ sales price

133,333 100,000 33,333

100,000 75,000 25,000

$18.80 $33.00

Note 1: Divisional transfer pricing is set equal to the variable cost of production. Costs incurred per unit: Materials Labour Variable manufacturing overhead Fixed manufacturing overhead Total

$

6.00 8.00 4.80 7.20 $ 26.00

Also take note of the date — this is only nine months of financial information. That could be important in your analysis.

Commented [CPA14]: R5: Corporate costs are divided evenly between the divisions, which may not be appropriate. The details in Appendix II should provide you with the details you need to determine whether the costs are allocated appropriately. Commented [CPA15]: R1 and R2: Based on the divisional financial information, Circuit is operating at a loss, which would be the reason for management’s request to discontinue the division.

(Note 1) Commented [CPA16]: R1 and R4: A lot of information is included in this chart. The first item shows the capacity for Circuit, which you can see in the next line has been met. The fact that Circuit is at capacity will be key information in determining the appropriate transfer price. Also included here is the fact that the internal sales are made at variable cost such that fixed overhead is not covered in any way by the internal transfers — which explains why the division is operating at a loss if the fixed overhead costs are allocated in the financial information above. It is also shown here that Circuit can sell its circuitry to external parties for a significantly higher amount of $33, which covers all its costs. This is further suggestion that it is the accounting and not the operations that is the issue here. The costs incurred per unit will be useful in your quantitative analysis

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Core 2 — Practice Case 2

Case

Appendix II Corporate costs Nine-month summary Information technology department (Note 1) Marketing department Legal department (Note 2) Human resource department Accounting department Year-to-date corporate costs

$

475,200 463,000 121,500 210,000 230,300 $ 1,500,000

Commented [CPA17]: R4: This appendix provides the information required to determine whether the corporate costs are allocated appropriately. The total of the corporate costs shown here agrees to the cost in the divisional information in the prior appendix, which is allocated equally between the divisions. Each of the departments’ costs listed in this appendix should be analyzed to determine how it should be allocated.

In accordance with corporate policy, these costs have been allocated evenly to each of the divisions. Notes: 1. Wallace purchased two new pieces of robotics equipment in January 2021. The equipment is intended to automate and reduce costs related to the packing process when shipping the assembled Electro and Consumer products. The total cost of the robots was expensed in the information technology department, so the cost allocation is about $125,000 higher than the same period last year. The cost breakdown is as follows: IT department time spent researching the best robots Cost of the robots Delivery Assembly and installation Testing to ensure correct functioning Repairs since installation Total cost of the robots

$

$

10,000 80,000 8,000 15,000 7,000 5,000 125,000

2. Electro is being sued for wrongful dismissal by a former division manager who was fired in January 2021. Electro has incurred an estimated $100,000 in outside legal fees in this case so far. Wallace anticipates returning to lower, more normal legal costs next year, as the case is expected to settle in early 2022. No provision for this settlement has been recognized. The outside legal team indicated that at this point there is a 55% likelihood that the courts will award the case in favour of the former division manager and Electro will be required to pay $350,000. Alternatively, if Electro wins the case, Electro will not have to pay anything to the former division manager. Electro proposed an out-of-court settlement to the former division manager of $120,000, but has not received a response. The lawyers have indicated they believe the other party is unlikely to accept the settlement.

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Commented [CPA18]: R3: Note 1 provides the information required to analyze the first accounting issue, which is whether the cost of the robots should be capitalized or expensed. A list of the costs incurred to acquire the robots is included, which is a trigger to consider each of the costs separately as there is likely to be different treatment for each based on the CPA Canada Handbook – Accounting criteria. R5: This information is also going to be useful when thinking about how corporate costs are allocated, and whether these specific costs should be allocated to all of the divisions.

Commented [CPA19]: R3: Note 2 provides the information for the second accounting issue, which relates to a wrongful dismissal suit. The issue is whether or not the contingent liability should be recognized based on the facts as given. R5: This is also directly related to the corporate costs and should be added to your outline to consider whether these costs should be allocated to all of the divisions.

Core 2 — Practice Case 2

Case

Appendix III Summary of the meeting with Edward Horton, Circuit general manager Edward Horton explained that Wallace is a decentralized organization and that each division is run independently by a general manager. Compensation for the managers is based on a salary with bonuses for achieving set profitability targets. Edward said:

Commented [CPA20]: R5: Information is provided here on the impact the transfer pricing policy and corporate cost allocations have on the performance bonuses.

“The other divisions are allowed to buy and sell as they wish, but we have to ensure that Wallace’s internal requirements are met before we can sell outside. I know that our division can generate additional revenue. The price we receive from our internal sales isn’t even close to what we receive when we sell our product to external buyers. The transfer price is based only on the variable cost of production. That only worked in the days when we could not sell all of our production. There is a robust external market for the circuitry, therefore, we could sell more to the outside market if management would let us. “On top of that, head office calls us a profit centre and bases our bonuses on our divisional net income. It isn’t fair. In addition to a low transfer price, we are allocated a high amount of costs from the corporate office. Take a look at the supporting information they sent us this quarter explaining the allocation (see Appendix II). It’s got nothing to do with our division, as far as I can tell. I wish senior management would do something to make it fairer for us.” “Also, I don’t think the proposed closure of Circuit is going to save as much as senior management thinks it is. Yes, most of the manufacturing overhead costs would be saved, but Circuit supervisors would be transferred to other divisions. Their total salaries are about $250,000 per year. There would be no savings in corporate costs even if Circuit is closed. Wallace would also have to discontinue sales of circuitry to external parties, as the sales team currently expensed in Circuit’s divisional costs would be let go.”

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Commented [CPA21]: R1: The cost details provided here will be useful for the outsourcing analysis....