CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 1

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1 CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 1 Overview The Core 1 and 2 examinations are a mix of objective format and case questions. The maximum length for an individual case will be 60 minutes. The Core cases must assess the cross-competency integration, problem-solving and communication elements, which will be introduced in Core 1 (see CPA Competency Map for the competency areas being integrated). The following case would be used at the end of Core 2 as it draws on a mix of Core 1 and Core 2 competencies, in addition to drawing on entry-level requirements. MAMMA JILL S PIZZA (Suggested time: 45 minutes) You, CPA, just got home from work when you get a call from John Mendelusk, a good friend and former roommate of yours who lives in Kenora, Ontario. John was always the chef in the house and had always dreamed of one day owning his own restaurant. John begins, Hi CPA, it is John! Guess what? The corner pizzeria is going up for sale. I ve been talking with the owner, Jill, and she s retiring, so she wants to sell the business. We re still in preliminary discussions but I m really excited about the prospects. CPA: Oh,? That place has great pizza and it s always busy. John: Exactly. Their specialty is using only the freshest ingredients which results in a great taste. This is totally consistent with my cooking philosophy! I think I m ready to make the leap into the restaurant world and my wife and kids fully support my decision. The pizza industry is competitive but I know my pizza pretty well. Jill sent me her latest financial statements. She got a private loan several years ago when she was having some cash flow issues, and the bank insists that she submit financial statements that are compliant with Accounting Standards for Private Enterprises, whatever that means. Jill also says an accounting firm, DKS LLP, performs a review of the financial statements every year. I was wondering if you could help by interpreting them for me, since you ve always been the numbers person! I m particularly interested in these things called financial ratios. I read an article about it the other day, it sounded very relevant but was all Greek to me. The only thing I know so far is that they have a lot of cash in the bank so I assume their cash flow issues have gone away. CPA: Sure John, I would love to help. John: Great! I will send you the financial statements (Exhibit I) and the magazine article (Exhibit II) by after we get off the phone. Oh, one other thing. I will be obtaining all the assets and liabilities of the business, but it is not currently incorporated. The article said that any good restaurant owner should be thinking about the tax advantages of incorporating. They are including an article on this topic in next month s issue, but I thought you might be able to tell me more. Incorporating never made sense to me and just sounds like a big administrative nightmare. How does incorporating differ from just including the income on my personal tax return? Do I really get tax advantages?

2 CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 2 EXHIBIT I FINANCIAL STATEMENTS AND SELECTED NOTES MAMMA JILL'S PIZZA BALANCE SHEET As at December 31 Assets Current Assets Cash $ 87,237 $ 96,225 $ 135,457 Accounts receivable 2,748 2,473 2,147 Inventories 1, Prepaid expenses 12,523 10,009 8,695 Non-current Assets Property and equipment 185, , ,971 $ 288,685 $ 296,226 $ 325,215 Liabilities and Owner s equity Current liabilities Accounts payable & accrued expenses $ 132,095 $ 115,446 $ 122,412 Non-current liabilities Long-term debt 79, , ,491 Owner s equity 77,465 72,296 50,312 $ 288,685 $ 296,226 $ 325,215

3 CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 3 EXHIBIT I (continued) FINANCIAL STATEMENTS AND SELECTED NOTES MAMMA JILL'S PIZZA INCOME STATEMENT For the year ended December 31 Revenue $ 525,841 $ 503,272 $ 503,818 Cost of sales 126, , , , , ,955 Salaries and benefits 162, , ,116 Advertising and related costs 49,035 47,174 45,593 Rent 32,278 32,343 31,685 Utilities 100,608 98,954 96,361 General and admin expenses 11,551 13,966 13,527 Depreciation and amortization 32,681 32,407 31,446 Interest expense 5,539 7,594 10, , , ,402 Net income $ 5,169 $ 21,984 $ 27,553

4 CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 4 EXHIBIT I (continued) FINANCIAL STATEMENTS AND SELECTED NOTES Select Notes to the Financial Statements For the year-ended December 31, Description of the Business is a food establishment registered as a sole proprietorship in the province of Ontario. These statements do not include all the assets, liabilities, revenues and expenses of the owner. The business is not subject to taxes as its income is taxed directly to its owner. Substantially all revenues are derived from retail sales of pizza and other food and beverage products. 2. Accounts Receivable Accounts receivable consists of amounts owing from catering clients. There are no allowances for doubtful accounts recorded against these amounts. 3. Long-term Debt Long-term debt consists of amounts owing to a private lender. The loan has an interest rate of 5%. The entire loan is due December 31, 2017, with interest accrued being paid yearly. can repay amounts owing early without penalty. 4. Related Party Transactions In 2015, paid Pappa Joel s Construction $32,000 for renovation of the store. The sole proprietor of also owns 50% of Pappa Joel s Construction. The amounts paid were at market value and in the ordinary course of operations. The amounts are recorded in Salaries and Wages for the year. In addition, there are amounts of $75,856 ( $72,444) paid to the sole proprietor for her time spent managing the store. These amounts are recorded in Salaries and Wages for the year.

5 CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 5 EXHIBIT II EXCERPTS FROM ARTICLE FROM MODERN CHEF MAGAZINE Financial Ratio Industry Averages for Local Pizzerias Gross margin 80% Prime costs as a percentage of sales 60% Inventory turnover (based on ending inventory balance) 7.2 days Prime costs is an area often overlooked by restaurant owners. Consisting of cost of sales and salaries and wages, this is where the battle for profitability is won or lost. Not only do these two costs represent the biggest expenditures in your restaurant, but these are areas where you have control over the costs.

6 CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 6 MARKING GUIDE MAMMA JILL S PIZZA To: From: Subject: John Mendelusk CPA (MJP) Attached is my memo outlining the financial ratio analysis to help interpret the financial statements and tax considerations related to incorporating. CPA Mapping-Technical competencies: Interprets financial reporting results for stakeholders (external or internal). (Core 1 Level A) Evaluates the entity s financial state (Core 2-Level A) Evaluates strategic alternatives (Core 2-Level B) Assesses a corporate entity s general tax issues. (Core 1 Level B; was also Level B at Entry so no new knowledge expected) CPA Mapping-Enabling competencies: Identifies the purpose of computations and analyses, and considers qualitative factors. 1. Financial Reporting (ratio analysis) (The candidates should calculate ratios and give an interpretation of the significance of these ratios. Candidates should recalculate only the three ratios provided in the magazine article and compare to the benchmarked data. Candidates could also recognize the hints in the simulation that there may be cash flow issues or the significant decrease in debt balances despite not having to repay the loan until 2014, and suggest ratios that may give some insight into these issues.) The magazine article you provided gave me some relevant information regarding financial ratios. I have calculated the ratios they have mentioned below. Gross margin Gross margin is calculated as: Revenues cost of sales Revenue Industry average 76% 78% 80% 80%

7 CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 7 MJP s gross margin has been declining since 2013, and has dropped below the industry average. Gross margin represents the percentage of total sales revenue that the company retains after considering its direct costs associated with producing the good, and is a measure of profitability potential. Given that MJP s specialty is providing the freshest ingredients on their pizza, I would have expected their gross margin to be lower than industry average, which is the case. However, the gross margin ratio has been declining. Although this is indicative that perhaps costs are not being controlled appropriately, it could also be due to other factors such as more stores being open in the area which could lead to more competition and thus MJP being forced to charge less per pizza (which would decrease the gross margin). More investigation would have to be done to determine if this is the case. Prime costs as a percentage of sales Prime costs as a percentage of sales, is calculated as: Cost of sales + Salaries and wages Revenues Industry average 55% 49% 49% 60% MJP s prime costs as a percentage of sales went up in 2015, but are overall significantly below the industry average. Prime costs as a percentage of sales is a good indicator of cost control, as it takes into account the most significant controllable expenses. This means that MJP s expenses are good compared to the rest of the industry. This is further evidence that the decrease in gross margin is likely not due to cost control issues but rather a competitive pricing issue. In addition, the increase in the ratio in 2015 appears to be a one-time event. The salaries and wages in 2015 included an amount of $32,000 for renovation costs which I would not expect to occur again in subsequent years. If you remove that amount from salaries and wages, the prime costs as a percentage of sales is 49%, which is in line with 2014 and Inventory turnover Inventory turnover (in days) is calculated as: 365 days Cost of sales Ending inventory balance Industry average 3.0 days 3.0 days 3.4 days 7.2 days

8 CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 8 MJP s inventory turnover has been fairly consistent since 2013, and is significantly below industry average. The inventory turnover ratio is a good measure of how long the inventory of a company (the food items in this case) is sitting at the store before being used. MJP s inventory turnover, when compared to industry average, is consistent with my expectations since MJP s focus is on fresh ingredients, and therefore the inventory of food would be expected to turn over more rapidly. There may be some room to maintain slightly higher inventory levels (especially with non-perishable items such as beverage sales) if there is a need to reduce costs, as high inventory turnover may mean you are not able to take advantage of price discounts on larger volumes of purchases. Current ratio You have mentioned that MJP has had cash flow problems in the past, but that you re not worried about it anymore because they have a significant cash balance. However, this may not necessarily be the case, as there may also be a significant amount owing to other parties at any point in time. A good way to measure financial health in terms of liquidity is to calculate the current ratio. The current ratio measures a company s ability to pay back its short-term liabilities. Current ratio is calculated as: Current assets Current liabilities A current ratio under 1 would suggest that a company cannot pay its liabilities as they become due. In this case, it is clear that MJP s current ratio has been declining significantly since 2013, and has fallen to below 1. I am concerned that MJP may not have sufficient resources to pay off its liabilities in the short term. Although this is not the only factor to consider, you should be prepared to infuse cash into the company if you are going to buy it to ensure it can pay off its liabilities in the short term, as well as ask some additional questions of Jill to determine the cause of the declining current ratio. At first glance, it appears as though the long-term debt has declined significantly since 2013, although repayment is not required until This may be a significant cause for why the current ratio has deteriorated so rapidly.

9 CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 9 Debt-to-equity ratio Another good measure of financial health is the amount of debt carried by an entity. The debt-to-equity ratio is a measure of what proportion of equity and debt the company is using to finance its assets. Debt-to-equity is calculated as: Total liabilities Total equity The debt-to-equity ratio has declined over the past 3 years. This is usually a sign of positive financial health of a company, as the company is able to finance more of its assets through equity rather than through debt. Overall (Candidates should recognize the need to give some qualitative considerations on the purchase, given that CPA is an advisor and the friend is coming to the CPA for advice.) Based on the above ratio analysis, MJP appears to be in relatively good financial health. There are some areas you should look into further (e.g., the deteriorating liquidity situation) but overall there are no concerns as a result of the analysis. Another factor you should consider is that the food industry is fairly risky due to the high capital costs required, and therefore companies are typically highly leveraged. In addition, it can be difficult to retain customers as customers can very easily purchase pizza from other companies. However, these risks can be mitigated with the appropriate operating strategy. 2. Tax (The candidates should discuss the advantages and disadvantages to incorporating. Inherent in this discussion is a quick overview of what would be the tax consequences of not incorporating (i.e., operating as a sole proprietor). Candidates should provide only generic advantages to incorporating. Candidates could recognize some of the case facts that would support these advantages (e.g., the friend has wife and kids so income splitting would be relevant, or MJP has been making money so there would be no losses to offset) and make a recommendation.)

10 CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 10 You have asked about the tax considerations of incorporating. Whether you incorporate or not depends on your personal circumstances. If you were to operate the company as a sole proprietor, any income from the company (the net income of the business) would be included in your tax return in the year it is earned and taxed at your marginal tax rate. Any salaries you take from the business would be considered owner s drawings and would not be taxed since the business income was already taxed in your hands. The main tax advantages of incorporating would be: a) Small Business Deduction If an entity qualifies as a Canadian Controlled Private Corporation (CCPC), it is taxed at a lower rate (currently 11%) on the first $500,000 of their active business income. A CCPC is a private corporation in Canada that is not controlled by non-residents. Since you reside in Kenora, Ontario, the corporation (MJP Inc.) would qualify as a CCPC. As there appears to be no investment income on the income statement, all of MJP Inc. s income would be active business income carried on in Canada. As such, MJP Inc. would use the Small Business Deduction and would be taxed at a lower rate (currently 11%) on the first $500,000 of its active business income. b) Capital Gains Exemption Each individual is entitled to be exempt from tax of up to $800,000 (indexed to inflation after 2014) of capital gains on qualified small business corporation (QSBC) shares. In order to qualify as QSBC shares, the shares must meet the following criteria: o At the time of disposition, they are shares of a small business corporation (SBC). An SBC is a CCPC, 90% of the fair market value of the assets of which are assets that are used principally in an active business carried on primarily in Canada. o For the 24 months preceding the disposition, the shares have been held by the person selling the shares or a person related to that person. o For the 24 months preceding the disposition, the shares are of a CCPC, more than 50% of the fair market value of the assets of which have been used principally in an active business carried on primarily in Canada. If you have not used your Capital Gains Exemption, incorporating would allow you to be tax exempt from the capital gains resulting from your shares when you sell them, up to at least $800,000. c) Tax deferral A corporation allows you to leave the income you earn each year within the corporation. As a result, you would not be taxed on the amount until you take it out of the company, as compared to a sole proprietorship where you would be taxed immediately on income from the company every year. This may allow you to defer your taxes until later on (say during retirement) where your marginal income tax rate is lower and thus you will end up paying lower taxes on the amount. d) Income splitting

11 CPA MOCK Evaluation End of Core 2 (combined Core 1 and Core 2) Page 11 A corporation also allows you to split the income from the company amongst your shareholders by issuing dividends. Therefore, you could have your wife and kids as shareholders of the company which would allow you to issue them dividends, thus spreading the income from the company across all family members. The main disadvantages of incorporating are: Additional administrative costs associated with incorporating and ongoing compliance, such as filing corporate tax returns. If your business is operating at a loss in any particular year, you would not be able to offset that loss against your personal income, like you would be able to as a sole proprietor. Given that MJP has been making money for the past three years, the disadvantages of incorporating are reduced. I would recommend you incorporate if you purchase MJP.