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Excerpt - Uniform Evaluation Report — 2004

THE INSTITUTES OF CHARTERED ACCOUNTANTS


OF CANADA

I
2004 Uniform Evaluation
PAPER I Time: 5 hours

NOTES TO CANDIDATES:

(1) Simulations requiring a knowledge of the Income Tax Act, the Income Tax Application Rules
1971, and the Income Tax Regulations are based upon the laws enacted at April 30, 2004, or in
accordance with the provisions proposed at April 30, 2004.

Provincial statutes, including those related to municipal matters, are not examinable.

(2) Tables of present values, certain capital cost allowance rates and selected tax information are
attached at the end of the evaluation paper as quick reference tools. These tables may be used in
answering any simulation on the paper.

(3) Answers or parts of answers to simulations will not be evaluated if they are recorded on anything
other than the writing paper provided.

**********

Copyright © 2004

The Canadian Institute of Chartered Accountants


277 Wellington Street West, Toronto, Canada M5V 3H2

Reprinted by the ICAO with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants, Toronto, Canada. Any
changes to the original material are the sole responsibility of the ICAO and have not been reviewed or endorsed by the CICA.
Excerpt - Uniform Evaluation Report — 2004 26

You are a CA who has just been hired by Saskatoon Fields Forever Inc. (SFF), formerly Mugs
Partnership (MUGS) as the controller. It is August 1, 2004, your first day at SFF. You are meeting
with Meghan Leslie, the company President. Meghan began, “I’m sure glad that you joined SFF. SFF
acquired all of Biosfair Inc.’s (BFI) outstanding shares on July 1, 2004. I will be relying on your
financial skills and leadership to guide us through this time of change. ”

Meghan continued, “Perhaps we should focus on preparing for our first Board of Directors’ meeting,
which is scheduled for September 27, 2004. I will need input from you concerning all financial
matters that should be reported to the Board in light of the recent transactions. We should send the
mailing to the directors at least two weeks in advance of the meeting. But I’m getting ahead of
myself. First you need some background information.”

Meghan proceeded to hand over stacks of paper:

• The first is a memo from Meghan describing the history of MUGS and its continuation as SFF
(Exhibit I). Meghan added, “You will need to know some of the background.”

• The financial statements for MUGS for the six months ended June 30, 2004, its last reporting
period as a partnership (Exhibit II). Meghan stated, “These statements provide you with a starting
point, but the Board will need to see the consolidated opening balance sheet as at July 1, 2004.”

• Information relating to the purchase of BFI (Exhibit III) and the financial statements of BFI for the
six months ended June 30, 2004 (Exhibit IV). “I would like to provide the Board with cash flow
projections for the next 18 months for the consolidated group. You will need to prepare them,”
added Meghan.

• “The Board is considering appointing Reed and Wright LLP (R&W) as auditor for the December
31, 2004 year end. The venture capital company (VC), as a preferred shareholder of SFF, has
requested audited consolidated financial statements, ” added Meghan. “I don’t know R&W well,
but they came highly recommended by VC. I understand that VC and R&W have had initial
discussions about the audit of SFF. The fee seems high, so I would appreciate your reviewing the
draft audit plan (Exhibit V) that was contained in their proposal so that I can go back to them and
negotiate a lower fee.”

Meghan continued, “We need to provide the federal government with an audit report of the costs
MUGS incurred to earn the BioSearch Program government grants. Will the R&W 2004 year-end
audit work cover that? If not, what additional work would be required?”

“The current intention is to operate SFF and BFI as two separate corporations. I would like to present
to the Board the tax implications of the change in structure and subsequent acquisition for both the
corporation and the prior partners of MUGS. To date there have been no tax filings with respect to the
transfer of the partnership assets to the corporation.”

Meghan went on to say, “I know you have a lot to do. At some point in the near future, we will need to
get back to these banks about their credit line proposals (Exhibit VI).”

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 27

INDEX TO EXHIBITS

EXHIBIT Page

I Historical Information About MUGS and SFF.................................................................. 28

II Financial Statements of MUGS Partnership ...................................................................... 29

III Information Relating to the Purchase of Biosfair Inc. ....................................................... 34

IV Financial Statements of Biosfair Inc................................................................................... 35

V Draft R&W Audit Plan ....................................................................................................... 39

VI Credit Line Options............................................................................................................. 40

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 28

EXHIBIT I

HISTORICAL INFORMATION ABOUT MUGS AND SFF

MUGS was established in January 2000 as a biotechnology partnership in Saskatoon, Saskatchewan


with the mission of enhancing yield, hardiness and flavour of berry crops. To achieve its mission,
MUGS conducts research into the biological composition of various berries. MUGS owns a
biotechnological laboratory where experiments, biotechnological grafts, and tests are carried out.
MUGS focuses most of its research on the Saskatoon berry, which is prominent in the region. The
MUGS laboratory and head office are located in a local research park. MUGS also owns two rural
plots of land, one for testing and development, and another for production of commercially saleable
berries.

MUGS has been owned by three equal partners since its inception. I, Meghan, am a biologist with
several years of experience in biological engineering. I manage the business and oversee the research
operations. I contributed $150,000 cash for a one-third share of the partnership in 2000. My two
partners, Arthur and Matthew, are my brothers. Arthur completed a Masters in Agricultural Studies in
the months prior to the commencement of the partnership and acts as my assistant in the day-to-day
operations. In return for his one-third share of the partnership, Arthur contributed the two parcels of
land that MUGS operates on. Matthew, a doctor residing in Saskatoon, is an inactive member of the
partnership. His professional corporation contributed $150,000 cash for his one-third interest in the
partnership. Arthur and I drew some money each year for the work done at MUGS. Matthew,
however, has received no cash from the partnership since its inception as there have yet to be earnings
to distribute.

In 2003, a report from a marketing research firm hired by MUGS, concluded that consumption of
berries is increasing. Their research showed that, due to flavour enhancements made through
biotechnology, customer demand is growing rapidly. It is expected that berry consumption will
increase by 300% to 500% over the next five to ten years. The report also stated that increasing
demand will cause berry prices to increase 20% in 2005.

On July 1, 2004, each partner exchanged his or her partnership interest for 100,000 voting shares of a
new corporation, Saskatoon Fields Forever Inc. (SFF). In addition, 220,000 non-voting shares of SFF
were issued to VC for $220,000 cash. SFF then purchased the shares of BFI. I was appointed
President and Chief Executive Officer of SFF and Arthur the Vice President of Operations. Both of us
are members of the board of directors and Matthew is the chair of the board. The current president of
BFI, the President of VC, and a university professor fill the remaining director’s positions.

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 29

EXHIBIT II

MUGS PARTNERSHIP
BALANCE SHEET
(unaudited)

June 30 December 31 December 31


2004 2003 2002
Current assets
Cash $99,000 $110,000 $124,000
Accounts receivable 32,000 22,000 15,000
Supplies inventory 10,000 10,000 10,000
141,000 142,000 149,000

Property, plant and equipment (note 1) 235,080 234,860 222,700

$376,080 $376,860 $371,700

Current liabilities
Accounts payable $55,000 $28,000 $25,000

Deferred credits (note 2) 108,000 80,000 -

Partners’ contributions 450,000 450,000 450,000


Partners’ deficit (236,920) (181,140) (103,300)
213,080 268,860 346,700

$376,080 $376,860 $371,700

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 30

EXHIBIT II (continued)

MUGS PARTNERSHIP
INCOME STATEMENT AND CHANGES IN PARTNERS’ DEFICIT
(unaudited)

Six months ended Year ended Year ended


June 30 December 31 December 31
2004 2003 2002

Revenues

Berry sales $125,000 $155,000 $115,000

Expenses

Research and development (note 3) 100,000 85,000 65,000


Operating and administrative costs (note 4) 15,000 22,000 18,000
Seasonal labour wages (note 5) 10,000 45,000 45,000
Amortization (note 1) 5,780 10,840 10,300

Total expenses 130,780 162,840 138,300

Net loss (5,780) (7,840) (23,300)

Partners’ deficit – beginning of period (181,140) (103,300) (10,000)

Partners’ drawings (50,000) (70,000) (70,000)

Partners’ deficit – end of period $(236,920) $(181,140) $(103,300)

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 31

EXHIBIT II (continued)

MUGS PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(unaudited)

1. Property, plant and equipment

June 30 December 31 December 31


2004 2003 2002

Land $150,000 $150,000 $150,000


Berry plants 30,000 30,000 30,000
Farm and research equipment 102,000 96,000 73,000
Farm and research equipment amortization (46,920) (41,140) (30,300)

$235,080 $234,860 $222,700

The land was appraised at December 31, 2003 at $600,000 and future-oriented appraisals
anticipate continued growth in the land value over the next decade.

Amortization is taken at capital cost allowance rates so that no adjustments are required in
allocating losses to the partners.

2. Deferred credits

June 30 December 31 December 31


2004 2003 2002

Deferred government grants $108,000 $80,000 -

Deferred government grants represent the proceeds of conditional grants received under the
federal government’s BioSearch program. As part of the program, MUGS is committed to a
minimum of $400,000 of direct and indirect research and development (R&D) spending between
January 1, 2000 and December 31, 2004. Once $400,000 has been spent, the federal government
will pay MUGS a total of $320,000. Installments of $108,000 have been received from the
government to date and are being deferred until the full amount of the grant has been received.
The balance of the grant will not be paid and the installments must be refunded if the government
does not receive the audited R&D cost report.

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 32

EXHIBIT II (continued)

MUGS PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(unaudited)

3. Research and development

All research and development costs are expensed. Research and development costs are related to
the following projects:

Six months Year ended Year ended


June 30 December 31 December 31
2004 2003 2002

Project More Berries $60,000 $25,000 -


Project Crantoon 15,000 40,000 $40,000
Project Better Berries 5,000 - -
Discarded endeavours 20,000 20,000 25,000

$100,000 $85,000 $65,000

Prior to 2002, MUGS spent an average of $60,000 per year on direct and indirect R&D. MUGS
has never claimed R&D tax credits.

Project More Berries

Project More Berries has worked toward modifying the genetic code of Saskatoon berries so that
the quantity of berries per plant can be increased. This project is a cost-shared venture between
MUGS and a local investor. The local investor agreed to fund 50% of costs attributable to the
project (costs above are shown net of recoveries from the investor). In return, the investor will
receive 10% of gross revenue from the first two years of production of the new plants. Originally,
the project had a five-year scope and anticipated commercial sales in 2008. However, due to a
research breakthrough in late 2003 that resulted in tripled production of berries from test plots,
MUGS has intensified its efforts on Project More Berries. Marketing efforts to alert retailers of
the coming product and trade-show displays of the research results represent approximately 25%
of the costs incurred in 2004. The remaining costs relate to testing, grooming, and monitoring the
new plants. Arthur has devoted almost all of his time in 2004 to Project More Berries. Berries
from the modified plants will be available for market in early 2005. Arthur believes that More
Berries plants will allow MUGS to increase total production by 30% in 2005 with no additional
cost or change in the quality of the berries. Additional costs of $20,000 on this project are
expected by the end of 2004 and should cease by December 31, 2004.

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 33

EXHIBIT II (continued)

MUGS PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(unaudited)

3. Research and development (continued)

Project Crantoon

The scientific research component was essentially completed in late 2003. MUGS developed a
hybrid berry that was a cross between a cranberry and a Saskatoon berry (the crantoon). Costs in
2004 relate to market development studies and efforts to test the market receptiveness to the new
product. To date, the product has not been especially well received. But, Meghan is optimistic
that foreign markets will be more receptive than the Canadian market. Market development
efforts will continue until December 2004, when the project will be re-evaluated.

Project Better Berries

Project Better Berries has just been started. This project investigates the resistance of plants to
diseases.

Discarded endeavours

MUGS starts several projects each year that are discarded due to poor test results. Additionally,
some of the research MUGS does is general in nature and is not tied to any specific project.

4. Operating and administrative costs

Operating costs include maintenance of the plants, fertilizer application and selling costs
associated with the berries. Donations, both charitable and political, are also made by the
partnership.

5. Seasonal labour

Seasonal labour is highest in the second half of the year during the harvesting of berries, with 75%
of costs incurred in that period.

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 34

EXHIBIT III

INFORMATION RELATING TO THE PURCHASE OF BIOSFAIR INC.

Biosfair Inc. (BFI) focuses all of its research on the enhancement and hardiness of raspberries and
strawberries, and has been very commercially successful. Additionally, BFI has made biotechnological
manipulations in raspberry and strawberry plants that have resulted in much larger and juicier fruit,
even in adverse growing conditions. SFF bought BFI because of a belief that the research
breakthroughs made by BFI on raspberries and strawberries will be applicable to Saskatoon berries
and because the existing relationships BFI has with grocers will benefit berry sales.

The acquisition of BFI closed on July 1, 2004. The purchase price for BFI of $650,000 was financed
as follows:

Cash $ 80,000
Proceeds from issuance of 220,000 non-voting shares of SFF to VC 220,000
Loan from VC at 10% interest repayable in 6 months 350,000

Purchase price $650,000

The purchase and sale agreement also provided for the President of BFI to be terminated on July 31,
2004 for a payment of $100,000. In addition, he will remain as a consultant for an eight-month
consulting contract for $10,000 per month.

Arthur notes that there is value to SFF in having access to the research that BFI has done. Subsequent
to the deal going through, Project ABC, a project touted by BFI as one with lots of potential, was
abandoned by SFF. Arthur doubts SFF will continue with any of the raspberry and strawberry research
BFI has undertaken. Arthur believes that by combining the efforts of both companies, the 2005 R&D
costs will amount to $230,000 for the group.

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 35

EXHIBIT IV

BIOSFAIR INC.
BALANCE SHEET
(unaudited)

June 30
2004
Current assets
Cash $6,000
Accounts receivable (note 1) 180,000
186,000

Property, plant and equipment (note 2) 255,000


Other assets (note 3) 260,000

$701,000

Current liabilities
Accounts payable $17,000
Notes payable (note 4) 300,000
317,000

Future income taxes (note 5) 60,000

Share capital 100,000


Retained earnings 224,000
324,000

$701,000

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 36

EXHIBIT IV (continued)

BIOSFAIR INC.
INCOME STATEMENT
(unaudited)

Six months
ended
June 30
2004

Revenues

Berry sales (note 1) $380,000

Expenses

Salaries 57,000
Other operating costs 12,000
Research costs (note 6) 22,000
Administration 8,000
Amortization 10,500
Interest expense 4,500
114,000

Income before taxes 266,000

Income taxes 53,000

Net income $213,000

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 37

EXHIBIT IV (continued)

BIOSFAIR INC.
NOTES TO THE FINANCIAL STATEMENTS
(unaudited)

1. Accounts receivable and sales

Approximately 45% of BFI’s sales are made to Foodmart, a leading national grocery chain,
under an exclusive supply agreement in force until June 30, 2006. Over the course of a fiscal
year, BFI sells an average of $1,500 of product to Foodmart each day. Sales are highest in the
late summer and autumn months, resulting in 75% of total sales recorded in the last half of the
year and lowest sales in the January-to-June period. A large portion of accounts receivable are
due from Foodmart. No allowance for doubtful accounts has been established due to a strong
collection history.

On June 20, 2004, Foodmart signed contracts with BFI. In these contracts, Foodmart
guaranteed to purchase at least $80,000 of product from BFI in the 61 days in October and
November. Should the purchases not reach $80,000, Foodmart will make up the deficiency to
BFI with a payment on December 15, 2004. The full amount has been booked to receivables
and revenue in June as a reflection of the certainty of receipt of cash.

2. Property, plant and equipment


June 30
2004

Land $ 85,000
Berry plants 40,000
Farm and research equipment 215,000
Farm and research equipment amortization (135,000)
Information system 50,000
$255,000

Land was purchased in 1991 and has been independently appraised at $300,000 at June 30,
2004.
Farm equipment comprises all equipment used in the fields to plant, tend, and harvest berries.
Research equipment is used in laboratories and in the fields to conduct scientific research and
development. It is recorded net of any related investment tax credits. At June 30, 2004, the
fair value of BFI’s farm and research equipment is $70,000.

Information system includes the cost of a new system acquired in June 2004. The system now
tracks invoicing and purchase orders better and has an automated back-up system. It can now
produce financial statements for up to five companies. One of the advantages of buying BFI is
that SFF will use the new system for both companies.

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 38

EXHIBIT IV (continued)

BIOSFAIR INC.
NOTES TO THE FINANCIAL STATEMENTS
(unaudited)

3. Other assets

June 30
2004

Deferred development costs $200,000


Patents 60,000

$260,000

Deferred development costs relate to Project ABC, in which BFI has been working on creating
strawberries and raspberries that will grow in half the time of the traditional berries.

Patents includes various patents that BFI owns relating to enhancements and improvements in
strawberry and raspberry production and quality. The patents expire in 2015.

4. Notes payable

The notes are payable to Foodmart. They bear interest at 3% per annum, and are due on June
30, 2005. Interest is payable monthly and the principal is due upon maturity.

5. Future income taxes

BFI computes future income taxes using the assets and liability method. Substantially all of
the balance relates to differences between the tax and accounting value of other assets. The
remaining balance relates to differences between the tax and accounting values of farm and
research equipment.

6. Research costs

Research costs are $42,000 gross less $20,000 of government grants received during the
period.

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 39

EXHIBIT V

DRAFT R&W AUDIT PLAN

Fees for the December 31, 2004 year-end audit are estimated to be $50,000 because of significant
documentation and startup requirements that our firm must undertake in a first-year audit. The costs
are almost double a normal audit fee mainly because audit risk will be assessed as high. The audit risk
is high because the company has just incorporated, made an acquisition and incurred new debt, and
has a new computer system. We have obtained from BFI documentation on controls and the structure
of the system from when it was implemented, and we will need to test these controls extensively.

Most of the testing will be substantively based and there will be limited reliance on controls unless the
assessment of the computer system permits reliance on some controls. Due to the high risk assessment,
materiality will be chosen at the lowest possible value.

The new Generally Accepted Auditing Standards (GAAS) requirements to assess fraud risk increases
the audit fee. In addition, the need to audit the financial statements of BFI both increases the audit fee
and adds to the complexity of the audit. Since BFI management will not be a part of the business after
the purchase is completed, extra work will be required to audit the BFI results.

An independent specialist will review the state of the berry plants and equipment to ensure that
writedowns due to other-than-temporary impairment are not required. A property appraiser will be
contracted to assess the value of the land reported on the financial statements and ensure no
writedowns are required.

For cash balances, confirmations will be sent and reconciliations reviewed. For accounts receivable,
we will send confirmations based on a statistically computed sample size. For non-current assets, we
will vouch all material purchases since inception to source documentation and utilize specialists as
noted above.

Accounts payable confirmations will be sent to a statistical sample of vendors.

We will document control procedures of the accounts receivable, accounts payable, and payroll
systems this year. In future years, we will update this documentation on a rotational basis.

Since the revenue of the business is quite seasonal, substantive testing will focus on the summer
months when the bulk of the revenue is earned (late May-September). Because a lot of the business
during the summer is from walk-up cash customers, cash register tapes will be reconciled to bank
deposits for several days. For expenses, each category of expenses will be evaluated individually and
substantively audited based on a statistically selected sample.

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered Accountants,
Toronto, Canada.
Excerpt - Uniform Evaluation Report — 2004 40

EXHIBIT VI

CREDIT LINE OPTIONS

Two credit lines have been proposed to SFF:

Option 1 Option 2

Bank Bank A Bank B


Relationship None MUGS’ current bank
Proposed credit line limit $1,000,000 $500,000
Interest rate Prime + 0.5% Prime + 1%
Line term Due on demand 18 months
Security General charge on assets plus General charge on assets
mortgage on land plus personal guarantee
from shareholders

Bank A will require a credit line establishment fee of 0.5% of the total line before the line can be
obtained. The agreement also includes a standby charge of 1.0% on the unused portion of the
credit line. Bank A has also offered personal lines of credit for the senior management at prime
plus 1%.

Bank A has an insurance wing that has offered to assist with any business insurance needs SFF
will have. Bank A representatives have inferred that they will halve the insurance rates for SFF if
SFF agrees to the credit line and takes out business interruption, directors’, key person life, and
crop insurance policies.

Bank A has said it would provide two months notice before demanding repayment of the loan,
providing there is no change in the business operations of SFF.

Because of its existing relationship with MUGS, Bank B has waived any credit line establishment
fee for SFF. Bank B has no insurance program. SFF has purchased insurance from a local broker
and obtained no discount.

The prime lending rate is currently 5% and is expected to remain the same for the immediate
future.

Reprinted with permission from the Uniform Evaluation Report 2004, The Canadian Institute of Chartered
Accountants, Toronto, Canada.

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