clear design limited (cdl) june 2005 exam cma

ENTRANCE EXAMINATION

PART 2 JUNE 2005

TABLE OF CONTENTS

June 2005 Entrance Examination Part 2

Page

Case Question:

Backgrounder ..................................................................................1

Additional Information ....................................................................24

General Comments on Candidate Performance .....................................36

Global Marking of the Part 2 Case ..........................................................41

Sample Response Successful Attempt #1 ...........................................75

Markers Comments Successful Attempt #1 ........................................97

Sample Response Successful Attempt #2 .........................................101

Markers Comments Successful Attempt #2 ......................................125

Sample Response Unsuccessful Attempt ..........................................129

Markers Comments Unsuccessful Attempt .......................................148

Supplement of Formulae and Tables*...................................................153

*This supplement is provided to all candidates with the examination.

Copyright 2005 by the Society of Management Accountants of Canada. All rights reserved. This material, in whole or in part, may not be reproduced or transmitted without authorization.


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The Societies of Management Accountants of Alberta, Manitoba, New Brunswick, Newfoundland, Northwest Territories, Nova Scotia, Ontario,

Prince Edward Island, Saskatchewan and the Yukon, Certified Management Accountants Society of British Columbia, Ordre des comptables en management accrdits du Qubec

June 2005

Entrance Examination

Part 2

Backgrounder The background information relating to the Part 2 case (Backgrounder) is provided to candidates in advance of the Part 2 examination date. The Backgrounder contains information about both the company and the industry involved in the case. Candidates are expected to familiarize themselves with this information in preparation for the strategic analysis that will be required during Part 2 of the Entrance Examination.

Candidates should note that they will not be allowed to bring any written material, including the advance copy of this Backgrounder, into the examination centre. A new copy of this Backgrounder, together with additional information about the company, will be provided at the writing centre for Part 2 of the Entrance Examination.

Candidates are reminded that no outside research on the industry related to this case is required. Examination responses will be evaluated on the basis of the industry information provided in the Backgrounder and the question paper (Additional Information).


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Clear Design Limited Backgrounder

Company History

Clear Design Limited (CDL) is a Canadian corporation providing electronic design services to companies that produce or design electronic devices and equipment.

On May 1, 1999, near the height of the high-technology boom, CDL was incorporated by Rick Smelkin. As President and CEO, he developed the following mission statement for his company: To provide high-quality electronic designs to the Canadian electronics industry at competitive, but profitable, prices. Smelkin was able to fund the company with investment capital from family, friends, and one angel investor (see Exhibit 1 for a glossary of terms and acronyms).

The Technology Bubble

The high-technology boom, often referred to as the high-tech bubble, lasted from about 1998 to 2001. It was driven by many factors, including the growth of the Internet, the resulting need for bandwidth, the deregulation of the long-distance telephone markets in North America, and the improvements in fibre optic technology. The capital markets abundantly rewarded revenue growth and technological promise. Venture capital funding was readily available for start-up ventures, however risky. Initial public offerings made the founders and investors of many companies very wealthy. Frequently, companies were bought out, some at outrageous valuations. During this period, there was a critical shortage of electronics designers and related professionals, and salaries rose significantly.

CDL commenced operations at the height of the boom to capitalize on the large number of technology companies needing timely electronic design. Despite the general lack of available engineers, Smelkin was able to hire some very talented people because of his extensive network of contacts and his persuasive recruitment skills. Companies investing heavily in new high-tech products tried to increase the speed at which they could bring such products to market by involving CDL in various aspects of the design work. As a result, CDL enjoyed high revenues and profits on a variety of projects, even in its first year of operation.

When the technology bubble deflated, it did so rapidly, causing an economic downturn. In general, the share prices of Internet companies that failed to generate profits plummeted. Many technology companies went bankrupt and venture capital funding became hard to obtain. Capital expenditures and investments in research and development in technologies decreased. Companies that had assembled huge research and development teams to develop the next breakthrough products laid off large numbers of these employees. CDL was able to draw from this talent pool and improve its own team by hiring some of the very best engineers and laying off poorer performers.

An example of an industry sector that was affected by the technology bubble and deflation is the information and communications technology (ICT) sector. Exhibit 2 provides general statistics on the ICT sector in Canada for the 2000 to 2002 period.


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In 2002 and 2003, as the market recovered slightly, companies that had undergone massive layoffs found they were short-staffed and, therefore, hard pressed to take advantage of new business opportunities. However, mindful of their experiences at the end of the high-tech bubble, they were unwilling to hire large numbers of full-time staff. This market dynamic resulted in a steady flow of business for CDL, but at lower fees and profits than those of the bubble period.

The Electronic Design Industry

The electronics industry, in Canada and around the world, has been growing steadily over the last 25 years. Electronics are involved in nearly every imaginable business, government, and consumer application. Demand has been rising because of steadily decreasing prices for components, increasingly powerful computer chips, and low-cost manufacturing. The electronic design industry services the broader electronics industry, and depends heavily on the outsourcing dynamics of the electronics industry and industries that use electronics.

The production of any kind of electronic device first requires a design team to develop the products electronics and to produce layout diagrams for the printed circuit boards (PCBs) in preparation for manufacture. Many companies have their own internal design teams, but it is generally impractical to maintain a staff of specialists in every possible area. When a company needs a design for an item beyond its core expertise, contracting out is more efficient. For example, companies with product ideas and marketing capabilities, but without design expertise, often outsource all product development to third parties. As well, some companies outsource design projects when they are operating at full capacity or when contracting out is less expensive than doing the work in-house. For example, salaries and real estate costs in Californias Silicon Valley are so high that outsourcing projects to companies in other regions is often more economical. In addition, some companies contract out the redesign of existing products, while their internal design teams work on new product designs. With the advances made in electronic data interchange, the movement of design files from electronic design companies to their customers has become more convenient, timely, and economical.

Although many companies handle the entire processdesign, manufacture, and salesof marketing electronic products, increasingly, the manufacturing aspect is outsourced to contract electronic manufacturers (CEMs). These firms own modern, well-equipped factories with specialized equipment, such as pick-and-place machines that operate at high speed with little human intervention, to manufacture components (such as PCBs) based on the layout plan provided by the customer. CEMs are located in Canada and around the world, and manufacture for a wide range of customers. Most North American companies outsource large-volume, low-cost manufacturing to CEMs in Asia, but lower-volume and higher-value jobs are still done extensively in North America.

CDL has a number of competitors in Canada and around the world. The main source of competition is the internal electronic design capability of potential customers. Members of in-house design teams, concerned about job security and loss of control, can be antagonistic towards contract designers and suspicious of the quality of their work. Competition is also provided by large CEMs that have branched into electronic design and, as a result, offer their customers one-stop shopping: design services, prototype building, and volume manufacturing. Often, these companies provide design services at cost and rely on the manufacturing business to generate profits.


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Numerous companies in Canada operate very similarly to CDL, including three in the area where CDL is located. Other competitors include the spin-off service businesses of electronic design tool companies, which offer a narrow range of services using the costly software tools developed by their parent companies. They have high infrastructure costs and charge high rates for their services. Although some went out of business shortly after the high-technology boom ended, several are still operating in competition with CDL.

Some independent contractors provide design services as well, working either on-site with the customers team or from their homes. Independents offer customers an attractive alternative to full-time employees because such arrangements can be terminated easily and employment costs (benefits, etc.) remain low. In addition, independent contractors offer very competitive rates because their infrastructure costs are minimal.

With the growth of the electronics industry, there has also been an increase in the number of overseas electronic design suppliers serving North American companies. In India, China, and Eastern Europe, such suppliers have the advantage of drawing from a large pool of skilled engineers and designers at lower salaries than those demanded by similarly skilled North Americans. Among overseas companies, Indian firms are often favoured because their employees have better English communication skills.

The largest overseas supplier of electronic design services is IED Inc. About 1,500 of the more than 10,000 employees of this Indian company work in electronic design. The firm began by offering software design services and quickly expanded into the electronic design services market. The companys success has been due in large measure to the low infrastructure costs of its Indian base. It does not have a design centre in Canada. At any given time, hundreds of its employees are working at customer sites in North America, its primary market, providing both software and electronic design services.

CDLs Approach

CDLs main objective has always been to build long-term relationships with customers in order to obtain repeat business. To that end, the company has focused on competing not only on the basis of its competitive prices but also on the basis of its broad capabilities and the high quality of its services. For its employees, the companys objective has been to create a pleasant work environment that fosters teamwork.

Because of the depth and breadth of the technical expertise at CDL, the company is able to offer a wide range of complex, expert services in a variety of disciplines. This gives CDL an advantage over CEMs, which offer a narrower range of design services, as well as over independent contractors, most of whom have a single speciality. In addition, CDL owns design and other engineering tools and equipment that the independent contractors could not afford, and has a larger network of contacts.

CDL has established alliances with some of the smaller and mid-size CEMs that do not have design expertise. As a result, these companies refer design and related work to CDL, and CDL refers manufacturing work to these CEMs.


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The overseas competition generally uses variable pricing based on actual service hours. To compete against these firms, CDL has offered North American customers firm quotes for entire projects, emphasizing the local or Canadian accessibility and connection. Because customers prefer fixed-price contracts for cost certainty and budget reasons, CDLs approach has been reasonably successful.

Most of CDLs early work involved developing electronic systems for clients in the Canadian telecommunications (telecom) industry (see Exhibit 3 for information regarding the telecom industry, which is a component of the ICT sector). The company also targeted clients in the aerospace and defence industries, with large airplane manufacturer or government contracts in mind. By 2003, CDL had various types of customers (see Table 1 below and Exhibit 4), but the telecom industry continued to generate the greatest amount of revenue for CDL.

Table 1 Number of Projects and Revenue by Customer Type Fiscal 2003

Customer Type Number of Projects Revenue Telephone service 42 $ 614,255 Telecom hardware 68 9,807,693 Computer chip 18 2,478,444 Consumer electronics 46 2,450,780 Defence 1 188,000 Transportation 18 748,522 Aerospace 2 178,999 Other 26 284,582 Total 221 $16,751,275

CDL has endeavoured to deliver complete service on time, remain accessible to the client throughout the project, and maintain flexibility in accommodating client needs. In addition to technical design, CDL has provided many other kinds of expert services, such as proof-of-concept consultation, and system simulation and modelling. Approximately 90% of the work has been carried out at CDLs premises, and the balance at the customers facilities.

By early 2003, the company had become well known in Canada and was believed to be among the top five electronic design services companies in the country, although there were no official industry statistics.

Management Team (see Exhibit 5 for Organizational Chart)

Rick Smelkin is 36 years old. He graduated first in his class from the electrical engineering program of a top Canadian university in 1991 and is a professional engineer. Upon graduation, he worked in engineering design for JKL Inc., a large telecom hardware manufacturer, and quickly worked his way up to head a large design team. Seeking to widen his experience in preparation for the entrepreneurial career he had always desired, Smelkin subsequently worked in sales, marketing JKL Inc.s devices to telecom industry companies in the Northeastern US. Consequently, he developed many contacts in this market, particularly in the Boston area. Smelkin greatly enjoys his work at CDL and is particularly intrigued with projects that are


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technologically interesting or stimulating. He likes to interact with the designers, chat with them about projects, and give them ideas, but not on a consistent basis.

Billy-John Carles, Vice-President, Business Development, is responsible for the companys sales function and is 44 years old. Carles holds a Bachelor of Computer Science degree, but has not written any computer programs since graduation. He held a progressive series of positions in software and hardware sales and, most recently, spent six years with a systems integrator selling services. Carles was recruited by Smelkin in 2001 and has been very successful in his role of developing new business for CDL.

Prudence Joy is Vice-President, Operations. Joy is 38 years old and holds a Bachelor of Commerce degree from a small Canadian university. She has a background in operations at several technology companies and worked with Smelkin at JKL Inc., joining CDL at the time of its incorporation. All the chargeable employees and the project coordinator report to her. In addition, she is responsible for the contract administration function as well as finance and information technology.

Annette Mulk, Controller, started with CDL in 2000 as the bookkeeper. When the previous controller left in mid-2002, Mulk took over that position. She has been taking night courses in accounting at a community college since 2000 and expects to earn her accounting diploma in 2005. Reporting to her are five employees that look after invoicing, accounts receivable, accounts payable, expense claims, payroll, and the preparation of monthly financial statements. Mulks work is very accurate and precise, and she is well-liked by her staff.

Cam Mondred, Project Coordinator, has a technology-related diploma from a community college and was originally hired by CDL as a designer in 2001. He quickly showed aptitude and interest in coordinating the companys staff and project requirements. In early 2002, he was rewarded for his efforts by being promoted to the new position of Project Coordinator.

John Bates, Manager, Information Technology, is responsible for the network, desktop support, security, and backup as well as design tool purchases and coordination. He has two assistants and has been with the company since 2002. Bates has a Bachelor of Computer Science degree and has taken many professional development courses to keep up to date.

Every two weeks, there is a management meeting to discuss the companys progress. The prospect list (i.e. the list of potential jobs from current and prospective clients) is reviewed and staff scheduling is considered. Revenue and profits on all active jobs are examined as well as the metric of staff utilization (i.e. the number of hours charged to customers divided by theoretical chargeable capacity, where theoretical chargeable capacity is equal to 40 hours per week per chargeable employee, 52 weeks per year).

Shares and Shareholders Agreement

Prior to incorporating the company, Smelkin developed a business plan that projected steady growth and allowed for generous dividends to shareholders by the second year of operations. Initially, he approached venture capital firms to invest in CDL, but found them unwilling to invest in service businesses. In general, these firms prefer to invest in product, software, or Internet businesses where the potential payoff is usually much greater than from companies that primarily offer services. He also approached family and friends and, ultimately, was introduced to an angel investor who was impressed with Smelkins business plan.


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By May 1, 1999, CDL had four shareholders in addition to Smelkin. Penny Fidal, a moderately wealthy cousin of Smelkins who made her money in real estate, invested $150,000 in CDL shares. Ralph Manton, an angel investor in several high-tech companies, invested $225,000 through G Holdings Limited. Dr. Marco Roberto, Smelkins dentist, invested $75,000. The final outside investor was Chantale Blanger, the owner of a company that developed and manufactured home alarms. She invested $150,000 and was one of the first customers of the company.

The company has only one class of sharescommon shares. Every shareholder was required to sign the companys shareholders agreement, which provides for a board of directors of at least five members and a maximum of six. The agreement also stipulates that the sale of any shares by a shareholder must be approved by all shareholders, except in the case of a buyout offer for the whole company. Shareholders are not allowed to compete in the same business with CDL as long as they hold shares in the company.

In 2002, three of the senior employees were permitted to purchase shares in CDL. In 2003, stock options with an exercise price of $1.50 per share were issued to the senior employees. Table 2 below shows the companys shareholdings and stock options as at April 30, 2003.

Table 2 Shareholdings & Stock Options as at April 30, 2003

Shareholder Shares Options Option Price Per Share Rick Smelkin 1,000,000 50,000 $1.50 Penny Fidal 100,000 G Holdings Limited (Ralph Manton) 150,000 Dr. Marco Roberto 50,000 Chantale Blanger 100,000 Billy-John Carles 20,000 20,000 $1.50 Prudence Joy 30,000 20,000 $1.50 Annette Mulk 1,000 4,000 $1.50 1,451,000 94,000

Board of Directors

At the end of fiscal 2003, the board of directors was comprised of Smelkin (Chair), Ralph Manton and Chantale Blanger (both shareholders), Neil Manro (a corporate and commercial lawyer, and a friend of Mantons), and Bruce Bunburger (a retired telecom industry executive).

The board of directors meets quarterly. Each meeting starts with a discussion of statutory and other legal approvals that are needed, and then turns to a consideration of strategic business decisions. Smelkin has found the meetings to be useful for discussing ideas with experienced people who present fresh views on the subject being discussed.


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Sales

Four senior salespeople, one junior salesperson, and three support staff report to Carles. All of the salespeople started their careers as engineers, but migrated to sales because of their inclinations and abilities. They understand the companys capabilities and the specifications of prospective projects at a high level, but they do not have a strong understanding of the technical details of the work that these projects require. The junior salesperson is responsible for making initial calls to potential clients across Canada (cold calls), whereas the senior salespeople service the current clients and follow up specific sales opportunities.

The salespeople spend a great deal of time on the road, networking with the project managers and engineers of current and potential clients, including those from companies with in-house electronic design capabilities that sometimes need to outsource projects that their internal design teams are either not equipped or not willing to undertake. The salespeople also spend a lot of time networking at electronics forums, conferences, lunches, and dinners.

One of the important roles of the salespeople is to respond to requests for proposals (RFPs). The preparation of these proposals requires the assistance of CDL engineers, because of the technical content, as well as contract administration personnel. The salespeople also prepare proposals when potential projects are brought to CDLs attention by independent sales agents.

CDL offers two types of contracts: 1) fixed price for the entire project, and 2) variable price. For the fixed-price projects, the salespeople initially propose a price that reflects the estimated hours to complete the project multiplied by an appropriate rate. For variable-price projects, an hourly rate is negotiated and customers agree to pay this rate times the number of actual billable hours required to complete the project. For both types of projects, the hourly rate specified or implied in the contract is referred to as the booked rate. Often, the contract specifies an upper limit to the number of billable hours that can be charged. When the specifications or deliverables for a project are not fully defined by the client, the salespeople prepare a variable-price contract proposal.

For both types of projects, the average target booked rate is $100 per hour; however, the rates that are proposed and negotiated depend on many factors, such as the nature of the work, the level of the staff employed, the cost of tools needed to complete the project, the season, and the local cost structure. Sometimes, a discount is provided for a large commitment or to secure a first job with a key customer.

Out-of-pocket costs related directly to a particular project are billed separately to the customer for both types of contracts. Such costs include travel expenses and the cost of outsourcing the assembly of prototypes.

In addition to a base salary, both senior and junior salespeople receive a 2% commission on all bookings with which they are involved, including those that are initiated by independent sales agents. Expense claims are submitted for all trip-related expenditures that were not made with a company credit card (e.g. tips) and for the use of a personal vehicle for business travel. The expense claims are approved by Carles.


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At the end of fiscal 2003, 22 independent sales agents in strategic locations across Canada, and three in the US, worked for CDL on a contract basis. These agents are knowledgeable with respect to electronic design services and advanced technology industries. Armed with CDLs brochures, they use their wide range of established contacts to bring business to CDL. In return, the independent sales agents receive a 5% commission from CDL. Most of these agents also represent several other technology companies that are not in direct competition with CDL (i.e. companies that sell components, computer chips, and other products).

Operations

Most projects involve working with a client company on an electronic product idea. CDL designs the electronics of the product, or a part thereof, and the intellectual property rights usually are transferred to the customer under the terms of the contract. As the company grew and completed projects, residual project knowledge has become an increasingly valuable asset of CDL. Residual knowledge is the information that remains in the inventors unaided memory, apart from notes and models; it is the designers expertise and experience. This knowledge has enabled CDL to provide ever-increasing value to clients in the area of technical expertise.

For security reasons, every CDL project is given a code name that does not reveal the purpose of the project. Sub-projects are then developed to classify the work categories within the project (e.g. planning, architectural design, coding, printed circuit board design, testing, layout, manufacturability, etc.).

Most of the design work is carried out in CDLs office, where the tools and laboratory are located. Typically, a project is handled by a self-directed team that could consist of a single engineer or layout designer, or as many as a dozen design staff, including engineers, software developers, layout professionals, and technologists. For larger projects, Cam Mondred usually designates one senior engineer to oversee the project as the technical lead. CDL contracts with a CEM to produce the physical components or prototypes required for some projects.

CDL employees are classified as either chargeable or non-chargeable personnel. A chargeable hour is defined as an hour spent working for a client under a signed contract and is charged as a direct cost to the specific contract. Occasionally, a chargeable employee spends time on work that is not directly related to a contract. This time, as well as the time of non-chargeable personnel, is charged to an appropriate general overhead account.

From time to time, CDL hires independent contractors to complement its team on a specific project. For example, if CDL does not have an employee with a particular engineering skill set required for a project, a contractor is hired, typically at about $60 per hour.

During the sales effort, the Project Coordinator and one or two engineers who are expected to be involved in the job assist the sales staff in estimating the number of hours that will be required to complete the project.


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Human Resources

As at April 30, 2003, CDL had 127 employees (see Table 3 below), most of whom are the engineers and designers who do the work required by the customers. Of CDLs chargeable employees (see Table 4 below), two have doctoral degrees, 23 have graduate degrees, 18 are registered professional engineers, and all but 22 have undergraduate degrees. Some layout professionals are very experienced with their layout tools, but are self-taught.

Table 3 Employees as at April 30, 2003

CEO & Assistant 2 Operations & Design 104 Accounting 6 Contract Administration 3 Information Technology 3 Sales & Marketing 9 127

Table 4

Chargeable Employees as at April 30, 2003

Average Annual Salary Number Senior designer $110,000 40 Intermediate designer $85,000 22 Junior designer $70,000 16 Layout specialist $75,000 10 Technologist $50,000 12 100 Total salaries, excluding benefits $8,740,000

Experience levels vary widely. Among the companys employees are new graduates who are willing to take low salaries in the current market, designers with between two and five years of experience, and experienced staff who have always worked in design services or are veterans of R&D teams in companies of various sizes.

CDL tries to promote from within, encouraging professional development, mentoring young engineers, and nurturing employer-employee loyalty. Designers generally enjoy their work and obtain satisfaction from meeting client needs.

Employees have a standard, 40-hour workweek. During downtime (i.e. time that is not chargeable), the chargeable employees work to improve internal processes, and assist the salespeople in researching companies and technologies and developing project proposals. When required to work large amounts of overtime, the chargeable employees usually receive time off in lieu of overtime pay.


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Every CDL employee is required to sign an employment contract that includes a position description, provides details pertaining to salary and benefits, outlines severance provisions, and provides for a probationary period, during which the employees position could be terminated or probation extended. The contract also includes a non-competition covenant that prohibits the individual from entering the employ of a CDL client within six months of working with that client on behalf of CDL. As well, the contract covers confidentiality and the ownership of intellectual property, two very important industry issues given that clients generally expect complete confidentiality surrounding their new product efforts.

CDLs employees come from diverse ethnic backgrounds and many have hobbies that relate to the companys business, both of which are viewed to add value to projects. For example, Alex Cvetovic, who emigrated from Eastern Europe where he received his first electrical engineering degree, joined CDL after receiving a masters degree in electrical engineering in Canada. His hobby is racing radio-controlled model cars and he improves the electronics of his handmade racer in his spare time. Software engineer Dennis Xhang, who was born in the Peoples Republic of China, earned a Bachelor of Computer Science degree in Canada. While writing top quality software for CDL, he also wrote software for a video game that he and his friends invented for their personal enjoyment.

Employee turnover in the post-boom period has been about two individuals per year and replacements have been easy to find. Since the collapse of the technology bubble, CDL has been inundated with resumes. Smelkins assistant has been trained to weed out those that are not worth considering before passing the remainder to Smelkin for review. Once reviewed, the approved resumes are saved in an electronic database, searchable by skill set. When the need arises, the resumes of the best applicants can be accessed and the right person found quickly.

At the time of incorporation, the basic human resource policies of the management teams former employers were combined and tailored to CDLs business and size. This set of policies has worked well thus far. As well as annual performance reviews, chargeable employee reviews are conducted shortly after the completion of each large project. Salaries are re-examined annually, but few changes have been made, given the current job market.

Design Tools and Equipment

CDL uses many different computer software toolsthe equivalent of hammers and nailsfor electronic design work. These software design tools are obtained from various vendors, mostly in the US. Some are acquired under a perpetual licence for a one-time, up-front fee. Others are obtained under time-based licences. For most of these tools, CDL has also purchased a maintenance contract that includes services such as technical support and software updates. At the end of the technology bubble, many suppliers were eager to gain new customers and had lowered their prices. For most of the software tools, the licence was for a specific number of concurrent users. For example, the Treble Claff layout software licence purchased by CDL allowed any two computers to run the software at one time.

For accounting purposes, the perpetual licences are amortized on a straight-line basis over their useful lives, usually four years. The cost of the time-based licences and the maintenance agreements are amortized over the duration of the contracts. The effective cost for the high-end software design tools can be as much as $150 per day or $55,000 per year.

CDL provides each employee with a computer. Those required to travel in performing their duties have laptops and those who work only at the office have desktop models. It has been


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company policy to purchase mid-market and mid-price brands with good track records for reliability.

Office

CDLs office is located in Eastern Canada, in a city close to the US border. Part of a high-technology triangle, the city is one of three in the province in which the industry is predominantly high tech.

The office is equipped with a high-speed fibre-optic cable that facilitates the transmission of large design files. CDL entered into a new, seven-year office lease on February 1, 2002, at a cost of $15.20 per square foot gross (including operating costs) for 18,102 square feet. A security badge system controls access to the facility to ensure confidentiality of client information at the site.

The office has a boardroom with electronic projection equipment and teleconferencing facilities, a laboratory accommodating eight workbenches, a recreation area with ping-pong and pool tables, and underground parking. At the end of the high-tech bubble, the company was able to purchase a set of lightly used office cubicles and furniture. The laboratory contains key testing equipment and other equipment required for design work, with which most of the employees are familiar. A few pieces of the laboratory equipment were vendor-financed over 10 years.

Insurance

CDL carries standard property insurance on its physical assets, with a limit of $2 million and a deductible of $5,000. The company has commercial general liability insurance of $10 million with a deductible of $20,000. The errors and omissions insurance policy (covering failure of designs to perform) has a limit of $15 million and a deductible of $25,000. The company has never made a claim under any of these policies and there have been no legal actions against the company for any reason.

Advertising and Promotion

In addition to and in support of the work of the salespeople, CDL markets itself through targeted advertising and promotion efforts. Advertisements are purchased in certain industry publications. Occasionally, the company rents booths at various trade shows, such as those that showcase telecom hardware. The companys logo is prominent at all promotional venues and in all advertising material.

CDLs Web site details the companys technical expertise and provides an overview of the companys values and approach. The site includes a search engine that allows visitors to access information on key types of expertise. CDLs Web site also contains links to its partners (e.g. allied CEMs) and independent sales agents.


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Banking and Financing

CDL has had a relationship with the same bank since incorporation. The bank granted CDL a variable line of credit equal to 75% of the companys North American receivables (under 30 days past due and deemed collectible) less prior claims up to a limit of $1,000,000. The receivables list must be submitted to the bank monthly along with financial statements. Prior claims are defined as statutory payments that rank ahead of the bank, such as rent and any unpaid taxes. At the end of most months, CDLs prior claims amount to approximately $70,000.

In 2002, Smelkin read in a business magazine that a large company effectively pays a processing cost of $800 per purchase order. Consequently, he reduced the use of purchase orders and encouraged the use of the company credit cards that were distributed to many CDL employees. All salespeople are issued credit cards to pay for their travel expenses. Certain engineers are given credit cards so that they can make emergency or late-night purchases of project components over the Internet, with minimal hassle. Each credit card has a limit of between $5,000 and $10,000.

SRED Tax Credit

CDL qualifies as a Canadian-controlled private corporation (CCPC) and is eligible to receive refundable investment tax credits for qualified scientific research and experimental development (SRED) expenditures. For CDL, these include qualifying costs of internal development projects and of projects undertaken for customers outside Canada. Canadian clients are eligible to claim the SRED tax credit for themselves for any qualifying development projects CDL performs on their behalf.

Although the calculations are complex, CDL estimates that, on average, the SRED refundable tax credit is about 40% of both project labour (not including benefits) and out-of-pocket costs. Any part of this credit that is not used to offset taxes payable for that year is refunded to CDL. For a company that is not a CCPC, the credit is calculated at a lower rate and any portion not used to offset current taxes payable must be carried forward or back (i.e. it is not refunded).

Financial Reporting and Systems

CDL uses the Dabit accounting system to invoice customers, pay bills, and produce its financial statements (see Exhibit 6 for audited financial statements). The software package includes a job-cost accounting module. Each project is set up as a different job in the system, and invoicing and costs are recorded by job. Each chargeable employee is required to complete an electronic time sheet so that time can be tracked by job for billing and budgeting purposes.

Customers are invoiced for projects at designated milestone dates according to the contracts. For recording revenue in the year-end financial statements, CDL uses the percentage-of-completion method, based on hours worked to date divided by estimated total project hours. On the year-end balance sheet, unbilled receivables representing revenue recognized in excess of billings are accrued, and invoiced amounts in excess of revenue recognized for the applicable projects are recorded as deferred revenue.

In accordance with Canadian generally accepted accounting principles, the SRED tax credit is deducted from related expenditures on the year-end income statement.


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Each February, a preliminary flexible annual budget is prepared for the following year and is finalized close to the April 30 year end. These budgets have proven to be accurate over the years.

The companys auditor and income tax advisor is Jacques Genest, CA, a sole practitioner. CDL has received an unqualified audit report since incorporation.

History of a Typical Client Project

Although every CDL project has unique aspects, the following account is representative of the way the company does business.

In June 2002, a former colleague of Carles approached CDL to design the electronics for a new device being developed by BabyKeep Inc. (BI). The concept involved a wireless unit that, when attached to a child, would send a signal causing a second (parent) unit to beep if the child moved more than a selected distance from the adult wearing the parent unit. At this time, the customer did not have clearly defined specifications for the design. The client had only a small design team, which was busy with other projects.

Carles assigned a salesperson to meet with the customer and prepare a proposal for the work. Numerous meetings were held, involving engineers from both CDL and the client, to try to clarify the scope of the engagement with respect to the deliverables, the milestones, and the terms of acceptance.

After BI accepted the preliminary proposal, work began on negotiating a formal contract. This process involved CDLs salesperson, one senior CDL engineer, and CDLs contract administration people. CDL pushed for a variable-price contract at $100 per hour, but BI insisted on a fixed-price contract of $96,000 to provide cost certainty for the venture. The contract specified, among other things, the basic design of the printed circuit board, the regulatory requirements, the requirement to provide six working prototypes (to be assembled by a CEM), the acceptance criteria for the prototypes, the billing milestones, the ownership of intellectual property, and the warranty. The salesperson and the senior engineer estimated that the project would require 960 billable hours to complete. Therefore, management knew that if this time budget were met, the target booked rate of $100 per hour would be earned.

One significant issue took time to resolve. The preliminary contract provided for unlimited liability to CDL should a unit fail and BI be taken to court. CDL has always been concerned that a problem with a design could leave the company open to lawsuits and tries to negotiate favourable liability clauses in its contracts. Considering the way in which the unit was to be used to safeguard children in the US, CDL insisted that liability be capped at the contract amount. Eventually, CDL was able to win this battle. After final legal review, and approval of the contract and the time budget by Carles, the contract was signed.

The time that CDL engineers spent on the project prior to the contract being signed (e.g. assisting in the development of the proposal and fine-tuning the contract) was not charged directly to the project. Instead, this time was charged to marketing activities.

The Project Coordinator assigned a project number to the project as well as a code name, Project Brazil. A team of three CDL engineers and one layout designer worked on the project continuously for several weeks. Most of the work was done at CDLs office, but there was occasional travel to the clients premises.


CMA Canada 15

Invoicing was carried out at the following milestones: upon signing of the contract, after 30 days, and upon approval of the preliminary design by the client. Out-of-pocket costs, primarily components and CEM fees for the prototype, were tracked so that they could be billed to the customer upon completion of the project. CDLs billing terms were net 30 days.

Halfway through the project, the customer requested that the unit be designed to transmit and receive over a distance of 30 metres, rather than the 20 metres specified in the contract, for no extra charge. After much discussion, the CDL salesperson was able to convince BI to sign an Engineering Change Order (ECO). An ECO serves as an amendment to the initial contract, providing additional fees for the additional agreed-upon service. This particular ECO was for $8,000, based on a budget of 80 hours to complete the work.

By week six, the project was nearly complete and the PCB layout had been delivered to the CEM that had been contracted to produce the prototypes. The prototypes were delivered to the customer in week eight along with the final electronic design files, after CDLs engineer was satisfied that all contract testing criteria had been met. After some negotiation regarding one of the acceptance criteria, the client signed off the final acceptance papers by the end of week ten, permitting the final invoice to be sent and the contract closed. By this time, actual project hours were 998 for the base project and 77 for the ECO component. The project thus earned $104,000 for 1,075 hours of work, or $96.74 per hour. BI was satisfied and planned to mass-produce the product offshore. BI also expected to apply for a patent for the design.

Four Other Typical Jobs

A local computer chip design company, Canot Inc., required the full design of an evaluation board (i.e. a PCB that enables the testing of custom computer chips). The company approached CDL because of its reputation. A fixed price of $340,000 was quoted and the project was carried out by a team of six CDL designers.

An independent sales agent promoted CDLs services to Medsystems Inc. (MI), a Western Canadian manufacturer of blood alcohol measurement devices and other medical equipment. MIs blood alcohol measurement device was originally designed in the 1980s by an R&D team no longer employed at MI. CDL was engaged to update the design of MIs basic product, using some newer, less expensive computer chips. Because the specifications required for the project were uncertain, MI agreed to a variable-price contract. Three CDL designers were able to complete this work in 440 hours instead of the originally expected 485 hours.

Local start-up company Vehicle Vision Electronics Inc. (VVEI) had an idea for a product that would use an infrared beam to trigger a beep when a vehicle reached a specified distance from a wall. The product would be battery-operated and sell for less than $50. The product was conceived when the founders wife drove her car into the wall at the end of his garage and caused serious damage to both the car and the wall. The company was financed by the founder, some family members, and two angel investors. Rather than hire an engineering team that would no longer be needed once the product had been developed, VVEI decided to outsource the work, and issued requests for proposals to CDL and two other electronic design companies. After reviewing the submitted proposals, CDL was awarded a contract to conduct an architectural study to define the specifications of the product, at $110 per hour. Upon completion of the study, for which VVEI paid $18,450, CDL then quoted a $77,000 fixed price to complete the project and deliver two working prototypes within four months. A team of two engineers and one technologist was assigned. VVEI obtained all intellectual property as part of the agreement.


16 CMA Canada

A large, local telecom hardware company needed expertise in signal integrity analysis for one of its projects, but did not have such high-level expertise internally. Therefore, it contracted CDL to provide consulting services at $120 per hour, with no maximum time specified.


CMA Canada 17

Exhibit 1 Clear Design Limited (CDL)

Glossary of Terms and Acronyms

Term or Acronym Explanation

Angel investor A wealthy individual interested in investing money in early-stage businesses with good potential.

BI BabyKeep Inc.

Booked rate Contracted hourly rate specified in variable-price contracts and the effective hourly rate implied in fixed-price contracts.

CCPC Canadian-controlled private corporation.

Contract electronic manufacturer (CEM)

A company that manufactures electronic products and components for other companies on a contract basis.

Engineering Change Order (ECO)

An amendment to the original contract.

Electronic design The act of designing the layout or circuitry of electronic components or products to be manufactured.

ICT sector Information and communications technologies sector - includes industries primarily engaged in producing or supplying goods, services or technologies used to process, transmit or receive information.

Industrial design The act of designing objects for manufacture by industry.

Layout A diagram of the design of a printed circuit board (PCB) from which a prototype of the PCB can be manufactured.

MI Medsystems Inc.

Perpetual licence A licence to use software for an unlimited period of time.

Printed circuit board (PCB)

A thin plate on which computer chips and other electronic components are mounted in electric circuits.

Product company A company that focuses on providing a product rather than a service.

R&D Research and development.

RFP Request for proposal.

SRED Scientific research and experimental development.

Technologist An individual holding a technology-related diploma from a community college.

Time-based licence A licence to use software for a specified period of time.

VVEI Vehicle Vision Electronics Inc.


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Exhibit 2 Information and Communications Technologies (ICT) Sector

in Canada Revenues (in millions of dollars): 2000 2001 2002 Telecommunications services $30,661.2 $32,404.2 $33,199.8 Software and computer services 25,708.8 27,378.2 27,651.4 Cable and other program distribution 3,998.2 4,539.8 5,110.4 ICT manufacturing 44,829.7 34,146.8 26,452.9

Number of Workers: 2000 2001 2002 Telecommunications services 103,692 104,879 105,096 Software and computer services 254,602 260,901 236,148 Cable and other program distribution 14,734 14,616 14,720 ICT manufacturing 118,051 113,568 97,694

R&D Expenditures (in millions of dollars): 2000 2001 2002 Telecommunications services, cable and other program distribution $ 64.6 $ 238.9 $ 219.1

Software and computer services 1,023.9 1,390.0 1,325.4 ICT manufacturing 4,731.0 4,878.7 3,496.7

Capital Expenditures (in millions of dollars): 2000 2001 2002 Total ICT services $10,728.2 $11,970.3 $9,696.8 ICT manufacturing 1,820.6 1,731.8 882.9


CMA Canada 19

Exhibit 3 Telecommunications (Telecom) Industry

The telecom industry suffered some of the heaviest blows as a result of the collapse of the technology bubble in the early 2000s. No other industry touches as many technology-related business sectors as telecom. It encompasses not only the traditional areas of local and long-distance telephone services, but also advanced technology-based services including wireless communications, the Internet, fibre optics, and satellites. Telecom has also become intertwined with cable television systems, since cable companies have begun to offer local exchange service and Internet service. Overall, the telecom industry is in a state of continuous technological and economic shift.

The Canadian telecom market was one of the few to weather the storm after the collapse of the technology bubble. Revenues continued to increase between 1999 and 2002, but began to plateau in 2003 as competition increased. Companies offering local telephone services experienced a drop in sales as the market shifted from fixed-lines to mobile phones. In terms of broadband penetration, Canada is one of the leading countries in the world. Broadband services are being driven by the governments desire to establish Canada as a leading information economy and an attractive country for investment. The high penetration of broadband Internet access is also beginning to fuel growth in other industries, such as interactive and digital television services and e-commerce. Capital expenditures in the Canadian telecom services industry increased from 1998 to 2001, but then decreased by 25% from a peak of $8.4 billion in 2001 to $6.3 billion in 2002. It is predicted that this decrease would continue in 2003, but at a slower rate.

In the US, equipment spending in the telecom industry dropped during 2001 and 2002 by a total of 24%, but showed signs of rebounding in 2003. As well, double-digit increases in wireless services, services in support of equipment, and high-speed Internet access offset the decrease in equipment spending. Spending as a whole in the US telecom industry totalled US$681 billion in 2002, up 3.5% over 2001. In 2002, US imports of telecom equipment declined by 9% to US$30.6 billion. Mexico was the largest supplier of imports to the US market, accounting for 19% of total imports. Korea, Taiwan, Canada and Malaysia were the next four top import suppliers. Overall, imports from Asia accounted for 5 of the top 10 suppliers, totalling US$14.5 billion.

International telecom spending, not including US figures, amounted to approximately US$1.27 trillion in 2002. It is predicted that spending will increase in this industry over the next few years, and that the international telecom markets will grow faster than the US market.


20 CMA Canada


Ten Largest Completed Projects in Fiscal 2003

Customer Final Value Contract

Type Booked Hourly Rate

BudgetedHours

Final Hours Work

Consumer Systems Inc.1

$314,288 Variable $104 3,022 3,022 Cost reduction, phone electronics

103313904 Canada Inc.2

$264,000 Fixed $105 2,514 2,477 Embedded software

Wireless Phone Inc.3

$514,211 Fixed $102 5,041 6,020 Wireless phone electronics

JX Corp.4 $400,000 Variable $100 3,678 4,011 Design & prototypes Chime Telephone Co.5

$401,200 Fixed $97 4,136 3,877 System simulation

Nesther Inc.6 $398,700 Fixed $111 3,592 4,877 System PCB Chip Design Ltd.7 $378,540 Variable $108 3,441 3,505 Computer chip evaluation

PCB Rec Vehicles Ltd.8 $402,155 Fixed $104 3,867 4,040 Computer chip evaluation

PCB White Defence Inc.9

$269,702 Fixed $88 3,065 3,090 Military control system

Rentokon Inc.10 $284,000 Fixed $98 2,898 4,020 Telecom hardware electronic design

Notes: 1 Ngar Inc. did the industrial design for this project 2 Five engineering change orders (ECOs) obtained, included in final value 3 Poor initial time budget 4 Contract called for a maximum of 4,000 hours 5 Excellent team performance 6 Customer kept asking for more 7 Three ECOs obtained, included in final value 8 Good experience with global positioning systems 9 Strategically low rate 10 Will not deal with this customer again


CMA Canada 21


Organizational Chart

President and CEO

Rick Smelkin

Board of Directors

Rick Smelkin (Chair) Ralph Manton

Chantale Blanger Neil Manro

Bruce Bunburger

Vice-President Operations

Prudence Joy

Project Coordinator

Cam Mondred

100 Design Staff

Manager, Information Technology

John Bates

3 Contract Administration

Staff

8 Sales Staff

Vice-President, Business

Development

Billy-John Carles

Controller

Annette Mulk

Assistant

2 IT Staff 5 Accounting Staff

2 Operations Support Staff


22 CMA Canada

Exhibit 6 Clear Design Limited (CDL) Balance Sheets (Audited)

As at April 30 ASSETS 2003 2002 2001 2000

Current assets:

Cash $ 147,051 $ 86,854 $ 88,152 $ 87,455

Accounts receivable & accrued revenue

1,861,253

1,856,050

1,845,595 1,906,258 Supplies inventory 28,478 19,785 28,748 41,855 Prepaid expenses 220,458 201,585 197,852 194,255

2,257,240 2,164,274 2,160,347 2,229,823 Capital assets:

Property, plant, equipment & design tools

2,537,753

2,387,491

2,232,706 1,945,221 Accumulated amortization 1,157,207 799,362 496,907 216,455

1,380,546 1,588,129 1,735,799 1,728,766

Total assets $3,637,786 $3,752,403 $3,896,146 $3,958,589

LIABILITIES & SHAREHOLDERS EQUITY

Current liabilities: Bank operating line $ $ 75,042 $ 283,038 $ 626,752 Accounts payable 660,121 671,194 696,612 817,264 Deferred revenue 44,222 54,522 58,443 39,444

704,343 800,758 1,038,093 1,483,460

Long-term liabilities: Future income taxes 22,288 17,706 17,706 9,852

Shareholders equity:

Common shares 2,186,211 2,186,211 2,084,211 2,084,211 Retained earnings 724,944 747,728 756,136 381,066

2,911,155 2,933,939 2,840,347 2,465,277

Total liabilities and equity $3,637,786 $3,752,403 $3,896,146 $3,958,589


CMA Canada 23

Exhibit 6 (contd) Clear Design Limited (CDL)

Statement of Income and Retained Earnings (Audited) For the Fiscal Years Ended April 30

2003 2002 2001 2000

Net revenue $16,751,275 $16,704,454 $18,455,952 $20,968,838

Operating expenses:

Salaries, commissions and benefits

12,405,122 13,061,032

13,973,607 15,681,746 Subcontractors 240,147 137,452 67,852 57,855

Commissions independent agents

332,071 317,852

310,478 745,875 Rent 275,150 285,842 287,888 289,741 Software maintenance 242,955 235,478 239,788 241,788 Insurance 140,785 139,722 110,422 109,758 Travel 450,422 440,228 442,853 841,222 Professional 174,488 171,895 189,745 199,748 Advertising & promotion 419,852 418,743 416,787 621,855 Communications 239,010 237,489 234,258 278,748 Office & other supplies 315,788 319,728 317,852 319,428 Other 474,825 476,845 471,852 532,042 Bad debt expense 167,513 167,045 184,560 209,688 Amortization expense 357,845 302,455 280,452 216,455 Interest & bank charges 4,027 5,785 29,011 27,473 16,240,000 16,717,591 17,557,405 20,373,422

Income (loss) before taxes 511,275 (13,137) 898,547 595,416 Income taxes current 179,477 (4,729) 315,623 204,498 Income taxes future 4,582 7,854 9,852Income taxes 184,059 (4,729) 323,477 214,350

Net income (loss) $ 327,216 $ (8,408) $ 575,070 $ 381,066

Beginning retained earnings $747,728 $756,136 $381,066 $ 0Net income (loss) 327,216 (8,408) 575,070 381,066Dividends (350,000) (200,000) Ending retained earnings $724,944 $747,728 $756,136 $381,066


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The Societies of Management Accountants of Alberta, Manitoba, New Brunswick, Newfoundland, Northwest Territories, Nova Scotia, Ontario,

Prince Edward Island, Saskatchewan and the Yukon, Certified Management Accountants Society of British Columbia, Ordre des comptables en management accrdits du Qubec

June 2005

Entrance Examination

Part 2

Additional Information

(Time Allowed: 4 hours)

Notes:

i) Part 2 consists of one case question to be answered in the four hours allotted.

ii) Candidates must not identify themselves in answering the question.

iii) All answers must be written on official answer sheets. Work done on the question paper or on the Backgrounder will NOT be marked.

iv) Included in the examination envelope is a standard supplement consisting of formulae and tables that may be useful for answering the question.

v) Examination answer sheets MUST NOT BE REMOVED from the examination writing centre. All used and unused answer sheets and working papers must be sealed in the examination envelope and submitted to the presiding officer before the candidate leaves the examination room.


CMA Canada 25

Clear Design Limited (CDL) Additional Information

Company Update

Clear Design Limited (CDL) has continued its operations but the financial results for fiscal 2004 and 2005 (see Appendix A) have been disappointing. Revenues have fallen short of the budgeted levels and losses have been realized. The competitiveness of design service companies in other areas of the world (e.g. Asia and Eastern Europe) has grown steadily, the Canadian dollar has strengthened (hurting many Canadian technology exporters), and the electronic design industry in Canada has weakened.

Sales

The breakdown of the projects undertaken by CDL during fiscal 2005, by customer type, is shown in Table 1 below:

Table 1 Number of Projects and Revenue by Customer Type Fiscal 2005

Customer Type Number of Projects Revenue % of Revenue Telephone service 21 $ 561,688 4% Telecom hardware 38 7,582,786 54% Computer chip 22 2,668,017 19% Consumer electronics 37 1,825,486 13% Defence 2 280,844 2% Transportation 22 702,110 5% Aerospace 3 140,422 1% Other 32 280,844 2% Total 177 $14,042,197 100%

CDL has tried to deal with the growing competition through increased sales efforts, including more advertising and sales calls on the road. In addition, CDL has held its budgeted average booked rate at $100 per hour. Competitors charge between $80 and $120 per hour. As a result of these efforts, CDL has maintained its market share, but the overall shrinkage of the Canadian market has caused sales to drop.

Although the sales focus has been on the Canadian market, approximately 2% of CDLs revenues were derived from US companies in 2004 and 5% in 2005. Some of this business has been generated by the three independent sales agents working for CDL in the US, but most of the contracts resulted from referrals to US parent companies by Canadian subsidiaries. A project contracted in fiscal 2005 for a customer in Silicon Valley, California, was one of the most profitable projects CDL has ever completed. CDL had been awarded the contract because the client believed that CDLs hourly rate of US$100 was a bargain and that no offshore company had the capabilities required for the project. In two other contracts with smaller US companies,


26 CMA Canada

the client insisted that CDL absorb all travel costs so that, for the customer, it was equivalent to dealing with a local design services partner.

Increasingly, CDL has lost bids and business to a new, aggressive, large Indian competitor that has been quoting very low rates. CDL management estimates that $2 million of business that CDL normally would have obtained has been lost to this new competitor since January 1, 2005. Two of CDLs local competitors have gone out of business as a result of these market pressures.

Operations

Because of the overall decline in sales, CDL has reduced its staff over the past two years, primarily through the dismissal of poorer performers. By April 30, 2005, the number of chargeable design staff had been lowered to 89, with total annual salaries excluding benefits amounting to $7,830,000.

One senior engineer has complained that there is a lack of consultation between sales and design employees and that sometimes the salespeople promise customers more than CDL can deliver. According to Prudence Joy, some customers have felt that CDLs proposals sounded better than what could reasonably be delivered within the parameters of the contract. The senior sales staff insist that they are just trying to save time by basing quotes on similar past projects. The design staff maintain that even subtle differences in project specifications can make significant differences, both more and less, in the time required to complete a project.

With respect to fixed-price projects, some customers request additional features or design changes not included in the original contract, but insist on paying the original, fixed price. With respect to variable-price contracts that stipulate a maximum number of billable hours, the project team continues working until the desired project targets are met, even if this requires the maximum hours to be exceeded. In such cases, the client is not charged for the extra hours of work. Often, deliverables are not clearly defined in contracts, and necessary engineering change orders (ECOs) are not obtained.

Financial Reporting and Systems

Mulk has continued her part-time accounting studies and expects to graduate at the end of June 2005. Although she understands the percentage-of-completion method of accounting, she has only applied it at year-end with the help of the auditor. Throughout the year, revenue is recorded upon invoicing because this method is easier to apply and most contracts take less than a year to complete. Monthly revenue and income fluctuates significantly because invoicing takes place on project milestone dates, which can be at highly irregular intervals. At year-end, it is usually necessary to accrue revenues on some projects and defer revenues on others as a result of applying percentage-of-completion accounting.

The monthly volume of credit card charges has reached several hundred transactions. Often, the salespeople neglect to report their charges to the accounting staff, making it necessary for an accounting clerk to track down the salespeople to verify charges when the monthly statement from the credit card company arrives. To avoid late payment charges, CDL often pays the bill before all of the charges have been properly verified.


CMA Canada 27

Chargeable employees are required to complete an electronic time sheet twice per month, detailing the number of hours they have worked on the various projects. Many employees ensure that the total time entered on the time sheet equals 40 hours per week regardless of the actual number of hours worked. Mondred is responsible for reviewing the time sheets before the information is downloaded into the Dabit accounting system and the payroll system. On one occasion, an employee entered on the time sheet 400 hours for a particular project in a single week, causing the customer to be billed for 400 instead of 40 hours.

Electronics Industry

Competition in the personal computer market has been increasing steadily, which has resulted in lower profits for manufacturers of computers and their components. Web browser and Internet security software issues have taken precedence over hardware issues to a certain extent. Sales of flat screen monitors have surged dramatically and there has been growth in the area of voice-over Internet protocol (VOIP) technology.

In Canada, sales of electronic equipment are expected to continue to decrease. Revenues, capital expenditures, and investments in R&D in the ICT industry continued to decrease in 2003 and 2004. Competition in the telecom industry intensified, causing profits to decrease in spite of a slight increase in revenues.

In the US, recent industry predictions indicate that sales of Internet equipment will grow at a rate of 6% in each of the next two years, and sales of other electronics equipment will grow by 8% per year. The Silicon Valley in California continues to be the largest high-tech centre in the US, followed by Texas, and then the Northeastern states. Salaries for electronic engineers and designers continue to be substantially higher in these areas than in Canada or the rest of the US.

Increasingly, for their outsourced work, firms in the US electronics industry have favoured suppliers that are ISO certified. Few companies that offer electronic design services in North America have this certification. Since 2003, a general feeling against foreign outsourcing has grown among the members of the US public because many white-collar, technology, and other service jobs in the US have effectively gone to India and China. However, businesses looking at the bottom line have not stopped reducing costs through all available means, including outsourcing to foreign companies.

Some companies have had significant intellectual property issues with design services companies outside North America. Trade secrets have been stolen by either the design services company or its employees and redress has proven very difficult to obtain, due to cross-border legal issues and the lack of intellectual property protection in many of these countries.

Tellcall Corp.

On April 27, 2005, Smelkin was asked to meet with Ben Jones, Vice-President, Strategic Planning & Analysis of Tellcall Corp. (TC), one of CDLs customers. TC is a fairly large, publicly traded Canadian telecom company offering long distance and local telephone service. During the past two years, CDL has invoiced TC for $1 million on four projects, representing an average booked rate of $100 per hour. The meeting initially focused on a prospective design project for a special telecom PCB. The focus then turned to broader issues.


28 CMA Canada

Jones indicated that, in order to remain competitive, TC will have to increase its focus on developing innovative ways to improve service to customers and to decrease operating costs. This will require more investment in electronic design as well as controlling the escalating costs of procuring design services. It was determined that hiring permanent staff to handle this ad hoc work would be neither efficient nor effective, and that procurement costs could be best controlled by developing a strategic partnership with a company that offers electronic design services. TC has been impressed with the work done by CDL over the past two years and would like to consider a strategic alliance. To this end, Jones asked to see CDLs financial statements. He indicated that the value of CDLs intellectual capital would be factored into any offer.

On May 10, Smelkin received TCs strategic partnership proposal, which included the following terms: 1) CDL given the option to swap 200,000 CDL common shares for 85,000 TC common shares or to sell 200,000 CDL common shares to TC for $850,000 cash; 2) CDL shareholders agreement to be amended to increase the maximum size of the board of directors to seven members and to stipulate that two members must be TC representatives; 3) on May 31, 2005, both companies sign a memorandum of understanding regarding future design work; 4) TC guarantees to give CDL at least $4 million of business per year for the following three years, based on variable-price contracts at the rate of $90 per billable hour; 5) CDL refrains from accepting any contracts from TCs main competitors; and, 6) TC recommends CDL to any of its customers requiring electronic design work. If CDL does not accept these terms, TC will form a strategic alliance with one of CDLs competitors and will no longer give any business to CDL.

Smelkin determined CDLs current contracts with TCs main competitors amount to about $3.5 million per year, and that TCs profits and share price have dropped over the past two years due to heavy competition. TCs shares are currently trading for $10 per share in the market.

Form Innovations Limited (FIL)

Over the past several years, CDL has worked on a few small projects for Form Innovations Limited (FIL). This small Canadian electronics company was founded by Marcus Mills, a very talented industrial designer, to develop innovative new products based on his ideas and take them to the market. Mills understands that being the first to take the products to market and gain market acceptance is critical to the companys success, and he has tried to achieve this in two ways. For some products with a relatively small potential market, FIL has manufactured the product in its small production facility and sold the units to a larger electronics company in the US, which has then incorporated the product into its own line of branded consumer products marketed through retail chains. For other products that have a larger potential market and require too large an investment in manufacturing processes for the company to handle, FIL has patented the products and licensed a large manufacturer to produce and market them. Both of these approaches have been successful and FILs products have retained respectable market shares even after competitors have introduced their own versions of the products.

Mills products have required increasingly sophisticated PCBs, which CDL has designed for him. His most recent idea is a small, inexpensive electronic device that would allow consumers to control programming for the recording of television programs and the subsequent playback from their home computers. FILs initial market research has suggested that, conceivably, this low-cost technology could replace VCRs and DVD players in the consumer market, and demand would be in the millions of units. Although production costs would be small, development of this product, designated as product X15, would require a significant investment in electronic design.


CMA Canada 29

FIL requested CDL to submit a proposal for completing the electronic design. CDL estimated that about 25,000 hours of work over twelve months, as well as $50,000 in out-of-pocket costs, would be required in order to create a working prototype. Rather than a fixed-price or variable-price contract based on design hours, FIL requested that the contract be based on a percentage of FILs revenues from product X15 and that the work be done on credit.

Smelkin knew that CDL could not afford to accept this project on credit unless additional financing could be found. He approached Ralph Manton of G Holdings Limited to ask for the necessary funds. Manton responded that G Holdings Limited would be willing to advance $1 million to CDL in the form of fully secured, five-year, 6% convertible bonds on the condition that FIL merge with CDL. The bonds would be convertible into 400,000 Class A common voting shares if CDL defaulted on payment at any time during the term of the debt.

Smelkin decided to explore the merger idea and met with Mills on April 29, 2005. At the meeting, Mills agreed to provide Smelkin with FILs financial statements (see Appendix B) in exchange for a copy of CDLs financial statements. He promised to consider a merger and respond by May 13.

Project Belleville

In late September 2004, CDL signed a contract with Multi-Comm Corp. (MCC) for project Belleville. This contract was for the design of telecom and Internet equipment for this large, private telecom company. Project Belleville was a fixed-price contract in the amount of $1.6 million, the largest contract that CDL had ever signed. This project was expected to be completed by July 31, 2005. By April 30, 2005, CDL had completed 70% of the work and had invoiced MCC on three milestone billing dates for a total of $900,000, but had received payment of only $300,000. Since MCC was a significant player in the telecom industry, CDL had not made any serious efforts to pursue collection of the overdue payments, and had recognized $1.12 million of the revenue from project Belleville in the year-end financial statements.

On May 12, 2005, CDL received the news that, because MCC had just filed for bankruptcy protection, project Belleville was cancelled and no further payments would be forthcoming. Mulk informed Smelkin that MCCs bankruptcy would cause CDL to violate the banks covenants for its line of credit and that something would have to be done quickly to avoid cancellation of the banks credit facility. The banks two covenants on CDL are as follows: 1) maintain a net book value, excluding intangibles but including software, of $2.0 million, and 2) maintain a current ratio of at least 1.5 to 1. If CDL violates either of these covenants, the bank can cancel the credit facility. The MCC bankruptcy will cause the 2005 after-tax loss to increase by $524,800 (i.e. $820,000 increase in bad debts less $295,200 increase in income tax refund due to loss carry-back).

Emergency Meeting

Smelkin called an emergency meeting of the members of senior management and the board of directors on May 13, 2005. They discussed the need to strengthen the balance sheet through an issue of long-term debt and, possibly, new shares. Those that held CDL shares indicated that they would prefer to avoid diluting their shareholdings, if possible, and Smelkin suggested that obtaining debt financing could be difficult. Another option was to develop a strong business plan that would address the problem of CDLs decreasing revenues and that could be used to


30 CMA Canada

convince the bank to increase the companys line of credit. This led to a discussion of the future direction of CDL.

Blanger and Manro felt that CDL should downsize further and reduce risk by seeking out strategic partnerships, such as the TC proposal. Smelkin was concerned that if staff levels are cut down any further, CDL would not have the capacity to match even last years revenues. Smelkin believes that the company has an excellent design team that is capable of returning the company to profitability. In his view, all the weaker employees of a few years earlier have either resigned or been encouraged to pursue other opportunities. He does not want to lose anybody from the current team, whose members he recruited. Before the news of the MCC bankruptcy, he felt that a profit of $800,000 for fiscal 2006 was achievable.

Bunburger and Carles argued that the focus of the sales effort should be shifted from the Canadian market to the US market. Carles indicated that a full-time sales office could be set up in the US for about CDN$200,000 per year, including travel, premises, and salaries, but excluding commissions. He also suggested that the possibility of success in the US would be enhanced greatly if CDL were ISO-certified.

Manton felt that the offshore providers of design services were growing too fast and too big for CDL to remain competitive as a service company and that CDL should change its focus to become a product company instead. He suggested that CDL should begin to develop and sell innovative electronic products and that a merger with FIL would be a step in the right direction. Smelkin indicated that he had just received an answer from Mills indicating that FIL would agree to a merger if certain conditions were met (see Appendix C). He also distributed a summary of some background information on FIL assembled by Prudence Joy and the results of a market study for product X15 conducted by Carles (see Appendix D).

At the end of the meeting, the participants agreed to recruit an independent consultant, Jana Sonn, CMA, to help them assess their options and recommend a course of action.

Other information

Since the news of the MCC bankruptcy, Bud Magee, a friend of Blanger, has expressed an interest in investing $420,000 in CDL common shares if there is a viable turnaround plan and the share price is no more than $3.50 per share. Aware of the problem with the MCC receivables, Magee says he is not deterred by short-term financial fluctuations and would be investing for the long term.

A professional business valuator has estimated that CDLs unrecorded intangible assets are worth around $4 million as at April 30, 2005.

The US dollar has weakened from nearly CDN$1.60 in 2001 to CDN$1.19 in April 2005. This development has hurt Canadian exporters, many of which use CDLs services.

In 2004 and 2005, approximately 41% of CDLs revenue came from business brought in by the independent sales agents. It had been expected that they would bring in about 50% of total revenue.

Since 2001, each of the two vice-presidents, Carles and Joy, have received a 1% commission for new business in addition to a base salary.


CMA Canada 31

CDL has not changed its salary levels to keep up with the market and, in 2004, three employees left for higher-paying jobs elsewhere.

Some of the design team members have experience in industrial design in addition to electronic design.

CDLs tax advisor has indicated that opening a sales office in the US would significantly increase the companys regulatory and tax burden.

Carles rarely turns down work because, in his view, unless all of the engineers are fully occupied, the work might as well be done by CDL.

During fiscal 2004, 20,000 stock options were exercised for $1.50 each bringing the total number of shares outstanding to 1,471,000.

CDL received SRED tax refunds of $196,300 in 2005 and $81,200 in 2004. The SRED tax credits claimed pertained mainly to qualifying work done for US customers. The MCC bankruptcy has no effect on the SRED tax credit.

During fiscal 2003, a total of 172,000 actual hours were spent on contracts by chargeable employees (168,000 hours) and subcontractors (4,000 hours), and 167,500 booked hours were reflected in the contract revenue.

The company has developed high-quality project documentation processes. Work is very well documented and files are stored in an orderly fashion.

Recently, three engineers admitted that, on their electronic time sheets, they did not record time spent on contract work that they felt was unproductive, such as pursuing a technical dead end or doing fruitless Internet research on a component. The related contracts addressed overall objectives, but not the use of every hour. Carles believes that clients with variable-price contracts should be charged for all hours worked on their projects, no matter how productive the designers time has been. Mondred, the Project Coordinator, has been debating the ethics of this with Carles.

An independent sales agent, who also holds a full-time job at Nesther Inc., is suspected of soliciting business for CDL from companies that compete with Nesther Inc. CDL is not sure what to do about this potential conflict of interest.

CDLs effective tax rate is 36% and its after-tax cost of capital is 10%. Required:

As Jana Sonn, CMA, develop an integrated report for CDLs board of directors, advising them on the strategic direction that should be taken, including recommendations and an implementation plan, and addressing other issues and concerns requiring their attention. In undertaking this task, you will need to take into consideration your background knowledge of the company as well as the additional information provided above.


32 CMA Canada

Appendix A Clear Design Limited (CDL)

Balance Sheet (Audited) As at April 30

ASSETS 2005 2004 Current assets:

Cash $ 83,520 $ 84,789 Accounts receivable and accrued revenue 2,340,366 1,867,653 Supplies inventory 26,924 28,144 Prepaid expenses 184,875 201,748

2,635,685 2,182,334 Capital assets:

Property, plant, equipment & design tools 3,070,460 2,972,608 Accumulated amortization 2,105,247 1,626,692

965,213 1,345,916

Total assets $3,600,898 $3,528,250

LIABILITIES & SHAREHOLDERS EQUITY Current liabilities:

Bank operating line $ 777,958 $ 25,969 Accounts payable 646,320 635,553 Deferred revenue 48,776 40,111

1,473,054 701,633

Long-term liabilities: Future income taxes 22,288 22,288

Shareholders equity: Common shares 2,216,211 2,216,211 Retained earnings (deficit) (110,655) 588,118

2,105,556 2,804,329

Total liabilities and equity $3,600,898 $3,528,250


CMA Canada 33

Appendix A (contd) Clear Design Limited (CDL)

Statement of Income and Retained Earnings (Audited) For the Fiscal Year Ended April 30

2005 2004

Net revenue $14,042,197 $15,127,990 Operating expenses: Salaries, commissions and benefits 11,039,208 11,544,004 Subcontractors 178,680 180,120 Commissions independent sales agents 287,865 310,124 Rent 275,150 275,150 Software maintenance 255,411 241,588 Insurance 151,888 149,785 Travel 614,788 463,285 Professional 174,090 176,222 Advertising & promotion 591,400 420,411 Communications 197,845 196,255 Office & other supplies 301,445 302,588 Other 428,444 456,485 Bad debt expense 140,422 151,280 Amortization expense 478,555 469,485 Interest & bank charges 18,839 4,998 15,134,030 15,341,780 Income (loss) before taxes (1,091,833) (213,790) Income taxes current (393,060) (76,964) Income taxes future - - Income taxes (393,060) (76,964)Net income (loss) $ (698,773) $ (136,826)

Beginning retained earnings $588,118 $724,944 Net income (loss) (698,773) (136,826)Dividends - - Ending retained earnings (deficit) $(110,655) $588,118

Statistics: Chargeable employee hours worked 148,666 156,240 Subcontractor hours 2,978 3,002 Actual hours worked on contracts 151,644 159,242

Total booked hours reflected in contract revenue 140,422 151,280

Number of jobs completed 177 221


34 CMA Canada

Appendix B Form Innovations Limited (FIL)

Balance Sheet (Unaudited) As at April 30

ASSETS 2005 2004 Current assets:

Cash $ 21,485 $ 28,485 Accounts receivable 214,810 207,376 Prepaid expenses 6,455 6,045

242,750 241,906 Capital assets (net) 214,792 215,819 Total assets $457,542 $457,725

LIABILITIES & SHAREHOLDERS EQUITY Current liabilities:

Accounts payable $166,601 $167,643 Shareholders equity:

Common shares 1 1 Retained earnings 290,940 290,081

290,941 290,082 Total liabilities and equity $457,542 $457,725

Income Statement (Unaudited) For the Year Ended April 30

2005 2004

Revenue: Product sales $2,298,472 $2,241,619 Licence revenue 428,863 60,259 2,727,335 2,301,878 Operating expenses: Production costs 726,841 744,762 Salaries and benefits 1,202,444 806,826 Subcontractors 76,458 73,485 Amortization expense 10,485 11,789 Selling and administration 388,975 364,664 2,405,203 2,001,526

Income before taxes 322,132 300,352 Income taxes 71,273 66,681 Net income $ 250,859 $ 233,671


CMA Canada 35

Appendix C Response from Marcus Mills, FIL

I have re

clear design limited (cdl) june 2005 exam cma

Documents

entrance examination

case backgrounder

examination centre

examination responses

examination date

industry information

background information

electronic design services