S&B is a medium-sized CPA firm. It is December 10, 2018, and the partner has called you into her office to discuss a new client. The client, Lilly Benjamin, is a naturopathic doctor who is employed at the local hospital. She is considering a business opportunity presented to her by Kareem Rosado, who recently opened Natural Health Haven (NHH), a natural health store located in Saskatoon. NHH is Kareem’s first business venture, as he has previously spent his career as a scientist working in a lab. NHH has been successful so far and Kareem wants to expand the operations to include naturopathic consulting services. Kareem would like Lilly to lead the consulting services and is offering her one-half of the shares in the business (health food store and proposed consulting services) for $100,000. Kareem provided S&B with excerpts from the draft financial statements along with some related notes (Appendix I). You have been asked to provide a report to Lilly on whether the purchase price is reasonable and whether she should proceed with the opportunity. The partner has asked you to analyze any accounting issues you identify in the financial statements. You should also include any other factors Lilly should consider in her decision to invest in NHH. The partner’s notes on a recent meeting with Lilly are included in Appendix II. You have also been advised that you can disregard any tax implications in your analysis.
Appendix I
Excerpts from Natural Health Haven’s draft financial statements Balance sheet As at September 30 2018 2017 Assets Cash $ 12,000 $ 3,000 Accounts receivable 1,400 11,800 Inventory 123,000 98,000 Deferred research and development 25,000 — Property, plant, and equipment, net 88,500 100,000 $ 249,900 $ 212,800 Liabilities and shareholders’ equity Accounts payable $ 18,000 $ 39,100 Long-term debt 45,000 50,000 63,900 90,000 Shareholders’ equity 186,900 136,700 $ 249,900 $ 212,800 Income statement For the year ended September 30 2018 2017 Sales $ 545,000 $ 379,000 Cost of sales 342,000 235,000 Gross profit 203,000 144,000 Operating expenses 152,800 152,300 Net income (loss) $ 50,200 $ (8,300)
Appendix I (continued) Excerpts from Natural Health Haven’s draft financial statements • NHH started developing a new botanical supplement in 2018 that helps to lower cholesterol. It will be marketed and sold exclusively at NHH. Results for the prototype have been positive and it is now in the final stages of testing. The product is not regulated by Canadian legislation so no external testing or approval is required. Market research indicates there is some interest in the product. The intention is to have it on the shelves of NHH by mid-2019. The estimated cash required to complete development is $100,000, and Kareem is trying to obtain funding but has not yet been successful. Costs of $25,000 related to development have been capitalized. NHH expects to continue with the research and development of products in the future, and this level of spending is considered normal. • NHH is being sued for $10,000 by a customer who had been taking WonderFace, a herbal remedy recommended to improve her acne. This customer started taking the herb on May 31 with hopes of a positive result by her July 1 wedding. Unfortunately, the opposite happened and her skin developed large blemishes that remained until her wedding day. She is suing NHH for the cost of the wedding she says was ruined. A pamphlet that comes with the acne supplement explicitly states that a skin condition could worsen in the first four to six weeks of taking it. NHH has recorded the amount as an expense in the financial statements to be conservative. • In August 2018, a local spa, Tranquil Moments Inc. (TMI), made NHH its sole supplier of organic essential oils used in massage, aromatherapy, and reflexology treatments. Under the contract, NHH is to provide a shipment of essential oils to TMI each quarter. The first shipment resulted in $13,000 in revenues. NHH secured this deal because it offered TMI a general right of return on all unused product as of the end of each quarter. The oils have a shelf life of only four months because they do not contain any preservatives or chemicals. Any returned product will be worthless.
Appendix II
Information on business proposal • Lilly did some research and believes that businesses such as NHH usually sell for three times normalized net income determined in accordance with accounting standards for private enterprises. Lilly’s research is based on similar businesses in the very health-conscious cities of Vancouver, Los Angeles, and Denver. The populations of these cities are significantly larger than Saskatoon. • Consulting fees are estimated to bring in an additional $130,000 per year. • The consulting service will generate additional sales because people will be in the store and in a health mindset. Kareem believes that this and other factors will increase product sales by 15% per year. Margins are expected to be approximately 42% of sales. • Operating expenses will increase by about $35,000 per year. These increases will cover any additional consulting services and health store expenses. Lilly earns $75,000 as an on-staff naturopathic doctor at the local hospital. Lilly’s husband stays at home with their three young children and will continue to do so. Therefore, she must maintain a reasonable salary to support her family. She enjoys working her standard hours of 8:30 a.m. to 4:30 p.m. and spending weekends and evenings with her family. • Lilly is excited about the opportunity presented by Kareem, as she studied business during her undergraduate degree. She has always wondered what it would be like to own a small business. She likes the idea of being her own boss. • Kareem has told her that it has been fun so far. He has been able to figure out all aspects of the business including the marketing and accounting for NHH. He is quite proud that he could prepare the draft financial statements entirely on his own.
