Wallace Inc. is a small, publicly traded manufacturer with three divisions: 1. Electronics (Electro) assembles electronic products for industrial users. 2. Consumer Products (Consumer) assembles electronic products for consumers. 3. Circuitry (Circuit) manufactures the electronic circuit common to the products sold by Electro and Consumer, and sells any excess Circuit output externally. Up until very recently, profits for Wallace exceeded expectations. However, increased competition and a recent downturn in demand for electronic products have caused a considerable drop in profits for the company. One of the divisions, Circuit, is losing money. Senior management believes that outsourcing the circuitry may be more cost effective than producing it internally. Management has negotiated a bulk purchase price of $28/unit with an outside supplier whose only line of business is building circuitry. At the board meeting on October 1, 2021, a proposal was presented to the board to outsource the circuitry for Wallace's other divisions and to shut down Circuit. Information about the profitability of its divisions for the first nine months of the current fiscal year, as well as specific information on Circuit, are provided in Appendix I. The fiscal year is January 1 to December 31. It is now October 15, 2021. The president of Wallace, Jeff Wallace, has approached you, CPA, an analyst in the corporate office, to assist in answering the board's requests. "After our last board meeting, some board members were surprised by our decision to outsource the circuit units and questioned whether it will truly be cost effective. Please prepare a memo for me evaluating the outsourcing of the circuitry work from a quantitative and qualitative perspective, and provide a recommendation. "As well, we are dealing with a couple of unusual financial reporting issues this year one with regard to a lawsuit and one with regard to the costs associated with the purchase of some new robotics equipment (Appendix II). Can you recommend appropriate accounting treatments for management's consideration?" Wallace reports under IFRS.

After your conversation with Jeff, you also met with the general manager of Circuit, Edward Horton. Edward blames the transfer pricing policy for the performance of Circuit. He is also concerned about the corporate costs allocation policy and the effect that this policy has on management bonuses. While you do not have sufficient information to recast the financial statements, you decide to discuss these concerns qualitatively in your memo to start. Your notes from your meeting with Edward are summarized in Appendix III.

Appendix I Divisional financial information For the nine months ended September 30, 2021 (Unaudited)

Electro Circuit Consumer Total

Sales- external 6,000,000 825,000 7,000,000 13,825,000

Sales internal 1,410,000 1,410,000

COGS 3,600,000 2,600,000 3,500,000 9,700,000

Gross Margin 2,400,000 (365,000) 3,500,000 5,535,000

Divisional Cost 1,000,000 4,00,000 1,700,000 3,100,000

Operating income 1,400,000 (765,000) 1,800,000 2,435,000

Corporate Cost allocation* 500,000 500,000 500,000 1,500,000

Income before taxes 900,000 (1,265,000) 1,300,000 935,000

Income tax 36% (336,600)

Net income 598,400

*Information on the corporate cost allocation can be found in Appendix II.

Circuitry division Units per year Units to Sept. 30, 2021 Transfer/ sales price

Capacity of

manufacturing facility 133,333 100,000

Internal transfers 100,000 75000 $18.80 (Note 1)

External Sales 33,333 25000 $33

Note 1: Divisional transfer pricing is set equal to the variable cost of production.

Costs incurred per unit:

Materials $ 6.00

Labour 8.00

Variable manufacturing overhead 4.80

Fixed manufacturing overhead 7.20

Total $ 26.00

Appendix II

Corporate costs

Nine-month summary

Information technology department (Note 1) $ 475,200

Marketing department 463,000

Legal department (Note 2) 121,500

Human resource department 210,000

Accounting department 230,300

Year-to-date corporate costs $ 1,500,000

In accordance with corporate policy, these costs have been allocated evenly to each of the divisions.

Notes:

1. Wallace purchased two new pieces of robotics equipment in January 2021. The equipment is intended to automate and reduce costs related to the packing process when shipping the assembled Electro and Consumer products. The total cost of the robots was expensed in the information technology department, so the cost allocation is about $125,000 higher than the same period last year. The cost breakdown is as follows:

IT department time spent researching the best robots $ 10,000

Cost of the robots 80,000

Delivery 8,000

Assembly and installation 15,000

Testing to ensure correct functioning 7,000

Repairs since installation 5,000

Total cost of the robots $ 125,000

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

Appendix III

Summary of the meeting with Edward Horton, Circuit general manager

Edward Horton explained that Wallace is a decentralized organization and that each division is run independently by a general manager. Compensation for the managers is based on a salary with bonuses for achieving set profitability targets.

Edward said: "The other divisions are allowed to buy and sell as they wish, but we have to ensure that Wallace's internal requirements are met before we can sell outside. I know that our division can generate additional revenue. The price we receive from our internal sales isn't even close to what we receive when we sell our product to external buyers. The transfer price is based only on the variable cost of production. That only worked in the days when we could not sell all of our production. There is a robust external market for the circuitry, therefore, we could sell more to the outside market if management would let us.

"On top of that, head office calls us a profit centre and bases our bonuses on our divisional net income. It isn't fair. In addition to a low transfer price, we are allocated a high amount of costs from the corporate office. Take a look at the supporting information they sent us this quarter explaining the allocation (see Appendix II). It's got nothing to do with our division, as far as I can tell. I wish senior management would do something to make it fairer for us." "Also, I don't think the proposed closure of Circuit is going to save as much as senior management thinks it is. Yes, most of the manufacturing overhead costs would be saved, but Circuit supervisors would be transferred to other divisions. Their total salaries are about $250,000 per year. There would be no savings in corporate costs even if Circuit is closed. Wallace would also have to discontinue sales of circuitry to external parties, as the sales team currently expensed in Circuit's divisional costs would be let go"