International Accounting Standard Individual Assignment

International Accounting Standard Individual Assignement

Diego Salzman1

November 2012

Abstract

This assignment is intended to assess your ability to critically scrutinise an investment op-

portunity by careful examination of the company accounts and decide whether if profits are

genuine and how strong companys finance really are.

The following data is based on a true story. Some of the names have been changed. Some

of the details have been changed and some situations simplified for academic purposes.

Keywords: Judgement under uncertainty, Decision Making, International Accounting, Fair Value

1Hult International Business School. [email protected]

1 Assignment Questions

1. Evaluate MIB Water For All business plan. What are its strengths and weaknesses? (20 marks)

2. What conclusions can you draw from your analysis of the financial statements? (30 marks)

3. Do you agree with all of the accounting assumptions made by MIB Water For All? If not, what

would you change?(30 marks)

4. Based on your analysis, would you invest in MIB Water For All?Why? (20 marks)

2 Introduction

Early in August 2010, Juan Perez and his MIB classmate John Stevens were on the ground in South

America. They were there to assess the progress of the first slow sand water filter of their company MIB

Water For All (MIBW4A). Four months earlier, Perez and Stevens, along with Marina Kaputt partnered

with Justin Knows and Jason Extract, two MD candidates at Kings College University of London, to win

the Inter-American Development Bank (IADB) Business Plan Contest. Their idea was to bring clean

water to several South American regions using a network of existing water vendors, readily available

water purification technology, and mobile-banking technology. If they were successful in Peru, the team

planned to expand operations into several other urban centres where water quality was poor.

MIBW4A seed money, the prize winnings from the IADB competition, would be gone at the end of

the month, and the team had a meeting scheduled in late November with some HULT ex-alumni working

on Venture Capital who were interested in investing in the company. At the meeting they intended to

present their business plan, updating their original financial analysis with experience gained from two

months of work getting MIBW4A started. Of particular importance was to show MIBW4A’s path to

profitability: the team knew there was considerable skepticism among investors that clean water could

be delivered profitably in South America.

3 Untreated Water and Health

In 2010, untreated drinking water remained a considerable health issue and a likely contributing factor

to premature deaths, especially in developing countries. In South America, malnutrition, the lack of safe

drinking water, and poor sanitation contributed to half of all childrens deaths. According to the teams

research, diarrhoea was the second leading cause of death around the world in children under 5 years old.

Waterborne pathogens accounted for many of the estimated 4 billion cases of endemic diarrhoea disease

1

(and 1.7 million deaths) each year. More children died every day from diarrhoea diseases associated with

unsafe water than from, malaria, and measles combined.

Wanting to use business as a force to do good, the team developed what they believed was an

economically viable and sustainable strategy to provide clean drinking water. The commercial nature of

their operation was important to the team. ”Most other efforts to bring clean water to the underserved

citizens had relied on volunteerism and had ultimately failed. Those efforts were not market-based and

proved to be unsustainable” Kaputt said. MIBW4A planned to distribute slow sand water filters to a

select network of water vendors so that the vendors could add the capability of selling clean drinking

water to their existing product line. According to the team, this partnership between MIBW4A and the

vendors would create a mutually profitable enterprise that brought affordable clean water to people who

otherwise did not have access.

3.1 Objectives of the company

• Public Health: Create a sustained reduction in the prevalence of severe diarrhoea in children

under five within three months of initiating business in any given city block.

• Profitability: Create a social business that would generate revenues sufficient to cover operating

costs, while financing future growth. Develop a recognisable brand that represented quality, success,

and dignity to the water vendor and end consumer.

• Community Building: Hire women to serve as the company’s water vendor service technicians.

The technicians would maintain and service the filters, and articulate and demonstrate clean water

testing, after-purchase clean water handling education, and other clean water community education

programs developed for water vendors and their customers.

• Environment: Reduce the environmental impact of deforestation associated with boiling water

using charcoal (the predominant mode of water treatment). Decrease the demand for bagged and

bottled water, which littered and polluted the land in the absence of recycling programs.

3.2 The Technology

Slow sand filtration was primarily a biological process that treated water much the way a natural spring

did. A column of water slowly passed through a three-foot layer of fine sand. At the top of the sand,

an intense layer of micro-organisms naturally developed. As the water passed through the deeper layers,

other processes such as sedimentation, mechanical filtration, and electrical attraction removed additional

contaminants. Both the U.S. Environmental Protection Agency (EPA) and the World Health Organisa-

tion (WHO) recognised slow sand filters as a superior water-purification technology.

2

MIBW4A planned to work with Blue Future Filters, a company that specialised in the manufacture

and installation of slow sand filters in developing countries, and had negotiated a one-time fee (USD

40,000) to have Blue Future Filters oversee the installation of the first filter and provide comprehensive

training on the workings of the filter to the local management team. MIBW4A also planned to work with

Blue Future Filters for the local manufacture of slow sand filters. The team believed if made locally, slow

sand filters would cost USD 250- almost halving the regular price Blue Future charged.

Mobile banking, also an important facet of MIBW4A’s technology platform, would be the primary

means to collect payments from the water vendors and to build community among them. A joint study

by the Centre of Economic Policy Research and Telefonica found that 97% of South American people

had access to a cell phone, most capable of running mobile applications. MIB4A had contacted an Indian

firm to develop a mobile phone application that would allow water vendors to make payments to the

company from their bank accounts. The use of mobile technology meant that MIBW4A’s technicians

would not carry large amounts of cash. Further, it decoupled the vendor service relationship from

collections, allowing MIBW4A technicians to work on behalf of the vendors without the sticky issues that

surrounded bill collection.

3.3 Delivering The Service

MIBW4a expected to provide each water vendor in its network a slow sand filter; the company was to

handle installation, maintenance, on-site water quality testing, and after-purchase hygiene education.

The selection of water vendors was critical, Kaputt noted: ”We were clear that we were only going

to engage with ’legal’ vendors, those who paid the city for the access to water which they had.” While

the team had yet to formally specify the criteria they were looking for in their technicians - those who

would maintain the filters, visit with the vendors, and educate the community on good water hygiene-

they strongly felt the technicians had to be women. ”Women have the knowledge of how the water sector

works in their communities,” Kaputt noted. Each technician was expected to support 20 water vendors.

The service plan called for MIBW4A water vendors to use their slow sand filter to produce clean water

and sell it in addition to the untreated water they typically sold. Water customers typically brought water

containers from home, filling their containers at the vendor station and carrying them home. MIBW4A

planned to provide end customers with either branded containers or logo stickers to clearly identify

containers with MIBW4A’s treated water. MIBW4A’s technicians would randomly sample water at its

vendor stations to ensure it was clean and met MIBW4A’s standards. If the treated water were to fail

MIBW4A’s tests, technicians would be instructed to disable the filter so that the vendor could not engage

in further sales.

3

In addition, the company planned to monitor the occurrence of diarrhoea in its markets via household

surveys.

3.4 The Business Plan

Water vendors averaged 150 to 350 customers per day. The physicians on the team concluded that each

customer needed at a minimum one litter of clean water per day for their household. The team planned to

have 50 filters operating by the end of their first year of operations, an additional 1,950 filters at the end

of year 2, and a further 1,000 filters operating by the end of the third year. Each vendor would have one

filter, so the network of vendors was expected to eventually grow to 3,000. After much market research,

the company decided to introduce its product, purified water, at a price of USD 0.08 per litter. At this

price, once all 3,000 slow sand filters were operational, the projected steady state unit sale of clean water,

assuming 150 customers, was 450,000 litters per day, or about 12% of the clean water market.

The major capital costs for the company were the slow sand filters. By using the expertise of water

treatment specialists from Blue Future and MIB’s own experience during year 1, the team predicted that

MIB4A would be able to locally manufacture filters beginning in year 2 for approximately USD 250 per

filter: filters in year 1 would have to be imported at USD 400 per filter.

In addition, the team expected to incur capital costs associated with purchasing motorcycles and

trucks needed to ferry technicians and equipment to the various filter locations. The team planned on

purchasing 3, 97, and 50 motorcycles, respectively, in years 1 through 3. The cost of each motorcycle was

estimated at USD 2,500. Flatbed trucks were necessary for the distribution of filters and filter servicing

equipment. MIBW4A would need to buy one truck in year 1, twenty trucks in year 2, and nine additional

trucks in year 3 at the price of USD 12,500 per truck (see Appendix for budgeted capital costs).

Capital expenditures needed to be depreciated in order to estimate the per unit cost of water dis-

tributed, which in turn was important for the unit pricing of water. The team expected the estimated life

of the slow sand filters to be 15 years and the vehicles five years. Also, the team concluded that ”straight-

line depreciation,” allocating an equal amount of depreciated capital in each period, was a reasonable

approximation of the use of filters and vehicles.

Operating costs included a USD 100 monthly salary for each water service technician. Since MIBW4A

would install 50 filters the first year, the company would need to hire three technicians. Therefore, the

annual costs for technicians would amount to USD 3,600 for year 1. With the addition of more filters,

the annual costs for technicians would amount to USD 120,000 and USD180,000 for years 2 and 3,

respectively.

A local management team consisting of a chief operating officer and several subordinates would draw

4

salaries of USD 120,000, USD 325,000 and USD 400,000 over the first three years. MIBW4A also planned

to have a sales staff of 20 in years 2 and 3, with each salesperson earning USD 150 a month (no sales staff

was planned in year 1). Thus, the annual costs of salespeople would be USD 36,000 in years 2 and 3.

The budget also called for each filter to be tested weekly at an expense of USD 2 per filter per week.

The estimated annual cost of testing for year 1 was USD 5,200, and it was expected to grow to USD

208,000 and USD 312,000 by years 2 and 3 as more filters were installed. In addition, the team projected

a USD 100 maintenance fee per filter per year, which included replacing the sand in the filter. The annual

costs of maintenance for years 1, 2, and 3 were estimated at USD 5,000, USD 200,000, and USD 300,000

respectively.

Marketing expenditures were planned to include advertising, logo stickers, and consumer education.

Marketing costs would amount to USD 10,000, USD 25,000, and USD 40,000, respectively, for the first

three years. In addition, the company planned on retaining a local celebrity to serve as a brand ambas-

sador. Such an ambassador would be necessary to build local trust in the MIBW4A filtration process.

The brand ambassador would be engaged on a three-year contract entitling her to receive payments of

USD100,000 for years 1 and 2 and one percent of annual revenues in year 3. There were also costs as-

sociated with operating the companys fleet of motorcycles and trucks. Vehicle operating expenses were

expected to be USD 2,500, USD 65,000, and USD 110,000, respectively, for the first three years.

There was considerable anxiety among the team about experiences shared by other entrepreneurs in

South America about the ”informal cost of doing business” . According to Transparency International,

most of the countries of the region rank among the most corrupt country in the world . The team

knew that for MIBW4A to achieve a timely launch of its operations, the company might need to engage

with local politicians and other officials. As undesirable as this practice was, the team was struggling

with how to balance political realities with its social mission of bringing clean water to the residents

An entrepreneur with experience in the region elaborated: ”In the city there are political blocks and

each block has a leader who can help with access to the right people and make important connections.

Unfortunately, one has to make a small contribution to engage them. The police also are apt to pull

people over without just cause and, to be honest, one has to give them a few dollars to be free to go.

One never knows what these informal costs will be. But one needs to make an estimate and factor that

into budgets. On average, one should figure on these costs being as high as 10% to 20% of a business’

revenues.”

A key challenge for the team was how to motivate, monitor, and compensate its network of water

vendors. The water vendors were at the heart of the company: they would be responsible for selling

the product and collecting the revenues. They were also the first line of defence on quality control. The

5

team considered several possible incentive contracts with the water vendors, including leasing the use

of filters for a flat fee and a profit sharing agreement. After much deliberating, the team decided to

pursue a revenue sharing agreement. Under this agreement, the water vendors would receive 20% of

the revenues associated with the sale of clean water. MIBW4A, which would receive the other 80% of

revenues, and would be responsible for all of the costs discussed above. With revenue sharing, MIBW4A

retained control over the price end-customers were charged for the clean water. This gave the company

better market intelligence and flexibility; moreover, it allowed the partners to ensure that their primary

goal of delivering clean water at affordable prices was not a victim to price gouging vendors.

The key risk with revenue sharing was underreporting: given their informational advantage, vendors

would have the means and incentives to underreport revenues to MIBW4A. The company estimated

that underreporting would decrease its gross revenue by 10% to 15%. To mitigate this risk, MIBW4A

planned to randomly audit the vendors’ sales data. Another risk with the revenue sharing agreement was

that it did not create a direct financial incentive for the vendors to care about MIBW4A’s costs. The

company was particularly concerned about vendors abusing or misusing the filter equipment (MIBW4A’s

key tangible asset). The founders were debating how to incorporate in their financial projections any

contingencies for filter-related losses given vendor abuse.

4 Investor’s presentation

Based on projected capital and operating outlays, MIBW4A estimated their external financing needs to

be about USD 200,000 for year 1 and USD 1,000,000 for year 2 (there were no external financing needs

in year 3 because year 3 growth was expected to be financed through year 2 profits). They planned to

raise the year 1 funds through a 20% equity investment in MIBW4A and the year 2 funds through a

one-year loan at a 10% interest charge, to be repaid at the end of the year. In order to attract such a

sizeable investment in a country with very little foreign capital, the team knew they would need to have

very sound financial projections. In anticipation of the meeting, the company has send you a the below

narratives of their project and three years of projected financial statements (Income Statements, Balance

Sheets, and Cash Flow Statements) which are provided to you as an appendix.

Now is up to you to decide...

6

5 Appendices

5.1 Capital Costs, Years 1 to 3

5.2 Slow Sand Filter

7

5.3 Additional Accounting Information

1. Worksheet year 1

2. Worksheet year 2

3. Worksheet year 3

4. Financial Statements year 2

5. Financial Statements year 3

8

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