New Line Plc: Blue Case Study Workshop

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New Line Plc
Suggested time : 85 minutes

New Line plc (New Line) is a small public company traded on local Smaller Companies Market.
New Line is controlled by its CEO, John Dykeman, who owns 51% of the common shares of
the company. The other significant shareholder is Michael Grey, who sits on New Line's Board
and holds 25% of the shares. The rest of the shares are widely held. It is now December 2010.

New Line has a research and development division (RDD) and a distribution division (DTD).
Each division has a manager and is operated independently. RDD is managed by Frank Black
and DTD is managed by Bill White. RDD performs research and development on leading-edge
pharmaceuticals intended to prevent or cure some of the most dangerous diseases from
around the world. Once drugs have been accepted by the authorities and are ready for use by
the general marketplace, the exclusive rights to manufacture and distribute the drugs are
transferred to DTD. DTD is responsible for patenting, manufacturing, and distributing the drugs.

You are Charlie Chase ACA, the newly appointed Assistant Financial Controller for New Line.
John calls you to his office to discuss some recent developments at New Line.

"We've been approached by a government body with a proposition. The United Nations, in
conjunction with the World Health Organization and Rotary International, have a stated
objective of eradicating polio from the face of the earth by the end of 2013. Over the past 20
years, polio has been eradicated from over 99% of the world's land mass. The last remaining
new cases of polio exist in northern India and eastern China. New Line has a polio vaccination
that is considered highly effective. The government has asked New Line to donate 10 million
doses of the polio vaccination to the United Nations in 2011 to immunize children in certain
parts of India and China who are at high risk of contracting the disease. I've spoken to Bill and
he estimates the cost for DTD to manufacture and distribute the vaccines to be C/10 million.
The largest shipment of polio vaccine we've done in the past is 1 million doses, and, after a
significant volume discount, the sales price was C/5 million.

"We've also been in discussions with a government body regarding our ongoing cancer drug
research. The government has received high praise in the medical community for the
advancements they've made in this area, but the government now feels that further progress
could be expedited through giving selected research companies access to its research.
Specifically, the government would provide the companies selected with a non-exclusive and
non-transferable access right to the research developed by the government in this area. The
government has also agreed not to charge royalty fees to the selected companies on any
marketable drug they are able to develop based on the research provided. The government has
told me that if we were to accept the proposition above to donate polio vaccines, New Line
would have a better chance tobe one of the companies selected to have access to the cancer
research. Frankly, I'm not entirely sure what our chances of being selected are if we don't
accept the proposition, but I'm optimistic. I've discussed this issue with Frank and he believes
the access rights will allow RD to develop, within the next five years, a drug that will reduce the
negative effects of certain cancers.

"To be honest, I consider myself a philanthropist and would like to help. I also believe the
proposition would benefit our reputation. However, Bill has indicated that he is concerned the
cost of this transaction is too high and does not believe we should accept this proposition.
Apparently, he's gone so far as to speak with Michael and has received his support on this one.
On the other hand, Frank has told me he believes the potential for a new cancer drug far
outweighs the short-term costs related to the polio vaccine and said Bill and Michael lacked
vision. I'm sure you've noticed that Bill and Frank never seem to get along. I'm leaning towards
accepting the proposal, but first, I'd like you to provide me with an explanation of the accounting
impact of this transaction. As part of your explanation, I'm curious to understand whether I
should be looking at the polio vaccination donation and the access rights to the cancer
research together or separately. As for Bill, Frank and Michael, I just don't understand why
New Line Plc: Blue Case Study Workshop
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there is disagreement on whether to accept the proposal. Isn't this proposal good for the entire
company and its stakeholders?I would like your views.

"I'd also like your help with some legal matters. I received some good news during the past
week about a lawsuit we had initiated. You're probably not familiar with the case as it dates
back to before you joined the company. New Line sued a competitor, Virtucon plc (Virtucon),
who was manufacturing and distributing Magma. Magma is a product very similar to a drug for
which we have the patent, and, consequently, the worldwide rights to manufacture and
distribute. Virtucon, like us, is a publicly-traded company. The judge concluded that Virtucon
had copied the drug produced by us and, as a result, we won the lawsuit. The judge has
ordered Virtucon to pay us for the Income it earned on Magma, defined as revenues less
expenses directly attributable to Magma, plus all legal and other costs associated with the
lawsuit. But before Virtucon pays up, we've been asked by the judge to do a couple of things.
Now that you're up to date on the case, I'd like you to take care of the judge's requests for me.

"Here's a schedule produced by Virtucon, by order of the judge, of the Magma income
calculation (Appendix I). The judge has asked us to review the schedule and determine if we
agree with the calculation. He also wants to know what procedures we would like to see
performed by an independent party to verify the accuracy of the schedule. The judge also
suggested that we identify where we would like additional information. However, he reminded
us that we would have to justify why we consider this additional information necessary. The
judge explained that he will review our analysis of the calculation and suggested procedures,
and if he believes the procedures are acceptable, an independent auditor will be appointed by
the court to carry them out.

"I have to step into a meeting right now, but why don't we meet at the end of the week and we
can discuss your memo to me with all of your recommendations."


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APPENDIX I

INFORMATION RELATED TO MAGMA
PRODUCED BY VIRTUCON PLC PURSUANT TO A COURT ORDER

Magma was produced and sold for 30 months by Virtucon. The schedule that follows captures
the Income associated with Magma.

Revenue
Sales associated with Magma (note
1) C / 13,750,000

Cost of Goods Sold
Manufacturing costs of Magma (note
2) 2,750,000
Gross Profit

11,000,000

Expenses
Distribution expenses (note 3) 1,250,000
Overhead (note 4) 1,185,000
Research and development (note 5) 3,565,000
Management bonuses (note 6) 371,000
Advertising and promotion (note 7) 1,290,000
Income taxes (note 8) 1,168,650


8,829,650
Income C /

2,170,350

Notes:

1. During the 30 months, Virtucon sold 1,375,000 units of Magma at an average price of C /
10 per unit. At the end of the 30-month period all the Magma inventory was sold.

2. The total manufacturing costs for Magma averaged C / 2.00 per unit. This ncludes C /
1.00 for raw materials, C / 0.50 for direct labour costs associated with the manufacturing,
and C / 0.50 for the manufacturing equipment amortization. The manufacturing equipment
has been fully amortized by Virtucon sInce it is no longer used to manufacture the Magma
drug, although it can be used for the manufacture of a variety of other products.

3. Distribution expenses nclude freight costs of C / 750,000 for distributing Magma and C /
500,000 for samples given to doctors.
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APPENDIX I (continued)

INFORMATION RELATED TO MAGMA
PRODUCED BY VIRTUCON PLC PURSUANT TO A COURT ORDER

4. Overhead Includes an allocation of all administrative costs associated with Virtucon. The
details of these costs are as follows:

Wages and benefits C / 1,700,000
Rent 250,000
Office supplies 175,000
Utilities 95,000
Amortization of office furniture 150,000
C / 2,370,000

Allocation to Magma C / 1,185,000

During the 30 months, Virtucon manufactured and distributed only two drugs. Therefore,
50% of the administrative costs have been allocated to Magma.

5. Costs directly associated with the development of Magma by Virtucon were C / 3,565,000
and were Incurred in the last 10 years. These costs have Included many failed development
attempts.

6. Management of Virtucon was paid a bonus equal to 10% of the pre-tax profits of the
company. The management bonuses of C / 371,000 represent 10% of the pre-tax Magma
drug profit. SInce these bonuses were paid to management, there is no way of reclaiming
them.

7. Virtucon has developed an advertising campaign to help promote its public image. The
costs of developing this campaign and of advertising over the 30-month period totalled C /
2,580,000. Half of these costs have been allocated to Magma.

8. Virtucon is a public company with an effective corporate tax rate of approximately 35%.