QUESTION

							Course 4590 - Practice Case - Solution

QUESTION

Suggested approach

Mr. Dichard
Ralding Ltd.

Dear Mr. Dichard:

Attached is a report outlining the various implications involved in selling your company to a private
consortium of investors.

If you need any further information please feel free to contact me.

Yours truly,

CA

REPORT ON SALE OF SHARES TO PRIVATE CONSORTIUM

Your decision to sell a portion of your shares to a private consortium has general business implications as
well as accounting & financial reporting and tax implications.

General Business Implications

Sale Price:

The sale price for the 28% of the shares outstanding to be sold, is based upon three times the company's
earnings for the year ended December 31, 1999. In Appendix I, the financial statements at September
30, 1999 are adjusted, to properly reflect Generally Accepted Accounting Principles (GAAP). After
adjustments, net income from continuing operations amounts to only $330,146. This would result in a
price of $277,322, which is approximately equal to 28% of the adjusted book value of the company of
$264,538 (as per Appendix I), rather than being twice as high as 28% of the net book value of the
company.

Furthermore it is likely, that the sale price for the 28 per cent interest is well below the fair market value
of 28 per cent of the net assets of the company. This would be the case, due to the fact that certain
assets may be worth more today than when they were purchased and this would not be reflected in the
financial statements in which values are based on historical cost (i.e. the original cost of the asset). For
example, the company had the opportunity to sell one of the buildings which had been purchased for
$430,000 and was already 50% depreciated, for $1,050,000. Assuming that the book value of the
building is approximately $215,000, (after being 50% depreciated, assuming straight line depreciation),
the market value of the building appears to be $835,000 in excess of its book value. Accordingly, after
considering this asset alone, the market value of the net assets of the company is $1,779,779 (compared
with a book value of $944,779) which results in the market value for 28% of the net assets of the
company amounting to $498,338. If we were to consider the market value of the company’s other plant,
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Course 4590 - Practice Case - Solution

also purchased in the 1970's, it is likely that the market value of the net assets would even be further
increased.

Accordingly, on the assumption that there will not be a major increase in income in the last three months
of fiscal year 1999, if you agree to sell 28% of the shares of the company based upon the agreed formula,
you will not even be recovering the market value of your assets, not to mention the value of an established
operation with a good reputation.

We would therefore recommend that you not sell 28 per cent of your shares at a price equal to “three
times your 1999 income from continuing operations based on Generally Accepted Accounting Principals
(GAAP).” Rather, you should re-negotiate a price that is more reflective of the true value of your
business. As your business (i.e. a portion thereof) is being sold as a going concern, the price should be
based upon annual earnings or cashflows. The earnings or cashflows used to calculate the price should
however be reflective of future expectations and should not simply be based on 1999 GAAP earnings (or
cashflows). For example, regardless of whether under GAAP, the termination of the basketball operation
constitutes a discontinued operation, for the purpose of determining a price for the shares, its losses
should not be taken into account if they are not reflective of future cash flows. Under no circumstances
should the business be sold for an amount less than 28% of the fair market value of its net assets.

Other Business Implications

The consortium of investors will have a significant impact on the operation of the business. Although
following the sale of shares you will still retain control of the business, the consortium of investors will
own a large block of shares and will expect to have some influence over the business, and be involved in
major strategic decisions even if they leave day-to-day operations to you.

For example, in order to safeguard their interest, they may ask certain members of the consortium to sit on
a Board of Directors for the company. The board of directors would likely assume responsibility for
assessing your performance (as well as the performance of any other senior management) and would
expect to be involved in approving major strategic decisions. The investors may also not be comfortable
with your "seat of the pants" management style and may wish to have a more in-depth analysis
performed before major projects are undertaken. Accordingly, you likely will not be able to function
with the same degree of flexibility as you are currently accustomed to and you must be able to live with
this, if you are to proceed with the sale.

The new investors will also probably not be agreeable to your giving special treatment to your brother’s
machinery repair and installation company, but rather will expect you to use the same competitive bidding
procedures for such work as they would expect you to use in awarding any major work to external
companies. They will also expect any transactions with your brother's company to be properly
documented through normal contracts.

A shareholder agreement should be drawn up between yourself and the consortium.




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Course 4590 - Practice Case - Solution

Accounting and Financial Reporting

If you were not to sell shares to the consortium, you would be preparing financial statements primarily for
tax purposes. Accordingly, your financial statement objectives would be geared toward minimizing
taxes. However, should you sell shares to the consortium, you will have to consider the other investors'
objectives given their large block of shares. The financial statement objectives of the new investors will
likely be to assess your stewardship of the company as well as maximize their cash distributions (i.e.
dividends). This will reduce your flexibility to choose accounting policies which will meet your
objective of minimizing income so as to minimize your tax burden.

The new investors will be particularly interested in knowing the extent of related party transactions.
Accordingly, the disclosure of related party transactions such as purchases from your brother’s company,
will be even more important than in the past.

The new investors may also expect to receive financial information on a periodic basis in order to monitor
their investment. Accordingly, it may be necessary to produce financial information on a monthly or
quarterly basis rather than simply producing annual financial statements.

As a final point, the investors may want to have an audit performed in order to ensure that they receive
their fair share of income. You will have to take this into consideration in deciding whether to have an
audit performed in future years.

Tax Implications

Sale of Shares:

When you sell the business, assuming it is sold at a fair price, you will experience a substantial capital
gain given that your initial investment in the business was only $200,000.

You will, however, be able to claim a deduction of up to $500,000 on the capital gain, provided the shares
sold constitute "Qualified Small Business Corporation Shares", assuming that you have not previously
used any part of the $500,000 exemption.

In order to qualify the following is required:

1.      all or substantially all of the assets of your corporation at the time of the share sale, must be used
        in an active business;

2.      the shares must have been held by you for the last 24 months; and

3.      throughout the last 24 months, more than 50 per cent of the fair market value of the assets of the
        company must have been used principally in an active business carried on by the corporation
        primarily in Canada.

Given that: (I) you have owned your shares since the inception of the company; (ii) it would appear that
all of the assets of the company are being used in an active business and to the best of our knowledge
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Course 4590 - Practice Case - Solution

have always been used for the active business of the company; and (iii) your business is primarily carried
on in Canada, it would appear that your sale of shares would qualify for the deduction. We will,
however, have to verify these facts.

Depending upon the price you receive for the company you may experience a gain in excess of $500,000.
With regard to the amount of the gain in excess of $500,000, 50% of the excess capital gain will be
included in taxable income and taxed at the personal marginal tax rate. You should consider structuring
the sale so that the proceeds in excess of $500,000 are received over a period of 5 years, as opposed to
collecting the proceeds immediately. You will be allowed to defer a portion of the gain for up to 5 years.
Specifically, the reserve you can take is the lesser of

(1)     (Proceeds not yet due / Total proceeds ) x gain and;

(2)     1/5 of the capital gain times (4 minus the number of preceding taxation years ending after the
        disposition of the property).

This option assumes that you do not require 100% of the cash immediately.

Should you choose the option of taking back a receivable for a portion of the proceeds, you should
demand security from the purchasers of the shares. The security should however not be the purchasers'
shares in Ralding or you will be dependent upon the success of Ralding in collecting the proceeds. This
runs counter to your objective of reducing your reliance on the sports equipment industry.

Other Tax Issues:

As discussed earlier, once there are other investors involved, you will have less opportunity to minimize
corporate taxes through choosing accounting policies that will minimize income. Furthermore, there will
be less opportunity to engage in income splitting (e.g. with your wife) to reduce your family's tax
obligation.




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Course 4590 - Practice Case - Solution

                                              APPENDIX I

            ADJUSTMENTS TO STATEMENT OF EARNINGS AND BALANCE SHEET


Statement of Earnings:

Net income from continuing operations for
9 months ended September 30, 1999                                              $824,196

Less    Adjustments to correct for GAAP deviations:
        Elimination of portion of gain on transfer of
        plant to joint venture (Note 1)                       $300,000

        Write-off of production software (Note 2)               80,000

        Treatment of losses from basketball
        equipment operation as losses from
        continuing operations (Note 3)                         266,050

Total adjustments on pre-tax basis                             646,050

Total adjustments on after tax basis (Note 4)                  494,050
Adjusted net income from continuing operations                                  330,146

Price for 28% of shares based upon adjusted income (Note 6)                    $277,322


Balance Sheet:

Net book value as at September 30, 1999                       1,172,779
Less total adjustments to income statement (Note 5)              228,000

Adjusted net book value                                                         944,779

28% of Adjusted net book value                                             $    264,538




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Course 4590 - Practice Case - Solution

                                       APPENDIX I (continued)

           ADJUSTMENTS TO STATEMENT OF EARNINGS AND BALANCE SHEET

NOTES:

1.     The adjustment reflects the fact that only $100,000 of the gain on sale of the plant to the joint
       venture can be recognized rather than the $400,000 recognized.

2.     As the future of the production software is very uncertain given the bugs in the software (which
       has led to the purchase of new software), there is not reasonable assurance regarding a future
       benefit. Accordingly, it is not permissible to capitalize the costs of producing the software.

3.     The losses from discontinued operations are added back to income from continuing operations as
       the basketball operation does not constitute a "discontinued operation" under GAAP.

4.     Assumed tax rate of 40% based upon effective rate reflected in financial statements for 9 months
       ended September 30, 1999. Did not tax effect losses from discontinued operations as losses from
       discontinued operations are presented in the financial statements on an after tax basis. (($300,00
       + $80,000) x (1 - .40)) + $266,050 = $494,050).

5.     Total adjustment to net book value based upon the following:

       Elimination of portion of gain on sale of plant                          $300,000
       Write-off of software                                                        80,000
       Total adjustment pre-tax                                                   380,000

       Total adjustment - after tax (at 40% tax rate)                           $228,000

6.     The price for 28% of the shares based on adjusted income is:

       Adjusted net income      $330,146 x 3 = $990,438 x 28% = $277,322.




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Course 4590 - Practice Case - Solution

Date: October 1999
Memo to: Partner
From: CA
Subject: Ralding Ltd., 1999 Audit Engagement

As requested, I have prepared an analysis of the accounting and audit issues for consideration for the 1999
audit of the above company.

Overall Considerations

Risk on this engagement is high for the following reasons:

1.      28 per cent of the shares are up for sale and the price of the shares are to be based upon the
        financial results of the company. In light of this, Mr. Dichard has a great incentive to inflate net
        income from continuing operations.

2.      Internal controls are very poor.

Materiality should be low given that any errors will impact the purchase price.

In light of the low materiality and lack of internal controls, a high level of detailed substantive testing will
be required.

1.      Discontinuance of Basketball Equipment Operation

        Ralding has chosen to treat this operation as a discontinued operation. We must determine
        whether in fact this operation constitutes a discontinued operation. This decision is critical as it
        will have a large impact on the audit, in particular due to the fact that the sale price is dependent
        upon net income from continuing operations. It is therefore to Mr. Dichard’s benefit to treat
        these operations as discontinued, given that this operation is producing losses.

        In order for the operations to be treated as discontinued

        (I)      there must be a formal plan to dispose of the operations; and

        (ii)     the basketball equipment operation must constitute "discontinued operations" rather
                 than simply a portion of a business segment.

        With regard to point (I), although Mr. Dichard has decided to discontinue the production and sale
        of basketball equipment, it is not clear whether there is a formal plan of disposal. Further work
        will be required to determine whether a formal plan exists.

        With regard to point (ii), in order to constitute a separate business segment, the nature of the
        activities, related assets and results of operations of the basketball operation would have to be
        distinguishable from those of the overall company’s sports equipment operation, such that it is
        subject to significantly different "risks and economic benefits" compared with the other activities
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Course 4590 - Practice Case - Solution

       of the company.

       It could be argued that the basketball operation caters to a similar market, relative to other
       segments of the company, (i.e. sports equipment stores and professional teams). Furthermore, it
       does not have many of its own employees or own its own major assets, given that it currently
       functions from the same plant as the company’s other operations. This would lend support to the
       contention that this operation is effectively integrated with those of the rest of the company and
       subject to the same "risks and economic benefits" rather than being a separate business segment
       which has been discontinued.

       Alternatively, it could be argued that to some degree it is subject to different risks and rewards
       given that (I) it is reliant on a new professional sport in Canada in and (ii) some of its sales are to
       stores specializing specifically in basketball as well as to professional and amateur basketball
       teams. Furthermore it is more reliant on the U.S. market than the other sports                      with
       approximately 50% of sales coming from the U.S. compared with only 25% for other sports and
       it could be argued that the U.S. market is subject to different risks and rewards than the Canadian
       market. (It is precisely due to the fact that the market for basketball equipment is not the same as
       that of the other sports that there is a separate product manager and assistant manager for
       basketball equipment.) As a final point, it could            be argued that it is due to these different
       risks and rewards that the basketball operation was not as successful as the company’s other
       operations.

       Although there are arguments for treating the basketball operation as a discontinued operation, I
       would conclude that the arguments against discontinued operation treatment are stronger, given
       that this operation is integrated with the other operations; it still caters to the same broad market
       being the sports equipment market; it sells in the same geographic markets as the other operations
       with the only difference being the proportion of sales in each market and it does not have its own
       distinct operation (given that for the most part it shares assets and employees with the other
       operations). Accordingly, for all intent and purposes it is simply a district product line integrated
       with the other operations of the company, subject to the risks and rewards associated with serving
       the overall sports equipment market.

       Accordingly, although treating the basketball operation as a discontinued operations would be
       more optimal in terms of maximizing the sales price for the shares, based on the current sales
       formula, I would recommend that it not be disclosed as a discontinued operation.

       We should however, ensure that appropriate accruals (e.g. severance costs) are made for the
       termination of the product manager and assistant product manager and that, there are no other
       costs which result from the shutdown of this operation, for which accruals are required.
       Furthermore, if we determine that a detailed exit plan exists, consideration should be given to
       accruing the loss expected in 2000 on the remaining existing basketball equipment contracts,
       given that some of these contacts are relatively significant, despite the fact that this operation
       does not represent a separate business for the purpose of discontinued operations disclosure. As
       a minimum the company should disclose in the notes to the financial statements the commitment
       to fulfill these contracts.

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Course 4590 - Practice Case - Solution


2.     Joint Venture with other Sports Equipment Manufacturer

       With regard to the joint venture, there are two issues:

       (I)     Consolidation of financial statements of joint venture with those of Ralding

       (II)    Sale of plant by Ralding to joint venture

       Consolidation of Financial Statements

       It will be necessary to consolidate the financial statements of the joint venture of Ralding using
       proportionate consolidation. As participation in the joint venture will have a material impact on
       the financial statements of Ralding, we will have to gain assurance regarding the financial
       statements of the joint venture by relying on the work of the joint venture’s auditors, Smith,
       Smith & Associates. In order to rely on their work, we will have to ensure that the level of
       materiality used is appropriate for our purposes, which should be likely, given that the joint
       venture’s operations are smaller than those of Ralding. We should inform Smith, Smith &
       Associates that we will be relying on their work. We should also investigate their reputation and
       competence in order to ensure that we can rely upon their work.

       Although the joint venture has a November 30 year end, we should be able to consolidate
       the joint venture based upon the November 30, 1999 financial statements provided we can
       ensure that there were no events in December that would materially impact on Ralding’s
       financial statements. As operations will not commence until 2000 it is unlikely that using
       November 30, 1999 financial statements will materially impact Raldings financial
       statements.

       Contribution of Plant to Joint Venture

       Ralding has recognized a gain of $400,000 on their sale of a plant to the joint venture,   in their
       financial statements for the period ended September 30, 1999. This is not correct as:

       (I)     Ralding can only recognize that portion of the gain that relates to the other
               venturer’s share of the joint venture, which amounts to $200,000;

       (II)    It is not possible to recognize the full $200,000 gain immediately. Rather
               only that portion of the $200,000 gain which relates to the cash received and
               does not represent a claim on the assets of the joint can be recognized immediately.
               The remaining portion of the $200,000 must be deferred and recognized over the
                         life of the plant.
               Accordingly, the amount of the gain which should have been recognized in
               1999, is $100,000 (see Appendix II). Therefore, income as at September 30,
               1999 will have to be adjusted downward by $300,000.

               We will have to verify the value of the plant at the time it was contributed to
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Course 4590 - Practice Case - Solution

       the joint venture, although the fact that the value was accepted by the other
       venturer, would seem to indicate that it was appropriately valued.

3.     Development of Design Software

       The salaries relating to the individuals who developed the design software have been capitalized.
       While it is legitimate to capitalize this cost if there is reasonable assurance of a future benefit,
       reasonable assurance does not appear to exist in this case. There are “bugs” in the system which
       are sufficiently significant, to have caused major design problems and led to the purchase of
       alternate software. The mere fact that at some point in the future Dichard hopes to revive the
       project is not indicative of “reasonable assurance” that the company will derive a future benefit
       from the software. Accordingly, these costs should be written off in 1999, although they will
       reduce income from continuing operations. In performing our audit we should ensure that no
       other costs relating to the software have been capitalized. Deferred charges per the financial
       statements amount to $148,976 which “may” be indicative that other costs were capitalized.

       In auditing inventory, we should ensure that if there are any goods that are defective due to the
       design problems experienced with the software, that they have been written down (or off) as
       appropriate.




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Course 4590 - Practice Case - Solution


                                               APPENDIX II

     CALCULATION OF GAIN ON CONTRIBUTION OF PLANT TO JOINT VENTURE TO BE
                             RECOGNIZED IN 1999


Total fair market value of plant                              $800,000
Carrying value of plant                                         400,000
Total gain                                                    $400,000

Portion relating to other venturer’s portion of gain
(i.e. 50% of $400,000)                                        $200,000

Of this $200,000 gain, the following amount can be
recognized immediately:

Consideration received (other than interest in JV)            $200,000

Less value of assets considered sold:

        $200,000 (consideration received)
        $800,000 (value at which asset transferred)

        X $400,000 (carrying value of plant)                  $100,000

Gain taken into income in 1999                                $100,000

Portion of gain deferred                                      $100,000




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