Question

Desai Developments Limited (DDL) is in the business of buying undeveloped land in the regions outside of Calgary and holding it until it has development permits and market conditions are favorable for development. DDL began operations 12 years ago. Once a property is ready for development, DDL contracts with various construction companies to build the houses. DDL handles all the promotions and sales of the houses once they are completed.
Because of recent changes in environmental laws and zoning restrictions, some of the sites DDL originally purchased for subdivisions can no longer be used for this purpose. However, golf courses are still permissible on these sites because they preserve wetlands and forests. DDL is, therefore, now undertaking a new business model that involves developing and operating golf courses. DDL will also sell off the outer edges of the golf course properties as building lots for large “estate lot” homes, which are still permitted because they have a low impact on the environment.
The president of DDL, Mira Desai, owns 51% of the DDL common shares. Her relatives hold the remainder. DDL also has financed its operation by bank mortgages on the land. Mira Desai now wants to issue preferred shares in DDL to private investors, and use the proceeds to pay back the bank mortgages and fund the golf course developments. The plan is for the preferred shares to be nonvoting, to pay a 6% noncumulative dividend per year, and to provide the preferred shareholder with a life-long membership in one of the golf courses. She has found several investors who are interested in the preferred shares, but DDL will need to provide prospective investors with DDL’s 20X5 financial statements prepared in accordance with generally accepted accounting principles (GAAP).
Mira Desai is considering engaging your audit firm to provide an audit opinion on DDL’s GAAP financial statements. Up until now DDL has only prepared unaudited financial statements primarily for tax purposes, and has always used accounting methods that result in paying the minimum amount of tax. In discussions with Mira Desai, and from reviewing DDL’s most recent annual financial statements (for the year ended December 31, 20X5), you learn the following:
1. DDL currently owns four properties that have been approved for golf course development. It has finalized the plans and will start development in the spring of 20X6. DDL owns five other properties that may be suitable for future golf course developments.
2. DDL owns another eight properties approved for residential subdivisions. Recently DDL received an offer from another property development company, Atim Corp., to purchase all eight of these properties for $50 million. The mortgages on these properties are $45 million. Mira Desai is interested in exiting from the subdivision development to allow DDL to focus on the golf course business. She is considering making a counter-offer in which DDL would form a 50:50 joint venture with Atim Corp. DDL would contribute the properties to this joint venture entity and Atim would contribute the cash and management skills to construct and sell the subdivision homes.
3. DDL has capitalized the purchase price of the land, legal fees relating to the purchase, and land transfer taxes. All other costs related to the properties, such as property taxes, interest, earth-moving costs, and fees for architectural and landscaping plans, have all been expensed to maximize tax deductions.
4. DDL’s net income from the subdivision business has varied widely over the years, with profits in years when housing developments are completed and sold, and losses in other years. Revenue is recognized when each house is sold. The average subdivision development takes about 18 months to complete. A golf course development will take about two years because of the extensive landscaping and planting required.
5. The golf course development costs can be partly financed by selling the estate lots around the golf course site to the custom home builders. As part of its agreement with these construction companies, DDL will handle the sales promotions and marketing of the houses for a 10% commission on selling prices.
6. To date, DDL has completed five housing subdivision developments. The first development, completed about 10 years ago, has recently been in the news because methane and other noxious gases have been seeping into basements.
Environmental assessments have determined that the subdivision was built on what was a landfill site in the 1950s. It was never properly sealed off prior to redevelopment and is now releasing gases that are dangerous to people.
Environmental consultants estimate it will cost up to $2 million to remediate the properties so the houses will be safe to live in. The current owners of these homes have started legal action against DDL. DDL’s lawyers believe that the company that sold DDL the land had fraudulently withheld relevant information about the prior use of the land, so that DDL will not be liable for the remediation costs.
7. DDL received a government loan of $6 million in early 20X5, under a program aimed at helping developers cope with the impact of the changes in environmental regulations. The entire loan is forgivable if DDL produces a commercially viable golf course by the end of 20X7. Half of the government loan amount was recorded as revenue in 20X5 since, in DDL management’s view, the golf course development is 50% complete.
8. Late in 20X5, DLL rented earth-moving equipment to start the golf course development work. The equipment lease agreement has a 10-year term and required a $200,000 payment at the start of the term, with payments of $200,000 thereafter at the start of each of the next nine years. The equipment could have been purchased for $1,265,650 in cash and has an expected useful life of 10 years. The relevant borrowing rate for assessing this lease is 12% per year.

Required:
a. Prepare a report outlining the considerations your firm would have to make before accepting the audit of DDL.
b. Assuming your firm accepts the engagement; prepare a detailed and complete audit plan that addresses the accounting and other information items noted previously.
Also, suggest any other information that you would want for planning the audit.



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  • CreatedJanuary 09, 2015
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