Enviro Facilities Inc. (EFI) is a large, diversified Canadian-controlled private company with several Canadian and U.S. subsidiaries, operating mainly in the waste management and disposal industry. EFI was incorporated more than 50 years ago, and has grown to become one of the top four waste management firms in Canada.
The Glass family started the business, but currently no family members are actively involved in the management. The shares are owned by family members, family trusts, and a limited number of friends. In Year 4, the Glass family decided to sell the company to a third party within the next two or three years, to realize the value of their shareholdings. EFI has an August 31 year-end. The company has elected to report using International Financial Reporting Standards ("IFRSs").
Up until the Year 4 fiscal year-end, a national firm of chartered accountants had audited EFI. In early Year 5, the company put the audit up for tender and replaced the incumbent firm with Bevan & Bevan (BB), Chartered Accountants, a regional firm.
It is now October 18, Year 6. Three days ago, BB resigned from the engagement because of a conflict of interest, although the audit was reportedly 60% complete. Chu and Partners (Chu), Chartered Accountants, was the runner-up firm in the Year 5 audit tender. EFI offered the engagement to Chu. After speaking with the BB partner in charge of the audit, Chu accepted the audit engagement on condition that BB provides all the audit documentation prepared to date. Chu was formally appointed auditors, and an engagement letter has been signed. Materiality has been set by Chu at $6.5 million, based on income and balance sheet trends.
You, the CA, work for Chu. BB's audit files have now arrived, and you and your staff have prepared the following notes:
1. A team of provincial sales tax auditors has been auditing EFI for nearly six months, but the audit is still not complete. The auditors are disputing the exemption claimed by EFI from the 8% tax on purchases of certain waste processing supplies and equipment. About 20% of total purchases of $451 million fell into this category during the four-year audit period, according to EFI.
2. On June 23, Year 6, EFI received a wire transfer of 10 million Hong Kong dollars to its general Canadian dollar bank account, in payment of an outstanding customer invoice. EFI's bank converted the funds to $7.5 million Canadian, incorrectly assuming that the transfer was for Singapore dollars.
On that day, 7.290 Hong Kong dollars would buy a Canadian dollar. EFI has not informed the bank of the error and has taken the difference into income.
3. During Year 6, EFI lost a decision in the Federal Court of Appeal in a law suit brought by Waste Systems Integrated Limited for patent infringement.
In an unusual award, the court ordered EFI to pay $18 million for shares of Waste Systems Integrated Limited, a private company, which had been in some financial difficulty. EFI has decided not to appeal the decision to the Supreme Court, and the shares were purchased before year-end.
4. EFI issues debt for long-term financing purposes through three major investment dealers. In July Year 6, Moody's, the credit rating agency, put EFI's credit rating on alert for downgrade due to the potential negative effects of progressive toughening of environmental legislation applying to waste disposal sites.
5. EFI bids on various municipal waste pick-up and disposal contracts. EFI buys waste-disposal sites to dump the waste collected and defers and amortizes the cost of the sites over the expected useful lives, stated in tonnes of capacity, years of remaining usage, or cubic metres of waste capacity. Amortization of the cost of these sites represents 41% of EFI's operating expenses.
Of EFI's assets, 64% are waste disposal sites. Provisions for cleanup and site sealing costs are accrued on the same basis as the amortization of the sites.
6. EFI defers and amortizes over five years the costs of locating new waste disposal sites and negotiating agreements with municipalities.
7. During Year 6, EFI was awarded a contract to collect and dispose of all the waste for the Regional Municipality of Onkon-Lakerton for five years, commencing in Year 7. The contract requires the municipality to pay EFI $9.50 per metrictonne of waste collected. Because of aggressive recycling, composting, and waste reduction programs being carried out by the municipality, EFI negotiated a clause in the agreement that states that the company will be paid a minimum of $3.2 million per annum, regardless of the collection volume.
EFI has recorded $16 million ($3.2 million 3 5 years) as revenue in Year 6.
8. In July Year 6, two U.S. subsidiaries of the company were notified that they are potentially responsible for violations of U.S. law. The legal proceedings have commenced, based on allegations that prior to being acquired by EFI, these subsidiaries improperly disposed of hazardous waste. The sale- purchase agreement under which the subsidiaries were acquired contains price-adjustment clauses to protect EFI against pre-purchase liabilities.
9. In October Year 6, EFI sold trucks and other garbage collection equipment to a U.S. subsidiary for $20 million, and reported a gain of $9 million. The terms of the sale required a cash payment of $12 million on delivery, with the balance due in annual installments of $4 million, plus interest over a 2-year period.
10. Every year, EFI updates the estimates of the remaining useful lives of waste disposal sites, using the services of a consulting engineering firm. In the past, EFI used Folk & Co., Environmental Engineers, for these reviews. Folk & Co. did no other work for EFI. Starting in Year 6, EFI used Cajanza Consulting Engineers for the reviews. Based on the new consultants' report, the useful lives of all waste-disposal sites have been increased between 4% and 26%, and the sealing/cleanup provision reduced by $13.6 million.
11. In light of the planned sale of EFI, the board of directors has decided to stop buying waste-disposal sites and to sell two sites where the cleanup provisions exceed the sites' carrying amounts. EFI plans to sell the two sites to Enviro (Bermuda) Inc. for a dollar. The controlling shareholders of Enviro (Bermuda) Inc. are the same as the controlling shareholders of EFI. EFI plans to dump waste in these sites. Chu's audit personnel heard a rumour that Enviro (Bermuda) Inc. does not plan to comply with environmental legislation.
12. During the year, EFI implemented a new cost accounting system for the production of composting material. Organic material is extracted from residential garbage collected, and then processed, composted, bagged, and sold for use by gardeners. In the past, no cost has been assigned to the raw material inputs. The new system allocates a portion of total collection costs to these raw material inputs at standard cost.
The partner has requested a memo that deals with the significant accounting issues.