Question

Global Touch Corporation (GTC) is one of Canada's largest public companies. GTC provides end users with networking capabilities through its system of copper and coaxial cable lines. GTC operates in Canada through a variety of subsidiaries and divisions. GTC is looking to expand into the more lucrative U.S. marketplace. Its common shares are among the most widely held shares in Canada; no single shareholder owns more than 5% of the company. GTC owns or has investments in various high-technology companies. Since 2007, the share price has ranged between $55 and $60 per share.
Electro Buzz Inc. (EBI) is a Canadian public company. EBI manufactures digital equipment used primarily by cable television companies for their networks. EBI was incorporated in 1991 by GTC as a wholly owned subsidiary. In 2006, EBI issued common shares to the public, raising $295 million in cash. As a result, GTC's ownership interest in EBI dropped to 25% of the total outstanding share capital.
The shareholders of GTC have expressed concern that there has been no significant increase in GTC's share price since 2007. On May 10, 2013, at GTC's annual shareholders' meeting, Shayna Evan was elected chair of GTC's board of directors and was also named GTC's chief executive officer (CEO). Ms. Evan signed a three-year employment contract with GTC. She had previously been the CEO of EBI since 2004. In 2004, EBI's share price had reached an all-time low of $2.25 per share. When Ms. Evan left EBI in April of 2013, EBI shares were trading at $32 per share. At the news conference announcing her appointment, Shayna Evan stated that her mission was to significantly increase the value of GTC shares by the year 2014. Ms. Evan predicted considerable growth in net income.
You are a CA with the firm of Rousseau and Singh (RS), Chartered Accountants. RS has been the auditor of GTC since the late 1970s. In addition, RS currently audits most of GTC's subsidiaries through its own offices across Canada and through international firms affiliated with RS.
It is now October 17, 2013, and GTC is preparing its quarterly consolidated financial statements for filing with various securities commissions. RS normally performs review engagement procedures on quarterly results and issues an audit opinion only at year end, based on the annual financial statements. GTC has a December 31 year end. Extracts from the draft income statement for the first nine months have been prepared by your staff (Exhibit C8-2[a]).
You have been provided with a summary of issues for your consideration (Exhibit C8-2[b]). The partner responsible for the GTC audit will be meeting with the Chief Financial Officer and Controller of GTC on October 19, 2013, to discuss the third-quarter financial statements and potential year-end issues. Accordingly, she has asked you to prepare a memo summarizing any significant accounting issues that will have to be addressed for year end. The GTC audit committee and board of directors are scheduled to review the third quarter financial statements on October 20 and 21, respectively. A press release discussing results will be made available to the public immediately after the board of directors' meeting.
Required
Prepare the memo requested by the partner.
EXHIBIT C8-2(b)
NOTES BASED ON THIRD-QUARTER REVIEW
EBI
Accounting staff at GTC complained quite openly about how difficult it has become to get timely financial information from EBI in the last year. Previously, EBI's net income was reported to GTC by the 15th of the month following the end of the quarter. Now, the information is made available only three days before GTC publicly announces its net earnings for a quarter, usually on the 28th of the month. EBI's staff has told GTC that EBI will announce its year-end results only on January 26, 2014, and such results will be made available to GTC on January 25. Shayna Evan has called a news conference on January 28 to announce GTC's 2013 consolidated results. GTC's board of directors is scheduled to approve the annual financial statements on January 27.
As part of EBI's initial public offering, GTC received options to purchase additional EBI shares that would allow it to increase its interest in EBI to 40% of the outstanding shares. The options became exercisable on July 8, 2013, and expire December 31, 2015. If the options are exercised, GTC must pay EBI a price equal to 90% of the stock price quoted on the date the options are exercised. GTC intends to exercise the options before year end if EBI's stock price remains below $50 per share.
GTC accounted for its investment in EBI using the equity method.
GTC's share of EBI earnings for 2013 was $100 million up to July 7, 2013. After July 7, 2013, GTC calculated its share of EBI earnings based on a 40% ownership interest, resulting in income of $95 million from July 8 to September 30, 2013.
Historically, GTC has not shown its share of EBI's earnings at the after-tax amount.
Investment in STI
In late 2012, GTC decided to enter the U.S. high-speed broadband market by opening up a fibre optic subsidiary called STI, Inc. (STI). Based in San Diego, STI is a wholly owned subsidiary providing high-speed Internet access services to residential and commercial customers throughout the U.S. southwest. GTC invested U.S. $60 million in STI. All accounting for STI is carried out by GTC head office personnel. As of September 30, 2013, the U.S. $60 million has been spent on the following:
U.S. $ millions
Customer sales and marketing .... $15
Fibre optic lines ........... $35
Administrative costs ........ $10
All costs were capitalized during the first nine months of 2013. The customer sales and marketing costs were incurred primarily to recruit customers. It is anticipated that such costs will decrease over time as STI's services become more widely known. Most of the costs related to advertisements on local television and radio. The administrative costs include U.S. $5 million of salaries and wages for administrative personnel and U.S. $5 million of payments made to attract and relocate senior management of some of GTC's other subsidiaries to San Diego. Managers who have relocated have signed three-year contractual commitments to remain with STI. If they do not abide by their commitment to stay, managers must refund any signing bonuses or relocation reimbursements.
The U.S. $35 million expenditure on fibre optic lines was for the acquisition, from an unrelated company, of the right to use the lines, which connect customers to the Internet. Ownership of the fibre optic lines remains with the unrelated company, which is also responsible for all maintenance. If properly maintained, the lines can last for more than 20 years.
The U.S. $35 million was paid on September 1, 2013. Under the terms of the agreement, the third party will provide STI with an exclusive right to use two fibre optic lines over a five-year period beginning September 1, 2013. The right-to-use agreement can be extended for another five years on September 1, 2018, for an additional payment of U.S. $30 million.
On September 1, 2013, STI began providing Internet access service to its customers. To attract subscribers, any customers who signed up prior to September 1, 2013, were given one month of free service. Accordingly, no revenue was recorded in September. As of October 1, 2013, STI had signed up 12,000 residential customers to one-year contracts at an average rate of U.S. $25 per month. In addition, as at October 1, 2013, some 150 commercial contracts had been signed for one year at an average rate of U.S. $2,250 per month. The commercial rate represents the rate to provide an entire office location with Internet access.
As at October 1, 2013, only one of the fibre optic lines was being used because there were not enough customers to justify using the second line. STI has capitalized the U.S. $35 million and allocated U.S. $17.5 million to each line. For the month of September 2013, amortization was charged for the one line. STI plans to amortize each line over five years, starting on the date on which they are first used. Currently, the one line being used is at 65% capacity, and GTC has charged to income only 65% of the amortization that would otherwise be charged.
GTC is not expecting STI to pay any dividends until both fibre optic lines are at 85% capacity. Until that time, any earnings will be reinvested to cover operating costs, including additional costs required for customer sales and marketing.
Restructuring
The restructuring charges shown on the income statement are based on GTC's plans to better integrate the operations of its wholly owned subsidiaries. For example, as a result of acquisitions over the last five years, two of GTC's wholly owned subsidiaries provide Internet access to the same market. GTC will amalgamate these two subsidiaries within two years and will, as a result, reduce its staff in Canada by some 4,000 employees or roughly 15% of its workforce. GTC will be meeting with senior management at these subsidiaries in the coming months to discuss staff reductions. The charge for estimated severance costs is about $10,000 per employee. The human resources department has calculated the provision based on job functions targeted to be abolished. Severance costs are included in the restructuring charges.
GTC and its subsidiaries own very little real estate and mainly rent office space for lease terms of 10 to 25 years. GTC believes that the personnel reductions will result in excess space at several locations. Accordingly, GTC has also accrued for the costs associated with lease cancellation penalties. These penalties are estimated at about $10 million, with an additional $15 million to be spent for moving and site restoration. The site restoration costs include the costs associated with getting the properties to specific standards as defined by the leases.
According to GTC's controller, the restructuring charges have been discussed and approved at the highest levels within GTC and were approved at a special GTC board meeting in August. Shayna Evan was very anxious to record the restructuring charges in the third-quarter financial statements as a sign that "things are getting done at GTC." She is concerned that GTC's landlords should not know too far in advance that GTC is planning to vacate space. She does not want to say too much about the charges because she has not yet met with senior management of the wholly owned subsidiaries and does not want the employees' unions to know too much at this point since some of the employees involved are unionized.
Other
EBI's shares were trading at approximately $40 per share on September 30, 2013. On September 30, 2013, GTC owned 11.5 million shares of EBI or 25% of the total outstanding share capital of the company.
At a GTC board meeting in July 2013, it was agreed that beginning with the year ending in 2013, executive bonuses will no longer be based on net income, but will be based on net income before taxes and special charges. An additional special bonus of $1 million will be paid to Shayna Evan if net income increases to $700 million in the year 2014.


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