It is now mid-September Year 3. Growth Investments Limited (GIL) has been owned by Sam and Ida Growth since its incorporation under the Canada Business Corporations Act many years ago. The owners, who are both 55 years of age, have decided to effect a corporate reorganization of capital in the form of an estate freeze. Sam and Ida will maintain control by holding voting preferred shares that carry a fixed dividend. New common shares will be issued to the three Growth children and to Mario Thibeault, a GIL manager who has been with the company since its inception.
GIL operates primarily in the real estate industry. It holds raw land, which will be subdivided and sold in the future, and it owns a variety of revenue-producing properties. The land and the properties are either directly or through wholly owned subsidiaries. A valuation of GIL's net assets will be done as of November 30, Year 3, the date of the proposed corporate reorganization.
Innes & Panners has audited GIL's financial statements for the past several years. The financial statements are used by the owners and the company's banker as well as for tax purposes. One of the rights of the preferred shareholders (Sam and Ida) will be to have audited financial statements for GIL's year-end, which has always been November 30.
You, the CA, have been hired as a consultant to GIL for the year ending November 30, Year 3. The board of directors of GIL has engaged your firm, at the request of Mario Thibeault, to advise on alternatives available with respect to accounting and reporting policies for the company for Year 3 and subsequent years. This engagement is separate from the audit engagement.
You will prepare a report that should be addressed to the board of directors of GIL. It should outline the feasible accounting and reporting alternatives that exist in preparing audited, comparative financial statements for Year 3 and subsequent years. You and your staff have learned the following about GIL's activities during the current fiscal year:
1. Under the plan for reorganizing capital, Sam and Ida are to be issued preferred shares on November 30, Year 3 in exchange for all their common shares. The preferred shares will be redeemable at the fair value of the company as determined at November 30, Year 3. Each of the four new share holders will pay $100 for 25% of the new voting common shares of GIL. The valuation of GIL's net assets is nearly complete.
2. Except for one parcel of raw land, all of GIL's real estate assets have an appraisal value that exceeds cost, or cost less capital cost allowance to date. (GIL has always used income tax methods and rates for depreciation purposes.) Each asset's fair value is based on an estimated net selling price as at November 30, Year 3. For the one parcel of raw land, fair value is expected to be approximately 70% of cost.
3. Current five-year mortgage interest rates on properties similar to GIL's range between 10% and 10 ½% per annum. GIL's debt, as of November 30, Year 3, will consist of:
$2,200,000; 14% rate; due in 3 years
1,600,000; 8% rate; due in 4 years
1,300,000; 10 ½% rate; due to bank on demand
4. In December Year 2, GIL sold an apartment building for $2,500,000 in a province that is subject to rent controls and took back a non-interest bearing note. Payments of $500,000 per year are due on December 15 for each of the next five years, commencing in Year 3. GIL's financial statements at August 31, Year 3, show the $2,500,000 as a current asset.
5. In all years to November 30, Year 2, GIL had expensed real estate taxes and interest on debt incurred to finance raw land purchases. The new shareholders have asked whether these sums ought to be capitalized retroactively for all raw land held at November 29, Year 3.
6. An application is pending to have one of GIL's apartment buildings converted to condominium status. Several levels of government have to approve the conversion, but ultimate approval is expected in Year 4 because other buildings in the vicinity have already been accepted as condominiums.
When approval is received, the fair value of this building will increase from $4,300,000 to about $5,700,000. Each condominium apartment unit will be offered for sale to its occupants, or to others.
7. GIL leases its head office building space on a 20-year lease; 14 years are left in the lease. GIL pays $100,000 per year plus all occupancy costs such as light, heat, insurance, and cleaning. Current leasing costs have increased, and GIL would have to pay $220,000 per year for equivalent space in the same building if it were to sign a lease in Year 3. The financial statements at November 30, Year 2 treat the head office situation as an operating lease. They contain a short note on lease obligations.
8. Construction of a shopping centre is in progress for GIL. A fixed-price contract for $8 million has been signed with a construction company, which has undertaken to complete the centre by August Year 4. Financing for 10 years at 12% interest per annum on a $6 million mortgage has been approved. GIL purchased the land on which the centre is being located several years ago. It paid $750,000 for the land and sold one-half interest to the 50% partner for $1,800,000 in December Year 2. Approximately one-half of the shopping centre space has been leased for 5 or 10 years commencing August Year 4.
Several of the leases contain escalation-of-rent clauses tied to store sales. GIL paid a demolition company $120,000 in December Year 2 to clear old farm buildings and fences and ready the site for construction. It also paid $110,000 in July Year 3 to the agent who arranged the leases.
9. In December Year 2, GIL sold a small office building for $4,200,000 cash, and paid off the $2 million mortgage on the property plus a penalty of $82,000. The purchase/sale agreement contains a clause that enables GIL to receive sums additional to the $4,200,000 if rental receipts for the next four years exceed an average of $700,000 per year. On the basis of new leases signed by the purchaser in Year 3, GIL ought to be receiving some additional compensation each year.
10. Traditionally, the senior management of GIL has received a bonus based on audited net income.
Prepare the report to the Board of Directors.

  • CreatedJune 08, 2015
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