Lauder Adventures Limited (LAL) was incorporated over 40 years ago as an amusement park and golf course. Over time, a nearby city has grown to the point where it borders on LAL's properties. In recent years LAL's owners, who are all members of one family, have seen LAL's land values increase significantly. LAL's majority shareholder, Hassan Poosti, owns 55% of the outstanding shares and is not active in LAL's day-to-day activities.
Last year, Hassan hired a new chief executive officer, Leo Titan. Leo has a reputation for being an aggressive risk taker. Hassan is committed, and has the personal financial resources required, to support Leo's plans. Eight months ago, LAL became the successful bidder for a new sports franchise, in conjunction with a minority partner. Under the terms of the fran chise agreement, LAL is required to build a sports arena, which is currently being constructed. The arena is being built on a section of the amusement park.
Another section of the amusement park is being relocated to ensure that the entrances to the arena are close to public transportation and parking. Conse quently, some of the rides will be relocated. LAL is the sole owner of the arena at present. The sports franchise is separately incorporated as Northern Sports Limited (NSL); LAL holds 75% of the shares in the company. Another bid is being prepared by NSL to obtain a second sports franchise so that the arena can be used more often. NSL will be required to lease space from LAL when the arena is completed, in about 22 months.
For the first two sports seasons, NSL will have to lease arena space from Aggres sive Limited (AL). During this time, NSL does not expect to be profitable because
• it may take time to build a competitive team;
• AL is charging a high rent, and it is not giving NSL a share of concession (hot dogs, drinks) revenue;
• AL cannot make the better dates (e.g., Saturday night) available to NSL to attract sports fans; and
• as a newcomer to the league, NSL is restricted with regard to the players who are available to it and the days of the week it can play in its home city.
Consequently, NSL has arranged to borrow funds from LAL and from others to finance costs and losses.
Your employer, Fabio & Fox, Chartered Accountants, has conducted the audit of LAL for several years. LAL has tended to be marginally profitable one year and then have losses the next year. The company has continued to operate because the directors know that the real estate holdings were becoming increasingly valuable.
Leo is expected to oversee the expanded accounting and finance functions in the company. He has met with you and the partner in charge of the LAL audit and discussed various issues related to the year ending September 30, Year 8. His com ments are provided in Exhibit I .
It is September 5, Year 8. You have been asked by the partner to prepare a report for him, which will be used for the next meeting with Leo. He would like
EXHIBIT I
NOTES FROM DISCUSSION WITH LEO TITAN
1. In order to build a road to the arena's parking lot, two holes of the 18-hole golf course will be relocated next spring. Costs of $140,000 are expected to be incurred this year in design, tree planting, ground preparation, and grass seeding in order to ready the area for next spring. These costs are to be capitalized as part of the golf course lands, along with related property taxes of $13,000 and interest of $15,000.
2. In May Year 8, LAL acquired, for $4.25 million, all of the shares of an amusement park in a different city when its land lease expired. The amusement park company was wound up and the equipment, rides, concessions, and other assets are being trans ported to LAL at a cost of $350,000. The estimated fair value of the assets and liabili ties (according to Leo) is as follows:
Concession prizes (e.g., stuffed animals) ......... $ 22,500
Rides and games .................. 4,200,000
Equipment and parts ................. 1,650,000
Electrical supplies .................. 75,000
Lighting and signs ................... 100,000
Estimated present value of tax loss carry-forward ...... 700,000
6,747,500
Liabilities .................... 1,200,000
Net assets ...................... $ 5,547,500
LAL expects to spend approximately $400,000 in getting the assets in operating order and $500,000 on foundations and site preparations for the rides. Leo wants to “capitalize as much as possible.”
3. Approximately $600,000 will be required to relocate the rides that are currently on land that is needed for the arena. This amount is to be capitalized, net of scrap recovery of $60,000 on dismantled and redundant equipment. Virtually all the rides were fully depreciated years ago.
4. To assist in financing the new ventures, LAL sold excess land to developers who intend to construct a shopping centre, office buildings, and expensive homes adjacent to the golf course and away from the amusement park. The developers and LAL agreed to these terms:
Paid to LAL on May 1, Year 8 ......... $ 6,000,000
To be paid to LAL on March 1, Year 9 ....... 10,000,000
To be paid to LAL on March 1, Year 10 ..... 8,000,000
$24,000,000
The land is to be turned over to the developers on or about February 1, Year 9, but the sale is to be reported in fiscal Year 8.
5. An additional "contingent profit" will accrue to LAL if the developers earn a return on investment of more than 25% when they re-sell the newly constructed buildings. Leo wants a note to the Year 8 financial statements that describes the probability of a con tingent gain.
6. The excess land that was sold to developers was carried on LAL's books at $1.35 million, on a pro rata cost basis. Leo would like to revalue the remaining land from $5.4 million to about $100 million in the Year 8 financial statements.
7. The golf course has been unprofitable in recent years. However, green fees are to be raised and specific tee-off times will be allotted to a private club, which is currently being organized. Members of the private club will pay a non-refundable entrance fee of $2,000 per member plus $100 per month for five years. The $2,000 is to be recorded as revenue on receipt. Approximately $350,000 is to be spent to upgrade the club facilities.
8. Leo wants to capitalize all costs of NSL on NSL's books until it has completed its first year of operations. In addition to the franchise fee, $20 million will have to be spent on the following:
Acquisition of player contracts ...... $12,000,000
Advertising and promotion ...... 1,500,000
Equipment ............. 3,200,000
Wages, benefits, and bonuses ..... 6,800,000
Other operating costs ......... 3,300,000
26,800,000
Less
Revenue - ticket sales ......... (6,000,000)
- Other .............. (800,000)
$20,000,000
The value of players can change quickly, depending upon their performance, injuries, and other factors.
9. The new sports arena will have private boxes in which a company can entertain groups of clients. The boxes are leased on a five-year contract basis, and they must be occupied for a fixed number of nights at a minimum price per night. To date, 12 boxes have been leased for $15,000 per box for a five-year period, exclusive of nightly charges. A down payment of $3,000 was required; the payments have been recorded as revenue.
10. Three senior officers of LAL, including Leo, receive bonuses based on income before income taxes. The three have agreed to have their fiscal Year 8 bonuses accrued in fis cal Year 9 along with their fiscal Year 9 bonuses. Actual payments to them are sched uled for January Year 10.
11. Insurance premiums on the construction activity that is taking place total $1.4 million in fiscal Year 8, and to date they have been capitalized.
12. A $500,000 fee was paid to a mortgage broker to arrange financing for LAL. This amount has been recorded as "Other assets." No financing has been arranged to date.
you to discuss the accounting issues related to your discussion with Leo. The part ner wants a thorough analysis of all important issues as well as support for your position. LAL has been and wishes to continue using IFRSs.
In your review of documents, and as a result of various conversations, you have learned the following:
1. The arena will be mortgaged, but only for about 50% of its expected cost. Lenders are concerned about the special-use nature of the arena and whether it will be successfully rented for other events such as concerts.
2. The mortgage lenders to LAL and the non-controlling shareholders in NSL are both expected to want to see appraisals and financial statements before decid ing whether to invest. Covenants will be required by the lenders to ensure that excessive expenditures are not undertaken and that cash is preserved.
3. Leo does not intend to consolidate NSL until it is profitable. The investment in NSL will be reported on LAL's financial statements at cost. Thus, LAL's financial statements will also be used for income tax purposes.
4. LAL's non-controlling shareholders are not active in the business and want quarterly financial statements in order to monitor progress and assess Leo's performance. The non-controlling shareholders have all expressed concern over Leo's growth strategy over the past year. Most are relying on LAL to supplement their income.
Required:
Prepare the report.