Mega Communications Inc. (MCI) is a Canadian-owned public company operating throughout North America. Its core business is communications media, including newspapers, radio, television and cable. The company's year-end is December 31.
You, a CA, have recently joined MCI's corporate office as a finance director, reporting to the chief financial officer, Robert Allen. It is October Year 3. Mr. Allen has asked you to prepare a report that discusses the accounting issues that might arise with the auditors during their visit in November.
MCI's growth in Year 3 was achieved through expansion into the United States by acquiring a controlling interest in a number of newspapers, television, and cable companies. Since the U.S. side of MCI's operations is now significant, management has decided to change the reporting currency from the Canadian dollar to the U.S. dollar for MCI's consolidated financial statements.
MCI uses the Canadian dollar for its internal record keeping and to account for its Canadian operations. All of MCI's foreign subsidiaries, which are all wholly owned, use the local currency for internal record keeping and for reporting purposes. MCI's shareholders' equity at the beginning of the period was $220 million, including a separately disclosed cumulative foreign exchange gain of $45 million primarily relating to its U.S. subsidiaries. Management merged this balance with retained earnings because "the operations it relates to are no longer considered foreign for accounting purposes, and as a result, no foreign currency exposure will arise."
With recent trends to international free trade, MCI decided to position itself for future expansion into the South American market. Therefore, in Year 3, MCI bought a company that owns a radio network in a country in South America, which has high inflation. MCI was willing to incur losses in the start-up, since it was confident that in the long run it would be profitable. The South American country has had a democratic government for the last two years. Its government's objectives are to open the country's borders to trade and lower its inflation rate.
The government was rather reluctant to let a foreign company purchase such a powerful communication tool. In exchange for the right to buy the network, MCI agreed, among other conditions, not to promote any political party, to broadcast only pre-approved public messages, and to let the government examine its books at the government's convenience. Management has recorded this investment on the books using the cost method.
In Year 3, MCI acquired a conglomerate, Cyril's Holdings (CH), which held substantial assets in the communications business. Over the past three months, MCI has sold off 80% of CH's non-communications related businesses. In the current month, MCI sold CH's hotel and recreational property business for $175 million, realizing a gain of $22 million ($14.5 million after tax). The assets related to the non-communications businesses were scattered throughout the U.S. and MCI lacked the industry expertise to value them accurately. Management therefore found it difficult to determine the net realizable value of each of these assets at the time CH was acquired.
Newspaper readership has peaked leaving no room for expansion. In Year 2, to increase its share of the market, MCI bought all the assets of a competing news paper for $10 million. In Year 3, MCI ceased publication of the competing newspaper and liquidated the assets for $4.5 million.
In Year 3, MCI decided to rationalize its television operations. Many of CH's acquisitions in the television business included stations in areas already being served by other stations operated by MCI. MCI systematically identified stations that are duplicating services and do not fit with MCI's long-range objectives.
These assets have been segregated on the balance sheet and classified as current. The company anticipates generating a gain on the disposal of the entire pool of assets, although losses are expected on some of the individual stations. Operating results are capitalized in the pool. Once a particular station is sold, the resulting gain or loss is reflected in income.
Nine stations are in the pool at the present time. In Year 3, three were sold, resulting in gains of $6.5 million after tax. Losses are expected to occur on several of the remaining stations. Although serious negotiations with prospective buyers are not underway at present, the company hopes to have disposed of them in early Year 4. In order to facilitate the sale of these assets, MCI is considering taking back mortgages.
In Year 3, MCI estimated the fair market value of its intangible assets at $250 million. Included, as intangibles, are newspaper and magazine circulation lists, cable subscriber lists, and broadcast licenses. Some of these assets have been acquired through the purchase of existing businesses; others have been generated internally by operations that have been part of MCI for decades.
Amounts paid for acquired intangibles are not difficult to determine; however, it has taken MCI staff some time to determine the costs of internally generated intangibles. In order to increase subscriptions for print and electronic media, MCI spends heavily on subscription drives by way of advertisements, cold calls, and free products. For the non-acquired intangibles, MCI staff has examined the accounting records for the past 10 years and have identified expenditures total ling $35 million that were expensed in prior years. These costs relate to efforts to expand customer bases. In addition, independent appraisers have determined the fair market value of these internally generated intangibles to be in the range of $60 million to $80 million. In order to be conservative, management has decided to reflect these intangibles on the December 31, Year 3, balance sheet at $60 million.
The market value of companies in the communications industry has been escalating in the past few years, indicating that the value of the underlying assets (largely intangibles) is increasing over time. MCI management would prefer not to amortize broadcasting licenses, arguing that these licenses do not lose any value and, in this industry, actually increase in value over time. One of the items included in the intangible category is MCI's patented converter, which was an unplanned by-product of work being done on satellite communications devices a few years ago.
MCI has sold $25 million of its accounts receivables to a medium-sized financial intermediary, PayLater Corp. The receivables are being re-sold to a numbered company whose common shares are owned by PayLater Corp. MCI receives one half of the consideration in cash and one half in subordinate non-voting, redeemable shares of the numbered company, bearing a dividend rate of 9%. The dividend payments and share redemption are based on the collectability of the receivables. The purchase price is net of a 4% provision for doubtful accounts.
MCI has recorded a loss of $1 million on this transaction. PayLater has an option to return the receivables to MCI at any time for 94% of their face value. The arrival of direct broadcast satellite that transmits multiple TV signals to digital boxes will revolutionize the television industry. The technology is expected to provide the choice of over 150 channels. In response to this new development, which is seen as a threat, the communication industry is developing its own inter active communication services at a cost of over $6 billion. This service will allow viewers to interact with banks, shops, and other viewers through the television.
MCI hopes this will allow it to maintain its market share of viewers. MCI has invested in the installation of fibre optic cable, which can transmit far more, far faster than conventional cable. The cost of the cable itself is negligible.
MCI will be using it for transmission between its stations in two major Canadian cities. MCI needed only six cables to link all its television and radio stations between the two cities, but decided that it might as well put in 36 cables, since it was doing the digging anyway. To date, MCI has sold six cables and charges a monthly fee to new owners to cover their share of all maintenance expenses. MCI is leasing 10 other cables for 15-year periods.
Prepare the report.