RAD Communications Ltd. (RAD), a Canadian public company, recently purchased the shares of TOP Systems Inc. (TOP), a Canadian-controlled private corporation. Both companies are in the communications industry and own television, radio, and magazine and newspaper businesses. Both companies have subsidiaries operating worldwide.
After it purchased TOP, RAD decided to divest itself of some of the TOP subsidiaries (the Group). BritCo is a private British company that is in the process of acquiring the shares of the Group from TOP. The purchase price for the Group being sold has been determined, in general terms, to be a fixed price adjusted for the working capital balance of the Group at RAD's year-end date of March 31, Year 9. March 31, Year 9, was also the closing date of the purchase-and-sale transaction. The parties have 90 days after the closing date of the transaction to agree on the calculation of the working capital balance.
Janis Marczynski, the chief negotiator for BritCo, has approached Paul Bouchard, a partner at Bouchard and Beatrix, Chartered Accountants (B&B), to provide her with advice on the purchase transaction. Specifically, Marczynski wants B&B to review the agreement and relevant facts to determine whether RAD has appropriately determined the amount of the closing working capital. Furthermore, if any matters come to B&B's attention that suggest the financial statements of the Group may have misled BritCo, then B&B should bring these items to her attention.
Marczynski has stated that BritCo now thinks that the purchase price for the Group may be too high and is looking for ways to reduce the price. Thus, she wants to be made aware of any possible points that she can use in her final negotiations.
BritCo has provided B&B with a copy of the purchase-and-sale agreement, excerpts of which are presented in Exhibit III.
TOP SYSTEMS INC. (VENDOR) AND BRITCO (PURCHASER) EXCERPTS FROM PURCHASE-AND-SALE AGREEMENT
5.1. The share purchase price shall be adjusted by an amount equal to the "consolidated working capital." This amount is hereafter referred to as the "price adjustment," as defined in clause 5.2.
5.2. The price adjustment shall be determined as follows:
a. Combine the working capital of the Group (aggregated current assets of the Group less aggregated current liabilities of the Group), less the non-controlling interest as at March 31, Year 9, adjusted for any sums payable to or receivable from other members of the Group.
b. Include accounts for each of the companies of the Group and, in the case of those companies with subsidiaries, on a consolidated basis, in accordance with International Financial Reporting Standards ("IFRSs").
5.3. The vendor shall prepare a draft consolidated working capital statement as soon as practicable after the agreement date.
5.4. For the purpose of review, the vendor agrees to instruct JR to permit the purchaser to examine all final working papers, schedules, and other documents used or prepared by JR.
5.5. If the purchaser objects to the calculation of the price adjustment, the purchaser shall give notice in writing to the vendor. The purchaser shall set out in reasonable detail the nature of any such objections and the amount by which the purchase price will be reduced if the purchaser's objections are accepted. The vendor shall have the right to recover from the purchaser any costs associated with reviewing and analyzing objections of the purchaser that are of a frivolous and unsupportable nature.
It is now May 15, Year 9, and BritCo has received the unaudited consolidated working capital statement of the Group prepared by RAD (Exhibit IV). Marczynski is concerned about the dramatic increase in the working capital compared with that reflected in previous financial statements.
RAD has arranged for Jeanette Riley, Chartered Accountant (JR), the auditor of TOP's financial statements for the year in question, to supply the necessary working papers to assist B&B in its review. JR will provide B&B with her working papers once they have completed their audit for Year 9. RAD has already provided B&B with excerpts of JR's working papers for Year 8, reproduced in Exhibit V, copies of which TOP had obtained informally from the audit staff during the course of the audit.
CONSOLIDATED WORKING CAPITAL STATEMENT OF THE GROUP (NOTE 1)
at March 31, Year 9
(in Millions of Canadian Dollars)
Cash ....................... $ 215
Receivables ................... 19,763
Inventory ................... 4,225
Prepaids ................... 7,655
Other ................... 2,917
Bank indebtedness .............. 7,000
Accounts payable .............. 1,191
Deferred revenue .............. 6,332
Other ................. 1,345
Consolidated working capital (price adjustment) ..... $18,907
EXCERPTS FROM THE WORKING PAPERS OF JR
RELATING TO THE AUDIT OF TOP SYSTEMS INC. AND ITS SUBSIDIARIES
FOR THE YEAR 8 FISCAL PERIOD
1. Only selected subsidiaries of TOP were audited. Those companies were audited on a limited basis only, owing to the consolidated materiality level.
2. Included in the "Receivables" balance of FranceCo. is an intercompany note receivable from a Canadian company that is not part of the Group. The note bears interest at the prime rate in Canada plus 3%. The rate charged on the note was generally about 4% below interest rates on French notes of similar terms and risks at the time that the note was issued. The Canadian company has recorded the note as a long-term obligation.
3. "Other current assets" include an amount reflecting the refundable dividend tax on hand (RDTOH). The amount of the RDTOH was immaterial; thus, no audit work in this area was warranted.
4. Included in the "Receivables" balance are certain income tax refunds that GermanyCo.
will receive when dividends are paid to its shareholders. No accruals are made for foreign withholding taxes that may be payable when dividends are paid by GermanyCo.
5. "Other current assets" include an amount for goodwill. This goodwill relates to the acquisition of a subsidiary by CanadaCo.
6. "Deferred revenues" include payments made by advertisers for long-term contracts.
Some of these contracts can be for up to five years. Some advertisers pay up-front signing fees, which are taken into income when received. Some advertisers who sign up for long-term contracts may receive one additional year of free advertising. Advertisers can elect to take this free year at the beginning or at the end of the contract term.
7. "Prepaids" include costs for various broadcasting licenses. The accounts include the initial costs of obtaining the licenses, such as various regulatory fees, legal and accounting fees, other consulting fees, etc., and various fees for limited-term licenses, ranging from one- to ten-year periods.
8. Certain printing presses of SwitzerlandCo. were leased instead of being purchased. The future lease payments were not disclosed in the consolidated financial statements.
The lease was immaterial and thus did not warrant any further audit work.
9. A Belgian company that is not being acquired effectively hedged certain current debts payable by CanadaCo. The financial statements did not record any gain or loss because of the fluctuations in the value of the Canadian dollar.
10. Foreign exchange losses on transactions were included as part of "Deferred revenue," while gains were taken into income in the current period.
You, a CA, work for B&B. Bouchard asks you to draft a memo addressing the concerns and requirements of Marczynski.
Prepare the memo.