You were recently approached by one of your clients, Wendy Wonders, the chief financial officer of Rock Group Ltd. (RGL), a Canadian public company with a 31 December year end. RGL manufactures and sells power precision hand tools and accessories, such as hammers and drills.

To complement RGL’s existing products, RGL is interested in purchasing 100% of the common shares of Scrulox Screws Inc. (SSI), a private company reporting under Accounting Standards for Private Enterprises (ASPE).

SSI was identified as an acquisition target because of its complementary product offerings, extensive internally generated customer database, and overall strong financial results, including a consistent gross margin on all sales of 60%. As of 31 December 20X2, the carrying value of SSI’s net assets, excluding the customer database, was $29 million (fair market value of $50 million), which includes two manufacturing plants with a carrying value of $11 million each (fair market value of $19 million each). SSI’s customer database is estimated to have a fair market value of $0.8 million. SSI’s financial statements have never been audited. The purchase price for SSI is based on two times net income for its year ended 31 December 20X2, which currently is estimated at $52 million (2 × $26 million SSI preliminary net income).

It is now 1 April 20X3. You have met with Wally, SSI’s bookkeeper and primary shareholder, to obtain additional information on SSI. Notes from this meeting are included in Exhibit 1.

EXHIBIT 1

NOTES FROM MEETING WITH SSI BOOKKEEPER

• In anticipation of being purchased by a public company, on 29 December 20X2, SSI signed a contract with a new controller, proficient in International Financial Reporting Standards (IFRS), and agreed to pay her $165,000 per year starting 1 February 20X3, her first day of work. Wally is excited to have a controller who will be able to teach him the fundamentals of IFRS! 

• SSI’s manufacturing plant in Barrie, Ontario, produces electric drills, with annual net cash flows of $10 million and manufacturing assets of $25 million. SSI management is committed to opening a new plant in Hamilton, Ontario, which will produce solar drills that power on solar energy and therefore do not require electricity. As a result, production at the Barrie plant will be adjusted to reflect the change, resulting in annual projected cash flows of $5 million expected for the next five years, after which the plant will be shut down.

• As the new plant is set to open in the future, no accounting entries have been recorded.

• To support the building of the new Hamilton plant, the Government of Ontario has provided SSI with $10 million to help with the cost of purchasing new manufacturing equipment and to support payroll costs of the various individuals directly involved in the construction project, including architects, construction workers, project managers, and those individuals indirectly involved in the project, such as marketing personnel who are promoting the new solar hammer.

• Wally recorded the receipt of the government funds as revenue. Wally notes that if the government grant was not received, SSI would be forced to obtain a bank loan to fund the construction at a costly interest rate of 8%.

• On 30 July 20X2, SSI made an $80,000 upfront payment to Print Inc. to print the new 20X3 SSI product catalogues, featuring the upcoming solar drill. The catalogues were delivered to SSI on 5 October 20X2 and will be distributed to the public in the spring of 20X3, at which point SSI will record an expense of $80,000.

• On 24 March 20X2 SSI’s Estevan, Saskatchewan, plant was the victim of theft. As of the last inventory count on 31 December 20X1, the plant had $1.8 million worth of products. SSI’s records indicate that sales from 1 January to 24 March were $1.48 million and during that same time, purchases were $1.3 million. SSI’s insurance will cover the cost of the lost inventory once Wally has filed the claim. Wally is not sure how much inventory was lost and therefore has yet to record an entry.

• Adjacent to the Estevan plant, SSI owns a parcel of land that is currently vacant and held for undetermined future use. Due to the increasing population of Estevan, the land has been gradually increasing in value. To better reflect the true value of the land, Wally recorded the land at fair value on the balance sheet, increasing the carrying value from $1 million to $6 million.

Wendy would like you to review SSI’s accounting under ASPE for the year ended 31 December 20X2 and provide your comments. For each significant transaction, she would also like to understand what alternatives and possible adjustment (if any) needs to be recorded to reflect the transaction under IFRS. As this is the first acquisition of a company for RGL,Wendy is unsure of the initial and subsequent accounting for SSI by RGL.

Required:

Prepare a report that responds to Wendy Wonders’ requests and concerns. Be specific and quantify, wherever possible.