Stephanie Baker is an audit senior with the public accounting firm of Wilson & Lang. It is February Year 9, and the audit of Canadian Development Limited (CDL) for the year ended December 31, Year 8, is proceeding. Stephanie has identified several transactions that occurred in the Year 8 fiscal year that have major accounting implications. The engagement partner has asked Stephanie to draft a memo addressing the accounting implications, financial statement disclosure issues, and any other important matters regarding these transactions.

CDL is an important player in many sectors of the economy. The company has both debt and equity securities that trade on a Canadian stock exchange. Except for a controlling interest (53%) owned by the Robichaud family, CDL's shares are widely held. The company has interests in the natural resources, commercial and residential real estate, construction, transportation, and technology development sectors, among others.

Changes in Capital Structure:

During Year 8, CDL's underwriters recommended some changes to the company's capital structure. As a result, the company raised $250 million by issuing one million convertible, redeemable debentures at $250 each. Each debenture is convertible into one common share at any time. CDL's controlling shareholders acquired a sizeable block of the one million debentures issued; a few large institutional investors took up the remainder.

The company proposes to partition the balance sheet in a manner that will include a section titled "Shareholders' Equity and Convertible Debentures." The company views this classification as appropriate because the convertible debt, being much more akin to equity than debt, represents a part of the company's permanent capital. Maurice Richard, the controller of CDL, has emphasized that the interest rate on the debentures is considerably lower than on normal convertible issues and that it is expected that the majority of investors will exercise their conversion privilege. The company has the option of repaying the debt at maturity in 20 years' time, through the issuance of common shares. The option will be lost if the company is unable to meet certain solvency tests at the maturity date. The company's intention was to raise additional permanent capital, and convertible debt was chosen because of the attractive tax savings. The debentures are redeemable by the investors at $250 from January 1, Year 15, to January 1, Year 18.

At the same time as the company issued the convertible debentures, two million common shares were converted into two million preferred, redeemable shares. The carrying amount of the two million common shares was $20 million. The preferred shares do not bear dividends and are mandatorily redeemable in five years at $20 per share. They have been recorded at their redemption value of $40 million, and the difference between this redemption value and the carrying amount of the common shares ($20 million) has been charged against retained earnings.

Disposal of Residential Real Estate Segment:

Intercity Real Estate Corporation (IRE) is a wholly owned subsidiary of CDL and has two operating divisions: a money-losing residential real estate division and a highly profitable commercial real estate division. The two divisions had been combined into one legal entity for tax purposes as the losses arising from the residential real estate division have more than offset the profits from the commercial real estate division.

During Year 8, CDL decided to dispose of its shares of IRE. However, CDL wished to retain the commercial real estate division and decided to transfer the division's assets to another corporation prior to selling the shares of IRE. As part of the sale agreement, just before the closing, the commercial real estate assets were transferred out of IRC to CDL, which then transferred the assets to a newly created subsidiary, Real Property Inc. (RPI). In order to maximize the asset base of RPI, the commercial real estate assets were transferred at fair values, which greatly increased their tax base and created considerable income for tax purposes.

Maurice has explained to Stephanie that since the transfer would create income for tax purposes, it was necessary for both CDL and the purchaser to agree on the fair value of the commercial real estate assets, even though they were not part of the IRC sale. IRC's purchaser agreed to the values used because the loss carry-forwards, which would otherwise have expired, offset the income for tax purposes.

CDL is planning to take RPI public sometime this year. The commercial real estate assets of RPI have been recorded at the values established in the sale of IRC, because management believes that this amount represents the cost of acquiring the business from IRC. Maurice has stressed that the transfer between IRC and RPI is very different from the majority of transactions between companies under common control. He argues that the transfer of the commercial real estate assets to RPI represents a bonafide business combination, since there is a change of substance and not just of form. CDL maintains a policy of granting subsidiaries a high degree of autonomy and, in substance, they do not function "under common control." Maurice indicated that the real estate assets are worth more to CDL as a result of this transaction because of the increase in the tax values of the assets. Finally, an unrelated party was involved in the transaction and in the determination of the fair value of the assets.

Stephanie noted that after the transfer the real estate business changed. RPI has undertaken a major refurbishing program and has just bought a large chain of shopping centres that has doubled the company's asset base.