Tail O’ the Dog operates a chain of seven gourmet hot dog stands in southern California. The firm’s first stand, built in 1948, was shaped like (what else?) a giant hot dog, in a giant hot dog bun, and with mustard, of course. Over the years, this humble counter has served the public over 5 million hot dogs—everything from the Mexican Ole (with chili, cheese, and onions) to the Boston Celtic (with baked beans). The company’s other six outlets maintain the original stand’s architectural kitsch.
Yesterday, Tail O’ the Dog was acquired by Conover Corporation in a stock-for-stock deal valued at $28 million based on the market value of Conover stock. Conover must now determine the fair value of each identifiable Tail O’ the Dog asset and liability, consistent with the requirements of applicable accounting standards.
There is a Tail O’ the Dog stand on the edge of Carlsbad, California, just north of San Diego. The stand sits on the east side of the Pacific Coast Highway, the state route that runs along the California coastline from Mexico to Oregon. Across the highway is a one-acre, paved parking lot also owned by Tail O’ the Dog (and now Conover). The beachfront parcel is zoned for commercial or residential use and has majestic coastline views. In attempting to determine the fair value of this parcel, Conover has learned that:
• The parking lot is carried on the books of Tail O’ the Dog at its 1962 historical cost of $12,000. Improvements made to the parcel over the years are now fully depreciated.
• Tail O’ the Dog allows free use of the parking lot by its customers, other businesses, neighborhood residents, and tourists seeking beach access. A local developer contacted the company last year and proposed converting the lot into monthly paid parking. According to the developer’s estimates, doing so would produce an income stream of $60,000 each year (net of improvements and annual operating costs) for Tail O’ the Dog. The developer’s offer was declined but Conover has calculated the capitalized value of this potential income stream to be $600,000.
• Because Tail O’ the Dog receives no income from the parcel, it is currently assessed for property tax purposes as an “unimproved commercial lot” at $200,000.
• A parking lot of similar size but located several blocks east of the highway and closer to downtown Carlsbad sold for $500,000 last year.
• An unimproved residential beachfront lot of similar size sold for $1.2 million last year.

That lot was also located several blocks closer to city center than is the Tail O’ the Dog lot. In speaking with several real estate professionals, Conover has learned that property values in the area are down slightly from a year ago.

1. Conover Corporation’s financial reporting problem is to determine the parking lot’s fair value in a manner consistent with GAAP. Which of the five measurements is the least relevant for this purpose? Why?
2. Which measurement is the most relevant for determining the parking lot’s fair value? Why?
3. Which of the five measurements (if any) correspond to Level 2 in the fair value measurement hierarchy? Which measurements (if any) correspond to Level 3?
4. Why might auditors be more challenged by a Level 3 fair value measurement than by a Level 2 fair value measurement?

  • CreatedSeptember 10, 2014
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