Tom Mullins, a long-time client of your employer, Spinney and Smith, Chartered Accountants, approached one of the firm's partners concerning a new business opportunity. Tom is a well-established local real estate agent with an excellent reputation for integrity and client service. He is excited about a new development in the real estate field, the sale of “reverse mortgages.”
Under such sales, senior citizens who own and live in homes with high market values, but who lack funds on which to live, enter into an agreement with a company whereby the senior citizens receive a cash settlement now in exchange for title to their home upon the death of the last survivor. The amount of the payment is based upon the value of the home and actuarial assumptions about life spans.
The senior citizens continue to live in the house, rent free, for the rest of their lives.
The only costs that they continue to bear after the transaction are the normal household expenses any homeowner bears, such as repairs, painting, cutting the lawn, insurance, and property taxes. Tom says that the price paid would be fair to both the senior citizens and the speculator: it would provide a reasonable return to the company, without cheating the senior citizens.
Tom intends to incorporate a company (Happy Valley Homes Ltd.) to capitalize on this opportunity. Tom told the partner: "I can pay $200,000 for a reverse mortgage now, and the house should be worth $400,000 when sold. My average holding period should be about six years. That’s a $200,000 gain, half of which would be taxable at, say, 40%.
I would net $160,000.”
Tom proposes to raise the necessary capital by way of an offering document to private investors. He wants Spinney and Smith to help put together a financial forecast and to attach “whatever opinion is appropriate. Use whatever accounting policies are best, as long as they are not too costly and complicated.” Spinney and Smith will also be engaged as auditors, but for the moment Tom is primarily concerned with "getting the project off the ground." Accordingly, he is interested only in Happy Valley’s immediate accounting and auditing concerns.
In the interim, Tom intends to borrow funds from his bank to cover initial expenses and the first few houses.
After outlining his discussions with Tom, the partner has requested you, CA, to perform the initial research and to draft a preliminary report to the client on the issues raised.
Required:
a. Prepare the draft report requested by the partner.
b. Consider the business model and discuss the impact of information asymmetry (adverse selection and moral hazard) on the potential success or failure of the proposed venture.
c. Discuss the ethical issues involved in the proposed venture.