Total Protection Limited TPL was incorporated on January 1 Year
Total Protection Limited (TPL) was incorporated on January 1, Year 1, by five homebuilders in central Canada to provide warranty protection for new-home buyers. Each shareholder owns a 20% interest in TPL. While most homebuilders provide one-year warranties, TPL offers ten-year warranties and includes protection for a number of items not usually covered. For example, if a problem arose as a result of faulty construction or construction materials, TPL would protect its customers against any resulting decline in the market value of their property and would provide for the costs of restoring the property. TPL does not, however, cover general declines in market value.
The five shareholders believe TPL will increase their home sales and at the same time minimize their individual risks. The idea for TPL originated with Safe-Way Builders and, therefore, this shareholder will receive a royalty payment of 5% of income before income taxes. The shareholders have engaged your firm to prepare a report that will assist them in managing TPL in order to maximize its long-term profitability.
In particular, they are wondering whether TPL is pricing its services appropriately and adequately controlling its costs. In addition, as a separate report, the shareholders would like your firm to recommend appropriate financial accounting policies for TPL.
It is mid-December Year 1. You, the CA, and the partner on the engagement, meet with Gina Filmore, president of Safe-Way Builders. Filmore is currently operating TPL from the offices of Safe-Way Builders, for which TPL will be charged rent. Filmore provides you with the following information on TPL's operations.
"TPL's revenues consist of an initial fee paid at the time of purchase of the warranty and an annual maintenance fee paid over the term of the warranty. Currently, the initial fee and annual maintenance fee depend on a number of factors, including the cost of the home, reputation of the builder, construction design of the home (e.g., brick versus aluminum siding), and the home's location. The warranties are sold through each builder, who can adjust the initial fee and the annual maintenance fee if it is considered necessary to make the sale. The builder receives a commission of 10% of the total warranty revenue, which should ensure that the builder would try to maximize the initial fee and the annual maintenance fee. Typically, a buyer of a brick house worth $250,000 that was constructed by a good-quality builder should expect to pay an initial fee of $2,000 plus an annual maintenance fee of $250.
"To date, TPL has been doing very well, primarily as a result of two factors: central Canada has been experiencing a boom in the residential construction industry, and TPL has expanded to offer coverage for homes built by builders other than the shareholders. Quite frankly, an increasing share of our business is from these outside builders, many of which have entered the industry just to try to capitalize on the demand. We don't think that permitting these homebuilders to sell coverage will hurt our home sales, since most of them are in the low-price segment of the market, keeping costs down by employing new, less expensive construction methods and materials. We require that their initial fee be at least $1,500 per home to ensure that they don't lower the price just to make a sale.
"Our real problem is keeping up with the paperwork. I have my own business to run and cannot devote much time to TPL. We haven't even had time to get organized or set up any system for TPL. Lately, I must admit that I've lost track of what's going on. All I know is that we're making money. In just 11 months, TPL has collected about
$1.6 million while paying out only $224,000 in repair costs. Keep in mind, however, that I've been able to keep these repair costs down by having Safe-Way Builders do the repairs. Business will only get better when we expand within the next month to offer coverage in western Canada and the southwestern United States.
"Since we have accumulated a lot of cash, we recently decided, in a 3-to-2 vote among the shareholders, to buy 100% of the shares of Gainery Construction Ltd., a local construction company. Mr. Gainery, the owner of the company, had a heart attack about six months ago and wanted to get out of the business. Details of the purchase agreement are provided in Exhibit I.”
Just before you leave the client's premises, you manage to collect some additional information on the operations of TPL (see Exhibit II).
When you return to the office, the partner reminds you that he will be meeting with TPL shareholders in one week and asks you to prepare the reports requested by the shareholders.
Prepare the reports requested by the partner.
1. Closing date will be December 31, Year 1.
2. TPL will purchase 100% of the shares of Gainery Construction Ltd. for $500,000 in cash on closing, plus $500,000 per year for the next two years.
3. Mr. Gainery will provide, without additional consideration, a minimum of 300 hours of consulting services in the first year and a minimum of 150 hours in the second year, to ensure a smooth transition of the business.
4. The carrying amount and estimated fair value of identifiable assets and liabilities were as follows on the date of acquisition:
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