Question

You, CA, have been working for Plener and Partners, Chartered Accountants (P&P), a mid-size CA firm, for three years. You have been assigned a new project for a long-term client of your firm, Oxford Developments Inc.
(ODI). For the last two years, you have worked on ODI's file, and for its most recent year ended November 30, 2012, you were the audit senior on the job. Information on ODI's operations and the property development industry can be found in Exhibit C6-3(a).
It is now September 5, 2013. You and Wendy Yan, the engagement partner, just sat down with Mike D'Silva, Chief Executive Officer of ODI. Mike came in to discuss a new business opportunity that ODI has recently undertaken.
"At ODI, we are always searching for new opportunities related to property development. ODI's focus is on providing a superior return on investment for its shareholders. ODI leverages existing equity with an appropriate amount of debt to acquire and develop properties for resale. As I've mentioned to you before, we have been thinking of getting into the hotel market for a couple of years now, but we were unsure how to get started. A little while ago, I had a chance meeting with Linda Kim, the general manager of Hospitality Management Inc. (HMI). After many meetings and much research, we decided that ODI and HMI are a good fit, and we have started working together on the development and operation of a boutique hotel. Our hotel will have a special feature-the hotel rooms will be sold to individual investors.
"We have established a separate company, Genuine Investments Inc. (GI), for this unique project. HMI agreed to contribute cash and ODI contributed the land and the building. To be successful and profitable, the hotel will require excellent marketing and management. HMI has a good track record in these areas, and I'm confident they will be able to achieve similar results for this property. HMI will operate the hotel under a management contract. I've provided some excerpts from the finalized agreement between ODI and HMI (Exhibit C6-3(b))."
After Mike leaves, Wendy says to you, "It is likely that we will be asked to perform the annual audit engagement of GI's IFRS financial statements, so I would appreciate your analysis of the accounting implications for the initial trans actions and ongoing operations of GI. I had a chance to meet with ODI's Chief Financial Officer, Amber Wolfe. My notes from that conversation are attached (Exhibit C6-3(c))."
Required
Prepare the report requested by Wendy Yan.
EXHIBIT C6-3(a)
INFORMATION ON OXFORD DEVELOPMENTS INC. AND THE PROPERTY DEVELOPMENT INDUSTRY
Oxford Developments Inc. (ODI) is a mid-size real estate development and sales company. It was founded by a small group of individuals who felt there was a significant amount of money to be made in real estate, and it has been in business for 10 years.
As the company grew, it brought in additional investors, and it is now owned by 25 individual shareholders. The investors have never been involved in the day-to-day management of the company; rather, it is professionally managed.
Over the past several years, ODI has acquired over 100 commercial and industrial properties all over Canada, which showed significant potential. ODI has renovated these properties and resold them, usually for a substantial gain. The average time between acquisition and sale of the properties has been 12 months, and the average profit margin has been over 12%.
Between 2004 and 2012, the Canadian real estate industry has been strong. The average annual increase in the value of commercial real estate has been 8.2% over this time period, compared with the historical annual rate of 4.6% in the 1980s and 1990s. ODI has been able to achieve a profit margin of over 12% due to its strategic acquisitions and its strong control of the renovation costs associated with these properties.
The hotel industry in Canada is fragmented, and significant differences exist between the various geographical areas of the country as well as the quality of hotel properties. Overall, the industry has achieved an occupancy rate of 76% over the past decade. This percentage has been steadily increasing over the past 10 years, with the occupancy rate going from 72% in 2003 to 79% in 2012.
More recently, the Canadian economy has slowed. The difficulties in the U.S. housing market caused by the subprime lending fiasco, as well as the uncertainties surrounding the financial industry in the United States, have precipitated a worldwide economic slowdown. Canada is not immune to these events.
ODI believes it is well situated to take advantage of the opportunities that a declining real estate market may present. ODI's strategy is to maintain a strong balance sheet, purchase strategic properties at distressed prices, renovate these properties at low costs using well-priced labour and construction materials, and resell the properties as the real estate market starts to recover.
EXHIBIT C6-3(b)
EXCERPTS FROM GENUINE INVESTMENTS INC. AGREEMENT
Incorporation
Genuine Investments Inc. (GI) was incorporated on December 1, 2012, to develop and operate a boutique hotel known as "The Genuine Hotel." The financial year end for GI will be November 30.
Authorized share capital of GI
There are two classes of shares, as follows:
• Class A voting common shares-20,000 shares authorized
• Class B non-voting shares-an unlimited number of shares authorized
Contributions
Oxford Developments Inc. (ODI) will contribute the land and building and $1,000 in cash to GI in exchange for 1,000 Class A shares and 100,000 Class B shares. The building is expected to have a useful life of 40 years.
Hospitality Management Inc. (HMI) will contribute cash equal to the fair value of the land and building contributed by ODI plus $1,000 in exchange for 1,000 Class A shares and 100,000 Class B shares.
Restriction on share sale
Shares cannot be sold or traded without the approval of both ODI and HMI. Both companies agree to hold the shares for five years. After that period, if either party wants to sell, the other party will have the right to purchase the shares at 90% of the market value at the time of sale.
Loans
ODI and HMI may periodically loan funds to GI. If funds need to be advanced to GI, both investors will provide an equal amount. Any funds advanced will bear interest at the prevailing market rate, and will be repayable on demand at the request of either ODI or HMI.
Board of directors
ODI and HMI will each appoint two individuals to the board of directors of GI. A fifth member, who will act as board chair, will be jointly appointed by ODI and HMI.
Profit distribution
GI will distribute 90% of its net earnings on an annual basis provided there is cash available. The distributions will be performed on a tax-effective basis in the form of either dividends or management fees. If the company is wound up or dissolved for any rea son, the final distribution of any amounts remaining shall be made in proportion to the Class B shareholdings of each investor.
Transactions between GI and ODI
All sales (and subsequent resales) of rooms will be done through the real estate division of ODI. ODI will receive a commission on initial sales from GI of 2.5% and on subsequent resales by room owners of 5%. These rates are based on existing market rates.
Operation
Operation of The Genuine Hotel will be contracted to HMI at a fee approximating the current market rate for management fees.
HMI will be responsible for reservations, guest services, housekeeping, regular ongoing maintenance of the hotel, and security. GI will be responsible for general administration. The contract will be renegotiated every five years. The management fee for the first five years is set at $75 per night per occupied hotel room.
EXHIBIT C6-3(c)
NOTES FROM CONVERSATION WITH AMBER WOLFE, CHIEF FINANCIAL OFFICER OF OXFORD DEVELOPMENTS INC.
"Thanks so much for meeting with me. Ever since this project began, I've had more work than I can handle. GI has minimal staff right now, including a manager looking after the construction and some secretarial and administrative support, so I've been helping out. As a result, I have questions about both ODI and GI.
"I'm hoping that P&P can take over the day-to-day bookkeeping for the next several months until GI can hire an experienced controller. On the bright side, a marketing person was recently hired, and we are actively hiring additional staff as required.
"Extensive renovations were required on the building, and they are now complete. Most of the furnishings, fixtures, and equipment have been installed, and we are busy planning for the grand opening. Since we wanted to get the project started quickly, ODI and HMI provided all of the initial financing. However, in the future, we would like GI to obtain its own bank financing. If GI does obtain financing, it would like to repay the amounts owing to ODI and HMI and repurchase 50% of the Class B shares held by each company at book value. I have brought along some financial information related to GI (Exhibits C6-3(d) and a-3(e)).
"Given that this investment is new and unique for ODI, it could become a model for future investments. Our shareholders are therefore very interested in how the accounting for our investment in GI will affect ODI's financial statements for the November 30, 2013, year end and in the future. I expect the gain on the sale of the land and building transferred to GI to improve ODI's overall financial position and increase its net income. I think it should also increase ODI's net assets, which is a key financial indicator reported to ODI's shareholders and ODI's bank.
"I think that's it for now. Again, thanks for your help with all of this, as my time seems to be at a premium these days."
EXHIBIT C6-3(d)
TRIAL BALANCE FOR GENUINE INVESTMENTS INC.
Generated for internal purposes only.
GENUINE INVESTMENTS INC.
TRIAL BALANCE
For the nine months ended August 31, 2013
($ thousands)
Note:
A – Asset
L – Liability
E – Equity (net asset)
R – Revenue/Income
X – Expense
EXHIBIT C6-3(e)
FINANCIAL INFORMATION ABOUT GENUINE INVESTMENTS INC.
1. Details of the land and building transferred from ODI to GI are as follows (in thousands):
2. Twenty-five hotel rooms have been sold to date at the listed price. Deposits of 5% of the sales price have been received for an additional 40 rooms. Investors interested in 7 of these 40 rooms have recently backed out. The deposits are non-refundable and are included in other income. GI expects that all hotel rooms will be sold to investors within the next three months.
3. All of the owners of the hotel rooms that have been sold to date (25 owners) have also entered into management contracts with GI to rent out their hotel rooms on their behalf. We anticipate that the buyers of the remaining 75 rooms will enter into management contracts as well. This is consistent with what similar projects have experienced: a very high percentage of owners have entered into management contracts to rent out their rooms.
4. GI retains 100% of the gross room rental revenue related to unsold rooms.
5. Room owners will be charged $2,000 per year to fund renovations and major furniture and equipment purchases (the "Reserve Fund Contribution"). The monies collected will be paid to GI and put into a reserve fund to be drawn upon as needed. The fund will not be used for ongoing maintenance, which will be done by HMI as part of its management responsibility. The $2,000 amount charged to each owner may be adjusted in future years to ensure the reserve fund is adequate to cover the costs associated with renovations and major furniture and equipment purchases.
Industry data indicate that annual major renovations typically amount to approximately 1% of the original cost of the building in the first five years of a building's life, and increase to 5% after five years.
6. Annual operating and administrative expenses are estimated at $360,000 and $300,000, respectively. These estimated expenses include property taxes, insurance, interest charges on shareholder and bank loans, accounting fees, and salaries associated with the overall administrative and financial areas of GI.
7. The hotel will include retail space and a restaurant. Agreements are in place with two retailers, and GI is in the process of sorting out the details of an agreement with Gizmos, a great restaurant chain. We anticipate that all the commercial operators will be in place by November 30, 2013. Budgeted sales revenue (annual) for each of these establishments is as follows:
Restaurant ........ $2,500,000
Convenience store ..... 700,000
Art gallery ........ 1,500,000
GI will receive a percentage of the operators' gross revenue. That percentage is 3% for the restaurant, 5% for the convenience store, and 3% for the art gallery.
8. GI intends to capitalize all the costs associated with the building renovations for accounting purposes. Many of the soft costs, such as interest and landscaping fees, will be expensed for tax purposes, if possible.


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