Eternal Rest Limited (ERL) is a public company; its shares are traded on a stock exchange in Canada. ERL operates both funeral homes and cemeteries in Canada. Funeral services (casket, flowers, cemetery stone, prayer service) are sold on an "as needed" basis and also "in advance" (prepaid). ERL recognizes revenue only as the funeral services are performed.
Cemetery land is purchased years in advance, and carrying costs (e.g., interest and property taxes) are capitalized. The company sells burial plots or gravesites in advance, or on an "as needed" basis. Revenues from plots sold in advance are recognized upon signing a contract, regardless of the timing of receipt of cash. The cost of maintenance for 100 years is recognized as an expense of earning revenue.
By law, funds for maintenance are sent to a trustee, for investment. Funds are allowed to be withdrawn annually for current maintenance costs. The cost of the cemetery land and land improvements (including trees, fencing, and pathways) is allocated to cost of sales. As a result of acquisitions, ERL tripled its assets in fiscal Year 5. Effective September 1, Year 4, ERL acquired the assets and liabilities of Tranquil Cemeteries Limited (Tranquil) by issuing common shares and debt. ERL also acquired, effec tive November 1, Year 4, 70% of the voting common shares of Peaceful Cemeteries Limited (Peaceful) in exchange for $1 million cash (borrowed from ERL's banker)
plus common shares of ERL. Peaceful was privately owned by a single share holder before the purchase of its shares by ERL. The common shares of ERL that were issued with respect to the acquisitions have been escrowed and may not be sold for one year from their issuance date. You, a CA, are a new manager with a CA firm. Your firm was appointed as the auditor of ERL in September Year 4, for the year ending June 30, Year 5. Your firm was also appointed as the auditor of Peaceful.
It is now September Year 5. Your firm has experienced severe staffing short ages. The partner has advised you that because of the recent departure of another manager, you have been assigned to the ERL and Peaceful engagements. The audit fieldwork has been completed, but the file review has not taken place. The partner has asked you to review the audit files and notes prepared by the senior in charge of the engagements and to prepare a memo that provides your analysis and disposition of the accounting issues. The following information was assembled from your review of the working papers of ERL and Peaceful.
1. The acquisition of Tranquil's net assets resulted in the following additions to ERL's balance sheet as at September 1, Year 4 (in thousands of dollars):
Working capital ................... $ 850
Land ........................ 1,400
Buildings and equipment, net .............. 3,700
Non-competition agreements ............ 3,000
Goodwill ...................... 11,250
Total net assets of Tranquil .............. $20,200
The $20.2 million was paid as follows:
5-year non-interest-bearing first mortgage bonds of ERL .. $18,150
Common shares of ERL, escrowed for one year ....... 2,050
$20,200
The auditors read the purchase and sale agreement and noted that $820,000 of the working capital represented funds that were being held in trust for future maintenance of the cemetery lands. The new common shares issued by ERL were measured at the market price on the day prior to the signing of the agreement.
The $3 million paid for non-competition agreements represents a pay ment to the sellers of Tranquil in exchange for their commitment not to engage in the same type of business for five years. The $3 million represents the oth erwise expected earnings of the sellers, discounted at the 9% market rate of interest that prevailed at the time. The $1.4 million and $3.7 million assigned to land, buildings, and equipment represent management's estimates of the fair values of these assets and coincide with carrying amounts on Tranquil's books.
2. The shares of Peaceful were acquired primarily because the company had non-capital loss carry-forwards for income tax purposes. The purchase price for the acquisition was a $1 million cash payment by ERL plus the issuance of $24 million of ERL shares for the 70% ownership. The acquisition cost was allocated to assets and liabilities in a manner similar to the allocation for the Tranquil acquisition. The auditors did not request that the estimated value of the loss carry-forward be recorded. ERL attributed $4 million to non-competition agreements (to be amortized over five years) and $14 million to goodwill.
3. After the acquisition of Peaceful by ERL, sufficient business was directed to Peaceful to commence the process of utilizing the tax loss carry-forwards. During fiscal Year 5, the benefit realized from the utilization of the loss carry forwards amounted to $2.36 million and was recognized as a gain on the income statement.
4. Excess cemetery land (acquired in the purchase of Tranquil) was sold in December Year 4 at a gain of $1.2 million. The proceeds were reported as "other revenue."
5. One working paper entitled "Land" contains the following note: "Land recorded on the books at $2,305,600 and called 'Sunset Hill' is undeveloped and is not scheduled for use until Year 8 or Year 9. It is subject to a Year 5 government order requiring that ERL clear up environmental concerns on the site. I asked one employee what the cost would be and was told 'half a million dollars.' No amount was accrued because of uncertainty."
6. A working paper entitled "Management Compensation" shows that senior management shares in what is called a "Bonus Pool." The bonus is 15% of income before income taxes.
Required:
Prepare the memo.