Planet Publishing Limited (Planet) is a medium-sized, privately owned Canadian company that holds exclusive Canadian distribution rights for the publications of Typset Daily Corporation (TDC). Space Communications Ltd. (Space), an unrelated privately owned Canadian company, held similar distribution rights for the publications of Worldwide Affairs Limited (WAL).
TDC and WAL were unrelated US publishers of magazines and books. WAL went into receivership in early Year 3 and was then purchased by TDC. TDC did not want the exclusive rights for its publications split between two companies, and it did not believe that either Planet or Space, individually, could adequately distribute its products in Canada. In order to retain the distribution rights that otherwise would have been lost at the expiry of the contracts, Space merged with Planet on July 31, Year 3. Details regarding the merger and the restructuring that followed soon after the merger are provided in Exhibit I.
In September Year 3, the directors of Planet requested that your firm let its name be offered as auditor for the year ending February 28, Year 4. Your firm accepted the request. In prior years, two other firms audited Planet and Space. It is now October Year 3, and your firm was appointed as auditors at a shareholders' meeting. Subsequent to your appointment as auditors, the president requested a report on the following matters:
1. The accounting treatment that should be given to the merger and to the transactions that have arisen since February 28, Year 3, together with full reasons for all recommendations.
2. Any other issues (other than tax and assurance) that the president should be aware of, arising from the merger, or from recent events, together with recommendations.
The partner in charge of the engagement asked you, aCA, a manager in the firm, to prepare the draft report. You and your staff have gathered information on Planet. This information is contained in Exhibit II .
EXHIBIT I INFORMATION REGARDING THE MERGER
1. The merger of Planet and Space took effect on July 31, Year 3, and involved these steps:
a. Planet issued voting shares of the company to the shareholders of Space in exchange for all the outstanding shares of Space. Planet's original shareholders now own 75% of Planet's voting shares.
b. Space was wound up.
c. Space's offices were closed, and its operations were moved to Planet's offices. Space had a 10-year lease with four years remaining. All warehouses remained in operation.
d. Several employees were terminated (and given two to six months' salary) or offered early retirement packages.
2. Planet retained the same year-end of February 28.
3. After the merger, Planet signed new exclusive distribution contracts with TDC and its wholly owned subsidiary, WAL. This gave Planet all the rights that had previously been assigned to Planet or to the former Space. The rights are for five years but are renewable for another five at the option of Planet. These rights include distribution of magazines, books, and videos that accompany books. TDC sells to Planet at a special discount that precludes Planet from returning any merchandise.
4. Before the merger Space had been in financial difficulty, incurring large losses over the past few years. During the merger negotiations Space and Planet approached Space's creditors with a plan to restructure Space's debt. In September Year 3, Planet had been able to finalize the restructuring of some of the debts of the former Space as follows:
a. A trade account of US$320,000 due to TDC was converted into a two-year note payable, due in September Year 5. The note is non-interest bearing and is unsecured.
b. Loans of $500,000 due to shareholders and accrued interest of $125,000 were converted in September Year 3 into convertible, preferred shares bearing an 8% non-cumulative dividend.
c. One of the major shareholders forgave a loan of $110,000 in September, Year 3.
d. Creditors who were owed $200,000 agreed to accept $0.80 on the dollar provided that they were paid before November 17, Year 3. Approximately 10% had been paid by the end of September, Year 3.
5. Under both the merger agreement and a separate contractual arrangement with Planet's banker, the shareholders of Planet were required to contribute $1.5 million of new equity into the company in August Year 3. After the funds had been deposited, the banker made the following loans:
a. A $1 million demand loan to be secured by receivables, inventory, and a registered debenture on all unencumbered assets of Planet. In order to borrow the full
$1 million, the company must maintain average balances of $1.2 million in receivables and $600,000 in inventory.
b. A $2 million term loan on real property belonging to the original Planet, and chattels, for which the bank holds the first mortgage or a lien claim with priority over those of other creditors. The term loan is for up to two years and can be drawn upon as needed.
6. As part of the distribution agreement with TDC, Planet must provide financial statements to TDC for fiscal Year 4, Year 5, and Year 6.
7. The bank wants monthly listings of inventory, aged receivables, and cash flows. The bank loan agreement stipulates covenants that must be adhered to, including debt-to-equity ratios, no dividends on voting shares, maximum salary limits, and limits on bonuses.
EXHIBIT II INFORMATION ON PLANET
1. In August Year 3, Planet made the following transactions:
a. To diversify, Planet invested $800,000 cash in a Canadian specialist magazine. This magazine has been successful for several years, and it is expected to generate over $150,000 per year in cash flows after taxes. Planet acquired customer and advertiser lists, title to the magazine, some files, and many back issues. Six staff members from the magazine joined Planet, forming the core management and pro viding continuity.
b. Planet decided to invest about $350,000 in cash in an advertising program to attract new subscribers to the specialist magazine. The $350,000 is to be amortized over the expected subscription life of the group of new subscribers. The $350,000 was paid to an advertising agency in August Year 3. In addition, Planet and the agency have agreed that the agency will provide the equivalent of another $300,000 for a promotion campaign in exchange for free advertising space in Plan et's specialist magazine. These free advertisements are expected to be published over the next six months.
In recent years, the cost of preparing or producing a magazine published in Canada has tended to be three to four times the average subscription price. Throughout Year 3, subscriptions were offered at half price if subscribers paid in advance for three years.
2. The sales of magazines published by TDC and other publishers account for most of Plan et's (and the former Space's) business. Retail sales dollars and margins have remained constant over the past few years in this market. Retailers are generally permitted to return each month's unsold magazines to the distributor for credit against future sales.
3. Arrangements with book stores allow them to return half of the books that they purchase, as long as the returns occur within six months of purchase. Over the past five to eight years, returns have varied considerably. Most book stores pay about 120 days after purchase.
4. Several small book stores have gone bankrupt during the recent recession, and only some of the inventory was returned prior to bankruptcy. Minimal payments from trustees for these bankrupt stores are expected over the next three to five years.
5. Over $400,000 had been withdrawn from Planet by the major shareholders in the two years leading to the merger. There are rumors that some minority shareholders may file a lawsuit against Planet.
6. Before the merger, both Space and Planet engaged in various non-arm's length transactions that were materially different from fair values. Notes to the respective financial statements mentioned that non-arm's length transactions had occurred but did not provide any details.
7. Planet's Year 4 financial statements will be included in documents designed to attract capital through an initial public offering in the near future. Planet wants to apply accounting standards for public enterprises.
8. Considerable investment in subscription drives is expected over the next several months. Management wants to capitalize all expenditures and employ a 10-year amortization period.
9. In the fiscal year ended in Year 3, about one-third of both Planet's and Space's sales came from Canadian published products and two-thirds from TDC and WAL products.
Required:
Prepare the draft report.