Dam Design Inc. (DDI) is a privately owned Canadian engineering and project management company. DDI has been in business since 1948 and is involved primarily in designing and building small and large hydro and irrigation dams. The company is currently owned by members of the family of the late founder, Dick Hydraul (64%), and three outside investors (36%). The company has a December 31 year end, and it has always been audited by Price, Cappuccitti & Co., Chartered Accountants.
Historically, the company has been fairly conservative in its business and accounting decisions. In April 2013, the company's board of directors decided to look beyond North America and to actively pursue international business opportunities. To assist with this expansion, the board further resolved that the company would either seek to be sold to a large international engineering firm within a year or go public, given the stock market success of a number of other Canadian engineering firms.
In July 2013, DDI submitted a bid to design and build the Super Dam in a developing Asian country. The dam is intended to generate electricity, control floods, and provide irrigation. On August 13, 2013, DDI was awarded the design and construction contract, and work started almost immediately in conjunction with another contractor. The customer is the Northern Province of the country. The other contractor's role is to carry out the earth-moving work in a separate contract with the province.
Environmental and human rights groups around the world are up in arms about the project. They claim that it will cause forced, uncompensated displacement of 140,000 local farmers and their families, as well as major disruption of local ecosystems.
It is now September 16, 2013. You, CA, work for Price, Cappuccitti & Co. The partner has asked you to meet with DDI to review the accounting issues raised by the Asian Super Dam project, so as to get this work done before year end. The partner has requested a memo discussing and making recommendations on the accounting issues and covering other relevant matters. You visit DDI and gather the information contained in Exhibits C7-4(a) and C7-4(b).
Required
Prepare the memo requested by the partner.
EXHIBIT C7-4(a)
CA’S NOTES ON SUPER DAM PROJECT
1. There are two contracts with the customer. The design contract is priced in U.S. dollars and has a total value of U.S. $26.4 million. Payments will be received 30 days after each of eight milestone-based invoices. The construction contract, worth C$915 million over the seven years of the project life, will be paid for under a more complex arrangement. The contract specifies a 10% down payment. For 60% of the contract value, payments will be made pro-rata, based on time, over the project life. The final payment of 30% of the contract value is due five years after project completion and is guaranteed by the Canadian government.
DDI will receive interest on the final payment at 7% per annum, payable at the end of the term. Interest will be calculated from the date the project is completed.
In order to win the contracts, DDI entered into a separate agreement to purchase 12 million tonnes of coal for C$40.80/tonne, from Northern Province. The purchase will be delivered to a Northern Province port in four equal shipments on December 31, 2013, through December 31, 2014. At the time the contract was signed, the current market price of such coal was C$37.05/ tonne. The requirement to purchase coal from Northern Province was never spelled out in the project master contracts, and the coal purchase agreement does not mention any link with the master contracts. However, DDI understood from the negotiations that this purchase was required. DDI will not use the coal in the Super Dam project.
2. As is standard practice in the country, local construction workers are paid weekly in U.S. dollars cash or cigarettes at the remote job site. Cigarettes are the most stable form of local currency after the U.S. dollar. Cigarettes are the preferred medium of pay ment, because the company can make a small profit given that the company can buy the cigarettes at a cheaper price.
3. The World Bank is financing 50% of the U.S. $26.4-million design contract. DDI paid the World Bank a C$3.2-million financing fee for this assistance.
4. To fund local expenses, Alexandre Laurier, the on-site project manager, has opened a bank account at a local bank in his name, as the paperwork for a corporate account was too complicated. He did this on his own initiative. The average balance in the account is about U.S. $3 million.
The standard procedure is for Laurier to send a wire when he needs the account to be replenished. Expenditures from the account will be primarily cash for the local payroll, but payments will be made by cheque for other purchases, some local materials, and the living expenses of the Canadian workers at the job site.
5. The Governor of the Northern Province has approached Laurier for a Canadian university scholarship for his daughter, in exchange for facilitating the release of the remaining construction permits.
6. DDI uses the percentage-of-completion method, based on costs relative to budget, to report revenue on all long-term contracts, including the Super Dam project. To date the project is tracking approximately to budget. The company's project management costs, budgeted to be C$32.04 million, are 55% labour and benefits and 45% other costs.
7. Local materials will be purchased in U.S. dollars on the Super Dam project. The U.S. dollar can currently be purchased for C$1.05.
8. The country's tax code is virtually incomprehensible even when translated. Therefore it was necessary to meet with the country's tax authorities to clarify how DDI would be taxed. DDI's controller met with the authorities on September 15, 2013.
Based on her fax to head office, taxation of foreign entities engaged in projects works as follows. The foreign entity must pay tax each year ended February 28. The tax rate in the country is 48.4%.
The taxable amount is calculated as:
Gross amount received by DDI from Northern Province
Less: - local and foreign materials purchased for use in the project
- Payroll to citizens of the Asian country
- Foreign project management costs attributable to the project, excluding payroll
9. The summary budget for DDI's design contract is as follows (in thousands of Canadian dollars):
Canadian design costs ..... $ 9,390
Subcontract costs ....... 8,320
Other costs .......... 1,470
Contingency ......... 300
$19,480
10. DDI’s construction contract summary budget is as follows (in thousands of Canadian dollars):
Canadian project management costs ........... $ 32,040
Local materials .................. 439,280
Canadian materials .................. 61,360
Local payroll ................... 170,040
Canadian labour in Northern Province .......... 32,920
Estimated proceeds on disposal of equipment ........ (2,040)
Provision for income taxes ............... 68,118
Contingency .................... 20,000
$821,718
11. Northern Province will reimburse DDI for the first C$10 million of income taxes paid to the Asian country, under the terms of the construction contract.
12. It was not possible to read the entire 3,027-page contract, including engineering drawings, during my brief visit.
13. Some old, specialized equipment will be taken overseas and used in the project. DDI plans to sell it there on project completion rather than ship it back.
EXHIBIT C7-4(b)
OTHER INFORMATION GATHERED BY THE CA
1. There is no tax treaty between Canada and the Asian country.
2. Northern Province's debt has not been rated by any large credit agency since a default two years ago.
3. Ignoring the Super Dam project, revenues are expected to be about C$110 million this fiscal year and C$130 million the year after. DDI's revenues to date are C$62 million, with net income of C$6.9 million. In fiscal 2012, revenues of C$98 million were reported, with net income of C$5.7 million.
4. The current market price of coal is C$38.10/tonne.
5. The client's controller has not spent much time looking at the implications of the April decisions of the Board.