Gerry's Fabrics Ltd. (GFL), a private company, manufactures a variety of clothing for women and children and sells it to retailers across Canada. Until recently, the company has operated from the same plant since its incorporation under federal legislation 40 years ago. Over the years, the profits of the company have varied widely, and there have been periods of losses.
In the year ended March 31, Year 1, the company entered into an arrangement whereby it issued common shares from treasury to a group of new shareholders. At the same time, the existing shareholders were given the option of exchanging their common shares for preferred shares, which are redeemable at the option of the company and retractable at the option of the shareholder. One shareholder, who had held 25 percent of the common shares, elected to accept the preferred shares, while the other shareholders elected to retain their common shares.
A "Preferred Share Agreement" (the Agreement), was signed by the share holder who had accepted the preferred shares (the "preferred shareholder"). Under the Agreement, the preferred shareholder can require GFL to redeem all of his shares in any year, after giving at least 90 days' notice prior to the fiscal year end. The Agreement does not provide for partial redemptions. The total redemption price for all shares is 1.25 times "income before taxes" for that year. The term income before taxes is defined in the Agreement as follows:
1. Income before taxes for the year of redemption must be calculated
• In accordance with the accounting policies set forth in this Agreement, or
• Where no accounting policy has been clearly specified, in accordance with policies consistent in intent with the policies contained in this Agreement.
2. Income before taxes for the year of redemption need not, for the purposes of the Agreement, be the same as that which is reported to shareholders or that which is used for calculating income taxes payable.
The Agreement specifies the applicable accounting policies as follows:
A. Revenue recognition:
1. In cases where a deposit of 10 percent or more of the sales price has been received from the customer, revenue shall be recognized on completion of the manufacturing of the goods ordered.
2. In all other cases, revenue shall be recognized upon shipment to the customer, and no allowance shall be made for returned merchandise or adjustments.
B. Cost of goods sold and inventory:
1. All inventory on hand at the end of a fiscal year (excluding raw materials) shall be costed at actual production costs, including its full share of all overhead expenditures.
2. Raw materials inventory shall include all expenditures that were needed to make the inventory available for use, including unpacking and storing costs.
C. Amortization:
1. All applicable amortization shall be computed on a straight-line basis using realistic residual values.
2. Amortization shall be recorded over the physical life of the assets, regard less of their useful life to the company.
3. No amortization shall be recorded on assets that are increasing in value.
D. Capitalization:
1. All expenditures shall be capitalized as assets unless their life is limited to the current financial period. All maintenance and repair costs that extend an asset's useful life shall be capitalized.
2. Assets shall be recorded at cost and amortized in accordance with C above.
E. Liabilities:
1. Each liability shall be recorded at the amount required to settle the obligation. A debt-to-equity ratio of 1:1 is assumed to exist. Interest incurred on debt in excess of this ratio will not be deductible in computing income before taxes.
F. Errors and adjustments:
1. All errors, adjustments, and changes in value shall be attributed to the year to which the error or adjustment or change relates.
G. Compensation and related transactions:
1. Average compensation per employee shall be in accordance with levels used in fiscal Year 1 adjusted by the Consumer Price Index.
2. All related-party transactions must be measured at fair value or values established in the marketplace for transactions between GFL and unrelated third parties.
The Agreement also contains a separate clause that deals with "arbitration procedures." These procedures allow an independent arbitrator to calculate the share redemption price after having obtained full access to the books and records of GFL.
The preferred shareholder has advised GFL of his intention to have GFL redeem his preferred shares and has provided GFL with the required 90 days' notice. The redemption price, calculated by GFL, was based on the March 31, Year 5, financial statements. However, the preferred shareholder disagrees with GFL's figure for income before taxes.
Since the price is being disputed, the matter is to be resolved by an independent arbitrator. Both parties have agreed to engage Cook & Co., Chartered Accountants, to make a binding decision. You, CA, are employed by Cook & Co. The engagement partner has asked you to prepare a memo providing complete analyses required for and recommendations to be considered in the calculation of the share redemption price. Your notes from your investigations are contained in Exhibit III.
Required:
Prepare the memo to the partner.
EXHIBIT III
NOTES FROM INVESTIGATION OF GFL
1. The disputed share-redemption price calculation was prepared by the vice-president of finance of GFL and is 1.25 times the company's unaudited income before taxes of $895,420 for the year ended March 31, Year 5.
2. The unaudited financial statements for the year ended March 31, Year 5, reflect the following transactions and accounting policies:
• During fiscal Year 4, GFL acquired all the shares of a competing company (J Ltd.) for $8 million. Most of the amount by which the purchase price exceeded the book value of the assets and liabilities acquired was recorded as goodwill and is being amortized over 10 years. The purchase was financed almost entirely by debt at 10 percent interest for five years.
• On January 1, Year 5, a volume discount policy was introduced. At March 31, Year 5, an estimated liability of $95,500 was provided for volume discounts that may become due. • In fiscal Year 4, the manufacturing processes were altered to introduce more mechanization, and standard costing was adopted. All variances from standard costs are being expensed.
• In order to reduce taxable income and save cash, all employee incentives are being accrued at year-end and paid five months later.
• In Year 3, GFL decided to account for one of its successful investments on the equity basis. During fiscal Year 5, the directors of GFL chose to revert to the cost basis for the investment.
• In fiscal Year 5, GFL commenced construction of another manufacturing facility at a cost of $1.8 million, including equipment. Some manufacturing occurred in a part of the new facility before the whole facility was ready for use. To be conservative, any costs that were incurred after manufacturing had commenced were expensed, except for new equipment installations.
• Land that has been held for several years for future expansion of the company was recorded at cost plus carrying costs (property taxes, maintenance, and similar) until fiscal Year 5. The land was reclassified in late fiscal Year 5 as inventory and was written down to the lower of cost and net realizable value.
• In March Year 5, GFL sold some of its capital assets under a deferred payment arrangement. Gains on disposal will be recorded as payment is received, on a proportional basis.
• In April Year 5, an enhanced executive pension plan was introduced. The March 31, Year 5, financial statements include pension expenses that reflect the additional costs resulting from the new pension plan enhancements.
3. Notes to the financial statements for fiscal Year 5 disclose the following:
• During the year, GFL sold $4 million worth of goods to DGR Ltd. DGR is owned by several of the common shareholders of GFL. DGR paid a special price for goods that were about $380,000 lower than the price paid by other retailers.
• A $200,000 liability has been recorded for legal costs pertaining to a patent infringement case that is before the courts.