Required:
(a) Prepare the memo to the partner.
(b) Briefly discuss how the following three investor groups would classify and account for their investment:
(i) Investor in Limited Partnership units
(ii) Investor in royalties
(iii) Investor in movie rights
“The thing you, the CA, have to understand is how these stage plays work. You start out with just an idea, but generally no cash. That’s where promoters like me come in. First, we set up a separate legal entity for each play. Then, we find ways of raising the money necessary to get the play written and the actors trained. If the play is a success, we hope to recover all those costs and a whole lot more, but cash flow is the problem. Since less than half of all plays make money, you cannot get very much money from banks.
“Take my current project, Penguins in Paradise. You only have to look at the cash inflows (Exhibit III) to see how many sources I had to approach to get the cash. As you can see, most of the initial funding comes from the investors in the Penguins in Paradise Limited Partnership (PIP). They put up their money to buy units in the limited partnership. One main reason a partnership is used is to let them immediately write off, for tax purposes, the costs of producing the play.
“Some investors do not want to invest the amount required for a partnership unit. So, for them, we structure the deal a little differently. Instead of buying a unit in the partnership, they buy a right to a royalty—a percentage of future operating profits (i.e., gross revenue less true operating expenses). In this way, these investors get an interest in the play without being in the partnership. Since they do not have a vote at the partnership meetings, they are more concerned about their risks. However, we agreed that PIP would get term insurance on my life in case I get hit by a truck!
“Funding the play is not that easy. The money that the investors put up is not enough to fund all the start-up costs, so you have to be creative. Take reservation fees, for example. You know how tough it is to get good seats for a really hot play. Well, PIP sold the right to buy great seats to some dedicated theatre-goers this year for next year’s performance. These amounts are non-refundable, and the great thing is that the buyers still have to pay full price for the tickets when they buy them.
EXHIBIT III
PENGUINS IN PARADISE (A LIMITED PARTNERSHIP)
SUMMARY OF CASH FLOWS
For the period ended December 31, Year 1
(in thousands of dollars)
Cash inflows
Investor contributions to limited partnership ..... $5,000
Sale of royalty rights ............. 1,000
Bank loan ................... 2,000
Sale of movie rights ............... 500
Government grant ............... 50
Reservation fees ................ 20
8,570
Cash outflows
Salaries and fees ................ 3,500
Costumes and sets .............. 1,000
Life insurance ............... 10
Miscellaneous costs ............. 1,250
5,760
Net cash inflows ................ $2,810
"Consider the sale of movie rights. Lots of good plays get turned into movies. Once the stage play is a success, the movie rights are incredibly expensive. My idea was to sell the movie rights in advance. PIP got a lot less money, but at least we got it up front when we needed it.
"The other sources are much the same. We received the government grant by agreeing to have at least 50% Canadian content. We also negotiated a bank loan with an interest rate of 5% a year plus 1% of the gross revenue of the play, instead of the usual 20% interest a year. Even my fee for putting the deal together was taken as a percentage of the operating profits, so just about everybody has a strong interest in the play's performance. "As you know, I know nothing about accounting, so I need you to put together a set of financial statements. I will need you to certify that they are in accordance with GAAP for enterprises such as Penguins in Paradise because the investors and the bank require this. Since everybody else has taken an interest in the play in lieu of cash, I would like you to consider doing the same for your fees." When you, the CA, discussed this conversation with a partner in your office, he asked you to prepare a memo addressing the major accounting implications of the client's requests.