Argonaut has to account for the acquisition of 100% of the shares of Moe's Lawn Care Limited (MLC) in Argonaut's June 30, 20X9, financial statements, even though MLC's numbers might be subject to change after its audit is completed. MLC's temporary bookkeeper, Chris, has done a great job so far in getting MLC's financial and tax records in better shape; however, there are still some outstanding issues. Chris has successfully reconciled the balances of cash, accounts receivable, prepaid expenses and trade accounts payable, and all of the necessary adjustments relating to these accounts have been reflected in the attached draft financial statements.

• The income tax return for 20X8 was filed and assessed, and all balances owing with respect to that taxation year, including interest and penalties, have been paid.
• Chris has not had a chance to correct the recording of unearned revenue. In addition, the capital lease has not been recorded.
• Chris has not had a chance to estimate the income tax provision for the six months ended June 30, 20X9. You should note that MLC will have a deemed year end for tax purposes for this six-month period (the "stub" period) because of the acquisition of control of its shares by Argonaut.

Required:

1. Prepare journal entries required to correct unearned revenue and record the capital lease. Provide supporting calculations where appropriate. (19 marks)

2. a. Calculate MLC's income taxes payable and the related tax expense for the six-month period ended June 30, 20X9, using the pre-tax income calculated in Part 1 above. (16 marks)

b. Prepare related journal entry. MLC uses the taxes payable method to account for income taxes. (4 marks)

3. a. Prepare the adjusted trial balance, posting the prepared journal entries (10 marks)

b. Prepare MLC's balance sheet as at June 30, 20X9 (10 marks)

c. Prepare MLC's income statement and statement of retained earnings for the six-month period ending June 30, 20X9. (10 marks)

4. The purchase price for the shares will be equal to the amount of retained earnings calculated in Part 3 above. It will be paid to Maureen Tillson in equal amounts on June 30 of each of the next three years. In other words, there will be a vendor note payable.

a. Calculate the fair value of the consideration being paid by Argonaut to acquire 100% of the shares of MLC using MLC's retained earnings from Part 3 above and a discount rate of 7%. To do so, calculate the present value of the vendor note payable. (3 marks)

b. Draft Argonaut's journal entry to record the acquisition of MLC on June 30, 20X9. (3 marks)

c. Prepare Argonaut's balance sheet as at June 30, 20X9, to reflect the acquisition of MLC using the cost method to account for the investment in its shares of MLC, and calculate the relevant balance sheet ratios. (10 marks)

d. Prepare Argonaut's balance sheet as at June 30, 20X9, to reflect the acquisition of MLC using the consolidation method to account for the investment in its shares of MLC, and calculate the relevant balance sheet ratios. (10 marks)

e. Under ASPE, as MLC shares are not actively publicly traded, Argonaut has the option to choose the cost, equity or consolidation methods to report its investment in MLC. Explain the implications of each method and recommend which method should be chosen. (5 marks)

(The "AssignmentSupport" document attached is the main one to work from, the rest are possibly important/useful to this question.)

To: Petropoulos Family From: Delphina Petropoulos Re: Moe's Lawn Care Limited (MLC) - Potential Acquisition Maureen (Moe) Tillson is the sole shareholder of MLC and she is looking to sell her business and retire in the near future. She approached me to see if Argonaut Inc. would be interested in purchasing her shares. We had a lunch meeting yesterday to discuss the possibility. Following are my notes about the potential acquisition. Meeting notes: 1. Moe is a single mother who incorporated MLC upon her retirement from the Canadian Armed Forces 20 years ago. Her adult son, Lawrence, worked for the company in the summers when he was in high school and university, but he is now pursuing a fulltime career in nursing. He has no interest in acquiring Moe's shares and/or succeeding her in operating the business. 2. Moe is only interested in selling her shares of the company and will not contemplate a sale of its assets. She has been advised that this is the only way that she can take advantage of the lifetime capital gains exemption so she won't have to pay any income tax on the sale of the company. 3. The company performed very well financially in earlier years, but lately it has only made a modest profit after paying Moe's salary. She is therefore willing to sell her shares for an amount equal to the company's retained earnings at the end of its most recent fiscal quarter. Moe is not looking for any premium for goodwill and the company has no goodwill recorded on its balance sheet. She is also willing to be paid for her shares over a threeyear period and won't require the first payment until one year after the deal closes. 4. MLC's assets recognized on its balance sheet consist of cash, accounts receivable, inventory, and property, plant and equipment. Inventory is comprised primarily of landscaping materials such as soil, grass sod, seed, plants, shrubs, trees, stonework, fertilizers and so on. Property, plant and equipment includes garden tools, leaf blowers, chainsaws, a large chipper, and one truck and trailer that MLC owns. The company leases two other trucks that are not capitalized as assets on the balance sheet. 5. MLC is in the second year of a fiveyear lease for its premises in Lethbridge. The premises consist of a small garage and fenced parking area suitable for storing materials and parking the vehicles. 6. Moe built the company without having it incur any bank borrowing. MLC's only recorded liabilities consist of trade accounts payable. 7. MLC's gardening and landscaping business is somewhat seasonal, with more activity in the spring, summer and fall than in the winter. However, MLC also offers snowclearing services to its customers to help even out the workload. MLC has also managed the seasonality of its cash flows by encouraging customers to enter into oneyear and twoyear contracts that are billed monthly in equal amounts. Certain incentives have also been offered to encourage customers to pay for their contracts 100% in advance. 8. Jerome Howard is the company's office manager and bookkeeper and has been MLC's most loyal employee. He prepares the annual financial statements and corporate tax returns. MLC's financial statements have never been audited or reviewed. Jerome has not taken a vacation in the last five years and Moe feels that he will continue to work for MLC under new ownership. Jerome is 45 years old and is unlikely to retire for at least 10 years. Additional thoughts about Argonaut's potential acquisition of MLC: 9. Although Moe will be retiring, I have the skill set necessary to run MLC because of my background in agriculture and experience at Argonaut. Jerome Howard will obviously be a key employee who can help with the transition in MLC's management. 10. Since Moe is willing to be paid for her shares over three years, Argonaut will not have to make any additional bank borrowings to fund the acquisition. Argonaut should be able to pay for the acquisition with the funds from dividends paid by MLC to Argonaut. 11. Although MLC is an existing customer of Argonaut, it also buys a great deal of its plant material from Argonaut's competitors. We will generate synergies by ensuring that MLC buys all of the plant materials that it can from Argonaut in the future. 12. MLC's relatively stable monthly cash flows will help smooth Argonaut's seasonal cash flows. 13. Since Argonaut's garden centre is not performing particularly well, we can consolidate the physical operations of MLC at Argonaut's garden centre location. This will result in additional synergies since MLC's existing location will no longer be needed. To: New Hire From: Frank White Date: June 2, 20X9 Re: MLC due diligence, Step 1: Financial statements logical integrity You will need to refer to Appendixes 1 through 5 in the Excel workbook to complete this set of tasks. As you can see from Appendix 1 and Appendix 2, Jerome Howard prepares MLC's financial statements in Excel rather than generating the statements directly from the accounting software. This is not uncommon, as many people like the formatting flexibility that Excel provides. However, it also introduces the potential for error and/or manipulation. For that reason, we need to check the logical integrity of the financial statements because the purchase price will be based on reported retained earnings. You and I will both work on this independently. When you're done, please compare your findings to mine. Specifically, I want you to: 1. Tie the trial balance in Appendix 3 into the balance sheet in Appendix 1 and the income statement in Appendix 2. Check the arithmetic accuracy of the statements and the continuity of retained earnings. 2. Examine the trial balance in detail to evaluate whether any items are obviously missing or have unusual amounts, and to ensure that it actually balances. 3. Tie the accounts receivable balance in Appendix 4 and the accounts payable balance in Appendix 5 into the trial balance. Check the arithmetic accuracy of both appendixes. To: New Hire From: Frank White Date: June 3, 20X9 Re: MLC due diligence, Step 2: Financial accounting issues You will need to refer to Appendixes A and B in the due diligence package to complete this set of tasks. Appendix A contains a sample of a customer contract, while Appendix B contains excerpts of the relevant clauses from MLC's three lease agreements. As we discovered in Step 1, we will need to evaluate the accounting treatments for both revenue recognition and leases because they will impact the purchase price, which is based on reported retained earnings. You and I will both work on this independently. When you're done, please compare your findings to mine. Specifically, I want you to: 1. Read the customer contract, and by applying the principles of revenue recognition under ASPE, determine whether revenue can be recognized upon receipt of payment, or whether (and how) it should be deferred and recognized at a future date. Consider both the monthly billing option and the prepayment plan. Detailed calculations are not required at this time, although they may prove helpful at a later date if Argonaut decides to proceed with the acquisition of MLC. 2. Evaluate each of the three leases to determine whether they should be capitalized under ASPE, and provide detailed support for your conclusions. You are not required to prepare a detailed amortization schedule for the related obligations under any capital leases, although they may prove helpful at a later date if Argonaut decides to proceed with the acquisition of MLC. To: New Hire From: Frank White Date: June 4, 20X9 Re: MLC due diligence, Step 3: Corporate income taxes MLC's tax return for the year ended December 31, 20X8, has not yet been filed. Jerome Howard has prepared a supported working paper in Appendix 6 of the Excel workbook. Based on his calculations, he feels that MLC has no corporate taxes owing. We will need to recalculate income taxes payable because they will impact the purchase price, which is based on reported retained earnings. You and I will both work on this independently. When you're done, please compare your findings to mine. Specifically, I want you to: 1. Critically examine Appendix 6 and describe any errors that you find, explaining the appropriate income tax treatment. 2. Recalculate the balance of income taxes payable or receivable, after correcting any errors noted in 1 above. Make assumptions if necessary. 3. Explain the implications of your findings with respect to deadlines for reporting and payments for 20X8 and future years. To: New Hire From: Frank White Date: June 5, 20X9 Re: MLC due diligence, Step 4: Potential synergies You will need to refer to Appendixes B and C in the due diligence package and Appendix 5 in the Excel workbook to complete this set of tasks. In her original memo about the potential acquisition of MLC, Delphina Petropoulos contemplated a couple of potential synergies relating to purchasing and premises that we need to explore further. You and I will both work on this independently. When you're done, please compare your findings to mine. Specifically, I want you to: 1. Read Delphina's purchasing analysis in Appendix C. Based on the purchases estimated in Appendix 5, calculate the benefit to the combined entity (Argonaut and MLC) that would be realized annually if MLC were to source all of the plant materials that it potentially can from Argonaut. 2. Consider the options available to the combined entity (Argonaut and MLC) if MLC's existing physical operations were to be moved to Argonaut's garden centre. Discuss any qualitative factors and perform any relevant calculations, based on your understanding of MLC's premises lease described in Appendix B. To: New Hire From: Frank White Date: June 6, 20X9 Re: MLC due diligence, Step 5: Due diligence procedures You will need to refer to all of the appendixes and our findings to date to complete this set of tasks. We have learned a great deal about MLC and its potential acquisition by Argonaut with the work that we've performed to date. However, we need to contemplate the next steps in the due diligence process. Ideally, Jerome Howard would be available to respond to the concerns that we've identified. However, he isn't even responding to emails while he's on what has now become an extended vacation. Since the only account that has tied in properly with the trial balance so far is accounts payable, I'd like you to develop procedures to deal with the completeness assertion. I also want you to reflect on the Jerome Howard situation. You and I will both work on this independently. When you're done, please compare your findings to mine. Specifically, I want you to: 1. Recommend procedures appropriate to audit trade accounts payable for completeness. Describe how you would select suppliers for confirmation using the information in Appendix 5. Describe the style(s) of confirmations that would be most appropriate. What additional procedures do you recommend? 2. Reflect on Delphina Petropoulos's comment that \"Jerome Howard will obviously be a key employee who can help with the transition in MLC's management.\" Provide an evaluation of his competence. Consider my earlier concerns about a lack of segregation of duties at MLC. Have you seen any examples of how this potential problem has manifested itself into a real problem? Appendix I Moe's Lawn Care Limited Unearned revenue In addition to specific landscaping work that is quoted and performed on a job-by-job basis, MLC also provides routine lawn care and snow removal. In January 20X9, MLC began offering one-year and two-year contracts that can be billed monthly in equal amounts. It also offered generous discounts to customers willing to pay for the contracts 100% in advance. In fact, the promotion was so popular that every customer that entered into these term contracts opted for the prepayment discount. MLC recognized revenue upon receipt of the contract prepayments. However, under ASPE, the revenue cannot be recognized on a cash basis and a portion must be deferred as unearned revenue for any services not yet performed. To complicate matters further, the effort required to provide monthly routine lawn care is typically twice the effort required to provide monthly snow removal. Lawn-care season is considered to be April through November and includes spring and fall cleanups. Snow-removal season is considered to be December through March. The contract details are as follows: Contract price Number of contracts sold in each month of 20X9: January February March April May June One year $ 4,000 Two years $ 7,200 4 2 3 2 1 0 1 1 2 1 0 1 All contracts cover services provided from the beginning of the month they are sold. also provides routine ts that can be billed ontracts 100% in contracts opted for the venue cannot be not yet performed. To wice the effort required and includes spring Appendix II Moe's Lawn Care Limited Capital lease MLC entered into a four-year lease for a new pickup truck on January 1, 20X9, and has been expensing the monthly lease payments. However, our analysis shows that this lease is a capital lease and adjusting journal entries must be made to record the related asset and lease obligation, together with properly recording the lease payments and depreciation of the asset. Following are the details: Lease term Lease payments (due at the beginning of each month) Interest rate Annual Monthly Depreciation (straight line) been expensing the monthly lease urnal entries must be made to e payments and depreciation of the $ 48 months 900 3.00% 0.25% 4 years Appendix III Moe's Lawn Care Limited Income tax The following data will help you estimate the income tax payable and related income tax provision for the six-month period 20X9. Note that CCA claims must be pro-rated for the short taxation "year" and that all lease payments are fully deductible treatment for accounting purposes. Combined federal and provincial corporate income tax rate Amount included in meals and entertainment expenses relating to the "Spring Fling" staff party to which all employees were invited Total income tax instalments Interest and penalties paid re: 20X8 Opening UCC balances and additions (there were no disposals) Class 8 Class 10 Class 12 * The Class 12 additions consisted of small tools that each cost less than $500. x provision for the six-month period ended June 30, ease payments are fully deductible, regardless of their 14% ng Fling" staff party to $ 2,000 $ 6,000 $ 415 Opening Additions $ 8,539 $ 4,325 60,512 3,207 2,400 * Appendix IV Moe's Lawn Care Limited Trial balance June 30, 20X9 A/C # 10100 10600 12100 12500 13100 15300 17100 18100 21000 21200 21300 21350 22000 24500 25200 27100 27500 30000 40000 50000 54000 55100 55200 55300 56000 75000 90000 Description Bank Petty cash Accounts receivable Allowance for doubtful accounts Inventory Prepaid expenses Property, plant and equipment Accumulated depreciation Accounts payable Source deductions payable GST charged on revenue GST input tax credits Income taxes payable Unearned revenue Obligation under capital lease Common shares Retained earnings (prior Y/E) Revenue Cost of goods sold Salaries and benefits Operating expenses Administrative expenses Meals and entertainment Leases and rentals Interest and bank charges Depreciation Income tax expense Unadjusted DR (CR) 86,518.64 100.00 172,007.55 (5,250.00) 16,718.25 6,900.00 97,940.00 (29,930.00) (24,239.59) (18,124.35) (10,120.00) 1,552.75 (100.00) (93,396.25) (803,500.00) 123,542.37 361,499.73 50,240.63 18,110.19 3,928.14 24,000.00 601.94 15,000.00 6,000.00 Note: The fair market value (FMV) of all of MLC's assets and liabilities approximates net book value (NBV), with the exception of equipment, which has a FMV that is $5,000 greater than NBV. et book value (NBV), with the Appendix V Argonaut Inc. Draft balance sheet As at June 30, 20X9 (unaudited, in $'000s) Assets (Note 1) Current Cash Accounts receivable Inventory Prepaid expenses $ 591 7 456 9 1,063 1,284 $ 2,347 $ 520 100 620 375 Capital assets, net Liabilities Current Bank indebtedness Accounts payable and accrued liabilities Current portion of long-term debt Long-term debt 995 Shareholders' equity Capital stock (Note 2) Retained earnings 1,352 1,352 $ Note: 1. Actual, prior to recording investment in Moe's Lawn Care Limited (MLC). 2. Shown as zero due to rounding. Total capital stock is $220.00. 2,347 MOE'S LAWN CARE LIMITED (MLC) DUE DILIGENCE PACKAGE PRIVATE AND CONFIDENTIAL Notes: The appendixes in this document are designated with capital letters (Appendix A, Appendix B and so forth). Additional appendixes are in the accompanying Excel workbook and are designated with numbers (Appendix 1, Appendix 2 and so forth). Appendix A Sample customer contract LIMITED TIME OFFER TO OUR VALUED MOE'S CUSTOMERS! You are currently on our month-to-month plan, paying $500 per month for lawn care (April through November) and $250 per month for snow removal (December through April). You are welcome to continue using this plan, which has no long-term commitment, but also no protection from price increases. If you wish, you can enter into a one-year or two-year contract and choose the monthly billing option. Under this option, you will be billed an equal amount of $416.67 per month for the duration of the contract. This will help you manage your monthly budget and will protect you from price increases during the term of the contract. You can also get a substantial discount under the prepayment plan by paying for your contract in full on the day it begins. Receive a 20% discount on a one-year contract and a 28% discount on a two-year contract! Please select an option (all payments subject to GST): ___ I would like to stay on the month-to-month plan. ___ I would like to choose the monthly billing option. Please bill me $416.67 per month for the next ___ (one or two) years. ___ I would like to pay $4,000 under the one-year prepayment plan. ___ I would like to pay $7,200 under the two-year prepayment plan. Customer name: Christine Chen, 284 Centre Street, Lethbridge, AB Customer signature: Christine Chen Date: March 1, 20X9 Paid by (cash or cheque) $4,200 cash Appendix B Excerpts from lease agreements 1. Premises lease Description: Commencement date: Term: Payment: Land and storage shed July 1, 20X7 Five years $2,500 monthly (at beginning of month) The tenant (MLC) may not sublet the premises without pre-approval by the landlord. The lease may be terminated at any time after 24 months with the payment of a penalty equal to 50% of the remaining lease payments. 2. Chevrolet truck lease Description: Commencement date: Term: Payment: Implicit interest rate: Price (if purchased): Estimated economic life: Chevrolet pickup truck March 1, 20X8 36 months $600 monthly (at beginning of month) 5% $35,000 10 years 3. Ford truck lease Description: Commencement date: Term: Payment: Implicit interest rate: Price (if purchased): Estimated economic life: Ford pickup truck January 1, 20X9 48 months $900 monthly (at beginning of month) 3% $45,000 10 years Appendix C Purchasing analysis prepared by Delphina Petropoulos MLC buys plant materials from both Argonaut Inc. and Wilson's Garden Supply. Because of the quantity that MLC buys from Argonaut, the materials are discounted and only generate a 30% gross margin to Argonaut. MLC likes the quality of our plant materials but has been slow to pay its accounts payable lately. Phyllis told me that MLC still owes Argonaut $3,150 from an invoice issued in January. MLC purchases from Wilson's when Argonaut can't match its prices. Wilson's prices are typically 20% less than Argonaut's, although their quality is often not as good. In addition, about one-quarter of MLC's purchases from Wilson's are at half the price that Argonaut would charge to MLC. These purchases relate to surplus plant materials that Wilson's is trying to clear out of its inventory. I am hopeful that with the acquisition of MLC, Argonaut will be able to control the purchasing, and no more plant materials will be sourced from Wilson's. We can also ensure that a 30% gross margin to Argonaut is maintained by managing the intercorporate transfer prices. Appendix 1 Moe's Lawn Care Limited Balance sheet (Note 1) As at March 31, 20X9 (unaudited) Assets Current Cash Accounts receivable Inventory Prepaid expenses $ 5,271 65,110 45,248 6,900 122,529 108,110 $ 230,639 $ 36,478 Property, plant and equipment (net) Liabilities Current Accounts payable Shareholders' equity Capital stock Retained earnings 100 194,062 194,162 $ Note: 1. Prepared by Jerome Howard. 230,639 Appendix 2 Moe's Lawn Care Limited Draft statement of income and retained earnings (Note 1) For the three-month period ended March 31, 20X9 (unaudited) Revenue Cost of goods sold $ Gross profit 253,281 Expenses Salaries, wages and benefits Operating Administrative expenses Meals and entertainment Leases and rentals Interest and bank charges Depreciation 141,259 16,720 8,951 915 12,000 270 7,500 187,616 Income before income taxes 65,666 Income tax expense Net income Note: 1. Prepared by Jerome Howard. 295,000 41,719 $ 65,666 Appendix 3 Moe's Lawn Care Limited Trial balance March 31, 20X9 A/C # 10100 10600 12100 12500 13100 15300 17100 18100 21000 21200 21300 21350 22000 24500 25200 27100 27500 30000 40000 50000 54000 55100 55200 55300 56000 75000 90000 Description Bank Petty cash Accounts receivable Allowance for doubtful accounts Inventory Prepaid expenses Property, plant and equipment Accumulated depreciation Accounts payable Source deductions payable GST charged on revenue GST input tax credits Income taxes payable Unearned revenue Obligation under capital lease Common shares Retained earnings (prior Y/E) Revenue Cost of goods sold Salaries and benefits Operating expenses Administrative expenses Meals and entertainment Leases and rentals Interest and bank charges Depreciation Income tax expense Unadjusted DR (CR) 5,171.39 100.00 61,110.00 4,000.00 45,248.00 6,900.00 95,540.00 (22,430.00) (21,450.50) (12,047.25) (4,200.00) 1,220.25 (100.00) (93,396.25) (295,000.00) 41,718.67 141,258.90 16,720.43 8,950.89 915.23 12,000.00 270.24 7,500.00 - Appendix 4 Moe's Lawn Care Limited Accounts receivable aging report As at March 31, 20X9 Customer name Aberdeen, William Berkeley Nursing Homes Chen, Christine Chow, William Downtown Beautification Committee Evergreen Cemetery Edwards, Jason Farah, Keisar Gran, Ernesto Harding, Tina Harvard Industries Kruger, Jordan Lake, Kevin Li, Eva MacDonald, Adam Moledina Inc. Niedling, Alison Ovechkin, Alex Terebushko and Associates Zinck, Gunther Total balance 262.50 5,250.00 4,200.00 262.50 4,000.00 7,875.00 7,350.00 262.50 262.50 787.50 2,625.00 262.50 262.50 787.50 525.00 21,000.00 525.00 525.00 262.50 262.50 262.50 2,625.00 262.50 262.50 262.50 262.50 21,000.00 262.50 262.50 262.50 262.50 57,550.00 43,312.50 0 to 30 2,625.00 4,200.00 262.50 2,625.00 7,350.00 262.50 Days outstanding 31 to 60 61 to 90 262.50 2,625.00 2,625.00 2,625.00 262.50 262.50 262.50 262.50 262.50 262.50 262.50 262.50 6,825.00 3,412.50 anding Over 90 4,000.00 4,000.00 Appendix 5 Moe's Lawn Care Limited Accounts payable and purchasing analysis As at March 31, 20X9 Supplier name Balance owing Adams Contracting Argonaut Inc. City of Lethbridge Electric Utility Farah Waste Disposal Leung Walls and Fencing Masonry Experts Steele and Associates Telus Wilson's Garden Supply Annual purchases (Note 1) 2,100.00 503.00 787.50 1,260.00 3,150.00 6,300.00 1,050.00 6,300.00 1,000.00 40,000.00 6,000.00 4,800.00 10,000.00 20,000.00 40,000.00 2,000.00 7,200.00 160,000.00 15,150.50 291,000.00 Note: 1. For 20X8; estimates prepared by Jerome Howard. Appendix 6 Moe's Lawn Care Limited December 31, 20X8, income tax working papers prepared by Jerome Howard Income before income taxes $ Add back: Depreciation Meals and entertainment (Note 1) 28,000 - Deduct: Lease payments (Note 2) Capital cost allowance (Note 3) (37,200) (44,575) Net income for tax purposes Income tax rate Income tax expense (recovery) Less: instalments (30) 14% (4) - Income taxes payable (receivable) (Note 4) Nil Say Notes: 1. The $7,814 of meals and entertainment expenses is fully deductible because it all related to entertaining customers. 2. Lease payments are fully deductible for tax purposes. 3. Class 8 Class 10 Class 10.1 Class 12 20% 30% 30% 100% Opening 9,258 86,446 5,000 100,704 Adds 1,258 35,000 6,414 42,672 CCA 1,977 25,934 5,250 11,414 44,575 Closing 8,539 60,512 29,750 98,801 The Class 10.1 addition is equal to the fair value of the leased truck. 4. 53,745 It's not worth carrying the loss back to get a $4 refund, so the loss will be carried forward. To: Petropoulos Family From: Delphina Petropoulos Date: May 7, 20X9 Re: Moe's Lawn Care Limited potential acquisition Maureen (Moe) Tillson is the sole shareholder of Moe's Lawn Care Limited (MLC) and she is looking to sell her business and retire in the near future. She approached me to see if Argonaut Inc. would be interested in purchasing her shares. We had a lunch meeting yesterday to discuss the possibility. Following are my notes about the potential acquisition. Meeting notes: 1. Moe incorporated MLC upon her retirement from the Canadian Armed Forces 20 years ago. Her adult son, Lawrence, worked for the company during the summer when he was in high school and university, but he is now pursuing a full-time career in nursing. He has no interest in acquiring Moe's shares or succeeding her in operating the business. 2. Moe is only interested in selling her shares of the company and will not contemplate a sale of its assets. She has been advised that this is the only way that she can take advantage of the lifetime capital gains exemption so she won't have to pay any income tax on the sale of the company. 3. The company performed very well financially in earlier years, but lately it has only made a modest profit after paying Moe's salary. She is therefore willing to sell her shares for an amount equal to the company's retained earnings at the end of its most recent fiscal quarter. Moe is not looking for any premium for goodwill, and the company has no goodwill recorded on its balance sheet. She is also willing to be paid for her shares over a three-year period and won't require the first payment until one year after the deal closes. 4. MLC's assets recognized on its balance sheet consist of cash, accounts receivable, inventory and property, plant and equipment. Inventory is composed primarily of landscaping materials, such as soil, grass sod, seed, plants, shrubs, trees, stonework, fertilizers and so on. Property, plant and equipment includes garden tools, leaf blowers, chainsaws, a large chipper and one truck and trailer that MLC owns. The company leases two other trucks that are not capitalized as assets on the balance sheet. 5. MLC is in the second year of a five-year lease for its premises in Lethbridge, Alberta. The premises consist of a small garage and fenced parking area suitable for storing materials and parking the vehicles. 6. Moe built the company without having it incur any bank borrowing. MLC's only recorded liabilities consist of trade accounts payable. 7. MLC's gardening and landscaping business is somewhat seasonal, with more activity in the spring, summer and fall than in the winter. However, MLC also offers snow-clearing services to its customers to help even out the workload. MLC has also managed the seasonality of its cash flows by encouraging customers to enter into one-year and two-year contracts that are billed monthly in equal amounts. Certain incentives have also been offered to encourage customers to pay for their contracts 100% in advance. 8. Jerome Howard is the company's office manager and bookkeeper and has been MLC's most loyal employee. He prepares the annual financial statements and corporate tax returns. MLC's financial statements have never been audited or reviewed. Jerome has not taken a vacation in the last five years, and Moe believes that he will continue to work for MLC under new ownership. Jerome is 45 years old and is unlikely to retire for at least 10 years. Additional thoughts about Argonaut's potential acquisition of MLC: 9. Although Moe will be retiring, I have the skill set necessary to run MLC because of my background in agriculture and experience at Argonaut. Jerome Howard will obviously be a key employee who can help with the transition in MLC's management. 10. Since Moe is willing to be paid for her shares over three years, Argonaut will not have to make any additional bank borrowings to fund the acquisition. Argonaut should be able to pay for the acquisition with the funds from dividends paid by MLC to Argonaut. 11. Although MLC is an existing Argonaut customer, it also buys a great deal of its plant material from Argonaut's competitors. We will generate synergies by ensuring that MLC buys all of the plant materials that it can from Argonaut in the future. 12. MLC's relatively stable monthly cash flows will help smooth Argonaut's seasonal cash flows. 13. Since Argonaut's garden centre is not performing particularly well, we can consolidate the physical operations of MLC at Argonaut's garden centre location. This will result in additional synergies since MLC's existing location will no longer be needed. To: New Hire From: Frank White Date: June 3, 20X9 Re: MLC due diligence, Step 1: Financial statements logical integrity (findings) Following are my findings for you to compare to your own: 1. Tie the trial balance in Appendix 3 into the balance sheet in Appendix 1 and the income statement in Appendix 2. Check the arithmetic accuracy of the statements and the continuity of retained earnings. Although the groupings weren't always immediately apparent, I was able to tie the trial balance into the financial statements with one important exception. Both property, plant and equipment and retained earnings appear to be overstated by $35,000. Although the arithmetic accuracy is fine, the continuity of retained earnings is out by the same $35,000, since opening retained earnings plus the income for the period does not equal the closing balance of retained earnings as reported on the balance sheet. 2. Examine the trial balance in detail to evaluate whether any items are obviously missing or have unusual amounts, and to ensure that it actually balances. Although the debits and credits on the trial balance equal each other in total (that is, the sum of the positive and negative balances is zero), there are some anomalies: The allowance for doubtful accounts (AFDA) is in a debit position. This is a contra-asset account used for valuation, and it should be in a credit position (or possibly have a zero balance). There is no balance of income taxes payable or any income tax expense, even though MLC is reporting a positive net income for the quarter. There should be income tax expense for the quarter, with income taxes payable normally equal to the same amount (adjusted for any instalments paid and any amounts relating to prior taxation years). There is no balance of unearned revenue, even though MLC has encouraged its customers to enter into one-year and two-year contracts that are billed monthly in equal amounts, with incentives for prepayment. We will have to examine these contracts to establish whether there should, in fact, be a deferral of revenue recognition and a related balance in the unearned revenue account. There is no balance in the obligation under capital lease account. MLC has two truck leases, and it also leases its premises. We will have to examine the lease documents to evaluate their terms and establish whether any of the leases require capitalization. 3. Tie the accounts receivable balance in Appendix 4 and the accounts payable balance in Appendix 5 into the trial balance. Check the arithmetic accuracy of both appendixes. Neither of the subledger balances agrees with its related control account in the trial balance. In the case of accounts receivable (A/R), Appendix 4 is totalled accurately, but the balance is $3,560 less than the amount in its control account in the trial balance. If Appendix 4 is correct, retained earnings and therefore the purchase price may be overstated. In the case of accounts payable (A/P), the balance in Appendix 5 is $6,300 less than the amount in its control account in the trial balance. This is the same as the amount owing to Wilson's Garden Supply. The reason for the discrepancy is that the formula in Excel is not totalling all of the rows that it should. Once this formula is corrected, the A/P balance ties into the trial balance. To: New Hire From: Frank White Date: June 4, 20X9 Re: MLC due diligence, Step 2: Financial accounting issues (findings) Following are my findings for you to compare to your own: 1. Read the customer contract, and by applying the principles of revenue recognition under ASPE, determine whether revenue can be recognized upon receipt of payment, or whether (and how) it should be deferred and recognized at a future date. Consider both the monthly billing option and the prepayment plan. Under ASPE, the revenue recognition criteria relate to performance, measurement and collectability. Measurement is not an issue because the amounts are noted explicitly in the contract. Collectability should not be a concern under the monthly billing option because this offer is being made to existing customers, who presumably have a good payment history. Collectability is not an issue under the prepayment plan because the payments are received at the commencement of the contract. The only revenue recognition criterion of concern, therefore, is performance. Revenue from service transactions and long-term contracts is usually recognized as the service or contract activity is performed, using either the percentage of completion method or the completed contract method. The percentage of completion method is used when performance consists of the execution of more than one act, and revenue would be recognized proportionately by reference to the performance of each act. Amounts billed are not an appropriate basis of measurement unless they reflect the work accomplished. The completed contract method would only be appropriate when performance consists of the execution of a single act or when the enterprise cannot reasonably estimate the extent of progress toward completion. In MLC's case, the percentage of completion method is appropriate because the performance consists of a number of acts of both lawn care and snow removal over the term of the contract. The recognition is complicated somewhat by the fact that lawn care has twice the value of snow removal. Therefore, it is not appropriate to recognize revenue, as amounts are billed on an equal basis under the monthly billing option. Instead, revenue of $250 should be recognized during snow removal months, and $500 should be recognized during lawn care months. Depending on when the customer enters into the contract, the cumulative impact will be either a debit to accounts receivable or a credit to unearned revenue that will draw down to a zero balance after 12 months. Under the prepayment plan, the initial receipt should be credited to unearned revenue. For each month, revenue should be credited (and unearned revenue debited) for the discounted value of the service performed. For example, in a snow removal month, the appropriate amount for a one-year contract would be $200 ($250 less 20%); for a two-year contract, $180 ($250 less 28% discount). The amounts would be doubled to $400 and $360, respectively, for lawn care months. 2. Evaluate each of the three leases to determine whether they should be capitalized under ASPE, and provide detailed support for your conclusions. Under ASPE, a capital lease (from the perspective of the lessee) is one that transfers substantially all the benefits and risks of ownership of the property to the lessee. This is typically the case when at least one of the following conditions is met: a. There is reasonable assurance the lessee will obtain ownership of the leased property by the end of the lease term (ownership transfer provisions or bargain purchase option are included in the lease). b. The duration of the lease term is equal to a major portion (usually 75% or more) of the economic life of the leased property. c. The lessor is assured of recovering the investment in the leased property and of earning a return on the investment as a result of the lease agreement. This occurs when the present value of the minimum lease payments, excluding any executory costs, is equal to substantially all (usually 90% or more) of the fair value of the leased property. Premises lease Unfortunately, we don't have all the data required to perform detailed calculations for the premises lease. However, there are no apparent ownership transfer provisions or bargain purchase options. The value of the land is presumably much greater than that of the storage shed, the land has an indefinite life, and the lease term is relatively short (five years, with the ability to terminate after two). All of these factors indicate that the lease does not transfer substantially all the benefits and risks of ownership of the property to MLC. It is therefore properly accounted for as an operating lease. Chevrolet truck lease There are no apparent ownership transfer provisions or bargain purchase options. The lease term is only 30% of the economic life of the truck. At 5%, the present value of the 36 monthly payments of $600 is $20,103, which is only 57% of the $35,000 fair value of the truck (that is, the price if purchased).This lease is therefore properly accounted for as an operating lease. Ford truck lease There are no apparent ownership transfer provisions or bargain purchase options. The lease term is only 40% of the economic life of the truck. However, at 3%, the present value of the 48 monthly payments of $900 is $40,762, which is 91% of the $45,000 fair value of the truck (that is, the price if purchased). This lease should therefore be accounted for as a capital lease. To: New Hire From: Frank White Date: June 5, 20X9 Re: MLC due diligence, Step 3: Corporate income taxes (findings) Following are my findings for you to compare to your own: 1. Critically examine Appendix 6, and describe any errors that you find, explaining the appropriate income tax treatment. I found several errors in Appendix 6: None of the meals and entertainment expense was added back in the calculation of net income for tax purposes. Although the amounts related to entertaining customers, 50% is not deductible and should have been added back. Lease payments were deducted twice. Although lease payments are fully deductible, they were already expensed in the calculation of income before income taxes. A $35,000 leased truck was added to UCC Class 10.1. This was inappropriate because the lease payments have already been fully deducted and the vehicle is not eligible for CCA claims in addition to the deduction already made. Note that $35,000 is the same amount by which the balance sheet accounts were out, as noted in Step 1 of the due diligence. This leads me to question whether Jerome Howard simply added the value of the truck to both property, plant and equipment and retained earnings, as well as to the 20X8 UCC balance. It should also be noted that trucks would not normally fall under Class 10.1, as they are not generally considered to be \"passenger vehicles\" and the class has a $30,000 limit for additions. A 100% CCA claim was made for Class 12, even though there were additions during the year. This implies that none of the additions would be subject to the half-year rule, which is unlikely, given that the class had an opening UCC balance. The exceptions to the half-year rule for this class are limited (for example, tools costing less than $500). 2. Recalculate the balance of income taxes payable or receivable, after correcting any errors noted in 1 above. Make assumptions if necessary. Assuming that none of the Class 12 additions are excepted from the half-year rule, I have calculated the balance of income taxes payable to be $6,935, as follows: Income before income taxes Add back: Depreciation Meals and entertainment Deduct: Capital cost allowance (note 1) Net income for tax purposes Income tax rate Income tax expense Less: instalments Income taxes payable Notes: 1. Class 8 Class 10 Class 12 20% 30% 100% Opening 9,258 86,446 5,000 100,704 $53,745 7,814 Adds 1,258 6,414 7,672 50% CCA 1,977 25,934 8,207 36,118 28,000 3,907 (36,118) 49,534 14% 6,935 $ 6,935 Closing 8,539 60,512 3,207 72,258 3. Explain the implications of your findings with respect to deadlines for reporting and payments for 20X8 and future years. Although the December 31, 20X8, corporation income tax return does not have to be filed until June 30, 20X9, the payment of the outstanding balance should have been made by March 31, 20X9, since CCPCs are required to pay within three months of the end of their taxation year. The late payment will give rise to a non-deductible interest charge. It is not clear whether MLC had any 20X8 instalment payment obligations, since instalment obligations depend on the level of taxes in the taxation year and the previous two years. However, if MLC did have any instalment obligations, it will also be subject to non-deductible interest charges for nonpayment. The level of taxes payable for 20X8 will also give rise to instalment obligations for 20X9, which will be relevant to us if Argonaut proceeds with the acquisition. To: New Hire From: Frank White Date: June 6, 20X9 Re: MLC due diligence, Step 4: Potential synergies (findings) Following are my findings for you to compare to your own: 1. Read Delphina's purchasing analysis in Appendix C. Based on the purchases estimated in Appendix 5, calculate the benefit to the combined entity (Argonaut and MLC) that would be realized annually if MLC were to source all of the plant materials that it potentially can from Argonaut. MLC purchases approximately $160,000 of plant materials from Wilson's Garden Supply each year. One-quarter of this amount ($40,000) is purchased at half the price that Argonaut would charge to MLC. Since Argonaut only generates a 30% gross margin from selling to MLC, Wilson's price for these deeply discounted materials is below Argonaut's cost. Therefore, it makes sense to continue to buy these deeply discounted materials from Wilson's. The remaining $120,000 of plant material purchases from Wilson's is sold at a price 20% less than the price that Argonaut would charge to generate a 30% margin. In other words, Argonaut would charge $150,000 and generate a $45,000 margin. However, the cost would be $30,000 greater to MLC, so the benefit to the combined entity would be the difference of $15,000. 2. Consider the options available to the combined entity (Argonaut and MLC) if MLC's existing physical operations were to be moved to Argonaut's garden centre. Discuss any qualitative factors and perform any relevant calculations, based on your understanding of MLC's premises lease described in Appendix B. The consolidation of the physical operations makes intuitive sense. Logistics with respect to plant material handling should be simplified, and there are also opportunities to integrate the administrative aspects of the operations. For example, Jerome Howard has been very busy, as he hasn't taken a vacation until now, and it will be easier to have appropriate segregation of duties if there are more administrative personnel involved in MLC's day-to-day operations. Delphina also plans to assume Moe Tillson's role at MLC, so I assume that it would be more convenient for her to remain on Argonaut's premises to deal with any ongoing responsibilities at Argonaut as well. Assuming that the physical operations integrate well without the need for additional expenditures, the issue becomes one of choosing the best option under MLC's existing premises lease. The best outcome would be to sublet the premises for the greatest amount possible. This, of course, is subject to the pre-approval of the landlord. If a subtenant willing to pay at least $1,250 per month (the equivalent to the penalty of $2,500 50%) cannot be found in the near future, it would make sense to terminate the lease and pay the 50% penalty, provided there is sufficient cash available to do so. For example, the penalty at July 31, 20X9, will be $43,750 (35 months $2,500 50%). To: New Hire From: Frank White Date: June 7, 20X9 Re: MLC due diligence, Step 5: Due diligence procedures (findings) Following are my findings for you to compare to your own: 1. Recommend procedures appropriate to audit trade accounts payable for completeness. Describe how you would select suppliers for confirmation using the information in Appendix 5. Describe the style(s) of confirmations that would be most appropriate. What additional procedures do you recommend? Confirmation letters are typically sent to a sample of suppliers, with the sample being chosen based on the level of activity during a period of time rather than the reported balance at the end of a period. That is because we are more concerned about understatement, and there is a greater risk when the reported balances are low. For example, Wilson's Garden Supply has four times the level of activity as Masonry Experts, even though the reported payable amount is the same for both companies. Therefore, there is greater risk that the Wilson's Garden Supply payable is understated. Obviously, we don't have to send a confirmation letter to Argonaut because we already know from Appendix C that Argonaut has a receivable from MLC in the amount of $3,150, even though MLC is not reporting a payable to Argonaut in Appendix 5. This is troubling and deserves further investigation, such as ensuring that the original invoice was recorded by MLC and tracing any payment that MLC has claimed to have made to a cancelled cheque. Since there are only nine other suppliers and because we have already noticed a discrepancy, it is worthwhile to send confirmation letters to all nine companies. We should send positive confirmation requests to test the balance outstanding at year end rather than confirmations of specific invoices. Once again, this is because we are concerned about understatements (that is, completeness, as opposed to existence). In addition, we should evaluate all payments made by MLC subsequent to year end to determine whether any of the payments relate to payables outstanding at year end that were not recorded appropriately in the accounts. 2. Reflect on Delphina Petropoulos's comment that \"Jerome Howard will obviously be a key employee who can help with the transition in MLC's management.\" Provide an evaluation of his competence. Consider my earlier concerns about a lack of segregation of duties at MLC. Have you seen any examples of how this potential problem has manifested itself into a real problem? I am very concerned about Jerome Howard's competence. We have discovered errors in financial statement and income tax preparation that may either be honest mistakes or intentional manipulations. These call into question his ability and/or his integrity. The lack of segregation of duties has undoubtedly worsened the problem. With no checks and balances, the opportunity was present to both commit and conceal these errors or manipulations. Since Jerome had not taken a vacation until now, nobody was in a position to perform his tasks or review his work in his absence. Although an audit is not designed to detect fraud, the fact that MLC's financial statements were not audited meant that none of the errors that were obvious to us were discovered. The most alarming discrepancy that I noted is the $4,200 account receivable from Christine Chen in Appendix 4. Since we know from the sample customer contract in Appendix A that she is on the prepayment plan, there is no apparent way that there should be a receivable from her. What's more, it's noted on the contract that she paid in cash and that the cash was \"Rec'd by J. Howard.\" My concern at this point is our ethical and perhaps legal responsibility. We have a number of alternatives: We could simply advise the Petropoulos family to abandon the prospect of the MLC acquisition. That would distance Argonaut from the problem, but would not resolve it for MLC and Moe Tillson. With the approval of the Petropoulos family, we could confront Jerome Howard with our questions to gather more evidence, but he is already difficult to reach and a discussion could alert him to our discoveries and enable him to cover his tracks. With the approval of the Petropoulos family, we could discuss the situation with Moe Tillson. We would have to be careful to present our findings objectively and not accuse Jerome Howard of fraud in case there are legitimate reasons for the discrepancies. With the approval of the Petropoulos family, we could discuss the situation with Argonaut's legal counsel, who can advise us on both the ethical and legal responsibilities and whether any police involvement is appropriate at this stage. I recommend the last alternative, consulting legal counsel. Abandoning the acquisition without raising these concerns does not seem right, and yet the course of raising our concerns needs to be steered carefully. The lawyer will be in the best position to give us this direction