Traveller Bus Lines Inc. (TBL) is a wholly owned subsidiary of Canada Transport Enterprises Inc. (CTE). CTE is a publicly traded transportation and communications conglomerate. TBL is primarily in the business of operating buses over short and long-distance routes in central and western Canada and the United States. TBL also has a school bus division operating in Eastern Canada. CTE and its subsidiaries are audited by DeBoy Shoot, which issued an unqualified audit opinion on CTE's June 30 year-end consolidated financial statements. This was the only audit opinion issued on the CTE group of companies. TBL has a July 31 year end. It is now September 8, 2012. CTE has been reporting operating losses for several years and has put TBL up for sale as part of a strategy to change its focus. This is the first of several planned divestitures, designed to restore CTE's lackluster stock price.
Currently, the only interested party is an employee group led by TBL's president, Dan "Driver" Williams. Williams' management buy-out team consists of the vice-president of operations and the chief financial officer.
Handling the negotiations at CTE's corporate office is Andrew Roche, vice-president of strategic divestitures. The first draft agreement of purchase and sale has been submitted by the buy-out team for review. Exhibit C4-1(a) contains extracts from the draft agreement; notes made by CTE's lawyer are shown in italics.
Andrew wants to maximize the total selling prices. He asked the partner in charge of the CTE audit to review the information given and provide his analysis and recommendations on how CTE can maximize the total selling price. In addition, he would like a summary of the accounting issues of significance to CTE that will arise on the sale of TBL. The partner has asked you, CA, to prepare the draft report to Andrew.
You have gathered some additional background information from the CTE permanent file and other sources (Exhibit C4-1(b)).
Required
Prepare the draft report.
EXHIBIT C4-1(a)
EXTRACTS OF DRAFT PURCHASE AND SALE AGREEMENT
Agreement of purchase and sale between the employee group (hereinafter the Purchaser) and Canada Transport Enterprises Inc. (hereinafter CTE) for the assets and liabilities of the business known as Traveller Bus Lines inc. (TBL).
1. The assets and liabilities of TBL are those included in its draft July 31, 2013 financial statements.
2. Excluded from the liabilities to be assumed by the purchaser are all environmental liabilities including, but not limited to, gasoline and diesel fuel spills and tank leakage, pesticide residues, and all other chemical contamination.
3. The purchase price is determined by the sum of:
(a) The book value of the net assets at July 31, 2013 which is twelve million dollars ($12 million), plus
(b) 55% of the net reported income after taxes, for the twelve month period ending July 31, 2014 (the contingent consideration).
Lawyer's Note - The contingent consideration should be worth at least $3.6 million since the division's earnings computed on this basis have averaged more than $6.6 million for the last four years before deducting head office charges.
4. This agreement is conditional on the Purchaser obtaining adequate financing, and, after inspection, finding TBL's records satisfactory.
5. CTE agrees not to compete with the Purchaser for 10 years.
6. US dollar amounts will be converted at the exchange rate determined by the Purchaser.
7. CTE will provide a loan guarantee for up to 25% of the purchase price for the Purchaser.
8. The Purchaser agrees to provide full maintenance services to the truck and trailer fleet of one of CTE's other subsidiaries for five years. Charges will be based on cost plus 10%.
9. The central bus station will be restored by CTE to its original condition by December 31, 2013.
10. CTE will provide free advertising to the Purchaser, on request, for one year following the closing date. The Purchaser will create all the advertising material, including TV commercials.
11. All bus route rights will be assigned to the Purchaser.
12. The purchase price will be allocated based on book values.
13. The sale will close on October 1, 2013, at 12:01 a.m., and the entire consideration with the exception of the contingent consideration will be due and payable one (1) month after closing. The contingent consideration is due one (1) month after the July 31, 2014 financial statements are finalized.
14. Overdue amounts will be charged interested at a rate of 11% per annum.
15. CTE will act in a consulting capacity to advise the Purchaser for a fee of $25,000 per annum.
16. Representation, warranties, and non-disclosure.
Lawyer's note - The details have yet to be discussed.
EXHIBIT C4-1(b)
INFORMATION GATHERED
1. Exclusive rights to most bus routes were obtained in the 1950s when the provincial governments were handing out the routes at no cost to the local bus lines. They had no competition at that time. Other similar bus routes were subsequently purchased for significant amounts.
2. TBL's summary draft financial statements for July 31, 2013 are as follows (in thousands of dollars):
Revenue ......................... $ 48,123
Expenses (including $2,403 of head office charges) ........ 40,239
Income before income taxes ................ 7,884
Current taxes ...................... 2,995
Deferred taxes ...................... 567
Net income ........................ $ 4,322
Current assets ....................... $ 14,133
Long-term assets ...................... 25,131
Liabilities ........................ (21,264)
Deferred taxes ...................... (6,000)
Equity .......................... $ 12,000
3. The TBL Maintenance Department has recently completed a study that demonstrated that the school buses will last 15 years rather than the 10 years on which the straight-line depreciation rates have always been based.
4. All school boards pay a non-refundable deposit, three months before the beginning of the school year in September, to guarantee bus service for the coming school year.
5. TBL ran a "Travel the Country" promotion in June 2013. Sales of the three-month passes for unlimited travel, costing $400, were brisk. The passes are punched by the driver each time the holders take a trip. To compensate travelers who use their passes fewer than 10 times in the three-month period, TBL permits them to trade in their passes for either a pair of skis or a pair of in-line skates or the case value of these items ($150).
6. CTE's consolidation entries for 2013 related to TBL are a fair value increment of $432,300 for capital assets; and goodwill, recorded at $2,332,000.
7. Included in TBL's long-term assets is a note receivable for $3.1 million, secured by the real property of a chain of four gas stations. Because of fierce competition from stations owned by the large oil companies, the value of the properties has declined from $4.2 million, the amount stated in the May 2012 appraisal, to $2.4 million, according to the May 2013 appraisal released on July 22, 2013. The payments on the note are being made on schedule.
8. On August 18, 2013, the Panamee School District announced the cancellation of all school bus services previously contracted for 2013-14 in the school district.
9. The management buyout team plans to spend $500,000 on TV advertisements that promote bus trail in a national advertising campaign, starting in early 2014. The team also plans to retrofit all long-distance buses at substantial cost.
10. TBL moved all maintenance operations to a new facility in June 2013. The building was purchases for $3.4 million, and the company had to vacate a leased facility 18 months before the end of the lease. The prospects of sub-letting the facility do not look good.