Question

Abbotsford Tile Ltd. (ATL) is a wholesaler of high quality glass, ceramic and marble tiles. In November 2019 the owner of ATL agreed to sell the company to Barrie Tile Inc. (BTI) another tile wholesaler. Each company is owned and operated by a single individual who originally founded his company. The owner of ATL decided to sell his business because he was beginning to get too old to run the store. The owner of BTI wants to purchase ATL to expand the size of his business. The two men agreed over lunch that BTI would buy ATL for an amount equal to five times ATL’s net income before tax for the year ended December 31, 2019. The deal is to be finalized on March 1, 2020. Closure of the deal requires that BTI approve of the financial statements prepared by ATL. The two men agreed that any disputes regarding the financial statements would be settled by negotiations and, if necessary, by arbitration by an independent third party. It is now January 15, 2020. You have been called by BTI’s owner to help him understand and assess a number of transactions that are reported in ATL’s December 31, 2019 financial statements. The owner of BTI explained that he does not have much experience working with financial statements but based on his examination, along with information obtained from other sources, he is concerned about a number of transactions reported in ATL’s statements. The owner has asked you for a detailed report explaining the impact of each event on the purchase price of ATL and your assessment of each of the issues. BTI’s owner said that he would like a full explanation of the implications of each event, your evaluation of the accounting used by ATL, and your supported recommendation of the appropriate treatment for each event. Your explanations are important because they will be used in negotiations with the owner of ATL and, if necessary, presented to the arbitrator.

The owner of BTI provided you with the following information about the events that are of concern to him:

a) In November 2019 ATL received a large order for tiles from a new customer. The customer’s normal supplier was on strike and had to find an alternative supplier and so the customer came to ATL. The contract requires that the parts be delivered in early January 2020. Production of the order was completed on December 18, 2019 and was ready to ship at that time. The contract requires that the customer must receive the tiles and must inspect and accept them before the contract is finalized. ATL shipped the tiles to the customer on December 31, 2019 and recognized the revenue in the year ended December 31, 2019.

b) Net income before taxes was $625,000 for the year ended December 31, 2019.

Answer 1

The Following points are to be considered before accapting the contract by BTL.

Since the purchase price of ATL by BTL is five times the net profits before tax. BTL should be sure of the calculation of the netprofits of ATL.

A. Now, In the given situation the income recoginsed by ATL as on December 31st, 2019 should not be considred.

reasons being - 1. Since the contract is finalised only on inspection and acceptance by the customer and since this inspection has not happned the contract is not finalised.

B.The reported income before taxes $ 625,000 for the year ended December 31, 2019 should not be considered as a whole, because this net income includes the income which is recognised from the customer which is not finalised yet.

So, The income which is related to the customer should be excluded from the net profits of $ 625,000.

And also - According to the Prudence concept in accouting. Income/profits which are not certain should not be recognised in the books of accounts or financials. But should be provided for expenses which are contingent.

The final conclusion is that the whole $ 625,000 should not be considered. The profits relating to customer should be excluded in the caluculation of purchase price of ATL by BTL.