Case 19-7

Accounting for Contingent Payments to Employees or Selling Shareholders in a Business Combination

Company G (G), an SEC registrant, is a global financial advisory and asset management firm. Company P (P), a private company, offers advisory services for (1) mergers, acquisitions, and divestitures; (2) capital structure (including initial public offerings); (3) government advisory, including strategic, finance and capital markets related policy considerations; and (4) restructurings.

Case Facts

On September 18, 20X8, (the “Closing”), G and P executed an acquisition agreement (the “Agreement”) whereby G acquired 100 percent of the outstanding shares of P (the “Acquisition”). At the time of close, P had 10 employees that had over 200 combined years of financial and strategic advisory experience. Company P was owned as follows:

• Founder — 85 percent.

• Senior advisor — 10 percent.

• Other employees (four in total) — 5 percent.

  The purchase price was calculated using a revenue multiple that was established using market data at the midpoint and transferred in exchange for 100 percent of the outstanding shares to the Founder ÷ employees who owned 100 percent of P (collectively, the “Shareholders”) on a pro rata basis. The total purchase price comprised the following:

  • Cash = $1 million.

  • Shares = 100,000 shares in G (worth $3.3 million).

  • Delayed Consideration = 120,000 G shares, but issued to the Shareholders under the terms below (value assuming a 4-year vesting restriction = $5 million; assuming a 10-year vesting restriction = $4 million).

o Delayed consideration is held by an independent third party (Exchange Co) and on the fourth anniversary of the Closing, Exchange Co shall release the Delayed Consideration to the Shareholders, subject to the Shareholder being employed on such date.

o If a Shareholder is no longer employed on the fourth anniversary, the Delayed Consideration issued to such Shareholder will continue to be held by Exchange Co until the tenth anniversary of the Closing, at which point Exchange Co shall release the Delayed Consideration to the Shareholders.

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Case 19-7: Accounting for a Contingent Payments to Employees or
Selling Shareholders in a Business Combination Page 2

• Earnout Consideration = Up to 600,000 shares (valued at total of $20 million).

o The Earnout Consideration will be contingent upon achievement of revenue hurdles over a period beginning on September 18, 20X8, and ending on December 31, 20X2 (“Earnout Period”).

o To the extent the performance targets below are achieved, Exchange Co shall deliver the relevant Earnout Shares to the Shareholders on a pro rata basis. However, if and to the extent certain performance targets described below are not achieved, in whole or in part, no Earnout Consideration will be paid.

•  First Earnout Consideration — If revenue exceeds $10 million in the Earnout Period, the Shareholders will be entitled to 200,000 shares.

•  Second Earnout Consideration — If revenue exceeds $20 million in the Earnout Period, the Shareholders will be entitled to an additional 200,000 shares.

•  Third Earnout Consideration — If revenue exceeds $30 million in the Earnout Period, the Shareholders will be entitled to an additional 200,000 shares.

o The Shareholders are still entitled to the Earnout Consideration in the event that targets are met, but they are not employees of G at the time the Earnout Consideration is earned.

Other Key Facts

• Company P meets the definition of a business under ASC 805.

• Each employment agreement executed by G and the Shareholders contains compensation that is commensurate with the service each respective Shareholder is providing to G.

• The Shareholders have at-will employment agreements with G.

• If the Shareholders were to leave, G would be able to replace them with an existing G investment banker; therefore, the Shareholders are not integral to the future success of the acquired business.

• The fair value of P was determined to be $24 million.

• The Earnout Consideration is not being treated as compensation expense for tax purposes.

Copyright 2019 Deloitte Development LLC All Rights Reserved.

Case 19-7: Accounting for a Contingent Payments to Employees or
Selling Shareholders in a Business Combination Page 3

Required:

1. Should the Earnout Consideration to Shareholders be accounted for as purchase consideration in exchange for the Acquisition or as compensation for postcombination services?

Case 19-7

Accounting for Contingent Payments to Employees or Selling Shareholders in a Business Combination

Company G (G), an SEC registrant, is a global financial advisory and asset management firm. Company P (P), a private company, offers advisory services for (1) mergers, acquisitions, and divestitures; (2) capital structure (including initial public offerings); (3) government advisory, including strategic, finance and capital markets related policy considerations; and (4) restructurings.

Case Facts

On September 18, 20X8, (the “Closing”), G and P executed an acquisition agreement (the “Agreement”) whereby G acquired 100 percent of the outstanding shares of P (the “Acquisition”). At the time of close, P had 10 employees that had over 200 combined years of financial and strategic advisory experience. Company P was owned as follows:

• Founder — 85 percent.

• Senior advisor — 10 percent.

• Other employees (four in total) — 5 percent.

  The purchase price was calculated using a revenue multiple that was established using market data at the midpoint and transferred in exchange for 100 percent of the outstanding shares to the Founder ÷ employees who owned 100 percent of P (collectively, the “Shareholders”) on a pro rata basis. The total purchase price comprised the following:

  • Cash = $1 million.

  • Shares = 100,000 shares in G (worth $3.3 million).

  • Delayed Consideration = 120,000 G shares, but issued to the Shareholders under the terms below (value assuming a 4-year vesting restriction = $5 million; assuming a 10-year vesting restriction = $4 million).

o Delayed consideration is held by an independent third party (Exchange Co) and on the fourth anniversary of the Closing, Exchange Co shall release the Delayed Consideration to the Shareholders, subject to the Shareholder being employed on such date.

o If a Shareholder is no longer employed on the fourth anniversary, the Delayed Consideration issued to such Shareholder will continue to be held by Exchange Co until the tenth anniversary of the Closing, at which point Exchange Co shall release the Delayed Consideration to the Shareholders.

Copyright 2019 Deloitte Development LLC All Rights Reserved.

Case 19-7: Accounting for a Contingent Payments to Employees or
Selling Shareholders in a Business Combination Page 2

• Earnout Consideration = Up to 600,000 shares (valued at total of $20 million).

o The Earnout Consideration will be contingent upon achievement of revenue hurdles over a period beginning on September 18, 20X8, and ending on December 31, 20X2 (“Earnout Period”).

o To the extent the performance targets below are achieved, Exchange Co shall deliver the relevant Earnout Shares to the Shareholders on a pro rata basis. However, if and to the extent certain performance targets described below are not achieved, in whole or in part, no Earnout Consideration will be paid.

•  First Earnout Consideration — If revenue exceeds $10 million in the Earnout Period, the Shareholders will be entitled to 200,000 shares.

•  Second Earnout Consideration — If revenue exceeds $20 million in the Earnout Period, the Shareholders will be entitled to an additional 200,000 shares.

•  Third Earnout Consideration — If revenue exceeds $30 million in the Earnout Period, the Shareholders will be entitled to an additional 200,000 shares.

o The Shareholders are still entitled to the Earnout Consideration in the event that targets are met, but they are not employees of G at the time the Earnout Consideration is earned.

Other Key Facts

• Company P meets the definition of a business under ASC 805.

• Each employment agreement executed by G and the Shareholders contains compensation that is commensurate with the service each respective Shareholder is providing to G.

• The Shareholders have at-will employment agreements with G.

• If the Shareholders were to leave, G would be able to replace them with an existing G investment banker; therefore, the Shareholders are not integral to the future success of the acquired business.

• The fair value of P was determined to be $24 million.

• The Earnout Consideration is not being treated as compensation expense for tax purposes.

Required:

Does the Delayed Consideration represent purchase consideration in exchange for the Acquisition or compensation for postcombination services? Is it contingent consideration? How much of the Delayed Consideration (if any) should be consideration for postcombination services?

Insomnia has become an epidemic in the United States. Much research has been done in the development of new pharmaceuticals to aide those who suffer from insomnia. Alternatives to the pharmaceuticals are being sought by sufferers. A new relaxation technique has been tested to see if it is effective in treating the disorder. Sixty insomnia sufferers between the ages of 18 to 40 with no underlying health conditions volunteered to participate in a clinical trial. They were randomly assigned to either receive the relaxation treatment or a proven pharmaceutical treatment. Thirty were assigned to each group. The amount of time it took each of them to fall asleep was measured and recorded. The data is shown below. Use the appropriate t-test to determine if the relaxation treatment is more effective than the pharmaceutical treatment at a level of significance of 0.05.

Blue Apron IPO Leaves a Bad Taste Founded in 2012, Blue Apron is one of the top meal-kit delivery services doing business in the United States. Started by three co-founders—Matt Salzberg, Matt Wadiak, and Ilia Pappas—Blue Apron provides pre-portioned ingredients (and recipes) for a meal, delivered to consumers’ front doors. According to recent research, the U.S. meal-kit delivery industry is an $800 million business with the potential to scale up quickly, as more and more consumers struggle to find time to go grocery shopping, make meals, and spend time with family and friends in their hectic daily lives. As word spread among foodies about the quality and innovative meals put together by Blue Apron, the company’s popularity took off, supported by millions in start-up funding. Costs to scale the business have not been cheap—estimates suggest that Blue Apron’s marketing costs have been high. Despite the challenges, by early 2017 the company was selling more than 8 million meal kits a month and decided to go public in an effort to raise more money and scale its operations, including a new fulfillment facility in New Jersey. According to the IPO paperwork filed with the SEC, the company had net revenues of $84 million in 2014, which increased to $795 million in 2016. However, those ambitious numbers were not without warnings: company losses increased in the same time period from $33 million to $55 million. Even with those larges losses on its balance sheet, Blue Apron decided to go ahead with the IPO and hired Goldman Sachs and Morgan Stanley, two top stock underwriters, to figure out the right price for the initial offering. While Blue Apron and its underwriters were finalizing stock prices, Amazon announced plans to acquire Whole Foods—a move that could negatively affect Blue Apron’s business going forward. Even after Amazon’s announcement, Blue Apron and its financial advisors priced the initial offering at $15 to $17 a share and met with investors across the country to inform them about the IPO, which would value the company on paper at more than $3 billion. As part of the IPO strategy, Blue Apron executives needed to communicate a strong financial picture while providing potential investors with an honest assessment of investor demand, especially for institutional investors, who typically are repeat buyers when it comes to IPOs. According to sources close to the IPO experience, Blue Apron’s bankers told investors late in the IPO pricing process that they were “closing their order books early,” which meant there was a heightened demand for the stock—a signal that the stock would be priced in the original $15–$17 range. A day later, however, Blue Apron amended its prospectus with a price range between $10 and $11 a share, which shocked potential investors—a move greeted with criticism that Blue Apron’s messaging now lacked credibility in the eyes of the investment community if the company priced the IPO $5 lower per share than originally estimated. With that sudden change in the IPO offering, investors walked away, and the $10 initial offering for Blue Apron stock actually declined on its first day of trading. As of this writing, the stock has lost close to 40 percent from the original $10-per-share price. With continued consolidation in the meal-kit delivery sector inevitable, Blue Apron is at a crossroads when it comes to generating revenue and stabilizing costs while trying to sign up more subscribers. One of its competitors, Plated, was recently acquired by the Alberstons grocery chain, and Amazon has already trademarked the phrase, “We do the prep. You be the chef,” as it relates to prepared food kits. Critical Thinking Questions What issues should executives of a company such as Blue Apron consider before deciding to go public? In your opinion, was the company ready for an IPO? Why or why not? How else could Blue Apron have raised funds to continue to grow? Compare the risks of raising private funding to going public. Use a search engine and a site such as Yahoo! Finance to learn about Blue Apron’s current Prepare a brief summary, including the company’s current financial situation. Is it still a public company, and how has its stock fared? Would you invest in it? Explain your reasoning.

Gruman Company purchased a machine for $198,000 on January 2, 2019. It made the following estimates:

In 2019, Gruman uses the machine for 2,000 hours and produces 50,000 units. In 2020, Gruman uses the machine for 1,200 hours and produces 32,000 units. If required, round your final answers to the nearest dollar.

Required:

1. Compute the depreciation for 2019 and 2020 under each of the following methods:

1. Straight-line method

   2019	$
   2020	$

2. Sum-of-the-years'-digits method

   2019	$
   2020	$

3. Double-declining-balance method

   2019	$
   2020	$

4. Activity method based on hours worked

   2019	$
   2020	$

5. Activity method based on units of output

   2019	$
   2020	$

2. For each method, what is the book value of the machine at the end of 2019? At the end of 2020?

1. Straight-line method

   2019	$
   2020	$

2. Sum-of-the-years'-digits method

   2019	$
   2020	$

3. Double-declining-balance method

   2019	$
   2020	$

4. Activity method based on hours worked

   2019	$
   2020	$

5. Activity method based on units of output

   2019	$
   2020	$

3. If Gruman used a service life of 8 years or 15,000 hours and a residual value of $9,000 , what would be the effect on the following under the straight-line, sum-of-the-years'-digits, and double-declining-balance depreciation methods?

Depreciation expense

1. Straight-line method

   2019	$
   2020	$

2. Sum-of-the-years'-digits method

   2019	$
   2020	$

3. Double-declining-balance method

   2019	$
   2020	$

Book value

1. Straight-line method

   2019	$
   2020	$

2. Sum-of-the-years'-digits method

   2019	$
   2020	$

3. Double-declining-balance method

   2019	$
   2020	$

Consider each of the following independent and material situations, identified below (i-v). In each case: • the balance date is 30 June 2020; • the field work was completed on 12 August 2020; • the Directors’ Declaration and the Audit report were signed on 19 August 2020; • the completed financial report accompanied by the signed Audit report was mailed to the shareholders on 25 August 2020. (i) On 29 September 2020, you discovered that a debtor at 30 June 2020 had gone bankrupt on 1 September 2020. The debt had appeared collectible at 30 June 2020 and 19 August 2020. (ii) On 12 August 2020, you discovered that a debtor had gone bankrupt on 1 August 2020. The sale took place on 15 July 2020. The cause of the bankruptcy was a major uninsured fire at one of the debtor’s premises on 1 July 2020. (iii) On 13 August 2020, you discovered that a debtor at 30 June 2020 had gone bankrupt on 5 August 2020. The cause of the bankruptcy was an unexpected loss of a major lawsuit issued against the debtor on 10 June 2020. (iv) On 20 August 2020, the company settled a legal action out of court that had originated in 2016 and was listed as a contingent liability at 30 June 2020. (v) On 1 September, you found a letter dated 15 August with a $2 million fine from Environmental Protection Agency. The letter stated that company had illegally dumped chemicals on 15 May 2020. Required: 1. For each of the events described above (i-v), select the appropriate action from the list below, and justify your response. A. Adjust the 30 June 2020 financial report. B. Disclose the information in the notes to the 30 June 2020 financial report. C. Request that the client recall the 30 June 2020 financial report for revision. D. No action is required. (5*1.5= 7.5 marks) 2. If no action is taken by management for each of the events described above (i-v), determine the most appropriate audit opinion to be issued.

For the year ended December 31, 2020, Stellar Ltd. reported income before income taxes of $100,000.

In 2020, Stellar Ltd. paid $54,000 for rent; of this amount, $18,000 was expensed in 2020. The remaining $36,000 was treated as a prepaid expense for accounting purposes and would be expensed equally over the 2021-2022 period. The full $54,000 was deductible for tax purposes in 2020.

The company paid $70,000 in 2020 for membership in a local golf club (which was not deductible for tax purposes).

In 2020 Stellar Ltd. began offering a 1-year warranty on all merchandise sold. Warranty expenses for 2020 were $38,000, of which $31,000 was actual repairs for 2020 and the remaining $7,000 was estimated repairs to be completed in 2021.

Meal and entertainment expenses totalled $17,000 in 2020, only half of which were deductible for income tax purposes.

Depreciation expense for 2020 was $190,000. Capital Cost Allowance (CCA) claimed for the year was $217,000.

Stellar was subject to a 20% income tax rate for 2020. Stellar follows IFRS. At January 1, 2020, Stellar Ltd. had no balances in deferred tax accounts.

Calculate taxable income and taxes payable for 2020.

Prepare the journal entries to record 2020 income taxes (current and deferred).

Hemming Co. reported the following current-year purchases and sales for its only product.

Jan. 1 Beginning inventory 205 units @ $10.20 = $ 2,091 (Units Acquired at Cost)

Jan. 10 Sales 160 units @ $40.20 (Units sold at Retail)

Mar. 14 Purchase 300 units @ $15.20 = 4,560 (Units Acquired at Cost)

Mar. 15 Sales 250 units @ $40.20 (Units sold at Retail)

July 30 Purchase 400 units @ $20.20 = 8,080 (Units Acquired at Cost)

Oct. 5 Sales 375 units @ $40.20 (Unites sold at Retail)

Oct. 26 Purchase 105 units @ $25.20 = 2,646 (Units Acquired at Cost)

Totals: 1,010 units acquired at cost, $17,377, 785 units sold at retail

(Required: Hemming uses a perpetual inventory system.)

1. Determine the costs assigned to ending inventory and to cost of goods sold using FIFO.

2. Determine the costs assigned to ending inventory and to cost of goods sold using LIFO.

3. Compute the gross margin for FIFO method and LIFO method.

Build a simple linear regression for (1) all 50 states, (2) Eastern Time zone states, (3) Central Time zone states, (4) Mountain Time zone states, and (5) Pacific, Alaska, and Hawaii Time zone states. Compare your results in all five parts and state your judgements. You may use charts and tables in the comparison. Your answers should have values for the coefficient of determination, AOV table, significance levels, residual plots, and the regression fit with their interpretations.

Data source: Kaiser Family Foundation, 4/20/2020, 5:38PM. (ET = eastern time, CT = central time, MT = mountain time, PT = Pacific time). Some states have a mix of two different time zones which I ignored here).

1. Explain why negative or harmful mutations have no role in the evolution of a population.
2. How do pseudogenes offer evidence in support of evolution?
3. Give an example of the bottleneck and founder effects.
4. Explain how bottleneck effect has affected cheetahs.
5. If variation in a species was only due to meiosis, how would that limit the evolution of that species?
6. If it is survival of the fittest, explain why organisms would show altruistic behaviour or kinship. For example, why would lions group together as a pride?
7. Explain how altruism and cooperation are not contrary to evolution.
8. Explain how cumulative selection allows for more detailed structures.