Our firm has been engaged with GPI for compilation engagements for the past two years. For year ending September 30, 20X0, a preparation of consolidated financial statements are required due to acquisition of foreign subsidiary on August 15, 20X0. This report addresses issues surrounding the preparation of the consolidated statements for Gourmet Products Inc. (GPI) and Abruzzi Oils Inc., and provides suggested adjustments as well as recommendations on other issues. Since GPI is a publicly traded company, IFRS provisions for reporting and presentations of financial statements must be adhered.
Valuation of goodwill
The current valuation of goodwill from the bottling machine is inappropriately reported. Under IFRS 3, all identifiable assets and liabilities are to be recognized at fair value. By not recognizing at fair value, the machine will be understated, goodwill will be overstated, and income will be overstated due to lower depreciation on the machine. Adjustment required: the machine should be reported at fair value and goodwill should be calculated by subtracting the fair value from the acquisition cost and be depreciated over the useful life of the machine.
Employees re-located to Italy
Some employees were temporarily relocated to Italy in order to maintain the operations there. However, these employees are being treated as consultants rather than GPI’s employees and as such GPI is no longer taking source deductions. The employee / contractor status must be determined, as certain requirements must be met. The inappropriate classification of these employees means the company is neglecting on payroll deductions. Adjustments required: record payroll liabilities and payroll taxes payable to avoid errors in financial reporting. Also, there is a possibility of fines being imposed by CRA due to not remitting payroll deductions correctly. Also, the amounts GPI paid to facilitate the employee’s job-related move are deductible as ordinary and necessary business expenses. These deductions will reduce taxable income of GPI.
Financing for labelling machine
GPI has purchased a labelling machine by borrowing EUR funds from Banca Cammerata in Italy. The machine is then transferred to Abruzzi for a note similar to the borrowing terms with the bank. GPI is opting not to charge Abruzzi interest and states this method reduces foreign currency risks. However, GPI is still obligated to pay the bank the 7% interest rate to the bank. In this situation the loan principle is appropriately hedged from foreign exchange risk exposure. However, the monthly interest payments are exposed to foreign exchange risk, as GPI has to pay interest in Euros to the Italian bank.
Recommendation: to reduce this risk, GPI should arrange a currency swap with Abruzzi or use another hedging instrument to eliminate or reduce the currency risk on interest payments. To an acceptable level. Another issue with the loan is potential tax avoidance by GPI, due to not charging interest on the loan. Interest income is fully taxable at corporate rate in Canada. This issue can be resolved by using the currency swap with Abruzzi for the amount of the interest.
Classification of Abruzzi
According to IAS 21, Abruzzi should be classified as a self-sustained subsidiary, and will use local currency (Euro) as functional currency in its operations.
Recommendations: for consolidation purposes, the Current rate method should be used. Under this method, any exchange gains or losses are deferred and included in OCI. Also, appropriate disclosure in financial statements should be included regarding presentation currency and functional currency used, as well as any exchange gains or losses recorded in OCI.
Revaluation of land and building
The revaluation of the land and building is inaccurately reported. Revalued amount should not increase the land and building accounts directly as these amounts are not realized.
Adjustment: the increase in value should be credited to other comprehensive income less the loss that was recognized in the prior year. EUR 5K should be recorded as a gain on the income statement because it reverses the previously recognized loss. The remaining EUR 15K should be recorded in OCI and accumulated in equity under revaluation surplus.
150% markup of Abruzzi goods
The transfer pricing of Abruzzi goods sold to GPI raises concerns. The markup of 150% seems unusually high with no explanation to support this decision. Due to the high markup cost, GPI would report a very low profit margin on the sales of these goods. Improper transfer pricing could provide an opportunity for GPI to income manipulation and income tax implications. The corporate tax rate in Italy is much lower than the tax rate in Canada so this may suggest potential tax avoidance by GPI. This issue has tax implications due to higher COS recorded in Canadian operations, thus decreasing the taxable income. Recommendation: review the transfer pricing policy by both CFO and CEO. Generally, transfer pricing is set close to the fair value market. To defer from this, there should be support to back-up this decision. There is a potential penalty from CRA due to inappropriate transfer pricing in a non-arm length transactions.
Implementation of new payroll system
The concern on the approach to implementing a new payroll system was mentioned by you at our meeting. Although the direct cutover conversion is faster to implement and costs less, the risk factor that come with this makes this approach less favorable. Because the transition will be dealing with sensitive employee information, the company should be due diligent in handling this information. As well, any errors on payroll will likely to frustrate and anger employees even more so than the delays.
Recommendation: It will be more favorable to choose a less risky parallel conversion. Parallel approach would provide a reliable transfer into new system, but it will be more costly due to more resources required for conversion.
Users of the consolidated financial statements
In addition to preparing consolidated financial statements, there is an option to prepare FS for each separate entity. However it’ll be more costly to provide another set of financial statements to shareholders. The cost of preparing additional set of statements need to be considered.
According to IFRS 3 and 12, disclosures regarding business combination and Interest in other entities is required.
These are the issues I have come across as I was preparing for the consolidation of the financial statements. It is important that you review these issues and consider the adjustments I have suggested. While some of the items will not impact the consolidated financial statements, they will have some implications during an audited or income tax preparation. If you have any questions or wish to discuss further on these matter, please do not hesitant to contact me.