The newly appointed financial accountant of Oxygen Ltd

QUESTION 1 90 marks
The newly appointed financial accountant of Oxygen Ltd, a large listed conglomerate company, has
requested your assistance in the following matters in respect of the financial year ended 31 December
2003 of the Oxygen Ltd group:
Zeta Ltd
Zeta Ltd, a wholly owned subsidiary of Oxygen Ltd, is a retailer with a number of local and
international branches. The company’s expansion into Australia has had limited success and all the
branches in Australia are to be closed down. Because of the high cancellation penalties of property
lease agreements, Zeta Ltd has decided to continue operating in Australia until 30 June 2004, at
which time all lease agreements will have come to an end, and those branches will be closed. The
public announcement of the closures was made on 30 December 2003.
The management of Zeta Ltd has prepared the following schedule of estimated losses in respect of
the Australia branches for the period January to June 2004:
Operating loss (4 500)
Lease rentals on properties (7 500)
Retrenchment packages for staff members (2 000)
Retraining costs for staff members transferred to other
Oxygen Ltd group operations
(3 000)
Expected loss on disposal of shop fittings (4 000)
Total expected loss (21 000)
These amounts were estimated in Australian dollars and converted into rand at the year-end spot
Beta Ltd
Beta Ltd is a financial services company. Oxygen Ltd acquired a strategic 35% holding in Beta Ltd in
1995. Oxygen Ltd also has a separate financial services division, which has entered into numerous
material transactions with Beta Ltd since 1995. Oxygen Ltd had the right to nominate two of the
seven directors that served on the board of Beta Ltd.
In November 2002 it was discovered that the chief executive officer and chief financial officer of Beta
Ltd had defrauded Beta Ltd. The two were dismissed immediately. The fraud was so extensive that it
caused a serious liquidity crisis for Beta Ltd and the company was considering going into liquidation.
At the request of the remaining directors of Beta Ltd, Oxygen Ltd made a proposal to acquire the
remaining shares in the company. The shareholders of both companies ratified the agreement with
immediate effect on 30 December 2002 and also agreed that Oxygen Ltd would take full management
control of Beta Ltd on this date.
As required by law, the agreement contained a suspensive condition, namely that validation would be
dependent on ratification by the Financial Services Board and the Competition Commission. Oxygen
Ltd was of the opinion that although the take-over would make Oxygen Ltd the dominant financial
services group in South Africa, these ratifications would be a mere formality and would be completed
in a few months. Oxygen Ltd believed it had met the conditions for acquisition of control of Beta Ltd
on 30 December 2002 and fully consolidated Beta Ltd from this date onwards.
On 31 October 2003 the Financial Services Board and Competition Commission ruled that Oxygen
Ltd could take over Beta Ltd, except for two divisions of Beta Ltd. For competitive purposes these
divisions had to be sold to an unrelated party. To date no successful bidder for the two divisions has
been found. Oxygen Ltd has therefore petitioned the Financial Services Board and Competition
Commission to allow for the two divisions to be acquired by Oxygen Ltd as per the original
agreement. The directors of Oxygen Ltd consider that their petition will be successful in view of the
potential loss of value that any further delays will have for the shareholders of Beta Ltd. The directors
are also of the opinion that they should continue to consolidate Beta Ltd (including the two divisions
mentioned previously) into the consolidated annual financial statements of Oxygen Ltd for the year
ended 31 December 2003.
Gamma Inc.
Gamma Inc., a US registered subsidiary of Oxygen Ltd, was acquired on 2 January 2003. Oxygen
Ltd acquired all the issued shares of Gamma Inc. unconditionally on this date. The previous two
shareholders of Gamma Inc. remained as directors and still manage the company.
In order to act as an incentive to the vendors of Gamma Inc., it was agreed that the purchase
consideration would be settled by the issue of 420 000 shares of Oxygen Ltd and an option to
subscribe for an additional 40 000 shares on 2 January 2005.
The vendors negotiated that the 420 000 shares would be issued at R40 per share, which was at a
discount to their trading price on 2 January 2003 of R43 per share.
The option to subscribe for an additional 40 000 shares on 2 January 2005 stipulated that the
exercise price on this date would also be R40 per share. On 2 January 2003 an independent expert
valued the option at R215 000. Using the same basis of calculation at year end, the option only had a
value of R60 000 because of a drop in the share price of Oxygen Ltd.
As a further incentive to the vendors of Gamma Inc., the purchase agreement provided that the two
previous shareholders of Gamma Inc. would be granted an extra bonus of US $80 000 each, payable
after two years, to continue acting as directors of the company for two years. A director will forfeit this
bonus if he resigns before the completion of the two-year service period.
Oxygen Ltd considered the plant and equipment of Gamma Inc. to be undervalued by US $200 000
on the date of acquisition. On that date this plant and equipment had a remaining useful life of five
years and no residual value. In the country in which it operates, Gamma Inc. is subject to a normal
tax rate of 25%.
Oxygen Ltd decided that all surplus funds in Gamma Inc. should be stripped out of the company. This
was effected via an interest free loan to the holding company on 2 January 2003. The loan is rand
denominated and repayable on 31 December 2004. Gamma Inc. is carrying the loan to Oxygen Ltd
at the original amount of the proceeds paid. The accountant of Gamma Inc. has indicated that no
foreign exchange differences have been calculated, as this loan needs to be eliminated on
The trial balances of Gamma Inc. as at 2 January and 31 December 2003 and exchange rates are
presented below. Oxygen Ltd has classified Gamma Inc. as a foreign entity.
2 January
31 December
US $’000 US $’000
Plant and equipment 1 100 900
Loan to holding company – 450
Other monetary net assets 600 600
Share capital (50) (50)
Retained earnings at 1 January 2003 (1 650) (1 650)
Revenue (1 800)
Expenses 1 200
Tax 150
Dividend paid 31 December 2003 200
Nil Nil
Exchange rates:
2 January 2003
31 December 2003
Average for 2003
US $1,00 = R8,50
US $1,00 = R7,10
US $1,00 = R7,50
The Oxygen Ltd group has adopted the following accounting policies with regard to foreign entities:
• Goodwill and fair value adjustments are denominated in the measurement currency of the
subsidiary and are translated at the closing exchange rate, and
• Goodwill, if any, is amortised over a period of ten years.
Alpha Ltd
Alpha Ltd is a property company that develops properties for sale and also constructs office parks that
are leased out on long-term leases.
Oxygen Ltd acquired a 25% shareholding in Alpha Ltd on 2 January 1999. At that date the carrying
value of Alpha Ltd’s net assets amounted to R10 million, which was considered to be its fair value.
Alpha Ltd acquired its 25% holding for R2 million. At that date Alpha Ltd was not expected to incur
future losses, and the non-monetary assets of the company amounted to R12 million with an
expected remaining useful life of ten years.
By March 2003 Alpha Ltd was experiencing difficulties, primarily as a result of poor management of
the Alpha Ltd construction projects. At a special shareholders’ meeting held on 31 March 2003, a
resolution was passed that Alpha Ltd would issue 2 750 000 shares to Oxygen Ltd for cash on 2 April
2003 to allow Oxygen Ltd to increase its holding to 80%. The issue price of the shares would be
R15 per share. This would inject sufficient cash to restore the company to profitability, while Oxygen
Ltd would utilise the assessed loss of the company in the foreseeable future.
The balance sheet of Alpha Ltd and relevant notes that were presented to shareholders at the
meeting are set out below:
Notes R’000
Plant and equipment 1 15 000
Investment properties 26 000
Construction work in progress 2 4 000
Accounts receivable 5 000
50 000
Share capital (R1 shares) 1 000
Retained income 9 500
Shareholders’ funds 10 500
Long-term liabilities 23 000
Accounts payable 5 500
Provisions 4 000
Overdraft facilities 7 000
50 000
Notes to balance sheet
1 Plant and equipment
Plant and equipment are stated at the carrying value at the company’s last year end, namely
31 December 2002. The fair value of plant and equipment is considered to be R20 million.
2 Construction work in progress
Construction work in progress represents work that has been carried out on property
developments that have not yet been sold. The directors of Alpha Ltd consider the fair value of
these developments to be R4,5 million at their current stage of completion, although they would
probably only realise R2 million in a forced sale.
3 Deferred tax
The deferred tax balance can be analysed as follows:
Capital allowances on plant and equipment 1 500
Debtors’ allowance on construction debtors (300)
Provision for future construction (600)
Assessed loss (1 620)
Net deferred tax asset (1 780)
Asset not recognised 1 780
Carrying value in balance sheet Nil
Draft a letter to the accountant of Oxygen Ltd, in which you deal with the following issues:
(a) Discuss, with reasons, whether each of the components of the total expected loss of Zeta Ltd’s
Australian branches for the period of January to June 2004 should be recognised in the
consolidated annual financial statements of Oxygen Ltd for the year ended 31 December 2003.
You are not required to discuss any disclosure and presentation requirements. (16)
(b) Discuss, with reasons, the appropriate date of acquisition of Beta Ltd in the consolidated annual
financial statements of Oxygen Ltd for the year ended 31 December 2003. (15)
(c) Calculate, with supporting reasons, Oxygen Ltd’s cost of acquisition of Gamma Inc. at
31 December 2003. In your answer you should consider the possible impact of the bonus
payable to the directors. (9)
(d) Prepare the translated trial balance of Gamma Inc. and the pro forma consolidation journal
entries required to consolidate the results and financial position of Gamma Inc. in the group
annual financial statements of Oxygen Ltd for the year ended 31 December 2003. (22)
(e) Prepare the relevant extracts from the consolidated cash flow statement and the notes thereto of
the Oxygen Ltd group for the year ended 31 December 2003 to reflect the acquisition of shares
in Alpha Ltd on 2 April 2003. (28)

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