Question #3

USERS & OBJECTIVES: Trey Dobson wants to ensure that he is able to transition to going public company without a problem and for that reason, would also like higher net profit and assets. Open market investors want integrity of financial statements to make sound investment decision. CES All reporting should be per IFRS standards and financial information disclosed candidly.

CONFLIC OF INTEREST: Trey might be motivated to inflate his earnings and assets as much as possible to get the best IPO for GMI possible. CONSTRAINTS: Must use IFRS because going public next year

ISSUE #1: Coupons According to IFRS, coupons have to be accounted for if they are of cash in nature or are expected to produce a loss. Since the vouchers that are being handed out are for $3 and the lowest priced item in the store is worth $2, it is likely that customers will use the voucher for lower priced items. Since gross margin is 80%, a $3 retail price would mean a cost of $0.60 to GMI. This means that as long as on average, if the customers use the coupon for around $4 or more, GMI would still make a profit. We will assume that most of the customers will likely only use the coupon to get items for which they dont pay anything themselves and hence the $3 coupon would result in a loos for GMI. GMI is required by IFRS then, to estimate the breakage rate for the coupons issued as well as record a coupon redemption liability. This would account for the loss that GMI would make on the issuing of the coupons. Makes the business less attractive for future investors, but not very significantly.

ISSUE #2: Construction Costs As per IFRS, construction & borrowing costs of a qualifying asset (one that takes a significant amount of time to complete) can be capitalized. Since the kitchen construction can be expected to last several months (6+), it is a qualifying asset. All costs that are directly associated with the construction (assuming all $1,250,000 are related costs) can be capitalized. In addition, the interest of $225,000 can also be capitalized, however, this can only be done once: (1) Interest is being incurred, (2) construction costs are being incurred and (3) construction activities are under way.

Furthermore, any income earned from temporarily investing the borrowed funds has to be netted out of the capitalized amount. Since there was a profit in this case, not all the interest cost may be capitalized. The capitalization of the interest cost will commence once construction starts (and the other 2 conditions are met as discussed before); but it must be halted during December when no work was done. Capitalization must stop once the construction activities have substantially ended in this case, this would be May 1, 2013 (not March 1 because the kitchen did not serve its full purpose). So, the $1,250,000 would have to be capitalized under IFRS (under ASPE, there would have been a choice b/w cap or expense); interest would be capitalized (no choice again) from Nov 1 Nov 30. And then Jan1 May 1, i.e.: when the conditions for capitalization were met. This is 5/12 X $225,000 = $93,750 Total amount to capitalize: $93,750 (profit from investment) + $1,250,000. This is very advantageous for GMI from the IPO viewpoint as it increases the assets as well as provides a tax shield, hence increasing NI.

ISSUE #3: Onerous Contract Since membership frees have fallen by 80% to $100,000; GMIs revenues would otherwise be $100,000 X 5 = $500,000. With this contract, GMI is making $100,000 + $350,000 = $450,000 per year. This means that the contract is causing GMI to incur a loss of $50,000 per year. According to IFRS, this represents an onerous contract. GMI should consider the cost of terminating the contract to see what the penalty is. If this is still causing a loss, IFRS would allow GMI to recognize a loss immediately in the lower of the 2 amounts, i.e.: contract termination vs. future cash flows. Assuming that $50,000 is the lower of the 2, GMI would immediately recognize a loss of $50,000 even though GMI will try to eliminate the loss next year. This will reduce GMIs NI, which is good for tax purposes, but not for the IPO. The onerous contract should be disclosed in the notes to the F/S.

ISSUE #4: Investment Gain The stick price appreciation from $78 to $85 represents a change in the value of the investment of GMI in RAI. Since this is a passive investment, it was fine to record it at cost under ASPE, but under IFRS, it should be recorded as FVTPL or FVTOCI (irrevocable). Since the investment is profitable, GMI would want to use FVTPL so that the NI is increased from it. The FV of the investment has to be tested every year, so GMI would record a gain on its income statement because of the appreciation in value. This is good for NI and hence, for the IPO

ISSUE #5: Hedge Derivative GMI has effectively purchased a hedge derivative (most likely a forwards contract). Since GMI does not use hedge accounting, IFRS requires that any gain or loss from the hedge be directly reflected in the P&L of GMI. The FV should be tested at year-end and (assuming there is still a gain) the gain should be recorded in the P&L. this will increase NI for GMI and is hence, good for the IPO next year. (No guidance in ASPE for hedges)

ISSUE #6: Contingent Liability Under ASPE, liabilities are recorded if they are likely and not recorded otherwise. For IFRS, we need to consider if the contingent liability is probable (>50%), which, based on the lawyers opinion of settling, it is. It needs to be recorded based on a reasonable estimate of how much GMI can expect to pay. Since it is unlikely that the settlement will be <$550,000, it is probably reasonable to create a provision for this amount as this is probable as well as material, GMI should add a disclosure note regarding this as well. This will increase GMIs liabilities and will not be good for the IPO.

ISSUE #7: Taxes Under ASPE, there is nothing wrong with using the taxes payable method. However, IFRS does not permit this. GMI needs to use the accrual (P/L) or the balance sheet method to account for taxes. This should not have any material impact on GMIs position other than potentially creating a temporary deferred income tax liability or asset.

FINANCING OPTIONS (1) The pref shares are an equity instrument since they can be called back at the corps option and there is no obligation for it to do so and no duress. Although the shares pay 10% while outstanding, this is again not an obligation. (2) Although the redeemable shares can be redeemed at the corporations option, there is no fixed price for this and hence the market would dictate whether management redeems or not. Furthermore since there is a cumulative 3% added to the rate each year, it almost twists managements arm into making a regular payment. These features make this a debt instrument. (3) The cumulative preferred shares that have to pay 20% of the common shared dividends are an equity instrument. If the company chooses not to pay div. on the common shares, it does not have to pay a dividend on the cumulative pref shares either i.e.: no obligation.

Based on all the financing options, (3) seems to be the best for GMI at this point as it would bear the least burden in terms of dividend payments etc. One might argue that (2) would attract more investment due to being attractive for the investors, but (3) will still attract investors if the company shows promise of growth, i.e.: offers appreciation of stock price.

BUSINESS ISSUES: 1. Issue: No Controller Impact: This can be disastrous right before an IPO since there can be many irregularities in the financial data. Recommendation: Find a replacement controller immediately and conduct a detailed audit of books to ensure no irregularity.

2. Issue: Opeining too many MoveBars Impact: Although the gross margin is high, it might not be profitable on a net level to open MoveBars and so, so many at the same time can prove disastrous right before the IPO. Recommendation: Should scale back on the investment in MoveBars until model is successful.

3. Issue: Keeping an eye on HR issues Impact: The lawsuit could be a big hit for GMI and it is concerning that some of the staff were involved and they were likely not disciplined. This can deteriorate the culture of GMI if left unchecked. Recommendation: Hire an HR Manager if Trey does not have time resolve this issue ASAP.