Saltonspruse Pty Ltd v Brencorp Investments No 3 Pty Ltd (formerly Vac-Tech Group Pty Ltd)
[2005] VSC 65
•24 March 2005
| IN THE SUPREME COURT OF VICTORIA | Not Restricted |
AT MELBOURNE
COMMERCIAL AND EQUITY DIVISION
No. 7012 of 1998
| SALTONSPRUSE PTY LTD (ACN 052 509 789) | Plaintiff |
| v | |
| BRENCORP INVESTMENTS NO.3 PTY LTD And BRENCORP INVESTMENTS NO.2 PTY LTD | First Defendant Second Defendant |
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JUDGE: | Byrne J | |
WHERE HELD: | Melbourne | |
DATE OF HEARING: | 14, 15, 16, 17, 21 and 22 February 2005 | |
DATE OF JUDGMENT: | 24 March 2005 | |
CASE MAY BE CITED AS: | Saltonspruse Pty Ltd v Vac-Tech Pty Ltd | |
MEDIUM NEUTRAL CITATION: | [2005] VSC 65 | |
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Contract – adjusted profit before tax – whether asset revaluation to be shown in accounts as expense – Accounting Standard AASB 1010 – whether profit on sale of assets to be shown in accounts as extraordinary item – Accounting Standard AASB 1018.
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APPEARANCES: | Counsel | Solicitors |
| For the Plaintiff | Mr M.A. Lincoln with Mr J.D. Wilson | Klonis Kirby & Co |
| For the Defendants | Ms Elspeth Strong SC | Freehills |
HIS HONOUR:
According to its Directors’ Report dated 23 October 1993, the firstnamed defendant, Brencorp Investments No 3 Pty Ltd, in the year 1992-3, conducted the business of catalyst handling and waste disposal, investment, industrial cleaning and oil recycling. This company was at the time called Vac-Tech Pty Ltd (“VT”) and I shall refer to it by that name notwithstanding the later change. There were, prior to September 1992, three directors at VT, Louis Rotman, David James Gravell and Douglas James Leech. Each of the directors, or interests associated with them, held 35 ordinary shares in VT.
VT conducted business in the period prior to September 1992 in Melbourne, Geelong and other parts of Victoria. It also expanded into other States. It purchased a Queensland operation called Brian Beckett Pty Ltd and shares in Enicraft which owned land in Sydney and Brisbane. In the late 1980s and early 1990s VT also established operations in Kwinana WA, Port Headland and Karratha, using connections established by Lyons & Peirce, another enterprise in Western Australia which it had acquired. According to Mr Gravell, a further business or businesses, Pics Axlo New South Wales and Pics Axlo Sydney and three other businesses were purchased but he does not identify whether this was before or after November 1992.
This expansion in its operations was funded by external borrowings at a time when interest rates were very high, so that its interest burden had become considerable and, in 1992, the directors decided to sell the shares in VT or some of them to an outside investor. A sale was ultimately agreed with Peter Daniel Scanlon and his Brencorp Group of Companies. In September 1992 a contract was entered into with Brencorp Investments Pty Ltd (“Brencorp”) whereby the Rotman and Leech shares and part of the Gravell shares in VT were sold to Brencorp. At the same time, consultancy agreements were entered into between VT and the outgoing directors or their interests, that is Mr Leech and Mr Rotman. Mr Gravell remained with VT as its managing director until 1995.
This case concerns the consulting agreement entered into between Mr Rotman’s company, the plaintiff, Saltonspruse Pty Ltd, and VT and the calculation of Profit before Tax (PBT) under that agreement. As part of this agreement, VT agreed to pay for the consulting services by a monthly base fee at the rate of $50,000 per annum for the four year consulting period from 1 September 1992 to 30 September 1995. This was paid and nothing turns on this. The second component of the consulting fee is an incentive fee which is dealt with in cl. 6.3 of the consultancy agreement. The relevant provisions of this clause are as follows:
“6.3Incentive Fee
(a) For the purposes of this clause 6.3 and Schedule:
‘Accounting Year’ means each financial year of the Company ending on 30 June during the Consultancy Period as defined in this clause 6.3(a);
‘Adjusted PBT’ means, in relation to an Accounting Year, the aggregate of the consolidated pre-tax profit of the Company for that Accounting Year (calculated in accordance with the principles set forth in the Schedule) and any Carried Over PBT included for that Accounting Year in accordance with clause 6.3(b);
‘Applicable Accounting Standards’ has the same meaning as in Section 9 of the Corporations Law;
‘Associate’ has the same meaning as in Section 11 of the Corporations Law;
‘Carried Over PBT’ means, in relation to any Accounting Year, any amount to be included in the Adjusted PBT for that Accounting Year in accordance with clause 6.3(b); and
‘Consultancy Term’ means a period of four (4) years commencing on 1 July 1992 and ending on 30 Jun 1996.
(b)If the Adjusted PBT in any Accounting Year exceeds $1,400,000 (one million four hundred thousand dollars), then the amount of the excess shall for the purposes of this clause 6.3 be included in the Adjusted PBT for the next occurring Accounting Year provided that, if the Consultant elects, all or part of such excess may instead be aggregated to the Adjusted PBT for a previous Accounting Year in which the Adjusted PBT was less than $1,400,000 (one million four hundred thousand dollars) (a 'Deficit Year') in which case the Adjusted PBT for that Deficit Year shall be recalculated and the Company shall pay the Consultant any additional Incentive Fee in respect of that Deficit Year at the same time as the payment of the Incentive Fee for the current Accounting Year.
(c)If the Adjusted PBT in any Accounting Year exceeds $800,000, (eight hundred thousand dollars) the Company shall pay to the Consultant an Inventive Fee equal to the aggregate of $80,000 (eighty thousand dollars) plus 20 per centum of the amount of the excess provided that, subject to clause 6.3(f) the maximum Incentive Fee payable in respect of any Accounting Year shall be $200,000 (two hundred thousand dollars).
(d)Subject to clause 6.3(e), the Company shall pay to the Consultant any Incentive Fee payable pursuant to this clause 6.3 within one month of the completion of the audited profit/loss and balance sheet for the Accounting Year to which that Incentive Fee relates and in any event no later than 31 October which shall be 'Due Date' for the purposes of clause 6.8 following that Accounting Year.”
For completeness, although the definition formed no part of the submissions of either party, I mention the definition of Applicable Accounting Standards. In s. 9 of the Corporations Law, “accounting Standard” in relation to the financial statements of a company or group of companies for an accounting period is there defined, rather unhelpfully, to mean “an accounting Standard that when the financial statements are made out:
(i) applies to that accounting period; and
(ii) is relevant to the accounts.”
The schedule to the consultancy agreement contains a Statement of Accounting Principles for the purposes of cl. 6.3. I set out the relevant provisions of this schedule.
“In calculating Adjusted PBT for the purposes of clause 6.3(e):
1.the Consultant and the Company acknowledge that the Company has in the past prepared its accounts using Applicable Accounting Standards;
2.the Company shall continue to prepare its accounts using Applicable Accounting Standards;
3.in calculating the consolidated pre-tax profit of the Company for any Accounting Year:
(a)extraordinary items (within the meaning of the Applicable Accounting Standards) shall be excluded;
(aa)the effects of any changes in application of accounting standards (as disclosed by the Company's auditor pursuant to clause 6.6) shall be added/subtracted (as the case may be) to the Adjusted PBT…”
Paragraph 3(d) of the schedule provides that the accounts are the consolidated accounts of VT and subsidiaries and associated companies. Shortly after the Brencorp takeover, VT sold its business to the secondnamed defendant Vac-Tech Group Pty Ltd which later became known as Brencorp Investments No. 2 Pty Ltd. I shall refer to this company also by its earlier name, Vac-Tech Group Pty Ltd (“VTG”). The accounts therefore which were the subject of examination at this trial were the consolidated accounts of VTG.
In the course of the trial many of the disputes regarding entries in the accounts of VTG have disappeared. So, too, has the contention of Saltonspruse that VTG had assumed liability to pay the incentive fee. It is now agreed that VTG will be jointly liable with VT for the incentive fee (if any) which is found to be due to Saltonspruse.
The accounts prepared on behalf of VTG show no incentive fee is payable, for in none of the four years did the PBT exceed $800,000. On behalf of Saltonspruse, it was contended that a further adjustment must be made for each of the years 1994, 1995 and 1996 so that for the years 1994 and 1996 the PBT, before the application of the cl. 6.3(e) profit carry over, exceeded $1.4M. The positions of the parties appear from the following table:
Y/E Saltonspruse VTG 1993 $778,088 $778,088 1994 $1,798,386 $(701,615) 1995 $(129,772) $165,473 1996 $2,126,974 $73,751
There were essentially two points of difference: whether an asset revaluation of $2.5M in the accounts for 1994 should be added to profit and whether the $2,247,500 profit on the sale of certain assets in Singapore in 1996 should be included in the profit for that year. The acceptance of these adjustments would have certain other consequences, but these were not contentious.
It will be recalled that the statement of accounting principles in the consultancy agreement requires an assumption that VT has in the past prepared its accounts using “Applicable Accounting Standards” and that it will continue to do so. It was not in issue before me that this was an accurate statement of fact.
There was some debate in the course of the trial as to what accounting Standards VTG was required by law or by accountancy convention to apply. This provoked evidence and debate directed to whether it was a “reporting entity” within the definition in Accounting Standard AASB 1025 cl. 27, so that it was required to prepare “general purpose financial reports”. VTG denied this. If, however, it was in fact, required to prepare general purpose financial reports, Accounting Standard AASB 1028 required it to comply with further Standards AASB 1010 and AASB 1018. VTG denied that it was obliged to comply with these further Standards.
This issue, like so many others in this case, disappeared as the trial moved on because the evidence showed, and it was accepted, that VT had, prior to the Bencorp sale, prepared its accounts to these further Standards and, after the sale, its accountants and auditors continued this practice. In terms of the consultancy agreement, the questions for my determination, thereafter, are whether the treatment of the two transactions in question complied with those Standards. I mention in passing, with some regret, that notwithstanding the extensive pleadings in this case these two issues were not identified in any of those documents.
The Asset Revaluation
The VTG consolidated accounts show that, as at 30 June 1993, some nine months after the sale to Brencorp, the value at cost of its plant and equipment was $2,697,051, which became, after depreciation, $2,468,007. This represented a substantial increase from the value after depreciation in the 1992 accounts of $311,713. It does not appear whether these purchases were made before or after the sale to Brencorp in September 1992. The policy of purchasing plant and equipment continued throughout 1993-4, for a further $2,403,981 was added to the inventory in that year. This meant that, after allowance is made for sales of assets and for depreciation, the value of plant and equipment on 30 June 1994 was $4,137,494. This was revalued down by the directors to $1,637,494, and this is the figure which appears in the notes to the 1994 balance sheet as the “directors valuation” of the non-current assets. The amount of the revaluation decrement was $2.5M.
It was for some time suggested on behalf of Saltonspruse that this was a deliberate transaction to defeat its claim for incentive fee for that year. This was denied by the directors and accountants for VTG who were called to give evidence. But the point was, in the end, not pressed. I accept that it may be proper for directors to revalue assets for good commercial reasons and I do not undertake any enquiry into this matter. The question is whether the revaluation decrement should be included in the accounts for the purposes of calculating the PBT and this question must be considered in terms of the applicable Accounting Standard AASB1010.
It was suggested on behalf of VTG that I should see this revaluation as part of a balance sheet restructure which also included what was called a debt for equity swap between another company in the Brencorp group, Brencorp No 2 Pty Ltd (“Brencorp No 2”), and VTG. This transaction, which was approved by the VTG board on 27 June 1994, involved two matters. First, the issue by VTG to Brencorp No 2 of one million fully paid $1 ordinary shares in exchange for $1M payment, which payment was effected by a reduction in the loan owed by VTG to Brencorp No 2. And, second, the forgiveness by Brencorp No 2 of a further $2.5M which VTG owed to it on loan account. This, the second part of the debt for equity swap transaction, would have the consequence of including as an abnormal profit item on the profit and loss account, the $2.5M notionally received for the forgiven debt. It was then put that the revaluation down of the assets in the same figure preserved the accuracy of the balance sheet and, at the same time, included this $2.5M as an abnormal loss item on the profit and loss account.
The response put by counsel on behalf of Saltonspruse was that I should not look at the transaction in this way. As with their suggestion that the revaluation had the objective of reducing the PBT so as to defeat the claim of Saltonspruse to the incentive fee, the suggested commercially respectable objective of the revaluation was equally irrelevant. I agree. The question remains whether the inclusion of the revaluation decrement in the accounts for the purposes of cl. 6 of the consultancy agreement represents a change in the application of the applicable Accountancy Standard, AASB1010. I therefore turn to this Standard, which is that reissued in April 1993.
Paragraph 12 of the Standard provides as follows:
12.Subject to paragraph 13, a downwards revaluation of a non-current asset shall be undertaken when, and only when, its carrying amount is greater than its recoverable amount. In this situation the asset shall be revalued to its recoverable amount.
Paragraph 13 is not relevant for present purposes. Paragraph 9 includes the following definitions:
“’carrying amount’ means:
(a)in relation to an asset, the amount at which the asset is recorded in the accounting records as at a particular date. In application to a depreciable asset, ‘carrying amount’ means the net amount after deducting accumulated depreciation or amortisation; and
(b)in relation to a class of assets, the sum of the carrying amounts of the assets in that class;
‘recoverable amount’ means, in relation to an asset, the net amount that is expected to be recovered through the cash inflows and outflows arising from its continued use and subsequent disposal;
‘revaluation’ means the act of recognising a reassessment of values of non-current assets as at a particular date.”
That this was accepted as the Standard for the revaluation of the non-current assets of VTG in 1994 is put beyond doubt by the following statement in its Financial Reports for that year in Note 1(e): “Where the carrying amount of an individual non-current asset is greater than its recoverable amount the asset is revalued to its recoverable amount”.
The carrying amount is in this case $4,137,494, being the written-down value in the books of VTG immediately prior to the revaluation. The question therefore is whether the revaluation reflected the recoverable amount of the assets in question.
The decision to revalue was made by two of the four[1] directors of VTG, Mark William Hardgrave and Mr Scanlon. Mr Scanlon who was also the principal executive officer of VTG did not give evidence. Mr Hardgrave said that he took primary responsibility for the decision although he did discuss it with Mr Scanlon. The other director, Mr Gravell, said that he did not participate in the decision.
[1]The fourth, Mr Kelsey, is shown on the ASIC search as ceasing to be a director on 30 June 1994.
It is apparent from Mr Hardgrave’s evidence that the decision to revalue down by $2.5M was not based on any independent evaluation of the assets individually, as suggested in Note 1(e) or of a group of assets. Nor was it based on any belief by him or the directors that the revalued figure represented the value, in the sense of market value, of the assets. Nor was it affected by the actual income which was expected to be recovered for the company from the assets concerned. Nor, it would seem, did it have regard to any “estimates of remaining useful lives” of them or of groups of them, as is mentioned in Note 1(h).
Mr Hardgrave spoke of the amount of the loan debt owed by VTG to Brencorp No 2. As at 31 May 1994 it stood at $4.9M. He said that the 15% interest payable to Brencorp No 2 was a crippling outgoing on the profit and loss account and that, as a director, he was not happy that it should continue. Accordingly, the debt for equity swap was commercially reasonable, and even necessary.
Be that as it may, it does not explain the revaluation. All Mr Hardgrave says about this is that the net effect of this and of the debt forgiveness was nil. This may be not quite correct, for it ignores the forgiveness of the accrued interest, but it is, in any event, not an explanation which addresses the requirements of the accounting Standard.
When asked about the provenance of the figure of $2.5M selected as the revaluation figure, Mr Hardgrave said that it was not to offset the $2.5M debt forgiveness; it was what he considered necessary to restore the profitability of the company. He explained this by saying that the depreciation of about 15% on these assets was a loss on the profit and loss account which was removed by reason of the asset revaluation.
Later, when pressed with the definition of recoverable amount in the accounting Standard, Mr Hardgrave asserted that his decision to revalue was made with para. 12 of the Standard in mind. He said that the company was making losses; accordingly, it must have been the case that the carrying value of the assets was too high. He was asked, too, how it was that all the assets were revalued down by 60.42% without regard to differences in value or utility between them or groups of them. His response was that he was looking at the “big picture” and that he did not want to go to the trouble and expense of a line by line valuation which, he said, would produce the same answer.
I must say I found this evidence very unconvincing. But it is not necessary for me to make a finding about this because his answers, whatever may be their accuracy, demonstrate that the essential criterion for revaluation contained in para. 12 of the accounting Standard was ignored. The analysis of the revaluation undertaken by the plaintiff’s forensic accountant, Peter Bruce Wilkinson, demonstrates this. He shows that all non-current assets of $4.13M were revalued by a uniform 60.42%. Of these assets, $2.4M were purchased within 12 months of the revaluation and some were even shown in the depreciation schedule as having been acquired in June 1994, the month of the revaluation. It is to my mind an irresistible conclusion that someone decided that the non-current asset item on the balance sheet must be reduced by $2.5M, and that this was given effect to with the consequence that the decrement was recognised as an expense in the profit and loss account and, as a result, it reduced the PBT for that year.
Of the commercial reasons for or even propriety of such revaluation, I say nothing. The fact remains that the accounts which were prepared including this revaluation did not fulfil the purpose of Standard AASB 1010 as expressed in para. 7 and did not comply with para. 12. It follows that, with respect to this item, the accounts were not prepared in a way that complied with the Applicable Accounting Standards which had been used in the past. There had been a change in the application of these Standards within the meaning of paragraph 3(aa) of the Schedule to the consultancy agreement so that, for the purpose of cl. 6.3 of that agreement, the item must be removed from the profit and loss account and the PBT for 1994 increased by $2.4M.
An agreed consequence of the reversal of this item is that the outgoings for depreciation in the PBT calculation must be increased by $295,245 in 1995 and $194,285 in 1996.
Profit on the Sale of the Singapore Operation
The point at issue here is whether $2,247.500, which is agreed to be the profit on the sale of certain assets of VTG and a Singaporean subsidiary, Vac-Tech (Singapore) Pte Ltd (VTS), should be treated as an extraordinary item within the meaning of the Applicable Accounting Standards and therefore excluded from the calculation of PBT pursuant to paragraph 3(a) of the Schedule to the consultancy agreement.
The relevant Standard is AASB 1018 in which the following definitions appear in paragraph 9:
“’extraordinary items’ means items of revenue and expense which are attributable to transactions or other events of a type that are outside the ordinary operations of the company or economic entity and are not of a recurring nature;
‘ordinary operations’ means operations of a kind carried on regularly from financial year to financial year to achieve the objectives of the company or economic entity;”
Paragraph 3 deals with interpretation.
3This Standard is to be interpreted in accordance with the Corporations Law, including Parts 1.2 and 3.6. The commentary contained in this Standard can be used, subject to section 109J[2] of the Corporations Law, as an aid to interpreting the accounting Standards set out in this Standard.”
[2]This section, which deals with extrinsic evidence as an aid to interpretation is not relevant for present purposes.
Paragraph 16 requires that the aggregate amount of all extraordinary items be disclosed in the accounts after operating profit or loss after income tax. Much reliance was placed on paragraph 17 of the Standard and the commentary on this paragraph:
“17Each extraordinary item shall be shown net of applicable income tax, the amount of such tax being stated for each item.
Commentary
(xiv)In most cases, items of revenue and expense recognised by a company or an economic entity during a financial year derive from the ordinary operations of the company or economic entity during that year or, whilst not deriving from ordinary operations, result from transactions or other events that are of a recurring nature. On rare occasions, however, there can be items which are extraordinary in that they have their origin outside those operations and are not of a recurring nature. A transaction or other event that would be outside the ordinary operations of one company or economic entity may well be part of the ordinary operations of another. For an item to be classified as extraordinary, it is necessary for it to be both outside the ordinary operations of the company or, for consolidated accounts, the economic entity and for the underlying transaction or other event to be of a type that is not of a recurring nature.
(xv)It is expected that only on rear occasions will items fall within the definition of extraordinary items. Examples of such items are:
(a)the sale or abandonment of a significant business or all the assets associated with such a business; and
(b)the condemnation, expropriation or unintended destruction of a property.
(xvi)The fact that an item relates to one or more prior financial years in no way contributes to its classification as an extraordinary item.”
I construe these definitions to mean that, before a transaction can be treated as extraordinary, it must satisfy both of two limbs of the definition –
(a) it is outside the entity’s normal operations; and
(b) it is not of a recurring nature.
The underlying facts were not very much in dispute. Soon after the sale to Brencorp, VTG expanded its operations into Singapore. It acquired a majority holding in VTS and, ultimately, VTS became its wholly owned subsidiary. According to Mr Gravell, the Singapore operation carried on the work of removing oil sludge from crude oil tanks and then processed the sludge to recover hydro-carbons which were reused in the refining process. It also removed catalyst from the reactors at refineries and transported the catalyst to Australia where it was reused as road base.
Mr Gravell said that the Singapore operation was set up as another division of VTG. Lawrence Andrew Fitzgerald, an experienced chartered accountant, said that VTS, as a subsidiary of VTG, may be seen as a branch of the group’s operation. There was, however, some debate between the witnesses as to whether it should be seen as a separate business within the VTG group of companies or as a branch of their single business.
It seems that in 1991 VT had constructed in Victoria a solid liquid treatment machine (SLT). This, and the technology associated with it, came to the Brencorp group of companies when they took control of VT in late 1992. Shortly thereafter, its assets including this technology passed to VTG. The SLT was operated in Australia as part of the activities of VTG until it was transferred to the new Singapore operation towards the end of 1993. By this time a second SLT had been constructed in Australia and this, too, was sent to Singapore. The second unit, however, returned to Australia in November 1994, presumably for use in this country, where it remained until mid-1995 when it was returned to Singapore for inclusion in the sale. Meantime, the first SLT unit deteriorated and a third unit was built in Singapore in about early 1995. I mention all of this because the second and third SLT units were substantial assets dealt with in the Singapore sale.
By agreement of sale dated 9 June 1995 entered into between VTS and VTG as vendors and Tat Lee Engineering Pte Ltd (“Tat Lee”), the business of sludge treatment, catalyst handling, environmental services and industrial cleaning services was sold to Tat Lee for $3.2M. The subject matter of the agreement was all, or nearly all, of the assets of VTS other than book debts recoverable[3] and liabilities of VTS[4] and VTG, cash and insurance claims. Sub-clauses 3(A) and (B) show that chattels sold by the vendors, VTS and VTG, represented $1.98M and that equipment and machinery sold by VTS represented $1.2M of the sale price. The remaining $20,000 must therefore represent the other assets transferred. In the separate accounts of VTS for 1996 the sum of A $2M is wholly attributed to the sale of fixed assets.
[3]Trade debtors, other debtors and cash are shown in the separate VTS balance sheet of 30 June 1995 at S$411,967.
[4]Trade creditors and accrued expenses are shown in the VTS separate balance sheet as at 30 June 1995 at S$499,356.
Paul Lom, a chartered forensic accountant, retained by Saltonspruse, analysed the transaction and concluded that the accounts showed that the chattels which were sold for $1.98M were recorded in the books as an asset of VTS, whereas the equipment and machinery, which were located partly in Australia and partly in Singapore, and for which $1.2M was allocated, were wholly recorded as an asset of VTG. The profit of VTS on the sale was S$731,186 (A$751,476[5]) and that of VTG was A$1,547,222.
[5]Conversion rate 0.9730 was adopted for the transaction.
It cannot be doubt that, at the time of the sale, the Singapore enterprise represented a considerable part of the operating activities of the VTG group of companies. Its assets, as shown in the 1995 accounts, of $1.645M represent 17% of consolidated assets before eliminations and it contributed 15% of total revenue. Notwithstanding this, it returned a net loss of $215,281 in that year which substantially off-set the profit of $380,754 earned by VTG from its Australian activities. In the preceding year, the accounts show that the Singapore loss was very much greater, $677,366. Notwithstanding that it remained a wholly-owned subsidiary of VTG after the sale, the financial statements of VTS were not included in the consolidated accounts of VTG for the year 1996 because it was placed in members’ voluntary liquidation on 29 April 1996. Its separate accounts for that year, however, described its principal activities as those of “waste management and environmental services” with a turnover in the ten months to liquidation of S$81,768 (A$84,037) and a profit before “other income”[6] of S$16,835 (A$17,302). The VTS accounts also show that part of its working capital, in excess of $2M, was provided upon an unsecured interest-free loan from VTG. The group profit on the sale of the operation of $2,247,500 was not in issue. The position taken on behalf of VTG was that it is an extraordinary item, first, because it is attributable to a transaction that was outside the ordinary operation of the reporting entity and, second, because it was not of a recurring nature.
[6]Including the profit on sale of assets of S$731,186.
The first of these reasons did not require much development. VTG and VTS were in the business of catalyst handling and waste disposal, industrial cleaning and oil recycling. In the Directors’ Reports of 1994, 1995 and 1996, these are described as its principal continuing activities.[7] It was not in the business of selling businesses for profit.
[7]Contrast the report of 1993 which has a further activity, that of investment. See [1] above.
On behalf of Saltonspruse, counsel pointed out that the acquisition of companies and businesses had been a feature of its activities over the past few years and that this should been seen as part of its operations carried on from year to year to achieve its businesses objectives. So too, the disposal of these assets at a profit should be viewed in the same light.
My attention was drawn to Commentary (xv) to paragraph 17 of the Standard which gives an example of an extraordinary item – the sale by the reporting entity of “a significant business or all assets associated with such a business”. On behalf of VTG it was put that this is a fair description of the sale of the Singapore business assets. In response, it was contended that this was not a sale of the assets of a significant business but, rather, the sale of the assets of a significant part of a business.
Notwithstanding that the words of the Standard are ordinary English words which do not have a special trade or professional meaning, each party led evidence without objection from experienced accountants as to how the expression “extraordinary items” in this Standard is understood in the accounting profession.
The first was Peter Bruce Wilkinson, a chartered and forensic accountant retained by Saltonspruse. He pointed out, and it was generally accepted, that an item of this kind may change its characteristic as the identity of the reporting entity changes. So, from the point of view of VTS which was selling most of its assets, the transaction would be viewed as extraordinary. On the other hand, from the point of view of the parent company, VTG, the position may be otherwise where the transaction is merely the disposal of a part of its business, akin to the closure of a branch office. He pointed out that the Singapore operation was truly part of the broader activities of VTG and its associated companies. VTG provided management time for its establishment and operation and, after the sale, the loan liability of VTS, which remained part of the VTG group of companies, to VTG of S$103,000 was forgiven before VTS was wound up. Accordingly, the item was not an extraordinary one.
Mr Lom, the other forensic accountant called by Saltonspruse, agreed with this conclusion. When pressed in cross-examination as to the basis for his opinion, he said this was because, after the sale, the economic entity, the VTG group of companies, continued operating exactly the same business. He added that not every sale of a business by an economic entity must be treated as outside its ordinary operations. “Companies do in their normal operation open businesses and close businesses. It is part of the normal operation of growing businesses and reallocating assets from one enterprise to another enterprise”. In this sense, too, it cannot be said that such a sale is a transaction that is not of a recurring nature. It is only when the entity disposes of a substantial and discrete business activity that the transaction satisfies the second limb of the definition, for one can only dispose of a discrete business once.
The independent accountant called on behalf of VTG was Mr Fitzgerald. He expressed the opinion that the transaction in question is clearly an extraordinary item. He explained in evidence that this was because the Singapore operation was sold as a business. It was a strategic decision by VTG to exit the market in Singapore by disposing of its separate business there. A disposition of that kind could not be seen as of a recurring nature because that business had gone.
It appeared that his view, like that of Mr Lom, was that a critical criterion of a sale of a business as an extraordinary item is whether the business sold was a separate entity. In the opinion of Mr Fitzgerald this may be determined by an examination of the organisational structure of the business and the group of which it forms part. If the business disposed of was independent, so that the purchaser could continue its operations using existing management, staff and assets, then it should be seen as sufficiently separate to treat the transaction as extraordinary. Mr Lom, on the other hand, would also want to have regard to the impact of the sale upon the commercial activities of the vendor. If these were unchanged notwithstanding the loss of the assets sold, it could not be said that the transaction satisfied the definition of “extraordinary” in the Standard.
Before I express my conclusions as to this conflict, I will make mention of the evidence on this point given by those who were actually involved in the accounts which recorded the transaction. It was not very illuminating. Mr Hasler, the company accountant, said only that he was guided in its treatment by Graeme Walker Arnold, a chartered accountant employed within the Brencorp group and a director and secretary of VTG. Mr Arnold said only that he was involved in the decision to treat the sale as an extraordinary item and had some discussions about it with John Charles Garrard, a fellow director. No further details were provided by either witness of these communications or of their reasoning. Mr Garrard said only that he signed off the accounts. All these men said, without much more, that they were aware of the provisions of the Standard AASB 1018 and were and remain of opinion that the transaction was properly characterised as extraordinary. I regret that the evidence of these witnesses was of little assistance to me.
Ultimately, the question comes down to a mater of construction, informed by the apparent objective of the Standard. This objective, which is set out in paragraph 1 is to require “the inclusion in the determination of the profit or loss of all items of revenue and expense including adjustments relating to prior financial years” subject to certain immaterial exceptions, and to require disclosure in the profit and loss account of information about this. For this purpose, profit or loss means “the operating profit or loss and extraordinary items of the company after applicable income tax expense”[8].
[8]See para 9 definition of “profit or loss”. See also para 16 of the Standard.
For revenue or expense from a transaction to be recorded as an extraordinary item, it is necessary that the transaction have the two characteristics which I have previously identified: that it be outside the ordinary operations of the entity and that it be of a non-recurring nature. The inquiry in each case does not involve an examination of the historical commercial activities undertaken by the entity, so much as an examination of the nature of the transaction itself in the context of the business of the entity. The expert accountants agreed that the sale of an item of manufacturing plant would not ordinarily satisfy either limb notwithstanding that the ordinary business of the entity was that of manufacturing, not that of buying or selling plant. Furthermore one can only sell a particular item of plant once. This is because it might be appropriate in the furtherance of the manufacturing business of the entity to sell obsolete plant and to acquire new plant. The revenue or expense generated by the sale, therefore, should appear in the profit and loss account as a normal or abnormal item, depending upon its size and significance. Likewise, I understood the experts to be in agreement that the sale of the whole manufacturing enterprise would be properly treated as extraordinary. The point of difference upon which opinions might legitimately differ is where the line is to be drawn between these two extremes.
The evidence showed that VTG and its subsidiaries in 1995 and 1996 conducted the business of catalyst handling, waste disposal, industrial cleaning and oil recycling, as they had for some years, even before the Singapore enterprise was established. For this purpose, the companies in Australia and Singapore in those two years used the SLT machines, and VTS enjoyed the benefit of management, engineering and financial resources and equipment and machinery worth A$1.2M provided by VTG. While it is true that the sold assets of the Singapore operation represented nearly all of the assets of VTS, it did not represent anything like the totality of the assets of resources of VTG. The parent company was able to continue as before conducting the same businesses, but not in Singapore. Within Singapore, VTS after the sale appeared to wind down what was left of its business until liquidation.
Mr Fitzgerald looked at the transaction from the point of view of Tat Lee, the purchaser. It seems from the terms of the sale agreement that Tat Lee acquired the whole of the fixed assets of VTS and perhaps other of its assets other than debtors. It took over its leases, its work in progress, contracts, goodwill and, it seems, the employees of VTS. It is, however, significant that the other resources available to VTS as a member of the VTG group of companies were not required by the sale. The technical expertise of Mr Leech, for example, was the subject of a separate consultancy agreement. VTS was presumably required to provide its own managerial and financial support for the conduct of the business which it acquired. In that sense, it was not an independent business which was disposed of.
For these reasons I conclude that the approach offered by the plaintiffs’ accounting witnesses is to be preferred. The accounting Standard AASB 1018, properly applied, required that the profit on the sale of the Singapore assets not be treated as an extraordinary item. Accordingly an adjustment must be made for it for the purposes of calculating PBT under the Soltanspruse consultancy agreement.
The consequence of such an adjustment was agreed by the parties to increase the PBT for the year 1996 to $2,126,974. Since this exceeds the threshold sum of $1.4M specified in cl. 6.3(b) of the Consulting Agreement, the excess of $726,974 was available to be applied as carried over PBT to any previous single accounting year. So much was agreed in final addresses. Counsel for Saltonspruse elected to apply this surplus to the year 1993 so that the adjusted PBT for each of the years 1993, 1994 and 1996 exceeded the amount of $1.4M specified in cl. 6.3(d). Accordingly, the maximum incentive fee of $200,000 is payable in respect of each of these three years.
The position may be demonstrated from the following table:
Year
Adjusted PBT
Incentive Fee
1993
1,505,062
200,000
1994
1,798,386
200,000
1995
(129,772)
Nil
1996
1,400,000
200,000
I will therefore propose that there be judgment for the plaintiff against each of the defendants in the sum of $600,000. I will hear counsel further as to interest and costs.
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