QUESTION

You are Leslie Canton, the recently appointed group financial manager of Sizacom Ltd. Sizacom Ltd is listed on the JSE Securities Exchange South Africa and is the owner and operator of a cellular telecommunications network in South Africa. The Group Financial Director of Sizacom Ltd, Mr James Parfitt, sent you the following memorandum:

TO: Leslie Canton, Group financial manager
FROM: James Parfitt, Group Financial Director
DATE: 15 January 2004
SUBJECT: Various accounting issues - financial year ended 31 December 2003

At the board meeting last week, Ms Tania Sookha, an independent, non-executive director, raised questions about a number of issues, which are described below. Ms Sookha is a recent appointee to our board who wants to ascertain whether these issues are being appropriately addressed as part of our current year-end procedures.

1 Customer acquisition costs

This matter relates to the two types of cell phone users that Sizacom Ltd has, namely contract customers and prepaid customers.

(a) Contract customers

The contract customers sign their contracts with service providers who act as agents for Sizacom Ltd in the sale of airtime. In terms of their contracts, these customers pay a fixed monthly amount for access to the Sizacom network. They are billed monthly in advance for the access fee and monthly in arrears for airtime usage (outgoing calls).

All contracts are for a period of 24 months and the customer may not cancel the contract during this initial 24-month period. After that period, customers may continue with the original contract, which they may cancel at any time with notice of one month, or alternatively sign a new non-cancellable 24- month contract (a renewal contract). Many customers choose the second option (a renewal contract) because the service providers offer discounted cellular phone handset upgrades as an incentive for entering into a new contract. The service providers are able to offer the discounted cellular phone handsets using the customer acquisition bonus described below.

When a contract is signed, irrespective of whether it is a first-time contract or a renewal contract, Sizacom Ltd pays an acquisition bonus of R1 500 to the relevant service provider. These acquisition costs are recognised as non-current assets and amortised over a period of 24 months.

(b) Prepaid customers

The prepaid customers purchase their "starter packs" and airtime vouchers from retailers such as garage shops, supermarkets and general dealers. Customers initially register for this service by purchasing a "starter pack", which includes a SIM card and an airtime voucher, and from then on prepay for their airtime by purchasing vouchers of various denominations from the retailers. Sizacom Ltd sells the vouchers to retailers at a discount to their face value.

For every "starter pack" purchased, Sizacom Ltd pays a customer acquisition bonus of R1 000 to the relevant retailer. However, the retailer is only entitled to the customer acquisition bonus once the SIM card has been activated. These customer acquisition costs are also recognised as non-current assets but are amortised over a period of 18 months.

2 Defined benefit fund

A report from Sizacom Ltd's actuaries, relating to the Sizacom Ltd Pension Fund, a defined benefit fund, was tabled at the board meeting. The report contained the following information:

31 December
2003 2002
R'000 R'000
Plan assets
Market value - beginning of year 25 900 25 000
Contingency reserve - beginning of year (2 590) (2 500)
Employer contributions 3 300 3 000
Employee contributions 3 300 3 000
Expected return on plan assets 2 900 4 200
Pension payments (5 300) (5 000)
Actuarial loss (2 800) (4 300)
Movement in contingency reserve (140) (90)
24 570 23 310
Market value - end of year 27 300 25 900
Contingency reserve - end of year (2 730) (2 590)
Defined benefit obligation
Balance - beginning of year 28 180 28 000
Current service cost 3 520 3 200
Interest cost 3 000 2 980
Pension payments (5 300) (5 000)
Actuarial (gain)/loss 500 (1 000)
Balance - end of year 29 900 28 180

Other information

Expected average remaining working life of plan participants

20 years
20 years

The actuaries' report indicated that all amounts, other than the contingency reserve, were determined on the basis of AC 116, Employee benefits. The contingency reserve is an amount set aside in the actuarial determination of contribution rates to cover unforeseen future occurrences.

Sizacom Ltd's annual financial statements for the year ended 31 December 2002 included the following notes:

Accounting policies
Defined benefit plans

If net cumulative unrecognised actuarial gains or losses at the end of a financial year exceed the greater of
• 10% of the present value of the defined benefit obligation at that date, and
• 10% of the fair value of the plan assets at that date,
the excess is recognised on a straight-line basis over the expected average remaining working life of employees in the plan.
Sizacom Ltd Pension Fund
Unrecognised net actuarial losses of R3,1 million (2001: gains of R200 000) are included in the deficit on the defined benefit plan.
3 Black empowerment transaction
On 1 January 2003, Sizacom Ltd issued 10 million ordinary shares to Dludla (Pty) Ltd, a black empowerment investor, for R50 million. In addition, Dludla (Pty) Ltd is entitled to a bonus payment on 31 December 2007 if the return on a notional investment in Sizacom Ltd shares for the period from 4
1 January 2003 to 31 December 2007 exceeds 15% per annum, compounded annually. In terms of the agreement, the bonus payment will be calculated as follows:
B = (P - Y) * 5 000 000
Where: B
P
Y
=
=
=
Bonus payment

Weighted average share price of Sizacom Ltd for the month of December 2007 Share price of Sizacom Ltd on 1 January 2003, inflated by 15% per annum, compounded annually and adjusted for dividend payments

According to the original proposal from Flag Bank Ltd, who structured the above deal, the fair value of the bonus payment element at 1 January 2003 was R3 million. Last week Flag Bank Ltd informed me that the fair value of the bonus payment element at 31 December 2003 amounted to R3,5 million.

REQUIRED

(a) Prepare a report to the Group Financial Director of Sizacom Ltd, in which you

• evaluate, with reasons, the recognition and measurement of customer acquisition costs; and
• recommend changes to these practices where appropriate.

(b) Discuss the current income tax and deferred tax implications of the customer acquisition costs for Sizacom Ltd.

(c) Prepare journal entries to record the movement in the defined benefit liability or asset arising from the Sizacom Ltd Pension Fund in the financial statements of Sizacom Ltd for the year ended 31 December 2003. Show all supporting workings. Narrations are not required.

(d) Prepare a reconciliation of the defined benefit liability / asset as disclosed in the annual financial statements of Sizacom Ltd at 31 December 2003 to the plan assets and defined benefit obligations of Sizacom Ltd Pension Fund at that date.

(e) Discuss, with reasons, the appropriate recognition and measurement of the potential bonus payment to Dludla (Pty) Ltd in the annual financial statements of Sizacom Ltd for the year ended 31 December 2003.