Advanced Financial Accounting - Comprehensive Consolidation Method

Overview

As arbitrator, it is necessary for me to apply my professional judgment and to be objective in my deliberation. There is no clear "right" or "best" solution for many of the issues in which there is disagreement. Many of the recommendations that I make are necessarily disadvantageous to one or more of the parties, since your objectives are in conflict. For example, both Citrus Growers Cooperative (Citrus) and Bottle Juices Corporation (Bottle) will want to maximize their charges to the Company, Tropical, to maximize their cash withdrawal from the Company. In addition, the previous owners of Bottle will want to shuffle revenues or expenses between years to minimize any payments to Douglas Investments Limited (DIL), as required by the sale agreement of Bottle.

To avoid interpretation problems from occurring in the future, it is necessary for the shareholder agreement to be clarified. For example, it is necessary to clarify whether the 16% charge that Bottle is permitted to charge Tropical is intended to represent interest, depreciation, or both. Furthermore, it is not clear whether this rate is to be applied to the original cost, or the net depreciated amount. Other vague terms in the agreement include "reasonable charges" and "fair value." Clarifying these terms may mean rewriting the agreement, or at least drafting a written addendum to the original agreement.

Interpretation of agreement

To ensure internally consistent reasoning on the issues presented, it is necessary to clarify the intent of the agreement.

The agreement could be interpreted as a means of reimbursing each of the owners for their transactions with Tropical. It would then be necessary to determine how to account for these disbursements within Tropical's financial statements. These statements should be prepared in accordance with generally accepted accounting principles for private enterprises (ASPE) as required by the agreement.

Alternatively, the agreement could be interpreted as a means of dictating how the "net income" of Tropical is to be determined for it to be distributed to each of the owners.

This latter alternative seems to be the likely intent of the agreement in view of its apparent efforts to try to match charges to the revenues (such as the 16% charge). However, the first alternative may be easier in implementing the agreement between DIL and the previous owners of Bottle, since the statements of Tropical would not have to be restated to comply with ASPE.

In analyzing each of the concerns you have presented to me, I have interpreted the agreement as the latter interpretation - as a means of reimbursing the owners for their transactions with Tropical. I have analyzed the accounting policies used by Tropical with reference to the shareholder agreement. DIL requires the accounting of Tropical to be in accordance with ASPE to determine the payments, if any, required by the previous owners of Bottle. Accordingly, I have indicated, where necessary, the adjustments that would have to be made to Tropical's statements so that they are in accordance with ASPE for DIL's purposes.

Below I have addressed the concerns raised by each of you.

Concerns of Citrus

Charge for bottles

The full charge by Bottle for the returnable bottles it purchased on behalf of Tropical can be considered appropriate, as it is a reimbursable disbursement in accordance with section 2(a) of the agreement. However, this may not seem "fair" to Citrus because the benefit to be derived from these bottles extends over two years. On the other hand, it may be "fair" to Bottle since it had to finance the purchase in the current year.

However, the purchase can also be considered to be a capital investment, since the bottles have a life extending beyond one year. In this case, Bottle should only be reimbursed at a rate of 16% per year based on the cost of the bottles. Obviously, this alternative would not be "fair" to Bottle since it must disburse cash about every two years, yet Bottle is reimbursed over a much longer period.

As a compromise between these two positions, it is recommended that the bottles be expensed in Tropical's statements over the two-year life of the bottles in accordance with the matching principle. [Section 1000.45] Bottle should also be reimbursed at a rate of 16% to reflect its interest cost. Note that I have assumed that the 16% charge allowed by the agreement is intended to represent interest. If it does not, then a market interest rate should be used.

Interest charge on machinery purchase

Whether or not Bottle can charge interest for the machinery purchased depends on the purpose of the 16% charge allowed by the agreement. If this charge is supposed to represent interest, then charging its own interest cost and 16% is double charging for the same item. In this case, I recommend that Bottle be allowed to charge 16% of the cost of the machinery as interest and no other interest.

Note that if the 16% charge is supposed to represent depreciation (contrary to my assumption), then the interest charge by Bottle is appropriate since it was a disbursement made on behalf of Tropical (section 2(a) of the agreement).

Training costs

The costs incurred by Bottle to train employees in the manufacturing and selling of Tropical juices can be fully charged to Tropical in the current year in accordance with section 2(a) of the agreement. Furthermore, if we assume that the benefit to be derived from this employee training will not last beyond the current year, then charging the full amount in the current period is appropriate since it reflects the cost of generating revenue in the current period. [Section 1000.45]

If, however, we assume that these costs provide a benefit beyond the current year alone, then the amount should be charged over the period during which the benefit would be derived. [Section 1000.46] In addition, Bottle would then be reimbursed the equivalent of 16% to reflect the interest on its disbursement (or other interest amount if 16% does not relate to interest only).

I recommend that the full amount be reimbursed to Bottle in the current year since any significant future benefit likely does not exist, and it would be very difficult to measure this period of future benefit. It is likely that there is high staff turnover and job reassignment, given the nature of the industry, and therefore training costs would continue to be incurred on an ongoing basis.

Note that I have assumed that these training costs relate to Tropical's products only. If this is not the case, then the cost should be apportioned between Bottle and Tropical, as required by section 2(b) of the agreement.

16% capital charge

Citrus has expressed concern about the time from which the 16% charge is supposed to apply. Although there are many alternatives as to when the 16% charge should apply, my recommendation is based on the intent of this 16% charge. As previously mentioned, I have assumed that the 16% charge is supposed to represent interest. Accordingly, the amount should be charged from the date that Bottle purchased the machinery.

Citrus's concern may stem from the fact that charges are being made to Tropical even though no revenues have yet been generated. In addressing this "mismatching" concern, we could include this charge as part of the cost of the inventory that was produced. In this manner, the amount would not be deducted from revenues until the inventory is sold, thereby matching expenses to revenues. However, this argument could be applied to all the 16% charges that could be made by Bottle, including those on training costs and bottles. To avoid such arbitrary allocations, I recommend that this amount be expensed in the current period. [Section 1000.45 & .46]

Computer charges

Citrus believes that Bottle should have charged Tropical for its computer services at its cost rather than at the fair value of these services.

Although this charge is reimbursable under section 2(b) of the agreement, the amount is uncertain because of the vagueness of the term "reasonable" in this section. "Reasonable" could be interpreted to mean fair value. Since Citrus can charge Tropical fair value for juice concentrates sold to Tropical, it can be inferred that Bottle should also be allowed to charge fair value for its services.

"Reasonable" could also be interpreted to mean cost, whether it is an allocation of Bottle's cost of the computer, or Bottle's incremental costs of providing the services.

I recommend that Bottle charge Tropical for its incremental costs of providing computer services to Tropical. In this manner, Bottle would be reimbursed for its out-of-pocket costs in providing this service. It appears that Bottle was already using a computer system for its own transactions. This amount is a fixed cost - it is incurred regardless of usage. Therefore, Bottle did not incur this charge on behalf of Tropical. Furthermore, I do not believe that a comparison with Citrus's ability to charge fair value for juice concentrates is appropriate. Juice concentrates are the primary business of Citrus. Under the agreement, Citrus is required to provide Tropical with the necessary supply. Therefore, I assume that fair value was allowed in this instance so that Citrus would not be financially hurt by capacity constraints that prevented it from supplying its own customers. In comparison, computer services provided by Bottle are merely part of its administrative support services.

Strike costs

Citrus is suggesting that Bottle reimburse Tropical for lost sales because of the nonavailability of juices. I assume that Citrus's concern is not the lost sales due to the strike but the fact that Bottle did not resume production of Tropical juices as soon as possible.

The agreement states that it is Bottle's responsibility to provide production facilities for Tropical juices. Citrus could therefore argue that Bottle should reimburse Tropical for all lost profits because of the strike.

This approach may seem unfair to Bottle given that a strike is out of its control to some extent. Furthermore, the strike may provide benefit to Tropical through lower future wage costs. However, Bottle does control how it will use its resources once the strike is over. Producing its own juices only is not in accordance with its responsibility under the agreement, although producing only Tropical's juices would not be "fair" to Bottle either.

As a compromise, I recommend that Tropical be reimbursed for the gross profit on sales that could have been made had Bottle resumed production of Bottle and Tropical juices in the same proportion that existed before the strike. Tropical should not be reimbursed for lost sales that would have occurred because of the strike.

Concerns raised by previous owners of Bottle

Advertising costs

The advertising costs of Citrus for its own products have been partly allocated to Tropical. One could argue that this is properly chargeable in accordance with section 2(b) of the agreement. To the extent that Tropical benefited from this advertising, then this is a joint cost, which could be allocated to Tropical.

However, these costs were not incurred specifically on behalf of Tropical. In fact, the advertising was intended to be for Citrus products only, since only Citrus brand names were included and the advertising was directed at the US population. Therefore, Citrus did not incur any incremental, or additional out-of-pocket, cost on behalf of Tropical.

In keeping with the treatment of computer services that Bottle provided, I recommend that this cost not be charged to Tropical, as there was no incremental cost to Citrus in providing this benefit.

Repair costs

Several factors must be clarified to determine whether the repair costs charged by Bottle are appropriate.

These repair costs are a joint cost and are properly chargeable under section 2(b) of the agreement. This interpretation assumes that the 16% charge on capital investment in assets employed by Bottle is not intended to cover repair costs. (As previously mentioned, I assume that this rate is supposed to represent interest.)

However, it could be argued that no charge is appropriate, since Bottle would have had to repair the machinery anyway for its own production. In essence, Bottle did not incur any additional cost on behalf of Tropical.

However, it can also be argued that the repairs costs would not have been necessary, or at least not as frequently, if Tropical juices were not also being produced on the same machinery. Therefore, I recommend that the repair costs be allocated between Bottle and Tropical, based on their relative utilization of this repaired equipment.

Inventory costing

While absorption costing is an acceptable method of costing inventory for reporting purposes, we must ensure that Bottle is not double charging for its costs. Absorption costing means that fixed manufacturing overhead costs are included in the determination of inventory cost. [Section 3031.13]

Items such as depreciation are appropriate if the 16% charge is not intended to cover depreciation. Interest is not chargeable since I have assumed that the 16% is meant to cover this cost.

Other fixed costs should be included only to the extent that they represent Bottle's incremental cost of producing Tropical juices. This recommendation is consistent with those made previously in this report, such as those for computer services and advertising.

Concerns of DIL

Revenue recognition policy

It may be inappropriate for Tropical to recognize revenue on juices shipped to distributors but not yet sold by them.

Although this issue is not specifically addressed by the shareholder agreement, revenue should be recognized only when it is relatively certain that the sale has taken place. In Tropical's case, revenue should be recognized when Tropical no longer retains any significant risks associated with the inventory. When the juices are shipped to the distributor, there is no certainty that the juices will be sold. More important, it is likely that the juices have a limited shelf life, and it may be very likely that the distributor will not sell the juices before the shelf life expires.

Therefore, I recommend that revenue be recognized only when the distributor has sold the juices and the eventual receipt of cash by Tropical seems likely. [Section 3400.13]

If there is a high inventory turnover, then this adjustment will probably be small.

Refrigerated tanker trucks

There are several approaches to dealing with the cost of the refrigerated tanker truck purchased by Citrus.

At the outset, it needs to be determined whether the fair market price charged by Citrus for its juice concentrates is supposed to include delivery. If it is, then this charge is not appropriate. I assume that the price does not include delivery, since DIL appears to be more concerned about the approach to determining the charge than the charge itself.

It can be argued that the charge by Citrus over three years is appropriate if this is the expected life of the truck. In this manner, the cost is appropriately matched to the revenues they help to generate. Under this approach, Citrus would then be reimbursed the equivalent of interest at 16% for each of the three years, in line with the approach adopted for Bottle for its capital expenditures. [Section 1000.45]

An alternative approach is to allow Citrus to be reimbursed fully in the current year since this disbursement was made on behalf of Tropical, as specified in section 2(a) of the agreement. However, it can be argued that an allocation is more appropriate since the new truck could have been used by Citrus, and Tropical could have used the older trucks. The fact that the tanker truck was purchased in the second year suggests that the truck was not needed solely for Tropical.

Consistent with the incremental-cost approach that has been taken in resolving the previous issues, I recommend that Citrus charge the additional cost of the tanker truck to Tropical over its useful life. In addition, Citrus should be allowed to charge 16% as the interest component, consistent with other capital expenditures made by Bottle.

Receivables

Whether or not Citrus can charge interest on its receivable from Tropical depends on the terms of its usual policy on sales. As it is industry practice, there is probably a period of, say, 30 days within which the amount is due without any interest charge. Given that Tropical pays fair value and assuming it pays within the required period, then no interest charge is appropriate. However, interest can be charged on late payments. I recommend the 16% rate that I have used in previous recommendations.

Manipulation of profits

Not enough facts are provided to permit an analysis of DIL's claim that the previous owners of Bottle were manipulating profits between years. However, this concern may not be relevant. The manipulation only matters if Tropical could have made more than the minimum specified in the agreement, or if the net amount of the manipulation exceeded the deficiency calculated in accordance with the agreement. Based on a comparison of the preliminary results of Tropical for year 1 and the sale agreement, the manipulation appears unlikely to affect the liability owed by the previous owners of Bottle.

Case 6-5

MEMORANDUM

To: Partner

From: CPA

Subject: The Wedding Planners Limited (“WP”)

Overview

WP is a private corporation. The financial statements will be used primarily by the bank to evaluate the company and its management. As a result, the company has incentives to increase earnings to present a favourable impression. The company will use ASPE.

WP has less than one month to obtain $700,000 to repay the credit facility from its bank. Our review of the financial statements needs to be completed before the tax refund can be calculated, as some of the financial statement adjustments may have a related tax adjustment. I have therefore completed my analysis of the accounting issues first.

Performance Measurement

Before WP’s tax refund can be calculated, it is necessary to finalize WP’s net income, as adjustments may be made as part of the review engagement that could also result in a tax adjustment. I was provided with the list of outstanding accounting issues and have made the necessary adjustments to the Year 6 net income in Exhibit I. Here is the accounting explanation that supports the adjustments made.

Refundable deposits

At year-end Year 6, WP holds $155,000 in refundable deposits from potential customers that have been recorded as revenue. Since WP has not yet performed a service for these customers (the weddings have not yet been held) and the amounts are presumably refundable, this revenue should be removed from the income statement. There was $130,000 in refundable deposits at year-end Year 5, so the gross margin error relating to Year 6 is $25,000. [Section 3400.05]

Inter-company transactions

1. Sale of van WP recorded a $30,000 ($55,000-$25,000) loss on the sale of a van to JJ. WP and JJ are both owned by Anne and are therefore related parties. ASPE requires that an income statement impact only be recorded if the transaction has commercial substance and if it is in the ordinary course of business. This transaction is not a normal part of WP’s operations (i.e., it is not in the business of selling vehicles). The transaction should therefore be recorded at the carrying amount of $55,000. The loss of $30,000 should be removed from the income statement and recorded in equity. [Section 3840.29] Also, in situations where WP realizes a gain or loss on the sale of assets, the amounts should not be in gross margin, but should be disclosed in a separate income or expense category. [Section 1520.04]

2. Janitorial costs and alcohol sales The janitorial costs for services provided by JJ to WP and alcohol sales from WP to DJ are both in the normal course of the provider’s business and represent the culmination of the earnings process. Accordingly, these transactions should be recorded at the exchange amount agreed upon between the companies. The companies have agreed that these transfers occur at cost, and are therefore reflected appropriately for accounting purposes. No adjustment is necessary. [Section 3840.18]

3. Payroll All the employees of the various companies are currently paid through WP. As a result, the expenses in WP are not properly matched with revenues. WP should charge the expenses to the other companies and consider charging a fee to JJ and DJ for doing the transfer of the payroll expenses related to the provision of services to each company. This adjustment will increase WP’s income for the year.

Five-year champagne contract – cancellation clause

The five-year, fixed-price champagne contract that was signed in January Year 4 no longer appears to be effective in protecting WP from higher prices. Currently, the contract is accounted for only as the champagne is purchased at the fixed rate of $360. However, the market price is $336 and is expected to stay at this level for the next two years.

Anne triggered the cancellation clause of $60,000 on December 31, Year 6. The question is whether the $60,000 is already accrued or needs to be accrued in the December 31, Year 6 financial statements. Since WP will no longer be purchasing champagne through the contract, there is no longer an obligation to buy inventory. Instead, WP has paid a one-time cancellation clause to terminate the contract. The cancellation amount should be accrued in accounts payable, if not already done, and should be charged to cost of goods sold, as it was incurred before year-end and is a liability of WP as of December 31, Year 6. [Section 1000.28 & .29]

Contingent gain on lawsuit

WP has been advised that their lawyer is “positive” that the $800,000 paid out in the lawsuit judgment against WP will be returned with interest. We must decide whether the recovery of this amount can be recorded on the Year 6 financial statements. Contingent gains can be recognized if it is virtually certain that the gain will be realized. It is too early in the process to determine the likelihood of winning the lawsuit. Therefore, the contingent gain cannot be recognized.

It appears that much of the information on the appeal is new and may have been obtained after December 31, Year 6. As a result, the contingent gain could be disclosed in the notes to the financial statements as a subsequent event if it is likely that the $800,000 will be realized. [Section 3290.22]

Reward program

WP has started giving away cases of champagne as recognition rewards for its employees. However, the cost of the champagne has been left in cost of goods sold rather than being classified as an employee benefit. WP has given away 50 cases at a cost of $360 (assuming they were bought as part of the contract and not on the market). An adjustment of $18,000 is required to reallocate the cost from cost of goods sold to an administrative-type expense, equivalent to where their salaries would be posted. Some of the employees work for the other companies, so the amount needs to be allocated to the various companies. [Section 1400.03]

Amortization

WP uses capital cost allowance for both tax and accounting amortization purposes. WP should establish a separate amortization method for its assets based on the useful life and pattern of use. [Section 3061.16]

EXHIBIT I

RESTATEMENT OF WP INCOME STATEMENT

Purpose: To correct errors in WP's preliminary net income balance. The revised net income will be used to estimate the tax refund.

WP Year 6

Net loss as stated $ (335,996)

Champagne contract cancellation fee (60,000)

Employee rewards (cases of champagne given away) - reclassification only –

Lawsuit judgment recovery –

Payroll expense – charge to other companies –

Van sale 30,000

Refundable deposits net change in Year 6 (25,000)

Tax effect of adjustments (assuming a 20% income tax rate) 11,000

Revised net income (loss) $ (379,996)

Conclusion: WP's original net loss is increased by adjusting the financial statements for the cancellation of the fixed price contract, and related party transactions.

SOLUTIONS TO PROBLEMS

Problem 6-1

(a)

Intercompany balances

Sales and purchases for Year 3 $190,000 (a)

Accounts receivable and payable at end of Year 3 $50,000 (b)

Intercompany inventory profits Before 40% After

tax tax tax

Opening inventory – Sub selling (upstream)

(70,000 x 0.3) $21,000 $8,400 $12,600 (c)

Closing inventory – Sub selling (upstream)

(80,000 x 0.3) $24,000 $9,600 $14,400 (d)

Consolidated account balances

Inventory (510,000 + 400,000 – (d) 24,000) $886,000

Accounts payable (700,000 + 420,000 – (b) 50,000) 1,070,000

Retained earnings, beginning of year

PAT $2,500,000

SAT R/E, beginning of year $1,200,000

SAT R/E, date of acquisition (1,000,000)

Change since acquisition 200,000

Less: unrealized after-tax profit in beginning

inventory (upstream) (c) (12,600)

187,400

PAT’s share x 90% 168,660

Consolidated retained earnings 2,668,660

Sales (4,100,000 + 2,600,000 – (a) 190,000) 6,510,000

Cost of sales (3,200,000 + 1,800,000 – (a) 190,000 + (d) 24,000 – (c) 21,000) 4,813,000

Income tax expense (180,000 + 150,000 – (d) 9,600 + (c) 8,400) 328,800

(b) Since the subsidiary was the seller of the intercompany sales, these transactions are upstream transactions and the non-controlling interest (NCI) will absorb their share of the adjustments to eliminate the unrealized profits. NCI on the income statement will decrease by $1,440 (10% x $14,400) for its share of unrealized after-tax profits in ending inventory and increase by $1,260 (10% x $12,600) for its share of after-tax profits in beginning inventory. NCI on the balance sheet will decrease by $1,440 (10% x $14,400) for its share of unrealized after-tax profits in ending inventory.

Problem 6-2

(a)

Intercompany revenues and expenses

Sales and purchases (100,000 + 80,000) 180,000 (a)

Rent revenue and expense 24,000 (b)

Interest revenue and expense (60% x 50,000) 30,000 (c)

Intercompany inventory profits Before 40% After

tax tax tax

Opening inventory – Sub selling (upstream) 5,000 2,000 3,000 (d)

Closing inventory – Parent selling (downstream)

(100,000 x .50 x .40) 20,000 8,000 12,000 (e)

Calculation of non-controlling interest:

Income of subsidiary (9,000 / 20%) 45,000

Add: Realized after-tax profit in opening inventory (upstream) (d) 3,000

Adjusted 48,000

20%

9,600 (f)

Parent Company

Consolidated Income Statement

for the Current Year

Sales (500,000 – (a) 180,000) 320,000

Rental revenue (24,000 – (b) 24,000)

Interest revenue (50,000 – (c) 30,000) 20,000

Total revenue 340,000

Cost of goods sold

(350,000 – (a) 180,000 – (d) 5,000 + (e) 20,000) 185,000

Rent expense (24,000 – (b) 24,000)

Interest expense (35,000 – (c) 30,000) 5,000

Administration expenses 45,000

Income tax expense (42,000 + (d) 2,000 – (e) 8,000) 36,000

Total expense 271,000

Profit 69,000

Attributable to:

Shareholders of parent 59,400

Non-controlling interests (f) 9,600

69,000

Proof:

Profit previously reported 69,000

Add: Realized after-tax profit in opening inventory (upstream) 3,000

Parent’s share x 80% 2,400

71,400

Less: Unrealized after-tax profit in closing inventory (downstream) 12,000

Consolidated profit attributable to shareholders of parent 59,400

(b)

The matching principle requires that expenses be matched to revenues. When intercompany revenues are eliminated from the consolidated financial statements, the related cost of goods sold should also be eliminated. When profits are eliminated, income tax expense related to those profits should also be eliminated. When the previously unrecognized intercompany profits are recognized in a later period, the income tax on these profits should be expensed.

Problem 6-3

* = fair value of land at date of acquisition

** = selling price to outsiders less amount paid at acquisition = 280,000 – 230,000

*** = 40% x gain on sale of land

Problem 6-4

(a)

Changes to acquisition differential

Plant – Waste

Years 4 – 8 ([15,000 / 8 years] x 5 years) 9,375 (a)

Year 9 (15,000 / 8 years) 1,875 (b)

Goodwill – Baste

Years 7 – 8 19,000 (c)

Year 9 –0–

Intercompany Revenues and Expenses

Sales (90,000 + 170,000 + 150,000) 410,000 (d)

Rent (25,000 + 14,000) 39,000 (e)

Interest 10,000 (f)

Dividend income: All intercompany from Waste & Baste 43,750 (g)

Intercompany Profits

Before tax 40% tax After tax

Opening inventory – Waste selling (upstream)

(15,000 x .30) 4,500 1,800 2,700 (h)

Ending inventory – Baste selling (upstream)

(60,000 x .30) 18,000 7,200 10,800 (i)

– Paste selling (downstream)

(22,000 x .30) 6,600 2,640 3,960 (j)

– Waste selling (upstream)

(60,000 x .30) 18,000 7,200 10,800 (k)

42,600 17,040 25,560) (l)

Calculation of Consolidated Net Income Attributable to Parent – Year 9

Profit of Paste $83,750

Less: dividend income from subsidiaries (43,750)

unrealized after-tax profit in ending inventory (j) (3,960)

36,040

Profit of Waste 104,000

Add: Realized after-tax profit in opening inventory (upstream) (h) 2,700

106,700

Less: Unrealized after-tax profit in ending inventory (upstream) (k) 10,800

Changes to acquisition differential (b) 1,875

94,025

Paste’s share x 80% 75,220

Profit of Baste 9,000

Less: Unrealized after-tax profit in ending inventory (upstream) (i) 10,800

(1,800)

Paste’s share x 75% (1,350)

Equity method income from subsidiaries 109,910 (m)

Paste Company

Consolidated Income Statement

for the Year Ended December 31, Year 9

Sales (450,000 + 270,000 + 190,000 – (d) 410,000) 500,000

Dividends (43,750 – (g) 43,750)

Interest (10,000 – (f) 10,000)

Rent (130,000 – (e) 39,000) 91,000

Total income 591,000

Cost of sales (300,000 + 163,000 + 145,000 – (d) 410,000

– (h) 4,500 + (l) 42,600 + (b) 1,875) 237,975

General & administrative (93,000 + 48,000 + 29,000 – (e) 39,000) 131,000

Interest (10,000 – (f) 10,000)

Income tax (27,000 + 75,000 + 7,000 + (h) 1,800 – (l) 17,040) 93,760

Total expenses 462,735

Profit 128,265

Attributable to:

Shareholders of Paste (m) 109,910

Non-controlling interests (20% x 94,025 + 25% x -1,800) 18,355

128,265

* see part (c) for calculation of 94,025 and –1,800

(b)

Calculation of consolidated retained earnings – December 31, Year 9

Retained earnings of Paste December 31, Year 9 703,750

Unrealized after-tax profit in ending inventory (downstream) (j) (3,960)

Retained earnings of Waste December 31, Year 9 146,000

Retained earnings of Waste – acquisition 40,000

Increase 106,000

Less: Unrealized after-tax profit in ending inventory (upstream) (k) 10,800

Changes to acquisition differential (a) 9,375 + (b) 1,875 11,250

Adjusted increase 83,950

Paste's ownership % 80% 67,160

Retained earnings of Baste December 31, Year 9 79,000

Retained earnings of Baste – acquisition 80,000

Decrease (1,000)

Less: Changes to acquisition differential for Baste (c) 19,000

Unrealized after-tax profit in ending inventory (upstream) (i) 10,800

(30,800)

Paste's ownership % 75% (23,100)

Consolidated retained earnings December 31, Year 9 743,850

(c)

Profit of Waste 104,000

Add: Realized after-tax profit in opening inventory (upstream) (h) 2,700

106,700

Less: Unrealized after-tax profit in ending inventory (upstream) (k) 10,800

Changes to acquisition differential (b) 1,875

94,025

Paste’s share x 80% 75,220

Profit of Baste 9,000

Less: Unrealized after-tax profit in ending inventory (upstream) (i) 10,800

(1,800)

Paste’s share x 75% (1,350)

Unrealized after-tax profit in ending inventory (downstream) (j) (3,960)

Equity method income from subsidiaries 69,910

(d)

Revenue should be recognized when it is earned i.e., when the benefits and risks have been transferred to an entity outside of the reporting entity. The reporting entity for consolidated financial statements encompasses the parent and all its subsidiaries. Since intercompany transactions are transactions within the reporting entity (not outside of the reporting entity), they must be eliminated when preparing consolidated financial statements. When the inventory is sold outside of the consolidated entity, the difference between the selling price and the original cost to the consolidated entity would be reported as profit of the consolidated entity.

Problem 6-5

(a) X's equity method journal entries

Year 3

Cash 18,750

Investment in Y Co. 18,750

75% x 25,000 dividends

Investment in Y Co. 97,500

Equity method income 97,500

75% x 130,000 net income

Equity method income 13,500

Investment in Y Co. 13,500

To hold back 75% of the 18,000 (i.e. 30,000 x [1 - .4]) after-tax

inventory profit – Y selling (upstream)

Equity method income 22,200

Investment in Y Co. 22,200

To hold back the after-tax land profit –

X selling (downstream) (37,000 x [1 - .4] = 22,200)

Equity method income 47,250

Investment in Y Co. 47,250

Changes to acquisition differential – Year 3

Inventory 60,000

Equipment 45,000/15 = 3,000

63,000

X Co.’s share (@ 75%) 47,250

Note: Year 3 equity method income is $14,550 ($97,500 – $13,500 – $22,200 – $47,250)

Year 4

Cash 3,750

Investment in Y Co. 3,750

75% x 5,000 dividends

Equity method income 12,000

Investment in Y Co. 12,000

75% x 16,000 net loss

Equity method income 2,250

Investment in Y Co. 2,250

Changes to acquisition differential (equipment) (3,000 x 75%)

Investment in Y Co. 13,500

Equity method income 13,500

To realize opening inventory profit – Y selling (upstream)

Investment in Y Co. 22,200

Equity method income 22,200

To realize land profit – X Selling (downstream)

Equity method income 7,200

Investment in Y Co. 7,200

To hold back after-tax inventory profit – X selling (downstream)

(12,000 x [1 - .4])

Note: Year 4 equity method income is $14,250 (–$12,000 – $2,250 + $13,500 + $22,200 – $7,200)

(b) Calculation of consolidated net income – Year 3

Net income of X 400,000

Less: Unrealized after-tax gain on land (downstream) 22,200

Adjusted 377,800

Net income of Y 130,000

Less: Unrealized after-tax profit in ending inventory (upstream) (18,000)

Changes to acquisition differential (63,000)

Adjusted 49,000

Consolidated net income 426,800

Attributable to:

Shareholders of X 414,550

Non-controlling interests (25% x 49,000) 12,250

426,800

Calculation of Consolidated Net income – Year 4

Net income of X 72,000

Less: Unrealized after-tax profit in ending inventory (downstream) 7,200

64,800

Add: Realized after-tax gain on land (downstream) 22,200

Adjusted net income 87,000

Net income (loss) of Y (16,000)

Add: realized after-tax profit in opening inventory (upstream) 18,000

Less: Changes to acquisition differential (3,000)

Adjusted net income (1,000)

Consolidated net income 86,000

Attributable to:

Shareholders of X 86,250

Non-controlling interests (25% x -1,000) (250)

86,000

(c)

Changes in Non-Controlling Interest

Years 3 and 4

Balance Jan. 1 Year 3 [25% x (170,000 + 105,000)] 68,750

Allocation of Y Co.’s adjusted net income Year 3

(25% x 49,000) 12,250

81,000

Less: dividends (25% x 25,000) 6,250

Balance Dec. 31, Year 3 74,750

Allocation of Y Co.’s adjusted net income Year 4

(25% x - 1,000) (250)

74,500

Less: dividends (25% x 5,000) 1,250

Balance Dec. 31, Year 4 73,250

Proof:

Y - Common shares 100,000

- Retained earnings (70,000 + 130,000 25,000 16,000 5,000) 154,000

- Shareholders' equity Dec. 31, Year 4 254,000

- Undepleted acquisition differential 39,000

293,000

25%

73,250

(d) Calculation of Investment in Y Co. (Equity Method)

As at December 31, Year 4

Shareholders' equity of Y Jan. 1, Year 3 170,000

Acquisition differential 105,000

275,000

X's ownership 75%

Cost of 75% investment in Y Jan. 1, Year 3 206,250

Equity method income – Year 3 14,550

Year 4 14,250 28,800

235,050

Less: Dividends received

Year 3 (75% x 25,000) 18,750

Year 4 (75% x 5,000) 3,750 22,500

Investment in Y Dec. 31, Year 4 212,550

Proof:

Shareholders' equity of Y 254,000

Balance, unamortized equipment  (45,000 6,000) 39,000

293,000

X's ownership 75%

219,750

Less: Unrealized after-tax profit in ending inventory (downstream) 7,200

Investment in Y, December 31, Year 4 212,550

Problem 6-6

The following answers are based on the 2017 consolidated financial statements for Empire Company Limited and are in millions of dollars:

(a) Empire uses the weighted average cost method to cost its inventory as per note 3(e) to the consolidated financial statements.

(b) Ending inventory would be 2% higher under FIFO than weighted average by

2% x 1,287.3 = 25.7 in 2016 and 2% x 1,322.2 = 26.4 in 2017 Inventory Turnover = Before After Cost of sales 18,099 (18,099 – 26.4 + 25.7) Average inventory (1,322.2 + 1,287.3)/2 (1,322.2 + 26.4 + 1,287.3 + 25.7) / 2 = 13.87 13.60 Earnings per share = Net earnings 172.5 (172.5 + 26.4 – 25.7) Average shares o/s 271.9 271.9 = 0.63 0.64 Both earnings and shares o/s are taken from statement of earnings

(c) As per the consolidated balance sheet, at the end of 2017, inventory represented 15.2% (1,322.2 / 8,695.5) of Empire’s total assets. Inventory increased by 2.7% (1,322.2 / 1,287.3) from last year.

(e) Empire does eliminate intercompany transactions and unrealized profits when preparing its consolidated financial statements as per note 3(a) to the consolidated financial statements.

(f) Land is valued at acquisition cost as per the accounting policy for property and equipment described in note 3(l).

(g) The total cash consideration for business acquisitions during 2017 was $21.9 as per note 23. The amount of $5.8 allocated to goodwill was 26.5% (5.8 / 21.9).

(h) As per note 23, goodwill recorded on the acquisitions was related to the acquired work force and customer base of the existing store location, along with the synergies expected from combining the efforts of the acquired stores with existing stores. These items were not recorded separately because they could not be sold separately. Even though the franchisees had customers, these customers were not likely locked into any contracts. Therefore, a purchaser would not pay an amount solely for the customers.

(i) As per note 23, the Company acquires stores, retail gas locations and prescription files. These assets were purchased directly.

Problem 6-7

Calculation, allocation, and changes to acquisition differential

Cost of 80% investment, Jan. 1, Year 3 1,600,000

Implied value of 100% investment 2,000,000

Carrying amounts of Least's net assets:

Assets 3,000,000

Liabilities 1,500,000

Total shareholders' equity 1,500,000

Acquisition differential 500,000

Allocation: FV - CA

Accounts receivable - 20,000

Inventories - 50,000

Plant and equipment (net) 35,000

Long-term liabilities 100,000 65,000

Balance – goodwill 435,000

Balance Changes Balance

Jan. 1 Dec. 31

Year 3 Years 3 to 8 Year 9 Year 9

Accounts receivable - 20,000 20,000

Inventories - 50,000 50,000

Plant and equipment (net) 35,000 - 26,250 - 4,375 4,375 (a)

Long-term liabilities 100,000 - 100,000

Goodwill 435,000 - 52,200 - 8,700 374,100 (b)

500,000 - 108,450 (c) - 13,075 (d) 378,475

Intercompany revenues and expenses

Sales and purchases (2,000,000 + 1,500,000) 3,500,000 (e)

Intercompany profits

Before tax 40% tax After tax

Loss on land, July 1, Year 7

realized in Year 9 – Most selling (downstream) 50,000 20,000 30,000 (f)

Opening inventory – Most selling (downstream)

(312,500 x 0.20) 62,500 25,000 37,500 (g)

– Least selling (upstream)

(857,140 x 0.30) 257,142 102,857 154,285 (h)

319,642 127,857 191,785 (i)

Ending inventory – Most selling (downstream)

(500,000 x 0.20) 100,000 40,000 60,000 (j)

– Least selling (upstream)

(714,280 x 0.30) 214,284 85,714 128,570 (k)

314,284 (l) 125,714 188,570

Intercompany dividends declared but not paid (80% x 100,000) 80,000 (m)

Deferred income taxes – ending inventory (40,000 + 85,714) 125,714 (n)

Calculation of consolidated retained earnings – Jan. 1 Year 9

Retained earnings of Most, Jan. 1, Year 9

(10,400,000 – 1,000,000 + 350,000) 9,750,000

Less: Unrealized after-tax profit in opening inventory (downstream) (g) 37,500

9,712,500

Add: Unrealized after-tax loss on land (downstream) (f) 30,000

Adjusted retained earnings 9,742,500

Retained earnings of Least, Jan. 1, Year 9

(2,300,000 – 400,000 + 100,000) 2,000,000

Retained earnings of Least at acquisition 1,000,000

Increase 1,000,000

Less: Unrealized after-tax profit in opening inventory (upstream) (h) 154,285

Changes to acquisition differential (c) 108,450

Adjusted increase 737,265 (o)

Most's ownership % 80% 589,812

Consolidated retained earnings, Jan. 1, Year 9 10,332,312

Calculation of consolidated net income – Year 9

Net income of Most 1,000,000

Less: Dividends from Least (100,000 x 80%) 80,000

Unrealized after-tax profit in closing inventory

(downstream) (j) 60,000

Realized after-tax loss on land (downstream) (f) 30,000 170,000

830,000

Add: Realized after-tax profit in opening inventory (downstream) (g) 37,500

Adjusted net income 867,500

Net income of Least 400,000

Add: Realized after-tax profit in opening inventory (upstream) (h) 154,285

554,285

Less: Unrealized after-tax profit in closing inventory (upstream) (k) 128,570

Changes to acquisition differential (d) 13,075

Adjusted net income 412,640

Consolidated net income 1,280,140

Attributable to:

Shareholders of Most 1,197,612

Non-controlling interests (20% x 412,640) 82,528

1,280,140

Calculation of consolidated non-controlling interests – Jan. 1 Year 9 (Method 1)

Least’s common shares, Jan. 1, Year 9 500,000

Retained earnings of Least, Jan. 1, Year 9 2,000,000

Less: Unrealized after-tax profit in opening inventory (upstream) (h) 154,285

Adjusted retained earnings 1,845,715

Undepleted acquisition differential (500,000 – 108,450) 391,550

2,737,265

NCI’s ownership % 20%

NCI, Jan. 1, Year 9 547,453

Calculation of consolidated non-controlling interests – Jan. 1 Year 9 (Method 2)

Non-controlling interests at date of acquisition (20% x [1,600,000 / .8) 400,000

Least’s adjusted increase in retained earnings (o) 737,265

NCI’s share @ 20% 147,453

NCI, Jan. 1, Year 9 547,453

(a) Most Company

Consolidated Statement of Changes in Equity

For Year Ended December 31, Year 9

Common Retained

Stock Earnings Total NCI Total

Balance, beginning of year 1,000,000 10,332,312 11,332,312 547,453 11,879,765

Add: net income 1,197,612 1,197,612 82,528 1,280,140

Less: dividends (350,000) (350,000) (20,000) (370,000)

Balance, end of year 1,000,000 11,179,924 12,179,924 609,981 12,789,905

Proof of consolidated retained earnings, end of Year 9

Retained earnings of Most, Dec. 31, Year 9 10,400,000

Less: Unrealized after-tax profit in ending inventory (downstream) (j) 60,000

Adjusted retained earnings 10,340,000

Retained earnings of Least, Dec. 31, Year 9 2,300,000

Retained earnings of Least at acquisition 1,000,000

Increase 1,300,000

Less: Unrealized after-tax profit in ending inventory (upstream) (k) 128,570

Changes to acquisition differential

((c) 108,450 + (d) 13,075) 121,525

Adjusted increase 1,049,905 (p)

Most's ownership % 80% 839,924

Consolidated retained earnings, Dec. 31, Year 9 11,179,924

Proof of non-controlling interest, end of Year 9 (Method 1)

Retained earnings of Least 2,300,000

Common shares of Least 500,000

Total shareholders' equity 2,800,000

Less: Unrealized after-tax profit in ending inventory (upstream)      (k) 128,570

Adjusted shareholders' equity 2,671,430

Add: undepleted acquisition differential 378,475

3,049,905

20%

Non-controlling interest, Dec. 31, Year 9 609,981

Calculation of consolidated non-controlling interests – end of Year 9 (Method 2)

Non-controlling interests at date of acquisition (20% x [1,600,000 / .8]) 400,000

Least’s adjusted increase in retained earnings (p) 1,049,905

NCI’s share @ 20% 209,981

Non-controlling interest, Dec. 31, Year 9 609,981

(b) Most Company

Consolidated Balance Sheet

December 31, Year 9

Cash (500,000 + 40,000) 540,000

Accounts receivable (1,700,000 + 500,000 – (m) 80,000) 2,120,000

Inventories (2,300,000 + 1,200,000 – (l) 314,284) 3,185,716

Plant and equipment (net) (8,200,000 + 4,000,000 + (a) 4,375) 12,204,375

Land (700,000 + 260,000) 960,000

Goodwill (b) 374,100

Deferred income taxes (n) 125,714

Total assets 19,509,905

Current liabilities (600,000 + 200,000 – (m) 80,000) 720,000

Long-term liabilities (3,000,000 + 3,000,000) 6,000,000

Common shares 1,000,000

Retained earnings 11,179,924

Non-controlling interest 609,981

Total liabilities & shareholders' equity 19,509,905

(c) The cost principle requires that certain assets such as inventory be reported at cost. When a profit is made on an intercompany sale, the inventory cost to the purchaser is higher than the cost incurred by the seller. An adjustment is made on consolidation to remove the profit from the inventory of the purchaser to bring the value of the inventory down to the original cost to the consolidated entity.

(d) The debt to equity ratio would increase because debt remains the same but the non-controlling interest within shareholders’ equity decreases. Non-controlling interests decreases because it does not contain the incorporate the non-controlling interests’ share of the value of the subsidiary’s goodwill.

Problem 6-8

Intercompany sales

January 7,200 (a)

February 10,800 (b)

Unrealized profits (sub. selling) (upstream) Before 40% After

Tax Tax Tax

Ending inventory for January (2,200 – [2,200 / 1.2]) 367 147 220 (c)

Ending inventory for February (4,500 – [4,500 / 1.2]) 750 300 450 (d)

INCOME STATEMENTS FOR JANUARY YEAR 8

Fazli Gervais Adjust Consolidation

Sales $6,250 $7,200 (a) – 7,200 $6,250

Cost of sales

Beginning inventory 0 0 0

Purchases 7,200 10,000 (a) -7,200 10,000

Goods available 7,200 10,000 10,000

Ending inventory 2,200 4,000 (c) -367 5,833

Cost of sales 5,000 6,000 4,167

Gross margin 1,250 1,200 2,083

Income tax expense (40%) 500 480 (c) -147 833

Net income $750 $720 $1,250

Attributable to:

Fazli’s shareholders $1,250

Non-controlling interest 0

INCOME STATEMENTS FOR FEBRUARY YEAR 8

Fazli Gervais Adjust Consolidation

Sales $10,625 $10,800 (b) – 10,800 $10,625

Cost of sales

Beginning inventory 2,200 4,000 (c) - 367 5,833

Purchases 10,800 12,000 (b) -10,800 12,000

Goods available 13,000 16,000 17,833

Ending inventory 4,500 7,000 (d) -750 10,750

Cost of sales 8,500 9,000 7,083

Gross margin 2,125 1,800 3,542

Income tax expense (40%) 850 720 (d-c) -153 1,417

Net income $1,275 $1,080 $2,125

Attributable to:

Fazli’s shareholders $2,125

Non-controlling interest 0

(b)

The only new account would be equity method income on Fazli’s income statement. Gervais’ income statement and the consolidated income statement would not change. The equity method income would be $500. This $500 would bring Fazli’s total income to $1,250, which is equal to consolidated net income attributable to Fazli’s shareholders. It can be calculated as follows:

Gervais’ net income $720

Less: unrealized after-tax profits in ending inventory (upstream) (220)

Gervais’ income from consolidated viewpoint 500

Fazli’s percentage ownership 100%

Equity method income from subsidiary $500

(c)

The only change would be split of the consolidated net income between the parent and non-controlling interest. Otherwise, all three income statements remain the same. The split of the consolidated net income can be calculated as follows:

Gervais’ net income $720

Less: unrealized after-tax profits in ending inventory (upstream) (220)

Gervais’ income from consolidated viewpoint 500

NCI’s percentage ownership 20%

Consolidated net income attributable to NCI 100

Consolidated net income attributable to parent (1,250 – 100) 1,150

Consolidated net income $1,250

(d)

The only change would be split of the consolidated net income between the parent and non-controlling interest. Otherwise, all three income statements remain the same. The split of the consolidated net income can be calculated as follows:

Fazli’s net income $750

NCI’s percentage ownership 20%

Consolidated net income attributable to NCI 150

Consolidated net income attributable to parent (1,250 – 150) 1,100

Consolidated net income $1,250

Alternatively:

Gervais’ net income $720

Less: unrealized after-tax profits in ending inventory (downstream) (220)

Gervais’ income from consolidated viewpoint 500

Gervais’ share of Fazli’s net income (750 x 80%) 600

Consolidated net income attributable to parent 1,100

Consolidated net income attributable to NCI (1,250 – 1,100) 150

Consolidated net income $1,250

Problem 6-9

Unrealized profits (subsidiary selling) (upstream) Before 40% After

Tax Tax Tax

Beginning inventory ([45,000 – 27,000] x 20%) 3,600 1,440 2,160 (a)

Ending inventory ([60,000 – 33,000] x 30%) 8,100 3,240 4,860 (b)

(a)

(i) Net income of Yosef 150,000

Less: dividend income from subsidiary (20,000 x 90%) (18,000)

132,000

Net income of Randeep 55,000

Add: realized after-tax profit in beginning inventory (upstream) (a) 2,160

Less: Unrealized after-tax profit in ending inventory (upstream) (b) (4,860)

52,300

Consolidated net income $184,300

(ii) Attributable to:

Controlling interest (132,000 + 90% x 52,300) $179,070

Non-controlling interest (10% x 52,300) 5,230

(iii) deferred income tax asset (b) 3,240

(iv) inventory (70,000 + 45,000 – (b) 8,100) 106,900

(v) net adjustment to retained earnings at beginning of year

pertaining to intercompany profits [(a) 2,160 x 90%)] 1,944

(vi) net adjustment to retained earnings at end of year

pertaining to intercompany profits [(b) 4,860 x 90%] 4,374

(b)

(i) Net income of Yosef 150,000

Less: dividend income from subsidiary (20,000 x 90%) (18,000)

132,000

Add: realized after-tax profit in beginning inventory (upstream) (a) 2,160

Less: unrealized after-tax profit in ending inventory (upstream) (b) (4,860)

129,300

Net income of Randeep 55,000

Consolidated net income $184,300

(ii) Attributable to:

Controlling interest (129,300 + 90% x 55,000) $178,800

Non-controlling interest (10% x 55,000) 5,500

(iii) deferred income tax asset (b) 3,240

(iv) inventory (70,000 + 45,000 – (b) 8,100) 106,900

(v) net adjustment to retained earnings at beginning of year

pertaining to intercompany profits (a) 2,160

(vi) net adjustment to retained earnings at end of year

pertaining to intercompany profits (b) 4,860

Problem 6-10

Intercompany revenues and expenses

Sales and purchases (90,000 + 177,000) 267,000 (a)

Rental revenue and expense (2,800 x 12) 33,600 (b)

Interest revenue and expense (360,000 x 0.05) 18,000 (c)

Intercompany profits

Before tax 40% tax After tax

Opening inventory – Evans selling (downstream)

(21,250 – [21,250 / 1.25]) 4,250 1,700 2,550 (d)

– Falcon selling (upstream)

(11,000 x 0.3) 3,300 1,320 1,980 (e)

7,550 3,020 4,530 (f)

Ending inventory – Evans selling (downstream)

(28,750 – [28,750 / 1.25]) 5,750 2,300 3,450 (g)

– Falcon selling (upstream)

(3,000 x 0.3) 900 360 540 (h)

6,650 2,660 3,990 (i)

Calculation of consolidated profit – current year

Profit of Evans 61,900

Less: Intercompany dividends (40,000 x 80%) 32,000

Unrealized after-tax profit in ending inventory (downstream) (g) 3,450 35,450

26,450

Add: Realized after-tax profit in opening inventory (downstream) (d) 2,550

Adjusted profit 29,000

Profit of Falcon 75,500

Less: Unrealized after-tax profit in ending inventory (upstream) (h) 540

74,960

Add: Realized after-tax profit in opening inventory (upstream) (e) 1,980

76,940

Consolidated profit 105,940

Attributable to:

Shareholders of Evans 90,552

Non-controlling interests (20% x 76,940) 15,388

105,940

(a) Evans Company

Consolidated Income Statement

for the Current Year

Sales (450,000 + 600,000 – (a) 267,000) 783,000

Raw materials & finished goods purchased

(268,000 + 328,000 – (a) 267,000) 329,000

Changes in inventory

(20,000 + 25,000 – (f) 7,550 + (i) 6,650) 44,100

Other expenses (104,000 + 146,000 – (b) 33,600) 216,400

Interest expense (30,000 – (c) 18,000) 12,000

Income taxes (31,700 + 43,500 + (f) 3,020 – (I) 2,660) 75,560

Total expenses 677,060

Profit 105,940

Attributable to:

Shareholders of Evans 90,552

Non-controlling interests (20% x 76,940) 15,388

105,940

(b)

Calculation of consolidated retained earnings – beginning of year

Retained earnings of Evans, beginning of year 632,000

Less: Unrealized after-tax profit in opening inventory (downstream) (d) 2,550

Adjusted retained earnings 629,450

Retained earnings of Falcon, beginning of the year 348,000

Less: Unrealized after-tax profit in opening inventory (upstream) (e) 1,980

Adjusted increase since acquisition 346,020

Evans' ownership % 80% 276,816

Consolidated retained earnings, beginning of year 906,266

Consolidated dividends declared 30,000

Problem 6-11

Calculation, allocation, and changes to the acquisition differential

Cost of 90% investment, Jan. 2, Year 6 90,000

Implied value of 100% investment 100,000

Carrying amounts of S's net assets:

Common shares 60,000

Retained earnings 20,000

Total shareholders' equity 80,000

Acquisition differential – patents 20,000

Changes:

Years 6 – 9 (a) 16,000

Year 10 (b) 4,000 20,000

Balance, Dec. 31, Year 10 –0–

Intercompany profits

Before tax 40% tax After tax

Opening inventory – S selling (upstream)

(7,000 x 0.40) 2,800 1,120 1,680 (c)

– P selling (downstream)

(3,000 x 0.40) 1,200 480 720 (d)

4,000 1,600 2,400 (e)

Ending inventory – S selling (upstream)

(20,000 x 0.40) 8,000 3,200 4,800 (f)

– P selling (downstream)

(5,000 x 0.40) 2,000 800 1,200 (g)

10,000 4,000 6,000 (h)

Sale of land – Year 8 S selling (upstream)

(50,000 – 40,000) 10,000 4,000 6,000 (i)

Calculation of consolidated net income – Year 10

Net income of P Company 60,000

Less: Dividends from S (10,000 x 90%) 9,000

Unrealized after-tax profit in ending inventory (downstream) (g) 1,200 10,200

49,800

Add: Realized after-tax profit in opening inventory (downstream) (d) 720

Adjusted net income 50,520

Net income of S Company 48,000

Less: Unrealized after-tax profit in ending inventory (upstream) (f) 4,800

patent amortization (b) 4,000

39,200

Add: Realized after-tax profit in opening inventory (upstream) (c) 1,680

40,880

Consolidated net income 91,400

Attributable to:

Shareholders of P Co. 87,312

Non-controlling interests (10% x 40,880) 4,088

91,400

Calculation of consolidated retained earnings – Jan. 1, Year 10

Retained earnings of P, Jan. 1, Year 10

113,000

Less: Unrealized after-tax profit in opening inventory (downstream) (d) 720

Adjusted retained earnings 112,280

Retained earnings of S 44,000

Retained earnings of S at acquisition 20,000

Increase since acquisition 24,000

Less: Amortization of patents (a) 16,000

Unrealized after-tax gain on land

(upstream) (i) 6,000

Unrealized after-tax profit in opening

Inventory (upstream) (c) 1,680 23,680

Adjusted increase 320 (j)

P's ownership % 90% 288

Consolidated retained earnings, Jan. 1, Year 10 112,568

Copyright 2019 McGraw-Hill Education. All rights reserved.

52 Modern Advanced Accounting in Canada, Ninth Edition

Copyright 2019 McGraw-Hill Education. All rights reserved.

Solutions Manual, Chapter 6 65

Calculation of consolidated non-controlling interests, beginning of Year 10 (Method 1)

Company S shareholders' equity

Common shares 60,000

Retained earnings 44,000

104,000

Less: Unrealized after-tax gain on land (upstream) (i) 6,000

Unrealized after-tax profit in beginning inventory

(upstream) (c) 1,680 7,680

Adjusted shareholders' equity 96,320

Undepleted acquisition differential 4,000 100,320

10%

Non-controlling interest, Jan 1, Year 10 10,032

Calculation of consolidated non-controlling interests – Jan. 1 Year 10 (Method 2)

Non-controlling interests at date of acquisition (10% x [90,000 / .9) 10,000

S Co.’s adjusted increase in retained earnings (j) 320

NCI’s share @ 10% 32

Non-controlling interest, Jan 1, Year 10 10,032

P Co.

Consolidated Statement of Changes in Equity

For Year Ended December 31, Year 10

Common Retained

Shares Earnings Total NCI Total

Balance, beginning of year 150,000 112,568 262,568 10,032 272,600

Add: net income 87,312 87,312 4,088 91,400

Less: dividends (12,000) (12,000) (1,000) (13,000)

Retained earnings, Dec. 31 150,000 187,880 387,880 13,120 351,000

Proof:

Retained earnings of P, Dec. 31, Year 10

(101,000 + 60,000) 161,000

Less: Unrealized after-tax profit in ending inventory (downstream) (g) 1,200

Adjusted retained earnings 159,800

Retained earnings of S, Dec. 31, Year 10

(34,000 + 48,000) 82,000

Retained earnings of S at acquisition 20,000

Increase since acquisition 62,000

Less: Amortization of the patents

((a) 16,000 + (b) 4,000) 20,000

Unrealized after-tax gain on land

(upstream) (i) 6,000

Unrealized after-tax profit in ending

inventory (upstream) (f) 4,800 30,800

Adjusted increase 31,200 (k)

P's ownership % 90% 28,080

Consolidated retained earnings, Dec. 31, Year 10 187,880

Calculation of consolidated non-controlling interests – Dec. 31 Year 10 (Method 1)

Company S shareholders' equity

Common shares 60,000

Retained earnings 82,000

142,000

Less: Unrealized after-tax gain on land (upstream) (i) 6,000

Unrealized after-tax profit in ending inventory (upstream) (f) 4,800 10,800

Adjusted shareholders' equity 131,200

Undepleted acquisition differential 0

131,200

10%

Non-controlling interests, Dec. 31, Year 10 13,120

Calculation of consolidated non-controlling interests – Dec. 31 Year 10 (Method 2)

Non-controlling interests at date of acquisition (10% x [90,000 / .9) 10,000

S Co.’s adjusted increase in retained earnings (k) 31,200

NCI’s share @ 10% 3,120

Non-controlling interest, Jan 1, Year 10 13,120

Problem 6-12

Changes to acquisition differential – Year 9

Plant and equipment depreciation (120,000/ 5) $24,000 (a)

Patent amortization (40,000/ 8) 5,000 (b)

Goodwill impairment loss 3,000 (c)

$32,000 (d)

Intercompany revenues and expenses

Sales – Runner to Road $480,000 (e)

Rental – Runner to Road $95,000 (f)

Intercompany profits

Before tax 40% tax After tax

Opening inventory – Runner selling (upstream) $247,000 $98,800 $148,200 (g)

Ending inventory – Runner selling (upstream) $100,000 $40,000 $60,000 (h)

(a) Road Ltd.

Consolidated Income Statement

for the Year Ended December 31, Year 9

Sales (4,600,000 + 2,160,000 - (e) 480,000) $6,280,000

Rental revenue (190,000 - (f) 95,000) 95,000

Total income 6,375,000

Materials used in manufacturing

(2,300,000 + 860,000 - (e) 480,000) $2,680,000

Change in work-in-progress & finished goods inventory

(105,000 - 10,000 - (g) 247,000 + (h) 100,000) (52,000)

Employee benefits (610,000 + 540,000) 1,150,000

Interest expense (310,000 + 200,000) 510,000

Depreciation (465,000 + 275,000 + (a) 24,000) 764,000

Patent amortization (55,000 + (b) 5,000) 60,000

Goodwill impairment loss (c) 3,000

Income tax (360,000 + 191,200 + (g) 98,800 - (h) 40,000) 610,000

Total expenses 5,725,000

Profit $650,000

Attributable to:

Shareholders of Road 561,500

Non-controlling interests

(30% x [238,800 – (d) 32,000 + (g) 148,200 - (h) 60,000]) 88,500

$650,000

(b)

Since Road uses the equity method of accounting for its investment in Runner, consolidated retained earnings at December 31, Year 9 would be $2,523,300, which is equal to Road’s retained earnings on its separate entity financial statements.

(c)

The return on equity attributable to shareholders of Road for Year 9 would not change. Only the NCI’s share of consolidated profit would change under the identifiable net assets method. The NCI’s share of consolidated profit would increase because the NCI’s share of Runner’s goodwill and goodwill impairment is not reported under this method.

Problem 6-13

Calculation, allocation, and changes to acquisition differential

Cost of 70% investment, January 1, Year 4 $84,000

Implied value of 100% investment $120,000

Carrying amounts of Sage's net assets:

Ordinary shares $50,000

Retained earnings 18,000

Total shareholders' equity 68,000

Acquisition differential $52,000

Allocation: FV – CA

Inventory (15,000)

Unfavourable lease agreement (21,000) (36,000)

Balance – goodwill $88,000

Balance Changes Balance

January 1 December 31

Year 4 Years 4 & 5 Year 6 Year 6

Inventory $(15,000) $15,000

Lease agreement (21,000) 8,400 $4,200 $(8,400) (a)

Goodwill 88,000 (3,240) (1,350) 83,410 (b)

$52,000 $20,160 (c) $2,850 (d) $75,010

Intercompany receivables and payables – notes $54,000 (e)

Intercompany revenues and expenses

Management fee $27,000 (f)

Sales and purchases

Post selling $130,000

Sage selling 102,000 232,000 (g)

Interest (12% x 1/2 x 54,000) $3,240 (h)

Intercompany profits

Before tax 40% tax After tax

Land – Sage selling (upstream) $34,000 $13,600 $20,400 (i)

Opening inventory – Sage selling (upstream)

(17,000 x 0.25) $4,250 $1,700 $2,550 (j)

Ending inventory – Sage selling (upstream)

(30,000 x 0.25) $7,500 $3,000 $4,500 (k)

– Post selling (downstream)

(21,000 x 0.25) $5,250 $2,100 $3,150 (l)

$12,750 $5,100 $7,650 (m)

Deferred income taxes – December 31, Year 6

Inventory $5,100

Land 13,600

$18,700 (n)

Accumulated depreciation at date of acquisition for Sage $13,000 (o)

Calculation of consolidated profit

Profit of Post $102,800

Less: Investment income from Sage $2,100

Unrealized after-tax profit in ending inventory (downstream) (l) 3,150 5,250

Adjusted profit 97,550

Profit of Sage 27,000

Add: Realized after-tax profit in opening inventory (upstream) (j) 2,550

29,550

Add: Changes to acquisition differential (d) 2,850

Less: Unrealized after-tax profit in ending inventory

(upstream) (k) $4,500

Unrealized after-tax gain on land

(upstream) (i) 20,400 (24,900)

Adjusted profit 7,500

Profit $105,050

Attributable to:

Shareholders of Post $102,800

Non-controlling interests (30% x 7,500) 2,250

$105,050

(a) (i) Post Corporation

Consolidated Statement of Profit

For the Year Ended, December 31, Year 6

Sales (930,000 + 259,000 – (g) 232,000) $957,000

Interest revenue (7,100 – (h) 3,240) 3,860

Total revenue 960,860

Cost of goods sold

(570,000 + 182,000 – (g) 232,000 - (j) 4,250 + (m) 12,750) 528,500

Interest expense (20,300 – (h) 3,240) 17,060

Other expense

(183,000 + 75,100 – (f) 27,000 - (a) 4,200) 226,900

Goodwill impairment loss (b) 1,350

Income tax expense

(83,000 + 16,000 + (j) 1,700 – (m) 5,100 – (i) 13,600) 82,000

Total expenses 855,810

Profit $105,050

Attributable to:

Shareholders of Post 102,800

Non-controlling interests (30% x 7,500) 2,250

$105,050

Calculation of non-controlling interests – December 31, Year 6

Ordinary shares $50,000

Retained earnings 89,000

Total shareholders' equity 139,000

Less: Unrealized after-tax profit in ending inventory (upstream) (k) $4,500

Unrealized after-tax gain on land (upstream) (i) 20,400 (24,900)

Add: undepleted acquisition differential 75,010

Adjusted shareholders' equity 189,110

Non-controlling interest’s share 30%

Non-controlling interest, December 31, Year 6 $56,733

(a) (ii) Post Corporation

Consolidated Statement of Financial Position

December 31, Year 6

Land (178,000 + 22,000 – (i) 34,000) $166,000

Plant and equipment (529,000 + 64,000 – (o) 13,000) 580,000

Accumulated depreciation ((233,000) + (20,000) – (o) 13,000)) (240,000)

Goodwill (b) 83,410

Deferred income taxes (n) 18,700

Inventory (34,000 + 30,000 – (m) 12,750) 51,250

Accounts receivable (17,500 + 10,200) 27,700

Cash (12,500 + 13,200) 25,700

Total assets $712,760

Ordinary shares $100,000

Retained earnings 266,200

Non-controlling interests 56,733

422,933

Unfavourable lease agreement 8,400

Accounts payable (247,027 + 34,400) 281,427

Total shareholders’ equity & liabilities $712,760

(b)

Goodwill impairment loss – fair value enterprise method $1,350

Less: NCI’s share @ 30% 405

Goodwill impairment loss – parent company extension method $945

NCI – fair value enterprise method $2,250

NCI’s share of goodwill impairment loss 405

NCI – identifiable net assets method $2,655

(c)

Goodwill – fair value enterprise method $83,410

Less: NCI’s share @ 30% 25,023

Goodwill – identifiable net assets method $58,387

NCI – fair value enterprise method $56,733

NCI’s share of goodwill impairment loss 25,023

NCI – identifiable net assets method $31,710

Copyright 2016 McGraw-Hill Education. All rights reserved.

62 Modern Advanced Accounting in Canada, Eighth Edition

Problem 6-14

(a) Acquisition Cost Allocation

Acquisition January 1, Year 7

Cost (60,000 x 80) $4,800,000

Implied value of 100% investment (80,000 shares x 80) $6,400,000

CA: Ordinary Shares $3,440,000

Retained Earnings 2,170,000 5,610,000

Acquisition differential $790,000

Allocation: Life

Inventory 30,000 Cr 1

Land 270,000 Dr

Equipment 270,000 Cr 10

Patents 470,000 Dr 5

L.T. Liability 170,000 Cr 4

Subtotal 270,000 Dr

Balance: Goodwill 520,000 Dr

790,000 Dr

Non-controlling interest (20,000 shares @ $80) $1,600,000

Changes to Acquisition Differential Table:

Allocation Life Changes Balance

YR 7 – YR 10 YR 11 Dec. 3, YR 11

Inventory 30,000 Cr 1 30,000 Dr 0 0

Land 270,000 Dr 0 0 270,000 Dr

Equipment 270,000 Cr 10 108,000 Dr 27,000 Dr 135,000 Cr

Patents 470,000 Dr 5 376,000 Cr 94 000 Cr 0

L.T. Liability 170,000 Cr 4 170,000 Dr 0 0

Goodwill 520,000 Dr 0 0 520,000 Dr

790,000 Dr 68,000 Cr 67,000 Cr 655,000 Dr

Devine’s accumulated depreciation at date of acquisition 570,000

Intercompany Amounts:

Dividends: 500,000 x 75% 375,000

Sales: Vine (YR 11) 2,070,000 + Devine (YR 11) 1,270,000 3,340,000

Advances from Vine to Devine: 270,000

Intercompany profits BT Tax AT

Unrealized gain on land: Devine selling (upstream) 470,000 188,000 282,000

Opening inventory: Devine selling (upstream)

170,000 @ 40% 68,000 27,200 40,800

Opening inventory: Vine selling (downstream)

321,000 @ 33 1/3% 107,000 42,800 64,200

Ending inventory: Devine selling (upstream)

570,000 @ 40% 228,000 91,200 136,800

Ending inventory: Vine selling (downstream)

621,000 @ 33 1/3% 207,000 82,800 124,200

(b) Consolidated Income Statement for the year ending December 31, Year 11

Sales (13M + 4.4M – 3.34M) $14,060,000

Dividend, Investment Income, and Gains

(1.8M + 2.4M – 375K – 470K) 3,355,000

17,415,000

Cost of Goods Sold

(10.1M + 2.9M – 3.34M - 68K – 107K + 228K + 207K) 9,920,000

Other Expenses (500K + 500K – 27K (Equip) + 94K (Patent) 1,067,000

Taxes (200K + 200K – 188K + 27.2K + 42.8K – 91.2K – 82.8K) 108,000

Total expenses 11,095,000

Profit $6,320,000

Attributable to:

Shareholders of Vine $5,631,250

Non-controlling interests (3.2M – 282K – 136.8K + 40.8K – 67K) x 0.25 688,750

$6,320,000

Reconciliation:

Vine Profit: $4,000,000

Dividends from Devine Included (375,000)

Equity in Earnings of Devine 2,006,250

Consolidated Profit Attributable to Vine’s Shareholders $5,631,250

(c) Consolidated Retained Earnings: Proof

Parent retained earnings at December 31, Year 11 $10,600,000

Sub retained earnings at December 31, Year 11 $5,600,000

Retained earnings at acquisition 2,170,000

Increase since acquisition 3,430,000

Less: unrealized after-tax profits in ending inventory

(upstream) (136,800)

Unrealized after-tax gain on land (upstream) (282,000)

Less: cumulative changes to acquisition differential (135,000)

Realized retained earnings since acquisition 2,876,200 (a)

Parent % 75% 2,157,150

Less: unrealized after-tax profits in ending inventory (downstream) (124,200)

Consolidated retained earnings $12,632,950

(d)

Consolidated Statement of Financial Position

December 31, Year 11

Assets

Land (6M + 2.5 M + 270K – 470K) $8,300,000

Plant and Equipment (20.2M + 13.2M – 270K – 570K) 32,560,000

Accumulated depreciation (4.4M + 3.6M – 135K – 570K) (7,295,000)

Goodwill 520,000

Deferred Income Tax (188K + 91.2K + 82.8K) 362,000

Inventories (6M + 3.8M – 228K – 207K) 9,365,000

Cash and Current Receivables (2.36M + 1.7M) 4,060,000

$47,872,000

Equities and Liabilities

Ordinary shares $10,000,000

Retained Earnings (See part c) 12,632,950

Non-controlling interests (See Below) 2,319,050

Long Term Liabilities (8M + 2.5M) 10,500,000

Deferred Income Taxes (1.6M + 100K) 1,700,000

Current Liabilities (5.03M + 5.96M – 270K advances) 10,720,000

$47,872,000

Non-controlling Interests: (Method 1)

Devine – Carrying amount December 31, Year 11 $9,040,000

Unrealized after-tax profits – Upstream:

Land (282,000)

Inventory (136,800)

Unamortized acquisition differential 655,000

9,276,200

25%

Non-controlling interest $2,319,050

Calculation of non-controlling interests – December 31, Year 11 (Method 2)

Non-controlling interests at date of acquisition (25% x [4,800,000 / 0.75) $1,600,000

Devine’s adjusted increase in retained earnings (a) $2,876,200

NCI’s share @ 25% 719,050

Non-controlling interest, December 31, Year 11 $2,319,050

(e)

Non-controlling interest – at date of acquisition

- under implied value approach (25% x 6,400,000) $1,600,000

- using market value of Devine’s shares (20,000 shares x 75) 1,500,000

Decrease in non-controlling interest 100,000

Non-controlling interest, December 31, Year 11

- as previously calculated 2,319,050

- as per new calculation $2,219,050

Goodwill at December 31, Year 11

- as previously calculated $520,000

- decrease due to change in non-controlling interest 100,000

- as per new calculation $420 000

(f)

Problem 6-15

(a)

Cost of 70% investment, January 1, Year 2 $ 84,000

Implied value of 100% investment 120,000

Carrying amount of Sand’s net assets:

Common shares 50,000

Retained earnings 30,000

Total shareholders’ equity 80,000

Acquisition differential 40,000

Allocation: FV – CA

Inventory - 9,000

Equipment 24,000 15,000

Goodwill as at January 1, Year 2 $ 25,000

Balance Changes to Balance

January 1, Year 2 Year 2-4 Year 5 Dec. 31, Year 5

Inventory $ (9,000) $ 9,000 — —

Equipment 24,000 (12,000) $ (4,000) $ 8,000 (a)

Goodwill 25,000 — (21,500) 3,500 (b)

$ 40,000 $ (3,000) $ (25,500) $ 11,500 (c)

(b) PAPER CORP.

Consolidated Income Statement

for the year ended December 31, Year 5

Sales (798,000 + 300,000 – 100,0002) $ 998,000

Investment and interest income (1,050 + 3,600 – 1,0504 – 2,7003) 900

Total revenue 998,900

Cost of goods sold (480,000 + 200,000 – 100,0002 + 10,5006) 590,500

Interest expense (10,000 – 2,7003) 7,300

Research & development expenses (40,000 + 12,000 + (a) 4,000) 56,000

Miscellaneous expense (106,000 + 31,600 + (b) 21,500 – 24,0001) 135,100

Income taxes (80,000 + 34,000 – 4,2006 – 10,0005) 99,800

Total expenses 888,700

Net income 110,200

Attributable to:

Shareholders of Paper 107,050

Non-controlling interest (51,000 – 15,0005 – (c) 25,500) (30%) 3,150

110,200

Notes:

1 Management fee (2,000 × 12) $ 24,000

2 Downstream sales 100,000

3 Interest (45,000 × 8% × 9/12) 2,700

4 Investment income from Sand 1,050

Intercompany profits

Before tax 40% tax After tax

5 Unrealized after-tax gain on land — Sand selling

(upstream) (45,000 – 20,000) $ 25,000 $10,000 $ 15,000

6 Unrealized after-tax profit in ending inventory — Paper

Selling (downstream) (30,000 × 35%) $ 10,500 $ 4,200 $ 6,300

(c)

i) Inventory (66,000 + 44,000 – 10,5006) $ 99,500

ii) Land (155,000 + 30,000 – 25,0005) $ 160,000

iii) Notes payable: The notes payable would not be shown on the consolidated balance sheet.

iv) Non-controlling interest (50,000+120,000–15,0005+(c) 11,500) (30%) $ 49,950

v) Common shares $ 150,000

(d)

Non-controlling interest – at date of acquisition

- under implied value approach (30% x 120,000) 36,000

- using independent appraisal 30,000

Decrease in non-controlling interest and goodwill 6,000

Goodwill impairment loss for the year ended December 31, Year 5

- as previously calculated 21,500

- decrease due to change in goodwill at acquisition 6,000

- as per new calculation 15,500

Allocation of and changes to goodwill

Paper’s NCI’s

share share Total

Total value of subsidiary at date of acquisition 84,000 30,000 114,000

Fair value of identifiable net assets 66,500 28,500 95,000

Goodwill at date of acquisition 17,500 1,500 19,000

Goodwill impairment in Year 5* 14,276 1,224 15,500

Goodwill at December 31, Year 5 3,224 276 3,500

* Proportional to amounts at date of acquisition

Profit attributable to non-controlling interest for the year ended December 31, Year 5

- as previously calculated 3,150

- increase due to reduced goodwill impairment loss

(30% x 21,500 – 1,224) 5,226

- as per new calculation 8,376

Copyright 2016 McGraw-Hill Education. All rights reserved.

66 Modern Advanced Accounting in Canada, Eighth Edition