Advanced Financial Accounting - Comprehensive Consolidation Method

If the transaction were to be reported at carrying amount, Enron would not report the gain. If the transaction were to be reported at exchange amount under IAS 24, Enron would be able to report the gain.

In most of the situations considered in this question, Enron should not have reported the gain. Gains from intercompany transactions are typically eliminated and not reported on the seller’s financial statement. Gains are typically not reported until they are realized in a transaction with a non-related party. This requirement applies to consolidated financial statements and investments reported under the equity method but does not necessarily apply under related party transactions.

Case 7-2

(a)

This case is designed to give life to a theoretical accounting issue discussed within the chapter: If a subsidiary's debt is retired, should the resulting gain or loss be assigned to the parent or to the subsidiary? The case attempts to illustrate that no clearcut solution to this question can be found. This lack of an absolute answer makes financial accounting both intriguing and frustrating. Interesting class discussion can be generated from this issue.

Students should note that the decision as to assignment only becomes necessary because of the presence of the non-controlling interest. Regardless of the level of ownership, all intercompany balances are eliminated on consolidation as per IFRS 3.B86. Not until the time that the non-controlling interest computations are made does the identity of the specific party become important.

All financial and operating decisions are assumed to be made in the best interest of the business entity as a whole. This debt would not have been retired unless corporate officials believed that Penston/Swansan would benefit from the decision. Thus, a strong argument can be made against any assignment to either separate party.

(b)

· Parent company officials made the actual choice that created the loss. Therefore, assigning the $300,000 to the subsidiary directs the impact of their reasoned decision to the wrong party. In effect, the subsidiary had nothing to do with this transaction (as indicated in the case) so that its financial records should not be affected by the $300,000 loss.

· The debt was that of the subsidiary. Because the subsidiary's debt is being retired, all of the $300,000 should be attributed to that party. Financial records measure the results of transactions and the retirement simply culminates an earlier transaction made by the subsidiary. The parent is doing no more than acting as an agent for the subsidiary (as indicated in the case). If the subsidiary had acquired its own debt, for example, no question as to the assignment would have existed. Thus, changing that assignment simply because the parent chose to be the acquirer is not justified.

· Both parties were involved in the transaction so that some allocation of the loss is required. If, at the time of repurchase, a discount existed within the subsidiary's accounts, this figure would have been amortized to interest expense (if the debt had not been retired). Thus, the $300,000 loss was accepted now in place of the later amortization. This reasoning then assigns this portion of the loss to the subsidiary. Because the parent was forced to pay more than face value, that remaining portion is assigned to the buyer.

Case 7-3

(a) The following amounts would be reported on the separate-entity financial statements:

Slum’s books Plum’s books

Years 6 + 7 Years 8 through 10

Amortization per year 180,000 / 5 = 36,000 210,000 / 3 = 70,000

Tax Rate 30% 40%

Tax savings per year 10,800 28,000

Gain on Sale at end of Year 7

Proceeds on sale 210,000

Carrying amount (180,000 x 3/5) 108,000

Gain on sale 102,000

Income tax (@30%) 30,600

The consolidated entity paid taxes of $30,600 at the end of Year 7 and gained a tax saving of $28,000 - $10,800 = $17,200 per year in Years 8 through 10. In nominal terms, it gained $17,200 x 3 - $30,600 = $21,000. In present value terms, it realized a return of over 30%. Therefore, the intercompany sale was a good financial decision.

(b) 40% of Slum’s after-tax gain on the sale of the machine would now be credited to the non-controlling interest i.e., ($102,000 - $30,600) x 40% = $28,560. Since this amount is greater than the overall tax saving of $21,000, Plum would realize an overall loss of $7,560 on the intercompany transaction. From Plum’s perspective, it is not a good financial decision.

(c) Because of the intercompany transaction, amortization expense has increased from $36,000 to $70,000 per year. The extra $34,000 must be eliminated on consolidation so that only $36,000 of amortization expense is reported on the consolidated income statement. Income tax on the $34,000 must also be eliminated. Three alternatives are presented below for the elimination of tax on the excess amortization for each of Years 8 through 10:

Controller Manager Other

Excess amortization $34,000 $34,000 $34,000

Proposed tax rate 30% 40% 50.588%

Tax saving eliminated 10,200 13,600 17,200

Tax saving before adjustment 28,000 28,000 28,000

Tax saving after adjustment 17,800 100 10,800

The controller’s suggestion of 30% can be supported on the basis that the total tax saving eliminated over 3 years will be $30,600 (10,200 x 3) which is equal to the tax paid by Slum when the gain was reported for tax purposes. The intercompany gain and related income tax were held back from consolidated net income in Year 7 because the gain was not realized from a consolidated perspective. The after-tax gain should be recognized from a consolidated perspective as the machine is used by the consolidated entity to produce income over the 3-year remaining useful life of the machine. This results in reporting a tax saving of $17,800 on amortization expense of $36,000 on the consolidated income statement. This is $7,000 per year more than Slum’s tax saving of $10,800 per year before it sold the machine to Plum. This fairly presents the actual situation because Plum is achieving an incremental tax benefit of $7,000 per year (i.e. $21,000 overall gain spread over 3 years) because of the intercompany transaction. [Conceptual framework for financial reporting: para QC12]

The other option can initially be supported on the basis that it would report a tax saving after adjustment of $10,800 on amortization expense of $36,000 on the consolidated income statement which is consistent with what was reported before the intercompany transaction occurred. It would eliminate a total of $51,600 (17,200 x 3) of tax saving over 3 years, which is $21,000 more than the tax paid on the original sale of the machine. Therefore, this alternative does not fairly present the true tax situation for the consolidated entity because it does not reflect that the consolidated entity did, in fact, realize a tax saving of $21,000 through the intercompany transfer. The manager’s suggestion would produce similar results as the other option because it would not portray the true saving realized to the consolidated entity as a result of the intercompany transfer.

Case 7-4

Memo to: Partner

From: Stephanie Baker, CPA

Subject: Canadian Developments Limited (CDL) Engagement

As requested, I have analyzed the accounting implications, financial statement disclosure, and other matters of importance relating to several transactions that CDL entered into during the Year 8 fiscal year.

Overall, the policies suggested by CDL management lead me to conclude that there is a bias towards adopting policies that maximize earnings and provide a strong balance sheet to attract new investors.

Changes in capital structure

If the convertible debentures are, in substance, permanent equity of CDL, then their classification as shareholders' equity is appropriate and gives the proper presentation of the economic substance of the transaction. Therefore, it is necessary to determine whether these debentures are, in substance, equity or debt.

Likelihood of conversion

The classification of the debenture will depend on the likelihood of the debenture being converted to common shares. In this instance, the holders of the debentures are a relatively small group (major shareholder (53%) and large institutions), and CDL may be able to find out from them what their intentions are. If the majority of the holders confirm their intention to convert, the question of uncertainty will be largely resolved.

CDL has the option to trigger (force) conversion by repaying the debt at maturity by issuing common shares. The existence of the option, however, is not sufficient to permit accounting for the debenture on the unsupported assumption that the conversion will occur. CDL must intend to force conversion if it wishes to account for the debentures as permanent equity.

Unusual features

The lower interest rate on the debenture indicates that a large portion of the security's value lies in the conversion feature, thus increasing the likelihood of conversion.

Future financial solvency

Although it is impossible to assess the company's solvency 20 years from now with accuracy, it is important to assess the financial stability and trends. This will provide insight into whether the company will be able to meet the solvency tests required to force conversion. Financial solvency is unlikely to be a concern in 20 years’ time in light of the following: the size of the company (lots of equity); publicly held debt (major financial institutions will have debt covenants aimed at solvency); and diversification that should insulate the company from shocks to one sector of the economy.

Other factors

There are other, less critical, factors that can be considered in determining whether the debenture should be classified as debt or equity:

· In common with other forms of debt the debenture pays interest and therefore the return is not dependent on earnings.

· The legal form of the instrument is debt; if CDL were liquidated, this debenture would take precedence over equity.

· The debentures can be redeemed by the holder at the purchase price.

The most important consideration in this decision is the intention of CDL and the debt holders regarding conversion. If we can establish that conversion is likely, then I would support the client's classification of this debenture as equity. [IAS 32.11 and .16]

There should be full disclosure in the notes to the financial statements regarding the classification of this transaction. We must ensure that the income statement treatment of the interest payments is consistent with the balance sheet presentation. That is, if this debenture is classified as equity, then the interest payments should be disclosed as dividends. If Revenue Canada requires debt treatment, then the dividends should be disclosed net of tax.

There will be no effect on CDL's basic earnings per share figure regardless of the balance sheet treatment given to this transaction because the amount available to the common shareholders will be the same under both presentations. However, if the conversion proved dilutive, then the effects of the conversion would have to be incorporated in the calculation of the fully diluted earnings per share. If CDL does not already disclose fully diluted earnings per share and the conversion is dilutive, then fully diluted earnings per share will have to be disclosed.

Redeemable preferred shares

Two issues need to be considered with respect to the redeemable preferred shares: their classification on the balance sheet (same issue as the convertible debentures), and their measurement on the balance sheet.

Classification

Since the preferred shares are mandatorily redeemable in five years' time, they do not constitute a part of CDL's permanent capital. CDL should classify share capital according to the substance i.e. debt, which would result in the preferred shares being excluded from the permanent equity section of the balance sheet. [IAS 32.11]

Measurement of the conversion

There are three alternatives for recording the conversion:

1) Record at $20 million

This alternative is supported by the historic cost concept. The cost to CDL of the preferred shares is $20 million. This approach would be reinforced if the $20 million were the legal, stated amount (i.e., the paid-in amount). CDL could then appropriate retained earnings for the future payment of $20 million.

2) Record at $40 million

The $40 million represents the effective "stake" of the shareholder in CDL. The excess $20 million should first be charged against contributed surplus, and then the balance charged against retained earnings.

3) Amortize $20 million over 5 years

This alternative would gradually reflect the increase in the effective stake of the shareholder over the five-year term. Since the shares are classified as debt, the charge would be to income.

Investors contribute cash to enterprises so that they can earn a return on their investment. Whether a payment is made each year or not, an investor expects ultimately to receive the return earned annually. In the case of a preferred share issue that is mandatorily redeemable, the return will be provided either annually or at maturity, usually in a fixed form.

In this instance, the return has been fixed at $40 million payable in five years' time. The $40 million represents both a return of capital and income over the five-year period until maturity. In substance, the earnings on the invested capital are accruing over the five years and will be paid out in one lump sum. Accounting for the substance of the transaction suggests discounting the $40 million payment and accruing the annual dividend each year as a form of interest expense. The discounted amount should approximate the fair value of the redeemable preferred shares. [IFRS 9.5.1.1]

The conversion will need to be disclosed in the notes to the financial statements.

Disposal of residential real estate segment

In substance, all that has happened to CDL is that it sold the residential real estate operations. However, control over the assets of the commercial division did not change since CDL controlled these assets both before and after this series of transactions. Therefore, under the historic cost concept, the assets of the commercial division should remain at carrying amounts. [IFRS 3.B86]

In RPI's case, the assets should be recorded at IRE’s historical cost for the following reasons:

· There is not a new economic entity.

· The fair values were not determined at arm's length, as the buyer had nothing to lose if an inflated price was chosen.

· Appraisal increments (which we could obtain) would be accepted if there had been a reorganization of capital.

RPI for its separate entity financial statements and CDL for it consolidated financial statements could use the revaluation model in IAS 16 to value the assets of the commercial division at fair value. However, it would have to do so on an ongoing basis and not on a one-shot deal.

Case 7-5

Memo to: File

Subject: Accounting Issues for BSL group of companies

Given the changes at BSL during the year, new accounting treatments will be applied. It appears that Jack has incorrectly handled some of the new situations from an accounting perspective. Because the changes typically affect more than one of the companies, they have been discussed from a transactional level rather than an entity level.

Fuel Tank Installation Sales [Section 3400]

Revenue — Multiple deliverables

The revenue generated from selling the installation and maintenance package possibly has three distinct streams of revenue: the revenue related to the fuel tank sale, the delivery and installation service of the fuel tank at the client’s site, and the five-year ongoing maintenance contract for the fuel tank. The total revenue that will be derived from the sale of the entire fuel tank package is $40,000.

If there is objective and reliable evidence of fair value for all units of accounting in an arrangement, the arrangement consideration should be allocated to the separate units of accounting based on their relative fair values. In this case, we need to determine if the tank itself, the delivery and installation costs, and the maintenance package represent separate units of accounting. The items are considered as separate units of accounting if:

1) The item has value to the customer on a stand-alone basis; the item has value on a stand-alone basis if it is sold separately by any vendor or the customer could resell the delivered item on a stand-alone basis. In the context of a customer's ability to resell the delivered item, this criterion does not require the existence of an observable market for that deliverable.

2) There is objective and reliable evidence of the fair value of the item; and

3) The items include arrangements with respect to general rights of return (if applicable).

Fair value of delivery and installation

Based on the information provided by Jack, Tanks doesn’t sell the tank without installing it. However, other vendors sell the installation separately from the tank, for the same tanks. Therefore, a fair value can be established for the delivery and installation component.

Fair value of maintenance contract

The value of the maintenance package can be calculated as follows: 5 years × $5,000 per year (fair market value), which totals $25,000. Therefore, if the total revenue generated from the sale of one tank is $40,000, $15,000 should be allocated to the sale and installation of the unit and $25,000 should be allocated to the maintenance package.

The maintenance contract therefore appears to meet the criteria to be considered a separate unit of accounting and should be accounted for as such. The value allocated to the maintenance package should be accounted for as deferred revenue. The amounts will be brought into income as the maintenance services are rendered over time.

Revenue-Recognition — Delivery and Installation Delays

We also need to consider the fact that delivery and installation are delayed and only happen two to three weeks after the agreement is signed. Revenue recognition says performance should be regarded as having been achieved when all the following criteria are met: a) persuasive evidence of an arrangement exists; b) delivery has occurred or services have been rendered; and c) the seller’s price to the buyer is fixed or determinable. In this case, there is a signed agreement, but delivery and installation are delayed (two to three weeks later), so Tanks cannot recognize the revenue at the point of signing the contract. It must wait until terms of the contract are fulfilled — in other words, the point of customer acceptance, which in this case is when the tank is installed and working — to recognize the revenue.

Related Party Transactions

There are many related party transactions taking place this year due to the creation of the two new subsidiaries. Upon consolidation, there should be complete elimination of unrealized intercompany gains or losses and adjustments of applicable income. [Section 1601.17] At an individual company level, related party transactions will have to be properly accounted for.

The sale of the trucks and trailers to Transport appears to have been handled incorrectly. BSL and Transport have both recorded this transfer, which took place after the subsidiary was set up, at the exchange amount, shown by the $84,000 gain appearing on BSL’s income statement and the $400,000 of property, plant and equipment appearing on Transport’s balance sheet ($431,000 purchase price less approximately $31,000 of amortization for the period).

The sale of trucks and trailers by BSL to Transport represents a related party transaction that is not in the normal course of operations for either of these businesses, since a sale of a capital asset is not considered to be in the course of normal operations. Secondly, because Transport is a 100%-owned subsidiary, the ownership has not significantly changed. For these two reasons, the carrying amount must be used to value this transaction. [Section 3840.08] There is no impact at the consolidated level because the transaction would be eliminated.

For Transport, the assets (trucks and trailers) must be recorded at their carrying amount of $347,000, and the difference between the assets and the note payable of $431,000 ($84,000) would be a reduction to equity.

The other related party transactions between BSL and its subsidiaries (Transport and Tanks), the interest payments and the rent for the property (which are both at fair market value), are in the normal course of business and should be recorded at the exchange amount [Section 3840.18]. Jack appears to be handling these transactions correctly. There should be disclosure of the fact that the subsidiaries received free rent from the parent company for the first two months of the year (in other words, the rent agreement for new location started in March, and based on the rental income in the financial statements, rent was free prior to that date).

Management may wish to disclose the guarantee made to the environmental authority by BSL related to Tanks’ operating license in the notes to the consolidated audited financial statements because it increases the overall risk of BSL on a consolidated basis. In Tanks’ stand-alone statement, management needs to consider whether it should disclose the fact that Tanks benefits from a guarantee from BSL of Tanks’ obligations since it is being provided for free. It is likely that this related party transaction should be disclosed. [Section 3840.51]

Capitalization of Training Costs and License [Section 3064]

Assets are economic resources controlled by an entity as a result of past transactions or events and from which future economic benefits may be obtained. An intangible asset must be identifiable, the entity must have control over the resource, and there must be future economic benefits. If an item does not meet the definition of an intangible asset, it is recognized as an expense when it is incurred.

Tanks has capitalized the $20,000 of training costs incurred to have Sean Piper certified as a fuel tank installer. While it might be argued that there are future benefits to Sean Piper being certified to operate the business and legally earn revenue, training costs are generally not capitalized under Canadian GAAP. It is too difficult to ascertain a) whether there will be any benefits (future revenue), and b) if there are, the appropriate period over which to amortize the benefits. In this case, the main reason for the uncertainty is that there is no way of guaranteeing that Sean will stay. Even though he owns 25% of the company, he could decide tomorrow to leave or to stop being an installer. Therefore, there is no way of controlling the use of the asset. Tanks should therefore expense the training costs in the year incurred. The Handbook provides examples of expenditures that are not part of the cost of an intangible, and training costs are included on that list, making the recommended treatment option even clearer.

However, we have noted that the value of the license itself does not appear to have been recorded as an intangible asset in Tanks. There is no indication of the cost of the license or how long it is good for, but if the amount is large enough and has future benefit to Tanks, management may want to capitalize the cost as an intangible asset.

Inventory Valuation [Section 3031]

The owners have decided to stockpile scrap metal inventory this year. In the past, scrap metal was not a material amount ($10,000 on the balance sheet of BSL). BSL is stockpiling the inventory because management expects the price at which they can sell the metal to increase above normal conditions.

In addition to establishing the inventory quantity, BSL needs to ensure it has properly valued its large inventory of scrap metal to ensure that the inventory has been accounted for in accordance with GAAP; in other words, at the lower of cost or net realizable value (NRV). The challenge in establishing the NVR of the entire inventory amount is coming up with the quantity. The metal prices should be easy for management to obtain since there is a market for scrap metal.

The Non-Controlling Interest (In Consolidated Financial Statements) [Section 1602]

The non-controlling interest is the equity in a subsidiary not attributable, directly or indirectly, to a parent. In this case, there is a non-controlling interest of 25% in Tanks, the portion owned by Sean Piper. BSL will have to properly account for the non-controlling interest when it prepares its consolidated financial statements.

Non-controlling interest should be presented in the consolidated statement of financial position within equity, separately from the equity of the owners of the parent. The consolidated income statement should present separately the net income attributable to owners of the parent and to non-controlling interest.

Warranty Provision [Section 1000.28]

There may be a need for a warranty provision related to the tank installations. Additional information is required to ascertain if this is the appropriate accounting treatment.

Asset Retirement Obligation [Section 3110]

There may be a need to establish a liability related to the stockpile of scrap metal. The large amounts of metal, if exposed to the elements, will likely rust, potentially creating a chemical runoff. BSL would be responsible for either preventing the runoff or cleaning it up. Depending on the legislative requirements related to the license held, there may be a contingent liability relating to Tanks’ license with the environmental authority. An environmental liability may need to be accrued. More information is required.

Case 7-6

To: Partner

From: CPA

Subject: Enviro Facilities Inc. Engagement

Overview

The Enviro Facilities Inc. (EFI) engagement has considerable risk associated with it. In reviewing the file, I noted many events that raise concerns about the integrity of EFI’s management. These events include:

1) management’s refusal to notify the bank of its error in converting foreign funds and the inclusion of the amount of the error in income;

2) the change in the accounting estimate of the useful lives of assets, which has the effect of increasing income;

3) the ongoing dispute with the provincial tax auditors;

4) the patent infringement suit; and

5) the rumour that an affiliated company may not comply with environmental legislation.

No single one of these circumstances provides compelling evidence of questionable management integrity. Changing accounting estimates is commonplace and often justifiable. There has been no conviction on the patent infringement suit and nuisance lawsuits are not unusual. An aggressive approach to tax can be in the interests of the shareholders, and the rumour regarding the affiliated company is just that: a rumour. Collectively however, these events give a hint that management may lack integrity, thus increasing the risk associated with the engagement.

Moody’s has put EFI’s credit rating on alert for downgrading due to a toughening of environmental legislation. EFI therefore has an incentive to improve the appearance of its financial statements to influence Moody’s decision. A downgrade in the credit rating would be costly to EFI as it would increase the cost of borrowing.

EFI’s managers and owners probably have an incentive to report higher income because of the pending sale of the company. EFI’s accounting policies and the estimates used suggest that this is the case. The prospective purchasers will likely use the financial statements to determine the price of the shares, particularly because the company is private and no market price is available for the shares. Furthermore, EFI operates in an industry where the valuation of assets is very subjective and requires estimates.

Provincial sales tax audit

The amount under investigation by the provincial auditors is $6,314,000 ($451,000,000 x 7% x 20%), which is greater than the materiality threshold. The result of the sales tax audit must therefore be carefully considered to determine whether and how it should be reported in the statements. The situation is difficult to assess because the audit is continuing and there has not yet been an assessment or even an indication by the provincial auditors of what they have determined. If they rule against EFI, both the balance sheet and the income statement will be affected. A negative ruling will increase the cost of the items purchased. Long-lived assets on the balance sheet will increase by the amount of the tax reassessment. [IAS 16.16] That amount will be amortized to the income statement over the lives of the assets. Thus, the income statement will reflect the portion of the tax that relates to the amortized portion of the assets. Similarly, the income statement will be affected by tax pertaining only to supplies that have been expensed. The effect on income is important because prospective purchasers in deciding what price to pay for EFI’s shares may rely on the statement. Once we receive the notice of assessment from the government, we will be able to evaluate whether the interpretation by the auditor is correct.

If the issue is not resolved by the time we sign the financial statements, we must decide whether this issue should be disclosed as a contingent liability or whether the amount should be accrued in the financial statements. If we determine that the liability is likely and the $6,314,000 is a reasonable estimate, then it should be accrued. We should consult our tax department to help us in this regard. The risk to us is that there could be inadequate disclosure of a material event, which is especially crucial because of the possible sale of the shares. Conversely, disclosure when the likelihood of the liability being realized is small may reduce the proceeds that the current owners of the company could receive. [IAS 37]

Bank error [Conceptual framework for financial reporting]

The treatment of the bank error results in income being increased by $7,459,168 ($9,000,000 – $10,000,000 / 6.49), an amount that is material. This misstatement of income could influence the decisions of potential buyers and bond-rating agencies. Clearly, including the amount in income is not correct accounting. The money does not belong to EFI, and the bank could ask for repayment once they discover the error. The amount of the error should be set up as a liability, not included as income. Of course, the liability may never be paid if the bank does not notice the error. If EFI refuses to change its method of accounting for the error, we should point out that the amount is taxable. The company may then agree to change its accounting approach since it imposes real economic costs. Our firm should also question whether we should remain associated with EFI given their unwillingness to return money that clearly does not belong to them.

Patent infringement award [Conceptual framework for financial reporting]

The award against EFI made by the court in the patent infringement case is unusual. Aggrieved parties normally receive a straightforward payment as compensation. The payment is usually treated as an expense for accounting purposes. In this case, however, EFI is receiving something that could have value, so the accounting is more complex. Various accounting approaches could reasonably be used. First, since the purchase is a court-imposed penalty, the $20 million share purchase could be considered to be a $20 million fine and shares to have been acquired at zero cost. This approach would be unattractive to EFI since it would have a significant effect on the income statement at a time when it is very concerned about the bottom line (because of the potential sale of the shares and the alert placed on EFI’s credit rating). An alternative approach would be to record the shares as an asset on the balance sheet at $20 million. This approach would be attractive to EFI’s management because the income statement would be unaffected.

It is clear that EFI may be receiving an asset because of the court decision. The first step would be to determine whether the shares would meet the definition of an asset. According to the IFRS Conceptual Framework, paragraph 49, “An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity”. The shares will be controlled by EFI and are the result of a past event (the court ruling); however, whether or not there will be any future benefits depends on the performance of Waste Systems. If EFI is likely to derive a future benefit from the shares, then the definition of an asset has been met.

The next question to be resolved is what the asset is worth. If the shares are to be recorded on the balance sheet at $20 million, they must be worth $20 million. If the market value is less than $20 million, then the amount in excess of the fair market value should be expensed since that amount represents a penalty. Since Waste Systems Integrated Limited is a private company, it could be difficult to arrive at a reasonable estimate of its fair market value. I strongly suggest that we have a valuation done of the company so that we have authoritative support for the value. Such support is especially important in view of EFI management’s concern about the income-statement figures at the present time. That Waste Systems had been in financial difficulty is an indication that its market value is low.

If we determine that Waste Systems has a value greater than zero and should be recorded as an asset, a number of accounting issues will need to be resolved. We must determine whether the shares should be considered a long- or short-term asset and whether we should consolidate, or use the equity method. We cannot make these accounting decisions until we have found out, for example, whether there are restrictions on EFI’s ability to sell the shares. (If there are, accounting as a financial asset would be appropriate; otherwise, we must determine what management’s intentions are.) Similarly, we need to find out what proportion of Waste Systems EFI owns, to help determine the method of accounting for the investment.

Waste-disposal sites

EFI has significantly lengthened the estimated lives of its waste disposal sites and decreased the estimated cost of sealing and cleaning up the sites. The change has a significant effect on income, which is important because the owners are considering selling their shares. Waste-disposal sites represent 64% of EFI’s assets and 41% of operating expenses. The disposal sites will be an important consideration for prospective purchasers, and they may rely on the financial statements. Thus, we must exercise great care in this highly risky part of the audit.

Compounding the problem is the fact that EFI changed consulting engineers this year and the new engineers, Cajanza Consulting Engineers (Cajanza), recommended the changes. However, there may be an independence problem. EFI owes Cajanza $2.9 million, and the amounts owing date back to Year 4. It is not clear why this amount has been outstanding for so long, but EFI may be using the debt to influence Cajanza’s judgment or Cajanza may feel pressure to provide results favorable to EFI to secure its money. It is difficult to understand how the costs of sealing and cleaning up sites can decrease at a time when environmental regulation is increasing, so the reduction in estimated costs requires some attention.

EFI uses three different methods for amortizing the cost of the sites. We must decide whether using three methods is justifiable. The IFRS Framework requires that consistent accounting policies be applied across the entity, so it is likely that using these different methods is not acceptable. “The measurement and display of the financial effect of like transactions and other events must be carried out in a consistent way throughout an entity and over time for that entity and in a consistent way for different entities.” [IFRS Framework, par.39] Therefore, the company should determine which accounting policy is the most appropriate and apply this accounting policy consistently. The same methodology should be used to calculate amortization expense across for an asset class.

Given the circumstances and the incentives for management to increase earnings, additional audit steps should be taken to satisfy us that the estimated lives and clean-up costs are reasonable. One approach would be for us to engage an engineering firm to assess the lives and clean-up costs of the sites.

In any case, it will be necessary for the changes in estimates to be disclosed in the notes.

Locating and negotiating costs

EFI amortizes the costs of locating new waste-disposal sites and negotiating agreements with municipalities. This approach is debatable and requires professional judgment to resolve.

IAS 16 states that the cost of an item of property, plant and equipment includes any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. One could argue that locating new waste-disposal sites and negotiating agreements with municipalities is a cost of bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.

On the other hand, one could argue that the cost associated with negotiating a contract would be considered an administrative cost and would be expensed as incurred. According to IAS 16.19 “Examples of costs that are not costs of an item of property, plant and equipment are … administration and other general overhead costs.”

We will have to discuss this matter with management to determine their rational for capitalizing the cost. If we deem that it is not a cost of bringing the asset to the location and condition necessary for use, the cost will need to be expensed.

Onkon-Lakerton contract [IFRS 15]

EFI has recognized the guaranteed portion of the contract with the Onkon-Lakerton municipality as revenue. IFRS 15.31 states that  “An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (i.e. an asset) to a customer”.

EFI may be able to support their position that the outcome of the contract with Onkon-Lakerton can be estimated reliably, due to the guaranteed minimum revenue of $3.4 million per year. However, IFRS still requires that revenue recognition be based on the stage of completion of the transaction. EFI has not performed any of the work in relation to the contract. Indeed, the contract period has not yet even begun. Therefore, EFI cannot recognize the $3.4 million of revenue related to this contract.

US subsidiary lawsuits [IAS 37]

Two US subsidiaries of the company are being sued for improper disposal of hazardous waste. The alleged activities took place before EFI acquired the subsidiaries, and the sale-purchase agreement provides for a price adjustment in the event of this type of liability. Provided that the agreement covers the situation in question, including costs of litigation, and the previous owner is able and willing to meet the obligation, then no additional audit work is necessary and it is not necessary to make any disclosure in the financial statements.

However, before we can come to that conclusion, we must assure ourselves that EFI is fully protected. We must be certain that the price-adjustment clauses cover legal claims of this type and that the clauses are still in force - for example, there may be limits on how long the seller remains responsible for actions of this type. We must determine whether the previous owner is ready, willing, and able to meet the terms of the contract. The previous owner could have gone out of business, could lack the resources to satisfy the claim, or could deny responsibility for some or all the damages.

If we conclude that there is some probability that EFI will be responsible for some or all the claims, we will have to consider a provision should be recorded in accordance with IAS 37.

Affiliated company dumping/purchases of disposal sites

In anticipation of the sale of shares by the owners, EFI plans to dispose of waste sites whose clean-up costs exceed their carrying amount. This transaction would be a related party transaction and must be disclosed in the notes of the financial statements [per IAS 24], which would draw attention to the users that the company was transferring the assets.

We must determine whether EFI will be free of liabilities after selling the sites. EFI may be liable contractually or legally for any future clean-up costs that result from past ownership. If potential liabilities exist, they must be reported in the financial statements. [IAS 37]

Regarding the rumour that Enviro (Bermuda) does not plan to comply with environmental legislation, it is not necessary for us to do anything at this point because the information is only a rumour and nothing illegal has been done yet. We should, however, be alert for information that substantiates the rumours.

New cost-accounting system

The new cost-accounting system will have an effect on the financial statements, so we need to consider the effect of the changes carefully. Compost is a by-product of the waste-collection process. Cost allocation to by-products is arbitrary. Costs can be allocated according to the amount of revenue generated by the sale of compost or based on direct costs, or by allocating just the incremental costs. What management needs to know is the incremental cost of producing compost so that management can determine whether it is profitable to make and sell compost.

An effect of the new cost accounting system will be to increase income in the first year because some of the costs of the waste-disposal business that would previously have been expensed will now be included in inventory as part of the cost of the compost. Only actual costs can be capitalized. We need to determine if the standard cost approximates actual cost. If not, an adjustment must be made to reflect actual costs. Depending upon the magnitude of the allocated costs and inventory, we should consider retroactive treatment. [IAS 2]

Overall conclusion

The effects of the bank error, the sales-tax audit, and the treatment of the waste disposal sites, etc., raise the possibility that the financial statements may be materially misstated. Management seems to have taken steps that have had the effect of increasing the net income and the assets on the balance sheet. We must consider whether we should resign from the engagement altogether because of the questionable integrity of management. Among other integrity concerns, the company’s handling of the bank error and changes in accounting estimates, apparently to window-dress the statements, should make us question whether we want to be associated with this client.

SOLUTIONS TO PROBLEMS

Problem 7-1

Before tax 40% tax After tax

Asset profit – Y Company selling

January 1, Year 2 – sale 45,000 18,000 27,000

Depreciation Year 2 9,000 3,600 5,400

Balance December 31, Year 2 36,000 14,400 21,600 (a)

Depreciation Year 3 9,000 3,600 5,400 (b)

Balance December 31, Year 3 27,000 10,800 16,200

Asset profit – X Company selling

April 30, Year 3 – sale 60,000 24,000 36,000

Depreciation Year 3 (12,000 8/12) 8,000 3,200 4,800

Balance December 31, Year 3 52,000 20,800 31,200 (c)

Investment in Y Company

Balance January 1, Year 2 $ 86,900)

Year 2 transactions:

Increase in Y Company retained earnings

([125,000 – 70,000] 80%) 44,000)

X’s share of changes to acquisition differential * (1,150)

Holdback of Year 2 asset profit (net) ((a) 21,600 80%) (17,280)

Year 3 transactions:

Increase in Y Company retained earnings

([104,000 – 70,000]) 80%) 27,200)

Changes to acquisition differential (*) (1,150)

Realization of Year 2 asset profit ((b) 5,400 80%) 4,320)

Holdback of Year 3 asset profit (net) (c) (31,200)

Balance December 31, Year 3 $111,640)

* (86,900 / 80% – 100,000) x 80% / 6 =1,150

Problem 7-2

Equipment gain

Before Tax 40% tax After tax

Year 2 sale – Sally selling 15,000

Depreciation Years 2 and 3 (3,000 2) 6,000

Balance December 31, Year 3 9,000 3,600 5,400

Depreciation Year 4 3,000 1,200 1,800 (a)

Balance December 31, Year 4 6,000 2,400 3,600 (b)

(a) Calculation of consolidated profit attributable to Peggy’s shareholders for Year 4

Profit of Peggy 185,000

Profit of Sally 53,000

Add: Equipment gain realized (a) 1,800

Adjusted profit 54,800 (c)

Consolidated profit 239,800

Attributable to:

Shareholders of Peggy 226,100

NCI (25% x 54,800) 13,700

239,800

(b) Peggy Company

Consolidated Income Statement

Year 4

Revenues (580,000 + 270,000) $850,000

Miscellaneous expense (110,000 + 85,000) 195,000

Depreciation expense (162,000 + 97,000 - (a) 3,000) 256,000

Income tax expense (123,000 + 35,000 + (a) 1,200) 159,200

Total expenses 610,200

Consolidated profit 239,800

Attributable to:

Shareholders of Peggy 226,100

NCI (25% x 54,800) 13,700

239,800

(c) Deferred income taxes - December 31, Year 4 (b) 2,400

Problem 7-3

Intercompany profits – subsidiary selling

Before tax 40% tax After tax

Equipment

Gain on sale, Sept. 30, Year 5 $28,000 $11,200 $16,800

Depreciation Year 5

(28,000 / 5 3/12) 1,400 560 840 (a)

Balance, Dec. 31, Year 5 26,600 10,640 15,960 (b)

Depreciation Year 6 (28,000 / 5) 5,600 2,240 3,360 (c)

Balance, Dec. 31, Year 6 $21,000 $8,400 $12,600

Building

Gain on sale, Jan. 1, Year 6 $59,500 $23,800 $35,700

Depreciation Year 6 (59,500 / 7) 8,500 3,400 5,100 (d)

Balance, Dec. 31, Year 6 $51,000 $20,400 $30,600 (e)

Intercompany Rent

Year 5 (42,000 3/12) $10,500 (f)

Year 6 $42,000 (g)

Calculation of consolidated net income

Year 5 Year 6

Incorrectly reported income $185,000 $269,000

Add: incorrect amount for NCI 45,000 8,160

Incorrect amount for consolidated net income 230,000 277,160

Less: Net unrealized profits

Equipment (b) (15,960) (h)

Building (e) (30,600) (i)

Add: equipment profit realized (c) 3,360 (i)

Corrected consolidated net income $214,040 $249,920

Attributable to:

Shareholders of Parent $173,030 $248,570

NCI ((45,000 – (25% × (h) 15,960)) 41,010

NCI ((8,160 – (25% × (i) 27,240)) 1,350

$214,040 $249,920

Parent Company

Corrected Consolidated Income Statements

Years 5 and 6

Year 5 Year 6

Miscellaneous revenues $875,000 $950,000

Miscellaneous expense 419,800 497,340

Rent expense (70,200 – (f) 10,500) 59,700

(71,800 – (g) 42,000) 29,800

Depreciation expense (100,000 – (a) 1,400) 98,600

(98,200 – (c) 5,600 – (d) 8,500) 84,100

Income tax expense (93,500 – (b) 10,640) 82,860

(107,000 + (c) 2,240 – (e) 20,400) 88,840

Consolidated net income $214,040 $249,920

Attributable to:

Shareholders of Parent $173,030 $248,570

NCI (45,000 – (25% x (h) 15,960)) 41,010

NCI (8,160 – (25% x (i) 27,240)) 1,350

$214,040 $249,920

Problem 7-4

(a) Before tax 40% tax After tax

Equipment (Parent selling)

Gain on sale, Dec. 31, Year 2 $500,000 $200,000 $300,000 (a)

Depreciation Year 3

(500,000 / 5) 100,000 40,000 60,000 (b)

Balance, Dec. 31, Year 3 400,000 160,000 240,000 (c)

Depreciation Year 4 100,000 40,000 60,000 (d)

Balance, Dec. 31, Year 4 $300,000 $120,000 $180,000 (e)

Dividends received by Hanna from Fellow (200,000 x 80%) 160,000 (f)

Equipment (7,000,000 + 4,000,000 – (a) 500,000) $10,500,000

Accumulated depreciation (2,700,000 + 1,450,000 – (b + d) 200,000) 3,950,000

Retained earnings, beginning of year, for Hanna $5,000,000

Unrealized gain, beginning of year (c) 240,000

4,760,000

Retained earnings, beginning of year, for Fellow 3,000,000

Retained earnings, date of acquisition 2,100,000

Change since acquisition 900,000

Hanna’s share x 80%

720,000

Consolidated retained earnings, beginning of year $5,480,000

Depreciation expense (800,000 + 610,000 – (d) 100,000) 1,310,000

Net income for Hanna 1,500,000

Dividends from Fellow (f) (160,000)

Realized gain on sale of equipment (d) 60,000

1,400,000

Net income for Fellow 550,000

Consolidated net income 1,950,000

· attributable to Hanna’s shareholders (1,400,000 + 80% x 550,000) 1,840,000

· attributable to non-controlling interest (20% x 550,000) 110,000

Dividends declared (only Hanna’s dividends declared) 500,000

(b)

Equipment (same as above) $10,500,000

Accumulated depreciation (same as above) 3,950,000

Retained earnings, beginning of year, for Hanna $5,000,000

Retained earnings, beginning of year, for Fellow 3,000,000

Retained earnings, date of acquisition 2,100,000

Change since acquisition 900,000

Unrealized gain, beginning of year (c) 240,000

660,000

Hanna’s share x 80%

528,000

Consolidated retained earnings, beginning of year 5,528,000

Depreciation expense (same as above) 1,310,000

Net income for Hanna 1,500,000

Dividends from Fellow (f) (160,000)

1,340,000

Net income for Fellow 550,000

Realized gain during Year 4 (d) 60,000

610,000

Hanna’s share x 80%

488,000

Consolidated net income 1,828,000

Dividends declared (same as above) 500,000

Problem 7-5

(a) (in 000s) i) ii) iii) iv)

NORD’s own income 200 200 200 200

HABS’s own income 500 500

Less: unrealized profit (500) (500)

HABS’s adjusted income 0 0

Consolidated net income 200

NORD’s ownership 75%

NORD’s share of HABS’s income 0

Dividend income from HABS (75% x 100) 75

NORD’s total income 200 200 275

Consolidated net income attributable to:

NORD’s shareholders 200

NCI (75% x 0) 0

200

(b) (in 000s) i) ii) iii) iv)

HABS’s own income 500 500 500 500

Less: unrealized profit - 500 - 500

HABS’s adjusted income 0 0

Dividend income from NORD (75% x 100) 75

NORD’s own income 200 200

Consolidated net income 200

HABS’s ownership 75%

HABS’s share of NORD’s income . 150 .

HABS’s total income 500 150 575

Consolidated net income attributable to:

HAB’s shareholders 150

NCI (25% x 200) 50

200

(c)

We can make the following observations about the income reported under the different reporting methods:

1. Net income under the equity method is equal to consolidated net income attributable to parent’s shareholders because the unrealized profit is eliminated in both situations.

2. The full amount of unrealized profit is eliminated regardless of whether the transaction is upstream as per part (a) or downstream as per part (b).

3. Unrealized profit is not eliminated under the cost method.

4. Income under cost method will be higher than income under the equity method and consolidated net income attributable to parent’s shareholders when dividends received from the investee exceed the investor’s share of the investee’s adjusted net income.

When the parent controls the subsidiary, the consolidated financial statements best reflect the financial position and results of operations of the combined entities. At the date of acquisition, the net assets of the subsidiary including goodwill are reported at fair values. The net assets of the parent are reported at their carrying values. Therefore, the consolidated financial statements do not reflect the fair value of all assets and liabilities. However, the assets and liabilities are reported at the values required by generally accepted accounting principles.

Problem 7-6

Calculation, allocation, and changes to acquisition differential

Cost of investment, July 1, Year 1 207,900

Implied value of 100% (207,900 / .9) 231,000

Total shareholders' equity of Garden 175,000

Acquisition differential 56,000

Allocation: FV – CA

Inventory 12,000

Buildings 10,000

Patents 16,000 38,000

Balance – goodwill 18,000

Changes

Balance Balance

July 1/1 Years 1 to 7 Year 8 Dec. 31/8

Inventory 12,000 -12,000

Buildings (10 years) 10,000 -6,500 -1,000 2,500 (a)

Patents (8 years) 16,000 -13,000 -2,000 1,000 (b)

Goodwill 18,000 -1,950 -7,150 8,900

56,000 -33,450 -10,150 12,400 (c)

Intercompany receivables and payables

On open account 22,000 (d)

Dividends (30,000 90%) 27,000 (e)

Intercompany profits and losses

Before tax 40% tax After tax

Opening inventory - Forest selling

(18,000 30%) 5,400 2,160 3,240 (f)

Ending inventory - Forest selling

(22,000 30%) 6,600 2,640 3,960 (g)

Land profit - Garden selling

August 1, Year 6 18,000 7,200 10,800 (h)

Sale of ¼ of land, Year 8 4,500 1,800 2,700 (i)

Balance, Dec. 31, Year 8 13,500 5,400 8,100 (j)

Intercompany bond transactions

Cost to retire bonds 57,968

Carrying amount on bonds retired (93,376 60/100) 56,026

Loss to the entity Jan. 1, Year 8 1,942 777 1,165

Interest elimination gain [(k) 882 – (m) 458] 424 170 254

Balance loss, Dec. 31, Year 8 1,518 607 911

Par value (100,000 60%) 60,000

Carrying amount (93,376 60%) 56,026

Loss to Forest 3,974 1,590 2,384)

Interest elimination gain (56,026 x 8% - 60,000 x 6%) 882 353 529)

Balance loss Dec. 31, Year 8 3,092 1,237 1,855) (l)

Par value 60,000

Cost to Garden 57,968

Gain to Garden 2,032 813 1,219)

Interest elimination loss (57,968 x 7% - 60,000 x 6%) 458 183 275)

Balance gain Dec. 31, Year 8 1,574 630 944) (n)

Deferred income taxes, Dec. 31, Year 8

Ending inventory (g) 2,640

Land (j) 5,400

Bond loss [(l) 1237 – (n) 630] 607 8,647) (o)

Garden’s accumulated depreciation, date of acquisition 95,000 (p)

Calculation of consolidated net income Year 8

Income of Forest 41,000)

Less: Dividends from Garden (50,000 90%) 45,000

Unrealized profit in ending inventory (g) 3,960

Realized loss on bonds (net) (l) 1,855 50,815)

(9,815)

Add: realized profit in opening inventory (f) 3,240)

Adjusted net income (loss) (6,575)

Income of Garden 63,000

Add: Realized bond gain (net) (n) 944

Realized gain on land (i) 2,700 3,644

66,644

Less: Changes to acquisition differential (c) 10,150

Adjusted income 56,494

Consolidated net income, Year 8 49,919

Attributable to:

Shareholders of Forest 44,270

NCI (10% x 56,494) 5,649

49,919

Calculation on consolidated retained earnings – Jan. 1, Year 8

Retained earnings of Forest, Jan. 1, Year 8 64,000

Less: Unrealized profit in opening inventory (f) 3,240

Adjusted retained earnings 60,760

Retained earnings of Garden, Jan. 1, Year 8 126,000

Retained earnings of Garden at acquisition (175,000 – 150,000) 25,000

Increase 101,000

Less: Changes to acquisition differential (c) 33,450

Unrealized profit on land (h) 10,800

Adjusted increase 56,750

Forest's ownership % 90% 51,075

Consolidated retained earnings, Jan. 1, Year 8 111,835

Calculation of non-controlling interest – Dec. 31, Year 8

Common shares 150,000

Retained earnings 139,000

Total shareholders' equity 289,000

Add: Undepleted acquisition differential (c) 12,400

Realized bond gain (net) (n) 944

302,344

Less: unrealized profit on sale of land (j) 8,100

Adjusted shareholders' equity 294,244

Non-controlling interest’s share 10%

Non-controlling interest, Dec. 31, Year 8 29,424

(a) (i) Forest Company

Consolidated Balance Sheet

December 31, Year 8

Cash (13,000 + 48,800) 61,800

Receivables (25,000 + 86,674 – (d) 22,000 – (e) 27,000) 62,674

Inventories (80,000 + 62,000 – (g) 6,600) 135,400

Plant and equipment (740,000 + 460,000 + (a) 10,000 – (j) 13,500 – 95,000 1,101,500

Accumulated depreciation (625,900 + 348,400 + (a) 7,500 – 95,000)) (886,800)

Patents (0 + 4,500 + (b) 1,000) 5,500

Goodwill 8,900

Deferred income taxes (o) 8,647

Total assets 497,621

Current liabilities (59,154 + 53,000 – (d) 22,000) 90,154

Dividends payable (6,000 + 30,000 – (e) 27,000) 9,000

6% bonds payable (94,846 40%) 37,938

Common shares 200,000

Retained earnings (see part (a) (ii)) 131,105

Non-controlling interest 29,424

Total liabilities and shareholders' equity 497,621

(a) (ii) Forest Company

Consolidated Retained Earnings Statement

Year 8

Retained earnings, Jan. 1 111,835)

Add: net income 44,270)

156,105)

Less: dividends 25,000)

Retained earnings, Dec. 31 131,105)

(b)

Dec. 31 Investment in Garden Company 50,845

Equity method income 50,845

To record 90% of adjusted subsidiary income

(56,494* 90%)

Dec. 31 Cash 45,000

Investment in Garden Company 45,000

To record 90% of Garden's dividend of 50,000

Equity method income 2,575

Investment in Garden Company 2,575

To record the adjustments to parent’s net income

(3,960 + 1,855 – 3,240)

* see the calculation of consolidated net income.

(c) A loss is recognized on the consolidated books when the subsidiary purchased the parent’s bonds in the open market because the bonds are deemed to be retired from a consolidated point of view. However, the bonds have not been retired from a separate company perspective. On the separate entity books, the discount on the bonds will continue to be amortized and income tax will be determined based on the amortization of the premium or discount. The total loss recognized over the remaining term of the bonds through the amortization of the discount will equal the loss on the deemed retirement – only the timing is different. Therefore, these differences are timing differences and would give rise to a deferred income tax asset.

(d) The debt-to-equity ratio would increase. Debt would stay the same while equity would decrease due to the reduction in NCI under the identifiable net assets method.

Problem 7-7

(a) Before tax 40% tax After tax

Equipment (Subsidiary selling)

Gain on sale, Jan. 1, Year 5 $240,000 $96,000 $144,000 (a)

Depreciation for January, Year 6

($240,000 / 4 / 12) 5,000 2,000 3,000 (b)

Balance, Jan. 31, Year 6 $235,000 $94,000 $141,000 (c)

Dividends received by Goodkey from Jingya (600,000 x 100%) 600,000 (d)

Goodkey Co.

Consolidated Income Statement

For month ended January 31, Year 5

Sales (10,000,000 + 6,000,000) $16,000,000

Gain on sale of equipment (0 + 240,000 – (a) 240,000) 0

Other income (800,000 + 50,000 – (d) 600,000) 250,000

16,250,000

Depreciation expense (450,000 + 180,000 – (b) 5,000) 625,000

Other expenses (6,600,000 + 4,300,000) 10,900,000

Income tax expense (1,220,000 + 719,000 – (a) 96,000 + (b) 2,000) 1,845,000

13,370,000

Net income $2,880,000

Attributable to:

Shareholders of parent $2,880,000

Non-controlling interest 0

(b)

Everything would be the same except for other income on Goodkey’s separate entity income statement. Under the equity method, it should exclude the dividends received from Jingya and should include Goodkey’s share of Jingya’s net income from a consolidated viewpoint, which is $190,000 calculated as follows:

Jingya’ net income $1,091,000

Unrealized gain from sale of equipment (c) 141,000

950,000

Goodkey's share x 100%

Equity method income $950,000 (e)

Goodkey’s other income should be (800 – (d) 600 + (e) 950) 1,150,000

Goodkey’s net income will now be $2,880,000 ($2,530,000 – $800,000 + $1,150,000), which is equal to consolidated net income attributable to Goodkey’s shareholders.

(c)

Everything would remain the same as in part (a) except for the following:

Goodkey’s other income (800 – (d) 600 + 80% x (d) 600) 680,000

Consolidated net income would remain the same at $2,880,000 but it would be attributable as follows:

Attributable to:

Shareholders of parent (2,880 – 190) $2,690,000

Non-controlling interest ([1,091 – (c) 141] x 20%) 190,000

Problem 7-8

(a)

Acquisition differential – buildings 1,250 (a)

Yearly amortization (25,000 / 20)

Intercompany revenues and expenses

Interest revenue and expense (12,000 ½) 6,000 (b)

Rental revenue and administrative expense 50,000 (c)

Sales and purchases 90,000 (d)

Intercompany profits

Before tax 40% tax After tax

Land gain – M selling

realized in Year 9 10,000 4,000 6,000 (e)

Opening inventory – K selling 12,000 4,800 7,200 (f)

Ending inventory – K selling 5,000 2,000 3,000 (g)

Machinery gain – M selling

realized by depreciation in Year 9

(13,000  5) 2,600 1,040 1,560 (h)

Calculation of non-controlling interest in profit of K Company – Year 9

Income of K 25,500

Add: realized profit in opening inventory (f) 7,200

32,700

Less: Changes to acquisition differential (a) 1,250

Unrealized profit in ending inventory (g) 3,000

Adjusted profit 28,450

Non-controlling interest’s share 20%

Non-controlling interest, Year 9 5,690 (i)

M Co.

Consolidated Income Statement

Year 9

Sales (600,000 + 350,000 – (d) 90,000) $860,000

Interest revenue (6,700 – (b) 6,000) 700

Gain on land sale (8,000 + (e) 10,000) 18,000

Total revenues 878,700

Cost of goods sold

(334,000 + 225,000 – (d) 90,000 – (f) 12,000 + (g) 5,000) 462,000

Distribution expense (80,000 + 70,000 – (h) 2,600 + (a) 1,250) 148,650

Administrative expense (147,000 + 74,000 – (c) 50,000) 171,000

Interest expense (1,700 + 6,000 – (b) 6,000) 1,700

Income tax expense

(20,700 + 7,500 + (e) 4,000 + (f) 4,800 – (g) 2,000 + (h) 1,040) 36,040

Total expenses 819,390

Profit 59,310

Attributable to:

Shareholders of M 53,620

Non-controlling interest (i) 5,690

$ 59,310

(b)

M Co.

Income Statement

December 31, Year 9

Sales $600,000

Interest revenue 6,700

Dividend income from subsidiary (20,000 x 80%)     16,000

  622,700

Cost of goods sold 334,000

Distribution expense 80,000

Administrative expense 147,000

Interest expense 1,700

Income tax expense     20,700

  583,400

Profit $  39,300

Problem 7-9

Calculation, allocation, and changes to acquisition differential

Total 70% 30%

Cost of investment, Jan. 1, Year 6 483,000 483,000

Fair value of NCI 195,000 195,000

678,000

Carrying amounts of Gold's net assets:

Ordinary shares 500,000

Retained earnings 40,000

Total shareholders' equity 540,000 378,000 162,000

Acquisition differential 138,000 105,000 33,000

Allocation: FV - CA

Inventory (12,000)

Land 50,000

Plant and equipment 70,000 108,000 75,600 32,400

Balance – goodwill 30,000 29,400 600

Balance Changes Balance

Jan. 1/6 Years 6 to 11 Dec. 31/11

Inventory (12,000) 12,000 –

Land 50,000 – 50,000 (a)

Plant and equipment 70,000 -21,000 49,000 (b)

108,000 -9,000 99,000

Goodwill – parent’s portion 29,400 -17,640 11,760

- NCI’s portion 600 -360 240

30,000 -18,000 12,000 (c)

Total 138,000 -27,000 111,000

Intercompany profits and losses

Before tax 40% tax After tax

Intercompany bonds – Dec. 31, Year 11

Investment in Gold Co. bonds

(230,000 – [30,000/10]) 227,000

Bonds payable

(477,500 [200,000 / 500,000]) 191,000

Realized loss – entity 36,000 14,400 21,600 (d)

Investment 227,000

Par value 200,000

Realized loss to Pure 27,000 10,800 16,200

Par value 200,000

Carrying amount 191,000

Realized loss to Gold 9,000 3,600 5,400 (e)

Patent – Gold selling

Selling price, July 1, Year 8 63,000

Carrying amount 42,000

Gain on sale 21,000 8,400 12,600

Amort. to Dec. 31, Year 11

([21,000/7] 3½) 10,500 4,200 6,300

Balance, Dec. 31, Year 11 10,500 4,200 6,300 (f)

Deferred income taxes, Dec. 31, Year 11

Gain on patent (f) 4,200

Loss on bonds (d) 14,400 18,600 (g)

Gold’s accumulated depreciation, date of acquisition 75,000 (h)

Calculation of non-controlling interest – Dec. 31, Year 11

Ordinary shares 500,000

Retained earnings 200,000

Total shareholders' equity – Gold 700,000

Less: Unrealized gain on sale of patent (f) 6,300

Realized loss on sale of bond (e) 5,400 11,700)

Adjusted shareholders' equity 688,300)

Non-controlling interest’s share 30%

206,490

Share of acquisition differential

- other than goodwill (30% x 99,000) 29,700

- goodwill 240 29,940

236,430

Pure Company

Consolidated Statement of Financial Position

December 31, Year 11

Land (100,000 + 150,000 + (a) 50,000) 300,000)

Plant and equipment (625,000 + 940,000 + (b) 70,000 – (h) 75,000) 1,560,000)

Less: accumulated depreciation

(183,000 + 220,000 + (b) 21,000 – (h) 75,000) (349,000)

Patent (net) (31,500 – (f) 10,500) 21,000)

Goodwill (c) 12,000)

Deferred income taxes (g) 18,600)

Inventory (225,000 + 180,000) 405,000)

Accounts receivable (212,150 + 170,000) 382,150)

Cash (41,670 + 57,500) 99,170)

Total assets 2,448,920)

Ordinary shares 750,000)

Retained earnings 1,019,960)

Non-controlling interest 236,430)

Bonds payable (477,500 [300,000 / 500,000]) 286,500)

Accounts payable (56,030 + 100,000) 156,030)

Total liabilities and shareholders' equity 2,448,920)

Problem 7-10

Calculation, allocation, and changes to acquisition differential

Cost of 80% investment in Spruce Ltd., Jan. 2, Year 4 2,000,000

Implied value of 100% 2,500,000

Carrying amounts of Spruce's net assets:

Common shares 500,000

Retained earnings 1,250,000

Total shareholders' equity 1,750,000

Acquisition differential 750,000

Allocation: FV – CA

Mineral rights 750,000

Balance 0

Balance Changes Balance

Jan. 1/4 Years 4 to 6 Year 7 Dec. 31/7

Mineral rights 750,000 (a) (225,000) (b) (75,000) 450,000 (c)

Intercompany sales and purchases 1,000,000 (d)

Intercompany profits

Before tax 40% tax After tax

Equipment Jan. 2/5 – Poplar selling

(500,000 – 400,000) 100,000 (e)

Depreciation Years 5 and 6 40,000

Balance, Dec. 31, Year 6 60,000 24,000 36,000 (f)

Depreciation, Year 7 20,000 8,000 12,000 (g)

Balance, Dec. 31, Year 7 40,000 16,000 24,000 (h)

Inventory Jan. 1, Year 7 – Spruce selling 200,000 80,000 120,000 (i)

Inventory Dec. 31, Year 7 – Spruce selling 105,000 42,000 63,000 (j)

Spruce’s accumulated depreciation, date of acquisition 600,000 (k)

Deferred income tax – Dec. 31, Year 7

Equipment (h) 16,000

Inventory (j) 42,000

Deferred income tax asset 58,000 (l)

Calculation of consolidated net income – Year 7

Income of Poplar 1,100,000

Less: Dividend from Spruce (250,000 80%) 200,000

Equipment profit realized (g) 12,000

Adjusted net income 912,000

Income of Spruce 521,500

Less: Changes to acquisition differential (b) 75,000

Unrealized profit in closing inventory (j) 63,000

383,500

Add: Realized profit in opening inventory (i) 120,000

Adjusted net income 503,500 (m)

Consolidated net income 1,415,500

Attributable to:

Shareholders of Poplar 1,314,800

NCI (20% x 503,500) 100,700

1,415,500

(a) (i) Poplar Ltd.

Consolidated Income Statement

Year 7

Sales (4,900,000 + 2,000,000 – 1,000,000 (d)) 5,900,000

Interest revenue (0 + 21,500) 21,500

Total revenues 5,921,500

Cost of goods sold

(2,400,000 + 850,000 – (d) 1,000,000 – (i) 200,000 + (j) 105,000) 2,155,000

Other expenses (962,000 + 300,000 + (b) 75,000 – (g) 20,000) 1,317,000

Interest expense (38,000 + 0) 38,000

Income tax expense

(600,000 + 350,000 + (i) 80,000 – (j) 42,000 + (g) 8,000) 996,000

Total expenses 4,506,000

Net income 1,415,500

Attributable to:

Shareholders of Poplar 1,314,800

NCI (20% x 503,500) 100,700

1,415,500

Calculation of consolidated retained earnings – Jan. 1, Year 7

Retained earnings of Poplar, Jan. 1, Year 7 10,000,000

9,964,000

Retained earnings of Spruce, Jan. 1, Year 7 2,000,000

At acquisition 1,250,000

Increase 750,000

Less: Change in acquisition differential (a) 225,000

Unrealized profit in opening inventory (i) 120,000

Adjusted increase 405,000 (n)

Poplar's ownership % 80% 324,000

Consolidated retained earnings, Jan. 1 Year 7 10,288,000

(ii) Poplar Ltd.

Consolidated Statement of Retained Earnings

Year 7

Retained earnings, Jan. 1, Year 7 $10,288,000

Add: net income 1,314,800

11,602,800

Less: dividends 600,000

Retained earnings, Dec. 31, Year 7 $11,002,800

Calculation of non-controlling interest – Dec. 31, Year 7

Common shares of Spruce 500,000)

Retained earnings of Spruce, Jan. 1, Year 7 2,000,000)

Net income, Year 7 521,500)

Dividends, Year 7 (250,000)

Total shareholders' equity, Dec. 31, Year 7 2,771,500)

Less: Unrealized profit in ending inventory (j) 63,000)

2,708,500)

Add: Undepleted acquisition differential (c) 450,000

Adjusted shareholders' equity, Spruce 3,158,500)

Non-controlling interest’s share 20%

Non-controlling interest, Dec. 31, Year 7 631,700)

(iii) Poplar Ltd.

Consolidated Balance Sheet

Dec. 31, Year 7

Cash (1,000,000 + 500,000) 1,500,000)

Accounts receivable (2,000,000 + 356,000) 2,356,000)

Inventory (3,000,000 + 2,006,000 – (j) 105,000) 4,901,000)

Plant and equipment (14,000,000 + 2,900,000 – (e) 100,000 – (k) 600,000) 16,200,000)

Accumulated depreciation (4,000,000 + 1,000,000 – (f) 60,000 – (k) 600,000) (4,340,000)

Investment in bonds 488,000

Mineral rights (c) 450,000)

Deferred income taxes (l) 58,000)

Total assets 21,613,000)

Accounts payable (2,492,000 + 2,478,500) 4,970,500

Bonds payable (500,000 + 0) 500,000

Premium on bonds payable (8,000 + 0) 8,000

Common shares 4,500,000

Retained earnings 11,002,800

Non-controlling interest 631,700

Total liabilities and shareholders' equity 21,613,000

(b) Investment Account, Dec. 31, Year 7 - Equity Method

Balance, Dec. 31, Year 7 – cost method 2,000,000

Less: Unrealized profit in equipment (h) 24,000

1,976,000

Add: Adjusted increase in Spruce's retained earnings to

Jan. 1, Year 7 (n) 405,000

Poplar's ownership % 80% 324,000

2,300,000

Add: Adjusted income of Spruce, Year 7 (m) 503,500

Poplar's ownership % 80% 402,800

2,702,800

Less: Dividend from Spruce (250,000 80%) 200,000

Balance, Dec. 31, Year 7 2,502,800

Alternative calculation:

Consolidated retained earnings, Dec. 31, Year 7 11,002,800

Retained earnings – Poplar Dec. 31, Year 7 – cost

method (10,000,000 + 1,100,000 – 600,000) 10,500,000

Difference 502,800

Investment in Spruce – cost method 2,000,000

Investment in Spruce – equity method, Dec. 31, Year 7 2,502,800

(c)

Gains should be recognized when they are realized i.e., when there has been a transaction with outsiders and consideration has been given/received. When the parent acquires the subsidiary’s bonds for cash in the open market, it is transacting with an outsider and giving cash as consideration. From the separate entity perspective, the parent is investing in bonds. However, from a consolidated point of view, the parent is retiring the bonds of the subsidiary when it purchases the bonds from the outside entity. Therefore, when the investment in bonds is offset against the bonds payable on consolidation, any difference in the carrying amounts is recorded as a gain or loss on the deemed retirement of the bonds.

Problem 7-11

Cost of bonds 150,064

Par value of bonds 800,000 (a)

Less: unamortized discount 73,065 (b)

Carrying amount of bonds 726,935

Intercompany portion (160,000 / 800,000) 20% 145,387

Loss to the entity 4,677 (c)

Tax at 40% 1,871 (d)

Realized loss after tax 2,806 (e)

Cost 150,064 Par 160,000

Par 160,000 Carrying amount 145,387

Gain to Alpha 9,936 (f) Loss to Beta 14,613 (i)

Tax at 40% 3,974 (g) Tax at 40% 5,845 (j)

Realized gain after tax 5,962 (h) Realized loss after tax 8,768 (k)

Bond Amortization Table for Alpha

Date Effective Interest (6%) Interest Paid (5%) Amortization Balance

Jan 1, Yr 4 150,064

June 30, Yr 4 9,004 8,000 1,004 151,068

Dec 31, Yr 4 9,064 8,000 1,064 152,132

Total 18,068 16,000 2,068 (l)

Bond Amortization Table for Beta

Date Effective Interest (6.5%) Interest Paid (5%) Amortization Balance

Jan 1, Yr 4 726,935

June 30, Yr 4 47,251 40,000 7,251 734,186

Dec 31, Yr 4 47,722 40,000 7,722 741,908

Total 94,973 80,000 14,973

Intercompany (20%) 18,995 16,000 2,995 (m)

Before tax 40% tax After tax

Alpha

Realized gain on bonds (f) 9,936 (g) 3,974 (h) 5,962

Interest elimination loss* (l) 2,068 827 1,241

Balance December 31, Year 4 gain 7,868 3,147 4,721 (n)

Beta

Realized gain (loss) on bonds (i) (14,613) (j) (5,845) (k) (8,768)

Interest elimination loss (gain) (m) (2,995) (1,198) (1,797)

Balance December 31, Year 4 gain (loss) (11,618) (4,647) (6,971) (o)

* from bond amortization

(a) Realized loss on bonds, Year 4 (c) 4,677

(b) December 31, Year 4

Investment in Beta Corporation 102,600

Equity method income 102,600

90% 114,000 share of Beta's profit

Cash 27,000

Investment in Beta Corporation 27,000

90% 30,000 dividends from Beta

Equity method income 6,274

Investment in Beta Corporation 6,274

Net bond loss allocated to Beta (90% (o) 6,971)

Investment in Beta Corporation (n) 4,721

Equity method income 4,721

Net bond gain allocated to Alpha

(c) Carrying amount of bonds 741,908

Intercompany portion (20%) 148,382

Consolidated bonds payable December 31, Year 4 593,526

Problem 7-12

Cost of bonds July 1, Year 7 381,250

Par value of bonds 400,000

Less: unamortized discount 20,000

Carrying amount 380,000

Realized loss to entity July 1, Year 7 (before tax) 1,250 (a)

Par value 400,000

Cost of bonds 381,250

Realized gain to Parent Co. (before tax) 18,750 (b)

Par value 400,000

Carrying amount (400,000 – 20,000) 380,000

Realized loss to Sub. Co. (before tax) 20,000 (c)

Before tax 40% tax After tax

Entity

Realized loss (gain) July 1, Year 7 (a) 1,250 500 750 (d)

Interest elimination gain (loss) Year 7* 125 50 75 (e)

Balance loss (gain) Dec. 31, Year 7 1,125 450 675

Parent Co.

Realized loss (gain) July 1, Year 7 (b) (18,750) (7,500) (11,250)

Interest elimination gain (loss)

Year 7* (1,875) (750) (1,125)

Balance loss (gain) Dec. 31, Year 7 (16,875) (6,750) (10,125) (f)

Sub. Co.

Realized loss (gain) July 1, Year 7 (c) 20,000 8,000 12,000

Interest elimination gain (loss)

Year 7* 2,000 800 1,200

Balance loss (gain) Dec. 31, Year 7 18,000 7,200 10,800 (g)

* 10 interest periods to maturity

Intercompany interest revenue

(400,000 10% ½ + [(b) 18,750 / 5 ½]) = 21,875 (h)

Intercompany interest expense

Interest expense (400,000 10%) 40,000

Discount amortization ([20,000 / 10 periods] 2) 4,000

Total interest expense for the year 44,000

Interest expense July 1 to Dec. 31, Year 7 22,000 (i)

Gain on elimination of intercompany revenues and expenses 125

Calculation of consolidated net income, Year 7

Income of Parent Co. 197,875

Add: Realized net bond gain (f) 10,125

Adjusted net income 208,000

Income of Sub. Co. 64,000

Less: Realized net bond loss (g) 10,800

Adjusted net income 53,200 (j)

Consolidated net income, Year 7 261,200

Attributable to:

Shareholders of Parent 247,900

NCI (25% x (j) 53,200) 13,300

261,200

Parent Co.

Consolidated Income Statement

Year 7

Interest revenue (21,875 + 0 – (h) 21,875) 0

Miscellaneous revenue (900,000 + 500,000) 1,400,000

Loss on retirement of intercompany bonds (a) 1,250

Interest expense (44,000 – (i) 22,000) 22,000

Other expense (600,000 + 350,000) 950,000

Income tax expense (124,000 + 42,000 – (d) 500 + (e) 50) 165,550

Total expenses 1,138,800

Net income 261,200

Attributable to:

Shareholders of Parent 247,900

NCI (25% x 53,200) 13,300

261,200

Problem 7-13

Intercompany bond purchase – Oct. 1, Year 5

Par value of 20% (80,000 / 400,000) of Palmer's bonds 80,000

Cost of 20% purchased 72,000

Realized gain to Scott Corporation (before tax) 8,000 (a)

Par value of 20% of Palmer's bonds 80,000

Carrying amount ([400,000 – 16,000] 20%) 76,800

Realized loss to Palmer Corporation (before tax) 3,200 (b)

Realized gain to entity ((a) 8,000 – (b) 3,200) (before tax) 4,800 (c)

Yearly interest elimination loss (4,800 / 4) 1,200 (d)

Interest elimination loss Year 5 ((d) 1,200 3/12) 300

60% 60%

Before tax After tax Before tax After tax

Entity Palmer

Realized gain (loss) Oct. 1,

Year 5 (c) 4,800 2,880 (b) (3,200) (1,920)

Interest elimination

loss (gain)* 300 180 (200) (120)

Balance gain (loss)

Dec. 31, Year 5 4,500 2,700 (3,000) (1,800) (e)

Scott

Realized gain (loss) Oct. 1,

Year 5 (a) 8,000 4,800

Interest elimination

loss (gain)* 500 300

Balance gain (loss)

Dec. 31, Year 5 7,500 4,500 (f)

* ¼ x 3/12

a) December 31, Year 5

Investment in Scott Corporation 42,000

Equity method income 42,000

70% $60,000 Share of Scott's profit

Cash 9,100

Investment in Scott Corporation 9,100

70% $13,000 Share of Scott's dividends

Equity method income (e) 1,800

Investment in Scott Corporation 1,800

Net bond loss allocated to Palmer

Investment in Scott Corporation (f) 3,150

Equity method income 3,150

Net bond gain allocated to Scott ($4,500 70%)

b) Carrying amount of bonds Oct. 1, Year 5 (400,000 – 16,000) 384,000

Discount amortization Oct. to Dec. Year 5 (16,000 / 4 x 3/12) 1,000

Carrying amount of bonds, Dec. 31, Year 5 385,000

Intercompany portion (20% 385,000) 77,000

Consolidated bonds payable Dec. 31, Year 5 308,000

Problem 7-14 (in 000s)

Calculation and allocation of acquisition differential

Cost of 60% investment in ENS $ 1,260

Implied value of 100% investment in ENS 2,100

Carrying amount of ENS:

Common shares $500

Retained earnings 130

Total shareholders’ equity 630

Acquisition differential $1,470

Allocated: (FV – CA)

Equipment (24)

Internet domain names 100

Land 150 226

Balance — goodwill $1,244

Changes to acquisition differential schedule

Balance Changes Balance

Dec. 31, Yr4 Yr5- Yr7 Yr8 Dec. 31, Yr8

Equipment (6 years) $ (24) $ 12 $ 4 $ (8) (a)

Internet domain names 100 - - 100

Land 150 - - 150 (b)

Goodwill 1,244 (1,144) (25) 75 (c)

Total $ 1,470 $ (1,132) $ (21) $ 317 (d)

Intercompany sales and cost of sales $650 (e)

Intercompany other revenues and other expenses (6 x 12) 72 (f)

Intercompany inventory profits – ENS selling

ENS’s gross margin % = (3,330 – 2,331) / 3,330 = 30%

Before tax 40% tax After tax

Closing inventory (30% x 450) $ 135 $ 54 $ 81 (g)

Beginning inventory (30% x 350) 105 42 63 (h)

Intercompany receivables and payables $182 (i)

Intercompany depreciable assets profits – RAV selling

Before tax 40% tax After tax

Proceeds on sale $782

Carrying amount 632

Unrealized gain on sale of building, July 1, Year 5 150 $60 $90

Realized gain per year (15 years remaining) 10 4 6 (j)

Realized gains to December 31, Year 8 (3.5 years) 35 14 21 (k)

Unrealized gains, December 31, Year 8 $ 115 $46 $69 (l)

ENS’s income (3,330 – 2,331 – 104 – 448) = $447 (m)

(a)

Sales (5,020 + 3,330 – (e) 650) $7,700

Other revenues (109 + 0 – (f) 72) 37

Total revenues 7,737

Cost of goods purchased (2,388 + 2,377 – (e) 650) 4,115

Change in inventory (92 – 46 + (g) 135 – (h) 105) 76

Amortization expense (208 + 104 – (a) 4 – (j) 10) 298

Goodwill impairment (0 + 0 + (c) 25) 25

Income tax and other expenses (912 + 448 – (g) 54 + (h) 42 +

(j) 4 – (f) 72) 1,280

Total expenses 5,794

Consolidated net income $1,943

Attributable to:

Shareholders of RAV 1,779.8

Non-controlling interest (40% x [(m) 447 – (g) 81 + (h) 63 – (d) 21]) 163.2

$1,943

(b)

Current assets

Cash (175 + 91) $266

Accounts receivable (261 + 242 – (i) 182) 321

Inventory (626 + 305 – (g) 135) 796

Property, plant & equipment

Land (700 + 330 + (b) 150) $1,180

Building – net (870 + 665 – (l) 115) 1,420

Equipment – net (722 + 397 – (a) 8) 1,111

Intangible assets

Internet domain names $100

Goodwill 75

(c)

Subsidiary’s retained earnings, beginning of year $279

Unrealized profit in beginning inventory (h) (63)

216

Subsidiary’s common shares 500

716

Undepleted acquisition differential (d) (317 + 21) 338

$1,054

NCI’s share (40%) $421.6

(d)

i) RAV’s separate entity income would decrease because it would report dividend income from ENS of $153.6 (60% x $256) instead of equity method income of $250.8.

ii) Consolidated net income would remain the same because intercompany dividends and other intercompany transactions are eliminated and only income from outsiders is reported. Income from outsiders remains the same.

(e)

See journal entries below.

Copyright 2019 McGraw-Hill Education. All rights reserved.

82 Modern Advanced Accounting in Canada, Ninth Edition

Copyright 2019 McGraw-Hill Education. All rights reserved.

Solutions Manual, Chapter 7 83

Problem 7-15

Year 10 income statements

P Company S Company

Sales $687,000 $416,000

Interest income 2,000

Equity method income 125,763

Gain on sale of land 7,000

Total revenues 819,763 418,000

Cost of sales 412,200 249,600

Interest expense 16,500

Selling and admin. expense 48,000 24,000

Income tax expense 15,000 9,690

Total expenses 491,700 283,290

Net income $328,063 $134,710

Bonds payable – P Company

Issued Jan. 1, Year 3 $200,000 (a)

Discount Jan. 1, Year 3 $5,000)

Amortized – Years 3 to 9 (5,000/ 10 7) (3,500)

– to July 1, Year 10 (500 ½) (250) 1,250

Balance, July 1, Year 10 198,750 (b)

Discount amortization July to Dec., Year 10 250

Balance, Dec. 31, Year 10 $199,000

Investment in bonds – S Company

Par value July 1, Year 10 $40,000

Purchase discount, July 1, Year 10 (40,000 – 38,000) $2,000)

Amortized, Year 10 (2,000 / 2½ ½) (400) (c) 1,600

Balance, Dec. 31, Year 10 $38,400

Cost of intercompany bonds July 1, Year 10 38,000

Par value 40,000

Realized gain on bond – S Company (before tax) $2,000 (d)

Par value, July 1, Year 10 40,000

Carrying amount ((b) 198,750 20%) 39,750

Realized loss on bonds – P Company (before tax) $250 (e)

Realized gain to entity, July 1, Year 10 ((d) 2,000 – (e) 250) $1,750 (f)

Before tax 40% tax After tax

Entity

Realized gain July 1, Year 10 (f) $1,750 $700 $1,050

Interest elimination gain Year 10* 350 140 210 (g)

Balance gain Dec. 31, Year 10 $1,400 $560 $840 (h)

P Company

Realized gain (loss) July 1, Year 10 (e) $(250) $(100) $(150)

Interest elimination gain (loss) Year 10* (50) (20) (30)

Balance gain (loss), Dec. 31, Year 10 $(200) $(80) $(120) (i)

S Company

Realized gain July 1, Year 10 (d) 2,000 800 1,200

Interest elimination gain Year 10* 400 160 240

Balance gain Dec. 31, Year 10 $1,600 $640 $960 (j)

* ½ year amortization, 2½ years to maturity

Intercompany revenues and expenses

Sales $76,000 (k)

Interest expense – P Company

8% 200,000 (a) $16,000

Discount amortization, Year 9 (250 + 250) 500

Total Year 10 $16,500

½ year 8,250

Intercompany portion (40,000/ 200,000) 20% $1,650

Interest revenue – S Company

8% (c) 40,000 ½ 1,600

Purchase discount amortized (c) 400 2,000

Interest elimination loss – Year 10 (g) $350

Intercompany profits

Before tax 40% tax After tax

Land – S selling – realized in Year 10

(28,000 – 21,000) $7,000 $2,800 $4,200 (l)

Calculation of equity method income

S Company net income $134,710

Add: Realized bond gain net (j) 960

Realized land gain (l) 4,200

Adjusted net income 139,870 (m)

P Company's ownership % 90%

125,883

Less: Realized bond loss (net) – P Company (i) 120

$125,763

(a) P Co.

Consolidated Income Statement

Year 10

Sales (687,000 + 416,000 – (k) 76,000) $1,027,000

Gain on bond retirement (f) 1,750

Gain on sale of land (7,000 + (l) 7,000) 14,000

Total revenues 1,042,750

Cost of sales (412,200 + 249,600 – (k) 76,000) 585,800

Interest expense (16,500 – 1,650) 14,850

Selling and admin. expense (48,000 + 24,000) 72,000

Income tax expense (15,000 + 9,690 + (h) 560 + (l) 2,800) 28,050

Total expenses 700,700

Net income $342,050

Attributable to:

Shareholders of P Co. $328,063

Non-controlling interest ((m) 139,870 × 10%) 13,987

Consolidated net income $ 342,050

(b) P Co.

Consolidated Retained Earnings Statement

Year 10

Retained earnings, Jan. 1, Year 10 $ 78,000

Add: net income 328,063

406,063

Less: dividends 10,000

Retained earnings, Dec. 31, Year 10 $396,063

Problem 7-16

Calculation, allocation, and changes to acquisition differential

Champlain NCI

(80%) (20%)

Cost of 80% investment in Samuel 129,200

Fair value of NCI’s Interest in Samuel (14 x 2,000) 28,000

Carrying amounts of Samuel's net assets:

Ordinary shares 50,000

Retained earnings 12,000

Total shareholders' equity 62,000 49,600 12,400

Acquisition differential, Jan. 1, Year 4 79,600 15,600

Allocation: FV – CA

Inventories (18,000) (14,400) (3,600)

Patent 14,000 11,200 2,800

Balance – Goodwill 82,800 16,400

Balance Changes Balance

Jan. 1/4 Years 4 to 7 Year 8 Dec. 31/8

Inventories (18,000) 18,000 - -

Patent 14,000 (7,000) (1,750) 5,250 (a)

Subtotal (4,000) 11,000 (1,750) 5,250

Goodwill – Champlain’s purchase 82,800 (34,800) (19,200) 28,800 (b)

- NCI’s share 16,400 (6,600) (3,600) 6,200 (c)

95,200 (30,400) (24,550) 40,250

Champlain’s share

(80% x subtotal + Goodwill) 79,600 26,000 20,600 33,000 (d)

NCI’s share

(20% x subtotal + Goodwill) 15,600 4,400 3,950 7,250 (e)

Intercompany profits

Before tax 40% tax After tax

Opening inventory – Samuel selling 1,900 760 1,140 (f)

Closing inventory – Samuel selling 3,300 1,320 1,980 (g)

Gain on equipment Jan. 1/6 – Samuel selling 21,000 (h)

Depreciation to Dec. 31, Year 7 ([21,000 / 6] 2) 7,000

Balance, Dec. 31, Year 7 14,000 5,600 8,400 (i)

Depreciation Year 8 (21,000  6) 3,500 1,400 2,100 (j)

Balance, Dec. 31, Year 8 10,500 4,200 6,300 (k)

Gain on land – Champlain selling 7,000 2,800 4,200 (l)

Intercompany revenues and expenses, receivables and payables

Sales and purchases 92,000 (m)

Receivables and payables 21,000 (n)

Dividends receivable and payable (5,500 80%) 4,400 (o)

Samuel’s accumulated depreciation, date of acquisition 17,000 (p)

Deferred income taxes (Dec. 31, Year 8)

Inventory (g) 1,320

Equipment (k) 4,200

Land (l) 2,800 8,320 (q)

Calculation of consolidated profit – Year 8

Profit of Champlain 42,800

Less: Dividends from Samuel (11,000 80%) 8,800 (r)

Adjusted profit 34,000

Profit of Samuel 13,000

Add: Realized profit in opening inventory (f) 1,140

Equipment gain realized (j) 2,100 3,240

16,240

Less: Unrealized profit in closing inventory (g) 1,980

14,260 (s)

Less: Changes to acquisition differential

· Champlain’s share (d) 20,600

· NCI’s share (e) 3,950 24,550

Adjusted profit (10,290)

Profit 23,710

Attributable to:

Shareholders of Champlain 24,808

NCI (20% x (s) 14,260 – (e) 3,950) - 1,098

23,710

(a) (i) Champlain Ltd.

Consolidated Income Statement

Year 8

Sales (535,400 + 270,000 – (m) 92,000) 713,400

Miscellaneous revenue (9,900 – (r) 8,800) 1,100

Total revenues 714,500

Cost of sales

(364,000 + 206,000 – (m) 92,000 + (g) 3,300 – (f) 1,900) 479,400

Selling expense (78,400 + 24,100) 102,500

Admin. exp. (including depreciation & goodwill impairment loss)

(46,300 + 20,700 + (a) 1,750 + (b) 19,200 + (c) 3,600 – (j) 3,500) 88,050

Income taxes (13,800 + 6,200 + (f) 760 – (g) 1,320 + (j) 1,400) 20,840

Total expenses 690,790

Profit 23,710

Attributable to:

Shareholders of Champlain 24,808

NCI (20% x (s) 14,260 – (e) 3,950) (1,098)

23,710

Calculation of consolidated retained earnings – Jan. 1, Year 8

Retained earnings of Champlain, Jan. 1/8 45,500

Less: Unrealized profit in land (l) 4,200

Adjusted retained earnings 41,300

Retained earnings of Samuel, Jan. 1/8 68,000

At acquisition 12,000

Increase 56,000

Less: Unrealized profit in opening inventory (f) 1,140

Unrealized equipment gain (net) (i) 8,400 9,540

Adjusted increase 46,460

Champlain's ownership % 80% 37,168

Less: Champlain’s share of changes to acquisition differential. (d) (26,000)

Consolidated retained earnings, Jan. 1, Year 8 52,468

Calculation of non-controlling interest – January 1, Year 8

Ordinary shares 50,000

Retained earnings 68,000

Total shareholders' equity, Dec. 31, Year 8 118,000

Less: Unrealized profit in opening inventory (f) 1,140

Unrealized equipment gain (i) 8,400 9,540

Adjusted shareholders' equity 108,460

Non-controlling interest’s share 20%

21,692

Add: NCI’s share of undepleted acquisition differential (e) 7,250 + 3,950 11,200

Non-controlling interest, Dec. 31, Year 8 32,892

(a) (ii) Champlain Ltd.

Consolidated Statement of Changes in Equity

For the Year Ended December 31, Year 8

Ordinary Retained Non-controlling

Shares Earnings Interest

Balance, Jan. 1, Year 8 200,000 52,468 32,892

Issued ordinary shares 25,000

Profit 24,808 (1,098)

Dividends declared by BCE (20,000)

Dividends declared by subsidiaries to NCI (11,000 x 20%) (2,200)

Balance, Dec. 31, Year 8 225,000 57,276 29,594

(a) (iii) Champlain Ltd.

Consolidated Statement of Financial Position

December 31, Year 8

Property, plant, and equipment

(198,000 + 104,000 – (l) 7,000 – (h) 21,000 – (p) 17,000) 257,000)

Accumulated depreciation (86,000 + 30,000 – 10,500* – (p) 17,000) (88,500)

Patent (a) 5,250)

Goodwill (b & c) 35,000)

Deferred income taxes (q) 8,320)

Inventories (35,000 + 46,000 – (g) 3,300) 77,700)

Accounts receivable (60,000 + 55,000 – (n) 21,000 – (o) 4,400) 89,600)

Cash (18,100 + 20,600) 38,700)

Total assets 423,070)

Ordinary shares 225,000)

Retained earnings 57,276)

Non-controlling interest 29,594)

Dividends payable (5,000 + 5,500 – (o) 4,400) 6,100)

Accounts payable (56,000 + 70,100 – (n) 21,000) 105,100)

Total liabilities and shareholders’ equity 423,070)

* 7,000 + (j) 3,500 = 10,500

(b) When the gain on the sale of the equipment is eliminated on consolidation, the equipment is restated to its carrying value on Champlain’s books prior to the intercompany sale. The carrying value represents Champlain’s original cost less accumulated amortization based on the historical cost. After the consolidation adjustment, the equipment is reported at the historical cost to the consolidated entity net of accumulated amortization.

(c) Goodwill under fair value enterprise method 35,000

Less: NCI’s share 6,200

Goodwill under identifiable net assets method 28,800

NCI on statement of financial position under fair value enterprise method 29,594

Less: NCI’s share of goodwill (20%) 6,200

NCI on statement of financial position under identifiable net assets method 23,394

(d) The return on equity attributable to the shareholders of Samuel would not change because the identifiable net assets method only affects values used for non-controlling interest.

(e)

See below for summary of journal entries.

Problem 7-17

Calculation, allocation, and changes to acquisition differential

Cost of 70% investment in Dandy $13,300

Implied value of 100% $19,000

Carrying amounts of Dandy’s net assets:

Common shares $1,250

Retained earnings 6,500

Total shareholders' equity 7,750

Acquisition differential, Jan. 1, Year 4 11,250

Allocation: FV – CA

Inventory $100

Equipment 500 600

Balance – Goodwill $10,650

Changes

Balance Balance

Jan. 1/4 Years 4 to 8 Year 9 Dec. 31/9

Inventory $100 $(100) - -

Equipment (10-year life) 500 (250) $(50) $200 (a)

Goodwill 10,650 (9,350) (190) 1,110 (b)

$11,250 $(9,700) $(240) $1,310 (c)

Intercompany profits

Before tax 40% tax After tax

Opening inventory – Dandy selling (3,400 x 50%) $1,700 $680 $1,020 (d)

Closing inventory – Dandy selling (4,500 x 50%) $2,250 $900 $1,350(e)

Gain on equipment Jan. 1/5 – Handy selling $360 (f)

Depreciation to Dec. 31, Year 8 ([360 / 8] 4) 180

Balance, Dec. 31, Year 8 $180 $72 $108 (g)

Depreciation Year 9 (360  8) 45 18 27 (h)

Balance, Dec. 31, Year 9 $135 $54 $81 (i)

Intercompany revenues and expenses, receivables and payables

Sales and purchases $5,900 (j)

Consulting revenues and expenses (50 x 12) $600 (k)

Deferred income taxes (Dec. 31, Year 9)

Inventory (e) $900

Equipment (i) 54 $954 (l)

Calculation of consolidated net income – Year 9

Income of Handy $1,960

Less: Dividends from Dandy (980 70%) (m) 686

1,274

Add: Realized gain on equipment (h) 27

Adjusted net income 1,301

Income of Dandy $1,060

Add: Realized profit in opening inventory (d) 1,020

Less: Changes to acquisition differential (c) (240)

Unrealized profit in closing inventory (e) (1,350)

Adjusted net income 490

Consolidated net income $1,791

Attributable to:

Shareholders of Handy $1,644

NCI (30% x 490) 147

$1,791

(a) Handy Company

Consolidated Income Statement

Year 9

Sales (22,900 + 8,440 – (j) 5,900) $25,440

Cost of sales (15,200 + 3,680 – (j) 5,900 + (e) 2,250 – (d) 1,700) 13,530

Gross profit 11,910

Other revenue (1,820 + 0 – (m) 686 – (k) 600) 534

Selling & admin expense (1,040 + 620 + (a) 50 – (h) 45) (1,665)

Other expenses (5,520 + 2,240 + (b) 190 – (k) 600) (7,350)

Income before income taxes 3,429

Income tax expense (1,000 + 840 + (d) 680 – (e) 900 + (h) 18) 1,638

Net income $1,791 Attributable to:

Shareholders of Handy 1,644

NCI (30% x 490) 147

$1,791

(b)

Calculation of consolidated retained earnings – Jan. 1, Year 9

Handy’s retained earnings $10,620

Unrealized gain on sale of equipment (g) (108)

Subtotal 10,512

Dandy’s retained earnings, beginning of Year 9 $7,050

Dandy’s retained earnings, at acquisition 6,500

Change in retained earnings since acquisition 550

Cumulative differential amortization and impairment (c) (9,700)

Unrealized profit in beginning inventory (d) (1,020)

(10,170)

Handy’s share @ 70% (7,119)

Consolidated retained earnings $3,393

Handy Company

Consolidated Statement of Retained Earnings

For the year ended December 31, Year 9

Retained earnings, beginning of year $3,393

Add: Net income 1,644

5,037

Less: Dividends paid (1,960)

Retained earnings, end of year $3,077

(c) When unrealized profit is eliminated from the carrying value of the equipment, the equipment ends up being reported at the original cost of the equipment less accumulated amortization based on the original cost, as if the intercompany transaction had never taken place. So, in effect, the equipment is reported at its historical cost.

(d) Goodwill impairment loss under fair value enterprise method $190

Less: NCI’s share (30%) 57

Goodwill impairment loss under identifiable net assets method $133

NCI on income statement under fair value enterprise method $147

Add: NCI’s share of goodwill impairment (30%) 57

NCI on income statement under identifiable net assets method $204

(e) See below for summary of journal entries.