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Solution Manual For Modern Advanced Accounting in Canada, 7th edition by Darrell Herauf and Murray Hilton

 

Description

Chapter 6

 

Intercompany Inventory and Land Profits

 

A brief description of the major points covered in each case and problem.

 

CASES

 

Case 6-1

In this case, students are asked to illustrate the impact of intercompany sales and unrealized profits in inventory on the separate entity and consolidated financial ; Students are also asked to explain how basic accounting principles are applied when accounting for these intercompany transactions.
Case 6-2

This case, adapted from a CA exam, involves a change from equity method to fair value method for an investment in a company that has experienced substantial losses during the period.

 

Case 6-3

This is a multi-subject case from a CA exam. Students are asked to resolve a number of accounting issues including revenue recognition, government grants, contingency and intercompany transactions.

 

Case 6-4

In this case, adapted from a CA exam, students are asked to identify accounting issues related to the preparation of consolidated financial statements for an 80%-owned subsidiary and a 40%-owned investee ; Intercompany transactions and acquisition differential have not been properly accounted for.

 

Case 6-5

In this case, adapted from a CA exam, management appears to be manipulating income to minimize the bonus paid to union ; Students are required to analyze controversial accounting issues including the valuation of inventory, purchase returns and goodwill.

 

Case 6-6

This is a multi-subject case from a CA exam. Students are asked to resolve a number of accounting issues including revenue and expense recognition, contributions to a partnership, contingent consideration and offsetting of assets against liabilities.

 

 

PROBLEMS

Problem 6-1  (25 min.)

A short problem requiring calculation of selected accounts for consolidated statements when there are unrealized profits in inventory and an explanation of impact of intercompany transactions on non-controlling interest.

 

Problem 6-2  (20 min.)

This problem consists of a consolidated income statement that has been incorrectly prepared and requires correcting. Intercompany transactions and unrealized profits in opening and closing inventory have been overlooked.

 

Problem 6-3  (20 min.)

A short problem requiring calculation of selected accounts related to land for separate entity and consolidated financial statements for three years when there are unrealized profits in and an acquisition differential pertaining to land.

 

Problem 6-4  (40 min.)

A parent has used the cost method to account for its investments in its two subsidiaries. There are unrealized profits in the inventory of all three companies. The problem requires the preparation of a consolidated income statement, a calculation of consolidated retained earnings, a calculation of investment income under the equity method and an explanation of how the revenue recognition principle is applied when adjusting for unrealized profits.

 

Problem 6-5  (40 min.)

Unrealized inventory and land profits are involved over a two-year period. The problem calls for equity method journal entries as well as the calculation of consolidated net income each year, a statement showing changes in non-controlling interest, and a calculation of the balance in the investment account under the equity method.

 

Problem 6-6  (30 min.)

Three related companies are involved in selling goods to each ; The problem requires a calculation of consolidated profit and consolidated retained earnings when the parent used the cost method.

 

Problem 6-7  (70 min.)

A comprehensive problem requiring an acquisition differential calculation, amortization schedule, and a consolidated balance sheet and statement of changes in equity under the entity theory plus an explanation of how the debt to equity ratio would change under the parent company extension theory. The subsidiary was acquired seven years ago; there are intercompany profits (and losses) in land and inventory; and the parent has used the cost method to account for its investment.

 

Problem 6-8  (30 min.)

A parent has three subsidiaries that conduct intercompany transactions with each other and the problem requires the parent’s equity method journal entries and calculations of consolidated net income and consolidated retained earnings.

 

Problem 6-9  (25 min.)

A parent has used the cost method to account for its investment and the problem requires the calculation of consolidated net income attributable to the parent’s shareholders when there are unrealized inventory and land profits involved.

 

Problem 6-10  (40 min.)

Intercompany sales, interest and rental revenue, and unrealized profits in opening and closing inventory are involved in this problem that requires the preparation of a consolidated income statement and a calculation of consolidated retained earnings. The parent has used the cost method.

 

Problem 6-11  (40 min.)

Unrealized profits in opening and closing inventory and in land have to be taken into account in the preparation of a consolidated statement of changes in equity when the parent has used the cost method.

 

Problem 6-12  (25 min.)

A parent has used the equity method to account for its investment. There are intercompany inventory profits involved. The problem requires the preparation of a consolidated income statement, a calculation of consolidated retained earnings and an explanation of the impact of using the parent company extension theory on the return on equity.

 

Problem 6-13  (70 min.)

This comprehensive problem covers everything illustrated to date and requires the preparation of a consolidated income statement and consolidated statement of financial position when the parent has used the equity method plus the calculation of goodwill and non-controlling interest under the parent company extension theory.

 

Problem 6-14 (70 min.)  (Prepared by Peter Secord, Saint Mary’s University)

A comprehensive problem requiring the preparation of a consolidated income statement and a statement of financial position when the parent has used the equity method. Also required is a calculation of goodwill and NCI using the trading price of the subsidiary’s shares at the date of ; There are intercompany profits in land and inventory.

 

Problem 6-15  (50 min.)

A comprehensive problem requiring the preparation of a consolidated income statement and the calculation of specified consolidated balance sheet ; Also required is a calculation of goodwill impairment loss and consolidated net income attributable to NCI when a business valuator measures the value of NCI at the date of acquisition. There are intercompany transactions and unrealized profits in land and inventory.

 

 

WEB-BASED PROBLEMS

Web Problem 6-1

The student answers a series of questions based on the 2011 financial statements of RONA inc., a Canadian company. The questions deal with intercompany transactions in inventory and land and the impact of changes in accounting policies for inventory and land on certain ratios.

 

Web Problem 6-2

The student answers a series of questions based on the 2011 financial statements of Cenovus Energy Inc., a Canadian company. The questions deal with intercompany transactions in inventory and land and the impact of changes in accounting policies for inventory and land on certain ratios.

 

 

SOLUTIONS TO REVIEW QUESTIONS

1. The pants are similar to a single economic entity composed of a parent company and its three subsidiaries. The transfer of economic resources between the pockets in these pants simply changes the location of the resources but does not represent revenue or expense, or profit or loss, to the combined entity.

 

2. The types of intercompany revenue and expenses eliminated in the preparation of the consolidated income statement include sales and purchases, rentals, interest, and management fees. These eliminations have no effect on the amount of consolidated net income or the net income attributable to non-controlling interest.

 

3. Intercompany sales when collected and paid, intercompany cash sales, and intercompany borrowings do not alter the total cash of the consolidated entity. It is the same concept as an individual transferring cash among his/her bank accounts, or from one pocket to another.

 

4. The intercompany profit recorded in Period one is considered to be realized when the particular asset is sold outside the consolidated entity by the purchasing affiliate.

 

5. Revenue should be recognized when it is earned with a transaction outside of the reporting entity. The reporting entity for consolidated financial statements encompasses the parent and all of its ; Since intercompany transactions are transactions within the reporting entity (not outside of the reporting entity), they must be eliminated when preparing consolidated financial statements.
6. This statement is true if the selling affiliate has an income tax rate of 40%. The $1,000 reduction from ending inventory reduces the consolidated entity’s net income. A corresponding reduction of $400 in income tax expense transfers the tax from an expense to an asset on the consolidated balance sheet. When the $1,000 profit is subsequently realized, the $400 is transferred from the consolidated balance sheet to the consolidated income statement in order to achieve a proper matching of expense to revenue.

 

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

 

8. There is no adjustment to income tax expense corresponding to the elimination of intercompany revenue and expenses because there is no change to the income before tax for the consolidated entity; therefore, there should be no change to the tax expense for the consolidated entity. Whatever tax was paid or saved for the two entities will not change for the consolidated entity since the income before tax did not change. Income tax expense is adjusted on consolidation when consolidated profits are changed due to adjustments for unrealized profits.

 

9. Ideally, intercompany losses should be eliminated in the same manner as intercompany gains. In turn, an impairment test would be carried out. If the recoverable amount were less than the carrying amount, an impairment loss would be reported. When the impairment loss is greater than the intercompany loss, one can get to the same result by not reversing the intercompany loss and simply reporting an impairment loss to bring the carrying amount down to the recoverable amount.
10. The elimination of intercompany sales and purchases reduces sales revenue and cost of goods sold on the consolidated income statement. No other items on the consolidated statements are affected. The elimination of intercompany profits in ending inventory affects the following elements of the consolidated statements: cost of goods sold is increased; income tax expense is decreased; net income is decreased; net income attributable to the parent is decreased; net income attributable to the non-controlling interest is decreased (if the subsidiary was the seller); the asset inventory is decreased; deferred income tax assets are increased; non-controlling interest in net assets is decreased (if the subsidiary was the seller); and consolidated retained earnings is decreased.
11. For a downstream transaction, the adjustment for unrealized profits is applied to the parent’s income and is fully charged or credited to the parent. For an upstream transaction, the adjustment for unrealized profits is applied to the subsidiary’s income which is shared between the parent and non-controlling ; In other words, the non-controlling interest is affected by elimination of profit on upstream transactions but is not affected by the elimination of profit on downstream transactions.
12. At the end of Year 1, the unrealized profit is removed from ending inventory and added to cost of goods sold which decreases income. In Year 2, the unrealized profit is removed from beginning inventory, which decreases cost of goods sold for Year 2 and increases income for Year ; Although Year 1 and Year 2 income both must be adjusted, the adjustments are ; Therefore, the combined income for the two years does not change as a result of the adjustments.

 

13. It will not be eliminated again on the consolidated income statement for subsequent years. However, if the land remains within the consolidated entity, the unrealized gain will be eliminated in the preparation of all subsequent consolidated balance sheets and statements of retained earnings until such time as the land is sold to outside parties.
14. Adjustments are required on consolidation to bring the consolidated balances to the amounts that would have been on the subsidiary’s books had it not sold the land to the parent. Therefore, any gain reported on sale would have to be eliminated. The revaluation surplus account would have to reflect the increase in fair value over the original cost of the land when it was purchased by the subsidiary.

 

15. The journal entry would be as follows:
    Investment income xxx
    Investment in subsidiary                                                                        xxx
    where xxx is equal to the parent’s share of the unrealized profits.

 

16. Under IFRSs, only the investor’s percentage ownership in the associate times the profit in ending inventory is considered to be unrealized; since the investor cannot control the associate or the other shareholders of the associate, the profit in ending inventory times the percentage ownership of the other shareholders is considered to be a transaction with outsiders. Under ASPE, the entire profit in ending inventory is considered to be unrealized. ASPE states that the unrealized profit is same amount that would be considered to be unrealized for consolidated financial statements. For downstream transactions between a parent and subsidiary, the entire amount of unrealized profit is eliminated and charged to the parent’s shareholders.

 

 

SOLUTIONS TO CASES

Case 6-1

Using the data provided in the question, the financial statements for the parent, subsidiary and consolidated entity would appear as follows for the 3 months:

 

                                                                     Parent            Subsidiary                      Consolidated

                                                                  Aug     Sept         July      Aug                   July       Aug     Sept

BALANCE SHEET

Inventory                                                   240                     200                                200       200

Prepaid tax                                                                                                                                16

 

INCOME STATEMENT

Sales                                                                     300                      240                                             300

Cost of goods sold                                                240                      200                                             200

Gross margin                                                          60                        40                                             100

Income tax expense                                               24                        16                                               40

Net income                                                             36                        24                                               60

 

The following comments outline how all of the above financial statements present fairly the financial position and financial performance of the company in accordance with GAAP:

1. The parent and subsidiary are separate legal ; Each entity will pay income tax based on the income earned by the separate legal ; Therefore, the subsidiary will pay income tax based on the profit it earned in August and the parent will pay income tax based on the profit it earned in September.
2. The consolidated statements combine the statements of the parent and subsidiary as if they were one entity , one set of statements for the family.
3. Accounting principles should be and have been properly applied for all of the individual financial ; The main principles involved with these statements are the historical cost principle, the revenue recognition principle, and the matching principle.
4. The historical cost principle requires that certain items such as inventory be reported at historical ; This has been done for all 3 financial ; Note that the historical cost for the inventory from a consolidated perspective was $200 which is the cost paid by the subsidiary when it purchased the goods from outsiders.
5. The revenue recognition principle requires that revenue be reported when it is earned , when the benefits and risks of ownership are transferred to the ; When the subsidiary sold to the parent, the benefits and risks were transferred to the ; Accordingly, the subsidiary reported ; However, from the consolidated perspective, the family retained the benefits and risks; they were not transferred to an outside ; Therefore, no revenue is reported on the consolidated income statement for August.
6. When the parent sells to an outside entity in September, it reports revenue on its separate entity income ; Since the family has sold the inventory to an outside entity, the family has earned the ; Accordingly, the revenue is reported in September on the consolidated income statement.
7. The matching principle requires that costs be expensed in the same period as the revenue to which it ; This provides the best measure of ; Since the subsidiary reported revenue in August, it reported cost of goods sold in August in order to match expenses to revenue in ; Similarly, the parent reported cost of goods sold in September to match expenses to revenue in ; Since revenue was reported in September from a consolidated viewpoint, the cost of goods sold is reported as an expense in September as ; The cost from a consolidated viewpoint was the amount paid by the subsidiary when it bought the inventory from outsiders.
8. Income tax must also be matched to the income to which it ; In August, the subsidiary reported income tax expense of $16 to match against the pre-tax income of $; Since no income was reported in the consolidated income statement for August, no tax expense should be reported in ; Given that the subsidiary probably paid the tax to the government, the tax is considered to have been prepaid from a consolidated viewpoint because the tax was not yet due from a consolidated viewpoint.

 

Case 6-2

Overview

The managers of King Limited (King) are planning a share issue and do not want King’s earnings impaired by the poor performance of Queen Limited (Queen). The financial statements of King will be widely distributed due to the share issue planned for Year 18. The auditor must be aware of management’s bias and must ensure that earnings and assets are not overstated.

The drug industry is highly competitive. The principal assets in this industry are intangible due to the large expenditures on research and development. The nature of these assets creates problems. Note disclosure will be very important.

The relationship between King and Queen is uncooperative. It will, therefore, be difficult to obtain sufficient and appropriate audit evidence to support the accounting method and values used to record the Queen investment.

Accounting for the investment

The choice of the appropriate method to account for the Queen investment depends primarily on whether King has significant influence over Queen. The following factors indicate that King does have significant influence:

• King’s ownership meets the 20% guideline;
• King had membership on the board of directors, and voluntarily gave it up;

 

The following factors indicate that King does not have significant influence:

• inter-company transactions have declined and are no longer material;
• dividends have not been paid recently, and perhaps earnings of Queen will not accrue to King; and
• given the uncooperative nature of Queen and King’s relationship, it does not appear that King has significant influence over Queen.

 

(Students could have discussed other valid factors in determining whether King exerts significant influence over Queen)

If King is able to exert significant influence over Queen, then it will continue to use the equity method of accounting for the investment. If King no longer has significant influence, the investment in Queen would be reported at fair value. It is difficult to determine whether management of King manipulated the change in influence by ceasing to trade with Queen and removing the King representative from Queen’s board of ; In any case, the change in method would be accounted for prospectively since the change was made due to a change in ; Therefore, the prior period adjustment reported in the draft financial statements would not be appropriate and should be reversed.

(Students should have reached a conclusion on the issue of significant influence and proceeded with their analysis of either the fair value method or the equity method. This response discusses both methods. However, students were not expected to provide an analysis of both the equity and the fair value methods.)

Equity method

King must reflect its share of Queen’s current loss. As shown in Appendix I, the investment would be written down from $ million to zero because King’s share of Queen’s losses exceed the balance in the investment ; However, the investment would not be valued as a negative amount because King is not legally obligated to pay any of Queen’s liabilities.

Fair value method

If King no longer has significant influence, it would adopt the fair value method starting on the date it lost significant ; The balance in the investment account under the equity method would be retained as the initial balance under the fair value ; If the change in significant influence occurred before Queen suffered the huge loss in Year 17, the balance in the investment account would be $ ; If the change in significant influence occurred after King accrued its share of Queen’s loss for Year 17, the balance in the investment account would be ; King will likely argue that it had lost significant influence before Queen incurred the loss and would thereby avoid the write down.

On the date that King lost its significant influence, it would make an irrevocable decision to report dividend income and the fair value adjustments in net earnings or other comprehensive income. At the end of each reporting period, the investment would be revalued to fair value.

At August 31, Year 17, Queen’s shares were trading at $13 per ; If this is a fair reflection of the fair value of the company, then King’s investment would be revalued to $26 million and the revaluation adjustment would be reported in net ; The adjustment would be a loss of $ million if the investment account had not been written down to zero or a gain of $26 million if the change in accounting method had occurred after King accrued its share of Queen’s loss.

Given that Queen suffered huge losses and given that Queen’s shares were trading as low as $5 per share during the year, one could argue that $13 is not a true reflection of the fair value of Queen. The following factors should be considered in evaluating whether the market price is an appropriate reflection of the fair value of the Queen shares:

• The fact that Queen refuses to disclose information may indicate a liquidity problem that the company is reluctant to publicize. On the other hand, Queen may be trying to maintain confidentiality about its new drug breakthrough.
• Stock prices have been volatile, so the stock price cannot be relied on as an indication of value unless the volatility can be explained by specific economic events (, generic drug competition, new viral drug).
• Queen has experienced severe losses this year; this situation may be considered unusual.
• There is no evidence to suggest that Queen will continue to incur losses unless economic circumstances have changed. If, for example, competition has increased, recurring write-offs of research and development expenditures can be expected.
• There is no evidence that the market value of King’s share of Queen has been less than the carrying value for a prolonged period.

 

These factors suggest that the decline in future cash flows is not permanent and that the market price of $13 may be a reasonable reflection of the fair value of Queen. However, the market price of Queen’s shares after year-end may provide additional evidence supporting this conclusion.

(Students should have reached a conclusion on the reasonability of the trading price as a reflection of the fair value of the Queen’s shares.)

The current situation is unusual and will require detailed note disclosure to describe the change in reporting method and the impact on the financial statements.

 

APPENDIX I

Valuation of Investment Account

(in thousands of dollars)

 

Carrying amount per draft financial statements                                                 $25,000

Reverse adjustment for prior period adjustment                                                     2,400

Restated balance under equity method, beginning of year                                  27,400

 

Entries for year under equity method:

Realized profit in beginning inventory (22% x 5,000)                                        1,100

Unrealized profit in ending inventory (22% x 1,000)                                          (220)

Share of Queen’s loss (22% x 140,000 = 30,800) (Note 1)                          (28,280)

Balance under equity method, end of year                                                    $  – o –

 

Note 1: The adjustment should be the amount required to bring the investment account to zero.

 

Case 6-3

Memo to:         Linda Presner, Partner

 

From:              CA

 

Subject:           Accounting issues regarding Metal Caissons Limited (MCL)

 

Overview of the engagement

 

The financial statements of MCL will be used by the two shareholders, the bank and the Department of National Defence (DND). Their needs must be considered when assessing appropriate accounting policies and disclosures. John Ladd and Paul Finch wish to present financial statements conveying a picture of profitability and a strong financial position to the bank and the DND. However, it would be in their best interests to adopt policies that will also minimize corporate taxes. The bank and the DND would likely expect generally accepted accounting principles for private enterprises (ASPE) to be used in all instances.

 

(Most candidates devoted too much time to the definition of the users of MCL’s financial statements and their needs. These candidates failed to incorporate this analysis in their analysis of the accounting issues.)

 

Going concern

 

This issue must be assessed to determine whether the financial statements should be stated on the basis of historical costs or liquidation values. A potential going concern problem is suggested by the following:

• By excluding the government grants from revenues, MCL would be in a loss position. If the year-to­-date results are typical, the long-term profitability of MCL may be marginal. However, such losses may, however, be normal in a start-up situation.
• DND is the sole client and can cancel the contract if the terms of the contract are not met. Delivery dates have been missed; however, recent deliveries have been made on time.
• MCL’s working-capital position indicates potential insolvency if government grants are not received. MCL has not met the terms of the job-creation grant, and this may explain why the grant has not yet been received.
• The working-capital position has deteriorated further because DND has not paid for the caissons received to date. The metal caissons must meet high standards of quality, and DND’s inspection process may have slowed down approvals. Alternatively, the fact that DND has not paid may mean that there are problems that have not yet been disclosed to us.
• There is nothing to indicate that the contract with DND will be renewed at the end of five years or that the manufacturing process can be changed to another product at that time.
• The lawsuit pending against MCL, if successful, could drive the company into bankruptcy.
• Although there are many factors that raise a concern about the ability of MCL to continue as a going concern, MCL continues to operate as a going concern. DND has not yet cancelled the contract and the bank has not called the loan. Therefore, MCL should continue to report on a going-concern basis. However, they should disclose their reliance on the DND contract and the significant risks that may bear on their ability to continue as a going concern.

 

(Candidates were expected to address the going-concern issue. The better responses presented some quantitative analysis. Most candidates failed to address this major issue in adequate depth.)

 

Government grants

 

At present, 79% of MCL’s total workforce is employed in the plant, which is below the 85% specified in the job-creation grant. If the conditions cannot be met by their due date, the grant receivable will need to be written off.

 

The recording of the grants as revenue is inappropriate under GAAP since the grants pertain to the cost of the plant and cost of employees. The grants do not pertain to the sale of goods or provision of services. The building grant should be netted against the capitalized cost of the plant, or recorded as a deferred credit and amortized to income over the life of the plant. The job-creation grant should be deferred and amortized to income over the three-year period of the agreement. It will be necessary to disclose the terms of the grants.

 

(Most candidates discussed the accounting implications of government grants in adequate depth.)

 

Late delivery penalties

 

Further review of the contract with DND is required. It is apparent that the late delivery penalties ($110,000 for 55 days at $2,000 per day) for the first three caissons have not been accrued, and this issue must be discussed with management. DND should be contacted to find out whether the penalties will be enforced or waived and whether specifications have been met on all the caissons delivered to date. If the penalty is not waived, an accrual for the amount of the penalty will be required.

 

Clarification is needed on the procedures to be followed if a caisson proves unacceptable. To date no caissons have been returned; however, the amount of the penalties may increase with each day that the specifications continue not to be met. Related disclosures for the contracts, including the penalties, will be required.

 

(Most candidates did not quantify the amount of the possible penalty payment.)

 

Investment in MSI

 

With a 60% ownership interest, MCL likely has control over MSI. Under ASPE, the investment in MSI can be reported on a consolidated basis or using the cost method or equity method. Since MSI is reporting profit in excess of dividends paid, the consolidated statements or the equity method would increase profits for MCL. Since consolidated statements are generally viewed as more useful, I will assume that MCL will choose to report its investment on a consolidated basis. Since MSI reported a profit of $40,000, the consolidated net income attributable to MCL’s shareholders would normally increase by $24,000 (60% x 40,000). However, some of MSI’s profit was made from intercompany transactions. The intercompany transactions should be eliminated when preparing the consolidated statements since they did not involve an outside entity. The unrealized profits in ending inventory should also be eliminated. This will reduce inventory by $30,000 30% x 100,000 and increase cost of goods sold by $30,000. Since the profit of $30,000 was initially reported by MSI, both the shareholders of MCL and the non-controlling interests in MSI will be affected when the profit is eliminated. The portion attributable to the shareholders of MCL is $18,000 (60% x 30,000). Therefore, the consolidated net income attributable to MCL’s shareholders will only increase by $6,000 (24,000 – 18,000).
Capitalized expenditures

 

Capitalizing costs is appropriate only if a likely future benefit is associated with the expenditure. The capitalized expenditures will likely be reclassified as follows:

 

Expenditure                           Accounting Treatment

Office furniture                       Amounts spent on the purchase of office equipment should be added to the capital asset account and depreciated over the life of these assets.

 

Travel costs                            Costs related to the search of the plant site should be included in the cost of land.

 

Calls for tender                       The cost of calls for tender should be included in the cost of the plant and depreciated over the life of the plant.

 

Product development costs    These costs should be capitalized as development costs if the costs can be recovered through future sales of products or services. The costs should be amortized over the life of the related product.

Grant negotiations                   These costs should be netted against the amount of the grants received and amortized on the same basis as the grants.

 

Contract negotiations              These costs should be capitalized as a cost of the DND contract and amortized over the life of the contract.
Admin & legal costs                These costs and the incorporation costs should be expensed as incurred since they do not provide any measurable future benefit

 

(Most candidates addressed capitalized expenditures in adequate depth.)

 

Miscellaneous issues

 

The following issues must also be considered:

1. We must discuss with management whether there are plans to manufacture products for customers other than the DND. MCL is economically dependent on the DND contract, and this relationship must be disclosed.
2. After reviewing the government contract and after discussions with management and the DND, we should consider whether the present method of recording revenue at the time the product is shipped is appropriate. Perhaps, revenue should not be recognized until the client confirms that the detailed specifications have been met.
3. MCL’s lawyers will be contacted to assess the progress of the Deutsch Production lawsuit. Either the amount of the potential damages must be accrued or the appropriate disclosure made about the contingent liability depending on the certainty with respect to the outcome of the lawsuit. This is a critical issue considering the materiality of the amount and its impact on MCL as a going concern.
4. We must find out why no principal payments of long-term debt have been recorded on the financial If required payments have not been made, MCL could be in default, and this would be yet another consideration in the assessment of whether MCL is a going concern. Principal payments may also have been erroneously charged as interest expense.
5. The current portion of the long-term debt should be classified separately and disclosure made of the debt agreement and the principal payments to be made over the next five years.
6. Interest can be capitalized during the construction period only until production commences. It appears that interest has been capitalized beyond this period and an adjustment should be made. Once properly calculated, the amount should be disclosed in the notes to the financial statements.
7. Depreciation has been calculated on plant equipment at what appears to be a low rate. The appropriateness of the rate will have to be assessed giving regard to the useful life of the related assets being depreciated.

 

Case 6-4

Memo to:  Audit Partner

From:      Audit Senior

Re:          D Ltd. – Consolidated Financial Statements

As requested, I have prepared the following memorandum, which outlines the impor­tant financial accounting issues of D and N, its subsidi­ary, and K, its investee company.

1. The shares issued by D to purchase N and K should be measured at their fair value at the date of acquisition. For now, I will assume that the fair value of 160,000 common shares was $2,000,000 when D purchased its investments in N and K.
2. It appears that there has been no allocation of the $640,000 acquisition cost excess for N in the consolidated financial statements. The excess should be first be allocated to identifiable assets. Any remaining excess should be allocated to goodwill. The goodwill should be checked for impairment at the end of each year and written down if there is an impairment loss.
3. Given that N had capitalized some research and development expenditures, there may be some value in what they were developing. The projects that met the conditions for capitalization should be measured at fair value at the date of acquisition assuming that the assets can be separately identified and reliably measured. In turn, these assets should be amortized over their useful lives. Amortization should commence once the assets are being used in operations and are generating revenue for the company.
4. D can use either the entity theory or parent company extension theory in preparing the consolidated financial statements. Under these theories, N’s assets and liabilities would be measured at fair value at the date of acquisition. It appears that the consolidated financial statements were prepared using the parent company theory because non-controlling interest is measured at $590,000, which is 20% of the carrying amount of N’s net assets at the end of Year 2 ( common shares of $1,000,000 plus retained earnings of $1,950,000). I will assume that D will use the entity theory. Non-controlling interest at the date of acquisition should have been $1,000,000 calculated as follows:Acquisition cost for 80% interest in N                               $4,000,000
   Implied value for 100% interest in N (4,000,000 / .8)          5,000,000
   NCI’s share (20%)                                                               1,000,000

    

   This assumes that there is a linear relationship between the value of 80% and the value of 100% of N.

5. Intercompany transactions and balances between D and K must be eliminated. Sales and cost of sales should be reduced by the intercompany sales of $1,200,000. The unrealized profit of $200,000 (1,200,000 – 1,000,000) should be taken out of ending inventory and added to cost of goods ; Since this was an upstream sale, non-controlling interest will be affected by this adjustment.
6. The investment in K has been accounted for using the cost method. This method is not acceptable under IFRSs. With a 40% interest in K, D would normally have significant influence. If so, the equity method would be ; For the purpose of this discussion, I will assume that D does have significant influence and the equity method should be used.
7. Under the equity method, the acquisition cost would have to be allocated in a manner similar to what is done for consolidation purposes. The acquisition differential would be allocated to identifiable net assets where the fair value is different than carrying amount. This fair value difference would have to be amortized and an adjustment made to the investment account on an annual ; We do not have sufficient information at this point to determine the adjustment for Year 1.
8. Since D paid less than the fair value of K’s identifiable net assets, there is negative goodwill in this acquisition cost. Negative goodwill is calculated to be $233,333 ($2,100,000 / .9 – $2,100,000). If we used the same principles applied for consolidation purposes, this negative goodwill would be reported as a gain on purchase.
9. Under the equity method, D’s share of the unrealized profit from intercompany transactions would have to be eliminated. Since K made an after-tax profit of $120,000 ([1,200,000 ­– 1,000,000] x [1 – ]) on sales to D, $48,000 (40% x 120,000) would have to be eliminated from the investment account. Since D and K are related parties, the details of intercompany transactions would need to be disclosed in the notes to the consolidated financial statements.

• Based on the discussion above, I have recalculated the following account balances for the consolidated financial statements in the schedules below:Goodwill
  Investment in K (under equity method)
  Non-controlling interest on balance sheet
  Profit

 

Allocation and amortization of acquisition cost for investment in N

Cost of 80% investment, September, Year 1                                                         4,000,000

Implied value of 100% investment (4,000,000 / .8)                                                5,000,000

Carrying amounts of N’s net assets:

Common shares                                                                       1,000,000

Retained earnings                                                                     1,850,000

Total shareholders’ equity                                                                           2,850,000

Acquisition differential                                                                                             2,150,000

Allocation:                                                                                         FV – CA

Land                                                                                             800,000

Plant and equipment                                                                    700,000

Research and development expenditures                                  – 90,000

Existing goodwill                                                                          – 60,000        1,350,000

Balance – newly calculated goodwill                                                                        800,000

 

Balance      Amortization      Balance

                                                             Sept 1                                    Aug. 31

                                                             Year 1             Year 2             Year 2

 

Land                                                   800,000                                   800,000

Plant and equipment                          700,000             70,000           630,000

Research and development              – 90,000                                   – 90,000

Old goodwill                                       – 60,000                                   – 60,000

New goodwill                                     800,000                                   800,000

2,150,000             70,000        2,080,000

Investment in K

Investment in K, at date of acquisition                                                                   2,100,000

Retained earnings of K,  Aug. 31, Year 2                                       1,710,000

Retained earnings of K, at acquisition                                            1,760,000

Change                                                                                    – 50,000

Less: profit in ending inventory (200,000 x [1 – .4])                         – 120,000

Adjusted increase                                                                            – 170,000

D’s ownership %                                                                                      40%           – 68,000

Investment in K, Aug. 31, Year 2                                                                            2,032,000

 

Non-controlling interest on balance sheet

Common shares of N                                                                                             1,000,000

Retained earnings of N                                                                   1,950,000

Less: unrealized profit in ending inventory

([850,000 – 630,000] x .6)                                                     – 132,000        1,818,000

Total shareholders’ equity                                                                                       2,818,000

Unamortized acquisition differential                                                                    2,080,000

4,898,000

     20%  

Non-controlling interest, Aug. 31, Year 2                                                                   979,600

 

Calculation of consolidated profit – Year 2

Profit of D                                                                                                                  600,000

Less:  Dividends from N (200,000 x 80%)                                        160,000

Dividends from K (150,000 x 40%)                                           60,000           220,000

380,000

Profit of N                                                                                          300,000

Less: profit in closing inventory (220,000 x .6)                                – 132,000

amortization of acquisition differential                                    – 70,000

Adjusted profit                                                                                                              98,000

Profit of K                                                                                           100,000

Less: profit in closing inventory (200,000 x .6)                                – 120,000

Adjusted profit                                                                                    – 20,000

D’s ownership %                                                                                      40%             – 8,000

Consolidated profit, Year 2                                                                                        470,000

 

Attributable to:

Shareholders of D                                                                                           450,400

Non-controlling interests (20% x 98,000)                                                          19,600

470,000

 

Case 6-5

REPORT ON ACCOUNTING POLICIES USED IN THE FINANCIAL STATEMENTS OF GOOD QUALITY AUTO PARTS LIMITED FOR THE YEAR ENDED FEBRUARY 28, Year 11.

 

To the members of the union, Good Quality Auto Parts Limited:

 

I have been engaged to analyze the financial statements of Good Quality Auto Parts Limited (GQ) for the year ended February 28, Year 11 and determine whether there are any controversial accounting issues. For the purposes of this report, “controversial accounting issues” will be defined as accounting policies that have the effect of reducing payments under the profit-sharing plan to the union members.

 

The existence of the profit-sharing contract creates incentives for the management of GQ to make accounting choices that reduce net income and thereby reduce the payments that must be made to the union members. Accounting standards for private enterprises (ASPE) allow considerable flexibility and judgment by the preparers of financial statements in selecting accounting policies. Since the company is privately owned, the costs (real or perceived) of reporting lower income may be small relative to the savings generated. For example, the effect of lower income on new or existing lenders may be considered less important than the savings derived from reduced profit sharing. In addition since the term of the contract is only three years, some of the income deferral may yield permanent savings if the profit-sharing component is not renewed in subsequent contracts.

 

In analyzing the accounting policies, I will be taking as strong a position as can be justified to support the union’s objective of making net income as large as possible. This is in conflict with the objective of management, which is to reduce net income.

 

Inventory write-down

Accounting practice requires that inventory be measured at the lower of cost and net realizable value. Thus, if the inventory cannot be sold, management can justify its write-off. However, since much of the inventory has been on hand for several years, the decision to write it off this year raises a question as to the motivation for the write-off. Management could be writing off the inventory solely to reduce income, thereby reducing the payments required under the profit-sharing plan. The problem must be considered from two points of view. First, is the inventory genuinely unsaleable? If not, then the entry to write down the inventory must be reversed, resulting in a higher net income figure. Assuming that the inventory is unsaleable, the next question is whether the write-off legitimately belongs in the current period. If the inventory became unsaleable in the current year, then the write belongs in the current period. If the inventory was unsaleable in prior years, it should have been written down in prior years. In that case, the financial statements should be retroactively restated to correct the error in the appropriate period.

 

Allowance for returns

The return estimate represents a legitimate cost of doing business during the period. What is in question is whether the more conservative estimate represents a genuine reflection of a change in economic conditions or an opportunistic use of accounting judgment to reduce net income. GQ’s auditor would probably not object to the increased expense since conservatism is a key accounting principle. However, the union’s interests are not served by conservatism.

 

Use of accelerated depreciation

There is no requirement that all assets owned by a firm be depreciated in the same way. Thus, GQ can argue that the use of an accelerated method on the new equipment better reflects the pattern in which the asset’s future economic benefits are expected to be consumed by GC. We can argue that the portfolio of manufacturing equipment acquired to produce similar products should be accounted for similarly. If there is no difference between the new and old equipment with respect to the effect of technological obsolescence, then either the new asset should be depreciated on a straight-line basis or similar assets acquired previously should be depreciated on the accelerated method. The financial impact of using the same depreciation method for both cannot be determined at this point.

 

Write-off of goodwill

Goodwill should be written down or written off if there has been a permanent impairment of its value if the recoverable amount of the cash generating unit in which the goodwill is located is less than the carrying amount of the net assets, including goodwill, of the cash generating ; The fact that the auto parts industry is suffering through poor economic times does not necessarily imply that what was purchased (the company name, its customers, etc.) no longer has any value. The auto industry is very sensitive to economic cycles, and it is expected that such downturns will occur. (Indeed, their occurrence should have been factored into the acquisition cost paid by GQ).

Unless GQ can come up with strong evidence that the intangibles purchased have been impaired, there is no justification for the write-off even though GQ’s auditors supported it. It is important to emphasize that their support may rest in conservatism: auditors are willing to accept accounting treatments that are conservative. However, conservatism is inconsistent with the union’s objectives. The value of the asset acquired in Year 5 must still exist unless there is specific evidence of its impairment. GQ should provide evidence of impairment.

 

Unrealized profits from intercompany sales

The unrealized profit from intercompany sales should be eliminated when preparing consolidated financial statements. CG has not made any adjustments for these intercompany transactions for Year 11. The unrealized profit in ending inventory is $28,000 (10% x 800,000 x 35%). When this profit is eliminated, CG’s net income will decrease by $28,000. The unrealized profit in beginning inventory is $70,000 (200,000 x 35%). When adjusting for this profit, CG’s net income will increase by $70,000. Therefore, CG’s Year 11 net income should be increased by $42,000 (70,000 – 28,000).

 

Bonus to president and chairman

The compensation approach selected by the senior managers has a significant effect on the money paid to the union members. Since bonuses are deducted from income whereas dividends are not, the maximum effect of the change in compensation for union members is $500,000 (an average of $2,500 per employee). If the amount of compensation has remained more or less the same as in prior years, with only the method of payment changing, then an argument can be made that GQ is violating the spirit of the contract by changing the method.

 

Change to tax allocation

Under ASPE, CG has the choice to use either the taxes-payable method or the liability method of accounting for income taxes. Accordingly, the new method is acceptable under ASPE. We could argue that the change is in violation of the contract, as the contract was signed on the understanding that major accounting policies would remain the same. The arbitrator may accept this argument. The arbitrator, however, would likely demand consistent treatment of accounting changes.

 

Case 6-6

 

REPORT TO PARTNER ON PLEX-FAME CORPORATION

 

Overview

 

PFC is a public ; Therefore, the financial statements will be used by stakeholders for a variety of purposes, including the evaluation of the company and its ; As a result, the managers have incentives to increase or smooth earnings to influence the share price or present a favourable impression of themselves to the ; In addition, the company is expanding rapidly and, therefore, may need to raise ; By using accounting choices to increase earnings or otherwise improve the appearance of the financial statements, management may be attempting to reduce the cost of capital by lowering the cost of debt or increasing the selling price of the ; The company may have a competing objective of minimizing tax by choosing accounting policies that reduce income in cases where Revenue Canada requires for tax purposes the same accounting policies that are used in the general-purpose financial statements. PFC also wants to ensure it does not violate the debt covenant and wants to keep the debt to equity ratio below 2:1.

 

Given that PFC is a public company and that it may raise capital, it is likely that management would choose accounting policies that increase ; Its financial statements must be in compliance with International Financial Reporting Standards (“IFRSs”).

 

The issues are discussed below. The impact of the accounting and reporting on the key metrics (income, debt and equity) are shown in the appendices. Appendix I shows the accounting impact for the issues where the accounting was not specified in the case. Appendix II shows the impact when the company’s policies must be changed to be in accordance with GAAP.

 

Penalty payment

 

PFC received a $2 million payment from a contractor who built a theatre complex for PFC in Montreal. The payment was for completing the project ; In its attempt to increase income, management will want to record the penalty as revenue.

 

Arguments could be made for treating the penalty payment either as income (revenue or reduction of expenses) or as a reduction in the capital cost of the complex (balance sheet).

 

If PFC incurred additional costs because of the delay in opening the new complex, and the penalty was compensation for those additional costs incurred, then the penalty should be used to offset those costs incurred. If the additional costs incurred related to the capital cost of the complex, then the penalty should be used to reduce the capital cost of the ; Analogies might be drawn with the IFRS standard on government grants (IAS 20).  This section recommends that payments such as grants should be treated as cost ; The parallel here is that the penalty payment is like a grant and therefore should be treated as a reduction in the capital cost of the complex or in costs expensed as incurred.

 

On the other hand, if the penalty payment was compensation for lost revenue, then an argument might be made for treating the penalty as ; If the penalty is treated as revenue, then we must consider whether it should be disclosed ; Since the penalty payment is non-recurring, financial statement users would find separate disclosure informative because the portion of revenue and income that is non-recurring can be valued differently by the market and by individual investors and influence the evaluation of ; Therefore, if material, the penalty should be disclosed as a separate revenue item either on the face of the income statement or in the notes.

 

“Rue St. Jacques”

 

Ticket proceeds

 

PFC would prefer to recognize revenue as early as possible with the earliest date being the sale of the ; However, the most appropriate treatment for recognizing revenue for “Rue St. Jacques” is when the show is performed.

 

IAS 18, paragraph 15- Admission fees, requires “revenue from artistic performances, banquets and other special events is recognized when the event takes place. When a subscription to a number of events is sold, the fee is allocated to each event on a basis which reflects the extent to which services are performed at each ;

 

Performance is the critical event in the earnings process, and therefore revenue is not earned until the show is put ; There is no assurance that the production will be completed, or that any performance for which tickets are sold will take place (for example, the show could be closed down before it begins its run or even after it begins its run).  In that case, it will be necessary to refund the acquisition cost of tickets to buyers.

 

Interest on ticket proceeds

 

PFC earns a significant amount of interest by holding the money paid in advance by ticket purchasers. The interest revenue could be treated as either income or deferred revenue depending on the facts and ; Management’s preference will be to include the interest in income since it will serve to improve the bottom ; Immediate recognition of interest revenue is ; If the show is cancelled, PFC will be able to keep the interest revenue—only the amount paid for the tickets will be ; In addition, by buying their seats in advance, purchasers guarantee their seats but pay a premium for the guarantee (the interest earned by PFC and forgone by the purchasers).

 

On the other hand, interest may be factored into the price and constitute a discount from future higher ; That is, PFC may be providing a discount to people who purchase their tickets in ; Prices may rise in the ; If this is the case, then treating the interest as deferred revenue may make sense.

 

Pre-production costs

 

PFC has incurred significant costs in advance of the opening of “Rue St. ;  We must determine whether these costs should be capitalized and amortized, or expensed as ; PFC would likely prefer to capitalize costs since this treatment would minimize the current effect on income at a time when it is considering going to the capital ; In principle, capitalization and amortization of the costs over the life of the show appears ; The issue is whether the show will generate adequate revenues (in excess of the capitalized costs) to justify including them on the balance sheet as ; It is very difficult, however, to determine whether a theatre production will be ; Indications are that the show will be a success, given its long run in Paris and the extent of advance ticket ; These facts support capitalization; expensing would likely be too conservative in light of these ; However, despite these indicators of success, the show could still bomb if costs are excessive or it does not suit the tastes of Canadian theatre ; As long as the definition of as asset can be met, setting it up as an asset is acceptable.

 

If PFC chooses to capitalize the pre-production costs, they must be amortized over a reasonable period of time. One method is to expense costs against net revenues dollar for dollar until the pre-production costs are covered ( cost recovery first method).  With this method the show will generate no income until the pre-production costs have been recovered. A second alternative is to amortize over the estimated life of the show.

 

Of course, once the show opens, ongoing production costs should be expensed as incurred.

 

Advertising and promotion

 

PFC paid $12 million for advertising and promotion costs a large part of which related to the “Rue St. Jacques” costs should be expensed as incurred because it is difficult to assess the effectiveness of advertising costs to determine whether they provide future benefit.

 

Debt defeasance

 

PFC has structured the debt-retirement transaction as an in-substance defeasance of ; The effect of the transaction is to remove debt from the balance sheet and thereby reduce the amount of debt reported (thus, for example, decreasing the debt-to-equity ratio).  Unfortunately, IFRSs do not allow the use of this type of arrangement.

 

IAS 1, paragraph 32 states “An entity shall not offset assets and liabilities or income and expenses, unless required or permitted by an ;  Paragraph 33 states “An entity reports separately both assets and liabilities, and income and ;  Offsetting in the statements of comprehensive income or financial position or in the separate income statement (if presented), except when offsetting reflects the substance of the transaction or other event, detracts from the ability of users both to understand the transactions, other events and conditions that have occurred and to assess the entity’s future cash flows.

 

IAS 32 (para. 42) includes the following requirement:

 

A financial asset and a financial liability shall be offset and the net amount presented in the balance sheet when, and only when, an entity:

 

1. currently has a legally enforceable right to set off the recognized amounts; and
2. intends either to settle on a net basis, or to realize the asset and settle the liability simultaneously.

 

Both of these conditions must be met in order to offset a financial asset and a financial ; However, the facts indicate that the holders of the company’s syndicated loan are not even aware of PFC’s intended method of settling its ; Therefore, the first condition for offsetting has not been met, PFC has no legally enforceable right to set off the amounts recognized for its syndicated loan, its investment in treasury bills and its forward ; Therefore, this arrangement would not allow the removal of these items from PFC’s balance ; The treasury bonds and the debt must be reinstated on the financial statements and reported separately as an asset and a liability. The $5 million difference between the value of the asset and the liability must be reversed. This will increase income if the difference was previously recorded as a loss or will reduce a non-current asset if it was previously recorded as a deferred charge.

 

From the information obtained to date, it is not currently clear how PFC is accounting for its forward ; PFC may want to consider whether the forward contract to buy US dollars qualifies as a hedge of its debt obligation. If hedge accounting is not applied, then PFC will be required to account for the forward contract  as a derivative instrument measured at fair value through the profit and loss.

 

Sale of theatres

 

PFC began selling theatres recently where economic conditions justified the sale of a particular ; This year, a significant part of net income was generated through the sale of ; PFC has included the proceeds from these sales as revenue on the income statement (as opposed to treating them as gains or losses on disposition) because it considers such sales as an ongoing part of its ; However, the sales could also be considered incidental to ongoing operations, with only gains or losses on disposition being reported in the income ; In the latter case, the gains and losses would not be included in ; Including the proceeds from the sale of theatres is consistent with management’s objective of making the financial statements more attractive for going to the capital markets.

 

Based on the information available, it is not possible to conclude whether these sales do represent part of ongoing operations. We should review the sale agreements and board minutes to confirm that these sales are indeed “; If the sales are ongoing, the theatres would have to be reported as a current asset similar to inventory. If the theatres continue to be reported as part of property, plant and equipment, then it would be inappropriate to report the sales through revenue; the sales should be reported as gains on sale.

If the sales can be considered part of ongoing operations, consideration should be given to whether there should be separate disclosure of the revenue from theatre ; Burying the revenues from theatre sales will make it more difficult for users and the capital markets to value the company because revenue from sales of theatres may not be as regular or predictable as revenues from other ; If such sales are material, separate disclosure of revenue should be made either on the face of the income statement or in the notes.

 

Selling off a significant number of theatres raises the question of whether the number being sold is large enough to be considered a discontinued operation, requiring separate disclosure of ; For the theatre sales to qualify as a discontinued operation, they must represent a separate major line of business or geographical area of ; My assessment is that the sale of theatres should not be considered a discontinued operation because PFC is continuing in the theatre ; If, for example, PFC were ceasing to operate all of its movie theatres to focus on live theatre, an argument for discontinued operations might be made. In this case, the sale of theatres appears to be part of a continuing reassessment of its portfolio of theatres.

 

The sales for profit are consistent with management’s apparent objective of income ; Management could manipulate the situation by selling only theatres that would generate a profit (instead of selling ones that have more economic value in some other use).

 

PFC will need to consider the balance sheet classification of the theatres it intends to sell, , whether they should be classified as non-current assets held for ; A non-current asset should be classified as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continued use, which seems to be the case ; However, certain additional criteria must be met to classify an asset as held for sale, which would also need to be ; If these criteria are met, then the theatre held for sale should be measured at the lower of its carrying amount and fair value less costs of ; Non-current assets held for sale (or assets and liabilities of a disposal group classified as held for sale) are presented separately on the balance sheet.

 

Partnership agreement

 

PFC formed a partnership with an unrelated company whereby the other company contributed cash and PFC contributed television production ; As part of the deal, PFC withdrew the cash contributed by the other company for its own ; The substance of the transaction appears to be the sale (rather than contribution) of assets to the partnership and the recording of the gain on ; By using this approach, management may be attempting to increase income artificially by recognizing the full gain.

 

The facts suggest that this transaction is a partial sale of ; If this is the case, the full gain should not be ; The facts supporting this assertion are as ; First, cash can be withdrawn immediately; thus the partnership acted as a conduit for selling of the ; Second, the deal is based on future profits; that is, the value of PFC’s contribution appears to be dependent on the future performance of the ; Third, Odyssey appears to be offering little expertise to the partnership and thus cash is simply being funneled to PFC via the ; If this transaction is just a partial sale of assets, the gain should only be $ million ($40 million (portion of assets sold) x $65 million (carrying amount of assets sold)) rather than $25 million.

 

The method preferred by PFC (recording full sale of the assets) might be supported by the fact that future profits will be shared, suggesting that this is a legitimate partnership ; However, more information is required to understand how the value of PFC’s contribution may be adjusted if the net income of Phantom earned between July 1, Year 7 and June 30, Year 8 does not meet expectations, since this adjustment would appear to impact the calculation of each partners’ respective interests.

 

In assessing the substance of this transaction, we must consider management’s ; We will have to discuss the transaction with management and review pertinent documents to determine its ; We can then form an opinion on the appropriate method of accounting.

 

The accounting for the investment in the partnership depends on PFC’s level of influence over the operating and financing policies for the partnership. With a 55% interest, PFC may be able to determine these policies and would have control over the partnership. If so, they would consolidate the partnership financial statements with their own financial statements.

 

If both parties to the partnership have equal say over the policies of the partnership, then the partnership would be deemed to be a joint venture. Under IFRS 11, PFC could report its investment using the equity method.

 

Conclusion

As indicated in Appendix I, income would decrease if the pre-production costs and/or advertising costs have been capitalized and should have been expensed. As indicated in Appendix II, income should be reduced for the unrealized gain on the transfer of assets to the partnership and debt should be increased to reverse the debt defeasance ; After adjustment, the return on equity on an annualized basis is only , which is below the company’s target return on equity. The debt to equity ratio is , which is slightly below the maximum amount set in the debt covenant. We will need to review major transactions in the last month of the year to ensure they are accounted for correctly. Otherwise, the company could be in violation of their debt covenant. This would raise concerns of the company’s ability to continue as a going concern.

APPENDIX I

IMPACT OF ACCOUNTING ENTRIES ON KEY METRICS

(in millions)

 

Transaction                                      Income          Debt       Equity          ROE   Debt:Equity

 

Penalty Payment

–  report as income                                        2                                  2                I*                    D*

–  report as reduction of capital cost

 

Rue St. Jacques ticket

–  report as unearned revenue

 

Interest on ticket proceeds

–  report as income                                     ;                              ;                I                     D

–  report as deferred revenue

 

Pre-production costs

–  capitalize and later expense

–  expense as incurred                              (15)                              (15)               D                       I

 

Advertising & promotion costs

–  capitalize and later expense

–  expense as incurred                              (12)                              (12)               D                       I

 

Debt defeasance

–  if loss was previously recorded                 5                                  5                 I                     D

–  if deferred charge was recorded

 

Sale of theatres as revenue

 

Investment in partnership

–  if full consolidation                                                        I                                                           I

–  if proportionate consolidation                                        I                                                           I

 

 

* Notations:

I   = increase

D  = decrease

NOTHING NOTED = no change

 

APPENDIX II

IMPACT OF ACCOUNTING CHANGES ON KEY METRICS

(in millions)

 

Adjustment                                          Income          Debt        Equity          ROE     Debt:Equity

 

Unadjusted position                                   147         1,490            780        ;               

 

Interest on tickets deferred                     ()                             ()

 

Debt defeasance                                                          25

 

Investment in partnership

– reduce gain to ;                        ()                         ()

 

Adjusted position                                           1,515               ;               

 

Annualized to 12 months (times 12/11)                                                     

 

Target ROE                                                                                               

Maximum debt to equity ratio                                                                                               

 

 

SOLUTIONS TO PROBLEMS

Problem 6-1

(a)

Intercompany balances

Sales and purchases for Year 3                                                                                180,000   (a)

Accounts receivable and payable at end of Year 3                                                    40,000   (b)

 

Intercompany inventory profits                                Before              40%                 After

tax                    tax                   tax

Opening inventory – Sub selling (60,000 x .3)           18,000               7,200             10,800   (c)

Closing inventory – Sub selling (70,000 x .3)              21,000               8,400             12,600   (d)

 

Consolidated account balances

Inventory (500,000 + 300,000 – (d) 21,000)                                                              779,000

Accounts payable (600,000 + 320,000 – (b) 40,000)                                                880,000

Retained earnings, beginning of year

PAT                                                                                                  2,400,000

SAT R/E, beginning of year                                 1,100,000

SAT R/E, date of acquisition                                   900,000

Change since acquisition                                        200,000

Less: unrealized profit in beginning inventory (c)   – 10,800

189,200

PAT’s share                                                             x  90%               170,280

Consolidated retained earnings                                                                              2,570,280

Sales (4,000,000 + 2,500,000 –  (a) 180,000)                                                        6,320,000

Cost of sales (3,100,000+1,700,000–(a)180,000+(d) 21,000–(c)18,000)              4,623,000

Income tax expense (80,000 + 50,000 – (d)8,400 + (c)7,200)                                 128,800

 

(b) Since the subsidiary was the seller of the intercompany sales, these transactions are upstream transactions and the non-controlling interest (NCI) will absorb their share of the adjustments to eliminate the unrealized ; NCI on the income statement will decrease by $1,260 (10% x 12,600) for its share of unrealized after-tax profits in ending inventory and increase by $1,080 (10% x 10,800) for its share of after-tax profits in beginning ; NCI on the balance sheet will decrease by $1,260 (10% x 12,600) for its share of unrealized after-tax profits in ending inventory.

 

Problem 6-2

(a)

Intercompany revenues and expenses

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

Rent revenue and expense                                                                                         24,000   (b)

Interest revenue and expense (70% x 50,000)                                                           35,000   (c)

 

Intercompany inventory profits                                Before              40%                 After

tax                    tax                   tax

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

Closing inventory – Parent selling

(100,000 x .50 x .30)                                         15,000               6,000               9,000   (e)

 

Calculation of non-controlling interest:

Income of subsidiary (9,000 / 10%)                                                                             90,000

Add: opening inventory profit                                                                                 (d)   3,000

Adjusted                                                                                                                       93,000

   10%

9,300   (f)

 

Parent Company

                                                  Consolidated Income Statement

                                                             for the Current Year

 

Sales (500,000 – (a) 180,000)                                                                                   320,000

Rental revenue (24,000 – (b) 24,000)

Interest revenue (50,000 – (c) 35,000)                                                                        15,000

Total revenue                                                                                                       335,000

Cost of goods sold

(350,000 – (a) 180,000 – (d) 5,000 + (e) 15,000)                                                      180,000

Rent expense (24,000 – (b) 24,000)

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

Administration expenses                                                                                              45,000

Income tax expense (42,000 + (d) 2,000 – (e) 6,000)                                                38,000

Total expense                                                                                                      263,000

Profit                                                                                                                            72,000

Attributable to:

Shareholders of parent                                                                                      62,700

Non-controlling interests (f)                                                                                 9,300

72,000

Proof:

Profit previously reported                                                                                            69,000

Add: opening inventory profit (3,000 x 90%)                                                                 2,700

71,700

Less: closing inventory profit                                                                                         9,000

Consolidated profit attributable to shareholders of parent                                          62,700

(b)

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

 

Problem 6-3

	Pike	Spike	Consolidated
December 31, Year 1
Land		100,000	115,000*
Gain on Sale
Income Tax on Gain
December 31, Year 2
Land	128,000		115,000*
Gain on Sale		28,000
Income Tax on Gain		11,200***
December 31, Year 3
Land
Gain on Sale	12,000		25,000**
Income Tax on Gain	4,800***		10,000***

* = fair value of land at date of acquisition

** = selling price to outsiders less amount paid at acquisition = 140,000 – 115,000

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

 

Problem 6-4

(a)

Acquisition differential amortization

 

Plant – Waste

Years 1– 5 ([15,000 / 8 years] x 5 years)                                        9,375   (a)

 

Year 6 (15,000 / 8 years)                                                                 1,875   (b)

 

Goodwill – Baste

Years 4 – 5                                                                                     19,000   (c)

 

Year 6                                                                                                 –0–  

 

Intercompany Revenues and Expenses

 

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

 

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

 

Interest                                                                                                 10,000   (f)

 

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

Intercompany Profits

 

Before tax      40% tax           After tax

Opening inventory  –   Waste selling

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

Ending inventory    –   Baste selling

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

–   Paste selling

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

–   Waste selling

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

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

 

Paste Company

                                                  Consolidated Income Statement

                                           for the Year Ended December 31, Year 6

 

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

Dividends (43,750 – (g) 43,750)

Interest (10,000 – (f) 10,000)

Rent (130,000 – (e) 39,000)                                                                                        91,000

Total income                                                                                                    591,000

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

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

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

Interest (10,000 – (f) 10,000)

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

Total expenses                                                                                                462,735

Profit                                                                                                                          128,265

Attributable to:

Shareholders of Paste                                                                                     109,910

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

128,265

 

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

 

(b)

Calculation of consolidated retained earnings – December 31, Year 6

 

Retained earnings of Paste December 31, Year 6                                                   703,750

Profit in ending inventory                                                                             (j)             (3,960)

Retained earnings of Waste December 31, Year 6                          146,000

Retained earnings of Waste – acquisition                                           40,000

Increase                                                                                   106,000

Less: profit in ending inventory                                                  (k)      10,800

amortization of acquisition differential (a) 9,375 + (b) 1,875    11,250

Adjusted increase                                                                                83,950

Paste’s ownership %                                                                               80%             67,160

 

Retained earnings of Baste December 31, Year 6                             79,000

Retained earnings of Baste – acquisition                                            80,000

Decrease                                                                                  (1,000)

Less: amortization of acquisition differential for Baste (c)        19,000

profit in ending inventory                                       (i)       10,800

(30,800)

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

Consolidated retained earnings December 31, Year 6                                             743,850

 

(c)

 

Profit of Waste                                                                                   104,000

Add: profit in opening inventory                                                 (h)        2,700

106,700

Less: profit in ending inventory                                                  (k)      10,800

amortization of acquisition differential                             (b)        1,875

94,025

Paste’s share                                                                                        x 80%             75,220

 

Profit of Baste                                                                                        9,000

Less: profit in ending inventory                                                  (i)      10,800

(1,800)

Paste’s share                                                                                        x 75%             – 1,350

Profit in ending inventory – Paste selling                                                    (j)            – 3,960

Investment income from subsidiaries                                                                          69,910

 

(d)

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

 

Problem 6-5

 

(a)      X’s equity method journal entries

 

Year 1

 

Cash                                                                                                     18,750

Investment in Y ;                                                                                              18,750

75% x $25,000 dividends.

 

Investment in Y ;                                                                            97,500

Investment income                                                                                                97,500

75% x $130,000 net income.

 

Investment income                                                                              13,500

Investment in Y ;                                                                                              13,500

To hold back 75% of the $18,000 after-tax

inventory profit – Y selling

(60% x $30,000 = $18,000).

 

Investment income                                                                              22,200

Investment in Y ;                                                                                              22,200

To hold back the after-tax land profit –

X selling (60% x $37,000 = $22,200).

 

Investment income                                                                              47,250

Investment in Y ;                                                                                              47,250

Acquisition differential amortization – Year 1

Inventory                                                                60,000

Equipment    $45,000/15 =                                      3,000

63,000

x ;s share (@ 75%)                                          47,250

Note: Year 1 investment income is $14,550 (97,500 – 13,500 – 22,200 – 47,250)

 

 

Year 2

 

Cash                                                                                                       3,750

Investment in Y ;                                                                                                3,750

75% x 5,000 dividends.

 

Investment income                                                                              12,000

Investment in Y ;                                                                                              12,000

75% x 16,000 net loss.

 

Investment income                                                                                2,250

Investment in Y ;                                                                                                2,250

Acquisition differential (equipment) amortization. (3,000 x 75%)

 

Investment in Y ;                                                                            13,500

Investment income                                                                                                13,500

To realize opening inventory profit – Y selling.

 

Investment in Y ;                                                                            22,200

Investment income                                                                                                22,200

To realize land profit – X Selling

 

Investment income                                                                                7,200

Investment in Y ;                                                                                                7,200

To hold back after-tax inventory profit – X selling

(60% x $12,000)

 

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

 

(b) Calculation of consolidated net income – Year 1

 

Net income of X                                                                                                         400,000

Less:  Land profit                                                                                                         22,200

Adjusted                                                                                                                     377,800

 

Net income of Y                                                                                 130,000

Less: closing inventory profit                                                             (18,000)

acquisition differential amortization                                        (63,000)

Adjusted                                                                                                                       49,000

Consolidated net income                                                                                           426,800

Attributable to:

Shareholders of X                                                                                                    414,550

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

426,800

 

Calculation of Consolidated Net income – Year 2

 

Net income of X                                                                                                           72,000

Less:  closing inventory profit                                                                                       7,200

64,800

Add: land profit realized                                                                                               22,200

Adjusted net income                                                                                                    87,000

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

Add: opening inventory profit realized                                                 18,000

Less: acquisition differential amortization                                           (3,000)

Adjusted net income                                                                                                    (1,000)

Consolidated net income                                                                                             86,000

Attributable to:

Shareholders of X                                                                                                      86,250

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

86,000

(c)

Changes in Non-controlling Interest

                                                                  Years 1 and 2

 

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

Allocation of Y ;s adjusted net income Year 1

(25% x 49,000)                                                                                                     12,250

81,000

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

Balance Dec. 31, Year 1                                                                                             74,750

Allocation of Y ;s adjusted net income Year 2

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

74,500

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

Balance Dec. 31, Year 2                                                                                             73,250

 

Proof:

 

Y    – Common shares                                                                                                100,000

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

– Shareholders’ equity Dec. 31, Year 2                                                               254,000

– Unamortized acquisition differential                                                                    39,000

293,000

   25%  

  73,250

 

 

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

As at December 31, Year 2

 

Shareholders’ equity of Y Jan. 1, Year 1                                                                   170,000

Acquisition differential                                                                                                105,000

275,000

X’s ownership                                                                                                                  75% 

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

Investment income –  Year 1                                                              14,550

Year 2                                                              14,250             28,800

235,050

Less:  Dividends received

Year 1 (75% x 25,000)                                                              18,750

Year 2 (75% x 5,000)                                                                 3,750             22,500

Investment in Y Dec. 31, Year 2                                                                               212,550

 

Proof:

 

Shareholders’ equity of Y                                                                                254,000

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

293,000

X’s ownership                                                                                                        75%

219,750

Less:  Holdback of inventory profit – X selling                                                             7,200

Investment in Y, December 31, Year 2                                                                    212,550

 

Problem 6-6

Intercompany profits

 

Before tax        40% tax           After tax

 

Opening inventory  Q selling                                      80,000             32,000             48,000   (a)

L selling                                       52,000             20,800             31,200   (b)

 

Ending inventory    Q selling                                       35,000             14,000             21,000   (c)

L selling                                      118,000             47,200             70,800   (d)

 

(a)  Calculation of consolidated profit

 

Profit of L                                                                                                                   580,000

Less:  Dividends

From M (80% x 200,000)                                                        160,000

From Q (70% x 150,000)                                                        105,000

Ending inventory profit                                                    (d)      70,800           335,800

244,200

Add: opening inventory profit                                                                             (b)      31,200

Adjusted profit                                                                                                            275,400

 

Profit of M                                                                                                                  360,000

 

Profit of Q                                                                                          240,000

Less: ending inventory profit                                                      (c)      21,000

219,000

Add: opening inventory profit                                                     (a)      48,000

267,000

Consolidated profit                                                                                                     902,400

Attributable to:

Shareholders of L                                                                                                    750,300

Non-controlling interests (20% x 360,000 + 30% x 267,000)                                  152,100

902,400

 

(b)

Calculation of consolidated retained earnings – beginning of current year

 

Retained earnings of L                                                                                               976,000

Less: opening inventory profit                                                                            (b)      31,200

Adjusted                                                                                                                     944,800

Retained earnings of M                                                                     843,000

Acquisition retained earnings                                                             500,000

Increase                                                                                   343,000

L’s ownership                                                                                           80%           274,400

 

Retained earnings of Q                                                                      682,000

Acquisition retained earnings                                                               50,000

Increase                                                                                   632,000

Less: opening inventory profit                                                    (a)      48,000

Adjusted increase                                                                              584,000

L’s ownership                                                                                           70%           408,800

Consolidated retained earnings – beginning of year                                              1,628,000

 

Problem 6-7

Calculation, allocation, and amortization of acquisition differential

 

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

Implied value of 100% investment                                                                         2,000,000

Carrying amounts of Least’s net assets:

Assets                                                                                       3,000,000

Liabilities                                                                                    1,500,000

Total shareholders’ equity                                                                           1,500,000

Acquisition differential                                                                                                500,000

Allocation:                                                                                          FV – CA

Accounts receivable                                                                    – 20,000

Inventories                                                                                   – 50,000

Plant and equipment (net)                                                             35,000

Long-term liabilities                                                                      100,000             65,000

Balance – goodwill                                                                                                    435,000

 

Balance               Amortization                     Balance

                                                             Jan. 1                                                             Dec. 31

                                                             Year 3        Years 3 to 8        Year 9             Year 9

Accounts receivable                          – 20,000           – 20,000

Inventories                                         – 50,000           – 50,000

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

Long-term liabilities                           100,000          100,000

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

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

 

Intercompany revenues and expenses

 

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

 

Intercompany profits

 

Before tax        40% tax           After tax

 

Loss on land, July 1, Year 7

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

 

 

Opening inventory   –   Most selling

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

–   Least selling

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

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

 

Ending inventory      –   Most selling

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

–   Least selling

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

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

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

 

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

 

Calculation of consolidated retained earnings – Jan. 1 Year 9

 

Retained earnings of Most, Jan. 1, Year 9

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

 

Less:  Profit in opening inventory                                                                      (g)      37,500

9,712,500

Add: land loss                                                                                                     (f)      30,000

Adjusted retained earnings                                                                                     9,742,500

Retained earnings of Least, Jan. 1, Year 9

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

Retained earnings of Least at acquisition                                       1,000,000

Increase                                                                                1,000,000

Less: profit in opening inventory                                                (h)    154,285

amortization of acquisition differential                             (c)    108,450

Adjusted increase                                                                              737,265                           (o)

Most’s ownership %                                                                                 80%           589,812

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

 

Calculation of consolidated net income – Year 9

Net income of Most                                                                                                1,000,000

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

Profit in closing inventory                                                (j)       60,000

Land loss                                                                         (f)      30,000           170,000

830,000

Add: profit in opening inventory                                                                         (g)      37,500

Adjusted net income                                                                                                  867,500

Net income of Least                                                                          400,000

Add: profit in opening inventory                                                 (h)    154,285

554,285

Less: profit in closing inventory                                                 (k)    128,570

amortization of acquisition differential                             (d)      13,075

Adjusted net income                                                                                                  412,640

Consolidated net income                                                                                        1,280,140

Attributable to:

Shareholders of Most                                                                                           1,197,612

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

1,280,140

 

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

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

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

Less: profit in opening inventory                                                (h)    154,285

Adjusted retained earnings                                                                                     1,845,715

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

2,737,265

NCI’s ownership %                                                                                                          20%

NCI, Jan. 1, Year 9                                                                                                    547,453

 

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

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

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

NCI’s share @ 20%                                                                                           147,453

NCI, Jan. 1, Year 9                                                                                            547,453

 

(a)                                                            Most Company

                                      Consolidated Statement of Changes in Equity

                                              For Year Ended December 31, Year 9

 

Common       Retained

Stock       Earnings             Total               NCI             Total

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

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

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

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

 

Proof of consolidated retained earnings, end of Year 9

 

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

Less:  profit in ending inventory                                                                         (j)       60,000

Adjusted retained earnings                                                                                   10,340,000

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

Retained earnings of Least at acquisition                                       1,000,000

Increase                                                                                          1,300,000

Less: profit in ending inventory                                                  (k)    128,570

amortization of acquisition differential

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

Adjusted increase                                                                           1,049,905                           (p)

Most’s ownership %                                                                                 80%           839,924

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

 

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

Retained earnings of Least                                                                                     2,300,000

Common shares of Least                                                                                          500,000

Total shareholders’ equity                                                                                       2,800,000

Less: profit in ending inventory                                                          (k)       128,570

Adjusted shareholders’ equity                                                                                 2,671,430

Add: unamortized acquisition differential                                                                   378,475

3,049,905

     20%  

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

 

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

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

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

NCI’s share @ 20%                                                                                           209,981

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

 

(b)                                                            Most Company

                                                      Consolidated Balance Sheet

                                                            December 31, Year 9

 

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

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

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

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

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

Goodwill                                                                                                          (b)       374,100

Deferred income taxes                                                                                   (n)       125,714

Total assets                                                                                                     19,509,905

 

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

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

Common shares                                                                                                     1,000,000

Retained earnings                                                                                                 11,179,924

Non-controlling interest                                                                                              609,981

Total liabilities & shareholders’ equity                                                             19,509,905

 

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

 

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

 

Problem 6-8

Intercompany profits

Before tax        40% tax           After tax

Opening inventory – L selling                                       5,000               2,000               3,000   (a)

Ending inventory – K selling                                          8,000               3,200               4,800   (b)

 

(a)

December 31

Cash                                                                                                     20,200

Investment in L Co. ($5,000 x 95%)                                                                        4,750

Investment in J Co. ($3,000 x 90%)                                                                        2,700

Investment in K Co. ($15,000 x 85%)                                                                   12,750

To record dividends received from subsidiary companies.

 

Investment in L Co. (20,000 x 95%)                                                    19,000

Investment in K Co. (30,000 x 85%)                                                   25,500

Investment in J Co. (5,000 x 90%)                                                                          4,500

Investment income                                                                                                40,000

To record share of subsidiaries’ profit

 

Investment Income                                                                                1,230

Investment in L Co. (3,000 x .95)                                                          2,850

Investment in K Co. (4,800 x .85)                                                                            4,080

To hold back after-tax inventory profit in ending inventory (K Co.) and add back after-tax inventory

profit in beginning inventory (L. Co.)

 

Investment Income is $40,000 – $1,230 = $38,770.

 

(b) Calculation of consolidated profit attributable to shareholders of H Co. – Year 5

 

Profit of L                                                                                             20,000

Add: profit in opening inventory                                               (a)         3,000

Adjusted profit                                                                                      23,000

H ;s ownership %                                                                               95%             21,850

 

Profit of J                                                                                             (5,000)

H ;s ownership %                                                                               90%             (4,500)

 

Profit of K                                                                                             30,000

Less: profit in ending inventory                                                (b)         4,800

Adjusted profit                                                                                      25,200

H ;s ownership %                                                                               85%             21,420

Consolidated profit attributable to shareholders of H Co. – Year 5                             38,770

 

(c)                                                               H Company

                                         Consolidated Retained Earnings Statement

for the Year Ended December 31, Year 5

 

Retained earnings, January 1                                                                                      12,000

Add:  profit                                                                                                                    38,770

50,770

Less: dividends                                                                                                            10,000

Retained earnings, December 31                                                                                40,770

 

Problem 6-9

 

Intercompany profits                                                 Before              40%               After

tax                    tax                 tax

 

Opening inventory* – Purple selling                            95,538             38,215            57,323

 

Ending inventory – Purple selling                              194,000             77,600           116,400

 

Land – Purple selling

(260,000 – 203,500)                                                   56,500             22,600            33,900

 

*     Inventory at selling price (690,000 x 60%)                                  414,000

Inventory at cost (414,000 / )                                                318,462

Profit                                                                                              95,538

 

Calculation of consolidated net income attributable to Purple’s shareholders – current year

 

Net income of Purple                                                                                                 568,100

Add: opening inventory profit                                                                                       57,323

625,423

Less:  Ending inventory profit                                                            116,400

Land profit                                                                                 33,900           150,300

Adjusted profit                                                                                                            475,123

Net income of Sand                                                                           248,670

Purple’s ownership                                                                                  70%           174,069

Consolidated net income attributable to Purple’s shareholders – current year         649,192

 

Note:

The intercompany rentals and interest revenue/expense cancel each other out when Sand’s net income is added to Purple’s.

 

 

Problem 6-10

Intercompany revenues and expenses

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

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

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

 

Intercompany profits

Before tax        40% tax         After tax

Opening inventory  –   Evans selling

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

–   Falcon selling

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

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

Ending inventory    –   Evans selling

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

–   Falcon selling

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

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

 

Calculation of consolidated profit – current year

 

Profit of Evans                                                                                                             61,900

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

Profit in ending inventory                                                (g)        3,450            35,450

26,450

Add: profit in opening inventory                                                                         (d)        2,550

Adjusted profit                                                                                                              29,000

Profit of Falcon                                                                                    75,500

Less: profit in ending inventory                                                  (h)           540

74,960

Add: profit in opening inventory                                                 (e)        1,980

76,940

Consolidated profit                                                                                                     105,940

Attributable to:

Shareholders of Evans                                                                                              90,552

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

105,940

 

(a)                                                           Evans Company

                                                  Consolidated Income Statement

                                                             for the Current Year

 

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

Raw materials & finished goods purchased

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

Changes in inventory

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

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

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

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

Total expenses                                                                                                     677,060

Profit                                                                                                                          105,940

Attributable to:

Shareholders of Evans                                                                                              90,552

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

105,940

 

(b) 

Calculation of consolidated retained earnings – beginning of year

 

Retained earnings of Evans, beginning of year                                                        632,000

Less: profit in opening inventory                                                                        (d)        2,550

Adjusted retained earnings                                                                                        629,450

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

Less: profit in opening inventory                                                (e)        1,980

Adjusted increase since acquisition                                                   346,020

Evans’ ownership %                                                                                80%           276,816

Consolidated retained earnings, beginning of year                                                   906,266

 

Consolidated dividends declared                                                                                 30,000

 

Problem 6-11

Calculation, allocation, and amortization of the acquisition differential

 

Cost of 90% investment, Jan. 2, Year 1                                                                      90,000

Implied value of 100% investment                                                                            100,000

Carrying amounts of S’s net assets:

Common shares                                                                            60,000

Retained earnings                                                                          20,000

Total shareholders’ equity                                                                                80,000

Acquisition differential – patents                                                                                  20,000

Amortization:

Years 1 – 4                                                                           (a)      16,000

Year 5                                                                                  (b)        4,000             20,000

Balance, Dec. 31, Year 5                                                                                                 –0–

 

Intercompany profits

 

Before tax      40% tax            After tax

Opening inventory  –   S selling

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

–   P selling

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

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

Ending inventory    –   S selling

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

–   P selling

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

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

 

Sale of land – Year 3 S selling (50,000 – 40,000)       10,000               4,000               6,000   (i)

 

 

Calculation of consolidated net income – Year 5

 

Net income of P Company                                                                                          60,000

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

Profit in ending inventory                                                (g)       1,200             10,200

49,800

Add: profit in opening inventory                                                                         (d)           720

Adjusted net income                                                                                                    50,520

Net income of S Company                                                                  48,000

Less: profit in ending inventory                                                  (f)        4,800

patent amortization                                                          (b)        4,000

39,200

Add: profit in opening inventory                                                 (c)        1,680

40,880

Consolidated net income                                                                                             91,400

Attributable to:

Shareholders of P ;                                                                                              87,312

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

91,400

 

Calculation of consolidated retained earnings – Jan. 1, Year 5

 

Retained earnings of P, Jan. 1, Year 5

(101,000 + 12,000)                                                                                                  113,000

Less:  profit in opening inventory                                                               (d)                  720

Adjusted retained earnings                                                                                        112,280

Retained earnings of S (34,000 + 10,000)                                          44,000

Retained earnings of S at acquisition                                                  20,000

Increase since acquisition                                                         24,000

Less:  Amortization of patents                           (a)      16,000

Land gain                                                 (i)         6,000

Profit in opening inventory                      (c)        1,680             23,680

Adjusted increase                                                                                     320                           (j)

P’s ownership %                                                                                      90%                  288

Consolidated retained earnings, Jan. 1, Year 5                                 112,568

 

Calculation of consolidated non-controlling interests, beginning of Year 5 (Method 1)

Company S shareholders’ equity

Common shares                                                                                                60,000

Retained earnings                                                                                             44,000

104,000

Less:  Land gain                                                                         (i)         6,000

Profit in beginning inventory                                            (c)       1,680               7,680

Adjusted shareholders’ equity                                                                                      96,320

Unamortized acquisition differential                                                                              4,000                                                                                                                                       100,320

   10%

Non-controlling interest, Jan 1, Year 5                                                                        10,032

 

Calculation of consolidated non-controlling interests – Jan. 1 Year 5 (Method 2)

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

S ;s adjusted increase in retained earnings (j)                                    320

NCI’s share @ 10%                                                                                                            32

Non-controlling interest, Jan 1, Year 5                                                                        10,032

 

P Co.

                                      Consolidated Statement of Changes in Equity

                                              For Year Ended December 31, Year 5

 

Common       Retained

Shares       Earnings             Total               NCI             Total

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

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

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

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

 

Proof:

Retained earnings of P, Dec. 31, Year 5

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

Less:  Profit in ending inventory                                                                 (g)              1,200

Adjusted retained earnings                                                                                        159,800

Retained earnings of S, Dec. 31, Year 5

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

Retained earnings of S at acquisition                                                  20,000

Increase since acquisition                                                         62,000

Less:  Amortization of the patents

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

Land gain                                                 (i)         6,000

Profit in ending inventory                        (f)        4,800             30,800

Adjusted increase                                                                                31,200                           (k)

P’s ownership %                                                                                      90%             28,080

Consolidated retained earnings, Dec., 31, Year 5                                                     187,880

 

Calculation of consolidated non-controlling interests – Dec. 31 Year 5 (Method 1)

Company S shareholders’ equity

Common shares                                                                                                60,000

Retained earnings                                                                                             82,000

142,000

Less:  Land gain                                                                         (i)         6,000

Profit in ending inventory                                                (f)       4,800             10,800

Adjusted shareholders’ equity                                                                                    131,200

Unamortized acquisition differential                                                                                     0

131,200

   10%

Non-controlling interests, Dec. 31, Year 5                                                                   13,120

 

Calculation of consolidated non-controlling interests – Dec. 31 Year 5 (Method 2)

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

S ;s adjusted increase in retained earnings (k)                              31,200

NCI’s share @ 10%                                                                                                       3,120

Non-controlling interest, Jan 1, Year 5                                                                        13,120

 

Problem 6-12

Acquisition differential amortization – Year 5

 

Plant and equipment depreciation (60,000 / 5)                                    12,000   (a)

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

Goodwill impairment loss                                                                       3,000   (c)

20,000   (d)

 

Intercompany revenues and expenses

 

Sales – Runner to Road                                                                    420,000   (e)

Rental – Runner to Road                                                                     35,000   (f)

 

Intercompany profits

 

Before tax        40% tax           After tax

 

Opening inventory – Runner selling                            75,000             30,000             45,000   (g)

 

Ending inventory – Runner selling                               40,000             16,000             24,000   (h)

 

(a)                                                                 Road Ltd.

                                                  Consolidated Income Statement

                                           for the Year Ended December 31, Year 5

 

Sales (4,000,000 + 2,100,000 – (e)420,000)                                                           5,680,000

Rental revenue (70,000 – (f)35,000)                                                                            35,000

Total income                                                                                                     5,715,000

Materials used in manufacturing

(2,000,000 + 800,000 – (e)420,000)                                                                  2,380,000

Change in work-in-progress & finished goods inventory

(45,000 – 20,000  – (g)75,000 + (h)40,000)                                                         (10,000)

Employee benefits (550,000 + 480,000)                                                                1,030,000

Interest expense (250,000 + 140,000)                                                                       390,000

Depreciation (405,000 + 245,000 + (a)12,000)                                                         662,000

Patent amortization (25,000 + (b)5,000)                                                                      30,000

Goodwill impairment loss                                                                                 (c)         3,000

Income tax (300,000 + 200,000 + (g)30,000 – (h)16,000)                                         514,000

Total expenses                                                                                                  4,999,000

Profit                                                                                                                          716,000

Attributable to:

Shareholders of Road                                                                                              625,700

Non-controlling interests

(30% x [300,000 – (d)20,000 + (g)45,000 – (h)24,000])                                        90,300

716,000

 

(b)

Since Road uses the equity method of accounting for its investment in Runner, consolidated retained earnings at December 31, Year 5 would be $2,525,700, which is equal to Road’s retained earnings on its separate entity financial statements.

 

(c)

The return on equity attributable to shareholders of Road for Year 5 would not change. Only the NCI’s share of consolidated profit would change under the parent company extension theory. The NCI’s share of consolidated profit would increase because the NCI’s share of Runner’s goodwill and goodwill impairment is not reported under this theory.

 

Problem 6-13

Calculation, allocation, and amortization of acquisition differential

 

Cost of 70% investment, January 1, Year 1                                                               63,000

Implied value of 100% investment                                                                              90,000

Carrying amounts of Sage’s net assets:

Ordinary shares                                                                             50,000

Retained earnings                                                                          15,000

Total shareholders’ equity                                                                                    65,000

Acquisition differential                                                                                                  25,000

Allocation:                                                                                         FV – CA

Inventory                                                                                       -12,000

Unfavourable lease agreement                                                    –18,000           -30,000

Balance – goodwill                                                                                                       55,000

 

Balance                   Amortization                Balance

                                                          January 1                                                    December 31

                                                             Year 1         Years 1 & 2         Year 3             Year 3

 

Inventory                                           –  12,000          –  12,000

Lease agreement                                -18,000              -7,200              -3,600              -7,200   (a)

Goodwill                                               55,000               3,060               1,530             50,410   (b)

25,000         –   16,140   (c)      –2,070   (d)      43,210

 

Intercompany receivables and payables – notes                                                  55,000   (e)

 

Intercompany revenues and expenses

 

Management fee                                                                                                        26,500   (f)

Sales and purchases

Post selling                                                                                   125,000

Sage selling                                                                                   90,000           215,000   (g)

Interest (12% x 1/2 x 55,000)                                                                                        3,300   (h)

 

Intercompany profits

Before tax      40% tax           After tax

Land                         –   Sage selling                            30,000             12,000             18,000   (i)

Opening inventory   –   Sage selling

(14,000 x )                        3,500              1,400              2,100   (j)

Ending inventory      –   Sage selling

(28,000 x )                         7,000               2,800               4,200   (k)

–   Post selling

(18,000 x )                        4,500              1,800              2,700   (l)

11,500              4,600              6,900   (m)

 

Deferred income taxes – December 31, Year 3

Inventory                                                                                                                        4,600

Land                                                                                                                             12,000

16,600   (n)

Accumulated depreciation at date of acquisition for Sage                                          10,000   (o)

Calculation of consolidated profit

Profit of Post                                                                                                              107,979

Less:  Investment income from Sage1,479

Profit in ending inventory                                                (l)        2,700               4,179

Adjusted profit                                                                                                            103,800

Profit of Sage                                                                                       24,000

Add: profit in opening inventory                                                 (j)         2,100

26,100

Add:   Amortization of acquisition differential                            (d)        2,070

Less:  Profit in ending inventory                        (k)        4,200

Land gain                                                 (i)       18,000            –22,200

Adjusted profit                                                                                                               5,970

Profit                                                                                                                          109,770

Attributable to:

Shareholders of Post                                                                                               107,979

Non-controlling interests (30% x 5,970)                                                                      1,791

109,770

 

(a) (i)                                                      Post Corporation

                                                  Consolidated Statement of Profit

                                          For the Year Ended, December 31, Year 3

Sales (900,000 + 240,000 – (g)215,000)                                                                   925,000

Interest revenue (6,800 – (h)3,300)                                                                               3,500

Total revenue                                                                                                       928,500

Cost of goods sold

(540,000 + 162,000 – (g)215,000 – (j)3,500 + (m)11,500)                                  495,000

Interest expense (20,000 – (h)3,300)                                                                          16,700

Other expense

(180,000 + 74,800 – (f)26,500 – (a)3,600)                                                           224,700

Goodwill impairment loss                                                                                   (b)        1,530

Income tax expense

(80,000 + 16,000 +(j) 1,400 – (m) 4,600 – (i) 12,000)                                           80,800

Total expenses                                                                                                           818,730

Profit                                                                                                                          109,770

Attributable to:

Shareholders of Post                                                                                               107,979

Non-controlling interests (30% x 5,970)                                                                      1,791

109,770

 

Calculation of non-controlling interests – December 31, Year 3

 

Ordinary shares                                                                                                           50,000

Retained earnings                                                                                                       81,000

Total shareholders’ equity                                                                                          131,000

Less:  Profit in ending inventory                                                (k)        4,200

Land gain                                                                         (i)       18,000           – 22,200

Add: unamortized acquisition differential                                                                    43,210

Adjusted shareholders’ equity                                                                                    152,010

Non-controlling interest’s share                                                                                       30% 

Non-controlling interest, December 31, Year 3                                                           45,603

 

(a) (ii)                                                      Post Corporation

                                       Consolidated Statement of Financial Position

                                                            December 31, Year 3

Land (175,000 + 19,000 – (i)30,000)                                                                         164,000

Plant and equipment (520,000 + 65,000 – (o) 10,000)                                              575,000

Accumulated depreciation ([229,400] + [17,000] – (o) 10,000)                              (236,400)

Goodwill                                                                                                             (b)      50,410

Deferred income taxes                                                                                      (n)      16,600

Inventory (34,000 + 27,000 – (m)11,500)                                                                   49,500

Accounts receivable (17,200 + 9,100)                                                                        26,300

Cash (12,200 + 12,900)                                                                                               25,100

Total assets                                                                                                          670,510

 

Ordinary shares                                                                                                         100,000

Retained earnings                                                                                                      265,707

Non-controlling interests                                                                                              45,603

411,310

Unfavourable lease agreement                                                                                     7,200

Accounts payable (212,000 + 40,000)                                                                      252,000

Total shareholders’ equity & liabilities                                                                  670,510

 

(b)

Goodwill impairment loss – entity theory                                                                       1,530

Less:  NCI’s share @30%                                                                                                 459

Goodwill impairment loss – parent company extension theory                                    1,071

 

NCI – entity theory                                                                                                         1,791

NCI’s share of goodwill impairment loss                                                                          459

NCI – parent company extension theory                                                                      1,332

 

(c)

Goodwill – entity theory                                                                                               50,410

Less:  NCI’s share @30%                                                                                            15,123

Goodwill – parent company extension theory                                                            35,287

 

NCI – entity theory                                                                                                       45,603

NCI’s share of goodwill impairment loss                                                                     15,123

NCI – parent company extension theory                                                                    30,480

 

Problem 6-14             

 

(a)       Acquisition cost Allocation             Acquisition January 1, Year 1

 

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

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

CA:  Ordinary Shares                                                             3,500,000

Retained Earnings                                                                  2,100,000

5,600,000

Acquisition differential                                                                                                                                                    800,000

 

Allocation:                                                                                                                   Life

Inventory                                                                                                                                                                                                           100,000  Cr      1

Land                                                                                                                                                                                                                              200,000  Dr

Equipment                                                                                                                                                                                                         200,000  Cr   10

Patents                                                                                                                                                                                                              400,000  Dr      5

Liability                                                                                                                                                                                                       100,000  Cr      4

Subtotal                                                                                                                                                             200,000  Dr

Balance: Goodwill                                                                                                                                 600,000  Dr

  800,000  Dr

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

 

Amortization Table:

 

 

Allocation                                                                                Life               Amortization                     Balance

 YR 1 – YR 4    YR 5                          Dec. 3, YR 5

 

Inventory                                                                                                           100,000  Cr      1           100,000Cr         0                                   0

Land                                                                                                                              200,000  Dr                                                                 200,000 Dr

Equipment                                                                                                         200,000  Cr   10            80,000Cr    20,000 Cr          100,000 Cr

Patents                                                                                                              400,000  Dr      5          320,000Dr    80,000Dr                      0

Liability                                                                                                       100,000  Cr      4          100,000Cr                                         0

Goodwill                                                                                                            600,000  Dr                                                                   600,000 Dr

  800,000  Dr                                                                                            40,000 Dr   60,000 Dr         700,000 Dr

 

Devine’s accumulated depreciation at date of acquisition                 500,000

 

Intercompany Amounts:

 

Dividends:  500,000 x 75%                                                                                                       375,000

 

Sales:                                                                                                  Vine (YR 5) 2 M + Devine (YR 5) ;                    3,200,000

 

Advances from Vine to Devine:                                                                                               200,000

 

BT                Tax                   AT

Land:     Upstream Gain   Sept 1, YR 5                                                           400,000         160,000           240,000

 

 

Unrealized Profits:                                                                                                                                                             BT                     Tax                     AT

 

Opening          Upstream        100 K @ 40%                       40,000          16,000      24,000

 

Downstream  300 K @ 33 1/3%           100,000            40,000               60,000

 

Ending                                                                                                                      Upstream        500 K @ 40%              200,000          80,000             120,000

 

Downstream                                                                                       600 K @ 33 1/3%        200,000            80,000             120,000

 

 (b)      Consolidated Income Statement for the year ending December 31, Year 5

 

Sales ( M + 3 M – M)                                                                                                 11,400,000

 

Dividend, Investment Income, and Gains

(400 K + 1,000 K – 375K – 400K)                                                                      625,000

 

12,025,000

 

Cost of Goods Sold

(8M + M – M – 40K – 100K + 200K + 200K)                 6,560,000

 

Other Expenses (500K + 300K – 20K (Equip) + 80 K (Patent)               860,000

 

Taxes (500K + 200K – 160K + 16K + 40K –80K – 80K)                         436,000

 

Total expenses                                                                                       7,856,000

 

Profit                                                                                                      4,169,000

Attributable to:

Shareholders of Vine                                                                            3,768,000

Non-controlling interests (2M – 240K –120K + 24K – 60K) x .25          401,000

 

 4,169,000

 

Reconciliation:

 

Vine Profit:                                                                                                                                                                  3,000,000

 

Dividends from Devine Included                                                                                               (375,000)

 

Equity in Earnings of Devine                                                                                                              1,143,000

 

Consolidated Profit Attributable to Vine’s Shareholders                     3,768,000

 

(c)       Consolidated Retained Earnings: Proof

 

Parent retained earnings at December 31, Year 5                                                                 12,000,000

Sub retained earnings at December 31, Year 5                     7,000,000

Retained earnings at acquisition                                                                     2,100,000

Increase since acquisition                                                       4,900,000

Less: unrealized profits, ending inventory                              (120,000)

Land                                (240,000)

Less: cumulative amortization of acquisition differential        (100,000)

Realized retained earnings since acquisition                                      4,440,000                                (a)

Parent %                                                                                                                                                                              75%     3,330,000

Less: unrealized profits, ending inventory                                                         (120,000)

Consolidated retained earnings                                                                                                                      15,210,000

 

(d) 

Consolidated Statement of Financial Position

December 31, Year 5

 

Assets

Land (6M + M + 200K – 400K)                                                                   8,300,000

 

Plant and Equipment ( + – 200K – 500K)                                 29,900,000

 

Accumulated depreciation ( + – 100K – 500K)                             (10,200,000)

 

Goodwill                                                                                                                                                               600,000

 

Deferred Income Tax (160K + 80K + 80K)                                                                                 320,000

 

Inventories ( M + M – 200K – 200K                                                                  6,600,000

 

Cash and Current Receivables (900K + 300K)                                                            1,200,000

 

36,720,000

Equities and Liabilities

 

Ordinary shares                                                                                                                                                          10,000,000

 

Retained Earnings                                                                  (See part c)                                                     15,210,000

 

Non-controlling interests (See Below)                                                              2,710,000

 

Long Term Liabilities ( M + M)                                                                                       7,700,000

 

Deferred Income Taxes (200K+100K)                                                    300,000

 

Current Liabilities (700K + 300K – 200K advances)                                           800,000

 

36,720,000

 

 

Non-controlling Interests: (Method 1)

 

Devine – Carrying amount December 31, Year 5                 10,500,000

Unrealized Profits – Upstream:

Land                    (240,000)

Inventory                                                           (120,000)

Unamortized acquisition differential                                                        700,000

10,840,000

25%

Non-controlling interest                                                              2,710,000

 

Calculation of non-controlling interests – December 31, Year 5 (Method 2)

Non-controlling interests at date of acquisition (25% x [4,800,000 / .75)               1,600,000

Devine’s adjusted increase in retained earnings (a)                       4,440,000

NCI’s share @ 25%                                                                                                1,110,000

Non-controlling interest, December 31, Year 5                                                      2,710,000

 

(e)

Non-controlling interest – at date of acquisition

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

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

Decrease in non-controlling interest                                                   100,000

Non-controlling interest, December 31, Year 3

– as previously calculated                                                                   2,710,000

– as per new calculation                                                                      2,610,000

 

Goodwill at December 31, Year 3

– as previously calculated                                                                   600,000

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

– as per new calculation                                                                      500,000

 

Problem 6-15             

 

(a)

 

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

Implied value of 100% investment                                                                                    120,000

Carrying amount of Sand’s net assets:

Common shares                                                                            50,000

Retained earnings                                                                         30,000

Total shareholders’ equity                                                                                                   80,000

Acquisition differential                                                                                                         40,000

Allocation:                                                                                   FV – CA

Inventory                                                                                     – 9,000

Equipment                                                                                   24,000                           15,000

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

 

                                                    Balance    Amortization/Impairment                    Balance

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

Inventory                                     $ (9,000)         $ (9,000)                    —                              —

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

Goodwill                                         25,000                    —             21,500                         3,500   (b)

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

 

(b)                                                                PAPER CORP.

Consolidated Income Statement

for the year ended December 31, Year 5

 

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

Investment and interest income ($1,500 + $3,600 – $15004 – $2,4003)                              1,200

Total revenue                                                                                                                    999,200

 

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

Interest expense ($10,000 – $2,4003)                                                                                   7,600

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

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

Income taxes ($80,000 + $32,000 – $4,2006 – $8,0005)                                                    99,800

Total expenses                                                                                                                  889,000

Net income                                                                                                                        110,200

Attributable to:

Shareholders of Paper                                                                                                    107,050

Non-controlling interest ($48,000 – $12,000 – $25,500) (30%)                                          3,150

110,200

 

Notes:

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

2  Downstream sales                                                100,000

3  Interest ($40,000 × 8% × 9/12)                                 2,400

4  Investment income from Sand                                  1500

 

Intercompany profits

                                                                                                Before tax     40% tax    After tax

5  Land — upstream                                                                   $ 20,000       $ 8,000     $ 12,000

6  Ending inventory — downstream($30,000 × 35%)                $ 10,500       $ 4,200       $ 6,300
(c)

1. i) Inventory ($66,000 + $44,000 – $10,5006) $ 99,500
2. ii) Land ($150,000 + $30,000 – $20,0005) $ 160,000

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

1. iv) Non-controlling interest ($50,000+$120,000–$12,000+(c)$11,500) (30%) $ 50,850
2. v) Common shares $ 150,000

 

(d)

Non-controlling interest – at date of acquisition

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

– using independent appraisal                                                 30,000

Decrease in non-controlling interest and goodwill                                6,000

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

– as previously calculated                                                                   21,500

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

– as per new calculation                                                                      15,500

 

Allocation of goodwill and goodwill impairment

                                                                                    Paper’s               NCI’s                       

                                                                                       share               share                Total

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

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

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

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

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

 

Profit attributable to non-controlling interest for the year ended December 31, Year 3

– as previously calculated                                                                     3,150

– increase due to reduced goodwill impairment loss

(30% x 21,500 – 1,224)                                                                        5,226

– as per new calculation                                                                        8,376

 

 

SOLUTIONS TO WEB-BASED PROBLEMS

Web Problem 6-1

The following answers are based on the 2011 consolidated financial statements for RONA Inc.:

• RONA uses the weighted average cost method to cost its inventory. This is disclosed in the inventory valuation accounting policy as described in note 3(d) to the consolidated financial statements.
• At the end of 2011, inventory represented (840,287 / 2,780,378) of RONA’s total assets. This was a slight decrease from (905,467 / 2,921,620) in 2010. This was determined using the consolidated statements of financial position.
• RONA does eliminate intercompany transactions and unrealized profits when preparing its consolidated financial statements as per note 3(a)(iii) to the consolidated financial statements.
• The numerator, cost of goods sold, will increase by the sales amount of the intercompany sale and decrease by the unrealized profit in ending inventory. The denominator, average inventory, will decrease by one-half of the unrealized profit in ending inventory because of the use of average inventory rather than year-end inventory. By using one-half of the unrealized profit in the denominator and the full unrealized profit in the numerator, the inventory turnover after the eliminating entries will be lower than the original inventory turnover. Earnings per share will decrease due to the elimination of the unrealized profit in ending inventory.
• Land is valued at cost as per the accounting policy for property, plant and equipment described in note 3(g) to the consolidated financial statements.
• The debt- to- equity ratio would decrease because debt would not change but equity would increase. The return on average equity would also decrease because net income would stay the same and equity would increase.

 

Web Problem 6-2

The following answers are based on the September 30, 2011 consolidated financial statements for Cenovus Energy Inc. which are available on the company’s website under the “Invest in us” section.

• Cenovus uses the first-in, first-out or weighted average cost methods to cost its product inventory as per the accounting policy for inventories in note 3(l) to the consolidated financial statements.
• At the end of 2011, inventories represented (1,291 / 622,194) of Cenovus’ total assets, which is higher than the 2010 portion, which was (880 / 19,840).
• As per the principles of consolidation accounting policy as described in note 3(a) to the consolidated financial statements, Cenovus does eliminate intercompany transactions and unrealized profits when preparing its consolidated financial statements.
• The numerator, cost of goods sold, will increase by the sales amount of the intercompany sale and decrease by the unrealized profit in ending inventory. The denominator, average inventory, will decrease by one-half of the unrealized profit in ending inventory because of the use of average inventory rather than year-end inventory. By using one-half of the unrealized profit in the denominator and the full unrealized profit in the numerator, the inventory turnover after the eliminating entries will be lower than the original inventory turnover. Earnings per share will decrease due to the elimination of the unrealized profit in ending inventory.
• Land is valued at per the accounting policy for property, plant and equipment described in note 3(o) to the consolidated financial statements.
• The debt- to- equity ratio would decrease because debt would not change but equity would increase. The return on average equity would also decrease because net income would stay the same and equity would increase.