Modern Advanced Accounting in Canada 7 Hilton SM
Chapter 7 (A)
Intercompany Profits in Depreciable Assets (B)
Intercompany Bondholdings A brief description of the major points covered in each case and problem.
CASES Case 7-1 In this case, students are asked to compare the accounting for an intercompany transaction depending on whether the investee company was a controlled entity, a significantly influenced entity, or a related party. Case 7-2 In this case, students are asked to discuss how a loss on intercompany bondholdings should be allocated to the parent and/or to the subsidiary. Case 7-3 In this real life case, students are asked to determine the economic benefits of transferring a machine from the subsidiary to the parent in order to increase the tax savings from depreciation expense. The case also requires a discussion of various alternatives for reporting the tax savings on the consolidated income statement. Case 7-4 In this case taken from a CA exam, students are asked to prepare a memo for the partner to address the accounting implications and disclosure requirements for transactions involving convertible debentures and spin off of a division from a subsidiary to the parent and then to a newly created subsidiary. Case 7-5 In this case taken from a CA exam, students are asked to prepare a statement of loss to support an insurance claim and to prepare an analysis of accounting issues involving nonmonetary transactions, asset impairments and lease termination payments. Case 7-6 In this case taken from a CA exam, students are asked to prepare a memo for the partner to address the accounting issues for a new client in the waste management business. The accounting issues include intercompany transactions in capital assets, revenue recognition, contingencies and capitalization of expenditures. PROBLEMS Problem 7-1 (15 min.) This is a relatively short problem requiring the reconstruction of the investment account when the parent used the equity method. Unrealized profit transactions in depreciable assets made by both companies are involved. Problem 7-2 (20 min.) This question requires the preparation of a consolidated income statement when the parent has used the cost method and where the realization of an unrealized profit in depreciable assets is involved. Problem 7-3 (30 min.) This problem consists of two-year consolidated income statements that have been incorrectly prepared and require correcting. Intercompany transactions and unrealized intercompany profits in depreciable assets have been overlooked. Problem 7-4 (40 min.) This problem focuses on a single transaction involving the intercompany sale of equipment. It contrasts the differences between an upstream and downstream transaction. It also compares the results when reporting under cost, equity, and consolidated bases. Problem 7-5 (80 min.) The preparation of a consolidated balance sheet and consolidated retained earnings statement when the parent has used the cost method is required. There are unrealized profits in inventories and land involved as well as intercompany bondholdings, which are accounted for using the effective-interest method. The question also requires the preparation of the year’s equity method journal entries, an explanation of why deferred income taxes arise with the elimination of intercompany bondholdings and an explanation as to how the parent company extension theory would affect the debt to equity ratio. Problem 7-6 (35 min.) The preparation of a consolidated income statement is required when the parent has used the equity method of accounting. Unrealized profits in depreciable and nondepreciable assets as well as inventories are involved. Every line on the income statement requires adjustment in the consolidation process. The preparation of the parent’s income statement under the cost method is also required. Problem 7-7 (35 min.) The preparation of a consolidated statement of financial position is required when the parent has used the equity method and there are intercompany bondholdings and intercompany profits in a depreciable asset. NCI is measured at the date of acquisition using the fair value as determined by an independent business valuator. Problem 7-8 (90 min.) A comprehensive problem that involves all of the consolidation adjustments taken to the end of Chapter 7. Problem 7-9 (55 min.) This is another problem from a CMA exam that involves unrealized profits in inventories and other assets when the parent has used the cost method. The calculation of selected items from the consolidated balance sheet is required as well as the calculation of total income of the parent company for the year if the equity method had been used. It also compares the straight-line and effective-interest method for bond amortization. Problem 7-10 (35 min.) This problem involves equity method journal entries and the calculation of selected accounts when there are intercompany bondholdings, which are accounted for using the effective-interest method. Problem 7-11 (35 min.) This problem requires the preparation of a consolidated income statement when the parent has used the cost method and there are intercompany bondholdings. Problem 7-12 (30 min.) This problem involves equity method journal entries and the calculation of selected accounts when there are intercompany bondholdings. Problem 7-13 (55 min.) This is a problem from a CGA exam that involves unrealized profits in inventories and building when the parent has used the equity method. It involves the preparation of a consolidated income statement, the calculation of selected items from the consolidated balance sheet, and an explanation of the difference if the parent had used the cost method. Problem 7-14 (50 min.) In this fairly difficult problem, selected trial balance accounts from the records of a parent and its 90%–owned subsidiary are given. The parent has used the equity method and there are intercompany bonds and unrealized gains on land. The preparation of a consolidated income statement and a consolidated retained earnings statement is required. Problem 7-15 (65 min.) In this comprehensive problem, the parent has used the cost method and there are unrealized profits in land, depreciable assets, and inventory. The preparation of the three consolidated financial statements is required along with an explanation of how the historical cost principle supports the elimination of unrealized profits. It also involves the calculation of goodwill, NCI (using the market price of the subsidiary’s shares at the date of acquisition) and return on equity under the parent company extension theory. Problem 7-16 (55 min.) This comprehensive problem originally appeared on a CMA national examination. It involves an intercompany loss on a building and unrealized gains on equipment and inventories when the parent has used the cost method. The preparation of a consolidated income statement and retained earnings statement is required along with an explanation of the rationale for not always eliminating intercompany losses in depreciable assets. It also compares the straight-line and effective-interest method for bond amortization. Problem 7-17 (60 min.) This problem appeared on a CGA national examination. It involves unrealized profits in inventory and equipment. The preparation of a consolidated income statement and retained earnings statement is required along with an explanation of how the historical cost principle supports consolidation adjustments. It also involves the calculation of goodwill impairment loss and NCI under the parent company extension theory. Problem 7-18 (40 min.) This problem involves an intercompany sale of equipment when both the parent and subsidiary use the revaluation model to account for equipment. The student must calculate account balance for selected account for the separate entity statements of the parent and subsidiary and for the consolidated statements. WEB-BASED PROBLEMS Web Problem 7-1 The student answers a series of questions based on the 2011 financial statements of Barrick Gold Corporation, a Canadian company. The questions deal with accounting policies for tangible and intangible long-term assets and the impact of changes in accounting policies on certain financial ratios. Web Problem 7-2 The student answers a series of questions based on the 2011 financial statements of RONA inc., a Canadian company. The questions deal with accounting policies for tangible and intangible long-term assets and the impact of changes in accounting policies on certain financial ratios. SOLUTIONS TO REVIEW QUESTIONS 1. A $2,700 intercompany gain recorded by a constituent company is held back in the preparation of the consolidated income statement by showing no gain on the statement. Income tax expense is reduced by the amount of income tax that the selling company recorded on this gain in the year of sale. In subsequent years, the intercompany gain is realized in the preparation of consolidated income statements by reducing depreciation expense. This reduction in expense increases consolidated net income and thus realizes a portion of the gain in before-tax dollars. Income tax expense is increased each year by the depreciation expense reduction multiplied by the tax rate used on the original gain transaction. This results in a portion of the gain being realized in after-tax dollars. Over the life of the asset, the reduction in depreciation exactly offsets the gain that had been eliminated. 2. The realization of an intercompany inventory profit is accomplished by decreasing consolidated cost of goods sold by the amount of the profit. The resultant cost of goods sold is stated at historical cost to the entity. The realization of an intercompany depreciable asset profit is accomplished by decreasing consolidated depreciation expense. The resultant depreciation expense is stated at historical cost to the entity. 3. Yes. The realization of the intercompany profit through the adjustment to consolidated depreciation is considered to be in effect an indirect sale of a portion of the equipment to customers outside the consolidated entity. Further, if a depreciable asset is sold to a third party, the remaining intercompany profit is then realized. 4. No. The only time an adjustment of this kind affects the non-controlling interest calculation is when the subsidiary was the selling company in the transaction that created the original intercompany gain. 5. As long as the purchaser continues to depreciate the depreciable asset an adjustment will be required on consolidation to change depreciation expense to what it would have been had the intercompany sale not taken place. 6. As the purchaser uses the depreciable asset and earns a profit by selling its own goods and services to outsiders, a portion of the previously unrecognized gain is considered to be realized from a consolidation viewpoint. As each year passes, the amount of unrealized gain is reduced and, in turn, the adjustment of beginning retained earnings is reduced. 7. Rather than simply eliminating the unrealized gain from the purchaser’s cost of the asset, both the cost of the asset and accumulated depreciation are adjusted to the amounts that would have been reported by the seller had the intercompany transaction not occurred. This usually means that the cost and accumulated amortization are both increased i.e. grossed up to get to the target amount. *8. The consolidated financial statements should report account balances as if the intercompany transaction has not occurred. The transfer from cumulative other comprehensive income to retained earnings should be reversed on consolidation. In turn, the equipment should be remeasured to fair value with the adjustment to fair value being added to/subtracted from cumulative other comprehensive income. *9. This statement is true. There should never be a gain on the consolidated income statement from an intercompany sale of equipment regardless of whether the companies are using the historical cost model or the fair value model to value the equipment because there has not been a transaction with outsiders. However, there could be a gain or loss on the separate entity income statement for the selling entity because the transaction may occur at a point in time when the financial statements have not been updated to the most recent fair value for the equipment. For example, the equipment may have been updated to fair value at the end of the previous period but the sale took place late in the current year when the fair value was higher than previously reported. 10. The four approaches are as follows: (a) The purchasing affiliate acted as an agent for the issuing affiliate; therefore gains or losses are allocated to the issuer. (b) Gains or losses are allocated to the purchasing affiliate because it made the open market purchase of the bonds. (c) Gains or losses are allocated to the parent company because it controls the actions of the affiliates. (d) Gains or losses are allocated to both the purchasing and the issuing affiliates. Approach (d) is conceptually superior because each affiliate will actually record the gain (loss) so allocated when it amortizes the premiums or discounts that caused the consolidated gains (losses) in the first place. As a result, the eliminations in consolidated statements mirror the entries made by both the purchaser and the issuer. 11. An “interest elimination loss” is created in the preparation of a consolidated income statement as a result of the unequal elimination of interest revenue and expense. When the elimination of interest revenue is greater than the elimination of interest expense, a reduction of the entity’s before-tax net income results. This “loss” does not appear as a separate item in the consolidated income statement. 12. The holdback of an intercompany asset gain results in the creation of a deferred tax asset in the preparation of the consolidated balance sheet because, although the selling affiliate has recorded the tax in its income statement, it will not be an expense of the entity until the asset is sold to outsiders. The adjustment in the preparation of a consolidated income statement creating a gain on bond retirement results in a deferred tax liability in the consolidated balance sheet because none of the constituent affiliates has paid (or recorded) the tax on the gain, but will do so in future periods when they amortize the premiums or discounts that caused the gain. 13. Gains (losses) on the intercompany sales of assets are realized for consolidated purposes when the assets have been used up or sold outside the entity. This event occurs in periods that are subsequent to the period in which the selling affiliate recorded the gain. Gains (losses) resulting from the elimination of intercompany bondholdings are realized for consolidation purposes in the period in which the intercompany acquisition takes place. The affiliates’ share of the gain (loss) is recorded in subsequent periods when the discounts or premiums that caused the gain (loss) are amortized by each affiliate. 14. Gains should be recognized when they are realized i.e., when there has been a transaction with outsiders and consideration has been given/received. When the parent acquires the subsidiary’s bonds for cash in the open market, it is transacting with an outsider and giving cash as consideration. From the separate entity perspective, the parent is investing in bonds. However, from a consolidated point of view, the parent is retiring the bonds of the subsidiary when it purchases the bonds from the outside entity. Therefore, when the investment in bonds is offset against the bonds payable on consolidation, any difference in the carrying amounts is recorded as a gain or loss on the deemed retirement of the bonds. 15. The matching principle requires that expenses be matched to revenues. When intercompany bondholdings are eliminated, a gain or loss on the deemed retirement of the bonds is recognized on the consolidated financial statements. In turn, the income tax on the gain or loss must be recognized to match to the gain or loss. Since the income tax is not currently payable or receivable but deferred until the temporary differences reverse, it is set up as deferred income tax. SOLUTIONS TO CASES Case 7-1 1. If Enron controlled LIM2, Enron did overstate its earnings by reporting a profit of $67 million on a transaction with LIM2. When consolidated financial statements are prepared, the intercompany transaction between Enron and LIM2 would be eliminated and the fibre optic cable would be remeasured to the carrying value of this asset prior to the sale. The profit on the fibre optic cable would only be recognized on the consolidated income statement when LIM2 sells this cable to outsiders or through reduced depreciation expense over the useful life of this asset. 2. If Enron only had significant influence over LIM2, it would use the equity method to report its investment. Since Enron does not control LIM2, it would not be able to dictate the selling price of the cable. Since Enron only has significant influence, the interests’ of the other shareholders would have to be considered in setting the price. It would be similar to Enron selling to outsiders. IAS 28 states that profit pertaining to the other shareholders’ interest would be considered realized and need not be eliminated; only the investor’s percentage interest in the investee times the profit must be eliminated. The unrealized profit would be eliminated from investment income. 3. IAS 24 does not deal with the measurement of related party transactions. It only deals with the disclosure requirements for related party transactions. If the transaction were to be reported at carrying amount, Enron would not report the gain. If the transaction were to be reported at exchange amount under IAS 24, Enron would be able to report the gain. In most of the situations considered in this question, Enron should not have reported the gain. Gains from intercompany transactions are typically eliminated and not reported on the seller’s financial statement. Gains are typically not reported until they are realized in a transaction with a non-related party. This requirement applies to consolidated financial statements and investments reported under the equity method but does not necessarily apply under related party transactions. Case 7-2 (a) This case is designed to give life to a theoretical accounting issue discussed within the chapter: If a subsidiary’s debt is retired, should the resulting gain or loss be assigned to the parent or to the subsidiary? The case attempts to illustrate that no clear cut solution to this question can be found. This lack of an absolute answer makes financial accounting both intriguing and frustrating. Interesting class discussion can be generated from this issue. Students should note that the decision as to assignment only becomes necessary because of the presence of the non-controlling interest. Regardless of the level of ownership all intercompany balances are eliminated on consolidation. Not until the time that the non-controlling interest computations are made does the identity of the specific party become important. All financial and operating decisions are assumed to be made in the best interest of the business entity as a whole. This debt would not have been retired unless corporate officials believed that Penston/Swansan would benefit from the decision. Thus, a strong argument can be made against any assignment to either separate party. (b) Students should be required to pick one method and justify its use. Discussion usually centers on the following issues: • Parent company officials made the actual choice that created the loss. Therefore, assigning the $300,000 to the subsidiary directs the impact of their reasoned decision to the wrong party. In effect, the subsidiary had nothing to do with this transaction (as indicated in the case) so that its financial records should not be affected by the $300,000 loss. • The debt was that of the subsidiary. Because the subsidiary’s debt is being retired, all of the $300,000 should be attributed to that party. Financial records measure the results of transactions and the retirement simply culminates an earlier transaction made by the subsidiary. The parent is doing no more than acting as an agent for the subsidiary (as indicated in the case). If the subsidiary had acquired its own debt, for example, no question as to the assignment would have existed. Thus, changing that assignment simply because the parent chose to be the acquirer is not justified. • Both parties were involved in the transaction so that some allocation of the loss is required. If, at the time of repurchase, a discount existed within the subsidiary’s accounts, this figure would have been amortized to interest expense (if the debt had not been retired). Thus, the $300,000 loss was accepted now in place of the later amortization. This reasoning then assigns this portion of the loss to the subsidiary. Because the parent was forced to pay more than face value, that remaining portion is assigned to the buyer. Case 7-3 (a) The following amounts would be reported on the separate-entity financial statements: Slum’s books Plum’s books Years 1 + 2 Years 3 through 6 Amortization per year 84,000 / 6 = 14,000 100,000 / 4 = 25,000 Tax Rate 30% 40% Tax savings per year 4,200 10,000 Gain on Sale at end of Year 2 Proceeds on sale 100,000 Carrying amount (84,000 x 4/6) 56,000 Gain on sale 44,000 Income tax (@30%) 13,200 The consolidated entity paid taxes of $13,200 at the end of year 2 and gained a tax saving of $10,000 – $4,200 = $5,800 per year in years 3 through 6. In nominal terms, it gained $5,800 x 4 – $13,200 = $10,000. In present value terms, it realized a return of nearly 30%. Therefore, the intercompany sale was a good financial decision. (b) 40% of Slum’s after-tax gain on the sale of the machine would now be credited to the non-controlling interest i.e., ($44,000 – $13,200) x 40% = $12,320. Since this amount is greater than the overall tax saving of $10,000, Plum would realize an overall loss of $2,320 on the intercompany transaction. From Plum’s perspective, it is not a good financial decision. (c) As a result of the intercompany transaction, amortization expense has increased from $14,000 to $25,000 per year. The extra $11,000 must be eliminated on consolidation so that only $14,000 of amortization expense is reported on the consolidated income statement. Income tax on the $11,000 must also be eliminated. Three alternatives are presented below for the elimination of tax on the excess amortization for each of Years 3 to 6: Controller Manager Other Excess amortization $11,000 $11,000 $11,000 Proposed tax rate 30% 40% 52.727% Tax saving eliminated 3,300 4,400 5,800 Tax saving before adjustment 10,000 10,000 10,000 Tax saving after adjustment 6,700 5,600 4,200 The controller’s suggestion of 30% can be supported on the basis that the total tax eliminated over 4 years will be $13,200 which is equal to the tax paid by Slum when the gain was reported for tax purposes. This results in reporting a tax saving of $6,700 on amortization expense of $14,000 on the consolidated income statement. This is $2,500 per year more than Slum’s tax saving of $4,200 per year before it sold the machine to Plum. This fairly presents the actual situation because Plum is achieving an incremental tax benefit of $2,500 per year (i.e. $10,000 overall gain spread over 4 years) as a result of the intercompany transaction. The other option can initially be supported on the basis that it would report a tax saving of $4,200 on amortization expense of $14,000 on the consolidated income statement which is consistent with what was reported before the intercompany transaction occurred. However, it would eliminate a total of $23,200 of tax over 4 years, which is $10,000 more than the tax paid on the original sale of the machine. Therefore, this alternative does not fairly present the true tax situation for the consolidated entity or the non-controlling interest. The manager’s suggestion would produce similar results as the other option. Case 7-4 Memo to: Partner From: Stephanie Baker, CA Subject: Canadian Developments Limited (CDL) Engagement As requested, I have analyzed the accounting implications, financial statement disclosure, and other matters of importance relating to several transactions that CDL entered into during the Year 8 fiscal year. Overall, the policies suggested by CDL management lead me to conclude that there is a bias towards adopting policies that maximize earnings and provide a strong balance sheet in order to attract new investors. Changes in capital structure If the convertible debentures are, in substance, permanent equity of CDL, then their classification as shareholders’ equity is appropriate and gives the proper presentation of the economic substance of the transaction. Therefore, it is necessary to determine whether these debentures are, in substance, equity or debt. Likelihood of conversion The classification of the debenture will depend on the likelihood of the debenture being converted to common shares. In this instance, the holders of the debentures are a relatively small group (major shareholder (53%) and large institutions), and CDL may be able to find out from them what their intentions are. If the majority of the holders confirm their intention to convert, the question of uncertainty will be largely resolved. CDL has the option to trigger (force) conversion by repaying the debt at maturity by issuing common shares. The existence of the option, however, is not sufficient to permit accounting for the debenture on the unsupported assumption that the conversion will occur. CDL must intend to force conversion if it wishes to account for the debentures as permanent equity. Unusual features The lower interest rate on the debenture indicates that a large portion of the security’s value lies in the conversion feature, thus increasing the likelihood of conversion. Future financial solvency Although it is impossible to assess the company’s solvency 20 years from now with accuracy, it is important to assess the financial stability and trends. This will provide insight into whether the company will be able to meet the solvency tests required to force conversion. Financial solvency is unlikely to be a concern in 20 years time in light of the following: the size of the company (lots of equity); publicly held debt (major financial institutions will have debt covenants aimed at solvency); and diversification that should insulate the company from shocks to one sector of the economy. Other factors There are other, less critical, factors that can be considered in determining whether the debenture should be classified as debt or equity: • In common with other forms of debt the debenture pays interest and therefore the return is not dependent on earnings. • The legal form of the instrument is debt; if CDL were liquidated, this debenture would take precedence over equity. • The debentures can be redeemed by the holder at the purchase price. The most important consideration in this decision is the intention of CDL and the debt holders regarding conversion. If we can establish that conversion is likely, then I would support the client’s classification of this debenture as equity. There should be full disclosure in the notes to the financial statements regarding the classification of this transaction. We must ensure that the income statement treatment of the interest payments is consistent with the balance sheet presentation. That is, if this debenture is classified as equity, then the interest payments should be disclosed as dividends. If Revenue Canada requires debt treatment, then the dividends should be disclosed net of tax. There will be no effect on CDL’s basic earnings per share figure regardless of the balance sheet treatment given to this transaction because the amount available to the common shareholders will be the same under both presentations. However, if the conversion proved dilutive, then the effects of the conversion would have to be incorporated in the calculation of the fully diluted earnings per share. If CDL does not already disclose fully diluted earnings per share and the conversion is dilutive, then fully diluted earnings per share will have to be disclosed. Redeemable preferred shares Two issues need to be considered with respect to the redeemable preferred shares: their classification on the balance sheet (same issue as the convertible debentures), and their measurement on the balance sheet. Classification Since the preferred shares are mandatorily redeemable in five years’ time, they do not constitute a part of CDL’s permanent capital. CDL should classify share capital according to the substance i.e. debt, which would result in the preferred shares being excluded from the permanent equity section of the balance sheet. Measurement of the conversion There are three alternatives for recording the conversion: 1) Record at $20 million This alternative is supported by the historic cost concept. The cost to CDL of the preferred shares is $20 million. This approach would be reinforced if the $20 million were the legal, stated amount (i.e., the paid-in amount). CDL could then appropriate retained earnings for the future payment of $20 million. 2) Record at $40 million The $40 million represents the effective “stake” of the shareholder in CDL. The excess $20 million should first be charged against contributed surplus, and then the balance charged against retained earnings. 3) Amortize $20 million over 5 years This alternative would gradually reflect the increase in the effective stake of the shareholder over the five-year term. Since the shares are classified as debt, the charge would be to income. Investors contribute cash to enterprises so that they can earn a return on their investment. Whether a payment is made each year or not, an investor expects ultimately to receive the return earned annually. In the case of a preferred share issue that is mandatorily redeemable, the return will be provided either annually or at maturity, usually in a fixed form. In this instance, the return has been fixed at $40 million payable in five years’ time. The $40 million represents both a return of capital and income over the five-year period until maturity. In substance, the earnings on the invested capital are accruing over the five years and will be paid out in one lump sum. Accounting for the substance of the transaction suggests discounting the $40 million payment and accruing the annual dividend each year as a form of interest expense. The conversion will need to be disclosed in the notes to the financial statements. Disposal of residential real estate segment In substance, all that has happened to CDL is that it sold the residential real estate operations. However, control over the assets of the commercial division did not change since CDL controlled these assets both before and after this series of transactions. Therefore, under the historic cost concept, the assets of the commercial division should remain at carrying amounts. In RPI’s case, the assets should be recorded at historical cost for the following reasons: • There is not a new economic entity. • The fair values were not determined at arm’s length, as the buyer had nothing to lose if an inflated price was chosen. • Appraisal increments (which we could obtain) would be accepted if there had been a reorganization of capital. RPI for its separate entity financial statements and CDL for it consolidated financial statements could use the revaluation model in IAS 16 to value the assets of the commercial division at fair value. However, it would have to do so on an ongoing basis and not on a one-shot deal. Case 7-5 Memo to: Engagement Partner From: CA Re: Accounting Issues for Bakersfield Ball Boys Limited (BBB) Users’ objectives and risk Below I have outlined the major accounting concerns facing the BBB engagement for the June 30, Year 11 financial statements. Before proceeding to the specific issues, I want to bring several broader issues to your attention. BBB is a private company. Accordingly, it can use IFRS or ASPE. BBB’s majority shareholder, Tall Bottle, is a public company. Since Tall Bottle must use IFRS, it will likely insist that BBB also uses IFRS to facilitate the preparation of consolidated financial statements. My comments below are made on the assumption that BBB is using IFRS. In analyzing and recommending accounting policies for the new issues facing BBB in Year 11, we must be sensitive to the fact that the objectives of the minority shareholders, Mr. Bill Griffin and Excavating Inc., conflict with those of the management of BBB and, probably, the majority shareholder of BBB, Tall Bottle Ltd. (Tall Bottle). Commencing with the current year, management’s remuneration contract includes a bonus based on annual pre-tax income. Accordingly, management is likely to want to maximize income. It appears that Tall Bottle supported the new bonus arrangement, possibly hoping to maximize income and net assets for consolidation. However, Mr. Bill Griffin and Excavating Inc. were opposed to the bonus arrangement. Therefore, these minority shareholders will want to ensure that income is not unjustifiably overstated. A factor that could mitigate this conflict is that BBB may want to decrease revenues, where possible, in order to minimize any payments (or maximize receipts) under the new equalization program. As a result of these conflicting objectives, our overall exposure on this engagement has increased. This exposure risk will be further increased if we recommend accounting policies, since they might ultimately cause financial harm to one of the users of the financial statements. We should therefore consider whether it would be prudent for us to avoid recommending accounting policies in light of the given conflicts. On the assumption that we will recommend accounting policies in spite of the increased exposure risk, I have given priority to the objectives of the management of BBB since they are preparing the financial statements, and the majority shareholder, Tall Bottle, supports their objectives. In light of the increased exposure, we must ensure that our recommendations are not too aggressive. (Candidates failed to identify the conflicting objectives of the users of the financial statements and the corresponding risks.) Sportsplus contract Exclusive rights Since the minority shareholders may have concerns that the management of BBB and the majority shareholder are benefiting from BBB at their expense, we must be careful in dealing with the Sportsplus contract arrangement. During the year, Sportsplus granted valuable advertising rights to Tall Bottle at no cost, in exchange for BBB’s local television rights. It appears that Tall Bottle may have benefited from this deal at the expense of the other shareholders. We will need to determine whether BBB gave up any revenues in its deal with Sportsplus so that Tall Bottle could become BBB’s official sponsor. Specifically, was the sale of television rights to Sportsplus at fair market value? This will be difficult for us to determine. If we establish that the sale was not at fair market value, we could suggest that a receivable from Tall Bottle be established for the difference between the contract price and fair value. Tall Bottle may suggest that the free advertising they received was compensation for management services provided to BBB. If so, BBB should recognize a management fee expense and revenue from sale of TV rights. If Tall Bottle opposes this accounting treatment, as a minimum this related party transaction should be disclosed in the notes to the financial statements so that other shareholders can assess its implications. (Candidates failed to recognize the reporting implications of the exclusive-rights contract.) Signing bonus The $250,000 signing bonus received by BBB for renewing its contract with Sportsplus can be accounted for in several ways. One approach is to take the full amount into income in the current year. Management may argue, for example, that the critical event in earning the payment is the signing of the contract in the current year. An alternative approach is to consider the payment as part of the total revenue for the contract. The amount of the signing bonus would then be taken into income over the contract term. Management will obviously favour recognizing all the income in Year 11. However, given the magnitude of the payment, the substance of the transaction is probably better portrayed by treating the payment as part of the total revenue for the contract. In light of the stronger theoretical support for amortizing this revenue over the contract term and the strong concerns that the minority shareholders may raise, it is my recommendation that the signing bonus be amortized over the three-year contract term. (Although candidates identified the alternative methods of recognizing revenue for the signing bonus, they did not analyze the merits of each alternative in adequate depth.) Payment for high ratings We must find out whether the $315,000 payment to BBB for its high ratings over the previous contract term was conditional on the re-signing of the television contract. If it was, then this amount relates to the new contract and should be recognized over the new contract term. If the amount relates to past ratings (i.e., it was not conditional on the re-signing) and if during any of the prior periods BBB could have made a reasonable estimate of the amount that would be paid, then the amount should have been accrued in that prior period. Under these conditions, a correction of an error will be necessary. However, if a reasonable estimate of the amount could not have been made in the prior periods, then it is appropriate to take the amount into income in the current year. As a minor matter, we may want management to consider whether it would be appropriate to allocate more of the revenues to certain games and less to others, based on their popularity, etc. (Candidates did not identify the accounting implications of the payments for high ratings. Most candidates tried to analyze the signing bonus issue and the high ratings payment issue together, even though they were based on different facts and therefore required separate analysis.) Player contracts Player contracts probably represent one of the most significant costs of BBB. Accordingly, these commitments should be disclosed in the notes to the financial statements, as required by generally accepted accounting principles (GAAP). Bill Board Bill Board’s injury has compelled him to retire from playing baseball. In view of the impairment in “future benefit,” we should consider whether we should expense in the current year a portion, or all, of the payments required under his guaranteed contract. The portion not written off should be included in administrative expenses on the income statement over the period of benefit, and not in player contracts. Frank Ferter It is uncertain at this time whether Frank Ferter will be selected to play for the All Star Team, which would oblige BBB to pay him a $50,000 bonus. Since Ferter is favoured to capture this honour, it is likely that the amount will be paid by BBB and, therefore, the amount should be accrued in the financial statements. If investigation reveals that his inclusion in the team is unpredictable, then this contingent liability should be disclosed in the notes to the financial statements. In any event, this amount is probably immaterial to the financial statements. Management’s proposal to amortize the cost of Ferter’s three-year contract over ten years seems overly aggressive. Their position is probably based on an attempt to increase their bonus. It is very difficult to estimate the future benefit of this player to the future of the team-the uncertainty of the future benefit is analogous to that of advertising expenditures. Given the uncertainty, it is recommended that the contract be expensed over the three-year period. (Overall, candidates were able to identify and appropriately discuss the accounting implications of the player contracts.) Termination payment As a result of the move to its new premises, BBB was required to make a final payment of $3.6 million to NoWay Park to terminate its lease. This payment can be accounted for in several ways. One approach is to expense the payment in the current year since no future benefit will be obtained by BBB from this site. An alternative approach is to amortize the payment over the ten-year term of the new lease with Big Top stadium. This approach is supported by the fact that the termination payment was a cost that had to be incurred in order to rent the new premises. This cost should therefore be matched to the period during which the benefit is to be derived from the new stadium. A final option is to amortize the cost over the remaining three-year period of the previous lease with NoWay. However, this approach has little theoretical support, except perhaps the argument that it is the first three years of the new lease that carry the highest cost. Although management would prefer to amortize the termination payment over the term of the new lease, it is hard to justify this alternative. It is unlikely that the annual rent under the new lease was affected by the termination cost on the old lease. BBB is no longer getting any benefit from the old lease.. Therefore, I recommend that the termination payment be expensed in the current year. (Candidates were able to identify the alternative accounting methods for the lease termination payment, and they discussed these alternatives in adequate depth.) Equalization costs As a result of the new equalization program, BBB may receive from, or be required to pay to, the league a portion of its revenues. However, the final amount cannot be determined until the season ends, since it depends on many variables, such as BBB’s revenues and the revenues of all other teams in the league. These amounts in turn depend on how each team is doing in the league, which teams are in the playoffs, etc. Furthermore, it is difficult to estimate BBB’s revenues in the new stadium because there is no basis for comparison. An accounting problem arises, however, because BBB’s year-end is mid-way through the season. One approach is to postpone recording any amount in the accounts until the net cost/revenue is known in October. One can argue that it is simply too difficult to make any reasonable estimate, given all the unknown variables discussed above. Under this approach, however, BBB would disclose the possible contingent liability. The alternative is to accrue for an amount that will likely be paid by BBB (contingent gains cannot be accrued). However, this accrual will be very difficult to measure, for the reasons discussed above. In light of the fact that the statements will be used to determine management bonuses and the difficulty associated with estimating the net revenue/cost, I recommend that no amount be accrued in the financial statements and only the contingent liability be disclosed. Although this treatment will cause an inconsistency between the period of management “effort” and the period in which the net amount is included, an estimate of the amount is simply too difficult at present. This approach will not require any adjustment to the prior year’s financial statements. (Candidates understood that the June 30 year-end caused an accounting problem with regard to these equalization payments. However, they did not identify or analyze the accounting implications.) Roof collapse We must determine the net cost to BBB of the roof collapse, after considering recoveries from the insurance company. If there is a material net cost to BBB, then this cost should be disclosed separately. Ticket refunds The ticket refunds should be reported as a reduction of net sales. The unused tickets should be recorded as unearned revenue. Gift certificates The gift certificates can be recorded as a liability. However, it seems more appropriate to give no accounting recognition to these certificates because the certificates are really only an executory contract at present and a portion of them may never be reimbursed. (Candidates failed to identify and discuss the accounting and audit implications of the roof collapse.) Insurance claim Attached to this memo is my draft report to BBB, which includes the statement of loss. REPORT TO BAKERS FIELD BALL BOYS LIMITED Bakersfield Ball Boys Limited Management Dear Sir/Madam: Attached in Appendix I is the statement of loss you requested to support your claim for damages in accordance with your business-interruption insurance policy. Our underlying premise in preparing this statement is that BBB should be put into the same position as if the roof collapse had not occurred. Our calculations show that your total claim amounts to $1,980,696. We must review the insurance policy to ensure that all items included in our statement of loss are appropriate and that no items to which BBB is entitled are missing from the statement. After reviewing the policy, we will make any changes needed. At present, the statement does not include several items that should be considered and perhaps added. For example, the insurance company should reimburse you for any legal, accounting and audit fees. Furthermore, BBB should consider whether there are any other indirect costs that it may incur. Have any lawsuits against BBB arisen? Will attendance at Big Top decline? Are the television ratings likely to be adversely affected? Please call us once you have had an opportunity to review the enclosed information so that we can discuss any comments you may have. Yours truly, CA (Generally, candidates understood the concepts to be applied in preparing the statement of loss (i.e. a differential revenue/cost analysis) and prepared an appropriate statement. APPENDIX I Bakersfield Ball Boys Ltd. Statement of Loss Re: Roof Collapse at Big Top Lost revenue Ticket sales (Note 1) $1,400,000 Confection gross profit (Note 2) 79,896 1,479,896 Additional costs (costs saved) Gift certificates (Note 3) 480,000 Stadium rental 132,500 Groundskeeper costs (Note 4) (7,500) Cleaning crew (Note 5) (10,500) Food vendors (Note 6) (13,700) 580,800 Net loss to BBB $2,060,696 Note 1: Number of Big Top cancelled tickets 40,000 Ticket price x $35 Lost ticket sale revenues $1,400,000 Note 2: Assuming that confection sales at Big Top would have been the same, on a per-seat basis, lost confection sales are ca1culated as follows: [Projected net sales at Big Top, less stadium’s share of sales] – [Actual net sales at NoWay, less stadium’s share of sales] = [($191,750 x 70,000/30,000 x 50% food cost) – (191,750 x 70,000/30,000 x 15% to stadium)] – [($191,750 X 50% food cost) – ($191,750 X 10% to stadium)] = $79,896 Note 3: Gift certificates issued 40,000 Value x $12 $480,000 Note that this amount may be reduced by the portion that is not likely to be redeemed. The insurance company may refuse to reimburse these costs, arguing that they were not a necessary cost as a result of the roof collapse. Note 4: NoWay actual costs $9,000 Big Top projected costs 16,500 Costs saved $7,500 Note 5: NoWay actual costs $15,250 Big Top projected costs 25,750* Costs saved $10,500 * Assumes that BBB did not have to pay for clean-up crews at Big Top. Note 6: No Way actual costs $19,200 Big Top projected costs 32,900 Costs saved $13,700 Case 7-6 To: Partner From: CA Subject: Enviro Facilities Inc. Engagement Overview The Enviro Facilities Inc. (EFI) engagement has considerable risk associated with it. In reviewing the file, I noted a number of events that raise concerns about the integrity of EFI’s management. These events include: (1) management’s refusal to notify the bank of its error in converting foreign funds and the inclusion of the amount of the error in income; (2) the change in the accounting estimate of the useful lives of assets, which has the effect of increasing income; (3) the ongoing dispute with the provincial tax auditors; (4) the patent infringement suit; and (5) the rumour that an affiliated company may not comply with environmental legislation. No single one of these circumstances provides compelling evidence of questionable management integrity. Changing accounting estimates is commonplace and often justifiable. There has been no conviction on the patent infringement suit and nuisance lawsuits are not unusual. An aggressive approach to tax can be in the interests of the shareholders, and the rumour regarding the affiliated company is just that: a rumour. Collectively however, these events give a hint that management may lack integrity, thus increasing the risk associated with the engagement. Moody’s has put EFI’s credit rating on alert for downgrading due to a toughening of environmental legislation. EFI therefore has an incentive to improve the appearance of its financial statements so as to influence Moody’s decision. A downgrade in the credit rating would be costly to EFI as it would increase the cost of borrowing. EFI’s managers and owners probably have an incentive to report higher income because of the pending sale of the company. EFI’s accounting policies and the estimates used suggest that this is the case. The prospective purchasers will likely use the financial statements to determine the price of the shares, particularly because the company is private and no market price is available for the shares. Furthermore, EFI operates in an industry where the valuation of assets is very subjective and requires estimates. Provincial sales tax audit The amount under investigation by the provincial auditors is $7.22 million, which is greater than the materiality threshold. The result of the sales tax audit must therefore be carefully considered to determine whether and how it should be reported in the statements. The situation is difficult to assess because the audit is continuing and there has not yet been an assessment or even an indication by the provincial auditors of what they have determined. If they rule against EFI, both the balance sheet and the income statement will be affected. A negative ruling will increase the cost of the items purchased. Long-lived assets on the balance sheet will increase by the amount of the tax reassessment. That amount will be amortized to the income statement over the lives of the assets. Thus the income statement will reflect the portion of the tax that relates to the amortized portion of the assets. Similarly, the income statement will be affected by tax pertaining only to supplies that have been expensed. The effect on income is important because prospective purchasers in deciding what price to pay for EFI’s shares may rely on the statement. Once we receive the notice of assessment from the government, we will be able to evaluate whether the interpretation by the auditor is correct. If the issue is not resolved by the time we sign the financial statements, we must decide whether this issue should be disclosed as a contingent liability or whether the amount should be accrued in the financial statements. If we determine that the liability is likely and the $7.22 million is a reasonable estimate, then it should be accrued. We should consult our tax department to help us in this regard. The risk to us is that there could be inadequate disclosure of a material event, which is especially crucial because of the possible sale of the shares. Conversely, disclosure when the likelihood of the liability being realized is small may reduce the proceeds that the current owners of the company could receive. Bank error The treatment of the bank error results in income being increased by $6,128,258, an amount that is material. This misstatement of income could influence the decisions of potential buyers and bond-rating agencies. Clearly, including the amount in income is not correct accounting. The money does not belong to EFI, and the bank could ask for repayment once they discover the error. The amount of the error should be set up as a liability, not included as revenue. Of course, the liability may never be paid if the bank does not notice the error. If EFI refuses to change its method of accounting for the error, we should point out that the amount is taxable. The company may then agree to change its accounting approach since it imposes real economic costs. Our firm should also question whether we should remain associated with EFI given their unwillingness to return money that clearly does not belong to them. Patent infringement award The award against EFI made by the court in the patent infringement case is unusual. Aggrieved parties normally receive a straightforward payment as compensation. The payment is usually treated as an expense for accounting purposes. In this case, however, EFI is receiving something that could have value, so the accounting is more complex. Various accounting approaches could reasonably be used. First, since the purchase is a court-imposed penalty, the $18 million share purchase could be considered to be an $18 million fine and shares to have been acquired at zero cost. This approach would be unattractive to EFI since it would have a significant effect on the income statement at a time when it is very concerned about the bottom line (because of the potential sale of the shares and the alert placed on EFI’s credit rating). An alternative approach would be to record the shares as an asset on the balance sheet at $18 million. This approach would be attractive to EFI’s management because the income statement would be unaffected. It is clear that EFI may be receiving an asset because of the court decision. The first step would be to determine whether the shares would meet the definition of an asset. According to the IFRS Framework, paragraph 49, “An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity”. The shares will be controlled by EFI and are the result of a past event (the court ruling), however whether or not there will be any future benefits depends on the performance of Waste Systems. If EFI is likely to derive a future benefit from the shares, then the definition of an asset has been met. The next question to be resolved is what the asset is worth. If the shares are to be recorded on the balance sheet at $18 million, they must be worth $18 million. If the market value is less than $18 million, then the amount in excess of the fair market value should be expensed since that amount represents a penalty. Since Waste Systems Integrated Limited is a private company, it could be difficult to arrive at a reasonable estimate of its fair market value. I strongly suggest that we have a valuation done of the company so that we have authoritative support for the value. Such support is especially important in view of EFI management’s concern about the income-statement figures at the present time. That Waste Systems had been in financial difficulty is an indication that its market value is low. If we determine that Waste Systems has a value greater than zero and should be recorded as an asset, a number of accounting issues will need to be resolved. We must determine whether the shares should be considered a long- or short-term asset and whether we should consolidate, or use the equity method. We cannot make these accounting decisions until we have found out, for example, whether there are restrictions on EFI’s ability to sell the shares. (If there are, accounting as a financial asset would be appropriate; otherwise, we must determine what management’s intentions are.) Similarly, we need to find out what proportion of Waste Systems EFI owns, to help determine the method of accounting for the investment. Waste-disposal sites EFI has significantly lengthened the estimated lives of its waste disposal sites and decreased the estimated cost of sealing and cleaning up the sites. The change has a significant effect on income, which is important because the owners are considering selling their shares. Waste-disposal sites represent 64% of EFI’s assets and 41% of operating expenses. The disposal sites will be an important consideration for prospective purchasers, and they may rely on the financial statements. Thus we must exercise great care in this highly risky part of the audit. Compounding the problem is the fact that EFI changed consulting engineers this year and the new engineers, Cajanza Consulting Engineers (Cajanza), recommended the changes. However, there may be an independence problem. EFI owes Cajanza $2.9 million, and the amounts owing date back to Year 4. It is not clear why this amount has been outstanding for so long, but EFI may be using the debt to influence Cajanza’s judgment or Cajanza may feel pressure to provide results favorable to EFI to secure its money. It is difficult to understand how the costs of sealing and cleaning up sites can decrease at a time when environmental regulation is increasing, so the reduction in estimated costs requires some attention. EFI uses three different methods for amortizing the cost of the sites. We must decide whether using three methods is justifiable. The IFRS Framework requires that consistent accounting policies be applied across the entity, so it is likely that using these different methods is not acceptable. “The measurement and display of the financial effect of like transactions and other events must be carried out in a consistent way throughout an entity and over time for that entity and in a consistent way for different entities.”[IFRS Framework, par.39] Therefore, the company should determine which accounting policy is the most appropriate and apply this accounting policy consistently. The same methodology should be used to calculate amortization expense across for an asset class. Given the circumstances and the incentives for management to increase earnings, additional audit steps should be taken to satisfy us that the estimated lives and clean-up costs are reasonable. One approach would be for us to engage an engineering firm to assess the lives and clean-up costs of the sites. In any case, it will be necessary for the changes in estimates to be disclosed in the notes. Locating and negotiating costs EFI amortizes the costs of locating new waste-disposal sites and negotiating agreements with municipalities. This approach is debatable and requires professional judgment to resolve. IAS 16 states that the cost of an item of property, plant and equipment includes any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. One could argue that locating new waste-disposal sites and negotiating agreements with municipalities is a cost of bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. On the other hand, one could argue that the cost associated with negotiating a contract would be considered an administrative cost and would be expensed as incurred. According to IAS 16.19 “Examples of costs that are not costs of an item of property, plant and equipment are…administration and other general overhead costs.” We will have to discuss this matter with management to determine their rational for capitalizing the cost. If we deem that it is not a cost of bringing the asset to the location and condition necessary for use, the cost will need to be expensed. Onkon-Lakerton contract EFI has recognized the guaranteed portion of the contract with the Onkon-Lakerton municipality as revenue. The revenue recognition criteria [IAS 18.20] states that “when the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognized by reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when all the following conditions are satisfied: (a) the amount of revenue can be measured reliably; (b) it is probable that the economic benefits associated with the transaction will flow to the entity; (c) the stage of completion of the transaction at the balance sheet date can be measured reliably; and (d) the costs incurred for the transaction and the costs to complete the transaction can be measured reliably. EFI may be able to support their position that the outcome of the contract with Onkon-Lakerton can be estimated reliably, due to the guaranteed minimum revenue of $3.2 million per year. However, IFRS still requires that revenue recognition be based on the stage of completion of the transaction. EFI has not performed any of the work in relation to the contract. Indeed, the contract period has not yet even begun. Therefore, EFI cannot recognize the $3.2 million of revenue related to this contract. US subsidiary lawsuits Two US subsidiaries of the company are being sued for improper disposal of hazardous waste. The alleged activities took place before EFI acquired the subsidiaries, and the sale-purchase agreement provides for a price adjustment in the event of this type of liability. Provided that the agreement covers the situation in question, including costs of litigation, and the previous owner is able and willing to meet the obligation, then no additional audit work is necessary and it is not necessary to make any disclosure in the financial statements. However, before we can come to that conclusion, we must assure ourselves that EFI is fully protected. We must be certain that the price-adjustment clauses cover legal claims of this type and that the clauses are still in force—for example, there may be limits on how long the seller remains responsible for actions of this type. We must determine whether the previous owner is ready, willing, and able to meet the terms of the contract. The previous owner could have gone out of business, could lack the resources to satisfy the claim, or could deny responsibility for some or all of the damages. If we conclude that there is some probability that EFI will be responsible for some or all of the claims, we will have to consider a provision should be recorded in accordance with IAS 37. Affiliated company dumping/purchases of disposal sites In anticipation of the sale of shares by the owners, EFI plans to dispose of waste sites whose clean-up costs exceed their carrying amount. This transaction would be a related party transaction and must be disclosed in the notes of the financial statements [per IAS 24], which would draw attention to the users that the company was transferring the assets. We must determine whether EFI will be free of liabilities after selling the sites. EFI may be liable contractually or legally for any future clean-up costs that result from past ownership. If potential liabilities exist they must be reported in the financial statements. With regard to the rumour that Enviro (Bermuda) does not plan to comply with environmental legislation, it is not necessary for us to do anything at this point because the information is only a rumour and nothing illegal has been done yet. We should, however, be alert for information that substantiates the rumours. New cost-accounting system The new cost-accounting system will have an effect on the financial statements, so we need to consider the effect of the changes carefully. Compost is a by-product of the waste-collection process. Cost allocation to by-products is arbitrary. Costs can be allocated according to the amount of revenue generated by the sale of compost or on the basis of direct costs, or by allocating just the incremental costs. What management needs to know is the incremental cost of producing compost so that management can determine whether it is profitable to make and sell compost. An effect of the new cost accounting system will be to increase income in the first year because some of the costs of the waste-disposal business that would previously have been expensed will now be included in inventory as part of the cost of the compost. Only actual costs can be capitalized. We need to determine if the standard cost approximates actual cost. If not, an adjustment must be made to reflect actual costs. Depending upon the magnitude of the allocated costs and inventory, we should consider retroactive treatment. Overall conclusion The effects of the bank error, the sales-tax audit, and the treatment of the waste disposal sites, etc., raise the possibility that the financial statements may be materially misstated. Management seems to have taken steps that have had the effect of increasing the net income and the assets on the balance sheet. We must consider whether we should resign from the engagement altogether because of the questionable integrity of management. Among other integrity concerns, the company’s handling of the bank error and changes in accounting estimates, apparently to window-dress the statements, should make us question whether we want to be associated with this client. SOLUTIONS TO PROBLEMS Problem 7-1 Before tax 40% tax After tax Asset profit – Y Company selling January 1, Year 2 – sale 45,000 18,000 27,000 Depreciation Year 2 9,000 3,600 5,400 Balance December 31, Year 2 36,000 14,400 21,600 (a) Depreciation Year 3 9,000 3,600 5,400 (b) Balance December 31, Year 3 27,000 10,800 16,200 Asset profit – X Company selling April 30, Year 3 – sale 60,000 24,000 36,000 Depreciation Year 3 (12,000 8/12) 8,000 3,200 4,800 Balance December 31, Year 3 52,000 20,800 31,200 (c) Investment in Y Company Balance January 1, Year 2 $ 86,900) Year 2 transactions: Increase in Y Company retained earnings ([125,000 – 70,000] 80%) 44,000) X’s share of acquisition differential amortization * (1,150) Holdback of Year 2 asset profit (net) ((a) 21,600 80%) (17,280) Year 3 transactions: Increase in Y Company retained earnings ([104,000 – 70,000]) 80%) 27,200) Acquisition differential amortization (1,150) Realization of Year 2 asset profit ((b) 5,400 80%) 4,320) Holdback of Year 3 asset profit (net) (c) (31,200) Balance December 31, Year 3 $111,640) * (86,900 / 80% – 100,000) x 80% / 6 =1,150 Problem 7-2 Equipment gain Before Tax 40% tax After tax Year 2 sale – Sally selling 15,000 * Depreciation Years 2 and 3 (3,000 2) 6,000 Balance December 31, Year 3 9,000 3,600 5,400 Depreciation Year 4 3,000 1,200 1,800 (a) Balance December 31, Year 4 6,000 2,400 (b) 3,600 * Assuming the sale took place at the beginning of Year 2 (a) Calculation of consolidated profit attributable to Peggy’s shareholders – Year 4 Profit of Peggy 185,000 Profit of Sally 53,000 Add: Equipment gain realized (a) 1,800 Adjusted profit 54,800 (c) Consolidated profit 239,800 Attributable to: Shareholders of Peggy 226,100 NCI (25% x 54,800) 13,700 239,800 (b) Peggy Company Consolidated Income Statement Year 4 Revenues (580,000 + 270,000) $850,000 Miscellaneous expense (110,000 + 85,000) 195,000 Depreciation expense (162,000 + 97,000 – (a) 3,000) 256,000 Income tax expense (123,000 + 35,000 + (a) 1,200) 159,200 Total expenses 610,200 Consolidated profit 239,800 Attributable to: Shareholders of Peggy 226,100 NCI (25% x 54,800) 13,700 239,800 (c) Deferred income taxes – December 31, Year 4 (b) 2,400 Problem 7-3 Intercompany profits – subsidiary selling Before tax 40% tax After tax Equipment Sale, Sept. 30, Year 5 8,000 3,200 4,800 Depreciation Year 5 (8,000 / 5 3/12) 400 160 240 (a) Balance, Dec. 31, Year 5 7,600 3,040 4,560 (b) Depreciation Year 6 (8,000 / 5) 1,600 640 960 (c) Balance, Dec. 31, Year 6 6,000 2,400 3,600 Building Sale, Jan. 1, Year 6 42,000 16,800 25,200 Depreciation Year 6 (42,000 / 7) 6,000 2,400 3,600 (d) Balance, Dec. 31, Year 6 36,000 14,400 21,600 (e) Intercompany Rent Year 5 (12,000 3/12) 3,000 (f) Year 6 12,000 (g) Calculation of consolidated net income Year 5 Year 6 Incorrectly reported income 120,000 142,000 Add: incorrect amount for NCI 32,500 5,160 Incorrect amount for consolidated net income 152,500 147,160 Less: Net unrealized profits Equipment (b) 4,560 Building (e) 21,600 Add: equipment profit realized (c) 960 (h) 4,560 (i) 20,640 Corrected consolidated net income 147,940 126,520 Attributable to: Shareholders of Parent 116,580 126,520 NCI (32,500 – 25% x (h) 4,560) 31,360 NCI (5,160 – 25% x (i) 20,640) 00,000 147,940 126,520 Parent Company Corrected Consolidated Income Statements Years 5 and 6 Year 5 Year 6 Miscellaneous revenues $750,000 $825,000 Miscellaneous expense 399,800 492,340 Rent expense (52,700 – (f) 3,000) 49,700 (64,300 – (g) 12,000) 52,300 Depreciation expense (75,000 – (a) 400) 74,600 (80,700 – (c) 1,600 – (d) 6,000) 73,100 Income tax expense (81,000 – (b) 3,040) 77,960 (94,500 + (c) 640 – (e) 14,400) 80,740 Consolidated net income 147,940 126,520 Attributable to: Shareholders of Parent 116,580 126,520 NCI (32,500 – 25% x (h) 4,560) 31,360 NCI (5,160 – 25% x (i) 20,640) 00,000 147,940 126,520 Problem 7-4 (a) (in 000s) i) ii) iii) iv) NORD’s own income 200 200 200 200 HABS’s own income 500 500 Less: unrealized profit – 500 – 500 HABS’s adjusted income 0 0 Consolidated net income 200 NORD’s ownership 75% NORD’s share of HABS’s income 0 Dividend income from HABS (75% x 100) 75 NORD’s total income 200 200 275 Consolidated net income attributable to: NORD’s shareholders 200 NCI (25% x 0) 0 200 (b) (in 000s) i) ii) iii) iv) HABS’s own income 500 500 500 500 Less: unrealized profit – 500 – 500 HABS’s adjusted income 0 0 Dividend income from NORD (75% x 100) 75 NORD’s own income 200 200 Consolidated net income 200 HABS’s ownership 75% HABS’s share of NORD’s income . 150 . HABS’s total income 500 150 575 Consolidated net income attributable to: HAB’s shareholders 150 NCI (25% x 200) 50 200 (c) We can make the following observations about the income reported under the different reporting methods: 1. Net income under the equity method is equal to consolidated net income attributable to parent’s shareholders because the unrealized profit is eliminated in both situations. 2. The full amount of unrealized profit is eliminated regardless of whether the transaction is upstream as per part (a) or downstream as per part (b). 3. Unrealized profit is not eliminated under the cost method. 4. Income under cost method will be higher than income under the equity method and consolidated net income attributable to parent’s shareholders when dividends received from the investee exceed the investor’s share of the investee’s adjusted net income. When the parent controls the subsidiary, the consolidated financial statements best reflect the financial position and results of operations of the combined entities. At the date of acquisition, the net assets of the subsidiary including goodwill are reported at fair values. The net assets of the parent are reported at their carrying values. Therefore, the consolidated financial statements do not reflect the fair value of all assets and liabilities. However, the assets and liabilities are reported at the values required by generally accepted accounting principles. Problem 7-5 Calculation, allocation, and amortization of the acquisition differential Cost of investment, July 1, Year 1 207,900 Implied value of 100% (207,900 / .9) 231,000 Total shareholders’ equity of Garden 175,000 Acquisition differential 56,000 Allocation: FV – CA Inventory 12,000 Buildings 10,000 Patents 16,000 38,000 Balance – goodwill 18,000 Amortization Balance Balance July 1/1 Years 1 to 7 Year 8 Dec. 31/8 Inventory 12,000 12,000 Buildings (10 years) 10,000 6,500 1,000 2,500 (a) Patents (8 years) 16,000 13,000 2,000 1,000 (b) Goodwill 18,000 1,950 7,150 8,900 56,000 33,450 10,150 12,400 (c) Intercompany receivables and payables On open account 22,000 (d) Dividends (30,000 90%) 27,000 (e) Intercompany profits and losses Before tax 40% tax After tax Opening inventory – Forest selling (18,000 30%) 5,400 2,160 3,240 (f) Ending inventory – Forest selling (22,000 30%) 6,600 2,640 3,960 (g) Land profit – Garden selling August 1, Year 6 18,000 7,200 10,800 (h) Sale of ¼ of land, Year 8 4,500 1,800 2,700 (i) Balance, Dec. 31, Year 8 13,500 5,400 8,100 (j) Intercompany bond transactions Cost to retire bonds 57,968 Carrying amount on bonds retired (93,376 60/100) 56,026 Loss to the entity Jan. 1, Year 8 1,942 777 1,165 Interest elimination gain [(k) 882 – (m) 458] 424 170 254 Balance loss, Dec. 31, Year 8 1,518 607 911 Par value (100,000 60%) 60,000 Carrying amount (93,376 60%) 56,026 Loss to Forest 3,974 1,590 2,384) Interest elimination gain (56,026 x 8% – 60,000 x 6%) 882 353 529) (k)(k) Balance loss Dec. 31, Year 8 3,092 1,237 1,855) (l) Par value 60,000 Cost to Garden 57,968 Gain to Garden 2,032 813 1,219) Interest elimination loss (57,968 x 7% – 60,000 x 6%) 458 183 275) (m)(m) Balance gain Dec. 31, Year 8 1,574 630 944) (n) Deferred income taxes, Dec. 31, Year 8 Ending inventory (g) 2,640 Land (j) 5,400 Bond loss [(l) 1237 – (n) 630] 607 8,647) (o) Garden’s accumulated depreciation, date of acquisition 95,000 (p) Calculation of consolidated net income Year 8 Income of Forest 41,000) Less: Dividends from Garden (50,000 90%) 45,000 Profit in ending inventory (g) 3,960 Loss on bonds (net) (l) 1,855 50,815) (9,815) Add: profit in opening inventory (f) 3,240) Adjusted net income (loss) (6,575) Income of Garden 63,000 Add: Bond gain (net) (n) 944 Realized gain on land (i) 2,700 3,644 66,644 Less: Amortization of the acquisition differential (c) 10,150 Adjusted income 56,494 Consolidated net income, Year 8 49,919 Attributable to: Shareholders of Forest 44,270 NCI (10% x 56,494) 5,649 49,919 Calculation on consolidated retained earnings – Jan. 1, Year 8 Retained earnings of Forest, Jan. 1, Year 8 64,000 Less: Profit in opening inventory (f) 3,240 Adjusted retained earnings 60,760 Retained earnings of Garden, Jan. 1, Year 8 126,000 Retained earnings of Garden at acquisition (175,000 – 150,000) 25,000 Increase 101,000 Less: Amortization of acquisition differential (c) 33,450 Unrealized profit on land (h) 10,800 Adjusted increase 56,750 Forest’s ownership % 90% 51,075 Consolidated retained earnings, Jan. 1, Year 8 111,835 Calculation of non-controlling interest – Dec. 31, Year 8 Common shares 150,000 Retained earnings 139,000 Total shareholders’ equity 289,000 Add: Unamortized acquisition differential (c) 12,400 Bond gain (net) (n) 944 302,344 Less: unrealized profit on sale of land (j) 8,100 Adjusted shareholders’ equity 294,244 Non-controlling interest’s share 10% Non-controlling interest, Dec. 31, Year 8 29,424 (a) (i) Forest Company Consolidated Balance Sheet December 31, Year 8 Cash (13,000 + 48,800) 61,800 Receivables (25,000 + 86,674 – (d) 22,000 – (e) 27,000) 62,674 Inventories (80,000 + 62,000 – (g) 6,600) 135,400 Plant and equipment (740,000 + 460,000 + (a) 10,000 – (j) 13,500 – 95,000 1,101,500 Accumulated depreciation (625,900 + 348,400 + (a) 7,500 – 95,000)) (886,800) Patents (0 +4,500 + (b) 1,000) 5,500 Goodwill 8,900 Deferred income taxes (o) 8,647 Total assets 497,621 Current liabilities (59,154 + 53,000 – (d) 22,000) 90,154 Dividends payable (6,000 + 30,000 – (e) 27,000) 9,000 6% bonds payable (94,846 40%) 37,938 Common shares 200,000 Retained earnings (see part (a) (ii)) 131,105 Non-controlling interest 29,424 Total liabilities and shareholders’ equity 497,621 (a) (ii) Forest Company Consolidated Retained Earnings Statement Year 8 Retained earnings, Jan. 1 111835) Add: net income 44,270) 156,105) Less: dividends 25,000) Retained earnings, Dec. 31 131,105) (b) Dec. 31 Investment in Garden Company 50,845 Investment income 50,845 To record 90% of adjusted subsidiary income (56,494* 90%) Dec. 31 Cash 45,000 Investment in Garden Company 45,000 To record 90% of Garden’s dividend of 50,000 Investment income 2,575 Investment in Garden Company 2,575 To record the adjustments to parent’s net income (3,960 + 1,855 – 3,240) * see the calculation of consolidated net income. (c) A loss is recognized on the consolidated books when the subsidiary purchased the parent’s bonds in the open market because the bonds are deemed to be retired from a consolidated point of view. However, the bonds have not been retired from a separate–company perspective. On the separate–entity books, the discount on the bonds will continue to be amortized and income tax will be determined based on the amortization of the premium or discount. The total loss recognized over the remaining term of the bonds through the amortization of the discount will equal the loss on the deemed retirement – only the timing is different. Therefore, these differences are considered to be timing differences and would give rise to a deferred income tax asset. (d) The debt-to-equity ratio would increase. Debt would stay the same while equity would decrease due to the reduction in NCI under the parent company extension theory. Problem 7-6 (a) Acquisition differential – buildings 1,250 (a) Yearly amortization (25,000 / 20) Intercompany revenues and expenses Interest revenue and expense (12,000 ½) 6,000 (b) Rental revenue and administrative expense 50,000 (c) Sales and purchases 90,000 (d) Intercompany profits Before tax 40% tax After tax Land gain – M selling realized in Year 6 10,000 4,000 6,000 (e) Opening inventory – K selling 12,000 4,800 7,200 (f) Ending inventory – K selling 5,000 2,000 3,000 (g) Machinery gain – M selling realized by depreciation in Year 6 (13,000 5) 2,600 1,040 1,560 (h) Calculation of non-controlling interest in profit of K Company – Year 6 Income of K 25,500 Add: profit in opening inventory (f) 7,200 32,700 Less: Amortization of acquisition differential (a) 1,250 Profit in ending inventory (g) 3,000 Adjusted profit 28,450 Non-controlling interest’s share 20% Non-controlling interest, Year 6 5,690 (i) M Co. Consolidated Income Statement Year 6 Sales (600,000 + 350,000 – (d) 90,000) $860,000 Interest revenue (6,700 – (b) 6,000) 700 Gain on land sale (8,000 + (e) 10,000) 18,000 Total revenues 878,700 Cost of goods sold (334,000 + 225,000 – (d) 90,000 – (f) 12,000 + (g) 5,000) 462,000 Distribution expense (80,000 + 70,000 – (h) 2,600 + (a) 1,250) 148,650 Administrative expense (147,000 + 74,000 – (c) 50,000) 171,000 Interest expense (1,700 + 6,000 – (b) 6,000) 1,700 Income tax expense (20,700 + 7,500 + (e) 4,000 + (f) 4,800 – (g) 2,000 + (h) 1,040) 36,040 Total expenses 819,390 Profit 59,310 Attributable to: Shareholders of M 53,620 Non-controlling interest (i) 5,690 $ 59,310 (b) M Co. Income Statement December 31, Year 6 Sales $600,000 Interest revenue 6,700 Dividend income from subsidiary (20,000 x 80%) 16,000 622,700 Cost of goods sold 334,000 Distribution expense 80,000 Administrative expense 147,000 Interest expense 1,700 Income tax expense 20,700 583,400 Profit $ 39,300 Problem 7-7 Calculation, allocation, and amortization of acquisition differential Total 70% 30% Cost of investment, Jan. 1, Year 6 483,000 483,000 Fair value of NCI 195,000 195,000 678,000 Carrying amounts of Gold’s net assets: Ordinary shares 500,000 Retained earnings 40,000 Total shareholders’ equity 540,000 378,000 162,000 Acquisition differential 138,000 105,000 33,000 Allocation: FV – CA Inventory -12,000 Land 50,000 Plant and equipment 70,000 108,000 75,600 32,400 Balance – goodwill 30,000 29,400 600 Balance Amortization Balance Jan. 1/6 Years 6 to 11 Dec. 31/11 Inventory -12,000 -12,000 – Land 50,000 – 50,000 (a) Plant and equipment 70,000 21,000 49,000 (b) 108,000 9,000 99,000 Goodwill – parent’s portion 29,400 17,640 11,760 – NCI’s portion 600 360 240 30,000 18,000 12,000 (c) Total 138,000 27,000 111,000 Intercompany profits and losses Before tax 40% tax After tax Intercompany bonds – Dec. 31, Year 11 Investment in Gold Co. bonds (230,000 – [30,000/10]) 227,000 Bonds payable (477,500 [200,000 / 500,000]) 191,000 Loss – entity 36,000 14,400 21,600 (d) Investment 227,000 Par value 200,000 Loss to Pure 27,000 10,800 16,200 Par value 200,000 Carrying amount 191,000 Loss to Gold 9,000 3,600 5,400 (e) Patent – Gold selling Selling price, July 1, Year 8 63,000 Carrying amount 42,000 Gain on sale 21,000 8,400 12,600 Amort. to Dec. 31, Year 11 ([21,000/7] 3½) 10,500 4,200 6,300 Balance, Dec. 31, Year 11 10,500 4,200 6,300 (f) Deferred income taxes, Dec. 31, Year 11 Gain on patent (f) 4,200 Loss on bonds (d) 14,400 18,600 (g) Gold’s accumulated depreciation, date of acquisition 75,000 (h) Calculation of non-controlling interest – Dec. 31, Year 11 Ordinary shares 500,000 Retained earnings 200,000 Total shareholders’ equity – Gold 700,000 Less: Gain on sale of patent (f) 6,300 Loss on sale of bond (e) 5,400 11,700) Adjusted shareholders’ equity 688,300) Non-controlling interest’s share 30% 206,49006,490 Share of acquisition differential – other than goodwill (30% x 99,000) 29,700 – goodwill 240 29,940 236,430 Pure Company Consolidated Statement of Financial Position December 31, Year 11 Land (100,000 + 150,000 + (a) 50,000) 300,000) Plant and equipment (625,000 + 940,000 + (b) 70,000 – (h) 75,000) 1,560,000) Less: accumulated depreciation (183,000 + 220,000 + (b) 21,000 – (h) 75,000) (349,000) Patent (net) (31,500 – (f) 10,500) 21,000) Goodwill (c) 12,000) Deferred income taxes (g) 18,600) Inventory (225,000 + 180,000) 405,000) Accounts receivable (212,150 + 170,000) 382,150) Cash (41,670 + 57,500) 99,170) Total assets 2,448,920) Ordinary shares 750,000) Retained earnings 1,019,960) Non-controlling interest 236,430) Bonds payable (477,500 [300,000 / 500,000]) 286,500) Accounts payable (56,030 + 100,000) 156,030) Total liabilities and shareholders’ equity 2,448,920) Problem 7-8 Calculation, allocation, and amortization of acquisition differential Cost of 80% investment in Spruce Ltd., Jan. 2, Year 1 2,000,000 Implied value of 100% 2,500,000 Carrying amounts of Spruce’s net assets: Common shares 500,000 Retained earnings 1,250,000 Total shareholders’ equity 1,750,000 Acquisition differential 750,000 Allocation: FV – CA Mineral rights 750,000 Balance 0 Balance Amortization Balance Jan. 1/1 Years 1 to 3 Year 4 Dec. 31/4 Mineral rights 750,000 (a) 0 (b) 0 750,000 (c) Intercompany sales and purchases 1,000,000 (d) Unrealized intercompany profits Before tax 40% tax After tax Equipment Jan. 2/2 – Spruce selling (500,000 – 400,000) 100,000 (e) Depreciation Years 2 and 3 40,000 Balance, Dec. 31, Year 3 60,000 24,000 36,000 (f) Depreciation, Year 4 20,000 8,000 12,000 (g) Balance, Dec. 31, Year 4 40,000 16,000 24,000 (h) Inventory Jan. 1, Year 4 – Spruce selling 200,000 80,000 120,000 (i) Inventory Dec. 31, Year 4 – Spruce selling 120,000 48,000 72,000 (j) Intercompany bonds Before tax 40% tax After tax Cost of bonds Jan. 2, Year 4 242,500 Carrying value of bonds purchased Par 500,000 Issue premium (14,000 – [14,000 / 7 2]) 10,000 510,000 Intercompany portion 50% 255,000 Gain to entity, Jan. 1, Year 4 12,500 5,000 7,500 (k) Interest elimination loss, Year 4* 2,500 1,000 1,500 Net gain to entity, Dec. 31, Year 4 10,000 4,000 6,000 (l) Allocation: Cost 242,500 Par value (500,000 50%) 250,000 Gain to Spruce, Jan. 1, Year 4 7,500 3,000 4,500 Interest elimination loss, Year 4* 1,500 600 900 Net gain to Spruce, Dec. 31, Year 4 6,000 2,400 3,600 (m) Par value 250,000 Carrying value 255,000 Gain to Poplar, Jan. 1, Year 4 5,000 2,000 3,000 Interest elimination loss, Year 4* 1,000 400 600 Net gain to Poplar, Dec. 31, Year 4 4,000 1,600 2,400 (n) * 5 years remaining to maturity. Spruce’s accumulated depreciation, date of acquisition 600,000 (o) Deferred income tax – Dec. 31, Year 4 Equipment (h) 16,000 Inventory (j) 48,000 Deferred income tax asset 64,000 Less: deferred tax liability – bonds (l) 4,000 Net deferred income tax asset 60,000 (p) Intercompany interest revenue and expense Interest revenue – Spruce 8% 250,000 20,000 Discount amortization (7,500 / 5) 1,500 21,500 Interest expense – Poplar 8% 500,000 40,000 Premium amortization (14,000 / 7) 2,000 38,000 Intercompany portion 50% 19,000 (q) Interest elimination loss – Year 4 (before tax) 2,500 Calculation of consolidated net income – Year 4 Income of Poplar 1,100,000 Less: Dividend from Spruce (250,000 80%) 200,000 900,000 Add: bond gain (net) (n) 2,400 Adjusted net income 902,400 Income of Spruce 521,500 Less: Amortization of acquisition differential (b) 0 Closing inventory profit (j) 72,000 449,500 Add: Opening inventory profit (i) 120,000 Equipment profit realized (g) 12,000 Bond gain (net) (m) 3,600 135,600 Adjusted net income 585,100 (r) Consolidated net income 1,487,500 Attributable to: Shareholders of Poplar 1,370,480 NCI (20% x 585,100) 117,020 1,487,500 (a) (i) Poplar Ltd. Consolidated Income Statement Year 4 Sales (4,900,000 + 2,000,000 – 1,000,000 (d)) 5,900,000 Gain on bond retirement (k) 12,500 Total revenues 5,912,500 Cost of goods sold (2,400,000 + 850,000 – (d) 1,000,000 – (i) 200,000 + (j) 120,000) 2,170,000 Other expenses (962,000 + 300,000 – (g) 20,000) 1,242,000 Interest expense (38,000 – (q) 19,000) 19,000 Income tax expense (600,000 + 350,000 + (i) 80,000 – (j) 48,000 + (g) 8,000 + (l) 4,000) 994,000 Total expenses 4,425,000 Net income 1,487,500 Attributable to: Shareholders of Poplar 1,370,480 NCI (20% x 585,100) 117,020 1,487,500 Calculation of consolidated retained earnings – Jan. 1, Year 4 Retained earnings of Poplar, Jan. 1, Year 4 10,000,000 Retained earnings of Spruce, Jan. 1, Year 4 2,000,000 At acquisition 1,250,000 Increase 750,000 Less: Opening inventory profit (i) 120,000 Net equipment profit (f) 36,000 Adjusted increase 594,000 (s) Poplar’s ownership % 80% 475,200 Consolidated retained earnings, Jan. 1 Year 4 10,475,200 (ii) Poplar Ltd. Consolidated Statement of Retained Earnings Year 4 Retained earnings, Jan. 1, Year 4 $10,475,200 Add: net income 1,370,480 11,845,680 Less: dividends 600,000 Retained earnings, Dec. 31, Year 4 $11,245,680 Calculation of non-controlling interest – Dec. 31, Year 4 Common shares of Spruce 500,000) Retained earnings of Spruce, Jan. 1, Year 4 2,000,000) Net income, Year 4 521,500) Dividends, Year 4 (250,000) Total shareholders’ equity, Dec. 31, Year 4 2,771,500) Less: Equipment profit (h) 24,000 Inventory profit (j) 72,000 96,000) 2,675,500) Add: Unamortized acquisition differential (c) 750,000 Bond gain (net) (m) 3,600) Adjusted shareholders’ equity, Spruce 3,429,100) Non-controlling interest’s share 20% Non-controlling interest, Dec. 31, Year 4 685,820) (iii) Poplar Ltd. Consolidated Balance Sheet Dec. 31, Year 4 Cash (1,000,000 + 500,000) 1,500,000) Accounts receivable (2,000,000 + 356,000) 2,356,000) Inventory (3,000,000 + 2,250,000 – (j) 120,000) 5,130,000) Plant and equipment (14,000,000 + 2,900,000 – (e) 100,000 – (o) 600,000) 16,200,000) Accumulated depreciation (4,000,000 + 1,000,000 – (f) 60,000 – (o) 600,000) (4,340,000) Mineral rights (c) 750,000) Deferred income taxes (p) 60,000) Total assets 21,656,000) Accounts payable (2,492,000 + 2,478,500) 4,970,500 Bonds payable (500,000 50%) 250,000 Premium on bonds payable (8,000 50%) 4,000 Common shares 4,500,000 Retained earnings 11,245,680 Non-controlling interest 685,820 Total liabilities and shareholders’ equity 21,656,000 (b) Investment Account, Dec. 31, Year 4 – Equity Method Balance, Dec. 31, Year 4 – cost method 2,000,000 Add: Adjusted increase in Spruce’s retained earnings to Jan. 1, Year 4 (s) 594,000 Poplar’s ownership % 80% 475,200 2,475,200 Add: Adjusted income of Spruce, Year 4 (r) 585,100 Poplar’s ownership % 80% 468,080 Bond gain (net) – Poplar (n) 2,400 2,945,680 Less: Dividend from Spruce (250,000 80%) 200,000 Balance, Dec. 31, Year 4 2,745,680 Alternative calculation: Consolidated retained earnings, Dec. 31, Year 4 11,245,680 Retained earnings – Poplar Dec. 31, Year 4 – cost method (10,000,000 + 1,100,000 – 600,000) 10,500,000 Difference 745,680 Investment in Spruce – cost method 2,000,000 Investment in Spruce – equity method, Dec. 31, Year 4 2,745,680 (c) Gains should be recognized when they are realized i.e., when there has been a transaction with outsiders and consideration has been given/received. When the parent acquires the subsidiary’s bonds for cash in the open market, it is transacting with an outsider and giving cash as consideration. From the separate entity perspective, the parent is investing in bonds. However, from a consolidated point of view, the parent is retiring the bonds of the subsidiary when it purchases the bonds from the outside entity. Therefore, when the investment in bonds is offset against the bonds payable on consolidation, any difference in the carrying amounts is recorded as a gain or loss on the deemed retirement of the bonds. Problem 7-9 Calculation, allocation, and amortization of acquisition differential Cost of 85% investment in Sloan Ltd. 3,026,000 Implied value of 100% 3,560,000 Carrying amounts of Sloan’s net assets: Common shares 2,200,000 Dr Retained earnings 1,100,000 Dr Total shareholders’ equity 3,300,000 Acquisition differential 260,000 Allocation: FV – CA Plant and equipment 200,000 Accounts receivable – 75,000 Long-term liabilities 52,680 177,680 Balance – goodwill 82,320 Amortization Balance Balance Jan. 1/1 Years 1 to 3 Year 4 Dec. 31/4 Plant and equipment 200,000 30,000 10,000 160,000 Accounts receivable – 75,000 – 75,000 – – Long-term liabilities * 52,680 15,804 5,268 31,608 (a) Goodwill 82,320 36,375 12,125 33,820 (b) Total 260,000 7,179 27,393 225,428 (c) *10 years remaining to maturity Intercompany dividend revenue (98,000 85%) 83,300) (d) Intercompany Profits (Losses) Before tax 40% tax After tax Patent, Jan. 1, Year 2 – Sloan selling (25,000) (10,000) (15,000) Amortization Years 2 and 3 (10,000) (4,000) (6,000) (e) Balance, Dec. 31, Year 3 (15,000) (6,000) (9,000) Amortization Year 4 (5,000) (2,000) (3,000) (f) Balance, Dec. 31, Year 4 (10,000) (4,000) (6,000) (g) Land Year 3 – Porter selling 21,000) 8,400) 12,600) (h) Inventories Beginning – Porter selling 14,000) 5,600) 8,400) (i) – Sloan selling 1,500) 600) 900) (j) Totals 15,500) 6,200) 9,300) Ending – Porter selling 10,000) 4,000) 6,000) (k) – Sloan selling 2,500) 1,000) 1,500) (l) Totals 12,500) 5,000) 7,500) (a) (i) Patent (263,000 + (g) 10,000) 273,000) (ii) Goodwill (b) 33,820) (iii Retained earnings Retained earnings Porter, Dec. 31, Year 4 4,833,000) Less: Land gain (h) 12,600 Ending inventory profit (k) 6,000 18,600) Adjusted retained earnings 4,814,400) Retained earnings Sloan, Dec. 31, Year 4 1,409,000 At acquisition 1,100,000 Increase 309,000 Add: patent loss (g) 6,000 315,000 Less: Acquisition differential amortization ((c) 7,179 + (c) 27,393) 34,572 ending inventory profit (l) 1,500 Adjusted increase 278,928 (m) Porter’s ownership % 85% 237,089) 5,051,489) (iv) Non-controlling interest (Method 1) Shareholders’ equity Sloan (1,409,000 + 2,200,000) 3,609,000 Add: unamortized acquisition differential (c) 225,428 patent loss (g) 6,000 3,840,428 Less: ending inventory profit (l) 1,500 Adjusted shareholders’ equity 3,838,928 Non-controlling interest’s share 15% 575,839 Calculation of consolidated non-controlling interests – end of Year 4 (Method 2) Non-controlling interests at date of acquisition (15% x [3,026,000 / .85) 534,000 Sloan’s adjusted increase in retained earnings (m) 278,928 NCI’s share @ 15% 41,839 Non-controlling interest, Dec. 31, Year 4 575,839 (v) Long-term liabilities (1,876,000 + 750,000 – (a) 31,608) 2,594,392 (b) Porter’s total revenues $2,576,000 Less: dividends from Sloan (d) 83,300 2,492,700 Sloan’s net income 177,000 Less: Amortization of acquisition differential (c) 27,393 Patent loss amortized (f) 3,000 Ending inventory profit (l) 1,500 31,893 145,107 Add: beginning inventory profit (j) 900 Adjusted net income 146,007 Porter’s ownership % 85% 124,106 Add: beginning inventory profit (Porter selling) (i) 8,400 132,506 Less: Ending inventory profit (k) 6,000 126,506 Total revenues Porter – equity $2,619,206 (c) Bond Amortization Table Date Effective Interest (1) Interest Paid (2) Amortization (3) Balance Jan 1, Yr 1 (750,000 – 52,680 = ) 697,320 Dec 31, Yr 1 48,812 45,000 3,812 701,132 Dec 31, Yr 2 49,079 45,000 4,079 705,211 Dec 31, Yr 3 49,365 45,000 4,365 709,576 Dec 31, Yr 4 49,670 45,000 4,670 714,246 Balance on consolidated balance sheet will be 1,876,000 + 714,246 = 2,590,246 Notes: 1) Balance x 7% 2) 750,000 x 6% 3) Effective interest – interest paid Problem 7-10 Cost of bonds 150,064 Par value of bonds 800,000 (a) Less: unamortized discount 73,065 (b) Carrying amount of bonds 726,935 Intercompany portion (160,000 / 800,000) 20% 145,387 Loss to the entity 4,677 (c) Tax at 40% 1,871 (d) Loss after tax 2,806 (e) Cost 150,064 Par 160,000 Par 160,000 Carrying amount 145,387 Gain to Alpha 9,936 (f) Loss to Beta 14,613 (i) Tax at 40% 3,974 (g) Tax at 40% 5,845 (j) Gain after tax 5,962 (h) Loss after tax 8,768 (k) Bond Amortization Table for Alpha Date Effective Interest (6%) Interest Paid (5%) Amortization Balance Jan 1, Yr 4 150,064 June 30, Yr 4 9,004 8,000 1,004 151,068 Dec 31, Yr 4 9,064 8,000 1,064 152,132 Total 18,068 16,000 2,068 (l) Bond Amortization Table for Beta Date Effective Interest (6.5%) Interest Paid (5%) Amortization Balance Jan 1, Yr 4 726,935 June 30, Yr 4 47,251 40,000 7,251 734,186 Dec 31, Yr 4 47,722 40,000 7,722 741,908 Total 94,973 80,000 14,973 Intercompany (20%) 18,995 16,000 2,995 (m) Before tax 40% tax After tax Alpha Gain on bonds (f) 9,936 (g) 3,974 (h) 5,962 Interest elimination loss* (l) 2,068 827 1,241 Balance December 31, Year 4 gain 7,868 3,147 4,721 (n) Beta Gain (loss) on bonds (i) (14,613) (j) (5,845) (k) (8,768) Interest elimination loss (gain) (m) (2,995) (1,198) (1,797) Balance December 31, Year 4 gain (loss) (11,618) (4,647) (6,971) (o) * from bond amortization (a) Loss on bonds, Year 4 (c) 4,677 (b) December 31, Year 4 Investment in Beta Corporation 102,600 Investment income 102,600 90% 114,000 share of Beta’s profit Cash 27,000 Investment in Beta Corporation 27,000 90% 30,000 dividends from Beta Investment income 6,274 Investment in Beta Corporation 6,274 Net bond loss allocated to Beta (90% (o) 6,971) Investment in Beta Corporation (n) 4,721 Investment income 4,721 Net bond gain allocated to Alpha (c) Carrying amount of bonds 741,908 Intercompany portion (20%) 148,382 Consolidated bonds payable December 31, Year 4 593,526 Problem 7-11 Cost of bonds July 1, Year 7 152,500 Par value of bonds 400,000 (a) Less: unamortized discount 20,000 Carrying amount 380,000 Intercompany portion 40% 152,000 Loss to entity July 1, Year 7 (before tax) 500 (b) Par value ((a) 400,000 40%) 160,000 Cost of bonds 152,500 Gain to Parent Co. (before tax) 7,500 (c) Par value 160,000 Carrying amount 152,000 Loss to Sub. Co. (before tax) 8,000 (d) Before tax 40% tax After tax Entity Loss (gain) July 1, Year 7 (b) 500 200 300 Interest elimination gain (loss) Year 7* 50 20 30 Balance loss (gain) Dec. 31, Year 7 450 180 (h) 270 Parent Co. Loss (gain) July 1, Year 7 (c) (7,500) (3,000) (4,500) Interest elimination gain (loss) Year 7* (750) (300) (450) Balance loss (gain) Dec. 31, Year 7 (6,750) (2,700) (4,050) (e) Sub. Co. Loss (gain) July 1, Year 7 (d) 8,000 3,200 4,800 Interest elimination gain (loss) Year 7* 800 320 480 Balance loss (gain) Dec. 31, Year 7 7,200 2,880 4,320 (f) * 10 interest periods to maturity Intercompany interest revenue (160,000 10% ½ + [(c) 7,500 / 5 ½]) = 8,750 Intercompany interest expense Interest expense ((a) 400,000 10%) 40,000 Discount amortization ([20,000 / 10 periods] 2) 4,000 Total interest expense for the year 44,000 Interest expense July 1 to Dec. 31, Year 7 22,000 Intercompany portion 40% 8,800 (g) Gain on elimination of intercompany revenues and expenses 50 Calculation of consolidated net income, Year 7 Income of Parent Co. 184,750 Add: Net bond gain (e) 4,050 Adjusted net income 188,800 Income of Sub. Co. 64,000 Less: Net bond loss (f) 4,320 Adjusted net income 59,680 (i) Consolidated net income, Year 7 248,480 Attributable to: Shareholders of Parent 233,560 NCI (25% x 59,680) 14,920 248,480 Parent Co. Consolidated Income Statement Year 7 Miscellaneous revenue (900,000 + 500,000) 1,400,000 Loss on retirement of intercompany bonds (b) 500 Interest expense (44,000 – (g) 8,800) 35,200 Other expense (600,000 + 350,000) 950,000 Income tax expense (124,000 + 42,000 – (h) 180) 165,820 Total expenses 1,151,520 Net income 248,480 Attributable to: Shareholders of Parent 233,560 NCI (25% x 59,680) 14,920 248,480 Problem 7-12 Intercompany bond purchase – Oct. 1, Year 5 Par value of 20% (80,000/400,000) of Palmer’s bonds 80,000 Cost of 20% purchased 76,000 Gain to Scott Corporation (before tax) 4,000 (a) Par value of 20% of Palmer’s bonds 80,000 Carrying amount ([400,000 – 8,000] 20%) 78,400 Loss to Palmer Corporation (before tax) 1,600 (b) Gain to entity ((a) 4,000 – (b) 1,600) (before tax) 2,400 (c) Yearly interest elimination loss (2,400 / 4) 600 (d) Interest elimination loss Year 5 ((d) 600 3/12 ) 150 60% 60% Before tax After tax Before tax After tax Entity Palmer Gain (loss) Oct. 1, Year 5 (c) 2,400 1,440 (b) (1,600) (960) Interest elimination loss (gain)* 150 90 (100) (60) Balance gain (loss) Dec. 31, Year 5 2,250 1,350 (1,500) (900) (e) Scott Gain (loss) Oct. 1, Year 5 (a) 4,000 2,400 Interest elimination loss (gain)* 250 150 Balance gain (loss) Dec. 31, Year 5 3,750 2,250 (f) * ¼ x 3/12 a) December 31, Year 5 Investment in Scott Corporation 49,000 Investment income 49,000 70% $70,000 Share of Scott’s profit Cash 10,500 Investment in Scott Corporation 10,500 70% $15,000 Share of Scott’s dividends Investment income (e) 900 Investment in Scott Corporation 900 Net bond loss allocated to Palmer Investment in Scott Corporation (f) 1,575 Investment income 1,575 Net bond gain allocated to Scott ($2,250 70%) b) Carrying amount of bonds Oct. 1, Year 5 (400,000 – 8,000) 392,000 Discount amortization Oct. to Dec. Year 5 (8,000 / 4 x 3/12) 500 Carrying amount of bonds, Dec. 31, Year 5 392,500 Intercompany portion (20% 392,500) 78,500 Consolidated bonds payable Dec. 31, Year 5 314,000 Problem 7-13 (in 000s) Calculation and allocation of acquisition differential Cost of 60% investment in ENS $ 780 Implied value of 100% investment in ENS 1,300 Carrying amount of ENS: Common shares $500 Retained earnings 120 Total shareholders’ equity 620 Acquisition differential 680 Allocated: (FV – CA) Equipment – 30 Internet domain names 100 Land 120 190 Balance — goodwill $ 490 Acquisition differential amortization and goodwill impairment schedule (in 000s) Balance Amortization/Impairment Balance Dec. 31, Yr1 Yr2- Yr4 Yr5 Dec. 31, Yr5 Equipment (6 years) $ (30) $ (15) $ (5) $ (10) (a) Internet domain names 100 – – 100 Land 120 – – 120 (b) Goodwill 490 390 25 75 (c) Total $ 680 $ 375 $ 20 $ 285 (d) Intercompany sales and cost of sales $600 (e) Intercompany other revenues and other expenses ($5 x 12) $60 (f) Intercompany inventory profits – ENS selling ENS’s gross margin % = (3,010 – 2,107) / 3,010 = 30% Before tax 40% tax After tax Closing inventory (30% x $200) $ 60 $ 24 $ 36 (g) Beginning inventory (30% x $250) $ 75 $ 30 $ 45 (h) Intercompany receivables and payables 150 (i) Intercompany depreciable assets profits – RAV selling Before tax 40% tax After tax Proceeds on sale $750 Carrying amount 600 Gain on sale of building, July 1, 2002 150 $60 $90 Realized gain per year (15 years remaining) 10 4 6 (j) Realized gains to December 31, 2005 (3.5 years) 35 14 21 (k) Unrealized gains, December 31, 2005 $ 115 $46 $69 (l) ENS’s income ($3,010 – $2,107 – $120 – $432) = $351 (m) (a) Sales (4,220 + 3,010 – (e) 600) 6,630 Other revenues (80 + 0 – (f) 60) 20 Total revenues 6,650 Cost of goods purchased (2,340 + 2,137 – (e) 600) 3,877 Change in inventory (60 – 30 + (g) 60 – (h) 75) 15 Amortization expense (240 + 120 – (a) 5 – (j) 10) 345 Goodwill impairment (0 + 0 + (c) 25) 25 Income tax and other expenses (960 + 432 – (g) 24 + (h) 30 + (j) 4 – (f) 60) 1,342 Total expenses 5,604 Consolidated net income $1,046 Attributable to: Shareholders of RAV 910 Non-controlling interest (40% x [(m) 351 – (g) 36 + (h) 45 – (d) 20]) 136 1,046 (b) Current assets Cash (150 + 75) 225 Accounts receivable (275 + 226 – (i) 150) 351 Inventory (594 + 257 – (g) 60) 791 Property, plant & equipment Land (600 + 170 + (b) 120) 890 Building – net (710 + 585 – (l) 115) 1,180 Equipment – net (690 + 349 – (a) 10) 1,029 Intangible assets Internet domain names 100 Goodwill 75 (c) Subsidiary’s retained earnings, beginning of year $279 Unrealized after-tax profit in beginning inventory (h) (45) 234 Subsidiary’s common shares 500 734 Unamortized acquisition differential (d) (285 + 20) 305 1,039 NCI’s share (40%) $415.6 (d) i) RAV’s separate entity income would decrease because it would report dividend income from ENS of $182.4 (60% x $304) instead of investment income of $210. ii) Consolidated net income would remain the same because intercompany dividends and other intercompany transactions are eliminated and only income from outsiders is reported. Income from outsiders remains the same. (adapted from CGA Canada) Problem 7-14 Year 9 income statements P Company S Company Sales 630,000 340,000 Interest income 1,850 Investment income 15,339 Gain on sale of land 7,000 Total revenues 652,339 341,850 Cost of sales 485,000 300,000 Interest expense 17,000 Selling and admin. expense 50,000 20,000 Income tax expense 34,000 8,740 Total expenses 586,000 328,740 Net income 66,339 13,110 Bonds payable – P Company Issued Jan. 1, Year 2 200,000 (a) Discount Jan. 1, Year 2 10,000) Amortized – Years 2 to 8 (10,000 / 10 7) (7,000) – to July 1, Year 9 (1,000 ½) (500) 2,500 Balance, July 1, Year 9 197,500 (b) Discount amortization July to Dec., Year 9 500 Balance, Dec. 31, Year 9 198,000 Investment in bonds – S Company Par value July 1, Year 9 40,000 Purchase discount, July 1, Year 9 (40,000 – 38,750) 1,250) Amortized, Year 9 (1,250 / 2½ ½) (250) (c) 1,000 Balance, Dec. 31, Year 9 39,000 Cost of intercompany bonds July 1, Year 9 38,750 Par value 40,000 Gain on bond – S Company (before tax) 1,250 (d) Par value, July 1, Year 9 40,000 Carrying amount ((b) 197,500 20%) 39,500 Loss on bonds – P Company (before tax) 500 (e) Gain to entity, July 1, Year 9 ((d) 1,250 – (e) 500) 750 (f) Before tax 40% tax After tax Entity Gain July 1, Year 9 (f) 750 300 450 Interest elimination gain Year 9* 150 60 90 (g) Balance gain Dec. 31, Year 9 600 240 360 (h) P Company Gain (loss) July 1, Year 9 (e) (500) (200) (300) Interest elimination gain (loss) Year 9* (100) (40) (60) Balance gain (loss), Dec. 31, Year 9 (400) (160) (240) (i) S Company Gain July 1, Year 9 (d) 1,250 500 750 Interest elimination gain Year 9* 250 100 150 Balance gain Dec. 31, Year 9 1,000 400 600 (j) * ½ year amortization, 2½ years to maturity Intercompany revenues and expenses Sales 75,000 (k) Interest expense – P Company 8% 200,000 (a) 16,000 Discount amortization, Year 9 (500 + 500) 1,000 Total Year 9 17,000 ½ year 8,500 Intercompany portion (40,000 / 200,000) 20% 1,700 Interest revenue – S Company 8% (c) 40,000 ½ 1,600 Purchase discount amortized (c) 250 1,850 Interest elimination loss – Year 9 (g) 150 Intercompany profits Before tax 40% tax After tax Land – S selling – realized in Year 9 (21,000 – 15,000) 6,000 2,400 3,600 (l) Calculation of investment income S Company net income 13,110 Add: Bond gain net (j) 600 Land gain (l) 3,600 Adjusted net income 17,310 (m) P Company’s ownership % 90% 15,579 Less: bond loss (net) – P Company (i) 240 15,339 (a) P Co. Consolidated Income Statement Year 9 Sales (630,000 + 340,000 – (k) 75,000) $895,000 Gain on bond retirement (f) 750 Gain on sale of land (7,000 + (l) 6,000) 13,000 Total revenues 908,750 Cost of sales (485,000 + 300,000 – (k) 75,000) 710,000 Interest expense (17,000 – 1,700) 15,300 Selling and admin. expense (50,000 + 20,000) 70,000 Income tax expense (34,000 + 8,740 + (h) 240 + (l) 2,400) 45,380 Total expenses 840,680 Net income 68,070 Attributable to: Shareholders of P Co. 66,339 Non-controlling interest ((m) 17,310 10%) 1,731 Consolidated net income $ 68,070 (b) P Co. Consolidated Retained Earnings Statement Year 9 Retained earnings, Jan. 1, Year 9 $ 85,000 Add: net income 66,339 151,339 Less: dividends 10,000 Retained earnings, Dec. 31, Year 9 $141,339 Problem 7-15 Calculation, allocation, and amortization of acquisition differential Champlain NCI (80%) (20%) Cost of 80% investment in Samuel 129,200 Fair value of NCI’s Interest in Samuel (14 x 2,000) 28,000 Carrying amounts of Samuel’s net assets: Ordinary shares 50,000 Retained earnings 12,000 Total shareholders’ equity 62,000 49,600 12,400 Acquisition differential, Jan. 1, Year 1 79,600 15,600 Allocation: FV – CA Inventories -18,000 – 14,400 – 3,600 Patent 14,000 11,200 2,800 Balance – Goodwill 82,800 16,400 Balance Amortization Balance Jan. 1/1 Years 1 to 4 Year 5 Dec. 31/5 Inventories -18,000 -18,000 – – Patent 14,000 7,000 1,750 5,250 (a) Subtotal -4,000 -11,000 1,750 5,250 Goodwill – Champlain’s purchase 82,800 34,800 19,200 28,800 (b) – NCI’s share 16,400 6,600 3,600 6,200 (c) 95,200 30,400 24,550 40,250 Champlain’s share (80% x subtotal + Goodwill) 79,600 26,000 20,600 33,000 (d) NCI’s share (20% x subtotal + Goodwill) 15,600 4,400 3,950 7,250 (e) Intercompany profits Before tax 40% tax After tax Opening inventory – Samuel selling 1,900 760 1,140 (f) Closing inventory – Samuel selling 3,300 1,320 1,980 (g) Equipment Jan. 1/3 – Samuel selling 21,000 (h) Depreciation to Dec. 31, Year 4 ([21,000 / 6] 2) 7,000 Balance, Dec. 31, Year 4 14,000 5,600 8,400 (i) Depreciation Year 5 (21,000 6) 3,500 1,400 2,100 (j) Balance, Dec. 31, Year 5 10,500 4,200 6,300 (k) Land – Champlain selling 7,000 2,800 4,200 (l) Intercompany revenues and expenses, receivables and payables Sales and purchases 92,000 (m) Receivables and payables 21,000 (n) Dividends receivable and payable (5,500 80%) 4,400 (o) Samuel’s accumulated depreciation, date of acquisition 17,000 (p) Deferred income taxes (Dec. 31, Year 5) Inventory (g) 1,320 Equipment (k) 4,200 Land (l) 2,800 8,320 (q) Calculation of consolidated profit – Year 5 Profit of Champlain 42,800 Less: Dividends from Samuel (11,000 80%) 8,800 (r) Adjusted profit 34,000 Profit of Samuel 13,000 Add: Opening inventory profit (f) 1,140 Equipment gain realized (j) 2,100 3,240 16,240 Less: Closing inventory profit (g) 1,980 14,260 (s) Less: Amortization of acquisition differential – Champlain’s share (d) 20,600 – NCI’s share (e) 3,950 24,550 Adjusted profit (10,290) Profit 23,710 Attributable to: Shareholders of Champlain 24,808 NCI (20% x (r) 14,260 – (e) 3,950) – 1,098 23,710 (a) (i) Champlain Ltd. Consolidated Income Statement Year 5 Sales (535,400 + 270,000 – (m) 92,000) 713,400 Miscellaneous revenue (9,900 – (r) 8,800) 1,100 Total revenues 714,500 Cost of sales (364,000 + 206,000 – (m) 92,000 + (g) 3,300 – (f) 1,900) 479,400 Selling expense (78,400 + 24,100) 102,500 Admin. exp. (including depreciation & goodwill impairment loss) (46,300 + 20,700 + (a) 1,750 + (b) 19,200 + (c) 3,600 – (j) 3,500) 88,050 Income taxes (13,800 + 6,200 + (f) 760 – (g) 1,320 + (j) 1,400) 20,840 Total expenses 690,790 Profit 23,710 Attributable to: Shareholders of Champlain 24,808 NCI (20% x (s) 14,260 – (e) 3,950) – 1,098 23,710 Calculation of consolidated retained earnings – Jan. 1, Year 5 Retained earnings of Champlain, Jan. 1/5 45,500 Less: Land profit (l) 4,200 Adjusted retained earnings 41,300 Retained earnings of Samuel, Jan. 1/5 68,000 At acquisition 12,000 Increase 56,000 Less: Inventory profit (f) 1,140 Equipment gain (net) (i) 8,400 9,540 Adjusted increase 46,460 Champlain’s ownership % 80% 37,168 Less: Champlain’s share of amort. of acquisition differential. (d) (26,000) Consolidated retained earnings, Jan. 1, Year 5 52,468 (a) (ii) Champlain Ltd. Consolidated Retained Earnings Statement Year 5 Retained earnings, Jan. 1, Year 5 52,468 Add: profit 24,808 77,276 Less: dividends 20,000 Retained earnings, Dec. 31, Year 5 57,276 Calculation of non-controlling interest – Dec. 31, Year 5 Ordinary shares 50,000 Retained earnings (68,000 + 13,000 – 11,000) 70,000 Total shareholders’ equity, Dec. 31, Year 5 120,000 Less: Inventory profit (g) 1,980 Equipment gain (k) 6,300 8,280 Adjusted shareholders’ equity 117,720 Non-controlling interest’s share 20% 22,344 Add: NCI’s share of unamortized acquisition differential (e) 7,250 Non-controlling interest, Dec. 31, Year 5 29,594 (a) (iii) Champlain Ltd. Consolidated Statement of Financial Position December 31, Year 5 Property, plant, and equipment (198,000+104,000–(l) 7,000–(h) 21,000 – (p) 17,000) 257,000) Accumulated depreciation (86,000 + 30,000 – 10,500* – (p) 17,000) (88,500) Patent (a) 5,250) Goodwill (b & c) 35,000) Deferred income taxes (q) 8,320) Inventories (35,000 + 46,000 – (g) 3,300) 77,700) Accounts receivable (60,000 + 55,000 – (n) 21,000 – (o) 4,400) 89,600) Cash (18,100 + 20,600) 38,700) Total assets 423,070) Ordinary shares 225,000) Retained earnings 57,276) Non-controlling interest 29,594) Dividends payable (5,000 + 5,500 – (o) 4,400) 6,100) Accounts payable (56,000 + 70,100 – (n) 21,000) 105,100) Total liabilities and shareholders’ equity 423,070) * 7,000 + (j) 3,500 = 10,500 (b) When the gain on the sale of the equipment is eliminated on consolidation, the equipment is restated to its carrying value on Champlain’s books prior to the intercompany sale. The carrying value represents Champlain’s original cost less accumulated amortization based on the historical cost. After the consolidation adjustment, the equipment is reported at the historical cost to the consolidated entity net of accumulated amortization. (c) The return on equity attributable to the shareholders of Samuel would not change because the parent company extension theory only affects values used for non-controlling interests. (d) Goodwill under entity theory 35,000 Less: NCI’s share 6,200 Goodwill under parent company extension theory 28,800 NCI on statement of financial position under entity theory 29,594 Less: NCI’s share of goodwill (20%) 6,200 NCI on statement of financial position under parent company extension theory 23,394 Problem 7-16 Calculation, allocation, and amortization of acquisition differential Cost of 80% investment, Dec. 31, Year 1 964,000 Implied value of 100% 1,205,000 Carrying amounts of Orange’s net assets: Assets 1,000,000 Liabilities 300,000 Total shareholders’ equity 700,000 Acquisition differential 505,000 Allocation FV – CA Receivables -25,000 Plant and equipment 300,000 Long-term liabilities -16,850 258,150 Goodwill 246,850 Balance Amortization Balance Dec. 31/1 Years 2 to 4 Year 5 Dec. 31/5 Receivables – 25,000 – 25,000 – – Plant and equipment 300,000 90,000 30,000 180,000 (a) Long-term liabilities – 16,850 – 10,110 – 3,370 – 3,370 (b) Goodwill 246,850 33,600 11,200 202,050 (c) 505,000 88,490 37,830 378,680 (d) Intercompany revenues and expenses Sales and purchases – Orange selling 300,000) – Peach selling 280,000) 580,000) (e) Management fees 25,000) (f) Intercompany profits and losses Before tax 40% tax After tax Warehouse – Orange selling Selling price 54,000) Cost (100,000) Acc. Depr. (2 5,000) 10,000) Loss on sale – Dec. 31, Year 4 (36,000) (14,400) (21,600) (g) Depreciation, Year 5 (36,000 / 18) (2,000) (800) (1,200) (h) Balance, Dec. 31, Year 5 (34,000) (13,600) (20,400) Opening inventory – Orange selling (250,000 – 120,000) 130,000) 52,000) 78,000) (i) Before tax 40% tax After tax Ending inventory – Orange selling (300,000 – 160,000) 140,000) 56,000) 84,000) (j) – Peach selling (1/2 160,000) 80,000) 32,000) 48,000) (k) 220,000) 88,000) 132,000) (l) Machine – Peach selling Selling price 28,000) Cost (32,000) Acc. Depr. (6 4,000) 24,000) Gain sale, Jan. 1, Year 5 20,000 8,000 12,000 (m) Depreciation, Year 5 (20,000 / 2 yrs remaining) 10,000 4,000 6,000 (n) Balance, Dec. 31, Year 5 10,000 4,000 6,000 (o) Dividends paid by Orange to Peach (50,000 x 80%) 40,000 (p) Calculation of consolidated net income – Year 5 Income of Peach 1,500,000 Less: Dividends from Orange (50,000 80%) (p) 40,000 Profit in ending inventory (k) 48,000 Profit on sale of machine (net) (o) 6,000 94,000 Adjusted net income 1,406,000 Income of Orange 330,000 Less: Amortization of the acquisition differential (d) 37,830 Profit in ending inventory (j) 84,000 Loss realized on sale of warehouse (h) 1,200 123,030 206,970 Add: profit in opening inventory (i) 78,000 Adjusted net income 284,970 Consolidated net income, Year 5 1,690,970 Attributable to: Shareholders of Peach 1,633,976 NCI (20% x 284,970) 56,994 1,690,970 (a) Peach Company Consolidated Income Statement Year 5 Sales (6,000,000 + 1,000,000 – (e) 580,000) 6,420,000 Other revenues (200,000 + 20,000 – (f) 25,000 – (m) 20,000 – (p) 40,000) 135,000 Total revenues 6,555,000 Cost of goods purchased (2,525,000 + 390,000 – (e) 580,000) 2,335,000 Change in inventory (-25,000 + 10,000 – (i) 130,000 + (l) 220,000) 75,000 Depreciation expense (500,000 + 80,000 + (a) 30,000 + (h) 2,000 – (n) 10,000) 602,000 Interest expense (400,000 + 16,000 – (b) 3,370) 412,630 Goodwill impairment loss (c) 11,200 Other expenses (1,300,000 + 194,000 – (h) 800 + (i) 52,000 – (l) 88,000 – (o) 4,000 – (f) 25,000) 1,428,200 Total expenses 4,864,030 Consolidated net income, Year 5 1,690,970 Attributable to: Shareholders of Peach 1,633,976 NCI (20% x 284,970) 56,994 1,690,970 Calculation of consolidated retained earnings – Jan. 1, Year 5 Retained earnings of Peach, Jan. 1, Year 5 4,200,000 Retained earnings of Orange, Jan. 1, Year 5 300,000 Retained earnings of Orange at acquisition 200,000 Increase 100,000 Add: loss on sale of warehouse (g) 21,600 121,600 Less: Amortization of the acquisition differential (d) 88,490 Profit in opening inventory (i) 78,000 Adjusted increase – 44,890 Peach’s ownership % 80% – 35,912 Consolidated retained earnings, Jan. 1, Year 5 4,164,088 (b) Peach Company Consolidated Retained Earnings Statement Year 5 Retained earnings, Jan. 1, Year 5 4,164,088 Add: net income 1,633,976 5,798,064 Less: dividends 200,000 Retained earnings, Dec. 31, Year 5 5,598,064 (c) Assets should never be reported on the balance sheet at an amount higher than the future economic benefits. If an asset is sold at a loss, this may indicate that the asset is impaired and the loss should be recognized even if the sale did not occur. If the selling price in the intercompany transaction is not a true reflection of the economic value, the loss would also not be realistic; if so, the loss would be eliminated on consolidation so that the asset is reflected at the amount it was reported at prior to the intercompany sale. (d) Bond Amortization Table for Consolidated Financial Statements Date Effective Interest Amortization Ending Interest Paid Balance Dec 31, Yr 1 216,850 Dec 31, Yr 2 13,011 16,000 2,989 213,861 Dec 31, Yr 4 12,832 16,000 3,168 210,693 Dec 31, Yr 4 12,642 16,000 3,358 207,335 Dec 31, Yr 5 12,440 16,000 3,560 203,774 Dec 31, Yr 6 12,227 16,000 3,773 200,002 Amortization of premium under straight-line method for Year 5 3,370 Amortization of premium under effective-interest method for Year 5 3,560 Reduction in interest expense under effective-interest method 190 Interest expense under straight-line method 412,630 Interest expense under effective-interest method 412,440 NCI on income statement as previously reported 56,994 NCI’s share of increased income due to change in interest method 190 x (1 – 40%) x 20% 23 NCI on income statement as restated for effective-interest method 57,017 Problem 7-17 Calculation, allocation, and amortization of acquisition differential Cost of 70% investment in Dandy 7,000 Implied value of 100% 10,000 Carrying amounts of Dandy’s net assets: Common shares 250 Retained earnings 4,500 Total shareholders’ equity 4,750 Acquisition differential, Jan. 1, Year 1 5,250 Allocation: FV – CA Inventory 100 Equipment 500 600 Balance – Goodwill 4,650 Amortization Balance Balance Jan. 1/1 Years 1 to 5 Year 6 Dec. 31/6 Inventory 100 100 – – Equipment (10 year life) 500 250 50 200 (a) Goodwill 4,650 3,550 70 1,030 (b) 5,250 3,900 120 1,230 (c) Intercompany profits Before tax 40% tax After tax Opening inventory – Dandy selling (2,000 x 40%) 800 320 480 (d) Closing inventory – Dandy selling (2,500 x 40%) 1,000 400 600(e) Equipment Jan. 1/2 – Handy selling 200 (f) Depreciation to Dec. 31, Year 5 ([200 / 8] 4) 100 Balance, Dec. 31, Year 5 100 40 60(g) Depreciation Year 6 (200 8) 25 10 15(h) Balance, Dec. 31, Year 6 75 30 45(i) Intercompany revenues and expenses, receivables and payables Sales and purchases 5,000(j) Consulting revenues and expenses (50 x 12) 600(k) Deferred income taxes (Dec. 31, Year 6) Inventory (e) 400 Equipment (i) 30 430(l) Calculation of consolidated net income – Year 6 Income of Handy 1,760 Less: Dividends from Dandy (800 70%) (m) 560 1,200 Add: Realized gain on equipment (h) 15 Adjusted net income 1,215 Income of Dandy 1,020 Add: Opening inventory profit (d) 480 Less: Amortization of acquisition differential (c) (120) Closing inventory profit (e) (600) Adjusted net income 780 Consolidated net income 1,995 Attributable to: Shareholders of Handy 1,761 NCI (30% x 780) 234 1,995 (a) Handy Company Consolidated Income Statement Year 6 Sales (21,900 + 7,440 – (j) 5,000) 24,340 Cost of sales (14,800 + 3,280 – (j) 5,000 + (e) 1,000 – (d) 800) 13,280 Gross profit 11,060 Other revenue (1,620 + 0 – (m) 560 – (k) 600) 460 Selling & admin expense (840 + 420 + (a) 50 – (h) 25) (1,285) Other expenses (5,320 + 2,040 + (b) 70 – (k) 600) (6,830) Income before income taxes 3,405 Income tax expense (800 + 680 + (d) 320 – (e) 400 + (h) 10) 1,410 Net income 1,995 Attributable to: Shareholders of Handy 1,761 NCI (30% x 780) 234 1,995 (b) Calculation of consolidated retained earnings – Jan. 1, Year 6 Handy’s retained earnings 10,420 Unrealized gain on sale of equipment – net of tax (g) (60) Subtotal 10,360 Dandy’s retained earnings, beginning of Year 6 $5,180 Dandy’s retained earnings, at acquisition 4,500 Change in retained earnings since acquisition 680 Cumulative differential amortization and impairment (c) (3,900) Profit in beginning inventory – net of tax (d) (480) -3,700 Handy’s share @ 70% – 2,590 Consolidated retained earnings 7,770 Handy Company Consolidated Statement of Retained Earnings For the year ended December 31, Year 6 Retained earnings, beginning of year 7,770 Net income 1,761 9,531 Dividends paid (1,600) Retained earnings, end of year 7,931 (c) When unrealized profit is eliminated from the carrying value of the equipment, the equipment ends up being reported at the original cost of the equipment less accumulated amortization based on the original cost, as if the intercompany transaction had never taken place. So, in effect, the equipment is reported at its historical cost. (d) Goodwill impairment loss under entity theory 70 Less: NCI’s share (30%) 21 Goodwill impairment loss under parent company extension theory 49 NCI on income statement under entity theory 234 Add: NCI’s share of goodwill impairment (30%) 21 NCI on income statement under parent company extension theory 255 (CGA-Canada adapted) Problem 7-18 Under historical cost accounting and ignoring the intercompany sale, depreciation expense would be $500,000 / 10 years = $50,000 per year. The equipment would be reported as follows on the balance sheet: Year 1 Year 2 Year 3 Cost 500,000 500,000 500,000 Accumulated depreciation 50,000 100,000 150,000 Carrying amount 450,000 400,000 350,000 Under the revaluation model and ignoring the intercompany sale, the equipment would be reported as follows on the balance sheet: Year 1 Year 2 Year 3 Grossed up cost 511,111 520,000 528,571 Grossed up accumulated depreciation 51,111 104,000 158,571 Carrying amount = fair value 460,000 416,000 370,000 The amounts are grossed up using the ratio of fair value / carrying amount under historical cost model. Under the revaluation model and ignoring the intercompany sale, the depreciation expense would be reported as follows on the income statement: Year 1 Year 2 Year 3 Carrying amount beginning of year 500,000 460,000 416,000 Remaining useful life 10 9 8 Depreciation expense for the year 50,000 51,111 52,000 Under the revaluation model and ignoring the intercompany sale, accumulated other comprehensive income (AOCI) would be reported as follows on the balance sheet: Year 1 Year 2 Year 3 Fair value under revaluation model 460,000 416,000 370,000 Carrying amount under historical cost model 450,000 400,000 350,000 AOCI 10,000 16,000 20,000 Using the above figures, the financial statement presentation would be as follows for the separate entity and consolidated financial statements: Year 1 MEL SENS CONS (a) Equipment 511,111 511,111 (b) Accumulated depreciation 51,111 51,111 Net carrying value of equipment 460,000 460,000 (c) AOCI 10,000 10,000 (d) Gain on sale (e) Depreciation expense 50,000 50,000 Year 2 MEL SENS CONS (a) Equipment 520,000 520,000 (b) Accumulated depreciation 104,000 104,000 Net carrying value of equipment 416,000 416,000 (c) AOCI 16,000 16,000 (d) Gain on sale (e) Depreciation expense 51,111 51,111 Year 3 MEL SENS CONS (a) Equipment 422,857 528,571 (b) Accumulated depreciation 52,857 158,571 Net carrying value of equipment 370,000 370,000 (c) AOCI (370,000 – (420,000 x 7/8) 2,500 20,000 (d) Gain on sale of equipment (420,000 – 416,000) 4,000 (e) Depreciation expense (420,000 / 8) 52,500 52,000 WEB-BASED PROBLEMS Web Problem 7-1 The following answers were determined using the 2011 consolidated financial statements for Barrick Gold Corporation. (a) The expenses on the consolidated statements of income are classified by function (e.g. corporate administration and exploration and evaluation. (b) It appears that no amortization was taken in 2011 as per note 18(b) . Amortization expense does not appear on the consolidated statements of income because expenses are classified by function and not by nature. (c) The annual depreciation rates for property, plant and equipment are listed in note 2(m). For all of these assets, the useful lives appear to be fairly short. For example, the maximum useful life for buildings is 25 years. The content of the disclosures in notes 2(o) and 18(b) to the consolidated financial statements do not include explicit useful lives assigned to the company’s intangible assets. The intangible asset “supply contracts” will be amortized to cost of sales over the effective term of the contract. Readers are not informed of the term to which this note refers. (d) Property, plant and equipment is $28,979 as per the consolidated balance sheets. This represents 59.3% of total assets, which is an increase from 51.6% in the previous year. (e) The company values its plant and equipment at cost, including all expenditures incurred to prepare the asset for its intended use plus applicable capitalized costs that meet the asset recognition criteria less accumulated depreciation and any accumulated impairment losses as per note 2(m) to the consolidated financial statements. (f) The asset turnover would be understated. Although sales are correctly stated, total assets are overstated because the gain on the intercompany sale (which took place two years ago) was not eliminated. The return on assets would also be understated; income is understated because the excess depreciation on the overstated asset was not eliminated and, again, assets are overstated because the gain was not eliminated. (g) Total equity, the denominator in the calculation of ROE, will increase by the difference between the fair value of plant and equipment and its carrying amount. Amortization expense attributable to plant and equipment will increase because it will now be based on fair value. In turn, net income will decrease. With the decrease in net income and increase in equity, the return on equity will decrease. If ROE were calculated using comprehensive income, the fair value increment, which is included in OCI, would increase comprehensive income. Then, the ROE would likely increase. The impact on share price is hard to assess because it depends on how the actual fair values compare to investors’ estimates of fair values. If the fair values reported in the financial statements were higher than expectations, the stock price would increase and vice versa. Web Problem 7-2 The following answers were determined using the 2011 consolidated financial statements of RONA Inc. (a) The expenses are classified by function (e.g. selling, general and administrative expenses) as per note 5.1. (b) Amortization expense on other intangible assets is $23,831 as per note 5.2. Amortization expense does not appear on the consolidated income statements and other comprehensive income because expenses on the income statement are classified by function and not by nature. (c) Notes 3(g) through (j) to the consolidated financial statements disclose the company’s accounting policies regarding property, plant, and equipment, non-current assets held for sale, intangible assets, and goodwill. The estimated useful lives of the tangible and intangible assets are usually expressed in a range of years (e.g. 15 to 40 years for buildings). The estimated useful life for furniture and equipment is 3 to 20 years; a 20-year useful life for a piece of furniture and/or equipment seems quite long and, as such, appears to be overstated. (d) Property, plant and equipment is $874,246 as per the consolidated statements of financial position. This represents 31.4% of total assets, which is an increase from 30.3% in the previous year. (e) The company values its plant and equipment at cost (including capitalized interest, if applicable) less accumulated depreciation and impairment losses as per notes 3(g) and (k). (f) The asset turnover would be understated. Although sales are correctly stated, total assets are overstated because the gain on the intercompany sale (which took place two years ago) was not eliminated. The return on assets would also be understated; income is understated because the excess depreciation on the overstated asset was not eliminated and, again, assets are overstated because the gain was not eliminated. (g) Total equity, the denominator in the calculation of ROE, will increase by the difference between the fair value of plant and equipment and its carrying amount. Amortization expense attributable to plant and equipment will increase because it will now be based on fair value. In turn, net income will decrease. With the decrease in net income and increase in equity, the return on equity will decrease. If ROE were calculated using comprehensive income, the fair value increment, which is included in OCI, would increase comprehensive income. Then, the ROE would likely increase. The impact on share price is hard to assess because it depends on how the actual fair values compare to investors’ estimates of fair values. If the fair values reported in the financial statements were higher than expectations, the stock price would increase and vice versa.