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Chapter 6

Intercompany Inventory and Land Profits

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A brief description of the major points covered in each case and problem.
CASES
Case 6-1
In this case, students are asked to illustrate the impact of intercompany sales and unrealized
profits in inventory on the separate entity and consolidated financial statements. Students are
also asked to explain how basic accounting principles are applied when accounting for these
intercompany transactions.
Case 6-2
This case, adapted from a CA exam, involves a change from equity method to fair value
method for an investment in a company that has experienced substantial losses during the
period.
Case 6-3
This is a multi-subject case from a CA exam. Students are asked to resolve a number of
accounting issues including revenue recognition, government grants, contingency and
intercompany transactions.
Case 6-4
In this case, adapted from a CA exam, students are asked to identify accounting issues related
to the preparation of consolidated financial statements for an 80%-owned subsidiary and a
40%-owned investee company. Intercompany transactions and acquisition differential have
not been properly accounted for.
Case 6-5
In this case, adapted from a CA exam, management appears to be manipulating income to
minimize the bonus paid to union employees. Students are required to analyze controversial
accounting issues including the valuation of inventory, purchase returns and goodwill.
Case 6-6
This is a multi-subject case from a CA exam. Students are asked to resolve a number of
accounting issues including revenue and expense recognition, contributions to a partnership,
contingent consideration and offsetting of assets against liabilities.
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PROBLEMS
Problem 6-1 (25 min.)
A short problem requiring calculation of selected accounts for consolidated statements when
there are unrealized profits in inventory and an explanation of impact of intercompany
transactions on non-controlling interest.
Problem 6-2 (20 min.)
This problem consists of a consolidated income statement that has been incorrectly prepared
and requires correcting. Intercompany transactions and unrealized profits in opening and
closing inventory have been overlooked.
Problem 6-3 (20 min.)
A short problem requiring calculation of selected accounts related to land for separate entity
and consolidated financial statements for three years when there are unrealized profits in and
an acquisition differential pertaining to land.
Problem 6-4 (40 min.)
A parent has used the cost method to account for its investments in its two subsidiaries. There
are unrealized profits in the inventory of all three companies. The problem requires the
preparation of a consolidated income statement, a calculation of consolidated retained
earnings, a calculation of investment income under the equity method and an explanation of
how the revenue recognition principle is applied when adjusting for unrealized profits.
Problem 6-5 (40 min.)
Unrealized inventory and land profits are involved over a two-year period. The problem calls for
equity method journal entries as well as the calculation of consolidated net income each year,
a statement showing changes in non-controlling interest, and a calculation of the balance in
the investment account under the equity method.
Problem 6-6 (30 min.)
Three related companies are involved in selling goods to each other. The problem requires a
calculation of consolidated profit and consolidated retained earnings when the parent used the
cost method.
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Problem 6-7 (70 min.)


A comprehensive problem requiring an acquisition differential calculation, amortization
schedule, and a consolidated balance sheet and statement of changes in equity under the
entity theory plus an explanation of how the debt to equity ratio would change under the parent
company extension theory. The subsidiary was acquired seven years ago; there are
intercompany profits (and losses) in land and inventory; and the parent has used the cost
method to account for its investment.
Problem 6-8 (30 min.)
A parent has three subsidiaries that conduct intercompany transactions with each other and
the problem requires the parent's equity method journal entries and calculations of
consolidated net income and consolidated retained earnings.
Problem 6-9 (25 min.)
A parent has used the cost method to account for its investment and the problem requires the
calculation of consolidated net income attributable to the parents shareholders when there are
unrealized inventory and land profits involved.
Problem 6-10 (40 min.)
Intercompany sales, interest and rental revenue, and unrealized profits in opening and closing
inventory are involved in this problem that requires the preparation of a consolidated income
statement and a calculation of consolidated retained earnings. The parent has used the cost
method.
Problem 6-11 (40 min.)
Unrealized profits in opening and closing inventory and in land have to be taken into account in
the preparation of a consolidated statement of changes in equity when the parent has used
the cost method.
Problem 6-12 (25 min.)
A parent has used the equity method to account for its investment. There are intercompany
inventory profits involved. The problem requires the preparation of a consolidated income
statement, a calculation of consolidated retained earnings and an explanation of the impact of
using the parent company extension theory on the return on equity.
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Problem 6-13 (70 min.)


This comprehensive problem covers everything illustrated to date and requires the preparation
of a consolidated income statement and consolidated statement of financial position when the
parent has used the equity method plus the calculation of goodwill and non-controlling interest
under the parent company extension theory.
Problem 6-14 (70 min.) (Prepared by Peter Secord, Saint Marys University)
A comprehensive problem requiring the preparation of a consolidated income statement and a
statement of financial position when the parent has used the equity method. Also required is a
calculation of goodwill and NCI using the trading price of the subsidiarys shares at the date of
acquisition. There are intercompany profits in land and inventory.
Problem 6-15 (50 min.)
A comprehensive problem requiring the preparation of a consolidated income statement and
the calculation of specified consolidated balance sheet accounts. Also required is a calculation
of goodwill impairment loss and consolidated net income attributable to NCI when a business
valuator measures the value of NCI at the date of acquisition. There are intercompany
transactions and unrealized profits in land and inventory.

WEB-BASED PROBLEMS
Web Problem 6-1
The student answers a series of questions based on the 2011 financial statements of RONA
inc., a Canadian company. The questions deal with intercompany transactions in inventory and
land and the impact of changes in accounting policies for inventory and land on certain ratios.
Web Problem 6-2
The student answers a series of questions based on the 2011 financial statements of Cenovus
Energy Inc., a Canadian company. The questions deal with intercompany transactions in
inventory and land and the impact of changes in accounting policies for inventory and land on
certain ratios.

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SOLUTIONS TO REVIEW QUESTIONS


1.

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

2.

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

3.

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

4.

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

5.

Revenue should be recognized when it is earned with a transaction outside of the


reporting entity. The reporting entity for consolidated financial statements encompasses
the parent and all of its subsidiaries. Since intercompany transactions are transactions
within the reporting entity (not outside of the reporting entity), they must be eliminated
when preparing consolidated financial statements.

6.

This statement is true if the selling affiliate has an income tax rate of 40%. The $1,000
reduction from ending inventory reduces the consolidated entity's net income. A
corresponding reduction of $400 in income tax expense transfers the tax from an
expense to an asset on the consolidated balance sheet. When the $1,000 profit is
subsequently realized, the $400 is transferred from the consolidated balance sheet to the
consolidated income statement in order to achieve a proper matching of expense to
revenue.

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7.

The matching principle requires that expenses be matched to revenues. When


intercompany profits are eliminated from the consolidated financial statements, the
income tax expense related to those profits must also be eliminated. When the
previously unrecognized intercompany profits are recognized in a later period, the income
tax on these profits must be expensed.

8.

There is no adjustment to income tax expense corresponding to the elimination of


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

9.

Ideally, intercompany losses should be eliminated in the same manner as intercompany


gains. In turn, an impairment test would be carried out. If the recoverable amount were
less than the carrying amount, an impairment loss would be reported. When the
impairment loss is greater than the intercompany loss, one can get to the same result by
not reversing the intercompany loss and simply reporting an impairment loss to bring the
carrying amount down to the recoverable amount.

10. The elimination of intercompany sales and purchases reduces sales revenue and cost of
goods sold on the consolidated income statement. No other items on the consolidated
statements are affected. The elimination of intercompany profits in ending inventory
affects the following elements of the consolidated statements: cost of goods sold is
increased; income tax expense is decreased; net income is decreased; net income
attributable to the parent is decreased; net income attributable to the non-controlling
interest is decreased (if the subsidiary was the seller); the asset inventory is decreased;
deferred income tax assets are increased; non-controlling interest in net assets is
decreased (if the subsidiary was the seller); and consolidated retained earnings is
decreased.
11. For a downstream transaction, the adjustment for unrealized profits is applied to the
parents income and is fully charged or credited to the parent. For an upstream
transaction, the adjustment for unrealized profits is applied to the subsidiarys income
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which is shared between the parent and non-controlling interest. In other words, the noncontrolling interest is affected by elimination of profit on upstream transactions but is not
affected by the elimination of profit on downstream transactions.
12. At the end of Year 1, the unrealized profit is removed from ending inventory and added to
cost of goods sold which decreases income. In Year 2, the unrealized profit is removed
from beginning inventory, which decreases cost of goods sold for Year 2 and increases
income for Year 2. Although Year 1 and Year 2 income both must be adjusted, the
adjustments are offsetting. Therefore, the combined income for the two years does not
change as a result of the adjustments.
13. It will not be eliminated again on the consolidated income statement for subsequent
years. However, if the land remains within the consolidated entity, the unrealized gain will
be eliminated in the preparation of all subsequent consolidated balance sheets and
statements of retained earnings until such time as the land is sold to outside parties.
14. Adjustments are required on consolidation to bring the consolidated balances to the
amounts that would have been on the subsidiarys books had it not sold the land to the
parent. Therefore, any gain reported on sale would have to be eliminated. The revaluation
surplus account would have to reflect the increase in fair value over the original cost of
the land when it was purchased by the subsidiary.
15. The journal entry would be as follows:
Investment income

xxx

Investment in subsidiary

xxx

where xxx is equal to the parents share of the unrealized profits.


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

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transactions between a parent and subsidiary, the entire amount of unrealized profit is
eliminated and charged to the parents shareholders.

SOLUTIONS TO CASES
Case 6-1
Using the data provided in the question, the financial statements for the parent, subsidiary and
consolidated entity would appear as follows for the 3 months:
Parent
Aug

Sept

Subsidiary
July

Aug

Consolidated
July

Aug

200

200

Sept

BALANCE SHEET
Inventory

240

200

Prepaid tax

16

INCOME STATEMENT
Sales

300

240

240

200

60

40

Income tax expense

24

16

Net income

36

24

300
Cost of goods sold
200
Gross margin
100

The following comments outline how all of the above financial statements present fairly the
financial position and financial performance of the company in accordance with GAAP:
1. The parent and subsidiary are separate legal entities. Each entity will pay income tax
based on the income earned by the separate legal entity. Therefore, the subsidiary will
pay income tax based on the profit it earned in August and the parent will pay income
tax based on the profit it earned in September.
2. The consolidated statements combine the statements of the parent and subsidiary as if
they were one entity i.e., one set of statements for the family.
3. Accounting principles should be and have been properly applied for all of the individual
financial statements. The main principles involved with these statements are the
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historical cost principle, the revenue recognition principle, and the matching principle.
4. The historical cost principle requires that certain items such as inventory be reported at
historical cost. This has been done for all 3 financial statements. Note that the
historical cost for the inventory from a consolidated perspective was $200 which is the
cost paid by the subsidiary when it purchased the goods from outsiders.
5. The revenue recognition principle requires that revenue be reported when it is earned
i.e., when the benefits and risks of ownership are transferred to the buyer. When the
subsidiary sold to the parent, the benefits and risks were transferred to the parent.
Accordingly, the subsidiary reported revenue. However, from the consolidated
perspective, the family retained the benefits and risks; they were not transferred to an
outside entity. Therefore, no revenue is reported on the consolidated income statement
for August.
6. When the parent sells to an outside entity in September, it reports revenue on its
separate entity income statement. Since the family has sold the inventory to an outside
entity, the family has earned the revenue. Accordingly, the revenue is reported in
September on the consolidated income statement.
7. The matching principle requires that costs be expensed in the same period as the
revenue to which it relates. This provides the best measure of performance. Since the
subsidiary reported revenue in August, it reported cost of goods sold in August in order
to match expenses to revenue in August. Similarly, the parent reported cost of goods
sold in September to match expenses to revenue in September. Since revenue was
reported in September from a consolidated viewpoint, the cost of goods sold is reported
as an expense in September as well. The cost from a consolidated viewpoint was the
amount paid by the subsidiary when it bought the inventory from outsiders.
8. Income tax must also be matched to the income to which it relates. In August, the
subsidiary reported income tax expense of $16 to match against the pre-tax income of
$40. Since no income was reported in the consolidated income statement for August,
no tax expense should be reported in income. Given that the subsidiary probably paid
the tax to the government, the tax is considered to have been prepaid from a
consolidated viewpoint because the tax was not yet due from a consolidated viewpoint.

Case 6-2
Overview
The managers of King Limited (King) are planning a share issue and do not want King's
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earnings impaired by the poor performance of Queen Limited (Queen). The financial
statements of King will be widely distributed due to the share issue planned for Year 18. The
auditor must be aware of management's bias and must ensure that earnings and assets are
not overstated.
The drug industry is highly competitive. The principal assets in this industry are intangible due
to the large expenditures on research and development. The nature of these assets creates
problems. Note disclosure will be very important.
The relationship between King and Queen is uncooperative. It will, therefore, be difficult to
obtain sufficient and appropriate audit evidence to support the accounting method and values
used to record the Queen investment.

Accounting for the investment


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

King's ownership meets the 20% guideline;

King had membership on the board of directors, and voluntarily gave it up;

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

inter-company transactions have declined and are no longer material;

dividends have not been paid recently, and perhaps earnings of Queen will not accrue
to King; and

given the uncooperative nature of Queen and King's relationship, it does not appear
that King has significant influence over Queen.

(Students could have discussed other valid factors in determining whether King exerts
significant influence over Queen)
If King is able to exert significant influence over Queen, then it will continue to use the equity
method of accounting for the investment. If King no longer has significant influence, the
investment in Queen would be reported at fair value. It is difficult to determine whether
management of King manipulated the change in influence by ceasing to trade with Queen and
removing the King representative from Queen's board of directors. In any case, the change in
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method would be accounted for prospectively since the change was made due to a change in
circumstance. Therefore, the prior period adjustment reported in the draft financial statements
would not be appropriate and should be reversed.
(Students should have reached a conclusion on the issue of significant influence and
proceeded with their analysis of either the fair value method or the equity method. This
response discusses both methods. However, students were not expected to provide an
analysis of both the equity and the fair value methods.)
Equity method
King must reflect its share of Queen's current loss. As shown in Appendix I, the investment
would be written down from $27.4 million to zero because Kings share of Queens losses
exceed the balance in the investment account. However, the investment would not be valued
as a negative amount because King is not legally obligated to pay any of Queens liabilities.
Fair value method
If King no longer has significant influence, it would adopt the fair value method starting on the
date it lost significant influence. The balance in the investment account under the equity
method would be retained as the initial balance under the fair value method. If the change in
significant influence occurred before Queen suffered the huge loss in Year 17, the balance in
the investment account would be $27.4 million. If the change in significant influence occurred
after King accrued its share of Queens loss for Year 17, the balance in the investment account
would be zero. King will likely argue that it had lost significant influence before Queen
incurred the loss and would thereby avoid the write down.
On the date that King lost its significant influence, it would make an irrevocable decision to
report dividend income and the fair value adjustments in net earnings or other comprehensive
income. At the end of each reporting period, the investment would be revalued to fair value.
At August 31, Year 17, Queens shares were trading at $13 per share. If this is a fair reflection
of the fair value of the company, then Kings investment would be revalued to $26 million and
the revaluation adjustment would be reported in net earnings. The adjustment would be a loss
of $1.4 million if the investment account had not been written down to zero or a gain of $26
million if the change in accounting method had occurred after King accrued its share of
Queens loss.

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Given that Queen suffered huge losses and given that Queens shares were trading as low as
$5 per share during the year, one could argue that $13 is not a true reflection of the fair value
of Queen. The following factors should be considered in evaluating whether the market price
is an appropriate reflection of the fair value of the Queen shares:
The fact that Queen refuses to disclose information may indicate a liquidity problem that
the company is reluctant to publicize. On the other hand, Queen may be trying to maintain
confidentiality about its new drug breakthrough.

Stock prices have been volatile, so the stock price cannot be relied on as an indication of
value unless the volatility can be explained by specific economic events (e.g., generic drug
competition, new viral drug).

Queen has experienced severe losses this year; this situation may be considered unusual.
There is no evidence to suggest that Queen will continue to incur losses unless economic
circumstances have changed. If, for example, competition has increased, recurring writeoffs of research and development expenditures can be expected.
There is no evidence that the market value of King's share of Queen has been less than
the carrying value for a prolonged period.
These factors suggest that the decline in future cash flows is not permanent and that the
market price of $13 may be a reasonable reflection of the fair value of Queen. However, the
market price of Queen's shares after year-end may provide additional evidence supporting this
conclusion.
(Students should have reached a conclusion on the reasonability of the trading price as a
reflection of the fair value of the Queens shares.)
The current situation is unusual and will require detailed note disclosure to describe the
change in reporting method and the impact on the financial statements.
APPENDIX I
Valuation of Investment Account
(in thousands of dollars)
Carrying amount per draft financial statements
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Reverse adjustment for prior period adjustment

2,400

Restated balance under equity method, beginning of year

27,400

Entries for year under equity method:


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

1,100

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

(220)

Share of Queens loss (22% x 140,000 = 30,800) (Note 1)

(28,280)

Balance under equity method, end of year

$ -o

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

Case 6-3
Memo to:

Linda Presner, Partner

From:

CA

Subject:

Accounting issues regarding Metal Caissons Limited (MCL)

Overview of the engagement


The financial statements of MCL will be used by the two shareholders, the bank and the
Department of National Defence (DND). Their needs must be considered when assessing
appropriate accounting policies and disclosures. John Ladd and Paul Finch wish to present
financial statements conveying a picture of profitability and a strong financial position to the
bank and the DND. However, it would be in their best interests to adopt policies that will also
minimize corporate taxes. The bank and the DND would likely expect generally accepted
accounting principles for private enterprises (ASPE) to be used in all instances.
(Most candidates devoted too much time to the definition of the users of MCLs financial statements
and their needs. These candidates failed to incorporate this analysis in their analysis of the
accounting issues.)
Going concern
This issue must be assessed to determine whether the financial statements should be stated
on the basis of historical costs or liquidation values. A potential going concern problem is
suggested by the following:

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By excluding the government grants from revenues, MCL would be in a loss position. If
the year-to-date results are typical, the long-term profitability of MCL may be marginal.
However, such losses may, however, be normal in a start-up situation.

DND is the sole client and can cancel the contract if the terms of the contract are not
met. Delivery dates have been missed; however, recent deliveries have been made on
time.

MCL's working-capital position indicates potential insolvency if government grants are


not received. MCL has not met the terms of the job-creation grant, and this may explain
why the grant has not yet been received.

The working-capital position has deteriorated further because DND has not paid for the
caissons received to date. The metal caissons must meet high standards of quality, and
DND's inspection process may have slowed down approvals. Alternatively, the fact that
DND has not paid may mean that there are problems that have not yet been disclosed
to us.

There is nothing to indicate that the contract with DND will be renewed at the end of
five years or that the manufacturing process can be changed to another product at that
time.

The lawsuit pending against MCL, if successful, could drive the company into
bankruptcy.

Although there are many factors that raise a concern about the ability of MCL to
continue as a going concern, MCL continues to operate as a going concern. DND has
not yet cancelled the contract and the bank has not called the loan. Therefore, MCL
should continue to report on a going-concern basis. However, they should disclose their
reliance on the DND contract and the significant risks that may bear on their ability to
continue as a going concern.

(Candidates were expected to address the going-concern issue. The better responses presented
some quantitative analysis. Most candidates failed to address this major issue in adequate depth.)
Government grants
At present, 79% of MCL's total workforce is employed in the plant, which is below the 85%
specified in the job-creation grant. If the conditions cannot be met by their due date, the grant
receivable will need to be written off.

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The recording of the grants as revenue is inappropriate under GAAP since the grants pertain
to the cost of the plant and cost of employees. The grants do not pertain to the sale of goods
or provision of services. The building grant should be netted against the capitalized cost of the
plant, or recorded as a deferred credit and amortized to income over the life of the plant. The
job-creation grant should be deferred and amortized to income over the three-year period of
the agreement. It will be necessary to disclose the terms of the grants.
(Most candidates discussed the accounting implications of government grants in adequate depth.)
Late delivery penalties
Further review of the contract with DND is required. It is apparent that the late delivery
penalties ($110,000 for 55 days at $2,000 per day) for the first three caissons have not been
accrued, and this issue must be discussed with management. DND should be contacted to find
out whether the penalties will be enforced or waived and whether specifications have been met
on all the caissons delivered to date. If the penalty is not waived, an accrual for the amount of
the penalty will be required.
Clarification is needed on the procedures to be followed if a caisson proves unacceptable. To
date no caissons have been returned; however, the amount of the penalties may increase with
each day that the specifications continue not to be met. Related disclosures for the contracts,
including the penalties, will be required.
(Most candidates did not quantify the amount of the possible penalty payment.)
Investment in MSI
With a 60% ownership interest, MCL likely has control over MSI. Under ASPE, the investment
in MSI can be reported on a consolidated basis or using the cost method or equity method.
Since MSI is reporting profit in excess of dividends paid, the consolidated statements or the
equity method would increase profits for MCL. Since consolidated statements are generally
viewed as more useful, I will assume that MCL will choose to report its investment on a
consolidated basis. Since MSI reported a profit of $40,000, the consolidated net income
attributable to MCLs shareholders would normally increase by $24,000 (60% x 40,000).
However, some of MSIs profit was made from intercompany transactions. The intercompany
transactions should be eliminated when preparing the consolidated statements since they did
not involve an outside entity. The unrealized profits in ending inventory should also be
eliminated. This will reduce inventory by $30,000 i.e. 30% x 100,000 and increase cost of
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goods sold by $30,000. Since the profit of $30,000 was initially reported by MSI, both the
shareholders of MCL and the non-controlling interests in MSI will be affected when the profit is
eliminated. The portion attributable to the shareholders of MCL is $18,000 (60% x 30,000).
Therefore, the consolidated net income attributable to MCLs shareholders will only increase by
$6,000 (24,000 18,000).
Capitalized expenditures
Capitalizing costs is appropriate only if a likely future benefit is associated with the
expenditure. The capitalized expenditures will likely be reclassified as follows:
Expenditure
Office furniture

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

Travel costs

Costs related to the search of the plant site should be included in


the cost of land.

Calls for tender

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

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

These costs should be netted against the amount of the grants


received and amortized on the same basis as the grants.

Contract negotiations

These costs should be capitalized as a cost of the DND contract


and amortized over the life of the contract.

Admin & legal costs

These costs and the incorporation costs should be expensed as


incurred since they do not provide any measurable future benefit

(Most candidates addressed capitalized expenditures in adequate depth.)


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Miscellaneous issues
The following issues must also be considered:
1. We must discuss with management whether there are plans to manufacture products for
customers other than the DND. MCL is economically dependent on the DND contract, and
this relationship must be disclosed.

2. After reviewing the government contract and after discussions with management and the
DND, we should consider whether the present method of recording revenue at the time the
product is shipped is appropriate. Perhaps, revenue should not be recognized until the
client confirms that the detailed specifications have been met.

3. MCL's lawyers will be contacted to assess the progress of the Deutsch Production lawsuit.
Either the amount of the potential damages must be accrued or the appropriate disclosure
made about the contingent liability depending on the certainty with respect to the outcome
of the lawsuit. This is a critical issue considering the materiality of the amount and its
impact on MCL as a going concern.

4. We must find out why no principal payments of long-term debt have been recorded on the
financial statements. If required payments have not been made, MCL could be in default,
and this would be yet another consideration in the assessment of whether MCL is a going
concern. Principal payments may also have been erroneously charged as interest expense.

5. The current portion of the long-term debt should be classified separately and disclosure
made of the debt agreement and the principal payments to be made over the next five
years.

6. Interest can be capitalized during the construction period only until production commences.
It appears that interest has been capitalized beyond this period and an adjustment should
be made. Once properly calculated, the amount should be disclosed in the notes to the
financial statements.

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7. Depreciation has been calculated on plant equipment at what appears to be a low rate.
The appropriateness of the rate will have to be assessed giving regard to the useful life of
the related assets being depreciated.

Case 6-4
Memo to: Audit Partner
From:

Audit Senior

Re:

D Ltd. Consolidated Financial Statements

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

$4,000,000

Implied value for 100% interest in N (4,000,000 / .8)

5,000,000

NCIs share (20%)

1,000,000

This assumes that there is a linear relationship between the value of 80% and the value of 100%
of N.
5. Intercompany transactions and balances between D and K must be eliminated. Sales and
cost of sales should be reduced by the intercompany sales of $1,200,000. The unrealized
profit of $200,000 (1,200,000 1,000,000) should be taken out of ending inventory and
added to cost of goods sold. Since this was an upstream sale, non-controlling interest will
be affected by this adjustment.
6. The investment in K has been accounted for using the cost method. This method is not
acceptable under IFRSs. With a 40% interest in K, D would normally have significant
influence. If so, the equity method would be appropriate. For the purpose of this
discussion, I will assume that D does have significant influence and the equity method
should be used.
7. Under the equity method, the acquisition cost would have to be allocated in a manner
similar to what is done for consolidation purposes. The acquisition differential would be
allocated to identifiable net assets where the fair value is different than carrying amount.
This fair value difference would have to be amortized and an adjustment made to the
investment account on an annual basis. We do not have sufficient information at this point
to determine the adjustment for Year 1.
8. Since D paid less than the fair value of Ks identifiable net assets, there is negative goodwill
in this acquisition cost. Negative goodwill is calculated to be $233,333 ($2,100,000 / .9
$2,100,000). If we used the same principles applied for consolidation purposes, this
negative goodwill would be reported as a gain on purchase.
9. Under the equity method, Ds share of the unrealized profit from intercompany transactions
would have to be eliminated. Since K made an after-tax profit of $120,000 ([1,200,000
1,000,000] x [1 0.4]) on sales to D, $48,000 (40% x 120,000) would have to be eliminated
from the investment account. Since D and K are related parties, the details of
intercompany transactions would need to be disclosed in the notes to the consolidated
financial statements.
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10.

Based on the discussion above, I have recalculated the following account balances for

the consolidated financial statements in the schedules below:


Goodwill
Investment in K (under equity method)
Non-controlling interest on balance sheet
Profit
Allocation and amortization of acquisition cost for investment in N
Cost of 80% investment, September, Year 1

4,000,000

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

5,000,000

Carrying amounts of Ns net assets:


Common shares

1,000,000

Retained earnings

1,850,000

Total shareholders' equity

2,850,000

Acquisition differential

2,150,000

Allocation:

FV CA

Land

800,000

Plant and equipment

700,000

Research and development expenditures

- 90,000

Existing goodwill

- 60,000

Balance newly calculated goodwill

800,000

Balance

Amortization

Sept 1
Year 1

Balance
Aug. 31

Year 2

Year 2

Land

800,000

Plant and equipment

700,000

Research and development

- 90,000

- 90,000

Old goodwill

- 60,000

- 60,000

New goodwill

1,350,000

800,000
70,000

800,000

630,000

800,000
2,150,000

70,000

2,080,000

Investment in K
Investment in K, at date of acquisition
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Retained earnings of K, Aug. 31, Year 2

1,710,000

Retained earnings of K, at acquisition

1,760,000

Change

- 50,000

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

- 120,000

Adjusted increase

- 170,000

Ds ownership %

40%

Investment in K, Aug. 31, Year 2

- 68,000
2,032,000

Non-controlling interest on balance sheet


Common shares of N

1,000,000

Retained earnings of N

1,950,000

Less: unrealized profit in ending inventory


([850,000 630,000] x .6)

- 132,000

Total shareholders' equity

1,818,000
2,818,000

2,080,000

Unamortized acquisition differential

4,898,000
20%
Non-controlling interest, Aug. 31, Year 2

979,600

Calculation of consolidated profit Year 2


Profit of D

600,000

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

160,000

Dividends from K (150,000 x 40%)

60,000

220,000
380,000

Profit of N

300,000

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


amortization of acquisition differential

- 132,000
- 70,000

Adjusted profit

98,000

Profit of K

100,000

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


Adjusted profit

- 120,000
- 20,000

Ds ownership %

40%

Consolidated profit, Year 2

- 8,000
470,000

Attributable to:
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Shareholders of D
Non-controlling interests (20% x 98,000)

450,400
19,600
470,000

Case 6-5
REPORT ON ACCOUNTING POLICIES USED IN THE FINANCIAL STATEMENTS OF GOOD
QUALITY AUTO PARTS LIMITED FOR THE YEAR ENDED FEBRUARY 28, Year 11.
To the members of the union, Good Quality Auto Parts Limited:
I have been engaged to analyze the financial statements of Good Quality Auto Parts Limited
(GQ) for the year ended February 28, Year 11 and determine whether there are any
controversial accounting issues. For the purposes of this report, "controversial accounting
issues" will be defined as accounting policies that have the effect of reducing payments under
the profit-sharing plan to the union members.
The existence of the profit-sharing contract creates incentives for the management of GQ to
make accounting choices that reduce net income and thereby reduce the payments that must
be made to the union members. Accounting standards for private enterprises (ASPE) allow
considerable flexibility and judgment by the preparers of financial statements in selecting
accounting policies. Since the company is privately owned, the costs (real or perceived) of
reporting lower income may be small relative to the savings generated. For example, the
effect of lower income on new or existing lenders may be considered less important than the
savings derived from reduced profit sharing. In addition since the term of the contract is only
three years, some of the income deferral may yield permanent savings if the profit-sharing
component is not renewed in subsequent contracts.
In analyzing the accounting policies, I will be taking as strong a position as can be justified to
support the union's objective of making net income as large as possible. This is in conflict with
the objective of management, which is to reduce net income.
Inventory write-down
Accounting practice requires that inventory be measured at the lower of cost and net realizable
value. Thus, if the inventory cannot be sold, management can justify its write-off. However,
since much of the inventory has been on hand for several years, the decision to write it off this
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year raises a question as to the motivation for the write-off. Management could be writing off
the inventory solely to reduce income, thereby reducing the payments required under the
profit-sharing plan. The problem must be considered from two points of view. First, is the
inventory genuinely unsaleable? If not, then the entry to write down the inventory must be
reversed, resulting in a higher net income figure. Assuming that the inventory is unsaleable,
the next question is whether the write-off legitimately belongs in the current period. If the
inventory became unsaleable in the current year, then the write belongs in the current period.
If the inventory was unsaleable in prior years, it should have been written down in prior years.
In that case, the financial statements should be retroactively restated to correct the error in the
appropriate period.
Allowance for returns
The return estimate represents a legitimate cost of doing business during the period. What is
in question is whether the more conservative estimate represents a genuine reflection of a
change in economic conditions or an opportunistic use of accounting judgment to reduce net
income. GQ's auditor would probably not object to the increased expense since conservatism
is a key accounting principle. However, the union's interests are not served by conservatism.
Use of accelerated depreciation
There is no requirement that all assets owned by a firm be depreciated in the same way.
Thus, GQ can argue that the use of an accelerated method on the new equipment better
reflects the pattern in which the assets future economic benefits are expected to be
consumed by GC. We can argue that the portfolio of manufacturing equipment acquired to
produce similar products should be accounted for similarly. If there is no difference between
the new and old equipment with respect to the effect of technological obsolescence, then
either the new asset should be depreciated on a straight-line basis or similar assets acquired
previously should be depreciated on the accelerated method. The financial impact of using
the same depreciation method for both cannot be determined at this point.
Write-off of goodwill
Goodwill should be written down or written off if there has been a permanent impairment of its
value i.e. if the recoverable amount of the cash generating unit in which the goodwill is located
is less than the carrying amount of the net assets, including goodwill, of the cash generating
unit. The fact that the auto parts industry is suffering through poor economic times does not
necessarily imply that what was purchased (the company name, its customers, etc.) no longer
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has any value. The auto industry is very sensitive to economic cycles, and it is expected that
such downturns will occur. (Indeed, their occurrence should have been factored into the
acquisition cost paid by GQ).
Unless GQ can come up with strong evidence that the intangibles purchased have been
impaired, there is no justification for the write-off even though GQ's auditors supported it. It is
important to emphasize that their support may rest in conservatism: auditors are willing to
accept accounting treatments that are conservative. However, conservatism is inconsistent
with the union's objectives. The value of the asset acquired in Year 5 must still exist unless
there is specific evidence of its impairment. GQ should provide evidence of impairment.
Unrealized profits from intercompany sales
The unrealized profit from intercompany sales should be eliminated when preparing
consolidated financial statements. CG has not made any adjustments for these intercompany
transactions for Year 11. The unrealized profit in ending inventory is $28,000 (10% x 800,000 x
35%). When this profit is eliminated, CGs net income will decrease by $28,000. The
unrealized profit in beginning inventory is $70,000 (200,000 x 35%). When adjusting for this
profit, CGs net income will increase by $70,000. Therefore, CGs Year 11 net income should
be increased by $42,000 (70,000 28,000).
Bonus to president and chairman
The compensation approach selected by the senior managers has a significant effect on the
money paid to the union members. Since bonuses are deducted from income whereas
dividends are not, the maximum effect of the change in compensation for union members is
$500,000 (an average of $2,500 per employee). If the amount of compensation has remained
more or less the same as in prior years, with only the method of payment changing, then an
argument can be made that GQ is violating the spirit of the contract by changing the method.
Change to tax allocation
Under ASPE, CG has the choice to use either the taxes-payable method or the liability method
of accounting for income taxes. Accordingly, the new method is acceptable under ASPE. We
could argue that the change is in violation of the contract, as the contract was signed on the
understanding that major accounting policies would remain the same. The arbitrator may
accept this argument. The arbitrator, however, would likely demand consistent treatment of
accounting changes.

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Case 6-6
REPORT TO PARTNER ON PLEX-FAME CORPORATION
Overview
PFC is a public corporation. Therefore, the financial statements will be used by stakeholders
for a variety of purposes, including the evaluation of the company and its management. As a
result, the managers have incentives to increase or smooth earnings to influence the share
price or present a favourable impression of themselves to the stakeholders. In addition, the
company is expanding rapidly and, therefore, may need to raise capital. By using accounting
choices to increase earnings or otherwise improve the appearance of the financial statements,
management may be attempting to reduce the cost of capital by lowering the cost of debt or
increasing the selling price of the shares. The company may have a competing objective of
minimizing tax by choosing accounting policies that reduce income in cases where Revenue
Canada requires for tax purposes the same accounting policies that are used in the generalpurpose financial statements. PFC also wants to ensure it does not violate the debt covenant
and wants to keep the debt to equity ratio below 2:1.
Given that PFC is a public company and that it may raise capital, it is likely that management
would choose accounting policies that increase income. Its financial statements must be in
compliance with International Financial Reporting Standards (IFRSs).
The issues are discussed below. The impact of the accounting and reporting on the key
metrics (income, debt and equity) are shown in the appendices. Appendix I shows the
accounting impact for the issues where the accounting was not specified in the case. Appendix
II shows the impact when the companys policies must be changed to be in accordance with
GAAP.
Penalty payment
PFC received a $2 million payment from a contractor who built a theatre complex for PFC in
Montreal. The payment was for completing the project late. In its attempt to increase income,
management will want to record the penalty as revenue.
Arguments could be made for treating the penalty payment either as income (revenue or
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reduction of expenses) or as a reduction in the capital cost of the complex (balance sheet).
If PFC incurred additional costs because of the delay in opening the new complex, and the
penalty was compensation for those additional costs incurred, then the penalty should be used
to offset those costs incurred. If the additional costs incurred related to the capital cost of the
complex, then the penalty should be used to reduce the capital cost of the complex. Analogies
might be drawn with the IFRS standard on government grants (IAS 20).

This section

recommends that payments such as grants should be treated as cost reductions. The parallel
here is that the penalty payment is like a grant and therefore should be treated as a reduction
in the capital cost of the complex or in costs expensed as incurred.
On the other hand, if the penalty payment was compensation for lost revenue, then an
argument might be made for treating the penalty as revenue. If the penalty is treated as
revenue, then we must consider whether it should be disclosed separately. Since the penalty
payment is non-recurring, financial statement users would find separate disclosure informative
because the portion of revenue and income that is non-recurring can be valued differently by
the market and by individual investors and influence the evaluation of management.
Therefore, if material, the penalty should be disclosed as a separate revenue item either on
the face of the income statement or in the notes.
Rue St. Jacques
Ticket proceeds
PFC would prefer to recognize revenue as early as possible with the earliest date being the
sale of the tickets. However, the most appropriate treatment for recognizing revenue for Rue
St. Jacques is when the show is performed.
IAS 18, paragraph 15- Admission fees, requires revenue from artistic performances, banquets
and other special events is recognized when the event takes place. When a subscription to a
number of events is sold, the fee is allocated to each event on a basis which reflects the extent
to which services are performed at each event.
Performance is the critical event in the earnings process, and therefore revenue is not earned
until the show is put on. There is no assurance that the production will be completed, or that
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any performance for which tickets are sold will take place (for example, the show could be
closed down before it begins its run or even after it begins its run). In that case, it will be
necessary to refund the acquisition cost of tickets to buyers.
Interest on ticket proceeds
PFC earns a significant amount of interest by holding the money paid in advance by ticket
purchasers. The interest revenue could be treated as either income or deferred revenue
depending on the facts and circumstances. Managements preference will be to include the
interest in income since it will serve to improve the bottom line. Immediate recognition of
interest revenue is justifiable. If the show is cancelled, PFC will be able to keep the interest
revenueonly the amount paid for the tickets will be refunded. In addition, by buying their
seats in advance, purchasers guarantee their seats but pay a premium for the guarantee (the
interest earned by PFC and forgone by the purchasers).
On the other hand, interest may be factored into the price and constitute a discount from future
higher prices. That is, PFC may be providing a discount to people who purchase their tickets
in advance. Prices may rise in the future. If this is the case, then treating the interest as
deferred revenue may make sense.
Pre-production costs
PFC has incurred significant costs in advance of the opening of Rue St. Jacques. We must
determine whether these costs should be capitalized and amortized, or expensed as incurred.
PFC would likely prefer to capitalize costs since this treatment would minimize the current
effect on income at a time when it is considering going to the capital markets. In principle,
capitalization and amortization of the costs over the life of the show appears reasonable. The
issue is whether the show will generate adequate revenues (in excess of the capitalized costs)
to justify including them on the balance sheet as assets.

It is very difficult, however, to

determine whether a theatre production will be successful. Indications are that the show will
be a success, given its long run in Paris and the extent of advance ticket sales. These facts
support capitalization; expensing would likely be too conservative in light of these facts.
However, despite these indicators of success, the show could still bomb if costs are excessive
or it does not suit the tastes of Canadian theatre goers. As long as the definition of as asset
can be met, setting it up as an asset is acceptable.
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If PFC chooses to capitalize the pre-production costs, they must be amortized over a
reasonable period of time. One method is to expense costs against net revenues dollar for
dollar until the pre-production costs are covered (i.e. cost recovery first method). With this
method the show will generate no income until the pre-production costs have been recovered.
A second alternative is to amortize over the estimated life of the show.
Of course, once the show opens, ongoing production costs should be expensed as incurred.
Advertising and promotion
PFC paid $12 million for advertising and promotion costs a large part of which related to the
Rue St. Jacques show.These costs should be expensed as incurred because it is difficult to
assess the effectiveness of advertising costs i.e. to determine whether they provide future
benefit.
Debt defeasance
PFC has structured the debt-retirement transaction as an in-substance defeasance of debt.
The effect of the transaction is to remove debt from the balance sheet and thereby reduce the
amount of debt reported (thus, for example, decreasing the debt-to-equity ratio).
Unfortunately, IFRSs do not allow the use of this type of arrangement.
IAS 1, paragraph 32 states An entity shall not offset assets and liabilities or income and
expenses, unless required or permitted by an IFRS. Paragraph 33 states An entity reports
separately both assets and liabilities, and income and expenses. Offsetting in the statements
of comprehensive income or financial position or in the separate income statement (if
presented), except when offsetting reflects the substance of the transaction or other event,
detracts from the ability of users both to understand the transactions, other events and
conditions that have occurred and to assess the entitys future cash flows.
IAS 32 (para. 42) includes the following requirement:
A financial asset and a financial liability shall be offset and the net amount presented in the
balance sheet when, and only when, an entity:
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a.

currently has a legally enforceable right to set off the recognized amounts; and

b.

intends either to settle on a net basis, or to realize the asset and settle the liability
simultaneously.

Both of these conditions must be met in order to offset a financial asset and a financial liability.
However, the facts indicate that the holders of the companys syndicated loan are not even
aware of PFCs intended method of settling its debt. Therefore, the first condition for offsetting
has not been met, i.e. PFC has no legally enforceable right to set off the amounts recognized
for its syndicated loan, its investment in treasury bills and its forward contract. Therefore, this
arrangement would not allow the removal of these items from PFCs balance sheet.

The

treasury bonds and the debt must be reinstated on the financial statements and reported
separately as an asset and a liability. The $5 million difference between the value of the asset
and the liability must be reversed. This will increase income if the difference was previously
recorded as a loss or will reduce a non-current asset if it was previously recorded as a deferred
charge.
From the information obtained to date, it is not currently clear how PFC is accounting for its
forward contract. PFC may want to consider whether the forward contract to buy US dollars
qualifies as a hedge of its debt obligation. If hedge accounting is not applied, then PFC will be
required to account for the forward contract as a derivative instrument measured at fair value
through the profit and loss.
Sale of theatres
PFC began selling theatres recently where economic conditions justified the sale of a particular
theatre. This year, a significant part of net income was generated through the sale of theatres.
PFC has included the proceeds from these sales as revenue on the income statement (as
opposed to treating them as gains or losses on disposition) because it considers such sales as
an ongoing part of its operations. However, the sales could also be considered incidental to
ongoing operations, with only gains or losses on disposition being reported in the income
statement.

In the latter case, the gains and losses would not be included in revenues.

Including the proceeds from the sale of theatres is consistent with managements objective of
making the financial statements more attractive for going to the capital markets.

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Based on the information available, it is not possible to conclude whether these sales do
represent part of ongoing operations. We should review the sale agreements and board
minutes to confirm that these sales are indeed ongoing. If the sales are ongoing, the theatres
would have to be reported as a current asset similar to inventory. If the theatres continue to be
reported as part of property, plant and equipment, then it would be inappropriate to report the
sales through revenue; the sales should be reported as gains on sale.
If the sales can be considered part of ongoing operations, consideration should be given to
whether there should be separate disclosure of the revenue from theatre sales. Burying the
revenues from theatre sales will make it more difficult for users and the capital markets to
value the company because revenue from sales of theatres may not be as regular or
predictable as revenues from other sources. If such sales are material, separate disclosure of
revenue should be made either on the face of the income statement or in the notes.
Selling off a significant number of theatres raises the question of whether the number being
sold is large enough to be considered a discontinued operation, requiring separate disclosure
of information.

For the theatre sales to qualify as a discontinued operation, they must

represent a separate major line of business or geographical area of operations.

My

assessment is that the sale of theatres should not be considered a discontinued operation
because PFC is continuing in the theatre business. If, for example, PFC were ceasing to
operate all of its movie theatres to focus on live theatre, an argument for discontinued
operations might be made. In this case, the sale of theatres appears to be part of a continuing
reassessment of its portfolio of theatres.
The sales for profit are consistent with managements apparent objective of income
maximization. Management could manipulate the situation by selling only theatres that would
generate a profit (instead of selling ones that have more economic value in some other use).
PFC will need to consider the balance sheet classification of the theatres it intends to sell, i.e.,
whether they should be classified as non-current assets held for sale. A non-current asset
should be classified as held for sale if its carrying amount will be recovered principally through
a sale transaction rather than through continued use, which seems to be the case here.
However, certain additional criteria must be met to classify an asset as held for sale, which
would also need to be considered. If these criteria are met, then the theatre held for sale
should be measured at the lower of its carrying amount and fair value less costs of disposal.
Non-current assets held for sale (or assets and liabilities of a disposal group classified as held
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for sale) are presented separately on the balance sheet.


Partnership agreement
PFC formed a partnership with an unrelated company whereby the other company contributed
cash and PFC contributed television production equipment. As part of the deal, PFC withdrew
the cash contributed by the other company for its own use. The substance of the transaction
appears to be the sale (rather than contribution) of assets to the partnership and the recording
of the gain on sale. By using this approach, management may be attempting to increase
income artificially by recognizing the full gain.
The facts suggest that this transaction is a partial sale of assets. If this is the case, the full
gain should not be recognized. The facts supporting this assertion are as follows. First, cash
can be withdrawn immediately; thus the partnership acted as a conduit for selling of the
assets. Second, the deal is based on future profits; that is, the value of PFCs contribution
appears to be dependent on the future performance of the partnership.

Third, Odyssey

appears to be offering little expertise to the partnership and thus cash is simply being funneled
to PFC via the partnership. If this transaction is just a partial sale of assets, the gain should
only be $10.75 million ($40 million -0.45 (portion of assets sold) x $65 million (carrying amount
of assets sold)) rather than $25 million.
The method preferred by PFC (recording full sale of the assets) might be supported by the fact
that future profits will be shared, suggesting that this is a legitimate partnership arrangement.
However, more information is required to understand how the value of PFCs contribution may
be adjusted if the net income of Phantom earned between July 1, Year 7 and June 30, Year 8
does not meet expectations, since this adjustment would appear to impact the calculation of
each partners respective interests.
In assessing the substance of this transaction, we must consider managements intentions.
We will have to discuss the transaction with management and review pertinent documents to
determine its substance.

We can then form an opinion on the appropriate method of

accounting.
The accounting for the investment in the partnership depends on PFCs level of influence over
the operating and financing policies for the partnership. With a 55% interest, PFC may be able
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33

to determine these policies and would have control over the partnership. If so, they would
consolidate the partnership financial statements with their own financial statements.
If both parties to the partnership have equal say over the policies of the partnership, then the
partnership would be deemed to be a joint venture. Under IFRS 11, PFC could report its
investment using the equity method.
Conclusion
As indicated in Appendix I, income would decrease if the pre-production costs and/or
advertising costs have been capitalized and should have been expensed. As indicated in
Appendix II, income should be reduced for the unrealized gain on the transfer of assets to the
partnership and debt should be increased to reverse the debt defeasance transaction. After
adjustment, the return on equity on an annualized basis is only 18.8%, which is below the
companys target return on equity. The debt to equity ratio is 1.98, which is slightly below the
maximum amount set in the debt covenant. We will need to review major transactions in the
last month of the year to ensure they are accounted for correctly. Otherwise, the company
could be in violation of their debt covenant. This would raise concerns of the companys ability
to continue as a going concern.
APPENDIX I
IMPACT OF ACCOUNTING ENTRIES ON KEY METRICS
(in millions)
Transaction

Income

Debt

Equity

ROE Debt:Equity

Penalty Payment
- report as income

I*

D*

1.7

1.7

- report as reduction of capital cost


Rue St. Jacques ticket
- report as unearned revenue
Interest on ticket proceeds
- report as income
- report as deferred revenue
Pre-production costs

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- capitalize and later expense


- expense as incurred

(15)

(15)

(12)

(12)

Advertising & promotion costs


- capitalize and later expense
- expense as incurred
Debt defeasance
- if loss was previously recorded
- if deferred charge was recorded
Sale of theatres as revenue
Investment in partnership
- if full consolidation

- if proportionate consolidation

* Notations:
I = increase
D = decrease
NOTHING NOTED = no change

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APPENDIX II
IMPACT OF ACCOUNTING CHANGES ON KEY METRICS
(in millions)
Adjustment
Unadjusted position
Interest on tickets deferred

Income

Debt

Equity

147

1,490

780

(1.7)

ROE Debt:Equity
18.8%

1.91

17.2%

1.98

(1.7)

Debt defeasance

25

Investment in partnership
- reduce gain to 10.75

(14.25)

Adjusted position

131.05

(14.25)
1,515

764.05

Annualized to 12 months (times 12/11)

18.8%

Target ROE

20.0%

Maximum debt to equity ratio

2.00

SOLUTIONS TO PROBLEMS
Problem 6-1
(a)
Intercompany balances
Sales and purchases for Year 3

180,000 (a)

Accounts receivable and payable at end of Year 3


Intercompany inventory profits

40,000 (b)
Before

40%

After

tax

tax

tax

Opening inventory Sub selling (60,000 x .3)

18,000

7,200

10,800 (c)

Closing inventory Sub selling (70,000 x .3)

21,000

8,400

12,600 (d)

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Consolidated account balances


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

779,000

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

880,000

Retained earnings, beginning of year


PAT

2,400,000

SAT R/E, beginning of year

1,100,000

SAT R/E, date of acquisition

900,000

Change since acquisition

200,000

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


189,200
PATs share

x 90%

170,280

Consolidated retained earnings

2,570,280

Sales (4,000,000 + 2,500,000 (a) 180,000)

6,320,000

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

4,623,000

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

128,800

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

Problem 6-2
(a)
Intercompany revenues and expenses
Sales and purchases (100,000 + 80,000)

180,000 (a)

Rent revenue and expense

24,000 (b)

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

35,000 (c)

Intercompany inventory profits


Opening inventory Sub selling

Before

40%

After

tax

tax

tax

2,000

3,000 (d)

5,000

Closing inventory Parent selling


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(100,000 x .50 x .30)

15,000

6,000

9,000 (e)

Calculation of non-controlling interest:


Income of subsidiary (9,000 / 10%)

90,000

Add: opening inventory profit

(d) 3,000

Adjusted

93,000
10%
9,300 (f)
Parent Company
Consolidated Income Statement
for the Current Year

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

320,000

Rental revenue (24,000 (b) 24,000)


Interest revenue (50,000 (c) 35,000)
Total revenue

15,000
335,000

Cost of goods sold


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

180,000

Rent expense (24,000 (b) 24,000)


Interest expense (35,000 (c) 35,000)
Administration expenses

45,000

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

38,000

Total expense
Profit

263,000
72,000

Attributable to:
Shareholders of parent
Non-controlling interests (f)

62,700
9,300
72,000

Proof:
Profit previously reported
Add: opening inventory profit (3,000 x 90%)

69,000
2,700
71,700

Less: closing inventory profit


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

Problem 6-3
Pike
December 31, Year 1
Land
Gain on Sale
Income Tax on Gain

Spike

100,000

December 31, Year 2


Land
Gain on Sale
Income Tax on Gain

128,000

Consolidate
d
115,000*

115,000*
28,000
11,200***

December 31, Year 3


Land
Gain on Sale
Income Tax on Gain
* = fair value of land at date of acquisition

12,000
4,800***

25,000**
10,000***

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


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

Problem 6-4
(a)
Acquisition differential amortization
Plant Waste
Years 1 5 ([15,000 / 8 years] x 5 years)

9,375 (a)

Year 6 (15,000 / 8 years)

1,875 (b)

Goodwill Baste
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Years 4 5

19,000 (c)

Year 6

Intercompany Revenues and Expenses


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

410,000 (d)

Rent (25,000 + 14,000)

39,000 (e)

Interest

10,000 (f)

Dividend Income: All intercompany from Waste & Baste

43,750 (g)

Intercompany Profits
Before tax

40% tax

After tax

Opening inventory Waste selling


(15,000 x .30)
Ending inventory

4,500

1,800

2,700 (h)

18,000

7,200

10,800 (i)

6,600

2,640

3,960 (j)

18,000

7,200

10,800 (k)

42,600

17,040

25,560) (l)

Baste selling
(60,000 x .30)
Paste selling
(22,000 x .30)
Waste selling
(60,000 x .30)

Paste Company
Consolidated Income Statement
for the Year Ended December 31, Year 6
Sales (450,000 + 270,000 + 190,000 (d)410,000)

500,000

Dividends (43,750 (g) 43,750)


Interest (10,000 (f) 10,000)
Rent (130,000 (e) 39,000)
Total income
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Cost of sales (300,000 + 163,000 + 145,000 (d) 410,000


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

237,975

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

131,000

Interest (10,000 (f) 10,000)


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

93,760

Total expenses

462,735

Profit

128,265

Attributable to:
Shareholders of Paste

109,910

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

18,355
128,265

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

(b)
Calculation of consolidated retained earnings December 31, Year 6
Retained earnings of Paste December 31, Year 6

703,750

Profit in ending inventory

(j)

Retained earnings of Waste December 31, Year 6

(3,960)

146,000

Retained earnings of Waste acquisition

40,000

Increase

106,000

Less: profit in ending inventory

(k)

10,800

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


Adjusted increase

83,950

Paste's ownership %

80%

Retained earnings of Baste December 31, Year 6

79,000

Retained earnings of Baste acquisition

80,000

Decrease

(1,000)

Less: amortization of acquisition differential for Baste (c)

19,000

profit in ending inventory

(i)

67,160

10,800
(30,800)

Paste's ownership %

75%

Consolidated retained earnings December 31, Year 6


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(c)
Profit of Waste
Add: profit in opening inventory

104,000
(h)

2,700
106,700

Less: profit in ending inventory


amortization of acquisition differential

(k)

10,800

(b)

1,875
94,025

Pastes share

x 80%

Profit of Baste

9,000

Less: profit in ending inventory

(i)

75,220

10,800
(1,800)

Pastes share
Profit in ending inventory Paste selling
Investment income from subsidiaries

x 75%

- 1,350

(j)

- 3,960
69,910

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

Problem 6-5
(a)

X's equity method journal entries

Year 1

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Cash

18,750

Investment in Y Co.

18,750

75% x $25,000 dividends.


Investment in Y Co.

97,500

Investment income

97,500

75% x $130,000 net income.


Investment income

13,500

Investment in Y Co.

13,500

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


inventory profit Y selling
(60% x $30,000 = $18,000).
Investment income

22,200

Investment in Y Co.

22,200

To hold back the after-tax land profit


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

47,250

Investment in Y Co.

47,250

Acquisition differential amortization Year 1


Inventory
Equipment

60,000
$45,000/15 =

3,000
63,000

x Co.s share (@ 75%)

47,250

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


Year 2
Cash

3,750

Investment in Y Co.

3,750

75% x 5,000 dividends.


Investment income

12,000
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Investment in Y Co.

12,000

75% x 16,000 net loss.


Investment income

2,250

Investment in Y Co.

2,250

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


Investment in Y Co.

13,500

Investment income

13,500

To realize opening inventory profit Y selling.


Investment in Y Co.

22,200

Investment income

22,200

To realize land profit X Selling


Investment income

7,200

Investment in Y Co.

7,200

To hold back after-tax inventory profit X selling


(60% x $12,000)
Note: Year 2 investment income is $14,250 (12,000 2,250 + 13,500 + 22,200 7,200)

(b) Calculation of consolidated net income Year 1


Net income of X

400,000

Less: Land profit

22,200

Adjusted

377,800

Net income of Y

130,000

Less: closing inventory profit

(18,000)

acquisition differential amortization


Adjusted

(63,000)
49,000

Consolidated net income

426,800

Attributable to:
Shareholders of X
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Non-controlling interests (25% x 49,000)

12,250
426,800

Calculation of Consolidated Net income Year 2


Net income of X

72,000

Less: closing inventory profit

7,200
64,800

Add: land profit realized

22,200

Adjusted net income

87,000

Net income (loss) of Y

(16,000)

Add: opening inventory profit realized

18,000

Less: acquisition differential amortization

(3,000)

Adjusted net income

(1,000)

Consolidated net income

86,000

Attributable to:
Shareholders of X

86,250

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

(250)
86,000

(c)
Changes in Non-controlling Interest
Years 1 and 2
Balance Jan. 1 Year 1 [25% x (170,000 + 105,000)]

68,750

Allocation of Y Co.s adjusted net income Year 1


(25% x 49,000)

12,250
81,000

Less: dividends (25% x 25,000)

6,250

Balance Dec. 31, Year 1

74,750

Allocation of Y Co.s adjusted net income Year 2


(25% x - 1,000)

(250)
74,500

Less: dividends (25% x 5,000)

1,250

Balance Dec. 31, Year 2

73,250

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Proof:
Y - Common shares

100,000

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

154,000

- Shareholders' equity Dec. 31, Year 2

254,000

- Unamortized acquisition differential

39,000
293,000
25%
73,250

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


As at December 31, Year 2
Shareholders' equity of Y Jan. 1, Year 1

170,000

Acquisition differential
105,000
275,000
X's ownership

75%

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

206,250

Investment income Year 1

14,550

Year 2

14,250

28,800
235,050

Less: Dividends received


Year 1 (75% x 25,000)

18,750

Year 2 (75% x 5,000)

3,750

Investment in Y Dec. 31, Year 2

22,500
212,550

Proof:
Shareholders' equity of Y

254,000

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

39,000
293,000

X's ownership

75%
219,750

Less: Holdback of inventory profit X selling

7,200

Investment in Y, December 31, Year 2

212,550

Problem 6-6
Intercompany profits
Before tax

40% tax

After tax

Opening inventory Q selling

80,000

32,000

48,000 (a)

L selling

52,000

20,800

31,200 (b)

Ending inventory

Q selling

35,000

14,000

21,000 (c)

L selling

118,000

47,200

70,800 (d)

(a) Calculation of consolidated profit


Profit of L

580,000

Less: Dividends
From M (80% x 200,000)

160,000

From Q (70% x 150,000)

105,000

Ending inventory profit

(d)

70,800

335,800
244,200

Add: opening inventory profit

(b)

31,200

Adjusted profit

275,400

Profit of M

360,000

Profit of Q
Less: ending inventory profit

240,000
(c)

21,000
219,000

Add: opening inventory profit

(a)

48,000
267,000

Consolidated profit

902,400

Attributable to:
Shareholders of L

750,300

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

152,100
902,400

(b)
Calculation of consolidated retained earnings beginning of current year
Retained earnings of L

976,000

Less: opening inventory profit

(b)

Adjusted

31,200
944,800

Retained earnings of M

843,000

Acquisition retained earnings

500,000

Increase

343,000

L's ownership

80%

Retained earnings of Q

274,400

682,000

Acquisition retained earnings

50,000

Increase

632,000

Less: opening inventory profit

(a)

Adjusted increase

48,000
584,000

L's ownership

70%

Consolidated retained earnings beginning of year

408,800
1,628,000

Problem 6-7
Calculation, allocation, and amortization of acquisition differential
Cost of 80% investment, Jan. 1, Year 3

1,600,000

Implied value of 100% investment

2,000,000

Carrying amounts of Least's net assets:


Assets

3,000,000

Liabilities

1,500,000

Total shareholders' equity

1,500,000

Acquisition differential

500,000

Allocation:

FV - CA

Accounts receivable

- 20,000

Inventories

- 50,000

Plant and equipment (net)

35,000

Long-term liabilities

100,000

Balance goodwill

435,000
Balance

Amortization

Balance

Jan. 1

Dec. 31

Year 3

Years 3 to 8

Accounts receivable

- 20,000

- 20,000

Inventories

- 50,000

- 50,000

35,000

26,250

100,000

100,000

Plant and equipment (net)


Long-term liabilities

65,000

Year 9

4,375

Year 9

4,375 (a)

Goodwill

435,000

52,200

500,000

108,450 (c)

8,700

374,100 (b)

13,075 (d) 378,475

Intercompany revenues and expenses


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

3,500,000 (e)

Intercompany profits
Before tax

40% tax

After tax

50,000

20,000

30,000 (f)

62,500

25,000

37,500 (g)

257,142

102,857

154,285 (h)

319,642

127,857

191,785 (i)

100,000

40,000

60,000 (j)

214,284

85,714

128,570 (k)

Loss on land, July 1, Year 7


realized in Year 9

Most selling

Opening inventory Most selling


(312,500 x 0.20)
Least selling
(857,140 x 0.30)

Ending inventory

Most selling
(500,000 x 0.20)
Least selling
(714,280 x 0.30)

314,284 (l)
Intercompany dividends declared but not paid (80% x 100,000)
Deferred income taxes ending inventory

(40,000 + 85,714)

125,714

188,570
80,000 (m)
125,714 (n)

Calculation of consolidated retained earnings Jan. 1 Year 9


Retained earnings of Most, Jan. 1, Year 9
(10,400,000 1,000,000 + 350,000)

9,750,000

Less: Profit in opening inventory

(g)

37,500

9,712,500
Add: land loss

(f)

Adjusted retained earnings

30,000
9,742,500

Retained earnings of Least, Jan. 1, Year 9


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

2,000,000

Retained earnings of Least at acquisition

1,000,000

Increase
Less: profit in opening inventory
amortization of acquisition differential

1,000,000
(h) 154,285
(c) 108,450

Adjusted increase

737,265

Most's ownership %

(o)

80%

Consolidated retained earnings, Jan. 1, Year 9

589,812
10,332,312

Calculation of consolidated net income Year 9


Net income of Most

1,000,000

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

80,000

Profit in closing inventory

(j)

60,000

Land loss

(f)

30,000

170,000
830,000

Add: profit in opening inventory

(g)

Adjusted net income

867,500

Net income of Least


Add: profit in opening inventory

37,500

400,000
(h) 154,285
554,285

Less: profit in closing inventory


amortization of acquisition differential
Adjusted net income
Consolidated net income

(k) 128,570
(d)

13,075
412,640
1,280,140

Attributable to:
Shareholders of Most
Non-controlling interests (20% x 412,640)

1,197,612
82,528
1,280,140

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


Leasts common shares, Jan. 1, Year 9

500,000

Retained earnings of Least, Jan. 1, Year 9

2,000,000

Less: profit in opening inventory

(h) 154,285

Adjusted retained earnings

1,845,715

Unamortized acquisition differential (500,000 108,450)

391,550
2,737,265

NCIs ownership %

20%

NCI, Jan. 1, Year 9

547,453

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


Non-controlling interests at date of acquisition (20% x [1,600,000 / .8)
Leasts adjusted increase in retained earnings (n)

400,000

737,265

NCIs share @ 20%

147,453

NCI, Jan. 1, Year 9

547,453

(a)

Most Company
Consolidated Statement of Changes in Equity
For Year Ended December 31, Year 9

Balance, beginning of year

Common

Retained

Stock

Earnings

Total

1,000,000 10,332,312 11,332,312

NCI

Total

547,453 11,879,765

Add: net income

1,197,612

1,197,612

82,528

1,280,140

Less: dividends

(350,000)

(350,000)

(20,000)

(370,000)

Balance, end of year

1,000,000 11,179,924 12,179,924

609,981 12,789,905

Proof of consolidated retained earnings, end of Year 9


Retained earnings of Most, Dec. 31, Year 9

10,400,000

Less: profit in ending inventory

(j)

Adjusted retained earnings

60,000

10,340,000

Retained earnings of Least, Dec. 31, Year 9

2,300,000

Retained earnings of Least at acquisition

1,000,000

Increase

1,300,000

Less: profit in ending inventory

(k) 128,570

amortization of acquisition differential


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

121,525

Adjusted increase

1,049,905

Most's ownership %

(p)

80%

839,924

Consolidated retained earnings, Dec. 31, Year 9

11,179,924

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


Retained earnings of Least

2,300,000

Common shares of Least

500,000

Total shareholders' equity

2,800,000
(k)

Less: profit in ending inventory


Adjusted shareholders' equity

128,570
2,671,430

Add: unamortized acquisition differential

378,475
3,049,905
20%

Non-controlling interest, Dec. 31, Year 9

609,981

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


Non-controlling interests at date of acquisition (20% x [1,600,000 / .8])
Leasts adjusted increase in retained earnings (o)
NCIs share @ 20%

400,000

1,049,905
209,981

Non-controlling interest, Dec. 31, Year 9

(b)

609,981

Most Company
Consolidated Balance Sheet
December 31, Year 9

Cash (500,000 + 40,000)


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

540,000
2,120,000

Inventories (2,300,000 + 1,200,000 (l) 314,284)

3,185,716

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

12,204,375

Land (700,000 + 260,000)

960,000

Goodwill

(b)

374,100

Deferred income taxes

(n)

125,714

Total assets

19,509,905

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

720,000

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

6,000,000

Common shares

1,000,000

Retained earnings

11,179,924

Non-controlling interest

609,981

Total liabilities & shareholders' equity

19,509,905

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

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

Problem 6-8
Intercompany profits
Before tax

40% tax

After tax

Opening inventory L selling

5,000

2,000

3,000 (a)

Ending inventory K selling

8,000

3,200

4,800 (b)

(a)
December 31
Cash

20,200

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

4,750

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

2,700

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

12,750

To record dividends received from subsidiary companies.


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

19,000

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

25,500

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

4,500

Investment income

40,000

To record share of subsidiaries' profit


Investment Income

1,230

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

2,850

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

4,080

To hold back after-tax inventory profit in ending inventory (K Co.) and add back after-tax
inventory
profit in beginning inventory (L. Co.)
Investment Income is $40,000 $1,230 = $38,770.

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


Profit of L

20,000

Add: profit in opening inventory

(a)

Adjusted profit

3,000
23,000

H Co.'s ownership %

95%

Profit of J

21,850

(5,000)

H Co.'s ownership %

90%

Profit of K

(4,500)

30,000

Less: profit in ending inventory

(b)

Adjusted profit

4,800
25,200

H Co.'s ownership %

85%

Consolidated profit attributable to shareholders of H Co. Year 5

(c)

21,420
38,770

H Company
Consolidated Retained Earnings Statement
for the Year Ended December 31, Year 5

Retained earnings, January 1

12,000

Add: profit

38,770
50,770

Less: dividends

10,000

Retained earnings, December 31

40,770

Problem 6-9
Intercompany profits

Opening inventory* Purple selling


Ending inventory Purple selling

Before

40%

After

tax

tax

tax

95,538

38,215

57,323

194,000

77,600

116,400

56,500

22,600

33,900

Land Purple selling


(260,000 203,500)
*

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

414,000

Inventory at cost (414,000 / 1.30)

318,462

Profit

95,538

Calculation of consolidated net income attributable to Purples shareholders current


year
Net income of Purple

568,100

Add: opening inventory profit

57,323
625,423

Less: Ending inventory profit


Land profit

116,400
33,900

Adjusted profit

475,123

Net income of Sand

248,670

Purples ownership

70%

Consolidated net income attributable to Purples shareholders current year


Note:

150,300

174,069
649,192

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

Problem 6-10
Intercompany revenues and expenses
Sales and purchases (90,000 + 177,000)

267,000 (a)

Rental revenue and expense (2,800 x 12)

33,600 (b)

Interest revenue and expense (360,000 x 0.05)

18,000 (c)

Intercompany profits
Before tax

40% tax

After tax

4,250

1,700

2,550 (d)

3,300

1,320

1,980 (e)

7,550

3,020

4,530 (f)

5,750

2,300

3,450 (g)

900

360

540 (h)

6,650

2,660

Opening inventory Evans selling


(21,250 [21,250 / 1.25])
Falcon selling
(11,000 x 0.3)
Ending inventory

Evans selling
(28,750 [28,750 / 1.25])
Falcon selling
(3,000 x 0.3)

3,990 (i)

Calculation of consolidated profit current year


Profit of Evans

61,900

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


Profit in ending inventory

32,000
(g)

3,450

35,450
26,450

Add: profit in opening inventory

(d)

Adjusted profit

29,000

Profit of Falcon
Less: profit in ending inventory

2,550

75,500
(h)

540
74,960

Add: profit in opening inventory

(e)

1,980
76,940

Consolidated profit
Attributable to:

105,940

Shareholders of Evans

90,552

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

15,388
105,940

(a)

Evans Company
Consolidated Income Statement
for the Current Year

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

783,000

Raw materials & finished goods purchased


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

329,000

Changes in inventory
(20,000 + 25,000 (f)7,550 + (i)6,650)

44,100

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

216,400

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

12,000

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

75,560

Total expenses

677,060

Profit

105,940

Attributable to:
Shareholders of Evans

90,552

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

15,388
105,940

(b)
Calculation of consolidated retained earnings beginning of year
Retained earnings of Evans, beginning of year

632,000

Less: profit in opening inventory

(d)

Adjusted retained earnings

629,450

Retained earnings of Falcon, beginning of the year


Less: profit in opening inventory
Adjusted increase since acquisition
Evans' ownership %
Consolidated retained earnings, beginning of year

2,550

348,000
(e)

1,980
346,020
80%

276,816
906,266

Consolidated dividends declared

30,000

Problem 6-11
Calculation, allocation, and amortization of the acquisition differential
Cost of 90% investment, Jan. 2, Year 1

90,000

Implied value of 100% investment

100,000

Carrying amounts of S's net assets:


Common shares

60,000

Retained earnings

20,000

Total shareholders' equity

80,000

Acquisition differential patents

20,000

Amortization:
Years 1 4

(a)

16,000

Year 5

(b)

4,000

Balance, Dec. 31, Year 5

20,000
0

Intercompany profits
Before tax

40% tax

After tax

Opening inventory S selling


(7,000 x 0.40)

2,800

1,120

1,680 (c)

1,200

480

720 (d)

4,000

1,600

2,400 (e)

8,000

3,200

4,800 (f)

2,000

800

1,200 (g)

10,000

4,000

6,000 (h)

10,000

4,000

6,000 (i)

P selling
(3,000 x 0.40)
Ending inventory

S selling
(20,000 x 0.40)
P selling
(5,000 x 0.40)

Sale of land Year 3 S selling (50,000 40,000)

Calculation of consolidated net income Year 5


Net income of P Company

60,000

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

9,000

Profit in ending inventory

(g)

1,200

10,200
49,800

Add: profit in opening inventory

(d)

Adjusted net income

720
50,520

Net income of S Company

48,000

Less: profit in ending inventory

(f)

4,800

patent amortization

(b)

4,000
39,200

Add: profit in opening inventory

(c)

1,680
40,880

Consolidated net income

91,400

Attributable to:
Shareholders of P Co.

87,312

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

4,088
91,400

Calculation of consolidated retained earnings Jan. 1, Year 5


Retained earnings of P, Jan. 1, Year 5
(101,000 + 12,000)

113,000

Less: profit in opening inventory

(d)

Adjusted retained earnings

112,280

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

44,000

Retained earnings of S at acquisition

20,000

Increase since acquisition


Less: Amortization of patents

720

24,000
(a)

16,000

Land gain

(i)

6,000

Profit in opening inventory

(c)

1,680

Adjusted increase
P's ownership %
Consolidated retained earnings, Jan. 1, Year 5

23,680
320
90%

(j)
288
112,568

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


Company S shareholders' equity
Common shares

60,000

Retained earnings

44,000
104,000

Less: Land gain


Profit in beginning inventory

(i)

6,000

(c)

1,680

7,680

Adjusted shareholders' equity

96,320

Unamortized acquisition differential

4,000

100,320
10%
Non-controlling interest, Jan 1, Year 5

10,032

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


Non-controlling interests at date of acquisition (10% x [90,000 / .9)
S Co.s adjusted increase in retained earnings (j)

10,000
320

NCIs share @ 10%

32

Non-controlling interest, Jan 1, Year 5

10,032
P Co.

Consolidated Statement of Changes in Equity


For Year Ended December 31, Year 5

Balance, beginning of year

Common

Retained

Shares

Earnings

Total

NCI

Total

150,000

112,568

262,568

10,032

272,600

87,312

87,312

4,088

91,400

(12,000)

(12,000)

(1,000)

(13,000)

187,880

387,880

13,120

351,000

Add: net income


Less: dividends
Retained earnings, Dec. 31

150,000

Proof:
Retained earnings of P, Dec. 31, Year 5
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(101,000 + 60,000)

161,000

Less: Profit in ending inventory

(g)

Adjusted retained earnings

1,200
159,800

Retained earnings of S, Dec. 31, Year 5


(34,000 + 48,000)

82,000

Retained earnings of S at acquisition

20,000

Increase since acquisition

62,000

Less: Amortization of the patents


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

20,000

Land gain

(i)

6,000

Profit in ending inventory

(f)

4,800

30,800

Adjusted increase

31,200

P's ownership %

90%

Consolidated retained earnings, Dec., 31, Year 5

(k)
28,080
187,880

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


Company S shareholders' equity
Common shares

60,000

Retained earnings

82,000
142,000

Less: Land gain


Profit in ending inventory

(i)

6,000

(f)

4,800

Adjusted shareholders' equity

10,800
131,200

Unamortized acquisition differential

0
131,200
10%

Non-controlling interests, Dec. 31, Year 5

13,120

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


Non-controlling interests at date of acquisition (10% x [90,000 / .9)
S Co.s adjusted increase in retained earnings (k)
NCIs share @ 10%
Non-controlling interest, Jan 1, Year 5

10,000
31,200
3,120
13,120

Problem 6-12
Acquisition differential amortization Year 5
Plant and equipment depreciation (60,000 / 5)

12,000 (a)

Patent amortization (40,000 / 8)

5,000 (b)

Goodwill impairment loss

3,000 (c)
20,000 (d)

Intercompany revenues and expenses


Sales Runner to Road

420,000 (e)

Rental Runner to Road

35,000 (f)

Intercompany profits
Before tax

40% tax

Opening inventory Runner selling

75,000

30,000

45,000 (g)

Ending inventory Runner selling

40,000

16,000

24,000 (h)

(a)

After tax

Road Ltd.
Consolidated Income Statement
for the Year Ended December 31, Year 5

Sales (4,000,000 + 2,100,000 - (e)420,000)


Rental revenue (70,000 - (f)35,000)
Total income

5,680,000
35,000
5,715,000

Materials used in manufacturing


(2,000,000 + 800,000 - (e)420,000)

2,380,000

Change in work-in-progress & finished goods inventory


(45,000 - 20,000 - (g)75,000 + (h)40,000)
Employee benefits (550,000 + 480,000)
Copyright
64

(10,000)
1,030,000

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Interest expense (250,000 + 140,000)

390,000

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

662,000

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

30,000

Goodwill impairment loss

(c)

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

3,000
514,000

Total expenses

4,999,000

Profit

716,000

Attributable to:
Shareholders of Road

625,700

Non-controlling interests
(30% x [300,000 (d)20,000 + (g)45,000 - (h)24,000])

90,300
716,000

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

(c)
The return on equity attributable to shareholders of Road for Year 5 would not change. Only
the NCIs share of consolidated profit would change under the parent company extension
theory. The NCIs share of consolidated profit would increase because the NCIs share of
Runners goodwill and goodwill impairment is not reported under this theory.

Problem 6-13
Calculation, allocation, and amortization of acquisition differential
Cost of 70% investment, January 1, Year 1

63,000

Implied value of 100% investment

90,000

Carrying amounts of Sage's net assets:


Ordinary shares

50,000

Retained earnings

15,000

Total shareholders' equity

65,000

Acquisition differential

25,000

Allocation:

FV CA

Inventory

-12,000

Unfavourable lease agreement

-18,000

-30,000

Balance goodwill

55,000
Balance

Amortization

January 1
Year 1
Inventory

December 31
Years 1 & 2

Year 3

Year 3

- 12,000

- 12,000

-18,000

-7,200

-3,600

-7,200 (a)

55,000

3,060

1,530

50,410 (b)

25,000

- 16,140 (c)

Lease agreement
Goodwill

-2,070 (d)

Intercompany receivables and payables notes

43,210
55,000 (e)

Intercompany revenues and expenses


Management fee

26,500 (f)

Sales and purchases


Post selling

125,000

Sage selling

90,000

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

215,000 (g)
3,300 (h)

Intercompany profits
Before tax
Land

Sage selling

40% tax

After tax

30,000

12,000

18,000 (i)

3,500

1,400

2,100 (j)

7,000

2,800

4,200 (k)

Opening inventory Sage selling


(14,000 x 0.25)
Ending inventory

Sage selling
(28,000 x 0.25)
Post selling

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Modern Advanced Accounting in Canada, Fifth Edition

(18,000 x 0.25)

4,500

1,800

2,700 (l)

11,500

4,600

6,900 (m)

Deferred income taxes December 31, Year 3


Inventory

4,600

Land

12,000
16,600 (n)

Accumulated depreciation at date of acquisition for Sage

10,000 (o)

Calculation of consolidated profit


Profit of Post

107,979

Less: Investment income from Sage1,479


Profit in ending inventory

(l)

2,700

Adjusted profit

4,179
103,800

Profit of Sage

24,000

Add: profit in opening inventory

(j)

2,100
26,100

Add: Amortization of acquisition differential


Less: Profit in ending inventory
Land gain

(d)
(k)

4,200

(i)

18,000

2,070
-22,200

Adjusted profit

5,970

Profit

109,770

Attributable to:
Shareholders of Post

107,979

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

1,791
109,770

(a) (i)

Post Corporation
Consolidated Statement of Profit
For the Year Ended, December 31, Year 3

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


Interest revenue (6,800 (h)3,300)
Total revenue

925,000
3,500
928,500

Cost of goods sold


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

495,000

Interest expense (20,000 (h)3,300)

16,700

Other expense
(180,000 + 74,800 (f)26,500 - (a)3,600)

224,700

Goodwill impairment loss

(b)

1,530

Income tax expense


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

80,800

Total expenses

818,730

Profit

109,770

Attributable to:
Shareholders of Post

107,979

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

1,791
109,770

Calculation of non-controlling interests December 31, Year 3


Ordinary shares

50,000

Retained earnings

81,000

Total shareholders' equity

131,000

Less: Profit in ending inventory


Land gain

(k)

4,200

(i)

18,000

- 22,200

Add: unamortized acquisition differential

43,210

Adjusted shareholders' equity

152,010

Non-controlling interests share

30%

Non-controlling interest, December 31, Year 3


(a) (ii)

45,603

Post Corporation
Consolidated Statement of Financial Position
December 31, Year 3

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

164,000

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

575,000

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


(236,400)
Goodwill
Copyright
68

(b)

50,410

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Modern Advanced Accounting in Canada, Fifth Edition

Deferred income taxes

(n)

16,600

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

49,500

Accounts receivable (17,200 + 9,100)

26,300

Cash (12,200 + 12,900)

25,100

Total assets

670,510

Ordinary shares

100,000

Retained earnings

265,707

Non-controlling interests

45,603
411,310

Unfavourable lease agreement


Accounts payable (212,000 + 40,000)

7,200
252,000

Total shareholders equity & liabilities

670,510

Goodwill impairment loss entity theory

1,530

(b)
Less: NCIs share @30%

459

Goodwill impairment loss parent company extension theory

1,071

NCI entity theory

1,791

NCIs share of goodwill impairment loss

459

NCI parent company extension theory

1,332

(c)
Goodwill entity theory

50,410

Less: NCIs share @30%

15,123

Goodwill parent company extension theory

35,287

NCI entity theory

45,603

NCIs share of goodwill impairment loss

15,123

NCI parent company extension theory

30,480

Problem 6-14
(a)

Acquisition cost Allocation

Acquisition January 1, Year 1

Cost
(60,000 x $80)

4,800,000
Implied value of 100% investment (80,000 shares x $80)
6,400,000
CA: Ordinary Shares

3,500,000

Retained Earnings

2,100,000
5,600,000

Acquisition differential

800,000

Allocati
on:

Life

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Modern Advanced Accounting in Canada, Fifth Edition

Inventory

100,0
00

Cr

1
Land

200,0
00

Dr

Equipment

200,0
00
10

Cr

Patents

400,0
00

Dr

5
L.T. Liability

100,0
00

Cr

4
Subtotal
200,000 Dr
Balance: Goodwill
600,000 Dr
800,000 Dr
Non-controlling interest (20,000 shares @ $80)

1,600,000

Amortization Table:
Allocation

Life
Amortization
Balance
YR 1 YR 4

Inventory
Copyright
72

YR 5

Dec. 3, YR 5
100,000 Cr

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Modern Advanced Accounting in Canada, Fifth Edition

100,000Cr
0
0
Land

200,000 Dr

200,000 Dr
Equipment

200,000 Cr

10

80,000Cr
20,000

Cr

100,000 Cr
Patents

400,000 Dr

320,000Dr
80,000Dr
0
L.T. Liability

100,000 Cr

100,000Cr
0
Goodwill

600,000 Dr
600,000 Dr
800,000 Dr

40,000 Dr
60,000

Dr

700,000 Dr
Devines accumulated depreciation at date of acquisition

500,000

Intercompany Amounts:
Dividends: 500,000 x 75%
375,000
Sales:

Vine (YR 5) 2 M + Devine


(YR 5) 1.2M
3,200,000

Advances from Vine to Devine:


200,000

BT
Land:

Tax

AT

Upstream Gain Sept 1, YR 5

400,000
160,000
240,000

Unrealized Profits:
BT
Tax
AT
Opening
Upstream
100 K
@ 40%
40,000 16,000
24,000

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

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

Copyright
74

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

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Modern Advanced Accounting in Canada, Fifth Edition

120,000

(b)

Consolidated Income Statement for the year ending December 31, Year 5
Sales (11.6 M + 3 M 3.2 M)
11,400,000
Dividend, Investment Income, and Gains
(400 K + 1,000 K 375K 400K)
625,000
12,025,000
Cost of Goods Sold
(8M + 1.5 M 3.2 M - 40K 100K + 200K + 200K)

6,560,000

Other Expenses (500K + 300K 20K (Equip) + 80 K (Patent)

860,000

Taxes (500K + 200K 160K + 16K + 40K 80K 80K)

436,000

Total expenses

7,856,000

Profit

4,169,000

Attributable to:
Shareholders of Vine

3,768,000

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

401,000

4,169,000
Reconciliation:
Vine Profit:
3,000,000
Dividends from Devine Included
(375,000)
Equity in Earnings of Devine
1,143,000
Consolidated Profit Attributable to Vines Shareholders

(c)

Consolidated Retained Earnings: Proof

3,768,000

Parent retained earnings at December 31, Year 5


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

7,000,000

Retained earnings at acquisition

2,100,000

Increase since acquisition

4,900,000

Less: unrealized profits, ending inventory

(120,000)

Land
Less: cumulative amortization of acquisition differential

(240,000)
(100,000)

Realized retained earnings since acquisition

4,440,000
(a)

Parent %
75%
Less: unrealized profits, ending inventory

3,330,000
(120,000)

Consolidated retained earnings


15,210,000

(d)
Consolidated Statement of Financial Position
December 31, Year 5
Assets
Land (6M + 2.5 M + 200K 400K)

8,300,000

Plant and Equipment (18.8M + 11.8M 200K 500K)

29,900,000

Accumulated depreciation (5.8M + 5.0M 100K 500K)

(10,200,000)

Goodwill
600,000
Deferred Income Tax (160K + 80K + 80K)
320,000
Inventories (4.6 M + 2.4 M 200K 200K
6,600,000
Cash and Current Receivables (900K + 300K)
1,200,000
36,720,000
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Modern Advanced Accounting in Canada, Fifth Edition

Equities and Liabilities


Ordinary shares
10,000,000
Retained Earnings

(See part c)
15,210,000

Non-controlling interests (See Below)

2,710,000

Long Term Liabilities (6.6 M + 1.1 M)


7,700,000
Deferred Income Taxes (200K+100K)

300,000

Current Liabilities (700K + 300K 200K advances)

800,000
36,720,000

Non-controlling Interests: (Method 1)


Devine Carrying amount December 31, Year 5

10,500,000

Unrealized Profits Upstream:


Land

(240,000)

Inventory

(120,000)

Unamortized acquisition differential

700,000
10,840,000
25%

Non-controlling interest

2,710,000

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


Non-controlling interests at date of acquisition (25% x [4,800,000 / .75)
Devines adjusted increase in retained earnings (a)

1,600,000

4,440,000

NCIs share @ 25%

1,110,000

Non-controlling interest, December 31, Year 5

2,710,000

(e)
Non-controlling interest at date of acquisition
- under implied value approach (25% x 6,400,000)
- using market value of Devines shares (20,000 shares x $75)

1,600,000
1,500,000

Decrease in non-controlling interest


Non-controlling interest, December 31, Year 3
- as previously calculated
- as per new calculation

100,000
2,710,000

2,610,000

Goodwill at December 31, Year 3


- as previously calculated
- decrease due to change in non-controlling interest
- as per new calculation

600,000
100,000

500,000

Problem 6-15
(a)
Cost of 70% investment, January 1, Year 2

$ 84,000

Implied value of 100% investment

120,000

Carrying amount of Sands net assets:


Common shares

50,000

Retained earnings

30,000

Total shareholders equity

80,000

Acquisition differential

40,000

Allocation:

FV CA

Inventory

- 9,000

Equipment

24,000

Goodwill as at January 1, Year 2


Balance

15,000
$ 25,000

Amortization/Impairment

Balance

January 1, Year 2

Year 2-4

Year 5

Dec. 31, Year 5

$ (9,000)

$ (9,000)

Equipment

24,000

12,000

$ 4,000

$ 8,000 (a)

Goodwill

25,000

21,500

3,500 (b)

$ 40,000

$ 3,000

$ 25,500

$ 11,500 (c)

Inventory

(b)

PAPER CORP.
Consolidated Income Statement
for the year ended December 31, Year 5

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Modern Advanced Accounting in Canada, Fifth Edition

Sales ($798,000 + $300,000 $100,000 2)

$ 998,000

Investment and interest income ($1,500 + $3,600 $1500 4 $2,400 3)

1,200

Total revenue

999,200

Cost of goods sold ($480,000 + $200,000 $100,000 2 + $10,500 6)

590,500

Interest expense ($10,000 $2,400 )

7,600

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

56,000

Miscellaneous expense ($106,000 + $31,600 + (b) 21,500 $24,000 1)

135,100

Income taxes ($80,000 + $32,000 $4,200 $8,000 )

99,800

Total expenses

889,000

Net income

110,200

Attributable to:
Shareholders of Paper

107,050

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

3,150
110,200

Notes:
1

Management fee ($2,000 12)

$ 24,000

Downstream sales

100,000

Interest ($40,000 8% 9/12)

2,400

Investment income from Sand

1500

Intercompany profits
5
6

Before tax

40% tax

After tax

Land upstream

$ 20,000

$ 8,000

$ 12,000

Ending inventory downstream($30,000 35%)

$ 10,500

$ 4,200

$ 6,300

(c)
i) Inventory ($66,000 + $44,000 $10,500 6)
5

ii) Land ($150,000 + $30,000 $20,000 )

$ 99,500
$ 160,000

iii) Notes payable: The notes payable would not be shown on the consolidated balance sheet.
iv) Non-controlling interest ($50,000+$120,000$12,000+(c)$11,500) (30%)
v) Common shares

$ 50,850
$ 150,000

(d)
Non-controlling interest at date of acquisition
- under implied value approach (30% x 120,000)
- using independent appraisal
Decrease in non-controlling interest and goodwill

36,000
30,000
6,000

Goodwill impairment loss for the year ended December 31, Year 5
- as previously calculated
21,500
- decrease due to change in goodwill at acquisition
6,000
- as per new calculation
15,500
Profit attributable to non-controlling interest for the year ended December 31, Year 3
- as previously calculated
3,150
- increase due to reduced goodwill impairment loss
6,000
- as per new calculation
9,150

SOLUTIONS TO WEB-BASED PROBLEMS


Web Problem 6-1
The following answers are based on the 2011 consolidated financial statements for RONA Inc.:
(a)

RONA uses the weighted average cost method to cost its inventory. This is
disclosed in the inventory valuation accounting policy as described in note 3(d) to
the consolidated financial statements.

(b)

At the end of 2011, inventory represented 30.2% (840,287 / 2,780,378) of RONAs


total assets. This was a slight decrease from 31.0% (905,467 / 2,921,620) in 2010.
This was determined using the consolidated statements of financial position.

(c)

RONA does eliminate intercompany transactions and unrealized profits when


preparing its consolidated financial statements as per note 3(a)(iii) to the
consolidated financial statements.

(d)

The numerator, cost of goods sold, will increase by the sales amount of the
intercompany sale and decrease by the unrealized profit in ending inventory. The
denominator, average inventory, will decrease by one-half of the unrealized profit in
ending inventory because of the use of average inventory rather than year-end
inventory. By using one-half of the unrealized profit in the denominator and the full
unrealized profit in the numerator, the inventory turnover after the eliminating entries
will be lower than the original inventory turnover. Earnings per share will decrease

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Modern Advanced Accounting in Canada, Fifth Edition

due to the elimination of the unrealized profit in ending inventory.


(e)

Land is valued at cost as per the accounting policy for property, plant and
equipment described in note 3(g) to the consolidated financial statements.

(f)

The debt- to- equity ratio would decrease because debt would not change but
equity would increase. The return on average equity would also decrease because
net income would stay the same and equity would increase.

Web Problem 6-2


The following answers are based on the September 30, 2011 consolidated financial
statements for Cenovus Energy Inc. which are available on the companys website under the
Invest in us section.
(a)

Cenovus uses the first-in, first-out or weighted average cost methods to cost its
product inventory as per the accounting policy for inventories in note 3(l) to the
consolidated financial statements.

(b)

At the end of 2011, inventories represented 5.8% (1,291 / 622,194) of Cenovus


total assets, which is higher than the 2010 portion, which was 4.4% (880 / 19,840).

(c)

As per the principles of consolidation accounting policy as described in note 3(a) to


the consolidated financial statements, Cenovus does eliminate intercompany
transactions and unrealized profits when preparing its consolidated financial
statements.

(d)

The numerator, cost of goods sold, will increase by the sales amount of the
intercompany sale and decrease by the unrealized profit in ending inventory. The
denominator, average inventory, will decrease by one-half of the unrealized profit in
ending inventory because of the use of average inventory rather than year-end
inventory. By using one-half of the unrealized profit in the denominator and the full
unrealized profit in the numerator, the inventory turnover after the eliminating entries
will be lower than the original inventory turnover. Earnings per share will decrease
due to the elimination of the unrealized profit in ending inventory.

(e)

Land is valued at per the accounting policy for property, plant and equipment
described in note 3(o) to the consolidated financial statements.

(f)

The debt- to- equity ratio would decrease because debt would not change but
equity would increase. The return on average equity would also decrease because

net income would stay the same and equity would increase.

Copyright
82

2008 McGraw-Hill Ryerson Limited. All rights reserved.


Modern Advanced Accounting in Canada, Fifth Edition