FA4 summary

Updated Sept 16/10, PA1-10-TU08

Module 1 summary

This module summarizes and explains the foundation of International Financial Reporting Standards
(IFRS). It also examines the nature of financial instruments and how the method of accounting for them
varies based on their nature.

Describe the development of International Financial Reporting Standards

(IFRS), and discuss the reasons and processes followed by the AcSB for
the adoption of international accounting standards in Canada.

The acceptance of IFRS continues to grow from a global perspective with more than 100 countries
represented by the IASB.

Public companies are required to report their financial statements in accordance with IFRS in the entire
EU and many other countries.

The Accounting Standards Board adopted IFRS as the required standard for publically accountable
enterprises for fiscal years beginning on or after January 1, 2011.

The adoption of IFRS provides Canadian companies with better access to global capital markets.
Moreover, the adoption of international accounting standards is more cost-effective than maintaining
separate sets of accounting standards.

Define the term financial instrument, then evaluate, classify, and

categorize types of financial instruments.

A financial instrument is a contract to which the entity is a party. The contract gives rise to a financial
asset for one party and a financial liability or equity instruments for another party.

Financial instruments are non-derivatives, derivatives including embedded derivatives separated from
host contracts, embedded derivatives combined with host contracts for which fair value is not obtainable,
and some contracts to buy or sell non-financial items when the contracts can be settled net in cash or
with another financial instrument or by exchange of financial instruments.

Financial instruments must be classified as financial assets or financial liabilities and should be
categorized as loans and receivables, held to maturity, held for trading, or available for sale.

Describe and apply the standards for comprehensive income and equity.

Comprehensive income is a combination of net income plus or minus all items contained in other
comprehensive income for a reporting period. It includes all changes to equity resulting from transactions
and other events and circumstances in a reporting period except for investments by and distribution to
owners.
Other comprehensive income comprises items of income and expense that are not recognized in profit or
loss as required or permitted by other IFRS.

IAS 1 describes the standards for the presentation of equity and changes in equity during a reporting
period. Equity capital and reserves must be disaggregated into their component parts in the financial
statements; however, the standard provides a great deal of latitude in the manner in which this is done.

Explain how IFRS recommendations for categorizing financial instruments

are applied.

Financial assets held for trading (HFT) are initially measured at fair value. All other financial assets are
initially measured at the fair value plus transaction costs directly attributable to the acquisition of the
asset

All financial assets must be classified as held for trading (HFT), held to maturity (HTM), loans and
receivables (L&R), or available for sale (AFS).

Financial assets may be designated as HFT when first recognized, providing that one of the criterion IAS
39, p9a, is met.

HTM investments are those which the entity has a positive intent and ability to hold to maturity.

L&R financial assets are financial assets arising from the delivery of cash or another asset by the lender
to a borrower in return for a promise to pay on a specified date.

AFS financial assets are financial assets that are not classified as HFT, HTM, or L&R.

Explain how IFRS recommendations for initial recognition, classification,

measurement, and derecognition of financial assets are applied.

An entity should recognize a financial asset or a financial liability on its balance sheet only when the
entity becomes a party to the contractual provision of a financial instrument. The classification of a
financial instrument as a financial asset or a financial liability as well as its designation into a given
category is made upon initial recognition following management’s intention and ability.

When a financial asset is initially recognized, it should be measured at either fair value (HFT) or fair value
plus transaction costs (AFS & HTM). When there is an active market for a financial instrument, the
quoted price is the best estimate of its fair value. When an active market does not exist, the fair value
should be estimated using valuation techniques.

Subsequent measurement depends on the category to which a financial instrument belongs. Held-for-
trading and available-for-sale financial instruments are measured at fair value. Loans and receivables and
held-to-maturity investments are measured at their amortized cost using the effective-interest-rate
method.

Accounting for gains and losses for the different categories of financial instruments is driven by the
underlying classification. While all realized gains and losses are reported on the income statement, the
same cannot be said about unrealized gains and losses. Unrealized gains and losses for the four
categories of financial assets are accounted for as follows:
 • HFT — reported in net income
• AFS — reported in other comprehensive income
• L&R and HTM — These are both measured at amortized cost. As such, unrealized gains and losses
due to market fluctuations are not reported in the financial statements. Unrealized gains and losses
due to the passage of time are reported in net income, however. This occurs when the asset is
acquired at a price differing from the maturity value; the discount or premium is amortized using
the effective interest method.

The impairment of a financial instrument should be recognized in net income in the period in which it
arises. Other than AFS investments in equity securities, impairment charges can be reversed to net
income if the value of the asset subsequently improves.

Discuss the requirements for initial recognition of financial instruments,

then analyze and compare the use of settlement-date accounting versus
trade-date accounting for recording the regular-way purchase/sale of a
financial asset.

The initial recognition of financial instruments is based on the cost principle for a regular-way purchase or
sale of a financial asset, which allows two accounting methods: trade-date accounting and settlement-
date accounting.

Trade-date accounting includes recognizing the asset to be received on the purchase commitment date
and derecognizing the asset on the sale commitment date.

Settlement-date accounting includes recognizing the asset on the day it is received and derecognizing it
on the day it is delivered.

Identify and explain the requirements for accounting after initial

recognition of financial instruments.

The example of Investment Company illustrates the accounting treatment of held-to-maturity, available-
for-sale, and held-for-trading investments from initial recognition to derecognition. The example deals
with bonds as financial assets with varying market interest rates.

Identify and explain the special issues associated with, and the
requirements for accounting for, loans and receivables, related party
transactions, and interest free loans.

Accounts receivable, bank deposits, and simple loans to other enterprises are examples of assets that will
normally fall into the loans and receivables category.

Loans and receivables are measured at amortized cost using the effective-interest-rate method.

A non-performing loan is not necessarily impaired.

Related party transactions involving the transfer of an existing financial asset or liability are disclosed in
accordance with IAS 24.
All financial assets are initially measured at the fair value (plus eligible transactions costs for AFS, HTM,
and L&R), which is usually equal to the consideration given when the enterprise becomes a party to the
contract creating the financial asset.

If the instrument is constructed in such way that it confers a benefit on one of the parties, fair value
must be determined taking into account the risks involved. For instruments with a stated maturity date
(such as an interest-free loan), this will require discounting future cash flows at an appropriate market
rate, with any premium or discount recognized in a manner consistent with the substance of the
transaction.

   
Module 2 summary

This module provides guidance on the application of select areas of IAS 12, IAS 32, IAS 39, and IFRS 7
pertaining to financial instruments and income taxes.

Define, describe, and apply the requirements for derivatives: futures,

options, and swap contracts.

A derivative is a contract whose value changes in response to changes in a specified interest rate,
security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit
index, or other variable; which requires nominal or no initial investment; and which is settled in the
future.

IAS 39 requires that all derivatives be classified as held for trading unless the derivative is used as part of
a hedging relationship.

Describe and apply the requirements for embedded derivatives.

An embedded derivative is a component of a hybrid instrument that also includes a non-derivative host
contract — with the result that some of the cash flows of the combined instrument vary in the same way
they would for a stand-alone derivative. An embedded derivative causes some or all of the cash flows
that otherwise would be required by the contract to be modified based on a specified interest rate,
security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit
index, or other variable. If a derivative attached to a financial instrument can be sold or transferred
independently of the compound instrument, it is not an embedded derivative but a separate financial
instrument.

Describe and apply the requirements for non-financial instruments to

which IAS 39 applies.

A non-financial contract must be accounted for under IAS 39 if the contract can be settled net in cash (or
by another financial instrument), and the contract is not for the entity's expected purchase, sale or usage
requirements, unless the price is based on a variable that is not closely related to the underlying item.

Describe the requirements for financial instruments as they pertain to not-

for-profit organizations.

Sections 3855 and 3865 apply to not-for-profit organizations (NFPOs).

NFPOs may elect not to apply section 3855 to the following:

a. derivatives embedded in leases (see paragraph 3855.07(b)(iii))

b. derivatives embedded in insurance contracts (see paragraph 3855.07(e))

c. contracts and obligations for stock-based payments in which the entity receives or acquires goods
or services to which this section otherwise applies [see paragraph 3855.07(h)]
 d. contracts to buy or sell a non-financial item including derivatives embedded therein (see paragraph
3855.14)

e. derivatives embedded in contracts to buy or sell a non-financial item in accordance with the entity's
expected purchase, sale or usage requirements (see paragraph 3855.14)

Discuss the requirements for recognition and recording of impairments for

various financial instruments.

When there is objective evidence that the value of a financial asset that is not designated as held for
trading has become impaired, an impairment loss is realized.

For available-for-sale financial instruments, the cumulative loss is removed from other comprehensive
income and reported in net income.

If the impaired asset subsequently recovers in value, the impairment loss may be reversed in certain
circumstances.

Held-for-trading financial instruments are not subject to impairment losses as they are carried at fair
value with gains and losses flowing through net income.

Discuss the requirements for reclassification and measurement for various

financial instruments.

The table that follows summarizes these requirements

Initial Reclassification Explanation

category into
HFT1 AFS/HTM Permitted in rare circumstances (IAS 39 p50B). The fair value at
reclassification date becomes the new cost or amortized cost.
HFT L&R Permitted if the entity has the intention and ability to hold the financial asset
for the foreseeable future or until maturity (IAS 39 p50D). The fair value at
reclassification date becomes the new amortized cost.
HTM HFT/L&R Not permitted. IAS 39 p51 stipulates that HTM must be reclassified as AFS.
HTM AFS Permitted subject to the provisions of IAS 39 p52. Remeasured at fair value.
The gain or loss upon reclassification flows to other comprehensive income.
IAS 39 p52 requires that, when more than an insignificant amount of HTMs
are sold or reclassified, all HTMs must be reclassified as AFS.
AFS HFT Not permitted (IAS 39 p50)
AFS HTM Permitted (IAS 39 p54). The fair value at reclassification date becomes the
new amortized cost. Gains or losses previously recognized in other
comprehensive income are amortized to net income over the remaining life
of the asset using the effective interest method.
AFS L&R Permitted if the entity has the intention and ability to hold the financial asset
for the foreseeable future or until maturity (IAS 39 p50E). The fair value at
reclassification date becomes the new amortized cost. Gains or losses
previously recognized in other comprehensive income are amortized to net
income over the remaining life of the asset using the effective interest
method.
L&R HFT Not permitted (IAS 39 p50)
L&R AFS Not specifically addressed by IAS 39
L&R HTM Not permitted as the HTM category specifically excludes L&R (IAS 39 p9)

Identify and explain presentation and disclosure requirements for financial

instruments.

Presentation requires classification of financial instruments as financial liabilities or equity and deals also
with offsetting.

Classification at inception as liability or equity is made according to the substance but not the form of
financial instruments. The reporting of dividends, losses, and gains in financial statements (that is, in the
income statement or in the equity section of the balance sheet) depends on this classification. It is
therefore critical to separate the debt component from the equity component of a compound financial
instrument.

Offsetting a financial asset against a financial liability or vice versa should be done and the net amount
reported in the balance sheet when both of the following criteria are met:

• The entity has a legally enforceable right to offset the recognized amounts.
• The entity intends either to settle on a net basis, or realize the asset and settle the liability
simultaneously.

The objective of disclosures for financial instruments is to require entities to provide disclosures in their
financial statement that enable users to evaluate the following:

• the significance of financial instruments for the entity’s financial position and performance
• the nature and extent of risks arising from financial instruments to which the entity is exposed
during the period and at the balance sheet date
• the entity’s management of those risks

As a result, there are two series of disclosures for financial instruments:

• disclosures related to the balance sheet, income and other comprehensive income, and other
disclosures
• disclosures related to the entity’s risk arising from financial instruments

Identify the sources of differences between accounting income before tax

and taxable income, explain their accounting treatment, and determine the
resulting deferred income tax (DIT) asset or liability.

The realization (recovery) of an asset, settlement of a liability, and determination of the taxable income
are sources of differences between accounting income before taxes and taxable income.

Temporary differences occur whenever the taxes calculated on the carrying amounts of an asset or
liability (as determined by the accounting standards) differ from taxes calculated according to the tax
rules.
Taxable temporary differences result in deferred tax liabilities. Deductible temporary differences result in
deferred tax assets.

The net income (loss) for a given period is obtained by deducting the total income tax expense from
income before income tax (or adding the total income tax benefit to the income before income tax).

DIT asset or DIT liability implies net DIT asset or net DIT liability.

In practice, for a given year, the net DIT asset or net DIT liability to be reported on the balance sheet is
calculated as follows:

1. Determine taxable temporary differences and calculate the related DIT liability.
2. Determine deductible temporary differences and calculate the related DIT asset.
3. Calculate the amount of net DIT liability or the amount of net DIT asset — the difference between
the DIT liability (related to taxable temporary differences) and the DIT asset (related to deductible
temporary differences).

The total income tax expense (benefit) results from the cost (benefit) of current income tax adjusted for
the cost (benefit) of deferred tax asset and deferred tax liability (that is, adjusted for the changes, during
the period, in the balances of deferred tax asset and deferred tax liability accounts).

Describe revaluations of carrying amounts (temporary differences) and

disclosure requirements, and explain the accounting treatment of
temporary differences and ensuing tax effects.

IAS 12 p56 requires that, at each balance sheet date, the carrying amount of an asset should be reduced
when it is no longer probable that a recognized deferred tax asset will be realized. Similarly, IAS 12 p37
calls for a previously unrecognized deferred tax asset to be recorded if it is now probable that it will be
realized in the future.

IAS 12 p79-p88 detail the required disclosures. Disclosure notes are more important than ever as the
profession pursues the goal of ensuring that potential investors are notified of all items relevant to
financial decision making.
Module 3 summary

This module provides an overview of accounting for the three levels of investment in one corporation by
another corporation: no significant influence, significant influence, and control. Alternative methods of
recording and reporting intercorporate investments are surveyed, with emphasis on long-term
investments. Business combinations, the acquisition method, and other issues related to investments in
previously existing companies are introduced.

The concepts of the economic entity and legal entity are explained, and consolidation and the equity
method of accounting are studied in detail.

Define the following terms: control, significant influence, and no significant

influence.

No significant influence usually occurs when the holding in the investment is a small percentage of the
outstanding voting shares of the investee company, affording the investor little right to participate in the
strategic decision making of the investee company. This type of investment is seen as passive and the
investor typically has a right only to cash payments such as dividends. These investments fall into the
categories of held for trading or available for sale.

Significant influence is the ability to significantly influence (but not to have the final say on) the strategic
policies of the investee company. Significant influence is frequently an initial step toward control.

Control is the ability to determine the strategic operating, investing, and financing activities of the
acquired company without the cooperation of others.

Explain the use of the equity method for recording and reporting
investments subject to significant influence.

The equity method is used for investments subject to significant influence. Under the equity method, the
investment is initially recorded at cost. Thereafter, the investment account is adjusted each year for the
investor’s proportionate share of the investee’s income or loss as if it were its own income or loss, and
the investor’s proportionate share of the investee’s declared dividends.

The equity method is known as one-line consolidation because the net effect of all consolidation-type
adjustments (purchase discrepancy amortization, goodwill impairments, and unrealized profits on
intercompany transactions) are reported through one line on the income statement (equity income) and
one line on the balance sheet (investment in investee). The net income of the parent is the same under
the equity method of reporting and under consolidation.

Discuss the IFRS approach to business combinations, and describe the

three other theoretical approaches.

A business combination is a transaction whereby one business unites with or obtains control over the
assets of another business. IFRS requires the uses of the acquisition method rather than the purchase,
new entity, or pooling-of-interests methods.
The acquisition method assumes that since the parent has purchased control over the net assets of the
acquired company, the fair values of the assets and liabilities of the acquiree should be reported. This
method portrays the economic substance of the transaction and, since the assets of the purchaser have
not been acquired, they remain at their book value. The acquisition method requires that

• an acquirer is identified
• the acquisition date is determined
• the fair value of the acquiree is measured
• the assets acquired and the liabilities assumed are measured and recognized

Discuss the difference between recording and reporting, and explain how
investors must report control, significant influence, and no significant
influence investments.

Recording refers to how journal entries are included in the general journal using either the cost method
or the equity method.

The cost method implies the following requirements:

• The investment is initially recorded at cost.

• Earnings from such investments are recognized (as investment income) only when received or
receivable.
• The amount of the investment is reduced by dividends received in excess of the investor's
proportionate share of post-acquisition income. (Since dividends are a way of distributing earnings,
a company cannot distribute as income more than it has earned. If a company does so, this
becomes a liquidating dividend, returning the capital to the owners.)

Reporting refers to how no significant influence, significant influence, or control investments are
included on the published financial statements. Reporting is determined by level of influence.

• Investments with no significant influence are reported depending on the investment category.
Held-for-trading investments are reported at fair value and available-for-sale investments are
reported at fair value if market quotes are available or at cost if not actively traded on the markets.
• Investments with significant influence are reported at a carrying value using the equity method of
accounting.
• Investments with control are reported using consolidated financial statements.

Outline the steps in the consolidation process.

There are two main procedures in the consolidation process: the calculations and the preparation of
consolidated financial statements.

A seven-step calculation method is required to prepare consolidated financial statements when the parent
has used the cost recording method for its investment in the subsidiary:

1. Calculate goodwill using fair values.

2. Calculate goodwill using net book value, calculation and allocation of purchase discrepancy, and the
completion of the purchase discrepancy amortization and goodwill impairment schedule.
3. Calculate unrealized intercompany profits in inventory.
4. Calculate intercompany profits in land and depreciable fixed assets.
 5. Calculate consolidated net income and non-controlling interest on the income statement (NCI/IS).
6. Calculate consolidated beginning of year retained earnings.
7. Calculate the non-controlling interest on the balance sheet.

Calculate goodwill and allocate the purchase discrepancy using the

acquisition method for a wholly owned subsidiary.

The excess of purchase price over the net book value of the subsidiary’s shareholders’ equity is called the
purchase discrepancy. Goodwill is the difference between purchase price and fair value of identifiable net
assets.

The purchase discrepancy is allocated first to the assets and liabilities to adjust them from book value to
fair value on the acquisition date. Any excess represents goodwill.

Prepare consolidated financial statements using the working paper and

direct approaches for a wholly owned subsidiary at the date of acquisition.

Consolidated financial statements replace the investment account with the underlying assets and liabilities
of the subsidiary.

Consolidated financial statements, in effect, add the fair value of the subsidiary’s assets and liabilities to
the net book value of the parent's own book value of assets and liabilities.

Consolidated shareholders’ equity equals the parent’s shareholders’ equity.

Explain negative goodwill and how it should be allocated in a business

combination.

Negative goodwill exists when the purchase price is less than the fair value of the subsidiary's identifiable
net assets. This may happen when the subsidiary's share prices are depressed and/or when the acquiree
has a recent history of operating losses.

If the fair value of the acquirer’s interest in the acquiree exceeds the amount paid, the excess is
recognized as a gain in net income.

Discuss the entity theory and parent company extension theory

approaches to consolidation, including how each one measures non-
controlling interests.

When an entity purchases less than 100% ownership of the acquire, the following may apply:

• Investors may simply want to acquire control, which can usually be accomplished by acquiring a
majority interest in the investee company, for example, by acquiring greater than 50% of the
voting shares.
• The investor may not have, or want to spend, the funds necessary to acquire 100% of the shares.
• Shareholders outside the parent company may provide alternative points of view and expertise,
diversifying the risk of 100% ownership and creating a stronger corporate group.
 • The non-controlling shareholders may provide business contacts and access to other companies or
businesses for the parent.

The less-than-100% ownership situation raises two issues: the acknowledgment and the amount of the
non-controlling interest. There are two options for valuing NCI at the acquisition date: the fair value
enterprise method and the identifiable net asset method. Subsequent to acquisition, the NCI is updated
to reflect the NCI's share of the subsidiary income adjusted to allow for amortization and/or impairment
of the purchase discrepancy. The practical outcome of this is that NCI is determined using the process set
out below:

Fair value enterprise method (FVE) Identifiable net asset method (INA)

NCI at the fair value at date of acquisition: This NCI at the fair value at date of acquisition: This
includes goodwill, excludes goodwill,

• less any amortization of the purchase price • less any amortization of the purchase price
discrepancy pertaining to the NCI's “share” of discrepancy pertaining to the NCI's “share” of
assets and liabilities, assets and liabilities,

• less a pro-rata portion of goodwill impairment,

if any,

• plus/minus the NCI's proportionate share of • plus/minus the NCI's proportionate share of
the subsidiaries' income/loss, the subsidiaries' income/loss,

• less a pro-rata adjustment for unrealized • less a pro-rata adjustment for unrealized
intercompany gains and losses. intercompany gains and losses.

Prepare consolidated financial statements using the working paper

approach for a non-wholly owned subsidiary at the date of acquisition.

When a parent purchases less than 100% of a subsidiary, IFRS requires the following:

• The subsidiary’s assets and liabilities are brought into the consolidated financial statements at
100% of their net book value plus the “fair value minus book value” differences (fair-value
increments).
• At date of acquisition, the non-controlling interest on the consolidated balance sheet is equal to
one of the following:
o Fair value enterprise approach: the non-controlling interest's percentage ownership times the
fair value of the subsidiary enterprise (including goodwill)
o Identifiable net asset approach: the non-controlling interest's percentage ownership times
the fair value of the net identifiable assets
• Non-controlling interests are shown as a separate component of equity on the consolidated balance
sheet.

The working paper approach is the same as for a wholly-owned subsidiary except that a non-controlling
interest account is added.
 • 100% of the subsidiary’s shareholders’ equity at acquisition is eliminated.
• The investment account is removed.
• The NCI is set up based on the subsidiary’s enterprise value at date of acquisition plus the effects
of transactions subsequent to that date.
• The assets and liabilities of the subsidiary are adjusted to their fair values at acquisition.
• Any goodwill is added.
• The direct approach involves adding or subtracting amounts to the parent’s statements on a line-
by-line basis.
• The investment account disappears and is replaced with the appropriate subsidiary values.
• No formal entries or spreadsheet are used.

Prepare consolidated financial statements using the direct approach for a

non-wholly owned subsidiary at the date of acquisition.

• The calculations are the same as for the working paper approach.
• Each line is calculated individually.

Explain contingent consideration, reverse takeovers, and financial

statement disclosure of control.

Contingent consideration 

The accounting treatment of any contingent consideration depends on whether the amount is reasonably
determined and whether the outcome can be determined beyond reasonable doubt.

Reverse takeovers

A reverse takeover occurs when the company that initiates the business combination issues shares such
that the shareholders of the acquired company gain control of the combined entity. The substance of the
transaction is that the acquired company becomes the acquirer. The issuing company is deemed to be a
continuation of the acquirer. The acquirer is deemed to have gained control over assets and business of
the issuing company in consideration for the issue of capital. The acquisition cost is determined as if the
acquiree had issued shares valued at their fair-market value to the shareholders of the initiator. The
number of shares that the acquiree would have issued to achieve the reverse takeover must therefore be
determined.

Financial statement disclosure of control

IAS 27 p13 suggests that there is a presumption of control when the parent directly or indirectly holds
more than half of the voting shares in an entity. There are circumstances that are contrary to that
presumption, though. Although these instances are not commonly encountered, it is important to inform
financial statement users about the circumstances. IAS 27 p41-43 describe the major recommendations
with regard to disclosure.

Reference information from computer spreadsheets to analyze the

relationship between the equity method of recording and consolidation.

Spreadsheet programs can significantly reduce the time required to prepare consolidated financial
statements.
Work through Computer illustration 3.13-1.
Module 4 summary

This module illustrates the use of the acquisition method to record and report wholly-owned and non
wholly-owned subsidiaries subsequent to acquisition. Topics include the calculation and amortization of
the purchase discrepancy, the impairment of goodwill, and analysis of consolidation using the equity and
cost methods of recording an intercorporate investment.

Explain how to calculate goodwill impairment.

Cash-generating units to which goodwill has been allocated must be tested annually for impairment.

A summary of the impairment testing process follows:

1. Compare the carrying value of the cash-generating unit (CGU) to the recoverable amount.
2. If the carrying value of the CGU is less than the recoverable amount, then the CGU is not impaired
and nothing more must be done.
3. If the carrying value of the CGU is more than the recoverable amount, then the CGU is impaired
and an impairment loss must be realized.
4. Impairment losses are used to reduce the carrying amount — first, of goodwill allocated to the CGU
and second, to the other assets in the CGU on a pro-rata basis.
5. Goodwill impairment losses are separately disclosed.
6. Goodwill impairment losses cannot be reversed.

Prepare the purchase discrepancy amortization and goodwill impairment

schedule for the first year after acquisition of a subsidiary.

Each year, the purchase discrepancy must be amortized to reflect the expiration through use of the
subsidiary's assets and liabilities, applying the same logic as if these assets and liabilities had been
acquired directly by the parent. Goodwill impairment losses are also recorded in this schedule.

When the subsidiary sells inventory and records cost of goods sold, it records the transaction using the
values on its own books. However, the consolidated financial statement should reflect the cost to the
parent for this inventory. If the purchase discrepancy includes a fair-value increment (FVI) for inventory,
then this fair-value excess must be added to the subsidiary's inventory cost when determining cost of
goods sold from a consolidated viewpoint. The same logic applies to all the other components of the
purchase discrepancy.

To prepare a purchase discrepancy amortization and impairment schedule, all the FVIs (including non-
depreciable ones such as land) and goodwill at acquisition are listed in the first column and should
total the purchase discrepancy amount.

Assumptions are made as to the remaining life of the item, the period to maturity, or when the
underlying item will be used (or paid) by the subsidiary. Note that some assets such as land are not
subject to depreciation, and the original FVI remains until the asset is sold outside the consolidated
entity.

The yearly amortization and impairment pertaining to the parent's interest for each item is calculated to
determine the annual adjustment to investment income. The entire unamortized balance of each asset or
liability at the end of the year is used to prepare the consolidated balance sheet.
Prepare equity method journal entries one or more years after acquisition,
and calculate the carrying value of the investment in investee account.

When the parent records its investment using the equity method and purchases 100% of the subsidiary,
the following entries are recorded in the parent's accounting records:

An entry is recorded at the purchase date to set up the investment account in the parent's books.

The following year-end entries are recorded each year:

• To record the parent’s percentage of the subsidiary’s net income for the year
• To record any dividends received from the subsidiary
• To record the amount of purchase discrepancy amortization and goodwill impairment claimed
during the year

As a result of recording these entries directly into the parent's books, consolidated net income is equal to
reported net income on the parent's separate entity income statement prepared using the equity method.

Consolidated retained earnings are equal to retained earnings on the parent’s own separate entity
balance sheet prepared using the equity method.

Prepare consolidated financial statements for a parent and its subsidiary

one or more years after acquisition when the parent uses the equity
method.

(Topics 4.4 through 4.7 are summarized below.)

When preparing consolidated financial statements, first determine what the final account balances should
be on the consolidated financial statements. This is done by using the seven-step calculations method
described in Topic 3.5.

Consolidated financial statements should be a straight addition of the financial statements of the parent
and subsidiary plus or minus the consolidation adjustments.

Preparation of consolidated financial statements is performed as follows:

Prepare schedules for the following in the order indicated to determine the following consolidation
adjustments:

• Calculation and allocation of purchase discrepancy

• Purchase discrepancy amortization and goodwill impairment schedule
• Intercompany receivables and payables
• Calculation of the non-controlling interest

Prepare consolidated financial statements using the schedules previously prepared.

Analyze the logic of the final balances.

Working paper approach 

The working paper approach requires the following entries:

• Remove the subsidiary’s current-year equity-based net income and dividends, reducing the
investment account to its balance at the beginning of the year.
• Eliminate the subsidiary’s beginning of the year retained earnings and common shares, set up the
opening balance of the NCI, and reverse the balance of the investment account.
• At the same time, record the total purchase discrepancy amortization for the current year
(including write-offs to cost of goods sold and interest expense) and any goodwill impairment
losses, and set up the unamortized balance of the FVIs and the unimpaired goodwill at the end of
the year according to the purchase discrepancy amortization and impairment schedule.
• Allocate to the NCI its share of the subsidiary’s separate entity adjusted current-year net income.
Reduce the NCI by its percentage of the subsidiary’s current-year dividends.
• Eliminate any intercompany payables or receivables.

Direct approach 

The direct approach requires the following adjustments:

• Replace the investment income account with 100% of the subsidiary’s revenue and expenses
adjusted for the parent’s share of the current year’s purchase discrepancy amortizations and any
goodwill impairments.
• Consolidated retained earnings are unchanged from the parent’s separate entity retained earnings
on the equity basis.
• Replace the investment account with the subsidiary’s assets and liabilities and adjust for
unamortized FVIs, including goodwill.
• Deduct the NCI’s portion of the subsidiary’s separate entity adjusted net income and net assets on
the consolidated income statement and include these amounts on the consolidated balance sheet.
• Eliminate any intercompany payables or receivables.

Whether the working paper or direct approach is used, the parent’s consolidated net income attributable
to the parent should equal the net income reported in its equity-based separate entity statements.

Explain why and how intercompany receivables and payables are

eliminated in consolidated financial statements.

IFRS requires that a parent and its subsidiary, even though they may be separate legal entities, be
treated as one economic entity from an accounting perspective.

When preparing consolidated financial statements, intercompany transactions and/or balances that
occurred during the year between a parent and a subsidiary must be removed. Intercompany balances in
receivables and payables, loans receivable and payable, and any other pair of offsetting accounts are
therefore eliminated for consolidation purposes.

Prepare consolidated financial statements for the first and subsequent

year ends after acquisition for a parent and its wholly owned or non-wholly
owned subsidiary when the parent uses the cost method.
(Topics 4.9 and 4.10 are summarized below.)

Final balances on the consolidated statements will be the same regardless of whether the cost method or
equity method is used in preparing the parent's separate entity statements. Since the starting position is
different, the consolidation adjustments must be different between the cost method and equity method in
order to end at the same consolidated statements.

To prepare consolidated financial statements when the cost method is used in the parent’s general
ledger, perform the following steps:

• Prepare schedules to convert the parent’s records from the cost method to the equity method. In
addition to those prepared when the equity method is used, it is helpful to calculate consolidated
net income and consolidated opening retained earnings.
• Perform the same procedures as when the equity method of recording has been used, with some
differences.
• Under the cost method, consolidation adjustments are recorded on a consolidated worksheet and
are never recorded in the parent’s separate entity books.

Topics 4.11 and 4.12 deal with consolidation using information obtained from computer-generated
working papers and summarize the process of consolidation.

Consolidation

Net income presents results for one reporting period, for example, for the year ended
December 31, 20X2. When calculating consolidated net income, only incorporate adjustments applicable
to the reporting period.

For example, if consolidation is being done three years after acquisition, then the current year’s
amortization of the FVIs and goodwill impairment impact this year’s consolidated net income, while the
past two year’s amortizations/impairments impact consolidated beginning retained earnings.

Retained earnings incorporate net income less dividends on a cumulative basis for all periods to the end
of the reporting period (for example, everything up to December 31, 20X2). When calculating
consolidated retained earnings, incorporate the cumulative effect of all consolidation adjustments made
from the acquisition date to the end of the reporting period. Remember that you only include
consolidated net income that is attributable to the parent in consolidated retained earnings.

NCI on the consolidated income statement presents the NCI’s share of the subsidiary’s adjusted net
income for one reporting period. When calculating NCI on the income statement, only incorporate
adjustments applicable to the reporting period.

NCI on the consolidated balance sheet presents NCI’s share of the subsidiary’s shareholders’ equity plus
any unamortized purchase price discrepancy at the reporting date. When calculating NCI, incorporate the
cumulative effect of all adjustments made from the acquisition date to the end of the reporting period.
Module 5 summary
Intercompany transactions

This module describes intercompany transactions, including intercompany revenues and expenses and
sales of inventory, land, and depreciable assets. Comprehensive examples are used to summarize all
consolidation material covered to this point.

Discuss the impact of the elimination of intercompany revenues and

expenses on consolidated net income.

Consolidated financial statements present the financial position and results of operations of the parent
and subsidiary as if they were combined as a single economic entity. The consolidated financial
statements should report only transactions with entities outside of the combined entity. Intercompany
profit is only considered realized when the items have been resold outside the entity.

Since the parent and subsidiary are part of the same economic entity, transactions between them are not
transactions with outsiders. Therefore, intercompany revenues and expenses must be eliminated (not
reflected as transactions on the consolidated financial statements).

The consolidated financial statements should reflect what the account balances would have been had the
intercompany transactions not occurred. If one entity records intercompany revenue and the other entity
records the intercompany expense, the two amounts net out on consolidation. However, the purpose of
eliminating these revenues and expenses is so that neither revenues nor expenses are overstated on the
consolidated statements.

Since NCI is based on the subsidiary’s separate entity net income, only the subsidiary’s unrealized profit
on sales to the parent needs to be eliminated when calculating the NCI.

Define downstream and upstream sales, and analyze their effect on the
allocation of profit from intercompany transactions.

Intercompany transactions are defined as either upstream or downstream depending on who is the seller.

Transactions flow down from the parent to the subsidiary and flow up from the subsidiary to the parent.

When a parent sells to the subsidiary, it is a downstream transaction. When profit is eliminated on
downstream sales, it is charged to the parent. 100% of any unrealized profit is removed from
consolidated net income. Since the NCI has no interest in the parent, the NCI is not affected by
downstream transactions.

When the subsidiary sells to the parent, it is an upstream transaction. When profit is eliminated on
upstream transactions, it is charged to the subsidiary. The NCI is affected by upstream transactions since
the NCI shares in the profits of the subsidiary. A portion of the unrealized profit is allocated to the NCI
and the parent ultimately receives the remainder.

Calculate intercompany inventory profit using the gross-profit-on-sales

and markup-on-cost methods.
Under the gross-profit-on sales method, also referred to as the markup-on-sales method, the gross profit
percentage is calculated as the gross profit amount divided by the sales amount. The calculation of the
intercompany inventory profit is as follows:
Profit = Sales x Gross profit percentage

Under the markup-on-cost method, the markup-on-cost percentage is equal to the gross profit amount
divided by cost of goods sold amount. The calculation of profit is as follows:
Profit = Selling price – Selling price ÷ (1 + Markup on cost percentage)

Always read the inventory carefully to determine whether you are given the markup as a percentage of
sales or as a percentage of cost.

Explain how upstream and downstream unrealized intercompany inventory

profits are included in consolidated financial statements.

Adjustments to eliminate unrealized profit in ending inventory are facilitated by preparing a schedule of
unrealized intercompany profit. The profit on the intercompany sale is multiplied by the percentage that
is unsold and remaining in ending inventory. For downstream and upstream sales, respectively: first, list
the before-tax unrealized profit amount; next, calculate the related tax on this amount; finally, determine
the after-tax unrealized profit.

Format for calculating intercompany inventory profits

In 20X3, P made sales of $100,000 to S at a 70% gross profit on sales. Half of these sales remained in
S’s inventory at year end. P’s tax rate is 45% (unrealized profit = 50% × $100,000 × 70% = $35,000).

Before-tax
unrealized profit 45% Tax After-tax profit

$35,000 $15,750 $19,250

The amount calculated as before-tax unrealized profit increases cost of goods sold on the income
statement and reduces inventory on the balance sheet.

The amount calculated as tax reduces income tax expense on the income statement and reduces
deferred credit — income taxes or increases deferred charge — income taxes on the consolidated balance
sheet.

If inventories are overstated at the end of the year, income is overstated for the year. The gross amount
of both upstream and downstream intercompany sales is removed from the sales and cost of goods sold
accounts when preparing the consolidated statements. The before-tax amount of unrealized profit is
removed from ending inventory and added to cost of goods sold, and the tax effect is removed from
income tax expense and reported as deferred charge — income taxes on the balance sheet. This way,
only the realized after-tax profit is reported.

Equity method journal entries when unrealized profit exists at the end of the year

The equity method incorporates the parent’s share of the net effect of all consolidation adjustments.
To prepare the journal entries, a calculation is prepared of the subsidiary’s net income for the year and
adjusted for unrealized profit.

For upstream transactions, after-tax unrealized profit in the current year’s ending inventory is deducted
from the subsidiary’s separate entity net income before applying the parent’s ownership percentage.

For downstream transactions, a journal entry records the parent’s percentage of the subsidiary’s adjusted
net income as investment income, less the entire 100% after-tax unrealized profit.

In summary, 100% of downstream profit is allocated to the parent, while upstream profit is split between
the parent’s share and the non-controlling interest’s (NCI) share.

Prepare consolidated financial statements that include upstream and/or

downstream realized intercompany inventory profit.

The gross profit on inventory is recognized when inventory is sold to outsiders.

At the time of intercompany sales, the profit has not yet been realized from a consolidated viewpoint.
However, profit is realized when the purchasing company resells the inventory to outsiders.

Since inventory is typically sold within a year of purchase, intercompany profits are usually eliminated in
one year, then realized and added to consolidated income in the next year.

The timing for recognition of profits is different between the separate entity books and the consolidated
statements. Over a time frame of several years, cumulative profits are the same for consolidated financial
statements and for the separate entity financial statements of the parent and subsidiary.

When preparing consolidated statements, the intercompany profit schedule will include the unrealized
profit in beginning inventory. The after-tax profit from last year’s ending inventory, once realized, is
added back to income. Adjust the parent’s income for downstream profit and adjust the subsidiary’s
income for upstream profit.

NCI-I/S is calculated on the subsidiary's income after it has been adjusted for upstream realized profit,
the NCI's share of any goodwill impairment, and/or any amortization of remaining purchase price
discrepancy.

On the consolidated income statement, the before-tax unrealized profit from last year's inventory is
removed from the current year's cost of goods sold, thereby increasing income and recognizing that this
profit has been realized in the current year. Since the related tax effects on last year's unrealized profit
were removed last year, they should be added to income tax expense in the year the profit is realized.

Calculate the impact on consolidation of unrealized profit from an

intercompany sale of land.

Accounting for intercompany transfers of land is very similar to accounting for intercompany sales of
inventory in that intercompany profits are not realized until the asset is resold to a third-party outsider.
The main difference is the timeframe. Whereas inventory is assumed to turn over each year, land or a
portion thereof may be sold any year after the transfer from parent to subsidiary or from subsidiary to
parent. Intercompany profit on land may therefore be realized in any year after the intercompany sale or
never, depending on when the sale to third-party outsiders occurs.

When an intercompany land sale occurs, land must be restated on the consolidated financial statements
to the original cost when it was first purchased from an outsider.

Each year, the land value is restated until it is resold outside the consolidated entity.

Any gain or loss on the intercompany transaction, including the tax effects, must be eliminated from
income in the year of the intercompany sale and from retained earnings thereafter, until the land is sold
to an outsider.

The NCI is only affected if the sale is upstream.

In the year the land is sold to outsiders, the original gain (loss) and taxes that were held back are
realized and must be added to the gain (loss) and also to tax expense reported in the consolidated
income statement.

Intercompany land sales do not affect the income statement except in the year the intercompany sale
occurs or the year(s) in which the land is sold outside the consolidated group.

The format is the same as for intercompany inventory profits except that the following three lines are
needed:

Before-tax profit Tax % After-tax profit

Beginning

This year

Ending

Each of these lines is used in the consolidation process:

• Beginning is used to calculate beginning consolidated retained earnings.

• This year is used to calculate consolidated net income and prepare the consolidated income
statement.
• Ending is used to prepare the consolidated balance sheet.

Note that land sold in an intercompany transaction in prior years has often not been resold outside the
consolidated entity. Intercompany profits therefore remain unrealized. In this case, the beginning and
ending lines are identical and the “this year” line is zero.
Calculate the impact on consolidation of unrealized profit from an
intercompany sale of a depreciable asset.

The depreciable asset must be restated on the consolidated financial statements to the net book value
based on the historical cost at the time it was purchased from outsiders.

Any gain (loss) on the intercompany transaction must be eliminated from income and/or retained
earnings until the depreciable asset is sold to an outsider.

The depreciation expense on the consolidated income statement must be adjusted to what it would have
been had the intercompany transaction not taken place.

Calculate the original before-tax profit on the intercompany sale and depreciate it (or realize it) over the
remaining useful life of the asset.

Determine how many years have elapsed since the intercompany sale to the beginning of the current
year.

Calculate the unamortized (or unrealized portion) of the before-tax intercompany profit to the beginning
of the current year.

The consolidation adjustment is charged/credited to the original seller. If the subsidiary sells a
depreciable asset at a profit, the unrealized profit on the sale is eliminated and charged back to the
subsidiary and the excess depreciation being taken by the parent is credited to the subsidiary.

The format is the same as for intercompany inventory profits except that the following three lines are
needed:

Before-tax profit Tax % After-tax profit

Beginning

This year

Ending

Each of these lines is used in the consolidation process:

• Beginning is used to calculate the impact on beginning consolidated retained earnings and to
prepare the statement of retained earnings.
• This year is used to calculate consolidated net income and to prepare the consolidated income
statement.
• Ending is used to prepare the consolidated balance sheet.
Example of an intercompany sale of a depreciable fixed asset

On January 1, 20X0, S sold a machine (with a remaining useful life of 9 years and with a net book value
of $210,000) to P for $300,000. Prepare the calculations to consolidate at December 31, 20X4.

The original gain is $300,000 – 210,000 = $90,000.

Depreciation of the gain is $90,000 ÷ 9 = $10,000.

The number of years from date of sale to the beginning of the current year is 4.

Beginning unamortized gain is $90,000 – (4 × $10,000) = $50,000.

Intercompany profits are as follows:

Before-tax profit 40% Tax After-tax profit

Original gain $90,000 $36,000 $54,000

Less: 4 years realized 40,000 16,000 24,000

Beginning, 20X4 50,000 20,000 30,000

This year 10,000 4,000 6,000

Ending, 20X4 $ 40,000 $ 16,000 $ 24,000

Prepare consolidated financial statements that include both realized and

unrealized intercompany profit on inventory, land, and depreciable fixed
assets.

This part of the module summarizes the preceding three sections and includes the calculations in the
preparation of consolidated financial statements.

Convert the account balances on the parent’s separate entity books from
the cost method to the equity method for net income, investment in a
subsidiary account, and retained earnings.

Calculation of consolidated net income 

When the parent uses the cost method to record its investment, consolidated net income ATP is
calculated as follows.

To the parent’s cost method separate entity net income, calculate the following:
 • Remove dividends received from the subsidiary that have been included in dividend income under
the cost method.

• Deduct/add the current year’s purchase discrepancy amortization/impairment.

Add the after-tax realized intercompany profit in opening inventory from downstream sales.

Deduct the after-tax unrealized profit in ending inventory from downstream sales.

Adjust for any after-tax gain/loss on downstream sales of land or depreciable assets during the year.

Add the parent's share of the subsidiary's net income, which has been adjusted for upstream
intercompany transactions net of tax (add beginning upstream inventory profit, subtract ending upstream
inventory profit, deduct profit on this year's upstream sale of land, add this year's realized portion of the
gain on an upstream sale of a depreciable fixed asset).

Calculation of consolidated beginning retained earnings

The parent’s separate entity ending retained earnings under the cost method will require the following
adjustments to equal the equity method balance of the consolidated beginning retained earnings:

• Deduct/add the cumulative purchase discrepancy amortization/impairment losses.

• Deduct/add any after-tax unrealized profit, gain, or loss as at the beginning of the year.

• Add or subtract the parent’s share of the subsidiary’s post-acquisition realized retained earnings or
decreases to retained earnings (deduct any unrealized after-tax profit or gain and add any
unrealized loss as at the beginning of the year).

Calculation of investment in subsidiary (short method)

The equity method balance for the investment in subsidiary account, at the balance sheet date, is
calculated as the parent’s ownership share of the subsidiary’s adjusted net assets value (that is, S’s net
book value adjusted for after-tax unrealized ending upstream profit or loss on intercompany
transactions).

• Add/deduct the parent’s share of unamortized FVIs (fair-value increments) from the FVI
amortization and goodwill impairment schedule.

• Adjust for after-tax unrealized profit or loss on downstream intercompany transactions.

Calculation of the investment in subsidiary (long method)

The equity method balance for the investment in subsidiary account, at the balance sheet date, should
consist of the following:

• The original cost of the investment

• Less the total of the parent’s purchase discrepancy amortizations/impairment losses to date
 • Less/plus any after-tax unrealized profit, gain, or loss at the end of the reporting period (100% for
downstream)

• Plus the parent’s share of the subsidiary’s adjusted post-acquisition retained earnings

The parent’s separate entity ending retained earnings under the cost method will require the following
adjustments to equal the equity method balance of retained earnings:

• Deduct/add the parent's share of the cumulative purchase discrepancy amortization/impairment

loss at the end of the year.

• Deduct/add any after-tax unrealized profit, gain, or loss from downstream transactions as at the
end of the year.

• Add the parent’s share of the change in the subsidiary’s post-acquisition realized retained earnings
as at the end of the year (for example, after deducting any after-tax unrealized profit or gain and
adding any unrealized loss at the end of the year).

Use computer-generated working papers and supporting schedules to

prepare eliminating journal entries and consolidated financial statements
involving intercompany profit.

The final topic offers the opportunity to practice working paper eliminating entries, in addition to
calculations that are necessary to prepare consolidated financial statements.
Module 6 summary

This module addresses the subsidiary’s preferred shares and the effects of changes in the parent’s
ownership interest. It also explains joint ventures, which are a type of intercorporate investment, and
indirect shareholdings.

Calculate increases in the parent’s ownership interest, including step

purchases, when control has been achieved.

When the parent already has control and purchases additional shares, the parent's percentage ownership
increases and a gain or loss on sale is calculated as the difference between the fair value of consideration
paid and the cost of shares purchased. As this is a capital transaction, the gain or loss goes directly to
equity, rather than flowing through the income statement.

The percentage ownership applicable for each period, or portion of a period, is used in accruing the
parent’s share of the investee’s income and unrealized profits.

Use the shortcut method to calculate the balance in the parent's

investment in subsidiary account before and after an increase in ownership
interest when the parent uses the equity method.

The shortcut method reduces the number of calculations required to determine the balance of the
investment account.

Explain the accounting treatment of an investment change from no

significant influence to significant influence.

Significant influence investments are accounted for using the equity method. Investments lacking
significant influence are accounted for in accordance with IAS 39, which requires that the investment be
recorded at fair value with unrealized gains and losses flowing through income (if held for trading) or
other comprehensive income (if available for sale).

When additional shares are acquired to the point where significant influence exists, the investment is
reported using the equity method as per IAS 28, rather than IAS 39.

IFRS does not specify how to account for the transition from AFS to significant influence. The method
illustrated on pages 406-407 of the textbook, “Purchase of Second Block of Shares,” is an acceptable
method and is to be used for the purposes of assignments, quizzes, and the final examination.

Perform consolidation calculations for a decrease in ownership subsequent

to sale of the subsidiary's shares by the parent, including the parent's gain
or loss on disposal, when the parent ceases to have control over the
subsidiary.

As a result of the sale of a subsidiary's shares, the parent’s percentage ownership decreases and a gain
or loss on sale is calculated as the difference between the fair value of consideration received and the
cost of shares sold.
As this is a capital transaction, the gain or loss goes directly to equity, rather than flowing through the
income statement.

The decrease in the parent’s ownership leads to an increase in the non-controlling interest’s ownership.

Perform consolidation calculations for the parent's non-participation in the

subsidiary's share issue, including gain or loss on deemed disposal of the
subsidiary's shares.

When a subsidiary issues new shares to the public and the parent does not purchase any of that
issue, the parent’s ownership interest decreases and the parent benefits from the increase in the
subsidiary’s net assets resulting from the share issue.

The decrease in percentage ownership is deemed to be a disposal of shares and a gain or loss on
this disposal is calculated. The gain or loss is the difference between the reduction to the
investment balance (calculated using the equity method) and the parent’s percentage increase in
the increase to the subsidiary’s net assets.

As this is a capital transaction, the gain or loss goes directly to equity, rather than flowing through the
income statement.

Describe and calculate the effects of a subsidiary’s preferred shares held

outside the consolidated entity on the preparation of consolidated financial
statements.

When the subsidiary has preferred and common shares, the subsidiary’s net income, dividends, retained
earnings, and shares must be split between the preferred and common shares before computing the
parent’s ownership interest in each type of share and before determining the consolidation adjustments.

The claim of the preferred shareholders will be the call or redemption value plus any cumulative
dividends in arrears. The claim of the common shareholders is the residual after the preferred
shareholders’ claim.

If there is a difference between the purchase price by the parent and the parent's share of the net book
value of the preferred shares on the subsidiary's books, the difference is charged or credited directly to
equity.

Calculate the effect on the purchase valuation of a subsidiary’s preferred

shares, and prepare calculations toward consolidated financial statements
when the subsidiary’s preferred shares are held by parties outside the
consolidated entity and when they are held by the parent.

When none of the subsidiary’s preferred shares are held by the parent, the preferred shares must all be
held by outsiders. The preferred shares would be included with NCI on the consolidated balance sheet
and income statement.
When a parent owns some of the subsidiary’s preferred shares, the parent accrues its share of the
subsidiary’s equity pertaining to the preferred shares and its share of the subsidiary’s equity pertaining to
the common shares when determining consolidated net income and consolidated retained earnings.

On consolidation, the parent’s investment in preferred shares account is eliminated and offset against the
subsidiary’s preferred shares. The NCI preferred portion is set up. From a consolidated viewpoint, the
parent’s investment is viewed as a retirement of the subsidiary’s preferred shares.

Calculate consolidated net income and non-controlling interest for a parent

that has gained control over subsidiaries through indirect shareholdings.

Consolidated financial statements should be prepared for the parent and all of its subsidiaries whether
the subsidiaries are controlled directly or indirectly.

The principles of consolidation and the principles of the equity method apply to the parent's ownership of
shares in each enterprise

To prepare consolidated financial statements when a parent controls a subsidiary and has an indirect
interest in a third company, start at the bottom of the structure and work your way up one company at a
time. That is, allocate the third company’s income to the subsidiary, then allocate the subsidiary’s equity
method net income (which includes its share of the third company) to the parent.

For example, assume A owns 80% of B and B owns 60% of C. B controls C and so will
consolidate. A (which controls B) will consolidate with B’s consolidated financial statements.
A’s interest in C is calculated as 80% of 60%, or 48%.

Identify joint ventures and explain how they are reported using
proportionate consolidation.

Under proportionate consolidation, the proprietary approach to consolidation is used. The legal form of
the relationship is presented and only the percentage of the assets that the venturer owns is reported in
the venturer’s statements. The investor’s share of the fair value of the investee’s net assets is recorded
on the consolidated financial statements. There is no non-controlling interest in a joint venture.

The investor owns a certain percentage of the net assets of the investee via its share ownership. This
percentage ownership is used in determining the percentage of the investee's net assets to include in the
consolidated financial statements.

IFRS also permits venturers to recognize their interest in a jointly controlled entity using the equity
method.

Prepare equity method journal entries for a joint venturer when

intercompany transactions have occurred during the year.

In a parent-subsidiary relationship, the subsidiary is not considered to be an outsider since the parent
controls the subsidiary.
In a joint venture relationship, the venturer cannot control the joint venture. The joint venture is
considered to be an outsider to the extent of the percentage of shares held by the other venturers.

For transactions with joint ventures, profit is considered realized to the extent of the other venturers’
percentage ownership.

The following explains upstream and downstream transactions in a joint venture with similar transactions
between parent and subsidiaries:

• For sales from the joint venture to the venturer (upstream transactions), the joint venturer’s
proportionately consolidated net income and consolidated retained earnings would give the same
result as for parent-subsidiary relationships, since the venturer (like a parent) absorbs its share of
unrealized profits only.

• For sales from the venturer to the joint venture (downstream transactions), consolidated net
income and consolidated retained earnings are different than under a parent-subsidiary
relationship. Under a joint venture, profits on intercompany transactions are eliminated and
charged back against the venturer only to the extent of the venturer’s percentage interest in the
joint venture. Under a parent-subsidiary relationship, 100% of the profit is eliminated and charged
back to the parent.
Module 7 summary

Module 7 covers hedges and the challenges faced in accounting for transactions denominated in a foreign
currency.

Record transactions denominated in a foreign currency in accordance with

IFRS recommendations.

Transactions denominated in a foreign currency must be recorded in Canadian dollars in the financial
statements. In determining how to best record these transactions, the objectives are to accurately
measure the impact of these transactions on the firm and to allow these transactions to be integrated
with the company’s other financial information.

Exchange rates used to convert from one currency to another may be quoted in two ways:

• A direct quotation lists the number of units of domestic currency (for example, Canadian dollars)
required to purchase one unit of foreign currency.

• An indirect quotation lists the number of units of foreign currency required to purchase one unit of
domestic currency (for example, one Canadian dollar).

Foreign currency transactions should be translated at the exchange rate in effect on the date of the
transaction.

Discuss the theoretical issues of reporting foreign-currency denominated

monetary and non-monetary items.

At each reporting date, most monetary assets and liabilities are translated at the exchange rate in effect
at the balance sheet date.

Foreign exchange gains or losses that arise on translation or settlement of monetary assets or liabilities
or a non-monetary item carried at market are immediately recognized in income.

Non-monetary balances are translated at historical rates except for those items that are reported at fair
value. These latter items are translated at the exchange rate in effect at the date on which the fair value
was determined.

Explain why hedge accounting is used and describe hedging using forward
contracts.

Hedging is designed to modify a firm’s exposure to risk. Usually, the types of risks that are hedged
include credit risk, interest rate risk, foreign currency risk, and liquidity risk. The idea is to enter in one or
more contracts aimed at offsetting exposure to one or more risks. For example, a Canadian firm that has
an account receivable denominated in U.S. dollars can offset the foreign exchange risk of gain or loss by
incurring a liability in U.S. dollars for an equal amount.

Hedge accounting consists of designating a hedging tool such as derivatives to offset the changes in fair
value or cash flows of a hedged item.
 • The purpose behind hedge accounting is to allow gains and losses on a hedging item to be
recognized in net income in the same period as the gains or losses on a hedged item.

• Hedge accounting is optional.

One of the most common hedging items is a forward exchange contract, typically acquired at no cost.

To qualify for hedge accounting, three conditions must be met at the onset of the hedging relationship:

• The company wishing to use hedge accounting has identified the risks that are being hedged and
has designated that hedge accounting will be used.
• The hedging relationship has been formally documented by the company.
• There is reasonable assurance that the hedge will be effective throughout its term until disposition.

Define fair-value hedge, and discuss its rationale, application, and

accounting treatment.

The hedged item must be a whole or portion of an asset or liability or firm commitment. The risk being
hedged is a change in the fair value of the hedged items. For example, fluctuations in exchange rates will
change the fair value of a receivable denominated in foreign currency. This change in the fair value of the
hedged items will affect the reported net income.

Define cash-flow hedge, and discuss its rationale, application, and

accounting treatment.

The hedged item must be a recognized (existing) asset or liability, forecasted transaction, or foreign
currency associated with unrecognized firm commitment. Cash flows are associated with the hedged
item. The exposure to risk lies in the volatility in these cash flows. The risk against which a company
wants to protect the hedged item is likely to affect reported net income.

To qualify for cash-flow hedge, the hedged items must subsequently generate future cash flows that
are exposed to variability as a result of a risk.

Under cash flow hedge, the gain or loss on the hedging item has two components and the following
accounting treatment applies:

1. The portion that is determined to be an effective hedge should be recognized in comprehensive

income.

2. The portion that is determined to be ineffective should be recognized immediately in net income.

The associated gains or losses that were recognized in other comprehensive income should be
reclassified into net income in the same period or periods during which the hedged item (asset acquired,
liability incurred, or anticipated transaction) affects net income.

Explain how companies can accommodate foreign readers of their financial

reports.

Following are some strategies to accommodate foreign users:

• Prepare statements using a common language such as English (or translate into the language of
the foreign readers) but leave the figures in the currency of the home country and accounting
principles unchanged.

• Prepare statements using a common language such as English and restate the figures to a common
currency such as U.S. dollars.

• Partially restate some figures or provide reconciliations to the foreign country’s accounting policies
in the notes to the financial statements.

• Issue new statements with the needs of the potential user in mind. Translate to their language and
their currency and restate to a common GAAP such as U.S. GAAP or IASB standards.
Module 8 summary

Module 8 considers translation and consolidation of a subsidiary resident in a foreign country and surveys
segment disclosures, international disclosure practices, and analysis of financial statements of foreign
subsidiaries.

Describe financial statement translation methods, and explain the

difference between economic exposure and accounting exposure caused by
fluctuations in foreign exchange rates.

Financial statements are translated using either the foreign operations approach or the foreign currency
transactions approach.

Accounting exposure versus economic exposure

Accounting exposure is the component of foreign currency risk that results from translating the
statements of foreign subsidiaries into Canadian dollars. The amount recognized in the financial
statements as foreign exchange gains and losses or as other comprehensive income varies depending on
the translation method used. It does not necessarily represent realized gains or losses or economic
exposure. Accounting exposure exists only on those financial statement elements translated at the closing
exchange rate.

Economic exposure is the risk that foreign exchange rate changes have on the earnings of foreign
operations and the long-term effects this may have on the parent company. The exposure is measured in
true economic terms (that is, whether the entity is economically better or worse off due to the exchange-
rate fluctuations), which are difficult to measure precisely.

Financial statements attempt to reflect economic results. Foreign exchange gains and losses recognized
in the financial statements should therefore reflect the true economic impact of foreign currency
fluctuations. Translation methods based on the parent’s relationship with its foreign subsidiary attempt to
reflect the parent’s exposure to exchange rate changes. Financial statements do not always accurately
reflect economic reality when historical cost accounting is used as the basis of measurement.

Determine whether a subsidiary should be accounted for as a foreign

operation or using the foreign currency transactions approach, and
prescribe the appropriate accounting method for translating its financial
statements.

Whether a subsidiary is a foreign operation or is accounted for using the foreign currency transactions
approach depends on the level of exposure of the parent to exchange rate changes.

Subsidiaries accounted for using the foreign currency transactions approach are those in which the parent
actively participates in the business's operating, investing, and financing activities. The parent's exposure
is the same as if it had directly undertaken the transactions of the foreign operation.

A foreign operation is one that operates independently of the parent. Although the parent controls the
subsidiary, it does not actively participate in the subsidiary's operating, investing, and financing activities.
The parent's exposure is limited to its investment in the subsidiary.
Calculate exchange gains and losses, and translate financial statements of
foreign subsidiaries.

Foreign currency transactions 

The foreign currency transactions approach translates financial statement elements using exchange rates
that will preserve the normal basis of valuation of these financial statement elements and presents the
results as if the parent itself had entered into these transactions in the first place.

• For the financial statement elements that would normally be valued at historical cost, the historical
exchange rate is used.
• For the financial statement elements that would normally be valued at market value, the closing
exchange rate is used.

Foreign exchange gains and losses for a subsidiary accounted for using the foreign currency transactions
approach are accounted for in exactly the same manner as domestically based foreign transactions.
Monetary balances are translated at current year-end spot rates. Exchange gains and losses on monetary
balances are reported in net income. Non-monetary balances are translated at historic rates and
therefore do not result in gains and losses.

Foreign operations

For foreign operations, most balance sheet items are translated at the closing rate while revenues and
expenses are converted at the rates in effect when they were recognized in income. However, in practice,
revenues and expenses are translated at the average rate. Dividends and share capital are translated at
the historical rates. Most financial statement relationships remain the same as they were when stated in
the foreign currency.

Where the economic environment of the foreign operation is highly inflationary, the foreign currency
transactions approach is used irrespective of the nature of the foreign subsidiary.

Translation gains and losses for foreign operations are reported in reserves (a separate component of
shareholders' equity) until they are realized when the investment in the subsidiary is sold. At that time,
the translation gains and losses held in reserves is removed and reported in income.

Describe reporting requirements for hedging of a net investment in a

foreign operation.

IAS 39 governs the reporting requirements for hedging a net investment in a foreign operation. The gain
or loss on the hedging item that is determined to be an effective hedge is recognized in other
comprehensive income, while the ineffective portion is recognized in net income.

Prepare consolidated financial statements for foreign subsidiaries using

computer-generated translated financial statements.

Two computer illustrations were presented in order to further your understanding of the translation and
consolidation process involving foreign operations.
Prepare the purchase discrepancy amortization and goodwill impairment
schedule and the ensuing consolidated financial statements for a
purchased foreign subsidiary.

Purchase discrepancy and goodwill impairment 

The purchase discrepancy is calculated in the normal fashion as the difference between the imputed
purchase price and the net book value of the subsidiary’s shareholders’ equity.

For the foreign currency transactions approach, the initial calculation is further complicated by the
necessity of translating each component of the purchase price into the reporting currency (usually
Canadian dollars).

Each of the underlying assets and liabilities is translated using the exchange rate in effect on the date of
acquisition, not the exchange rate in effect when the subsidiary acquired the assets/liabilities prior to the
parent's acquisition of the subsidiary.

In the years following acquisition under the current rate method, amortization in the purchase
discrepancy amortization schedule is translated at the average exchange rate for the current year and the
unamortized amount is translated at the year-end current rate. The resulting translation gain/loss that
pertains to the parent is included in the accumulated other comprehensive income on the consolidated
balance sheet.

In the years following acquisition, foreign operations translate items in the purchase discrepancy
amortization schedule at the average exchange rate for the current year and the unamortized amount is
translated at the year-end closing rate. The resulting translation gain/loss is apportioned between the
parent and the NCI. The parent's portion is included in reserves on the consolidated balance sheet.

In the years following acquisition under the foreign currency transactions approach, everything in the
purchase discrepancy amortization/impairment schedule is translated at historic rates in effect on the
date of acquisition, and there is no resulting gain/loss from this translation.

Consolidated financial statements

First, translate the financial statements using the principles and techniques learned in Modules 7 and 8.
Then, consolidate using the principles and techniques learned in Modules 3 through 6.

The investment account is replaced with the assets and liabilities of the subsidiary, the unamortized
purchase discrepancy, and the NCI. From a consolidated viewpoint, the parent indirectly acquired the
assets of the subsidiary on the date of acquisition. Use the exchange rate on the date of acquisition as
the historical rate. The non-controlling interest (NCI) shares in values recorded on the subsidiary's books,
the unamortized PPD and unimpaired goodwill, and in adjustments arising from unrealized gains and
losses on upstream transactions.

The purchase discrepancy is not recorded on the subsidiary's books but is used only for the purpose of
consolidation. Translation gains and losses pertaining to the purchase discrepancy are not recorded on
the subsidiary's books but are included only on the consolidated financial statements; they are then
credited or charged fully to the parent.
Consolidation of foreign subsidiaries accounted for using the foreign currency transactions approach

The unamortized purchase discrepancy translated at the historic rate is included on the balance sheet.
The current year's purchase discrepancy amortization and any impairment loss in the income statement
are translated at historical rates.

NCI on the balance sheet is the NCI's ownership percentage times the subsidiary's translated
shareholders' equity, adjusted for the NCI's share of the unamortized PPD and unimpaired goodwill, and
for any unrealized gains or losses on upstream transactions. The foreign exchange gain/loss on the
translated income statement is the gain/loss on translation of all monetary items, both current and non-
current. The NCI on the income statement is the NCI's ownership percentage times the subsidiary's
translated income after allowing for amortization of the PPD, impairment of goodwill, and adjustments for
unrealized gains or losses on upstream transactions after the foreign exchange gain/loss has been
included.

Consolidation of foreign operations

The unamortized purchase discrepancy is translated at the current year-end rate and is included on the
balance sheet. The current year’s purchase discrepancy amortization and any impairment loss in the
income statement are translated at the average rate for the current year.

NCI on the balance sheet is the NCI's percentage times the subsidiary's translated shareholders' equity
including reserves, adjusted for the NCI's share of the unamortized PPD and unimpaired goodwill and for
any unrealized gains or losses on upstream transactions.

• The other comprehensive income component from translating the subsidiary statements and
income arising from the amortization of the PPD and impairment losses are allocated between the
parent and the NCI.
• The sum of the parent's share of these two components of other comprehensive income flows
through to the reserves account in consolidated shareholders' equity.

The NCI on the income statement is the NCI’s ownership percentage times the subsidiary’s translated
income statement after allowing for amortization of the PPD, impairment of goodwill, and adjustments for
unrealized gains or losses on upstream transactions.

Explain the benefits of segmented financial reporting in assessing the

quality and predictability of a company’s earnings, and describe the
current standards for segment disclosures.

Consolidated statements combine and summarize results, making it difficult to assess the different types
of businesses and economic environments in which the entity operates.

Segmented financial reporting is useful to users in assessing the entity's performance and the amount,
timing, and certainty of future cash flows. If a company has various operating segments and these
segments have varying degrees of risk, profitability, and capital investment requirements, the users
would want to see financial information for these operating segments.
Module 9 summary

This module describes the major reporting issues and accounting approaches of not-for-profit
organizations (NFPOs) and the public sector.

Define not-for-profit organizations and compare their financial reporting

objectives with those of profit-oriented organizations.

Not-for-profit organizations — governmental and non-governmental — often exist to provide a service

that is beneficial to society as a whole. They have no transferable ownership and may operate without
concern for generating wealth.

The fundamental difference between NFPOs and profit-oriented companies is that, while both the
preparers and users of profit-oriented companies are interested in the ability of the company to earn a
profit, the preparers and users of NFPOs generally do not aim to make a profit. However, both types of
organizations want to provide information that is reliable, timely, and useful to readers.

Explain the major financial reporting issues in not-for-profit organizations.

The accrual basis of accounting is used to better present the financial position and results of operations.

In a profit-oriented organization, revenue is recognized when earned and then expenses are matched to
revenues. In an NFPO, expenses are recognized when goods or services are used or consumed and,
under the deferral method, revenues are matched to expenses.

NFPOs with two-year average annual revenues of $500,000 or more should capitalize their capital assets
and amortize them over their useful lives. This practice will present a better measure of the total cost of
operating the NFPO on a year-by-year basis.

An NFPO may report donated materials and services if their fair value can be reasonably determined and
if they would have been purchased had they not been donated. Donated capital assets should be
reported at fair value (if reasonably determinable) or at a nominal value and amortized over their
estimated useful lives.

Explain the basics of accounting for, and reporting of, contributions under
the restricted fund and deferred contribution methods.

Fund accounting is commonly used in NFPOs. Fund accounting is a procedure that allows organizations to
separately monitor different sources of revenue, diverse activities, and specific resources. Reporting by
programs is also frequently used in practice.

Determine appropriate accounting policies for not-for-profit organizations.

It is important to understand the logic of the Handbook recommendations in terms of basic accounting
principles of financial statement elements, recognition, and measurement. Accountants should be able to
do the following:
 • Explain to a client the fundamental differences between the deferral and restricted fund method,
what the accounting procedures to be implemented would be, and how the results of their
operations would be presented in the financial statements under the deferral method or the
restricted fund method of recognizing contributions.

• Determine who the users of the statements will be, what their needs are, and the extent to which
recommendations provide relevant and reliable information for these users.

Explain how formal recording of a budget helps NFPO managers to control

operations.

Budgets provide an ethical framework for management decisions and a tool for assessing management’s
performance. Budgetary accounts used as part of a fund accounting framework can provide managers
with up-to-date information regarding amounts available, amounts committed, and amounts spent from a
specific fund or for a specific purpose.

Apply the requirements for financial instruments as they pertain to not-for-

profit organizations.

There are special circumstances under which financial instruments are accounted in not-for-profit
organizations.

The application of the underlying principles will depend on which of the following accounting methods the
NFPO employs:

• the deferral method of accounting for contributions

• the deferral method of accounting for contributions and fund accounting
• the restricted fund method of accounting for contributions

Explain the reporting implications of governments’ unique characteristics,

and describe the key messages the financial statements should convey.

Governments must publish financial statements that convey clear key messages about government
finances. The required statements, and the information contained in each, are outlined below:

Each financial statement should convey clear key messages about government finances:

• Statement of operations
o net cost of services and affordability of services
o ability to maintain net assets in the year

• Statement of changes in net debt

o actual to budget comparisons
o capital spending and its effect on net debt
o An increase in net debt sends a signal that there is a need for future revenue to pay for past
transactions.
o Net debt at the end of the year indicates whether additional spending is affordable.
 • Statement of financial position
o availability of economic resources to meet future needs or need for future revenues to pay
for past transactions and events

• Statement of cash flow

o Capital transactions are highlighted separately.

Explain the concept of the public sector, determine the handbook

applicable to each component of the public sector, and describe the
objectives of public sector financial statements.

The concept of public sector includes several categories of entities, which should present financial
statements as follows:

• Governments must present their financial statements in accordance with the PSA Handbook.
• Government business enterprises must present their financial statements in accordance with IFRS.
• Government not-for-profit organizations currently must report their financial statements in
accordance with Part V of the CICA Handbook — Accounting.
• Other government organizations have the choice of presenting their financial statements in
accordance with IFRS or the PSA Handbook.

The objectives of government financial statements are outlined below:

• Account for the full scope of government's resources, including consolidating related enterprises.

• Measure the financial position of the government.

• Measure the changes in financial position of the government including sources and uses of funds
and the change in the net debt.

• Measure the government's stewardship over its resources and compliance with parliament.
Module 10 summary
Discuss current issues in international financial reporting

IASB standards are continually evolving.

The FASB has established a roadmap for transitioning U.S. GAAP to IFRS.

The standard setters’ goals include developing accounting standards that result in companies providing
clear, accurate, and useful information to investors. Political interference in the standard setting process
can be an impediment to success in this respect, however.