Professional Documents
Culture Documents
Chapter 6
CASES
Case 6-1
In this case, students are asked to illustrate the impact of intercompany sales and unrealized
profits in inventory on the separate entity and consolidated financial statements. Students are
also asked to explain how basic accounting principles are applied when accounting for these
intercompany transactions.
Case 6-2
In this case, adapted from a CPA exam, students are asked to resolve accounting issues related
to the preparation of consolidated financial statements for an 80%-owned subsidiary and a 40%-
owned investee company. Intercompany transactions and acquisition differential have not been
properly accounted for.
Case 6-3
In this case, adapted from a CPA exam, management appears to be manipulating income to
minimize the bonus paid to union employees. Students are required to analyze controversial
accounting issues including the valuation of inventory, purchase returns and goodwill.
Case 6-4
This is a multi-subject case from a CPA exam. Students are asked to resolve a number of
accounting issues including revenue and expense recognition, contributions to a partnership,
contingent consideration and offsetting of assets against liabilities.
Case 6-5
In this case, adapted from a CPA exam, students are asked to resolve accounting issues in order
to help a client obtain a term loan. The issues include non-monetary transactions, related party
transactions and contingent gain.
Problem 6-14 (70 min.) (Prepared by Peter Secord, Saint Mary’s University)
A comprehensive problem requiring the preparation of a consolidated income statement,
statement of financial position and consolidation worksheet when the parent has used the cost
method. Also required is a calculation of goodwill and NCI using the trading price of the
subsidiary’s shares at the date of acquisition. There are intercompany profits in land and
inventory.
2. The types of intercompany revenue and expenses eliminated in the preparation of the
consolidated income statement include sales and purchases, rentals, interest, and
management fees. These eliminations have no effect on the amount of consolidated net
income or the net income attributable to non-controlling interest.
4. The intercompany profit recorded in Period one is considered to be realized when the
particular asset is sold outside the consolidated entity by the purchasing affiliate.
5. Revenue should be recognized when it is earned with a transaction outside of the reporting
entity. The reporting entity for consolidated financial statements encompasses the parent
and all of its subsidiaries. Since intercompany transactions are transactions within the
reporting entity (not outside of the reporting entity), they must be eliminated when
preparing consolidated financial statements.
6. This statement is true if the selling affiliate has an income tax rate of 40%. The $1,000
reduction from ending inventory reduces the consolidated entity's net income. A
corresponding reduction of $400 in income tax expense transfers the tax from an expense
to an asset on the consolidated balance sheet. When the $1,000 profit is subsequently
realized, the $400 is transferred from the consolidated balance sheet to the consolidated
income statement in order to achieve a proper matching of expense to revenue.
10. The elimination of intercompany sales and purchases reduces sales revenue and cost of
goods sold on the consolidated income statement. No other items on the consolidated
statements are affected. The elimination of intercompany profits in ending inventory affects
the following elements of the consolidated statements: cost of goods sold is increased;
income tax expense is decreased; net income is decreased; net income attributable to the
parent is decreased; net income attributable to the non-controlling interest is decreased (if
the subsidiary was the seller); the asset inventory is decreased; deferred income tax
assets are increased; non-controlling interest in net assets is decreased (if the subsidiary
was the seller); and consolidated retained earnings is decreased.
11. For a downstream transaction, the adjustment for unrealized profits is applied to the
parent’s income and is fully charged or credited to the parent. For an upstream
transaction, the adjustment for unrealized profits is applied to the subsidiary’s income
which is shared between the parent and non-controlling interest. In other words, the non-
controlling interest is affected by elimination of profit on upstream transactions but is not
affected by the elimination of profit on downstream transactions.
12. At the end of Year 1, the unrealized profit is removed from ending inventory and added to
cost of goods sold which decreases income. In Year 2, the unrealized profit is removed
from beginning inventory, which decreases cost of goods sold for Year 2 and increases
income for Year 2. Although Year 1 and Year 2 income both must be adjusted, the
adjustments are offsetting. Therefore, the combined income for the two years does not
change as a result of the adjustments.
13. It will not be eliminated again on the consolidated income statement for subsequent years.
However, if the land remains within the consolidated entity, the unrealized gain will be
eliminated in the preparation of all subsequent consolidated balance sheets and
14. Adjustments are required on consolidation to bring the consolidated balances to the
amounts that would have been on the subsidiary’s books had it not sold the land to the
parent. Therefore, any gain reported on sale would have to be eliminated. The revaluation
surplus account would have to reflect the increase in fair value over the original cost of the
land when it was purchased by the subsidiary.
16. Under IFRS, only the investor’s percentage ownership in the associate times the profit in
ending inventory is considered to be unrealized; since the investor cannot control the
associate or the other shareholders of the associate, the profit in ending inventory times
the percentage ownership of the other shareholders is considered to be a transaction with
outsiders. Under ASPE, the entire profit in ending inventory is considered to be unrealized.
ASPE states that the unrealized profit is same amount that would be considered to be
unrealized for consolidated financial statements. For downstream transactions between a
parent and subsidiary, the entire amount of unrealized profit is eliminated and charged to
the parent’s shareholders.
SOLUTIONS TO CASES
Case 6-1
Using the data provided in the question, the financial statements for the parent, subsidiary and
consolidated entity would appear as follows for the 3 months:
The following comments outline how all of the above financial statements present fairly the
financial position and financial performance of the company in accordance with GAAP:
1. The parent and subsidiary are separate legal entities. Each entity will pay income tax
based on the income earned by the separate legal entity. Therefore, the subsidiary will
pay income tax based on the profit it earned in August and the parent will pay income
tax based on the profit it earned in September.
2. The consolidated statements combine the statements of the parent and subsidiary as if
they were one entity i.e., one set of statements for the family.
3. Accounting principles should be and have been properly applied for all of the individual
financial statements. The main principles involved with these statements are the
historical cost principle, the revenue recognition principle, and the matching principle.
4. The historical cost principle requires that certain items such as inventory be reported at
historical cost. This has been done for all 3 financial statements. Note that the historical
cost for the inventory from a consolidated perspective was $400 which is the cost paid
by the subsidiary when it purchased the goods from outsiders.
5. The revenue recognition principle requires that revenue be reported when it is earned
i.e., when the benefits and risks of ownership are transferred to the buyer. When the
subsidiary sold to the parent, the benefits and risks were transferred to the parent.
Accordingly, the subsidiary reported revenue. However, from the consolidated
perspective, the family retained the benefits and risks; they were not transferred to an
outside entity. Therefore, no revenue is reported on the consolidated income statement
for August.
6. When the parent sells to an outside entity in September, it reports revenue on its
separate entity income statement. Since the family has sold the inventory to an outside
Copyright © 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 8 9
entity, the family has earned the revenue. Accordingly, the revenue is reported in
September on the consolidated income statement.
7. The matching principle requires that costs be expensed in the same period as the
revenue to which it relates. This provides the best measure of performance. Since the
subsidiary reported revenue in August, it reported cost of goods sold in August in order
to match expenses to revenue in August. Similarly, the parent reported cost of goods
sold in September to match expenses to revenue in September. Since revenue was
reported in September from a consolidated viewpoint, the cost of goods sold is reported
as an expense in September as well. The cost from a consolidated viewpoint was the
amount paid by the subsidiary when it bought the inventory from outsiders.
8. Income tax must also be matched to the income to which it relates. In August, the
subsidiary reported income tax expense of $32 to match against the pre-tax income of
$80. Since no income was reported in the consolidated income statement for August, no
tax expense should be reported in income. Given that the subsidiary probably paid the
tax to the government, the tax is considered to have been prepaid from a consolidated
viewpoint because the tax was not yet due from a consolidated viewpoint.
Case 6-2
As requested, I have prepared the following memorandum, which outlines the important
financial accounting issues of D and N, its subsidiary, and K, its investee company.
1. The shares issued by D to purchase N and K should be measured at their fair value at the
date of acquisition. For now, I will assume that the fair value of 160,000 common shares
was $2,000,000 when D purchased its investments in N and K.
2. It appears that there has been no allocation of the $640,000 acquisition cost excess for N in
the consolidated financial statements. The excess should be first be allocated to identifiable
assets. Any remaining excess should be allocated to goodwill. The goodwill should be
checked for impairment at the end of each year and written down if there is an impairment
loss.
3. Given that N had capitalized some research and development expenditures, there may be
4. D can use either the entity theory or parent company extension theory in preparing the
consolidated financial statements. Under these theories, N’s assets and liabilities would be
measured at fair value at the date of acquisition. It appears that the consolidated financial
statements were prepared using the parent company theory because non-controlling interest is
measured at $590,000, which is 20% of the carrying amount of N’s net assets at the end of Year 2
(i.e. common shares of $1,000,000 plus retained earnings of $1,950,000). I will assume that D will
use the entity theory. Non-controlling interest at the date of acquisition should have been
$1,000,000 calculated as follows:
This assumes that there is a linear relationship between the value of 80% and the value of 100% of
N.
5. Intercompany transactions and balances between D and K must be eliminated. Sales and
cost of sales should be reduced by the intercompany sales of $1,200,000. The unrealized
profit of $200,000 ($1,200,000 – $1,000,000) should be taken out of ending inventory and
added to cost of goods sold. Since this was an upstream sale, non-controlling interest will
be affected by this adjustment.
6. The investment in K has been accounted for using the cost method. This method is not
acceptable under IFRS. With a 40% interest in K, D would normally have significant
influence. If so, the equity method would be appropriate. For the purpose of this discussion,
I will assume that D does have significant influence and the equity method should be used.
7. Under the equity method, the acquisition cost would have to be allocated in a manner similar
to what is done for consolidation purposes. The acquisition differential would be allocated to
identifiable net assets where the fair value is different than carrying amount. This fair value
difference would have to be amortized and an adjustment made to the investment account
8. Since D paid less than the fair value of K’s identifiable net assets, there is negative goodwill
in this acquisition cost. Negative goodwill is calculated to be $233,333 ($2,100,000 / .9 –
$2,100,000). If we used the same principles applied for consolidation purposes, this negative
goodwill would be reported as a gain on purchase. Before recording the gain on purchase,
we need to ensure that the fair value of the identifiable net assets is $2,333,333 ($2,100,000
/ .9)
9. Under the equity method, D’s share of the unrealized profit from intercompany transactions
would have to be eliminated. Since K made an after-tax profit of $120,000 ([$1,200,000 –
$1,000,000] x [1 – 0.4]) on sales to D, $48,000 (40% x $120,000) would have to be
eliminated from the investment account. Since D and K are related parties, the details of
intercompany transactions would need to be disclosed in the notes to the consolidated
financial statements.
10.Based on the discussion above, I have recalculated the following account balances for the
consolidated financial statements in the schedules below:
Goodwill
Investment in K (under equity method)
Non-controlling interest on balance sheet
Profit
Attributable to:
Shareholders of D 450,400
Non-controlling interests (20% x 98,000) 19,600
470,000
Case 6-3
REPORT ON ACCOUNTING POLICIES USED IN THE FINANCIAL STATEMENTS OF GOOD
QUALITY AUTO PARTS LIMITED FOR THE YEAR ENDED FEBRUARY 28, YEAR 11.
I have been engaged to analyze the financial statements of Good Quality Auto Parts Limited
(GQ) for the year ended February 28, Year 11 and determine whether there are any
controversial accounting issues. For the purposes of this report, "controversial accounting
issues" will be defined as accounting policies that have the effect of reducing payments under
the profit-sharing plan to the union members.
The existence of the profit-sharing contract creates incentives for the management of GQ to
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14 Modern Advanced Accounting in Canada, Eighth Edition
make accounting choices that reduce net income and thereby reduce the payments that must
be made to the union members. Accounting standards for private enterprises (ASPE) allow
considerable flexibility and judgment by the preparers of financial statements in selecting
accounting policies. Since the company is privately owned, the costs (real or perceived) of
reporting lower income may be small relative to the savings generated. For example, the effect
of lower income on new or existing lenders may be considered less important than the savings
derived from reduced profit sharing. In addition since the term of the contract is only three
years, some of the income deferral may yield permanent savings if the profit-sharing
component is not renewed in subsequent contracts.
In analyzing the accounting policies, I will be taking as strong a position as can be justified to
support the union's objective of making net income as large as possible. This is in conflict with
the objective of management, which is to reduce net income.
Inventory write-down
Accounting practice requires that inventory be measured at the lower of cost and net realizable
value. Thus, if the inventory cannot be sold, management can justify its write-off. However,
since much of the inventory has been on hand for several years, the decision to write it off this
year raises a question as to the motivation for the write-off. Management could be writing off the
inventory solely to reduce income, thereby reducing the payments required under the profit-
sharing plan. The problem must be considered from two points of view. First, is the inventory
genuinely unsaleable? If not, then the entry to write down the inventory must be reversed,
resulting in a higher net income figure. Assuming that the inventory is unsaleable, the next
question is whether the write-off legitimately belongs in the current period. If the inventory
became unsaleable in the current year, then the write belongs in the current period. If the
inventory was unsaleable in prior years, it should have been written down in prior years. In that
case, the financial statements should be retroactively restated to correct the error in the
appropriate period.
Write-off of goodwill
Goodwill should be written down or written off if there has been a permanent impairment of its
value i.e. if the recoverable amount of the cash generating unit in which the goodwill is located
is less than the carrying amount of the net assets, including goodwill, of the cash generating
unit. The fact that the auto parts industry is suffering through poor economic times does not
necessarily imply that what was purchased (the company name, its customers, etc.) no longer
has any value. The auto industry is very sensitive to economic cycles, and it is expected that
such downturns will occur. (Indeed, their occurrence should have been factored into the
acquisition cost paid by GQ).
Unless GQ can come up with strong evidence that the intangibles purchased have been
impaired, there is no justification for the write-off even though GQ's auditors supported it. It is
important to emphasize that their support may rest in conservatism: auditors are willing to
accept accounting treatments that are conservative. However, conservatism is inconsistent with
the union's objectives. The value of the asset acquired in Year 5 must still exist unless there is
specific evidence of its impairment. GQ should provide evidence of impairment.
Case 6-4
Overview
PFC is a public corporation. Therefore, the financial statements will be used by stakeholders for
a variety of purposes, including the evaluation of the company and its management. As a result,
the managers have incentives to increase or smooth earnings to influence the share price or
present a favourable impression of themselves to the stakeholders. In addition, the company is
expanding rapidly and, therefore, may need to raise capital. By using accounting choices to
increase earnings or otherwise improve the appearance of the financial statements, management
may be attempting to reduce the cost of capital by lowering the cost of debt or increasing the
selling price of the shares. The company may have a competing objective of minimizing tax by
choosing accounting policies that reduce income in cases where Revenue Canada requires for
tax purposes the same accounting policies that are used in the general-purpose financial
statements. PFC also wants to ensure it does not violate the debt covenant and wants to keep
the debt to equity ratio below 2:1.
Copyright © 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 8 17
Given that PFC is a public company and that it may raise capital, it is likely that management
would choose accounting policies that increase income. Its financial statements must be in
compliance with IFRS.
The issues are discussed below. The impact of the accounting and reporting on the key metrics
(income, debt and equity) are shown in the appendices. Appendix I shows the accounting impact
for the issues where the accounting was not specified in the case. Appendix II shows the impact
when the company’s policies must be changed to be in accordance with GAAP.
Penalty payment
PFC received a $2 million payment from a contractor who built a theatre complex for PFC in
Montreal. The payment was for completing the project late. In its attempt to increase income,
management will want to record the penalty as revenue.
Arguments could be made for treating the penalty payment either as income (revenue or reduction
of expenses) or as a reduction in the capital cost of the complex (balance sheet).
If PFC incurred additional costs because of the delay in opening the new complex, and the penalty
was compensation for those additional costs incurred, then the penalty should be used to offset
those costs incurred. If the additional costs incurred related to the capital cost of the complex,
then the penalty should be used to reduce the capital cost of the complex. Analogies might be
drawn with the IFRS standard on government grants (IAS 20). This section recommends that
payments such as grants should be treated as cost reductions. The parallel here is that the
penalty payment is like a grant and therefore should be treated as a reduction in the capital cost
of the complex or in costs expensed as incurred.
On the other hand, if the penalty payment was compensation for lost revenue, then an argument
might be made for treating the penalty as revenue. If the penalty is treated as revenue, then we
must consider whether it should be disclosed separately. Since the penalty payment is non-
recurring, financial statement users would find separate disclosure informative because the
portion of revenue and income that is non-recurring can be valued differently by the market and
by individual investors and influence the evaluation of management. Therefore, if material, the
penalty should be disclosed as a separate revenue item either on the face of the income statement
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18 Modern Advanced Accounting in Canada, Eighth Edition
or in the notes.
Ticket proceeds
PFC would prefer to recognize revenue as early as possible with the earliest date being the sale
of the tickets. However, the most appropriate treatment for recognizing revenue for “Rue St.
Jacques” is when the show is performed.
IFRS 15, paragraph 31 states that “An entity shall recognize revenue when (or as) the entity
satisfies a performance obligation by transferring a promised good or service (i.e., an asset) to a
customer. An asset is transferred when (or as) the customer obtains control of that asset.”
Performance is the critical event in the earnings process, and therefore revenue is not earned
until the show is put on. There is no assurance that the production will be completed, or that any
performance for which tickets are sold will take place (for example, the show could be closed
down before it begins its run or even after it begins its run). In that case, it will be necessary to
refund the acquisition cost of tickets to buyers.
PFC earns a significant amount of interest by holding the money paid in advance by ticket
purchasers. The interest revenue could be treated as either income or deferred revenue
depending on the facts and circumstances. Management’s preference will be to include the
interest in income since it will serve to improve the bottom line. Immediate recognition of interest
revenue is justifiable. If the show is cancelled, PFC will be able to keep the interest revenue—
only the amount paid for the tickets will be refunded. In addition, by buying their seats in advance,
purchasers guarantee their seats but pay a premium for the guarantee (the interest earned by
PFC and forgone by the purchasers).
On the other hand, interest may be factored into the price and constitute a discount from future
higher prices. That is, PFC may be providing a discount to people who purchase their tickets in
advance. Prices may rise in the future. If this is the case, then treating the interest as deferred
revenue may make sense.
Copyright © 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 8 19
Pre-production costs
PFC has incurred significant costs in advance of the opening of “Rue St. Jacques.” We must
determine whether these costs should be capitalized and amortized, or expensed as incurred.
PFC would likely prefer to capitalize costs since this treatment would minimize the current effect
on income at a time when it is considering going to the capital markets. In principle, capitalization
and amortization of the costs over the life of the show appears reasonable. The issue is whether
the show will generate adequate revenues (in excess of the capitalized costs) to justify including
them on the balance sheet as assets. It is very difficult, however, to determine whether a theatre
production will be successful. Indications are that the show will be a success, given its long run
in Paris and the extent of advance ticket sales. These facts support capitalization; expensing
would likely be too conservative in light of these facts. However, despite these indicators of
success, the show could still bomb if costs are excessive or it does not suit the tastes of Canadian
theatre goers. As long as the definition of as asset can be met, setting it up as an asset is
acceptable.
If PFC chooses to capitalize the pre-production costs, they must be amortized over a reasonable
period of time. One method is to expense costs against net revenues dollar for dollar until the pre-
production costs are covered (i.e. cost recovery first method). With this method the show will
generate no income until the pre-production costs have been recovered. A second alternative is
to amortize over the estimated life of the show.
Of course, once the show opens, ongoing production costs should be expensed as incurred.
PFC paid $12 million for advertising and promotion costs a large part of which related to the “Rue
St. Jacques” show. These costs should be expensed as incurred because it is difficult to assess
the effectiveness of advertising costs i.e. to determine whether they provide future benefit.
Debt defeasance
PFC has structured the debt-retirement transaction as an in-substance defeasance of debt. The
effect of the transaction is to remove debt from the balance sheet and thereby reduce the amount
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20 Modern Advanced Accounting in Canada, Eighth Edition
of debt reported (thus, for example, decreasing the debt-to-equity ratio). Unfortunately, IFRS
does not allow the use of this type of arrangement.
IAS 1, paragraph 32 states “An entity shall not offset assets and liabilities or income and
expenses, unless required or permitted by an IFRS.” Paragraph 33 states “An entity reports
separately both assets and liabilities, and income and expenses.” Offsetting in the statements of
comprehensive income or financial position or in the separate income statement (if presented),
except when offsetting reflects the substance of the transaction or other event, detracts from the
ability of users both to understand the transactions, other events and conditions that have
occurred and to assess the entity’s future cash flows.
A financial asset and a financial liability shall be offset and the net amount presented in the
balance sheet when, and only when, an entity:
a. currently has a legally enforceable right to set off the recognized amounts; and
b. intends either to settle on a net basis, or to realize the asset and settle the liability
simultaneously.
Both of these conditions must be met in order to offset a financial asset and a financial liability.
However, the facts indicate that the holders of the company’s syndicated loan are not even aware
of PFC’s intended method of settling its debt. Therefore, the first condition for offsetting has not
been met, i.e. PFC has no legally enforceable right to set off the amounts recognized for its
syndicated loan, its investment in treasury bills and its forward contract. Therefore, this
arrangement would not allow the removal of these items from PFC’s balance sheet. The treasury
bonds and the debt must be reinstated on the financial statements and reported separately as an
asset and a liability. The $5 million difference between the value of the asset and the liability must
be reversed. This will increase income if the difference was previously recorded as a loss or will
reduce a non-current asset if it was previously recorded as a deferred charge.
From the information obtained to date, it is not currently clear how PFC is accounting for its
forward contract. PFC may want to consider whether the forward contract to buy US dollars
qualifies as a hedge of its debt obligation. If hedge accounting is not applied, then PFC will be
required to account for the forward contract as a derivative instrument measured at fair value
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Solutions Manual, Chapter 8 21
through the profit and loss.
Sale of theatres
PFC began selling theatres recently where economic conditions justified the sale of a particular
theatre. This year, a significant part of net income was generated through the sale of theatres.
PFC has included the proceeds from these sales as revenue on the income statement (as
opposed to treating them as gains or losses on disposition) because it considers such sales as
an ongoing part of its operations. However, the sales could also be considered incidental to
ongoing operations, with only gains or losses on disposition being reported in the income
statement. In the latter case, the gains and losses would not be included in revenues. Including
the proceeds from the sale of theatres is consistent with management’s objective of making the
financial statements more attractive for going to the capital markets.
Based on the information available, it is not possible to conclude whether these sales do represent
part of ongoing operations. We should review the sale agreements and board minutes to confirm
that these sales are indeed “ongoing.” If the sales are ongoing, the theatres would have to be
reported as a current asset similar to inventory. If the theatres continue to be reported as part of
property, plant and equipment, then it would be inappropriate to report the sales through revenue;
the sales should be reported as gains on sale.
If the sales can be considered part of ongoing operations, consideration should be given to
whether there should be separate disclosure of the revenue from theatre sales. Burying the
revenues from theatre sales will make it more difficult for users and the capital markets to value
the company because revenue from sales of theatres may not be as regular or predictable as
revenues from other sources. If such sales are material, separate disclosure of revenue should
be made either on the face of the income statement or in the notes.
Selling off a significant number of theatres raises the question of whether the number being sold
is large enough to be considered a discontinued operation, requiring separate disclosure of
information. For the theatre sales to qualify as a discontinued operation, they must represent a
separate major line of business or geographical area of operations. My assessment is that the
sale of theatres should not be considered a discontinued operation because PFC is continuing in
the theatre business. If, for example, PFC were ceasing to operate all of its movie theatres to
focus on live theatre, an argument for discontinued operations might be made. In this case, the
sale of theatres appears to be part of a continuing reassessment of its portfolio of theatres.
Copyright © 2016 McGraw-Hill Education. All rights reserved.
22 Modern Advanced Accounting in Canada, Eighth Edition
The sales for profit are consistent with management’s apparent objective of income maximization.
Management could manipulate the situation by selling only theatres that would generate a profit
(instead of selling ones that have more economic value in some other use).
PFC will need to consider the balance sheet classification of the theatres it intends to sell, i.e.,
whether they should be classified as non-current assets held for sale. A non-current asset should
be classified as held for sale if its carrying amount will be recovered principally through a sale
transaction rather than through continued use, which seems to be the case here. However,
certain additional criteria must be met to classify an asset as held for sale, which would also need
to be considered. If these criteria are met, then the theatre held for sale should be measured at
the lower of its carrying amount and fair value less costs of disposal. Non-current assets held for
sale (or assets and liabilities of a disposal group classified as held for sale) are presented
separately on the balance sheet.
Partnership agreement
PFC formed a partnership with an unrelated company whereby the other company contributed
cash and PFC contributed television production equipment. As part of the deal, PFC withdrew
the cash contributed by the other company for its own use. The substance of the transaction
appears to be the sale (rather than contribution) of assets to the partnership and the recording of
the gain on sale. By using this approach, management may be attempting to increase income
artificially by recognizing the full gain.
The facts suggest that this transaction is a partial sale of assets. If this is the case, the full gain
should not be recognized. The facts supporting this assertion are as follows. First, cash can be
withdrawn immediately; thus the partnership acted as a conduit for selling of the assets. Second,
the deal is based on future profits; that is, the value of PFC’s contribution appears to be dependent
on the future performance of the partnership. Third, Odyssey appears to be offering little expertise
to the partnership and thus cash is simply being funneled to PFC via the partnership. If this
transaction is just a partial sale of assets, the gain should only be $10.75 million ($40 million -0.45
(portion of assets sold) x $65 million (carrying amount of assets sold)) rather than $25 million.
The method preferred by PFC (recording full sale of the assets) might be supported by the fact
that future profits will be shared, suggesting that this is a legitimate partnership arrangement.
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Solutions Manual, Chapter 8 23
However, more information is required to understand how the value of PFC’s contribution may be
adjusted if the net income of Phantom earned between July 1, Year 7 and June 30, Year 8 does
not meet expectations, since this adjustment would appear to impact the calculation of each
partners’ respective interests.
The accounting for the investment in the partnership depends on PFC’s level of influence over
the operating and financing policies for the partnership. With a 55% interest, PFC would normally
have more power than the other shareholder. Although the two parties discuss all major decisions,
PFC has the power to make the decision on any contentious issues. Therefore, PRC has control
and would have to consolidate the partnership financial statements with their own financial
statements.
Conclusion
As indicated in Appendix I, income would decrease if the pre-production costs and/or
advertising costs have been capitalized and should have been expensed. As indicated in
Appendix II, income should be reduced for the unrealized gain on the transfer of assets to the
partnership and debt should be increased to reverse the debt defeasance transaction. After
adjustment, the return on equity on an annualized basis is only 18.8%, which is below the
company’s target return on equity. The debt to equity ratio is 1.98, which is slightly below the
maximum amount set in the debt covenant. We will need to review major transactions in the last
month of the year to ensure they are accounted for correctly. Otherwise, the company could be
in violation of their debt covenant. This would raise concerns of the company’s ability to
continue as a going concern.
Penalty Payment
- report as income 2 2 I* D*
- report as reduction of capital cost
Pre-production costs
- capitalize and later expense
- expense as incurred (15) (15) D I
Debt defeasance
- if loss was previously recorded 5 5 I D
- if deferred charge was recorded
Investment in partnership
- if full consolidation I I
- if proportionate consolidation I I
* Notations:
I = increase
D = decrease
NOTHING NOTED = no change
Debt defeasance 25
Investment in partnership
- reduce gain to 10.75 (14.25) (14.25)
Case 6-5
MEMORANDUM
To: Partner
From: CPA
Subject: The Wedding Planners Limited (“WP”)
Overview
WP is a private corporation. The financial statements will be used primarily by the bank to
evaluate the company and its management. As a result, the company has incentives to increase
earnings to present a favourable impression. The company will use ASPE.
WP has less than one month to obtain $700,000 to repay the credit facility from its bank. Our
review of the financial statements needs to be completed before the tax refund can be calculated,
Performance Measurement
Before WP’s tax refund can be calculated, it is necessary to finalize WP’s net income, as
adjustments may be made as part of the review engagement that could also result in a tax
adjustment. I was provided with the list of outstanding accounting issues and have made the
necessary adjustments to the Year 6 net income in Exhibit I. Here is the accounting explanation
that supports the adjustments made.
Refundable deposits
At year-end Year 6, WP holds $155,000 in refundable deposits from potential customers that
have been recorded as revenue. Since WP has not yet performed a service for these customers
(the weddings have not yet been held) and the amounts are presumably refundable, this
revenue should be removed from the income statement. There was $130,000 in refundable
deposits at year-end Year 5, so the gross margin error relating to Year 6 is $25,000.
Inter-company transactions
1. Sale of van
WP recorded a $30,000 ($55,000-$25,000) loss on the sale of a van to JJ. WP and JJ are
both owned by Anne and are therefore related parties. ASPE requires that an income
statement impact only be recorded if the transaction has commercial substance and if it is in
the ordinary course of business. This transaction is not a normal part of WP’s operations
(i.e., it is not in the business of selling vehicles). The transaction should therefore be
recorded at the carrying amount of $55,000 (Part II of CICA Handbook Accounting, Section
3840.29). The loss of $30,000 should be removed from the income statement and recorded
in equity.
Also, in situations where WP realizes a gain or loss on the sale of assets, the amounts
should not be in gross margin, but should be disclosed in a separate income or expense
category.
2. Janitorial costs and alcohol sales
The janitorial costs for services provided by JJ to WP and alcohol sales from WP to DJ are
both in the normal course of the provider’s business and represent the culmination of the
earnings process. Accordingly, these transactions should be recorded at the exchange
amount agreed upon between the companies (CICA Handbook-Accounting, Section
3840.18). The companies have agreed that these transfers occur at cost, and are therefore
reflected appropriately for accounting purposes. No adjustment is necessary.
Copyright © 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 8 27
3. Payroll
All the employees of the various companies are currently paid through WP. As a result, the
expenses in WP are not properly matched with revenues. WP should charge the expenses
to the other companies and consider charging a fee to JJ and DJ for doing the transfer of
the payroll expenses related to the provision of services to each company. This adjustment
will increase WP’s income for the year.
Reward program
WP has started giving away cases of champagne as recognition rewards for its employees.
However, the cost of the champagne has been left in cost of goods sold rather than being
classified as an employee benefit. WP has given away 50 cases at a cost of $360 (assuming
they were bought as part of the contract and not on the market). An adjustment of $18,000 is
required to reallocate the cost from cost of goods sold to an administrative-type expense,
Copyright © 2016 McGraw-Hill Education. All rights reserved.
28 Modern Advanced Accounting in Canada, Eighth Edition
equivalent to where their salaries would be posted. Some of the employees work for the other
companies, so the amount needs to be allocated to the various companies.
Amortization
WP uses capital cost allowance for both tax and accounting amortization purposes. WP should
establish a separate amortization method for its assets based on the useful life and pattern of
use.
EXHIBIT I
RESTATEMENT OF WP INCOME STATEMENT
Purpose: To correct errors in WP's preliminary net income balance. The revised net income will
be used to estimate the tax refund.
WP Year 6
Net loss as stated $ (335,996)
Champagne contract cancellation fee (60,000)
Employee rewards (cases of champagne given away) - reclassification only –
Lawsuit judgment recovery –
Payroll expense – charge to other companies –
Van sale 30,000
Refundable deposits net change in Year 6 (25,000)
Tax effect of adjustments (assuming a 20% income tax rate) 11,000
Revised net income (loss) $ (379,996)
Copyright © 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 8 29
Conclusion: WP's original net loss is increased by adjusting the financial statements for the
cancellation of the fixed price contract, and related party transactions.
SOLUTIONS TO PROBLEMS
Problem 6-1
(a)
Intercompany balances
Sales and purchases for Year 3 $190,000 (a)
Accounts receivable and payable at end of Year 3 $50,000 (b)
(b) Since the subsidiary was the seller of the intercompany sales, these transactions are
upstream transactions and the non-controlling interest (NCI) will absorb their share of the
adjustments to eliminate the unrealized profits. NCI on the income statement will decrease
by $1,440 (10% x $14,400) for its share of unrealized after-tax profits in ending inventory
and increase by $1,260 (10% x $12,600) for its share of after-tax profits in beginning
inventory. NCI on the balance sheet will decrease by $1,440 (10% x $14,400) for its share
of unrealized after-tax profits in ending inventory.
Problem 6-2
(a)
Intercompany revenues and expenses
Sales and purchases (100,000 + 80,000) 180,000 (a)
Rent revenue and expense 24,000 (b)
Interest revenue and expense (70% x 50,000) 35,000 (c)
Parent Company
Consolidated Income Statement
for the Current Year
Problem 6-3
Pike Spike Consolidated
December 31, Year 1
Land 200,000 230,000*
Gain on Sale
Problem 6-4
(a)
Acquisition differential amortization
Plant – Waste
Years 4 – 8 ([15,000 / 8 years] x 5 years) 9,375 (a)
Year 9 (15,000 / 8 years) 1,875 (b)
Goodwill – Baste
Years 7 – 8 19,000 (c)
Year 9 –0–
Intercompany Revenues and Expenses
Sales (90,000 + 170,000 + 150,000) 410,000 (d)
Rent (25,000 + 14,000) 39,000 (e)
Interest 10,000 (f)
Dividend income: All intercompany from Waste & Baste 43,750 (g)
Intercompany Profits
Before tax 40% tax After tax
Opening inventory – Waste selling (upstream)
(15,000 x .30) 4,500 1,800 2,700 (h)
Ending inventory – Baste selling (upstream)
Paste Company
Consolidated Income Statement
for the Year Ended December 31, Year 9
(b)
Calculation of consolidated retained earnings – December 31, Year 9
(c)
Profit of Waste 104,000
Add: Realized after-tax profit in opening inventory (upstream) (h) 2,700
106,700
Less: Unrealized after-tax profit in ending inventory (upstream) (k) 10,800
amortization of acquisition differential (b) 1,875
94,025
Paste’s share x 80% 75,220
(d)
Revenue should be recognized when it is earned i.e., when the benefits and risks have been
transferred to an entity outside of the reporting entity. The reporting entity for consolidated
financial statements encompasses the parent and all of its subsidiaries. Since intercompany
transactions are transactions within the reporting entity (not outside of the reporting entity), they
must be eliminated when preparing consolidated financial statements. When the inventory is
sold outside of the consolidated entity, the difference between the selling price and the original
cost to the consolidated entity would be reported as profit of the consolidated entity.
Problem 6-5
Year 3
Year 4
Cash 3,750
Investment in Y Co. 3,750
75% x 5,000 dividends
Note: Year 4 equity method income is $14,250 (–$12,000 – $2,250 + $13,500 + $22,200 –
$7,200)
Proof:
Proof:
Problem 6-6
Intercompany profits
Before tax 40% tax After tax
Opening inventory Q selling (upstream) 80,000 32,000 48,000 (a)
L selling (downstream) 52,000 20,800 31,200 (b)
Profit of L 580,000
Less: Dividends
From M (80% x 200,000) 160,000
From Q (70% x 150,000) 105,000
Unrealized after-tax profit in ending inventory
(downstream) (d) 70,800 335,800
244,200
Add: Realized after-tax profit in opening inventory (downstream) (b) 31,200
Adjusted profit 275,400
Profit of M 360,000
Profit of Q 240,000
Less: Unrealized after-tax profit in ending inventory (upstream)(c) 21,000
219,000
Add: Realized after-tax profit in opening inventory (upstream) (a) 48,000
267,000
Consolidated profit 902,400
Attributable to:
Shareholders of L 750,300
Copyright © 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 8 41
Non-controlling interests (20% x 360,000 + 30% x 267,000) 152,100
902,400
(b)
Calculation of consolidated retained earnings – beginning of current year
Problem 6-7
Calculation, allocation, and amortization of acquisition differential
Intercompany profits
Before tax 40% tax After tax
Common Retained
Stock Earnings Total NCI Total
Balance, beginning of year 1,000,000 10,332,312 11,332,312 547,453 11,879,765
Add: net income 1,197,612 1,197,612 82,528 1,280,140
(c) The cost principle requires that certain assets such as inventory be reported at cost. When
a profit is made on an intercompany sale, the inventory cost to the purchaser is higher than
the cost incurred by the seller. An adjustment is made on consolidation to remove the profit
from the inventory of the purchaser to bring the value of the inventory down to the original
cost to the consolidated entity.
(d) The debt to equity ratio would increase because debt remains the same but the non-
controlling interest within shareholders’ equity decreases. Non-controlling interests
decreases because it does not contain the incorporate the non-controlling interests’ share
of the value of the subsidiary’s goodwill.
(b)
The only new account would be equity method income on Fazli’s income statement. Gervais’
income statement and the consolidated income statement would not change. The equity method
income would be $500. This $500 would bring Fazli’s total income to $1,250, which is equal to
consolidated net income attributable to Fazli’s shareholders. It can be calculated as follows:
Gervais’ net income $720
Less: unrealized after-tax profits in ending inventory (upstream) (220)
Gervais’ income from consolidated viewpoint 500
Fazli’s percentage ownership 100%
Equity method income from subsidiary $500
(c)
The only change would be split of the consolidated net income between the parent and non-
controlling interest. Otherwise, all three income statements remain the same. The split of the
consolidated net income can be calculated as follows:
Gervais’ net income $720
Less: unrealized after-tax profits in ending inventory (upstream) (220)
Gervais’ income from consolidated viewpoint 500
NCI’s percentage ownership 20%
Consolidated net income attributable to NCI 100
Consolidated net income attributable to parent (1,250 – 100) 1,150
Consolidated net income $1,250
(d)
The only change would be split of the consolidated net income between the parent and non-
controlling interest. Otherwise, all three income statements remain the same. The split of the
consolidated net income can be calculated as follows:
Fazli’s net income $750
Copyright © 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 8 49
NCI’s percentage ownership 20%
Consolidated net income attributable to NCI 150
Consolidated net income attributable to parent (1,250 – 150) 1,100
Consolidated net income $1,250
Alternatively:
Gervais’ net income $720
Less: unrealized after-tax profits in ending inventory (downstream) (220)
Gervais’ income from consolidated viewpoint 500
Gervais’ share of Fazli’s net income (750 x 80%) 600
Consolidated net income attributable to parent 1,100
Consolidated net income attributable to NCI (1,250 – 1,100) 150
Consolidated net income $1,250
Problem 6-9
Unrealized profits (subsidiary selling) (upstream) Before 40% After
Tax Tax Tax
Beginning inventory ([45,000 – 27,000] x 20%) 3,600 1,440 2,160 (a)
Ending inventory ([60,000 – 33,000] x 30%) 8,100 3,240 4,860 (b)
(a)
(i) Net income of Yosef 150,000
Less: dividend income from subsidiary (20,000 x 90%) (18,000)
132,000
Net income of Randeep 55,000
Add: realized after-tax profit in beginning inventory (upstream) (a) 2,160
Less: Unrealized after-tax profit in ending inventory (upstream) (b) (4,860)
52,300
Consolidated net income $184,300
(ii) Attributable to:
Controlling interest (132,000 + 90% x 52,300) $179,070
Non-controlling interest (10% x 52,300) 5,230
(iii) deferred income tax asset (b) 3,240
(iv) inventory (70,000 + 45,000 – (b) 8,100) 106,900
(b)
(i) Net income of Yosef 150,000
Less: dividend income from subsidiary (20,000 x 90%) (18,000)
132,000
Add: realized after-tax profit in beginning inventory (upstream) (a) 2,160
Less: unrealized after-tax profit in ending inventory (upstream) (b) (4,860)
129,300
Net income of Randeep 55,000
Consolidated net income $184,300
(ii) Attributable to:
Controlling interest (129,300 + 90% x 55,000) $178,800
Non-controlling interest (10% x 55,000) 5,500
(iii) deferred income tax asset (b) 3,240
(iv) inventory (70,000 + 45,000 – (b) 8,100) 106,900
(v) net adjustment to retained earnings at beginning of year
pertaining to intercompany profits (a) 2,160
(vi) net adjustment to retained earnings at end of year
pertaining to intercompany profits (b) 4,860
Problem 6-10
Intercompany revenues and expenses
Sales and purchases (90,000 + 177,000) 267,000 (a)
Rental revenue and expense (2,800 x 12) 33,600 (b)
Interest revenue and expense (360,000 x 0.05) 18,000 (c)
Intercompany profits
Before tax 40% tax After tax
Opening inventory – Evans selling (downstream)
(21,250 – [21,250 / 1.25]) 4,250 1,700 2,550 (d)
(b)
Calculation of consolidated retained earnings – beginning of year
Problem 6-11
Calculation, allocation, and amortization of the acquisition differential
Intercompany profits
P Co.
Consolidated Statement of Changes in Equity
For Year Ended December 31, Year 10
Common Retained
Shares Earnings Total NCI Total
Balance, beginning of year 150,000 112,568 262,568 10,032 272,600
Add: net income 87,312 87,312 4,088 91,400
Less: dividends (12,000) (12,000) (1,000) (13,000)
Retained earnings, Dec. 31 150,000 187,880 387,880 13,120 351,000
Proof:
Retained earnings of P, Dec. 31, Year 10
(101,000 + 60,000) 161,000
Less: Unrealized after-tax profit in ending inventory (downstream) (g) 1,200
Adjusted retained earnings 159,800
Retained earnings of S, Dec. 31, Year 10
(34,000 + 48,000) 82,000
Retained earnings of S at acquisition 20,000
Increase since acquisition 62,000
Less: Amortization of the patents
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56 Modern Advanced Accounting in Canada, Eighth Edition
((a) 16,000 + (b) 4,000) 20,000
Unrealized after-tax gain on land
(upstream) (i) 6,000
Unrealized after-tax profit in ending
inventory (upstream) (f) 4,800 30,800
Adjusted increase 31,200 (k)
P's ownership % 90% 28,080
Consolidated retained earnings, Dec., 31, Year 10 187,880
Intercompany profits
(b)
Since Road uses the equity method of accounting for its investment in Runner, consolidated
retained earnings at December 31, Year 9 would be $2,526,300, which is equal to Road’s retained
earnings on its separate entity financial statements.
(c)
The return on equity attributable to shareholders of Road for Year 9 would not change. Only the
NCI’s share of consolidated profit would change under the parent company extension theory.
The NCI’s share of consolidated profit would increase because the NCI’s share of Runner’s
goodwill and goodwill impairment is not reported under this theory.
Problem 6-13
Calculation, allocation, and amortization of acquisition differential
Intercompany profits
Before tax 40% tax After tax
Land – Sage selling (upstream) $34,000 $13,600 $20,400 (i)
Opening inventory – Sage selling (upstream)
(17,000 x 0.25) $4,250 $1,700 $2,550 (j)
Ending inventory – Sage selling (upstream)
(30,000 x 0.25) $7,500 $3,000 $4,500 (k)
– Post selling (downstream)
(21,000 x 0.25) $5,250 $2,100 $3,150 (l)
$12,750 $5,100 $7,650 (m)
(b)
Goodwill impairment loss – entity theory $1,350
Less: NCI’s share @ 30% 405
Goodwill impairment loss – parent company extension theory $945
(c)
Goodwill – entity theory $83,410
Less: NCI’s share @ 30% 25,023
Goodwill – parent company extension theory $58,387
Attributable to:
Shareholders of Peter $ 102,800
Non-controlling interest 13 2,250 2,250
Total $ 316,390 $ 289,390 $ 105,050
$ 660,083 $ 660,083 0
$ 660,083 $ 660,083
Notes:
a NCI, end of Year 6 $ 56,733
Less: NCI's share of consolidated net income for Year 6 -2,250
Add: NCI's share of Sage's dividends for Year 6 0
NCI, beginning of Year 6 $ 54,483
Problem 6-14
(a) Acquisition cost Allocation
Acquisition January 1, Year 7
Intercompany Amounts:
(b) Consolidated Income Statement for the year ending December 31, Year 11
Reconciliation:
(d)
Consolidated Statement of Financial Position
December 31, Year 11
(f)
CONSOLIDATED FINANCIAL STATEMENT WORKING PAPER
VINE
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, YEAR 11
In thousands of dollars
Eliminations
Vine Devine Dr. Cr. Consolidated
Income Statements - Year 11
Sales $ 13,000 $ 4,400 7 3,340 $ 14,060
Dividend, Investment Income,
and Gains 1,800 2,400 5 375 3,355
10 470
Total income 14,800 6,800 17,415
JOURNAL ENTRIES
6 Other expenses 67
Accum depreciation - equip 27
Patents (net) 94
To amortize acquisition differential for the year
7 Sales 3,340
Cost of sales 3,340
To eliminate intercompany sales
Notes
a Consolidated retained earnings, end of Year 11 $12,632,950
(= Vine's Retained earnings, end of Year 11 under equity method)
Vine's Retained earnings, end of Year 11 under cost method) 10,600,000
Difference between cost and equity method, end of Year 11 2,032,950
Less: Vine's net income under equity method for Year 11 (5,631,250)
Add : Vine's net income under cost method for Year 11 4,000,000
Vine's difference in retained earnings, beginning of Year 11 $ 401,700
Problem 6-15
(a)
Notes:
1
Management fee (2,000 × 12) $ 24,000
2
Downstream sales 100,000
3
Interest (45,000 × 8% × 9/12) 2,700
4
Investment income from Sand 1,050
Intercompany profits
Before tax 40% tax After tax
5
Unrealized after-tax gain on land — Sand selling
(upstream) (45,000 – 20,000) $ 25,000 $10,000 $ 15,000
6
Unrealized after-tax profit in ending inventory — Paper
Selling (downstream) (30,000 × 35%) $ 10,500 $ 4,200 $ 6,300
(c)
(d)
Non-controlling interest – at date of acquisition
- under implied value approach (30% x 120,000) 36,000
- using independent appraisal 30,000
Decrease in non-controlling interest and goodwill 6,000
Goodwill impairment loss for the year ended December 31, Year 5
- as previously calculated 21,500
- decrease due to change in goodwill at acquisition 6,000
- as per new calculation 15,500
Profit attributable to non-controlling interest for the year ended December 31, Year 3
- as previously calculated 3,150
- increase due to reduced goodwill impairment loss
(30% x 21,500 – 1,224) 5,226
- as per new calculation 8,376