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Consolidation Subsequent to
Acquisition Date
CASES
Case 5-1 In this case, students must discuss how to value employees and patentable products
and how these assets should be amortized or checked for impairment on an annual basis.
Case 5-2
In this case, adapted from a CPA exam, students are asked to determine appropriate
accounting policies relating to a restructuring of a real estate company. A special purpose
balance sheet needs to be prepared that reports all assets and liabilities at fair value.
Case 5-3
In this case, adapted from a CPA exam, students are asked to provide advice in managing a
new company providing warranties for new homes. Students must also recommend appropriate
accounting policies relating to revenue recognition, warranty obligations and a business
combination involving some unique factors in allocating the acquisition cost.
Case 5-4
In this real life case, students are asked to provide advice in resolving a salary dispute for a
hockey team. The owner of the hockey team states that he cannot afford the demands from the
union. However, consolidated statements are not being prepared for the combined operations of
the hockey team and Stadium, which is a subsidiary of the hockey team.
Case 5-5
In this case, adapted from a CPA exam, management appears to be manipulating income to
minimize the payment required under a share-redemption agreement. Students are required to
apply special accounting policies when analyzing controversial accounting issues including the
valuation of inventory, capitalization policies, goodwill, and related party transactions.
Case 5-6
In this case, adapted from a CPA exam, management appears to be manipulating income to
maximize its bonus. Students must recommend appropriate accounting policies relating to
revenue recognition, research and development costs and identifiable assets in a business
PROBLEMS
2. The process for testing for impairment is essentially the same in that the assets are written
down to recoverable amount when they are less than the carrying amount. Recoverable
When the intangible assets must be tested for impairment is not the same for the different
types of intangible assets. Goodwill impairment tests must be conducted at least once a year
unless it is clear that there has been no impairment during the year and more often than
once a year when there is an indication that the cash-generating unit may be impaired. For
intangible assets with a definite useful live, the recoverable amount is only compared to
carrying amount if there is an indication that the asset may be impaired. Intangible assets
with indefinite useful lives must be checked for impairment on an annual basis and
whenever there is an indication that the intangible asset may be impaired.
3. The asset “Investment in subsidiary” on the balance sheet of the parent company is
removed and replaced with the individual assets and liabilities from the balance sheet of the
subsidiary (which are remeasured by the unamortized acquisition differential), and by the
non-controlling interest in the net assets of the subsidiary (in cases of less than 100%
ownership). The item of income “Investment income” on the income statement of the parent
company is removed and replaced with the income and expenses from the income
statement of the subsidiary (adjusted for the amortization of the acquisition differential), and
by the non-controlling interest in the net income of the subsidiary (in cases of less than
100% ownership). As well, any intercompany transactions such as payables and receivables
would be eliminated upon consolidation, whereas under the equity method they remain.
5. IFRS does not specify any method for internal record keeping purposes because the parent
is required to prepare consolidated statements for external financial reporting purposes, and
these statements are not affected by the method used by the parent to record the
investment. However, if the parent wants to issue separate entity financial statements in
accordance with GAAP, IAS 27 requires that the investment in subsidiary on the separate
entity financial statements shall be reported at cost or in accordance with IAS 39 Financial
Copyright 2016 McGraw-Hill Education. All rights reserved.
6 Modern Advanced Accounting in Canada, Eighth Edition
Instruments: Recognition and Measurement (or IFRS 9 Financial Instruments: Classification
and Measurement if it is adopted early).
6. The dividends that appear in the retained earnings column in the consolidated statement of
changes in equity are those of the parent company only. The subsidiary’s dividends that
were paid outside the entity to the non-controlling shareholders would appear on a
statement of changes in non-controlling interest (if such a statement was prepared). The
subsidiary’s dividends that were paid to the parent do not appear on any consolidated
statement because no cash left the combined economic entity.
7. This statement is partially true. As long as the parent continues to control the subsidiary and
as long as the subsidiary continues to hold the land, this part of the acquisition differential
will be used to remeasure the land on all subsequent consolidated balance sheets. If the
land is sold by the subsidiary, the acquisition differential will in part be used to determine the
loss or gain for consolidated purposes and will no longer appear on the consolidated
balance sheet. If consolidation of this subsidiary ceases (due to loss of control), the
acquisition differential would become redundant since the acquisition differential only
appears within the consolidated financial statements.
8. What this statement means is that in addition to recording the investor’s share of net income
earned by the investee since acquisition, entries must also be made for the amortization of
the acquisition differential, and for the holdback and realization of any unrealized profits
regardless of whether the profit was recorded by the investee or the investor. The
calculations for these entries are identical to those that would be made when consolidating.
(If equity method journal entries had been made to holdback unrealized profits, we would
not get this result.)
11. Any fair value excess arising from the acquisition must be eliminated or amortized on
consolidation in the same way that a cost of an individual asset purchased directly by an
entity is eliminated or amortized. The matching principle states that the cost of an asset
should be expensed in the same period as the benefits received from using the asset. The
benefits are received over the useful life of an asset. Consequently, assets such as property,
plant and equipment should be amortized over their useful lives and assets such as
inventory should be expensed in the year they are sold.
12. The balance sheet accounts of the parent that have different balances are:
Investment in subsidiary, and
Retained earnings.
In addition, the following two income statement accounts differ in amount and their
description:
Dividend income (using the cost method)
Investment income (or equity earnings) (using the equity method)
13. This adjusts the parent's retained earnings under the cost method to what they would be
using the equity method. Under the equity method, the retained earnings of the parent
contain the parent's share of the subsidiary's net income since acquisition. Under the cost
method, the parent's retained earnings contain the parent's share of the subsidiary's
dividends since acquisition. Net income less dividends equals the change in retained
earnings. When we add the parent's share of the increase in the retained earnings of the
subsidiary to the retained earnings of the parent, the resultant amount now contains the
parent's share of the subsidiary's net income earned since acquisition.
14. The subsidiary’s revenue and expenses included in the consolidated income statement are
only those that have occurred since acquisition. Also, the non-controlling interest is based
on the subsidiary’s income earned subsequent to the date of acquisition.
*15.The initial entry adjusts the parent's investment account and retained earnings at the
beginning of the year to equity method balances. The investment account now reflects the
Copyright 2016 McGraw-Hill Education. All rights reserved.
8 Modern Advanced Accounting in Canada, Eighth Edition
equity method balance at the beginning of the current year.
16. Under the cost method, the parent has recorded only its share of dividends received from
the subsidiary. It has not recorded its share of the subsidiary’s change in retained earnings
or its share of the amortization of the acquisition differential. Therefore, an entry or entries
must be made on the consolidation to record the parent’s share of the subsidiary’s change
in retained earnings and its share of the amortization of the acquisition differential. Since the
starting point for consolidation is the separate entity records of the parent and subsidiary, a
cumulative entry is required each year on consolidation to adjust the parent company’s
retained earnings to what it would be under the equity method. When the equity method is
used, the parent’s retained earnings already reflect its share of the subsidiary’s retained
earnings and its share of the amortization of the acquisition differential.
SOLUTIONS TO CASES
Case 5-1
a) None of the acquisition cost should be allocated to BIO’s skilled workers as long as the
workers are not under contract. The skilled workers are not capable of being separated
or divided from the acquired enterprise and cannot be sold, transferred, licensed, rented,
or exchanged. Therefore, the value of the skilled workers would be included as a part of
goodwill.
b) Part of the acquisition cost should be allocated to patentable technology because this
technology has a value in the marketplace and it could be separated or divided from the
acquired enterprise and sold, transferred, licensed, rented, or exchanged. An appraiser
could be hired to estimate a value for the patentable technology. The technology would
be amortized over its expected useful life, which is likely to be short because of rapid
changes in technology. The technology would be checked for impairment whenever
events or changes in circumstances indicate that its carrying amount may not be
recoverable.
c) Goodwill is the difference between the acquisition cost and the fair value of identifiable
net assets. The goodwill can only be determined once all of the identifiable assets
including the patentable technology and identifiable liabilities have been measured at fair
(b) The most recent determination of recoverable amount resulted in an amount that
exceeded the carrying amount of the cash-generating unit by a substantial margin.
(c) Based on an analysis of events that have occurred and circumstances that have
changed since the most recent determination of recoverable amount, the
likelihood that today’s recoverable amount would be less than the current carrying
amount of the reporting unit is remote.
A two-step impairment test should be used to identify potential goodwill impairment and
measure the amount of a goodwill impairment loss to be recognized, if any:
(a) The recoverable amount of the cash-generating unit should be compared with its
carrying amount, including goodwill, in order to identify a potential impairment.
When the recoverable amount of a cash-generating unit exceeds its carrying
amount, goodwill of the reporting unit is considered not to be impaired and the
second step of the impairment test is unnecessary.
(b) When the recoverable amount is less than the carrying amount, an impairment
loss should be recognized and should be allocated to reduce the carrying amount
of the assets of the unit (group of units) in the following order:
(i) first, to reduce the carrying amount of any goodwill allocated to the cash-
generating unit; and
(ii) then, to the other assets of the unit pro rata on the basis of the carrying amount of
each asset in the unit. However, an entity shall not reduce the carrying amount of
an individual asset below the higher of its recoverable amount and zero. The
amount of the impairment loss that could not be allocated to an individual asset
because of this limitation shall be allocated pro rata to the other assets of the unit
(group of units).
Case 5-2
Memo to: Board of Directors of GIL
In determining appropriate accounting policies for GIL, I considered the users of GIL’s financial
statements and their information needs. There are many users, with varied and often conflicting
information needs. Accordingly, I have had to make assumptions when ranking the users in
order to determine the most appropriate policies.
The bank will be concerned about liquidity and its security. Cash flow and current value
information would be useful for this purpose.
Sam and Ida Growth will be concerned that the valuation of GIL’s net assets are
calculated fairly so that the redemption value of their preferred shares is fair. They will
also want information to evaluate the performance of GIL’s management since they still
have voting control.
The common shareholders, the Growth children and Mario Thibeault, will be interested
in evaluating management’s performance and the performance of GIL’s investments.
Current value information is necessary for this purpose.
The senior management of GIL will want to maximize income since it receives a bonus
based on net income.
CRA requires historical cost information on realized gains and losses to assess income
taxes.
In my view, the most important users are Sam and Ida Growth, the preferred shareholders
because they have the most at stake in the company and could redeem their shares at any time
for fair value of GIL at November 30, Year 3. Thus, accounting policies have been chosen to
meet Sam and Ida’s objective of receiving a fair redemption value for their preferred shares and
of evaluating management. The valuation of the redemption creates a conflict. The common
To satisfy the information needs of Sam and Ida for a one-time revaluation of the net assets of
GIL at November 30, Year 3, a special purpose balance sheet should be prepared. The balance
sheet will report all assets and liabilities at fair value. This will determine the redemption value
of, and the value assigned to, the preferred shares. The old common shares will be cancelled.
The new common shares will be valued at $400, the cash received on issuance of these new
shares.
The special purpose balance sheet will not comply with generally accepted accounting policies
(GGAP) because GAAP only allows for a comprehensive revaluation of net assets when there
has been a change in control. Since Sam and Ida controlled GIL both before and after the
reorganization, there has not been a change in control.
To satisfy the information needs of the other users for Year 3 and subsequent years, general
purpose financial statements should be prepared in accordance with ASPE. The net assets of
GIL will be retained at their carrying value. Accordingly, the value assigned to the preferred
shares will be equal to the carrying value of the common shareholders’ equity prior to the
reorganization. As noted above, the new common shares will be valued at $400, the cash
received on issuance of these new shares.
In the ensuing discussion, I will indicate the accounting and reporting requirements for both the
special purpose balance sheet and the general-purpose financial statements.
The special purpose balance sheet will show the fair value of Sam and Ida preferred shares at
the date of the reorganization. This value will be used as the base for future dividend
distribution. This balance sheet will not be updated on an annual basis.
Fair value is defined in IFRS 13 Fair Value Measurement as the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between market participants
at the measurement date (i.e., an exit price). It would reflect the highest and best use for the
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12 Modern Advanced Accounting in Canada, Eighth Edition
asset.
The various properties should be valued at appraised value regardless of whether the appraised
value is higher or lower than carrying value. The non-interest bearing note receivable should be
discounted at current market rates to reflect the true value. Assuming an interest rate of 10%
(based on current five-year mortgage interest rates), the present value of the receivable is
$1,895,000 ($500,000 x 3.79).
GIL’s outstanding debt bears varying interest rates. These liabilities should also be discounted
at current market rates to reflect their true value.
In revaluing the assets and liabilities of GIL, we must consider the tax effects of the revaluation.
Selling costs should be deducted in determining the fair value of these assets and liabilities.
Then, future income taxes should be set up to reflect the tax that would be payable or
receivable if these assets and liabilities were sold or paid off at their fair value.
There would be no benefit in capitalizing the real estate taxes and interest on the debt incurred
to finance the raw land purchases since the land is being revalued to its fair value. If these costs
were capitalized, the land would be reported at a value in excess of its fair value.
A professional appraiser should appraise the apartment building that is planned to be converted
to a condominium. The appraised value should reflect the likelihood of conversion and the
potential profits from the conversion.
GIL should record the benefits of the low lease payments ($100,000 versus $220,000 per year)
as an asset at the time of reorganization because the new shareholders will benefit from the
leasing decision made by the previous owners. Using a discount rate of 10% for 14 years, the
remaining term of the lease, the reduced payments have a value of $884,400 ($120,000 x 7.37).
The investment in the joint venture should be valued at fair value by valuing the net assets
owned by the joint venture at fair value and multiplying by GIL’s 50% interest.
The likely amount of contingent consideration to be received from the sale of the office building
should be included in the redemption value of the shares since the decision to sell the building
was made by Sam and Ida.
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 5 13
General Purpose Financial Statements
The general-purpose financial statements will be prepared in accordance with ASPE and will be
prepared on an annual basis. Unless otherwise noted below, the assets and liabilities of GIL will
not be revalued to fair value on the date of the reorganization.
The non-interest bearing note receivable should be valued at $1,895,000, as calculated above,
on the date of the sale of the building. The difference between the face value and the present
value of the note, $605,000, represents deferred interest revenue. It should be reported as a
deferred credit on the balance sheet and amortized into income over the five-year term of the
receivable. The $605,000 of interest revenue will reduce the amount of gross profit recognized
on the sale. Only $500,000 of the note receivable should be reported as a current asset. The
remainder should be reported as a long-term asset.
The real estate taxes and interest on debt incurred to finance the raw land purchase should be
added to the cost of the land. These are costs of getting the land ready for sale or ready for use.
These costs will be recovered through future sales.
The increase in value of the building due to conversion to condominium status will not be
reflected in the financial statement on conversion. The gain will be reported if and when the
building is sold.
GIL should report a gain as a result of the sale to the joint venture partner of one-half of its
interest in the land on which the shopping center is being built as this portion was deemed to be
sold to an arm’s length party.
GIL has an accounting policy choice to report its investment in the joint venture using the cost
method, equity method or proportionate consolidation. The equity method or proportionate
consolidation both reflect GIL’s share of the income in the joint venture as the income is earned
by the joint venture. The cost method is easier to account for but doesn’t reflect income until it is
received as a dividend from the joint venture. The details of the joint venture arrangement
should be disclosed including its significant commitment to the construction company.
The sales agreement for the office building contains a contingent fee clause. Any additional
Copyright 2016 McGraw-Hill Education. All rights reserved.
14 Modern Advanced Accounting in Canada, Eighth Edition
sums received are really a part of the selling price of the building. These additional amounts
should be added to the selling price once they are measurable. Since new leases have already
been signed, no uncertainty exists regarding at least a portion of the contingent consideration.
GIL is currently using the same depreciation rates and methods for tax purposes and
accounting purposes. However, the rates used for tax purposes do not necessarily reflect the
true economic lives of the assets. GIL should review all its depreciation rates and ensure that
they properly represent the actual usage of the assets over time.
According to paragraph .23 of section 3856 of Part II in the CPA Canada Handbook, an entity
that issues preferred shares in a tax planning arrangement should present the shares at par,
stated or assigned value as a separate line item in the equity section of the balance sheet, with
a suitable description indicating that they are redeemable at the option of the holder. When
redemption is demanded, the issuer shall reclassify the shares as liabilities and measure them
at the redemption amount. Any adjustment shall be recognized in retained earnings. Extensive
note disclosure will be required of the share exchange and the conditions of the preferred share
issue.
Case 5-3
We have been engaged to provide you with recommendations that will assist you in managing
Total Protection Limited (TPL or the Company) profitably on a long-term basis. The key
decisions that TPL will be making concern pricing, cost control, and cash management and
investment. Our report offers advice intended to assist the Company with these decisions, as
they are the determinants of future profitability.
Pricing
There appears to be no rationale for pricing other than charging what the market will bear. It is
important to set prices for each builder that will more than offset the costs of warranty repairs
and price guarantees if long-term profitability is to be achieved. The attached accounting
policies report discusses the problems with estimating warranty costs, so the discussion is not
I have done an analysis of warranty revenues and costs by builder (see Appendix I). No undue
reliance should be placed on the data, given the condition of the Company's records. However,
some problems seem apparent:
1. The prices being charged for the warranties and repair costs incurred vary widely among
the builders.
2. Warranty revenues charged by Kings Road and Safe-Way Builders are low in
comparison to those of the other builders and are unlikely to cover future warranty costs.
3. Repair costs bear no relationship to the price of the warranties. Not surprisingly,
warranties for houses built by the companies using lower cost materials are experiencing
higher repair cost claims. These builders are also charging only the minimum amount for
the upfront fees.
4. Safe-Way has the highest repair cost per warranty sold of the shareholder participants
and is, therefore, probably the least qualified to do the warranty repairs.
5. Kings Road has the smallest margin between cost and revenues and given the length of
the warranty, its costs will soon exceed its revenues.
6. Repair costs based on experience to date are highest for the builders that are not
shareholders in the Company, and they may be using the warranties to increase their
own profits.
All these problems suggest that a major overhaul of the pricing structure is in order to allow
flexibility for homes of different quality. Although the current commission structure helps
maximize the price that is received for the warranties sold, it does not motivate the builders to
minimize the repair costs incurred as a result of using lower quality materials.
The minimum premiums for Kings Road, Safe-Way Builders, and the other builders will all have
to be increased substantially to cover repair costs adequately and ensure fairness to all
shareholder participants in the Company. At present, the better-quality builders are subsidizing
the lower-quality builders. Perhaps a large deductible should be imposed on each repair claim
to reduce the amount of this differential, or some other variation of pricing structure should be
considered that relates price to cost history.
Larkview, Towne and Granite have sold warranties at reasonably high prices and have relatively
Safe-Way Builders are currently performing all the repair work on warranties. There is a problem
in having any shareholder solely responsible for the repair work. The motivation for any builder
will be to maximize the price of the repair work in order to increase its own profits. TPL should
therefore institute certain controls to ensure that all repair work performed is in fact required and
that it is performed at the best price to TPL.
Standards should be developed for hourly rates and the number of hours required for the
various types of repairs.
An approval process for repairs should be introduced whereby another shareholder must
approve the warranty work of a given builder. A system of reporting should also be
implemented, requiring TPL to report the various repair claims it undertakes to each of the
shareholders and to include an analysis of the variances from standard,
Hiring independent staff and increasing the segregation of duties in the Company may help
improve controls over warranty claims and will reduce the need for involvement by the
shareholders in the future.
As warranty costs are usually incurred in the future while the warranty revenue (initial fee) is
received currently, TPL will always have excess cash balances that must be invested.
Investments in low risk government/corporate bonds and other investments typically used for
trusts would be the most appropriate. A cash budget should be completed, and the terms to
maturity of such investments should coincide with the requirements identified in the cash
budgets. A large portion of the investments should be highly liquid because the future cash
flows cannot be estimated with a high degree of certainty.
Real estate investments can be illiquid and risky in cyclical markets and should be avoided. The
acquisition of the local construction company was probably not a good idea at this time because
you are likely going to need the cash for warranty work in the near future. You should seriously
Dividends should not be declared and management fees should not be charged by the
participants until the Company has more experience with warranty repair claims.
There are a number of users of the financial statements of TPL, each with different interests:
1. The shareholders/builders will use the financial statements to assess the profitability of the
Company and to determine what cash, if any, should be distributed.
2. Safe-Way will calculate its royalties on the basis of the revenue-recognition policies adopted
by the Company.
3. Customers may use the statements to determine the liquidity and viability of the Company
before purchasing a warranty.
4. Other builders may rely on the statements before participating in the warranty programs.
Their reputations are at stake.
5. The government may use the statements as part of its review of the Company's operations
from time to time.
Accordingly, policies for accruals of future warranty costs will be of great importance to all the
users and will affect the long-term viability of TPL. Given the number of users and high levels of
assurance each requires, statements should be prepared in accordance with generally accepted
accounting principles, with the appropriate disclosures.
Since TPL is a private company, it can choose to use IFRS or ASPE. Assuming that the five
shareholders are also private companies and assuming that they all use ASPE, it would be
appropriate for TPL to also use ASPE.
The most significant accounting policies that must be developed are for warranty liabilities and
expenses, revenue recognition and business combinations.
Matching the revenues and expenses is the critical issue because the largest portion of cash
from warranty sales is received up front and expenditures will be made on warranty repairs
unevenly over the following ten years.
To the extent that cash reserves are in place to meet future contingencies, interest will be
Copyright 2016 McGraw-Hill Education. All rights reserved.
18 Modern Advanced Accounting in Canada, Eighth Edition
earned on those funds. Policies should be re-evaluated from year to year according to repair
experience and potential increases in reserves from investment income.
Future warranty expenses are difficult to estimate because few warranties of 10 years have
been offered in the marketplace. Accordingly, data on repair history for warranties longer than
one year are not available in the industry. Further complicating estimations is the fact that new
builders do not use materials and construction techniques of identical quality, and there are no
controls over the builders participating in the plan.
Despite the problems with warranty cost estimation, an attempt must be made to quantify the
estimated future liability by reviewing the repair history of each builder participating in the plan
and the nature of the repairs incurred to date. Otherwise, revenue cannot be recognized until
the end of the warranty period.
Historical repair data from each builder should be reviewed to properly estimate the current
portion of the warranty liability at the balance-sheet date. This is particularly important in light of
the Company's liquidity objective.
Revenue recognition
1. Recognize all revenues from warranties sold, including discounted maintenance payments
(at the time the contract is signed).
This method is appropriate if the total warranty costs can be estimated and if the collection of all
maintenance fees is assured. The method provides information to the shareholders and other
users on the expected profitability from yearly sales. It is unlikely that the estimations required
by this method can be made with sufficient certainty.
2. Defer all revenues until the end of the warranty period (year ten).
This method is the most conservative and implicitly recognizes that warranty cost estimation is
This method is of limited usefulness to the shareholders because profitability is not assessed
(although regulators would likely be most satisfied with this treatment because of its
conservative nature).
3. Recognize the initial warranty fee and annual maintenance fees on a cash basis.
A percentage of total warranty costs is expensed in the same proportion as the income
recognized. The problems with estimating total warranty costs have been discussed previously.
Using the cash basis of revenue recognition avoids the problem of estimating the collection of
future maintenance fees.
This method provides the shareholders with information on cash flows and estimated future
liabilities that are required to determine dividend payments.
This is similar to the previous method except that warranty costs drive revenue recognition.
Warranty-cost estimation is still very subjective and is not an appropriate basis on which to
recognize revenue.
5. Amortize the initial payment received for the warranties equally over the ten-year life and
recognize maintenance fees as received.
This method assumes that the initial fee represents the present value of future cash flows.
Again, warranty expenses must still be estimated and are unlikely to be incurred equally
throughout the life of the warranty, resulting in a mismatch of revenues and expenses in most
years.
I recommend recognizing revenues and expenses on a cash basis because this method
recognizes the reality of warranties for homes (i.e., that the majority of claims will occur in the
first two years). If there is a problem with construction, it is much more likely to become
apparent in the first year than in later years. The cash method recognizes more revenues and
expenses in the first year, and the maintenance payments should cover repairs that may be
Business combinations
By purchasing 100% of the shares of Gainery Construction Ltd. (Gainery), TPL has obtained
control over Gainery. Under ASPE, TPL can report its investment in Gainery on a consolidated
basis or by using the cost method or equity method. The cost method is the simplest but only
reports income as dividends are received. Given that Gainery probably needs its cash for
operating purposes, it may be more meaningful to use the equity method or consolidation
method. Both methods will report the same amount of income. As indicated in Appendix II, the
amount paid by TPL for Gainery appears to be less than the fair value of the identifiable net
assets. You will need to verify that these fair values are realistic. If they are realistic, then TPL
could report a gain on purchase in the amount of $280,868 on the consolidated income
statement for Year 1. However, when the homes under construction and undeveloped land are
sold, the acquisition differential for these assets will have to be expensed. This will reduce the
gains reported on the consolidated income statement. The acquisition differential pertaining to
the equipment should be amortized over the life of the equipment. This will reduce depreciation
expense reported on the consolidated income statement.
The repairs and rent charged by Safe-Way to TPL and the royalties received by Safe-Way from
the Company are related party transactions. Details of these transactions must be fully
disclosed in the financial statements.
APPENDIX I
* Readers should be cautioned that these figures have not been independently verified.
APPENDIX II
Less: amount attributable to consulting services provided by Mr. Gainery (Note 2) (22,500)
Notes:
1. Assuming an incremental borrowing rate of 8%, annuity of $500,000 per year for 3
years.
2. Assuming that consulting services are worth $50 per hour: $50 x (300 + 150)
Case 5-4
(a)
It appears that Mr. Slim is trying to hide profits of the hockey operations by funnelling the profits
of the Stadium through a separate company and not disclosing the results of the Stadium’s
operations as part of the salary negotiations. Furthermore, the price for the use of the Stadium
may be inflated to transfer profits from the Club to the Stadium.
Since the Club owns 90% of the Stadium, it controls the Stadium and it would normally prepare
consolidated financial statements to present the financial situation for the combined economic
entity. Furthermore, since the Stadium is used primarily by the Oilers, it would be appropriate to
incorporate the Club’s share of the Stadium’s income when considering the Club’s ability to pay
increased salaries to the players.
Revenues
Tickets $6,000,000
Concessions 2,400,000
Parking 200,000
Total revenues 8,600,000
Expenses
Cost of concessions 800,000
Player salaries 1,200,000
Staff salaries 2,400,000
Depreciation of stadium 1,000,000
Advertising 400,000
Total expenses 5,800,000
Net income $2,800,000
Attributable to:
Shareholders of the Club $2,440,000
Non-controlling interest (10% x 3,600,000) 360,000
$2,800,000
The consolidated net income attributable to the shareholders of the Club of $2,440,000 presents
a much different situation than the net loss of $800,000 presented by the Club on its separate
entity income statement. The consolidated financial statement is the more relevant figure as it
presents the overall picture of the hockey operations.
To determine what a fair salary increase is for the players, the following additional information is
required:
What did the owner pay for the Club and what is a fair return on this investment?
What was the cost of the Stadium and over what period is the Stadium being amortized?
Who owns the other 10% of the Stadium and what is the relationship to Mr. Slim?
How much of the staff salaries are paid to Mr. Slim and parties related to Mr. Slim?
(b)
Since Mr. Slim owns the Stadium, GAAP would not require that consolidated financial
statements be prepared for the Club and the Stadium since the Club does not control the
Stadium. Since the Club has no financial interest in the Stadium, one could argue that the
employees and players of the Club should not expect to share in any of the profits earned by the
Stadium. However, employees and players of the Club would expect that a fair price be paid for
use of the Stadium. If the Stadium were owned by a non-related party, a fair price would likely
be negotiated between the Club and the Stadium.
Since the Club and Stadium are both owned by Mr. Slim, these two companies are related. Any
transactions between the two companies can be used to manipulate the profits of the individual
companies. To ensure that a fair salary is paid by the owners, I would want to determine
whether the price paid for the use of the Stadium is fair. To make this determination, I would like
to see the financial statements for the Stadium and get answers to questions presented in (a)
above.
Case 5-5
MEMO TO PARTNER
My initial assessment of the Preferred Share Agreement (the Agreement), suggests that the
policies listed lean towards recognizing revenue as early as possible while also delaying
recognition of expenses as long as possible. Therefore, in reviewing the policies used in Year
45 we must ensure that they conform to the policies specified in the Agreement or are
consistent with the intent of the Agreement (Clause 1). Further, parties to the Agreement had
reason to assume that policies in effect in Year 1 (when the Agreement was signed) but not
One point to note is that the figure for income before tax of $895,420 is unaudited and was
prepared by the vice-president of finance of GFL. The validity of this figure will need to be
established before a share-redemption price is calculated.
It appears from a review of the disputed items that GFL has been trying to minimize its
revenues and maximize its expenses. This bias is understandable since it is in GFL's best
interests to minimize the amount it has to pay the shareholder. The preferred shareholder had
to notify GFL by January Year 45 of his intention to redeem his shares. After this date, GFL
entered into transactions and changed certain policies; these actions tend to confirm a bias on
GFL's part since they lower the redemption price.
The above factors will need to be taken into consideration when determining the share-
redemption price.
ANALYSIS OF TRANSACTIONS
J. Ltd.
Allocating the difference between acquisition cost and carrying amount to goodwill may not
conform to the Agreement if other assets should have been debited instead. Identifiable assets
and liabilities acquired should have been recorded at their fair values at the time of acquisition.
By choosing to debit goodwill instead of debiting the appropriate asset, GFL may or may not
achieve a low-income figure for Year 45. For example, if GFL had debited an asset such as
inventory in Year 44, the inventory would have been expensed in Year 44. In turn, the Year 45
income figure would have been higher because it would not contain the amortization of
goodwill or the cost of goods sold. Conversely, if GFL had debited a larger amount to an asset
that was not sold until Year 45, the fair value excess would be expensed in Year 45. The fair
value excess would likely have been higher than the amortization of goodwill, which would
cause a lower income than what was reported. Similarly, if GFL had assigned a value greater
than carrying amount to an asset with a physical life of more than 10 years, income would be
higher than what was reported since the amortization on the capital asset would be less than
the amortization of the goodwill. Overall, the value of each asset and liability will have to be
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 5 25
examined to determine whether the correct amount was recorded initially. If adjustments are
needed the share-redemption price will be affected.
Even though the Agreement does not refer to intangible assets, Clause C can be used for
guidance on the goodwill component of the purchase (whether the goodwill figure is changed
or not). Clause C refers, however, to the physical life of an asset, and an intangible asset by
definition, does not have a physical life. Although the Agreement specifies that physical life be
used regardless of the useful life of the asset, perhaps in this instance the use of useful life can
be justified.
Goodwill should not be amortized on an annual basis. Instead, it should only be written down if
there is impairment. Furthermore, only the impairment for Year 45 should be reported in Year
45. Impairment tests will have to be performed at the end of Year 44 and end of Year 45 to
determine the amount of impairment for Year 45.
Goodwill is impaired when the recoverable amount is less than carrying amount. Recoverable
amount is the higher of fair value less costs of disposal and value in use, which is defined as
the present value of future cash flows. J Ltd. does not need to use fair value because the value
in use is higher than fair value. An impairment loss must be reported because the value in use
is less than carrying amount. The amount of the impairment is dependent on whether the
discount rate is 6 percent or 3 percent. 6 percent would be most appropriate because it reflects
J Ltd.’s borrowing rate. At 6 percent, the impairment loss would be $0.9 million and the overall
loss for the year would be $0.8 million.
If the assumed debt pushes GFL's debt-to-equity ratio beyond the 1: 1 ratio required under
Clause E, then additional interest above the ratio should be added back to income for the
purpose of calculating the share-redemption price.
Volume discounts
One could argue that since Clause A2 prohibits the setting up of an allowance for returns, no
allowance should be set up for volume discounts. Or, it could be argued that a discount is
similar to an adjustment and, therefore, should be recorded in the year to which it relates, in
accordance with Clause F. Accordingly, if the volume to which the discount applies was to be
reached after year-end, it can be argued that it should not be accrued. On the other hand, if the
Copyright 2016 McGraw-Hill Education. All rights reserved.
26 Modern Advanced Accounting in Canada, Eighth Edition
volume to which the discount applies is reached before year-end, then the discount should be
accrued. More information is needed to determine how to account for the discount, but the
intent of the agreement to delay expenses suggests that the discount should not be accrued.
Standard costing
Standard costing variances are not specifically mentioned in the Agreement, but expensing all
variances seems inconsistent with its intent. The variance allocation likely does not result in
inventory being costed with its full share of all designated overhead expenditures as required in
Clause B1. Since the current policy was introduced in Year 4, it is possible that income reflects
the actual costs of the inventory, but only if opening and closing inventories were constant.
Inventory, and hence cost of goods sold, should be adjusted to reflect the actual production
costs; no adjustment may be necessary if Year 44 variances offset Year 45 variances.
Incentives
The cost method recognizes dividends that GFL receives as income whereas the equity
method recognizes GFL's share (based on its percentage ownership) of the investment’s
earnings. The change in policy from equity to cost could be an attempt by GFL to manipulate
net income if dividends were low compared to its proportional share of earnings. This
manipulation could have an even greater effect if GFL can influence the amount of dividends
distributed during GFL's Year 45 fiscal year.
The equity method reflects Clause F better than the cost method since the adjustment under
the equity method causes an increase in the carrying amount on GFL's books and is closer to
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 5 27
the change in the value of the investment.
If GFL owned the investment in Year 41, we should determine how it was accounted for then,
since that was what was expected at the time the Agreement was signed. We should also
investigate whether there have been any significant changes in the investment since Year 41
that warrant changing the accounting method used.
Clause D1 states that expenditures should be capitalized as assets unless their useful life is
limited to the current financial period. Accordingly, all costs of constructing the plant should be
capitalized. These construction costs are necessary for the long-term operations of a plant,
and thus their useful life is longer than one year. Further, although it is difficult to state exactly
when construction has been completed, it is hard to justify calling it completed just because
some form of manufacturing began. It would seem that both parties are satisfied with
capitalizing construction costs since GFL did capitalize the costs until manufacturing activities
began. In this case, capitalizing costs until economic production levels are attainable is
reasonable i.e., until the plant is able to produce what it was built to produce.
On the other side of this issue is revenue recognition. It would make sense to argue that
revenue recognition should be delayed while costs are still being capitalized since there is no
expense to offset revenue. The Agreement, however, recognizes revenue up-front (Clause A –
when production is completed or items are shipped). If revenue is recognized up-front,
perhaps expenses associated with the production should be accrued.
It would be useful to determine which expenditures create future income since we could then
infer that the life of those expenditures was greater than one year. If any expenditure can be
shown to benefit GFL over a period longer than the Year 45 fiscal period, they should be
capitalized and amortized over their useful life, regardless of whether manufacturing activity
has begun. Some amortization should occur in the period related to the space that was used
Copyright 2016 McGraw-Hill Education. All rights reserved.
28 Modern Advanced Accounting in Canada, Eighth Edition
for production.
If the land can legitimately be considered inventory, Clause B of the Agreement should be
followed. Clause B does not mention writing down the asset; it specifies only that all
expenditures needed to make the inventory available for use must be included. If the land was
unjustifiably reclassified as inventory, Clause D applies, since there was no change in GFL's
handling of the property. Clause D states that assets should be recorded at cost; like Clause B,
Clause D does not refer to writing down an asset's value.
If a write down can be justified under Clause F (all changes in value should be attributed to
the year to which the error or adjustment relates), then only the decline in value that occurred
in Year 45 should be charged against income of the period. There should be a write down only
if the decline in value is felt to be permanent. However, only the change in value during Year
45 should be charged to income in Year 45.
Regular sales are not recognized on a cash basis for purposes of the Agreement but rather
when inventory is shipped (Clause A). The only reason for deferring recognition of the income
from the sale of assets might be the possibility that the purchaser will not pay. However, in
Clause A2 the Agreement specifically states that no allowances should be made for returned
merchandise. If the same line of reasoning is followed, then no allowance for uncollectible
amounts should be set up. Therefore, the full gain on the sale of the asset should be recorded
for the benefit of the preferred shareholder.
It could be counter-argued that selling of property, plant and equipment does not fall under
Clause A, which deals with revenue from the sale of inventory. If so, then the intent of the
Agreement to recognize revenue early and delay expenses becomes applicable. Thus the
previous recommendation still applies.
The deferral of payment (and hence deferral of revenue recognition) may be a deliberate
attempt on the part of GFL to decrease income. The deal was entered into in March, at which
time GFL would have known that the shareholder was cashing in his preferred shares based
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 5 29
on the financial statements of fiscal Year 45.
Pension benefits are probably considered part of compensation and hence should be
measured as prescribed in Clause G. If these pension benefits are not considered part of
compensation, then we must determine what basis was used for determining the charges that
were made against income. Actuarial reports may contain some of this information.
If the costs relate to past service, then the expense should be charged to the year that it
relates to (Clause F of the Agreement). However, Clause F could also be interpreted to mean
that since the adjustment in pension was made in Year 45, the increase in expenses should
be charged to Year 45.
DGR transactions
Sales to DGR must be recorded at fair value since it is a related party, in accordance with
Clause G of the Agreement. An adjustment would increase the redemption price by $475,000
($380,000 x 1.25).
Under Clause F of the Agreement, legal costs should be applied to the year in which the patent
infringement occurred. We must examine legal documentation to find out when the infringement
occurred.
Another question is whether Clause F will apply if in the future there is an award (fine) in the
case. If the answer is yes, then a recalculation will need to be made at that time.
CONCLUSION
It is evident from the preceding analysis that some of the accounting policies used in GFL's
March 31, Year 45 financial statements do not comply with the Agreement. Policies that have
changed since the Agreement was signed to accommodate operational changes do not lead to
suspicions about GFL's intent. However, when circumstances have not changed, GFL's sole
Copyright 2016 McGraw-Hill Education. All rights reserved.
30 Modern Advanced Accounting in Canada, Eighth Edition
reason for making the change may have been to lower the redemption price.
Case 5-6
Attached is my memo describing the accounting issues relevant to Digital Future Technologies
(DFT). You indicated that you were concerned about the impact of any accounting issues on
income due to the new management compensation plan that is based on EBITDA. A number of
the issues I have discussed have an impact on interest, taxes, depreciation and amortization,
or elements included in earnings before tax. As a result, I have explained the impact of these
issues on EBITDA as applied in the bonus calculation.
I believe you will need to speak with Anne as soon as she is available with respect to the
bonus. In my conversation with her, she explained that she was confident management would
be getting its bonus and planned to accrue an estimated amount. Based on my revised
projected income, management may not meet the threshold amount, and therefore would not
obtain a bonus. I have also provided some additional comments and considerations with
respect to the new bonus plan.
Revenue Recognition
Non-recurring engineering (NRE)
NRE represents a significant revenue stream. DFT has booked a total of $2.5 million in NRE
revenue. The first $1.5 million in NRE revenue, which appeared to have no further obligations
beyond the initial engineering work, was appropriate to recognize under IFRS 15, as it had
been fully earned.
However, the latest arrangement differs from previous NRE revenue. DFT obtained NRE work
Indo-Tech (Indo)
The arrangement with Indo is structured in such a way that revenue is earned either when Indo
takes possession of the inventory or when 60 days have elapsed from receipt at the third-party
warehouse. As a result of the agreement in place, all of the $1.50 million related to inventory
shipped by June 30 could be recognized by September 30, even if Indo had not taken the
inventory on August 2. It is appropriate to recognize the revenue.
However, the remaining $1.85 million of revenue related to the inventory shipped to the third-
party warehouse cannot be recognized as revenue unless Indo takes the inventory by
September 30, since 60 days will not have passed since its arrival at the warehouse (we don’t
know the exact shipping and arrival dates, but if we assume it was shipped on August 3, it is
about 57 days at September 30). The only revenue that should be recognized by September 30
is the sales value of the items taken by Indo by September 30. The remainder of the items
should be recorded in inventory at cost until the 60 days in the warehouse have passed.
The agreement with Indo is an unusual one in that it passes title to Indo after 60 days for goods
sitting in a warehouse. It seems unlikely that Indo would pay for goods it hasn’t taken from the
warehouse. If the goods sit in the warehouse and are not paid for, there may be issues of
collectability.
Zeus — Inventory
Zeus was expected to be developed by mid-August. The delayed development, and the
subsequent entry into the market of a competing product before Zeus, may raise concerns
about the valuation of the Zeus inventory (just beginning to be produced). A writedown would
be required if the net realizable value of inventory is below the recorded cost. Given that DFT’s
products generally have a 40% gross margin, a decrease in the planned selling price, while
reducing DFT’s margins, would likely not result in a net realizable value that is below cost, and
therefore, no writedown would likely be required as of September 30.
Since production just began, there is the risk of there being potential quality assurance issues,
which could lead to the need to set up a warranty provision for potential claims. This risk is
increased when considering management’s bias to increase sales in order to achieve a higher
bonus.
Ares
The abandoned development of the Ares product would normally indicate the need for a
writedown. Under IAS 38, the conditions for recognizing an intangible asset include the
technical feasibility of and intention to complete the intangible asset so that it will be available
for use or sale, and the probability it will generate future economic benefits. These conditions
must be met at a point in time, such as when evaluating the project. Although the related
development may be at least partially transferable to the new product, Hades, DFT clearly has
no intention of continuing with Ares. At some point in time there would need to be an
assessment of Hades to determine whether the conditions of IAS 38 are met. It would not be
possible to link the Ares costs to the Hades project, unless some of the costs had been
identified as applying to both projects when first initiated. As a result, the related development
costs of $450,000 should be written off. The write-off results in an increase in expenses of
$450,000.
Contingency
The reassessment of $125,000 related to GST/HST has already been paid, and there is no
guarantee that the courts will allow the money to be returned, even though DFT believes there
has been an error. As a result, it is a contingent asset. Because DFT cannot be certain that the
courts will allow the money to be returned, virtual certainty does not exist, and therefore no
asset should be recorded.
Contingent assets are not recognized under IAS 37, but can be disclosed in the notes to the
financial statements when an inflow of economic benefits is probable. It appears to be too early
to determine whether the amount will be realized or not. As a result, the amount should not be
recorded as a prepaid asset, nor should it be disclosed in the financial statements. Rather, DFT
should examine the source of the reassessment — was it due to not charging GST/HST when
it should have, or to claiming an ITC when it was not eligible? Instead of booking as a prepaid,
Impairment Loss
The impairment loss of $100,000, related to obsolete production equipment, should not be
included in amortization of capital assets (adjusted general and administrative), but in cost of
sales.
Practically speaking, since amortization of production-related assets is included in cost of
sales, it could be argued that the impairment charge should also be included in cost of sales
since it is related to the production equipment. In addition, it should be disclosed separately
from amortization in the notes to the financial statements under IAS 1, rather than grouped into
one amount to ensure full disclosure, depending on how material the amount is. As a result of
this writedown, management may also need to question the amortization periods.
Consideration should be given to the impact on the bonus calculation. Since the bonus is
based on EBITDA, including the impairment loss in amortization means it is excluded as an
expense in the calculation. If, however, it is separately disclosed, it could be argued that it is
part of cost of sales and should be included in EBITDA. The $100,000 impairment adjustment
should be moved from general and administrative expenses to cost of sales, and should not be
considered amortization.
Business Acquisition
Corolla has control over Dao by holding 70% of the outstanding common shares. It will have to
include Dao in its consolidated financial statements from August 31, Year 12. The acquisition
differential for 100% of the value of Dao at the date of acquisition was $3,000,000 ($5,600,000 /
.7 – [$1,000,000 + $4,000,000]). Contrary to management’s preference, a portion of this
acquisition differential will need to be assigned to the long-term sales contract with Customer.
Although the agreement does not meet the separability criterion, it does meet the contractual-
legal criterion because Dao does have a long-term contract with Customer. This contract must
be valued at fair value using appropriate valuation techniques such as market value of similar
contracts. The excess of $3,000,000 over the fair value of this contract will be allocated to
goodwill. The value assigned to the contract will need to be systematically amortized over the
period of benefit, which would range from the remaining term on the current contract to the total
period involving expected renewals. The amortization of the contract will increase expenses for
Year 12.
Adjusted Net Income for the Year Ended September 30, Year 12 (in thousands)
DFT adjusted Accounting Revised
projection adjustments Note projection
Revenue $59,224 (2,779) A1 $56,445
Cost of sales 33,872 (1,010) A1, A4 32,862
Gross margin 25,352 (1,769) 23,583
Operating expenses
Research and development 3,991 250 A2, A1 4,241
Sales and marketing 2,622 - 2,622
General and administrative 7,924 25 A3,A4,A5 7,949
Interest 314 - 314
Total operating expenses 14,851 275 15,126
Income before taxes 10,501 (2,044) 8,457
Income taxes 3,150 (613) A6 2,537
Net income $7,351 $(1,431) $5,920
Notes:
Note A1
Sales have been reduced by $129,000 for 57% of the NRE discount of $225,000.
Sales have been reduced by $800,000 for government grants since they cannot be
accounted for as revenue. Along with the related deferred development costs, $600,000 should
be deferred. The remaining balance of $200,000 has been moved to R&D expenses.
Earnings before interest, taxes, depreciation and amortization (EBITDA) based on revised
projected net income
After
Per DFT July Adjusted DFT accounting
projection projection adjustments COMMENTS
Income before taxes $ 8,681 $ 10,501 $ 8,457 (as adjusted-- see previous
worksheet)
Add back:
Interest 314 314 314
Amortization of
production-related assets 430 430 430
deferred development costs 1,620 1,620 1,620
Note 1 - Development costs amortized over estimated life of product, generally 3 years or less
Assume 3 years are remaining on project for which government grant was received and on Ares
SOLUTIONS TO PROBLEMS
Problem 5-1
Part A
(a)
Carrying value of assets as a group $2,094
Fair value of assets as a group 1,860
Total impairment loss $234
(b)
Tangible assets, net $1,164
Recognized intangible assets, net 510
Internally developed patent 0
Goodwill (420 – 234) 186
Total $1,860
Part B
(a)
Carrying value of assets as a group $2,094
Fair value of assets as a group 1,450
Total impairment loss 644
Assigned to goodwill 420
Assigned to other assets on a proportionate basis as follows: $224
(b)
Tangible assets, net $1,008
Recognized intangible assets, net 442
Internally developed patent 0
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 5 41
Goodwill (420 – 420) 0
Total $1,450
Part C
Tangible assets, net $1,174
Recognized intangible assets, net 520
Internally developed patent 60
Goodwill 106
Total $1,860
When allocating the acquisition cost at the date of acquisition, identifiable net assets are measured
at fair value and any amount paid over the fair value of identifiable net assets is allocated to
goodwill. Fair value accounting is used for identifiable assets. When checking for impairment at
any reporting date, the assets are reported at the lesser of carrying value and recoverable amount.
In most cases, identifiable assets are reported at historical costs.
Problem 5-2
Cost of 70% investment $770,000
Implied cost of 100% investment 1,100,000
Carrying amount of Small’s net assets = Carrying amount of Small’s shareholders’ equity
Ordinary shares $560,000
Retained earnings 260,000
820,000
Acquisition differential – Jan. 1, Year 6 $280,000
Allocated:
Inventory 71,000
Patents (90,000) (19,000)
Balance – goodwill $299,000
Balance Balance
Jan. 1 Amortization Dec. 31
Year 6 Yr 6 & 7 Year 8 Year 8
Inventory $71,000 $71,000
Patents (90,000) (36,000) $ (18,000) $ (36,000)
Goodwill 299,000 0 20,900 278,100
Copyright 2016 McGraw-Hill Education. All rights reserved.
42 Modern Advanced Accounting in Canada, Eighth Edition
$280,000 $35,000 $2,900 $242,100
PART A
Year 6 Year 7 Year 8
Investment in Small 770,000
Cash 770,000
Cash 28,700 18,200 39,200
Dividend income 28,700 18,200 39,200
PART B
(i) Goodwill (299,000 – 20,900) $278,100
(ii) Small’s ordinary shares $560,000
Small’s retained earnings (260,000 + 144,000 – 41,000 –
51,000 – 26,000 + 106,000 – 56,000) 336,000
896,000
Unamortized acquisition differential 242,100
$1,138,100
NCI’s share (30%) $341,430
(iii) Large’s retained earnings $660,000
Small’s retained earnings (260,000 + 144,000 – 41,000 -
51,000 – 26,000) 286,000
Small’s retained earnings, date of acquisition 260,000
Change since acquisition 26,000
Less: cumulative amortization of acquisition differential (35,000)
Adjusted change since acquisition (9,000)
Large’s share (70%) (6,300)
Consolidated retained earnings $653,700
PART C
(i) Year 6 Year 7 Year 8
Investment in Small 770,000
Cash 770,000
Investment in Small (70% x Small’s profit) 100,800 (35,700) 74,200
Investment income 100,800 (35,700) 74,200
Cash (70% x Small’s dividends) 28,700 18,200 39,200
Investment in Small 28,700 18,200 39,200
Investment income (70% x amortization of PD) 37,100 (12,600) 2,030
Investment in Small 37,100 (12,600) 2,030
Problem 5-3
Cost of 70% investment 84,000
Implied cost of 100% investment 120,000
Carrying amount of Petite’s net assets = Carrying amount of Petite’s shareholders’ equity
Petite Common shares 35,000
Retained earnings 25,000
60,000
Acquisition differential – Jan. 1, Year 2 60,000
Allocated:
Inventory 10,000
Equipment 20,000 30,000
Copyright 2016 McGraw-Hill Education. All rights reserved.
44 Modern Advanced Accounting in Canada, Eighth Edition
Balance - goodwill 30,000
Non-controlling interest (30% x 120,000) 36,000 (1)
Balance Amortization Balance
Jan. 1 & Impairment Dec. 31
Year 2 Yrs 2 to 5 Year 6 Year 6
Inventory 10,000 10,000
Equipment 20,000 8,000 2,000 10,000
Goodwill 30,000 0 2,000 28,000
60,000 18,000 4,000 38,000
(a)
Goodwill 28,000
Net income
Gros’s net income 90,000
Less: dividends from Petite (10,000 x 70%) (7,000)
83,000
Petite’s net income 48,000
Less: amortization of acquisition differential 4,000
44,000
Consolidated net income 127,000
(a)
Non-controlling interest 280,000 / (600,000 + 800,000) = 20%
Therefore, Corner owns 80% of Brook.
(b)
Net income of Brook – Year 4 140,000
80%
112,000
Net loss of Corner – Year 4 (60,000)
Consolidated net income attributable to Corner’s shareholders – Year 4 52,000
(c)
Consolidated retained earnings – Dec. 31, Year 4 180,000
Consolidated net income – Year 4 52,000
Corner's retained earnings Dec. 31, Year 3 (equity) 128,000
(d)
640,000 / 80% is shareholders' equity of Brook 800,000
Common shares – Brook 600,000
Retained earnings – Brook – date of acquisition 200,000
Problem 5-5
Cost of 85% investment 646,000
Implied cost of 100% investment 760,000
Carrying amount of Silk’s net assets = Carrying amount of Silk’s shareholders’ equity
Silk Common shares 500,000
Retained earnings 100,000
600,000
Acquisition differential – Dec. 31, Year 1 160,000
Allocated:
Inventory 70,000
Balance Balance
Dec. 31 Amortization Dec. 31
Year 1 Year 2 Year 3 Year 3
Inventory 70,000 70,000
Patents 90,000 9,000 9,000 72,000
160,000 79,000 9,000 72,000
(a)
Non-controlling interest in profit
(b)
Year 2 Year 3
Profit (loss) Pen 28,000 (45,000)
Dividends from Silk
Year 2 0
Year 3 (85% 15,000) (12,750)
28,000 (57,750)
Share of Silk’s profit
85% (30,000 – 79,000) (41,650)
85% (52,000 – 9,000) _ 36,550_
Consolidated profit (loss) attributable to Pen’s shareholders (13,650) (21,200)
(c)
Retained earnings Pen – Dec. 31, Year 3 (cost method) 91,000
Retained earnings Silk – Dec. 31, Year 3
(100,000 + 30,000 + 52,000 – 15,000) 167,000
Acquisition retained earnings 100,000
Increase since acquisition 67,000
Copyright 2016 McGraw-Hill Education. All rights reserved.
48 Modern Advanced Accounting in Canada, Eighth Edition
Less: acq. diff. amort. to date (79,000 + 9,000) 88,000
Adjusted increase since acquisition (21,000) (a)
85% (17,850)
Consolidated retained earnings – Dec. 31, Year 3 73,150
(d)
Method 1:
Silk – Common shares 500,000
Retained earnings Dec. 31, Year 3 167,000
667,000
Unamortized acquisition differential 72,000
739,000
15%
Non-controlling interest – Dec. 31, Year 3 110,850
Method 2:
Non-controlling interest – date of acquisition (a) 114,000
Retained earnings Silk – Dec. 31, Year 3
(100,000 + 30,000 + 52,000 – 15,000) 167,000
Acquisition retained earnings 100,000
Increase since acquisition 67,000
Less: acq. diff. amort. to date (79,000 + 9,000) 88,000
(21,000)
NCI’s share 15% (3,150)
Non-controlling interest – Dec. 31, Year 3 110,850
(e)
Cost of investment 646,000
Retained earnings Silk – Dec. 31, Year 3
(100,000 + 30,000 + 52,000 – 15,000) 167,000
Acquisition retained earnings 100,000
Increase since acquisition 67,000
Less: acq. diff. amort. to date (79,000 + 9,000) 88,000
(21,000)
(f)
See amortization schedule above.
Alternative calculation:
Problem 5-6
(a) Cherry’s Year 4 dividends were $48,750 ($39,000 / 80%)
(b) Cherry’s Year 5 dividends were $57,500 ($46,000 / 80%)
Therefore, the Year 5 reported profit of Cherry was $115,000 ($57,500 / 50%)
(d)
Because the entire acquisition differential was recognized as goodwill, and because we know
the equity method balance in the investment account as at December 31, Year 6 we can use it
to calculate goodwill on that date as follows:
Problem 5-7
Grant NCI
Cost of 80% Interest in Lee 70,000
Fair value of NCI’s Interest in Lee (7 x 2,000 shares) 14,000
Carrying amount of Lee’s net assets = Carrying amount of Lee’s shareholders’ equity
Common shares 25,000
Retained earnings 30,000
55,000
Shareholders’ interest 44,000 11,000
Acquisition differential 26,000 3,000
Allocated:
FV – CA
Inventory 5,000 4,000 1,000
Patent 10,000 8,000 2,000
Goodwill 14,000 -0-
(a)
Acquisition 30,000
Increase 35,000
80% 28,000
313,600
18,400
12,800
242,800
Total 433,000
Attributable to:
247,500
Grant Corporation
Goodwill 10,000
1,119,000
1,119,000
Note 1:
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Solutions Manual, Chapter 5 53
Non-controlling interest (Method 1)
92,000
22,000
Problem 5-8
(a)
Cost of investment $914,000
Fazli’s shareholders’ equity
Ordinary shares $484,000
Retained earnings 200,000 684,000
Acquisition differential – Jan. 1, Year 1 230,000
Allocated:
Equipment 50,000
Balance – goodwill $180,000
Balance Balance
(b)
Equipment (net) (714,000 + 614,000 + (a) 30,000) 1,358,000
Goodwill (b) 180,000
(d) The reported consolidated balances are not affected by the parent’s method of accounting
for its investment. Thus, consolidated expenses of $1,394,000 ($674,000 + $710,000 +
amortization of acquisition differential of $10,000) are the same regardless of whether the
cost method or equity method is used by Cyrus.
(e) The reported consolidated balance of $1,358,000 as calculated in (b) is not affected by the
parent’s method of accounting for its investment.
(f) Cost Equity
Retained earnings, January 1, Year 5, cost method 814,000
Parent’s retained earnings, January 1, Year 5, cost method 814,000
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Solutions Manual, Chapter 5 55
Subsidiary’s change in retained earnings since acquisition
(250,000 – 200,000) x parent’s share of 100% 50,000
Cumulative amortization of acquisition differential (1 year) (10,000)
Parent’s retained earnings, January 1, Year 5, equity method 854,000
(g)
Consolidated retained earnings at January 1, Year 5 are $854,000. It is equal to the parent’s
retained earnings under the equity method as calculated in (f). It is not affected by the method
used by the parent to account for its investment in the subsidiary for internal record keeping.
Problem 5-9
(a)
Cost of 80% investment 122,080
Implied value of 100% 152,600
Carrying amount of Little’s net assets = Carrying amount of Little’s shareholders’ equity
– July 1, Year 5
Common shares 54,000
Retained earnings 32,400
86,400
Acquisition differential 66,200
Allocated: FV – CA
Government contract 50,000
Equipment (21,600)
28,400
Balance – goodwill 37,800
Amortization Schedule
Balance Amortization Balance
July 1 year ending June 30
Year 5 June 30, Year 6 Year 6
Equipment (8 years) –21,600 –2,700 –18,900
Government contract (5 years)50,000 10,000 40,000
Goodwill 37,800 17,800 20,000
66,200 25,100 41,100
The government contract should be recognized as an identifiable asset because it can meet the
separability test. It can be sold separately and provides future economic benefits.
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56 Modern Advanced Accounting in Canada, Eighth Edition
(b) Calculation of consolidated net income attributable to Big’s shareholders – Year 6
Income of Big 109,620
Less: dividends from Little (13,500 80%) 10,800
98,820
Income of Little 39,420
Less: acquisition differential amortization 25,100
14,320
80% 11,456
110,276
Big
Consolidated Income Statement
for the Year Ended June 30, Year 6
Big
Consolidated Retained Earnings Statement
for the Year Ended June 30, Year 6
Balance July 1, Year 5 459,000
Net income 110,276
569,276
Dividends 32,400
Big
Consolidated Balance Sheet
June 30, Year 6
(d)
Total Parent NCI
100% 80% 20%
Total value of Little at date of acquisition 147,080 122,080 25,000
Carrying amount of Little’s net assets 86,400 69,120 17,280
Acquisition differential 60,680 52,960 7,720
Fair value excess for identifiable assets 28,400 22,720 5,680
Balance – goodwill, date of acquisition 32,280 30,240 2,040
Goodwill impairment for the year 12,280 11,504* 776
Goodwill, June 30, Year 6 20,000 18,736 1,264
Problem 5-10
Cost of 80% of Storm $350,000
Implied value of 100% $437,500
Carrying amount of Storm’s net assets
= Carrying amount of Storm’s shareholders’ equity
Ordinary shares $240,000
Retained earnings 64,000
304,000
Acquisition differential $133,500
Allocated: FV – CA
Plant assets $44,000
Trademarks 36,000 80,000
Goodwill $53,500
Bal Amortization Loss Bal
Dec. 31/Yr2 to Dec.31/Yr5 Yr6 Yr6 Dec. 31/Yr6
Plant assets $44,000 $16,500 $5,500 $22,000
Trademarks 36,000 9,000 3,000 $9,650 14,350
Goodwill 53,500 ----- ------ 3,500 50,000
Palm Inc.
Consolidated Statement of Financial Position
December 31, Year 6
(i) The return on equity would decrease because net income would decrease by $23,350
(($39,500 - $13,150) + ($5,500 - $8,500)) i.e., the change in amortization and
impairment of the acquisition differential for Year 6 and total shareholders’ equity would
Problem 5-11
Cost of 80% investment – July 1, Year 4 543,840
Implied value of 100% investment 679,800
Carrying amount of Bondi’s net assets
Assets 936,000
Liabilities 307,200
628,800
Acquisition differential 51,000
Allocated: FV – CA
Accounts receivable 24,004
Inventory 48,000
Plant assets (90,000)
Bonds payable 13,466 (4,530)
Balance – goodwill 55,530
Bond Carrying
Cash Interest Premium Amount
Date Paid Expense Amortization of Bonds
July 1/ Year 4 $186,534
Dec 31/ Year 4 $6,0001 $7,4612 $1,4613 187,9954
June 30, Year 5 6,000 7,520 1,520 189,515
Dec 31/ Year 5 6,000 7,580 1,580 191,095
June 30, Year 6 6,000 7,644 1,644 192,739
Dec 31/ Year 6 6,000 7,710 1,710 194,449
1 2
$200,000 x 6% x 6/12 = $6,000 $186,534 x 4% = $7,461
3
$7,461 – $6,000 = $1,461 4
$186,534 + $1,461 = $187,995
(a)
Aaron Co.
Consolidated Financial Statements
December 31, Year 6
Income Statement
(b)
(c)
Problem 5-12
Total Rabb NCI
100% 75% 25%
Consideration given for share ownership 152,000 117,000 35,000
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Solutions Manual, Chapter 5 65
Carrying amount of Rabb’s net assets
= Carrying amount of Rabb’s shareholders’ equity
– common shares 50,000
– retained earnings 30,000
80,000 60,000 20,000
Acquisition differential 72,000 57,000 15,000
Allocated:
Inventory (11,000)
Equipment 24,000
Software 15,000
28,000 21,000 7,000
Goodwill 44,000 36,000 8,000
(a)
Foxx Corp.
Year 6 Consolidated Income Statement
Sales (821,000 + 320,000) 1,141,000
Investment income (15,000 – 15,000 + 3,600) 3,600
1,144,600
Cost of sales (480,000 + 200,000) 680,000
Administrative expenses (40,000 + 12,000 + 5,500) 57,500
Miscellaneous expense (116,000 + 31,600 + 1,000 + 19,636 +4,364) 172,600
Income tax (80,000 + 32,000) 112,000
1,022,100
Net income 122,500
Attributable to:
(b)
(c)
If Foxx had used the parent company extension theory rather than the entity theory, the debt to
equity ratio would have increased because shareholders’ equity would have decreased due to
the decrease in non-controlling interest while debt would remain the same.
Problem 5-13
Amortization Schedule
Balance Amortization Balance
July 1 Dec. 31 Dec. 31 Dec. 31 Dec. 31
Year 2 Year 2 Years 3 to 5 Year 6 Year 6
Inventory $326,000 $326,000
Equipment 652,000 40,750 $244,500 $81,500 $285,250
Goodwill 652,000 79,000 29,000 544,000
$1,630,000 $366,750 $323,500 $110,500 $829,250
(a)
Pearl Company
Consolidated Income Statement
for the Year Ended December 31, Year 6
Pearl Company
Consolidated Retained Earnings Statement
for the Year Ended December 31, Year 6
Pearl Company
Consolidated Balance Sheet
December 31, Year 6
(c)
Goodwill– entity theory $544,000
Less: NCI’s share @ 20% 108,800
Goodwill – parent company extension theory $435,200
(d)
CONSOLIDATED FINANCIAL STATEMENT WORKING PAPER
PEARL
CONSOLIDATED FINANCIAL STATEMENTS
December 31, Year 6
Eliminations
PEARL SILVER Dr. Cr. Consolidated
Income Statements - Year 6
Sales $ 4,450,000 $1,450,00 $5,900,000
Dividend income 232,000 0 2 $ 232,000 0
4,682,000 1,450,000 5,900,000
Cost of sales 2,590,000 490,000 7 81,500 3,161,500
Miscellaneous expenses 365,000 79,000 444,000
Administrative expense 89,000 19,000 7 29,000 137,000
Income tax expense 295,000 165,000 460,000
Total expenses 3,339,000 753,000 4,202,500
Net income $ 1,343,000 $ 697,000 $1,697,500
Attributable to:
Pearl's Shareholders $1,580,200
Non-controlling interest 8 117,300 117,300
$459,800 $ - $1,697,500
Retained Earnings Statements-Year 6
Balance, January 1 $ 3,800,000 $890,000 1 $196,200
4 890,000 $3,603,800
JOURNAL ENTRIES
5 Equipment 652,000
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Solutions Manual, Chapter 5 73
Accumulated depreciation 285,250
Goodwill 573,000
Acquisition differential 939,750
To allocate the acquisition differential at beginning of year
Notes
a Consolidated retained earnings, beginning of Year 6
(= Pearl's retained earnings, beginning of Year 6 under equity method) $ 3,603,800
Pearl's retained earnings, beginning of Year 6 under cost method 3,800,000
Difference between cost and equity method, beginning of Year 6 $ (196,200)
Problem 5-14
Cost of 80% investment 272,000
Implied value of 100% investment 340,000
Carrying amount of Bach’s net assets = Carrying amount of Bach’s shareholders’ equity
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74 Modern Advanced Accounting in Canada, Eighth Edition
Common shares 200,000
Retained earnings 30,000
230,000
Acquisition differential 110,000
Allocated: FV – CA
Inventory (50,000 – 20,000) 30,000
Land (45,000 – 25,000) 20,000
Equipment (78,000 – 60,000) 18,000
Misc. intangibles (42,000 – 0) 42,000 110,000
Goodwill 0
Non-controlling interest (20% x 340,000) 68,000 (a)
(b)
Albeniz Company
Consolidated Balance Sheet
December 31, Year 6
Problem 5-15
Amortization Schedule
Balance Amortization Balance
Jan. 2 Dec. 31 Dec. 31 Dec. 31
Year 4 Years 4 & 5 Year 6 Year 6
Inventory $220,000 $220,000
Patents 520,000 104,000 $52,000 $364,000
Bonds payable (320,000) (64,000) (32,000) (224,000)
Goodwill 339,000 31,000 18,000 290,000
$759,000 $291,000 $38,000 $430,000
Brady Ltd.
Consolidated Income Statement
for the Year Ended December 31, Year 6
Sales (10,100,000 + 5,100,000) $15,200,000
Cost of goods purchased (6,950,000 + 2,910,000) 9,860,000
Change in inventory (72,000 + 120,000) 192,000
Depreciation expense (920,000 + 402,000) 1,322,000
Patent amortization (120,000 + 52,000) 172,000
Interest expense (490,000 + 310,000 – 32,000) 768,000
Other expense (700,000 + 870,000) 1,570,000
Goodwill impairment loss 18,000
Income tax (620,000 + 160,000) 780,000
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78 Modern Advanced Accounting in Canada, Eighth Edition
14,682,000
Profit $518,000
Attributable to:
Brady’s shareholders = profit under equity method $484,000
Non-controlling interest [20% (208,000 – 38,000)] 34,000
$518,000
Brady Ltd.
Consolidated Statement of Financial Position
December 31, Year 6
Plant and equipment (8,200,000 + 5,200,000) $13,400,000
Patents (720,000 + 364,000) 1,084,000
Goodwill 290,000
Inventory (4,800,000 + 2,000,000) 6,800,000
Accounts receivable (1,100,000 + 1,400,000) 2,500,000
Cash (420,000 + 620,000) 1,040,000
$25,114,000
Retained earnings under the cost method would also be decreased by $264,000. It would
change from $6,382,000 under the equity method to $6,118,000 ($6,382,000 - $264,000) under
the cost method.
(in 000s) Equity Cost Consolidation
Current assets $6,320 $6,320 $10,340
Current liabilities $3,522 $3,522 $5,062
Current ratio 1.79 1.79 2.04
* $484 – equity method income of $136 + dividend income of $110 x 80% = $436
(d)
The consolidation method shows the highest liquidity because it had the highest current
ratio.
The consolidation method shows the highest risk of insolvency because it had the
highest debt-to-equity ratio.
The equity method and consolidation method report the highest profitability because
they had the highest return on equity
(e)
CONSOLIDATED FINANCIAL STATEMENT WORKING PAPER
BRADY
CONSOLIDATED FINANCIAL STATEMENTS
JOURNAL ENTRIES
4 Patents 416,000
Goodwill 308,000
Bonds payable 256,000
Acquisition differential 468,000
To allocate the acquisition differential at the beginning of the year