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Chapter 6

Intercompany Inventory and Land


Profits

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Solutions Manual, Chapter 8 1
A brief description of the major points covered in each case and problem.

CASES

Case 6-1
In this case, students are asked to illustrate the impact of intercompany sales and unrealized
profits in inventory on the separate entity and consolidated financial statements. Students are
also asked to explain how basic accounting principles are applied when accounting for these
intercompany transactions.

Case 6-2
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.

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2 Modern Advanced Accounting in Canada, Eighth Edition
PROBLEMS

Problem 6-1 (25 min.)


A short problem requiring calculation of selected accounts for consolidated statements when
there are unrealized profits in inventory and an explanation of impact of intercompany
transactions on non-controlling interest.

Problem 6-2 (20 min.)


This problem consists of a consolidated income statement that has been incorrectly prepared
and requires correcting. Intercompany transactions and unrealized profits in opening and
closing inventory have been overlooked.

Problem 6-3 (20 min.)


A short problem requiring calculation of selected accounts related to land for separate entity and
consolidated financial statements for three years when there are unrealized profits in and an
acquisition differential pertaining to land.

Problem 6-4 (40 min.)


A parent has used the cost method to account for its investments in its two subsidiaries. There
are unrealized profits in the inventory of all three companies. The problem requires the
preparation of a consolidated income statement, a calculation of consolidated retained earnings,
a calculation of equity method income and an explanation of how the revenue recognition
principle is applied when adjusting for unrealized profits.

Problem 6-5 (40 min.)


Unrealized inventory and land profits are involved over a two-year period. The problem calls for
equity method journal entries as well as the calculation of consolidated net income each year, a
statement showing changes in non-controlling interest, and a calculation of the balance in the
investment account under the equity method.

Problem 6-6 (30 min.)


Three related companies are involved in selling goods to each other. The problem requires a
calculation of consolidated profit and consolidated retained earnings when the parent used the
cost method.

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Solutions Manual, Chapter 8 3
Problem 6-7 (70 min.)
A comprehensive problem requiring an acquisition differential calculation, amortization
schedule, and a consolidated balance sheet and statement of changes in equity under the entity
theory plus an explanation of how the debt to equity ratio would change under the parent
company extension theory. The subsidiary was acquired seven years ago; there are
intercompany profits (and losses) in land and inventory; and the parent has used the cost
method to account for its investment.

Problem 6-8 (30 min.)


This problem involves intercompany sales of inventory. It requires the preparation of an income
statement for two separate months for the parent, subsidiary and consolidated entity. Then,
students are asked to explain the impact of switching to the equity method from the cost method
and from upstream transactions to downstream transactions.

Problem 6-9 (25 min.)


This problem involves intercompany sales of inventory. It requires the calculation of account
balances for specified accounts and two scenarios: 1) intercompany transactions were
upstream and 2) intercompany transactions were downstream.

Problem 6-10 (40 min.)


Intercompany sales, interest and rental revenue, and unrealized profits in opening and closing
inventory are involved in this problem that requires the preparation of a consolidated income
statement and a calculation of consolidated retained earnings. The parent has used the cost
method.

Problem 6-11 (40 min.)


Unrealized profits in opening and closing inventory and in land have to be taken into account in
the preparation of a consolidated statement of changes in equity when the parent has used the
cost method.

Problem 6-12 (25 min.)


A parent has used the equity method to account for its investment. There are intercompany
inventory profits involved. The problem requires the preparation of a consolidated income

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4 Modern Advanced Accounting in Canada, Eighth Edition
statement, a calculation of consolidated retained earnings and an explanation of the impact of
using the parent company extension theory on the return on equity.

Problem 6-13 (70 min.)


This comprehensive problem covers everything illustrated to date and requires the preparation
of a consolidated income statement, consolidated statement of financial position and
consolidation worksheet when the parent has used the equity method plus the calculation of
goodwill and non-controlling interest under the parent company extension theory.

Problem 6-14 (70 min.) (Prepared by Peter Secord, Saint 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.

Problem 6-15 (50 min.)


A comprehensive problem requiring the preparation of a consolidated income statement and the
calculation of specified consolidated balance sheet accounts. Also required is a calculation of
goodwill impairment loss and consolidated net income attributable to NCI when a business
valuator measures the value of NCI at the date of acquisition. There are intercompany
transactions and unrealized profits in land and inventory.

SOLUTIONS TO REVIEW QUESTIONS


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

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

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Solutions Manual, Chapter 8 5
3. Intercompany sales when collected and paid, intercompany cash sales, and intercompany
borrowings do not alter the total cash of the consolidated entity. It is the same concept as
an individual transferring cash among his/her bank accounts, or from one pocket to
another.

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

5. Revenue should be recognized when it is earned with a transaction outside of the reporting
entity. The reporting entity for consolidated financial statements encompasses the parent
and all of its subsidiaries. Since intercompany transactions are transactions within the
reporting entity (not outside of the reporting entity), they must be eliminated when
preparing consolidated financial statements.

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

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


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

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


intercompany revenue and expenses because there is no change to the income before tax
for the consolidated entity; therefore, there should be no change to the tax expense for the
consolidated entity. Whatever tax was paid or saved for the two entities will not change for
the consolidated entity since the income before tax did not change. Income tax expense is
adjusted on consolidation when consolidated profits are changed due to adjustments for
unrealized profits.
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6 Modern Advanced Accounting in Canada, Eighth Edition
9. Ideally, intercompany losses should be eliminated in the same manner as intercompany
gains. In turn, an impairment test would be carried out. If the recoverable amount were less
than the carrying amount, an impairment loss would be reported. When the impairment
loss is greater than the intercompany loss, one can get to the same result by not reversing
the intercompany loss and simply reporting an impairment loss to bring the carrying
amount down to the recoverable amount.

10. The elimination of intercompany sales and purchases reduces sales revenue and cost of
goods sold on the consolidated income statement. No other items on the consolidated
statements are affected. The elimination of intercompany profits in ending inventory affects
the following elements of the consolidated statements: cost of goods sold is increased;
income tax expense is decreased; net income is decreased; net income attributable to the
parent is decreased; net income attributable to the non-controlling interest is decreased (if
the subsidiary was the seller); the asset inventory is decreased; deferred income tax
assets are increased; non-controlling interest in net assets is decreased (if the subsidiary
was the seller); and consolidated retained earnings is decreased.

11. For a downstream transaction, the adjustment for unrealized profits is applied to the
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
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Solutions Manual, Chapter 8 7
statements of retained earnings until such time as the land is sold to outside parties.

14. Adjustments are required on consolidation to bring the consolidated balances to the
amounts that would have been on the 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.

15. The journal entry would be as follows:


Equity method income xxx
Investment in subsidiary xxx
where xxx is equal to the parent’s share of the unrealized profits.

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:

Parent Subsidiary Consolidated


Aug Sept July Aug July Aug Sept
BALANCE SHEET
Inventory 480 400 400 400
Prepaid tax 32

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8 Modern Advanced Accounting in Canada, Eighth Edition
INCOME STATEMENT
Sales 600 480 600
Cost of goods sold 480 400 400
Gross margin 120 80 200
Income tax expense 48 32 80
Net income 72 48 120

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
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
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Solutions Manual, Chapter 8 9
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

Memo to: Audit Partner


From: Audit Senior
Re: D Ltd. – Consolidated Financial Statements

As requested, I have prepared the following memorandum, which outlines the important
financial accounting issues of D and N, its subsidiary, and K, its investee company.

1. The shares issued by D to purchase N and K should be measured at their fair value at the
date of acquisition. For now, I will assume that the fair value of 160,000 common shares
was $2,000,000 when D purchased its investments in N and K.

2. It appears that there has been no allocation of the $640,000 acquisition cost excess for N in
the consolidated financial statements. The excess should be first be allocated to identifiable
assets. Any remaining excess should be allocated to goodwill. The goodwill should be
checked for impairment at the end of each year and written down if there is an impairment
loss.

3. Given that N had capitalized some research and development expenditures, there may be
some value in what they were developing. The projects that met the conditions for
capitalization should be measured at fair value at the date of acquisition assuming that the
assets can be separately identified and reliably measured. In turn, these assets should be
amortized over their useful lives. Amortization should commence once the assets are being

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10 Modern Advanced Accounting in Canada, Eighth Edition
used in operations and are generating revenue for the company.

4. D can use either the entity theory or parent company extension theory in preparing the
consolidated financial statements. Under these theories, 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:

Acquisition cost for 80% interest in N $4,000,000


Implied value for 100% interest in N (4,000,000 / .8) 5,000,000
NCI’s share (20%) 1,000,000

This assumes that there is a linear relationship between the value of 80% and the value of 100% of
N.

5. Intercompany transactions and balances between D and K must be eliminated. Sales and
cost of sales should be reduced by the intercompany sales of $1,200,000. The unrealized
profit of $200,000 ($1,200,000 – $1,000,000) should be taken out of ending inventory and
added to cost of goods sold. Since this was an upstream sale, non-controlling interest will
be affected by this adjustment.

6. The investment in K has been accounted for using the cost method. This method is not
acceptable under 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
on an annual basis. We do not have sufficient information at this point to determine the
adjustment for Year 1.

8. Since D paid less than the fair value of 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 –

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Solutions Manual, Chapter 8 11
$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

Allocation and amortization of acquisition cost for investment in N


Cost of 80% investment, September, Year 1 4,000,000
Implied value of 100% investment (4,000,000 / .8) 5,000,000
Carrying amounts of N’s net assets:
Common shares 1,000,000
Retained earnings 1,850,000
Total shareholders' equity 2,850,000
Acquisition differential 2,150,000
Allocation: FV – CA
Land 800,000
Plant and equipment 700,000
Research and development expenditures - 90,000
Existing goodwill - 60,000 1,350,000
Balance – newly calculated goodwill 800,000

Balance Amortization Balance


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12 Modern Advanced Accounting in Canada, Eighth Edition
Sept 1 Aug. 31
Year 1 Year 2 Year 2

Land 800,000 800,000


Plant and equipment 700,000 70,000 630,000
Research and development - 90,000 - 90,000
Old goodwill - 60,000 - 60,000
New goodwill 800,000 800,000
2,150,000 70,000 2,080,000
Investment in K
Investment in K, at date of acquisition 2,100,000
Retained earnings of K, Aug. 31, Year 2 1,710,000
Retained earnings of K, at acquisition 1,760,000
Change - 50,000
Less: Unrealized after-tax profit in ending inventory
(upstream) (200,000 x [1 - .4]) - 120,000
Adjusted increase - 170,000
D’s ownership % 40% - 68,000
Investment in K, Aug. 31, Year 2 2,032,000

Non-controlling interest on balance sheet


Common shares of N 1,000,000
Retained earnings of N 1,950,000
Less: Unrealized after-tax profit in ending inventory
(upstream) ([850,000 – 630,000] x .6) - 132,000 1,818,000
Total shareholders' equity 2,818,000
Unamortized acquisition differential 2,080,000
4,898,000
20%
Non-controlling interest, Aug. 31, Year 2 979,600

Calculation of consolidated profit – Year 2


Profit of D 600,000
Less: Dividends from N (200,000 x 80%) 160,000
Dividends from K (150,000 x 40%) 60,000 220,000
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Solutions Manual, Chapter 8 13
380,000
Profit of N 300,000
Less: Unrealized after-tax profit in closing inventory
(upstream) (220,000 x .6) - 132,000
amortization of acquisition differential - 70,000
Adjusted profit 98,000
Profit of K 100,000
Less: Unrealized after-tax profit in closing inventory
(upstream) (200,000 x .6) - 120,000
Adjusted profit - 20,000
D’s ownership % 40% - 8,000
Consolidated profit, Year 2 470,000

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.

To the members of the union, Good Quality Auto Parts Limited:

I have been engaged to analyze the financial statements of Good Quality Auto Parts Limited
(GQ) for the year ended February 28, Year 11 and determine whether there are any
controversial accounting issues. For the purposes of this report, "controversial accounting
issues" will be defined as accounting policies that have the effect of reducing payments under
the profit-sharing plan to the union members.

The existence of the profit-sharing contract creates incentives for the management of GQ to
make accounting choices that reduce net income and thereby reduce the payments that must
be made to the union members. Accounting standards for private enterprises (ASPE) allow
considerable flexibility and judgment by the preparers of financial statements in selecting
accounting policies. Since the company is privately owned, the costs (real or perceived) of
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14 Modern Advanced Accounting in Canada, Eighth Edition
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.

Allowance for returns


The return estimate represents a legitimate cost of doing business during the period. What is in
question is whether the more conservative estimate represents a genuine reflection of a change
in economic conditions or an opportunistic use of accounting judgment to reduce net income.
GQ's auditor would probably not object to the increased expense since conservatism is a key
accounting principle. However, the union's interests are not served by conservatism.

Use of accelerated depreciation


There is no requirement that all assets owned by a firm be depreciated in the same way. Thus,
GQ can argue that the use of an accelerated method on the new equipment better reflects the
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Solutions Manual, Chapter 8 15
pattern in which the asset’s future economic benefits are expected to be consumed by GC. We
can argue that the portfolio of manufacturing equipment acquired to produce similar products
should be accounted for similarly. If there is no difference between the new and old equipment
with respect to the effect of technological obsolescence, then either the new asset should be
depreciated on a straight-line basis or similar assets acquired previously should be
depreciated on the accelerated method. The financial impact of using the same depreciation
method for both cannot be determined at this point.

Write-off of goodwill
Goodwill should be written down or written off if there has been a permanent impairment of its
value i.e. if the recoverable amount of the cash generating unit in which the goodwill is located
is less than the carrying amount of the net assets, including goodwill, of the cash generating
unit. The fact that the auto parts industry is suffering through poor economic times does not
necessarily imply that what was purchased (the company name, its customers, etc.) no longer
has any value. The auto industry is very sensitive to economic cycles, and it is expected that
such downturns will occur. (Indeed, their occurrence should have been factored into the
acquisition cost paid by GQ).
Unless GQ can come up with strong evidence that the intangibles purchased have been
impaired, there is no justification for the write-off even though GQ's auditors supported it. It is
important to emphasize that their support may rest in conservatism: auditors are willing to
accept accounting treatments that are conservative. However, conservatism is inconsistent with
the union's objectives. The value of the asset acquired in Year 5 must still exist unless there is
specific evidence of its impairment. GQ should provide evidence of impairment.

Unrealized profits from intercompany sales


The unrealized profit from intercompany sales should be eliminated when preparing
consolidated financial statements. CG has not made any adjustments for these intercompany
transactions for Year 11. The unrealized profit in ending inventory is $28,000 (10% x $800,000
x 35%). When this profit is eliminated, CG’s net income will decrease by $28,000. The
unrealized profit in beginning inventory is $70,000 ($200,000 x 35%). When adjusting for this
profit, CG’s net income will increase by $70,000. Therefore, CG’s Year 11 net income should be
increased by $42,000 ($70,000 – $28,000).

Bonus to president and chairman


The compensation approach selected by the senior managers has a significant effect on the
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16 Modern Advanced Accounting in Canada, Eighth Edition
money paid to the union members. Since bonuses are deducted from income whereas
dividends are not, the maximum effect of the change in compensation for union members is
$500,000 (an average of $2,500 per employee). If the amount of compensation has remained
more or less the same as in prior years, with only the method of payment changing, then an
argument can be made that GQ is violating the spirit of the contract by changing the method.

Change to tax allocation


Under ASPE, CG has the choice to use either the taxes-payable method or the liability method
of accounting for income taxes. Accordingly, the new method is acceptable under ASPE. We
could argue that the change is in violation of the contract, as the contract was signed on the
understanding that major accounting policies would remain the same. The arbitrator may accept
this argument. The arbitrator, however, would likely demand consistent treatment of accounting
changes.

Case 6-4

REPORT TO PARTNER ON PLEX-FAME CORPORATION

Overview

PFC is a public corporation. Therefore, the financial statements will be used by stakeholders for
a variety of purposes, including the evaluation of the company and its management. As a
result, the managers have incentives to increase or smooth earnings to influence the share
price or present a favourable impression of themselves to the stakeholders. In addition, the
company is expanding rapidly and, therefore, may need to raise capital. By using accounting
choices to increase earnings or otherwise improve the appearance of the financial statements,
management may be attempting to reduce the cost of capital by lowering the cost of debt or
increasing the selling price of the shares. The company may have a competing objective of
minimizing tax by choosing accounting policies that reduce income in cases where Revenue
Canada requires for tax purposes the same accounting policies that are used in the 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.

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.
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Solutions Manual, Chapter 8 17
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 or in the notes.

“Rue St. Jacques”

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18 Modern Advanced Accounting in Canada, Eighth Edition
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.

Interest on ticket proceeds

PFC earns a significant amount of interest by holding the money paid in advance by ticket
purchasers. The interest revenue could be treated as either income or deferred revenue
depending on the facts and circumstances. 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.

Pre-production costs

PFC has incurred significant costs in advance of the opening of “Rue St. Jacques.” We must
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Solutions Manual, Chapter 8 19
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.

Advertising and promotion

PFC paid $12 million for advertising and promotion costs a large part of which related to the
“Rue St. Jacques” show. These costs should be expensed as incurred because it is difficult to
assess the effectiveness of advertising costs i.e. to determine whether they provide future
benefit.

Debt defeasance

PFC has structured the debt-retirement transaction as an in-substance defeasance of debt. The
effect of the transaction is to remove debt from the balance sheet and thereby reduce the
amount of debt reported (thus, for example, decreasing the debt-to-equity ratio). Unfortunately,
IFRS does not allow the use of this type of arrangement.

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20 Modern Advanced Accounting in Canada, Eighth Edition
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.

IAS 32 (para. 42) includes the following requirement:

A financial asset and a financial liability shall be offset and the net amount presented in the
balance sheet when, and only when, an entity:

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
through the profit and loss.

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Solutions Manual, Chapter 8 21
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.

The sales for profit are consistent with management’s apparent objective of income
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22 Modern Advanced Accounting in Canada, Eighth Edition
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.
However, more information is required to understand how the value of PFC’s contribution may
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Solutions Manual, Chapter 8 23
be adjusted if the net income of Phantom earned between July 1, Year 7 and June 30, Year 8
does not meet expectations, since this adjustment would appear to impact the calculation of
each partners’ respective interests.

In assessing the substance of this transaction, we must consider management’s intentions. We


will have to discuss the transaction with management and review pertinent documents to
determine its substance. We can then form an opinion on the appropriate method of
accounting.

The accounting for the investment in the partnership depends on 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.

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24 Modern Advanced Accounting in Canada, Eighth Edition
APPENDIX I
IMPACT OF ACCOUNTING ENTRIES ON KEY METRICS
(in millions)

Transaction Income Debt Equity ROE Debt:Equity

Penalty Payment
- report as income 2 2 I* D*
- report as reduction of capital cost

Rue St. Jacques ticket


- report as unearned revenue

Interest on ticket proceeds


- report as income 1.7 1.7 I D
- report as deferred revenue

Pre-production costs
- capitalize and later expense
- expense as incurred (15) (15) D I

Advertising & promotion costs


- capitalize and later expense
- expense as incurred (12) (12) D I

Debt defeasance
- if loss was previously recorded 5 5 I D
- if deferred charge was recorded

Sale of theatres as revenue

Investment in partnership
- if full consolidation I I
- if proportionate consolidation I I

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

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Solutions Manual, Chapter 8 25
APPENDIX II
IMPACT OF ACCOUNTING CHANGES ON KEY METRICS
(in millions)

Adjustment Income Debt Equity ROE Debt:Equity

Unadjusted position 147 1,490 780 18.8% 1.91

Interest on tickets deferred (1.7) (1.7)

Debt defeasance 25

Investment in partnership
- reduce gain to 10.75 (14.25) (14.25)

Adjusted position 131.05 1,515 764.05 17.2% 1.98

Annualized to 12 months (times 12/11) 18.8%

Target ROE 20.0%


Maximum debt to equity ratio 2.00

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

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26 Modern Advanced Accounting in Canada, Eighth Edition
calculated, as some of the financial statement adjustments may have a related tax adjustment. I
have therefore completed my analysis of the accounting issues first.

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.
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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.

Five-year champagne contract – cancellation clause


The five-year, fixed-price champagne contract that was signed in January Year 4 no longer
appears to be effective in protecting WP from higher prices. Currently, the contract is accounted
for only as the champagne is purchased at the fixed rate of $360. However, the market price is
$336 and is expected to stay at this level for the next two years.
Anne triggered the cancellation clause of $60,000 on December 31, Year 6. The question is
whether the $60,000 is already accrued or needs to be accrued in the December 31, Year 6
financial statements. Since WP will no longer be purchasing champagne through the contract,
there is no longer an obligation to buy inventory. Instead, WP has paid a one-time cancellation
clause to terminate the contract. The cancellation amount should be accrued in accounts
payable, if not already done, and should be charged to cost of goods sold, as it was incurred
before year-end and is a liability of WP as of December 31, Year 6.

Contingent gain on lawsuit


WP has been advised that their lawyer is “positive” that the $800,000 paid out in the lawsuit
judgment against WP will be returned with interest. We must decide whether the recovery of this
amount can be recorded on the Year 6 financial statements. CICA Handbook-Accounting,
Section 3290 Contingencies, says that contingent gains cannot be accrued.
It appears that much of the information on the appeal is new and may have been obtained after
December 31, Year 6. As a result, the contingent gain should be disclosed in the notes to the
financial statements as a subsequent event.

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,
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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.

Due from shareholder


During Year 6, WP made a loan to Anne and François of $135,000 instead of paying them their
normal salaries. The loan is a financial instrument; we do not know the terms of repayment
associated with it. However, we do know that the loan is between related parties so CICA
Handbook-Accounting, Section 3855.60 Financial Instruments-Recognition and Measurement
provides guidance on how to account for it. The section states that “When the transaction
resulting in initial recognition of a financial asset or financial liability is a related party transaction
involving the transfer of an existing financial asset or financial liability, the transaction is first
measured at carrying amount or exchange amount in accordance with Section 3840 Related
Party Transactions.” In this case, the carrying amount appears appropriate, as the transaction is
not in the normal course of operations (unless WP can support that amount of salary paid with
what would normally be paid to a manager in this type of business).

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)
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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)

Intercompany inventory profits Before 40% After


tax tax tax
Opening inventory – Sub selling (upstream)
(70,000 x 0.3) $21,000 $8,400 $12,600 (c)
Closing inventory – Sub selling (upstream)
(80,000 x 0.3) $24,000 $9,600 $14,400 (d)

Consolidated account balances


Inventory (510,000 + 400,000 – (d) 24,000) $886,000
Accounts payable (700,000 + 420,000 – (b) 50,000) 1,070,000
Retained earnings, beginning of year
PAT $2,500,000
SAT R/E, beginning of year $1,200,000
SAT R/E, date of acquisition (1,000,000)
Change since acquisition 200,000
Less: unrealized after-tax profit in beginning
inventory (upstream) (c) (12,600)
187,400
PAT’s share x 90% 168,660
Consolidated retained earnings 2,668,660
Sales (4,100,000 + 2,600,000 – (a) 190,000) 6,510,000
Cost of sales (3,200,000 + 1,800,000 – (a) 190,000 + (d) 24,000 – (c) 21,000) 4,813,000
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30 Modern Advanced Accounting in Canada, Eighth Edition
Income tax expense (180,000 + 150,000 – (d) 9,600 + (c) 8,400) 328,800

(b) Since the subsidiary was the seller of the intercompany sales, these transactions are
upstream transactions and the non-controlling interest (NCI) will absorb their share of the
adjustments to eliminate the unrealized profits. NCI on the income statement will decrease
by $1,440 (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)

Intercompany inventory profits Before 40% After


tax tax tax
Opening inventory – Sub selling (upstream) 5,000 2,000 3,000 (d)
Closing inventory – Parent selling (downstream)
(100,000 x .50 x .30) 15,000 6,000 9,000 (e)

Calculation of non-controlling interest:


Income of subsidiary (9,000 / 10%) 90,000
Add: Realized after-tax profit in opening inventory (upstream) (d) 3,000
Adjusted 93,000
10%
9,300 (f)

Parent Company
Consolidated Income Statement
for the Current Year

Sales (500,000 – (a) 180,000) 320,000


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Solutions Manual, Chapter 8 31
Rental revenue (24,000 – (b) 24,000)
Interest revenue (50,000 – (c) 35,000) 15,000
Total revenue 335,000
Cost of goods sold
(350,000 – (a) 180,000 – (d) 5,000 + (e) 15,000) 180,000
Rent expense (24,000 – (b) 24,000)
Interest expense (35,000 – (c) 35,000)
Administration expenses 45,000
Income tax expense (42,000 + (d) 2,000 – (e) 6,000) 38,000
Total expense 263,000
Profit 72,000
Attributable to:
Shareholders of parent 62,700
Non-controlling interests (f) 9,300
72,000
Proof:
Profit previously reported 69,000
Add: Realized after-tax profit in opening inventory (upstream) 3,000
Parent’s share x 90% 2,700
71,700
Less: Unrealized after-tax profit in closing inventory (downstream) 9,000
Consolidated profit attributable to shareholders of parent 62,700
(b)
The matching principle requires that expenses be matched to revenues. When intercompany
revenues are eliminated from the consolidated financial statements, the related cost of goods
sold should also be eliminated. When profits are eliminated, income tax expense related to
those profits should also be eliminated. When the previously unrecognized intercompany profits
are recognized in a later period, the income tax on these profits should be expensed.

Problem 6-3
Pike Spike Consolidated
December 31, Year 1
Land 200,000 230,000*
Gain on Sale

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32 Modern Advanced Accounting in Canada, Eighth Edition
Income Tax on Gain
December 31, Year 2
Land 256,000 230,000*
Gain on Sale 56,000
Income Tax on Gain 22,400***
December 31, Year 3
Land
Gain on Sale 24,000 50,000**
Income Tax on Gain 9,600*** 20,000***
* = fair value of land at date of acquisition
** = selling price to outsiders less amount paid at acquisition = 280,000 – 230,000
*** = 40% x gain on sale of land

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)

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Solutions Manual, Chapter 8 33
(60,000 x .30) 18,000 7,200 10,800 (i)
– Paste selling (downstream)
(22,000 x .30) 6,600 2,640 3,960 (j)
– Waste selling (upstream)
(60,000 x .30) 18,000 7,200 10,800 (k)
42,600 17,040 25,560) (l)

Calculation of Consolidated Net income Attributable to Parent – Year 9

Profit of Paste $83,750


Less: dividend income from subsidiaries (43,750)
unrealized after-tax profit in ending inventory (j) (3,960)
36,040
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

Profit of Baste 9,000


Less: Unrealized after-tax profit in ending inventory (upstream) (i) 10,800
(1,800)
Paste’s share x 75% (1,350)
Equity method income from subsidiaries 109,910 (m)

Paste Company
Consolidated Income Statement
for the Year Ended December 31, Year 9

Sales (450,000 + 270,000 + 190,000 – (d) 410,000) 500,000


Dividends (43,750 – (g) 43,750)
Interest (10,000 – (f) 10,000)
Rent (130,000 – (e) 39,000) 91,000
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34 Modern Advanced Accounting in Canada, Eighth Edition
Total income 591,000
Cost of sales (300,000 + 163,000 + 145,000 – (d) 410,000
– (h) 4,500 + (l) 42,600 + (b) 1,875) 237,975
General & administrative (93,000 + 48,000 + 29,000 – (e) 39,000) 131,000
Interest (10,000 – (f) 10,000)
Income tax (27,000 + 75,000 + 7,000 + (h) 1,800 – (l) 17,040) 93,760
Total expenses 462,735
Profit 128,265
Attributable to:
Shareholders of Paste (m) 109,910
Non-controlling interests (20% x 94,025 + 25% x -1,800) 18,355
128,265

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

(b)
Calculation of consolidated retained earnings – December 31, Year 9

Retained earnings of Paste December 31, Year 9 703,750


Unrealized after-tax profit in ending inventory (downstream) (j) (3,960)
Retained earnings of Waste December 31, Year 9 146,000
Retained earnings of Waste – acquisition 40,000
Increase 106,000
Less: Unrealized after-tax profit in ending inventory (upstream) (k) 10,800
amortization of acquisition differential (a) 9,375 + (b) 1,875 11,250
Adjusted increase 83,950
Paste's ownership % 80% 67,160

Retained earnings of Baste December 31, Year 9 79,000


Retained earnings of Baste – acquisition 80,000
Decrease (1,000)
Less: amortization of acquisition differential for Baste (c) 19,000
Unrealized after-tax profit in ending inventory (upstream) (i) 10,800
(30,800)

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Solutions Manual, Chapter 8 35
Paste's ownership % 75% (23,100)
Consolidated retained earnings December 31, Year 9 743,850

(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

Profit of Baste 9,000


Less: Unrealized after-tax profit in ending inventory (upstream) (i) 10,800
(1,800)
Paste’s share x 75% (1,350)
Unrealized after-tax profit in ending inventory (downstream) (j) (3,960)
Equity method income from subsidiaries 69,910

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

Problem 6-5

(a) X's equity method journal entries

Year 3

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36 Modern Advanced Accounting in Canada, Eighth Edition
Cash 18,750
Investment in Y Co. 18,750
75% x 25,000 dividends

Investment in Y Co. 97,500


Equity method income 97,500
75% x 130,000 net income

Equity method income 13,500


Investment in Y Co. 13,500
To hold back 75% of the 18,000 (i.e. 30,000 x [1 - .4]) after-tax
inventory profit – Y selling (upstream)

Equity method income 22,200


Investment in Y Co. 22,200
To hold back the after-tax land profit –
X selling (downstream) (37,000 x [1 - .4] = 22,200)

Equity method income 47,250


Investment in Y Co. 47,250
Acquisition differential amortization – Year 3
Inventory 60,000
Equipment 45,000/15 = 3,000
63,000
x Co.’s share (@ 75%) 47,250
Note: Year 3 equity method income is $14,550 ($97,500 – $13,500 – $22,200 – $47,250)

Year 4

Cash 3,750
Investment in Y Co. 3,750
75% x 5,000 dividends

Equity method income 12,000


Investment in Y Co. 12,000
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Solutions Manual, Chapter 8 37
75% x 16,000 net loss

Equity method income 2,250


Investment in Y Co. 2,250
Acquisition differential (equipment) amortization. (3,000 x 75%)

Investment in Y Co. 13,500


Equity method income 13,500
To realize opening inventory profit – Y selling (upstream)

Investment in Y Co. 22,200


Equity method income 22,200
To realize land profit – X Selling (downstream)

Equity method income 7,200


Investment in Y Co. 7,200
To hold back after-tax inventory profit – X selling (downstream)
(12,000 x [1 - .4])

Note: Year 4 equity method income is $14,250 (–$12,000 – $2,250 + $13,500 + $22,200 –
$7,200)

(b) Calculation of consolidated net income – Year 3

Net income of X 400,000


Less: Unrealized after-tax gain on land (downstream) 22,200
Adjusted 377,800

Net income of Y 130,000


Less: Unrealized after-tax profit in ending inventory (upstream) (18,000)
acquisition differential amortization (63,000)
Adjusted 49,000
Consolidated net income 426,800
Attributable to:

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38 Modern Advanced Accounting in Canada, Eighth Edition
Shareholders of X 414,550
Non-controlling interests (25% x 49,000) 12,250
426,800

Calculation of Consolidated Net income – Year 4

Net income of X 72,000


Less: Unrealized after-tax profit in ending inventory (downstream) 7,200
64,800
Add: Realized after-tax gain on land (downstream) 22,200
Adjusted net income 87,000
Net income (loss) of Y (16,000)
Add: realized after-tax profit in opening inventory (upstream) 18,000
Less: acquisition differential amortization (3,000)
Adjusted net income (1,000)
Consolidated net income 86,000
Attributable to:
Shareholders of X 86,250
Non-controlling interests (25% x -1,000) (250)
86,000
(c)
Changes in Non-controlling Interest
Years 3 and 4

Balance Jan. 1 Year 3 [25% x (170,000 + 105,000)] 68,750


Allocation of Y Co.’s adjusted net income Year 3
(25% x 49,000) 12,250
81,000
Less: dividends (25% x 25,000) 6,250
Balance Dec. 31, Year 3 74,750
Allocation of Y Co.’s adjusted net income Year 4
(25% x - 1,000) (250)
74,500
Less: dividends (25% x 5,000) 1,250

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Solutions Manual, Chapter 8 39
Balance Dec. 31, Year 4 73,250

Proof:

Y - Common shares 100,000


- Retained earnings (70,000 + 130,000  25,000  16,000  5,000) 154,000
- Shareholders' equity Dec. 31, Year 4 254,000
- Unamortized acquisition differential 39,000
293,000
25%
73,250

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


As at December 31, Year 4

Shareholders' equity of Y Jan. 1, Year 3 170,000


Acquisition differential 105,000
275,000
X's ownership 75%
Cost of 75% investment in Y Jan. 1, Year 3 206,250
Equity method income – Year 3 14,550
Year 4 14,250 28,800
235,050
Less: Dividends received
Year 3 (75% x 25,000) 18,750
Year 4 (75% x 5,000) 3,750 22,500
Investment in Y Dec. 31, Year 4 212,550

Proof:

Shareholders' equity of Y 254,000


Balance, unamortized equipment (45,000  6,000) 39,000
293,000
X's ownership 75%

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40 Modern Advanced Accounting in Canada, Eighth Edition
219,750
Less: Unrealized after-tax profit in ending inventory (downstream) 7,200
Investment in Y, December 31, Year 4 212,550

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)

Ending inventory Q selling (upstream) 35,000 14,000 21,000 (c)


L selling (downstream) 118,000 47,200 70,800 (d)

(a) Calculation of consolidated profit

Profit of L 580,000
Less: Dividends
From M (80% x 200,000) 160,000
From Q (70% x 150,000) 105,000
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
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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

Retained earnings of L 976,000


Less: Unrealized after-tax in opening inventory (downstream) (b) 31,200
Adjusted 944,800
Retained earnings of M 843,000
Acquisition retained earnings 500,000
Increase 343,000
L's ownership 80% 274,400

Retained earnings of Q 682,000


Acquisition retained earnings 50,000
Increase 632,000
Less: Unrealized after-tax profit in opening inventory (upstream) (a) 48,000
Adjusted increase 584,000
L's ownership 70% 408,800
Consolidated retained earnings – beginning of year 1,628,000

Problem 6-7
Calculation, allocation, and amortization of acquisition differential

Cost of 80% investment, Jan. 1, Year 3 1,600,000


Implied value of 100% investment 2,000,000
Carrying amounts of Least's net assets:
Assets 3,000,000
Liabilities 1,500,000
Total shareholders' equity 1,500,000
Acquisition differential 500,000
Allocation: FV - CA
Accounts receivable - 20,000

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42 Modern Advanced Accounting in Canada, Eighth Edition
Inventories - 50,000
Plant and equipment (net) 35,000
Long-term liabilities 100,000 65,000
Balance – goodwill 435,000

Balance Amortization Balance


Jan. 1 Dec. 31
Year 3 Years 3 to 8 Year 9 Year 9
Accounts receivable - 20,000 - 20,000
Inventories - 50,000 - 50,000
Plant and equipment (net) 35,000 26,250 4,375 4,375 (a)
Long-term liabilities 100,000 100,000
Goodwill 435,000 52,200 8,700 374,100 (b)
500,000 108,450 (c) 13,075 (d) 378,475

Intercompany revenues and expenses

Sales and purchases (2,000,000 + 1,500,000) 3,500,000 (e)

Intercompany profits
Before tax 40% tax After tax

Loss on land, July 1, Year 7


realized in Year 9 – Most selling (downstream) 50,000 20,000 30,000 (f)

Opening inventory – Most selling (downstream)


(312,500 x 0.20) 62,500 25,000 37,500 (g)
– Least selling (upstream)
(857,140 x 0.30) 257,142 102,857 154,285 (h)
319,642 127,857 191,785 (i)

Ending inventory – Most selling (downstream)


(500,000 x 0.20) 100,000 40,000 60,000 (j)
– Least selling (upstream)
(714,280 x 0.30) 214,284 85,714 128,570 (k)
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Solutions Manual, Chapter 8 43
314,284 (l) 125,714 188,570
Intercompany dividends declared but not paid (80% x 100,000) 80,000 (m)

Deferred income taxes – ending inventory (40,000 + 85,714) 125,714 (n)

Calculation of consolidated retained earnings – Jan. 1 Year 9

Retained earnings of Most, Jan. 1, Year 9


(10,400,000 – 1,000,000 + 350,000) 9,750,000

Less: Unrealized after-tax profit in opening inventory (downstream) (g) 37,500


9,712,500
Add: Unrealized after-tax loss on land (downstream) (f) 30,000
Adjusted retained earnings 9,742,500
Retained earnings of Least, Jan. 1, Year 9
(2,300,000 – 400,000 + 100,000) 2,000,000
Retained earnings of Least at acquisition 1,000,000
Increase 1,000,000
Less: Unrealized after-tax profit in opening inventory (upstream) (h) 154,285
amortization of acquisition differential (c) 108,450
Adjusted increase 737,265 (o)
Most's ownership % 80% 589,812
Consolidated retained earnings, Jan. 1, Year 9 10,332,312

Calculation of consolidated net income – Year 9


Net income of Most 1,000,000
Less: Dividends from Least (100,000 x 80%) 80,000
Unrealized after-tax profit in closing inventory
(downstream) (j) 60,000
Realized after-tax loss on land (downstream) (f) 30,000 170,000
830,000
Add: Realized after-tax profit in opening inventory (downstream) (g) 37,500
Adjusted net income 867,500
Net income of Least 400,000
Add: Realized after-tax profit in opening inventory (upstream) (h) 154,285
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44 Modern Advanced Accounting in Canada, Eighth Edition
554,285
Less: Unrealized after-tax profit in closing inventory (upstream) (k) 128,570
amortization of acquisition differential (d) 13,075
Adjusted net income 412,640
Consolidated net income 1,280,140
Attributable to:
Shareholders of Most 1,197,612
Non-controlling interests (20% x 412,640) 82,528
1,280,140

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


Least’s common shares, Jan. 1, Year 9 500,000
Retained earnings of Least, Jan. 1, Year 9 2,000,000
Less: Unrealized after-tax profit in opening inventory (upstream) (h) 154,285
Adjusted retained earnings 1,845,715
Unamortized acquisition differential (500,000 – 108,450) 391,550
2,737,265
NCI’s ownership % 20%
NCI, Jan. 1, Year 9 547,453

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


Non-controlling interests at date of acquisition (20% x [1,600,000 / .8) 400,000
Least’s adjusted increase in retained earnings (n) 737,265
NCI’s share @ 20% 147,453
NCI, Jan. 1, Year 9 547,453

(a) Most Company


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

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

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Solutions Manual, Chapter 8 45
Less: dividends (350,000) (350,000) (20,000) (370,000)
Balance, end of year 1,000,000 11,179,924 12,179,924 609,981 12,789,905

Proof of consolidated retained earnings, end of Year 9

Retained earnings of Most, Dec. 31, Year 9 10,400,000


Less: Unrealized after-tax profit in ending inventory (downstream) (j) 60,000
Adjusted retained earnings 10,340,000
Retained earnings of Least, Dec. 31, Year 9 2,300,000
Retained earnings of Least at acquisition 1,000,000
Increase 1,300,000
Less: Unrealized after-tax profit in ending inventory (upstream) (k) 128,570
amortization of acquisition differential
((c) 108,450 + (d) 13,075) 121,525
Adjusted increase 1,049,905 (p)
Most's ownership % 80% 839,924
Consolidated retained earnings, Dec. 31, Year 9 11,179,924

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


Retained earnings of Least 2,300,000
Common shares of Least 500,000
Total shareholders' equity 2,800,000
Less: Unrealized after-tax profit in ending inventory (upstream) (k) 128,570
Adjusted shareholders' equity 2,671,430
Add: unamortized acquisition differential 378,475
3,049,905
20%
Non-controlling interest, Dec. 31, Year 9 609,981

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


Non-controlling interests at date of acquisition (20% x [1,600,000 / .8]) 400,000
Least’s adjusted increase in retained earnings (o) 1,049,905
NCI’s share @ 20% 209,981
Non-controlling interest, Dec. 31, Year 9 609,981

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46 Modern Advanced Accounting in Canada, Eighth Edition
(b) Most Company
Consolidated Balance Sheet
December 31, Year 9

Cash (500,000 + 40,000) 540,000


Accounts receivable (1,700,000 + 500,000 – (m) 80,000) 2,120,000
Inventories (2,300,000 + 1,200,000 – (l) 314,284) 3,185,716
Plant and equipment (net) (8,200,000 + 4,000,000 + (a) 4,375) 12,204,375
Land (700,000 + 260,000) 960,000
Goodwill (b) 374,100
Deferred income taxes (n) 125,714
Total assets 19,509,905

Current liabilities (600,000 + 200,000 – (m) 80,000) 720,000


Long-term liabilities (3,000,000 + 3,000,000) 6,000,000
Common shares 1,000,000
Retained earnings 11,179,924
Non-controlling interest 609,981
Total liabilities & shareholders' equity 19,509,905

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

(d) The debt to equity ratio would increase because debt remains the same but the 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.

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Solutions Manual, Chapter 8 47
Problem 6-8
Intercompany sales
January 7,200 (a)
February 10,800 (b)
Unrealized profits (sub. selling) (upstream) Before 40% After
Tax Tax Tax
Ending inventory for January (2,200 – [2,200 / 1.2]) 367 147 220 (c)
Ending inventory for February (4,500 – [4,500 / 1.2]) 750 300 450 (d)

INCOME STATEMENTS FOR JANUARY YEAR 8


Fazli Gervais AdjustConsolidation
Sales $6,250 $7,200 (a) – 7,200 $6,250
Cost of sales
Beginning inventory 0 0 0
Purchases 7,200 10,000 (a) -7,200 10,000
Goods available 7,200 10,000 10,000
Ending inventory 2,200 4,000 (c) -367 5,833
Cost of sales 5,000 6,000 4,167
Gross margin 1,250 1,200 2,083
Income tax expense (40%) 500 480 (c) -147 833
Net income $750 $720 $1,250
Attributable to:
Fazli’s shareholders $1,250
Non-controlling interest 0

INCOME STATEMENTS FOR FEBRUARY YEAR 8


Fazli Gervais AdjustConsolidation
Sales $10,625 $10,800 (b) – 10,800 $10,625
Cost of sales
Beginning inventory 2,200 4,000 (c) - 367 5,833
Purchases 10,800 12,000 (b) -10,800 12,000
Goods available 13,000 16,000 17,833
Ending inventory 4,500 7,000 (d) -750 10,750
Cost of sales 8,500 9,000 7,083

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48 Modern Advanced Accounting in Canada, Eighth Edition
Gross margin 2,125 1,800 3,542
Income tax expense (40%) 850 720 (d-c) -153 1,417
Net income $1,275 $1,080 $2,125
Attributable to:
Fazli’s shareholders $2,125
Non-controlling interest 0

(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
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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

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50 Modern Advanced Accounting in Canada, Eighth Edition
(v) net adjustment to retained earnings at beginning of year
pertaining to intercompany profits [(a) 2,160 x 90%)] 1,944
(vi) net adjustment to retained earnings at end of year
pertaining to intercompany profits [(b) 4,860 x 90%] 4,374

(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)

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Solutions Manual, Chapter 8 51
– Falcon selling (upstream)
(11,000 x 0.3) 3,300 1,320 1,980 (e)
7,550 3,020 4,530 (f)
Ending inventory – Evans selling (downstream)
(28,750 – [28,750 / 1.25]) 5,750 2,300 3,450 (g)
– Falcon selling (upstream)
(3,000 x 0.3) 900 360 540 (h)
6,650 2,660 3,990 (i)

Calculation of consolidated profit – current year

Profit of Evans 61,900


Less: Intercompany dividends (40,000 x 80%) 32,000
Unrealized after-tax profit in ending inventory (downstream) (g) 3,450 35,450
26,450
Add: Realized after-tax profit in opening inventory (downstream) (d) 2,550
Adjusted profit 29,000
Profit of Falcon 75,500
Less: Unrealized after-tax profit in ending inventory (upstream) (h) 540
74,960
Add: Realized after-tax profit in opening inventory (upstream) (e) 1,980
76,940
Consolidated profit 105,940
Attributable to:
Shareholders of Evans 90,552
Non-controlling interests (20% x 76,940) 15,388
105,940

(a) Evans Company


Consolidated Income Statement
for the Current Year

Sales (450,000 + 600,000 – (a) 267,000) 783,000


Raw materials & finished goods purchased

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52 Modern Advanced Accounting in Canada, Eighth Edition
(268,000 + 328,000 – (a) 267,000) 329,000
Changes in inventory
(20,000 + 25,000 – (f) 7,550 + (i) 6,650) 44,100
Other expenses (104,000 + 146,000 – (b) 33,600) 216,400
Interest expense (30,000 – (c) 18,000) 12,000
Income taxes (31,700 + 43,500 + (f) 3,020 – (I) 2,660) 75,560
Total expenses 677,060
Profit 105,940
Attributable to:
Shareholders of Evans 90,552
Non-controlling interests (20% x 76,940) 15,388
105,940

(b)
Calculation of consolidated retained earnings – beginning of year

Retained earnings of Evans, beginning of year 632,000


Less: Unrealized after-tax profit in opening inventory (downstream) (d) 2,550
Adjusted retained earnings 629,450
Retained earnings of Falcon, beginning of the year 348,000
Less: Unrealized after-tax profit in opening inventory (upstream) (e) 1,980
Adjusted increase since acquisition 346,020
Evans' ownership % 80% 276,816
Consolidated retained earnings, beginning of year 906,266

Consolidated dividends declared 30,000

Problem 6-11
Calculation, allocation, and amortization of the acquisition differential

Cost of 90% investment, Jan. 2, Year 6 90,000


Implied value of 100% investment 100,000
Carrying amounts of S's net assets:
Common shares 60,000

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Solutions Manual, Chapter 8 53
Retained earnings 20,000
Total shareholders' equity 80,000
Acquisition differential – patents 20,000
Amortization:
Years 6 – 9 (a) 16,000
Year 10 (b) 4,000 20,000
Balance, Dec. 31, Year 10 –0–

Intercompany profits

Before tax 40% tax After tax


Opening inventory – S selling (upstream)
(7,000 x 0.40) 2,800 1,120 1,680 (c)
– P selling (downstream)
(3,000 x 0.40) 1,200 480 720 (d)
4,000 1,600 2,400 (e)
Ending inventory – S selling (upstream)
(20,000 x 0.40) 8,000 3,200 4,800 (f)
– P selling (downstream)
(5,000 x 0.40) 2,000 800 1,200 (g)
10,000 4,000 6,000 (h)

Sale of land – Year 8 S selling (upstream)


(50,000 – 40,000) 10,000 4,000 6,000 (i)

Calculation of consolidated net income – Year 10

Net income of P Company 60,000


Less: Dividends from S (10,000 x 90%) 9,000
Unrealized after-tax profit in ending inventory (downstream) (g) 1,200 10,200
49,800
Add: Realized after-tax profit in opening inventory (downstream) (d) 720
Adjusted net income 50,520
Net income of S Company 48,000
Less: Unrealized after-tax profit in ending inventory (upstream) (f) 4,800
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54 Modern Advanced Accounting in Canada, Eighth Edition
patent amortization (b) 4,000
39,200
Add: Realized after-tax profit in opening inventory (upstream) (c) 1,680
40,880
Consolidated net income 91,400
Attributable to:
Shareholders of P Co. 87,312
Non-controlling interests (10% x 40,880) 4,088
91,400

Calculation of consolidated retained earnings – Jan. 1, Year 10

Retained earnings of P, Jan. 1, Year 10


(101,000 + 12,000) 113,000
Less: Unrealized after-tax profit in opening inventory (downstream) (d) 720
Adjusted retained earnings 112,280
Retained earnings of S (34,000 + 10,000) 44,000
Retained earnings of S at acquisition 20,000
Increase since acquisition 24,000
Less: Amortization of patents (a) 16,000
Unrealized after-tax gain on land
(upstream) (i) 6,000
Unrealized after-tax profit in opening
Inventory (upstream) (c) 1,680 23,680
Adjusted increase 320 (j)
P's ownership % 90% 288
Consolidated retained earnings, Jan. 1, Year 10 112,568

Calculation of consolidated non-controlling interests, beginning of Year 10 (Method 1)


Company S shareholders' equity
Common shares 60,000
Retained earnings 44,000
104,000
Less: Unrealized after-tax gain on land (upstream) (i) 6,000
Unrealized after-tax profit in beginning inventory
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Solutions Manual, Chapter 8 55
(upstream) (c) 1,680 7,680
Adjusted shareholders' equity 96,320
Unamortized acquisition differential 4,000
100,320
10%
Non-controlling interest, Jan 1, Year 10 10,032

Calculation of consolidated non-controlling interests – Jan. 1 Year 10 (Method 2)


Non-controlling interests at date of acquisition (10% x [90,000 / .9) 10,000
S Co.’s adjusted increase in retained earnings (j) 320
NCI’s share @ 10% 32
Non-controlling interest, Jan 1, Year 10 10,032

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
((a) 16,000 + (b) 4,000) 20,000
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56 Modern Advanced Accounting in Canada, Eighth Edition
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

Calculation of consolidated non-controlling interests – Dec. 31 Year 10 (Method 1)


Company S shareholders' equity
Common shares 60,000
Retained earnings 82,000
142,000
Less: Unrealized after-tax gain on land (upstream) (i) 6,000
Unrealized after-tax profit in ending inventory (upstream) (f) 4,800 10,800
Adjusted shareholders' equity 131,200
Unamortized acquisition differential 0
131,200
10%
Non-controlling interests, Dec. 31, Year 10 13,120

Calculation of consolidated non-controlling interests – Dec. 31 Year 10 (Method 2)


Non-controlling interests at date of acquisition (10% x [90,000 / .9) 10,000
S Co.’s adjusted increase in retained earnings (k) 31,200
NCI’s share @ 10% 3,120
Non-controlling interest, Jan 1, Year 10 13,120

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Solutions Manual, Chapter 8 57
Problem 6-12
Acquisition differential amortization – Year 9

Plant and equipment depreciation (120,000/ 5) $24,000 (a)


Patent amortization (40,000/ 8) 5,000 (b)
Goodwill impairment loss 3,000 (c)
$32,000 (d)

Intercompany revenues and expenses

Sales – Runner to Road $480,000 (e)


Rental – Runner to Road $95,000 (f)

Intercompany profits

Before tax 40% tax After tax

Opening inventory – Runner selling (upstream) $247,000 $98,800 $148,200 (g)

Ending inventory – Runner selling (upstream) $100,000 $40,000 $60,000 (h)

(a) Road Ltd.


Consolidated Income Statement
for the Year Ended December 31, Year 9

Sales (4,600,000 + 2,160,000 - (e) 480,000) $6,280,000


Rental revenue (190,000 - (f) 95,000) 95,000
Total income 6,375,000
Materials used in manufacturing
(2,300,000 + 860,000 - (e) 480,000) $2,680,000
Change in work-in-progress & finished goods inventory
(105,000 - 10,000 - (g) 247,000 + (h) 100,000) (52,000)
Employee benefits (610,000 + 540,000) 1,150,000
Interest expense (310,000 + 200,000) 510,000
Depreciation (465,000 + 275,000 + (a) 24,000) 764,000
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58 Modern Advanced Accounting in Canada, Eighth Edition
Patent amortization (55,000 + (b) 5,000) 60,000
Goodwill impairment loss (c) 3,000
Income tax (360,000 + 191,200 + (g) 98,800 - (h) 40,000) 610,000
Total expenses 5,725,000
Profit $650,000
Attributable to:
Shareholders of Road 561,500
Non-controlling interests
(30% x [238,800 – (d) 32,000 + (g) 148,200 - (h) 60,000]) 88,500
$650,000

(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

Cost of 70% investment, January 1, Year 4 $84,000


Implied value of 100% investment $120,000
Carrying amounts of Sage's net assets:
Ordinary shares $50,000
Retained earnings 18,000
Total shareholders' equity 68,000
Acquisition differential $52,000
Allocation: FV – CA
Inventory (15,000)
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Solutions Manual, Chapter 8 59
Unfavourable lease agreement (21,000) (36,000)
Balance – goodwill $88,000

Balance Amortization Balance


January 1 December 31
Year 4 Years 4 & 5 Year 6 Year 6

Inventory $(15,000) $(15,000)


Lease agreement (21,000) (8,400) $(4,200) $(8,400) (a)
Goodwill 88,000 3,240 1,350 83,410 (b)
$52,000 $(20,160) (c) $(2,850) (d) $75,010

Intercompany receivables and payables – notes $54,000 (e)

Intercompany revenues and expenses

Management fee $27,000 (f)


Sales and purchases
Post selling $130,000
Sage selling 102,000 232,000 (g)
Interest (12% x 1/2 x 54,000) $3,240 (h)

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)

Deferred income taxes – December 31, Year 6


Inventory $5,100
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60 Modern Advanced Accounting in Canada, Eighth Edition
Land 13,600
$18,700 (n)
Accumulated depreciation at date of acquisition for Sage $13,000 (o)
Calculation of consolidated profit
Profit of Post $102,800
Less: Investment income from Sage $2,100
Unrealized after-tax profit in ending inventory (downstream) (l) 3,150 5,250
Adjusted profit 97,550
Profit of Sage 27,000
Add: Realized after-tax profit in opening inventory (upstream) (j) 2,550
29,550
Add: Amortization of acquisition differential (d) 2,850
Less: Unrealized after-tax profit in ending inventory
(upstream) (k) $4,500
Unrealized after-tax gain on land
(upstream) (i) 20,400 (24,900)
Adjusted profit 7,500
Profit $105,050
Attributable to:
Shareholders of Post $102,800
Non-controlling interests (30% x 7,500) 2,250
$105,050

(a) (i) Post Corporation


Consolidated Statement of Profit
For the Year Ended, December 31, Year 6
Sales (930,000 + 259,000 – (g) 232,000) $957,000
Interest revenue (7,100 – (h) 3,240) 3,860
Total revenue 960,860
Cost of goods sold
(570,000 + 182,000 – (g) 232,000 - (j) 4,250 + (m) 12,750) 528,500
Interest expense (20,300 – (h) 3,240) 17,060
Other expense
(183,000 + 75,100 – (f) 27,000 - (a) 4,200) 226,900

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Solutions Manual, Chapter 8 61
Goodwill impairment loss (b) 1,350
Income tax expense
(83,000 + 16,000 + (j) 1,700 – (m) 5,100 – (i) 13,600) 82,000
Total expenses 855,810
Profit $105,050
Attributable to:
Shareholders of Post 102,800
Non-controlling interests (30% x 7,500) 2,250
$105,050

Calculation of non-controlling interests – December 31, Year 6

Ordinary shares $50,000


Retained earnings 89,000
Total shareholders' equity 139,000
Less: Unrealized after-tax profit in ending inventory (upstream) (k) $4,500
Unrealized after-tax gain on land (upstream) (i) 20,400 (24,900)
Add: unamortized acquisition differential 75,010
Adjusted shareholders' equity 189,110
Non-controlling interest’s share 30%
Non-controlling interest, December 31, Year 6 $56,733

(a) (ii) Post Corporation


Consolidated Statement of Financial Position
December 31, Year 6
Land (178,000 + 22,000 – (i) 34,000) $166,000
Plant and equipment (529,000 + 64,000 – (o) 13,000) 580,000
Accumulated depreciation ((233,000) + (20,000) – (o) 13,000)) (240,000)
Goodwill (b) 83,410
Deferred income taxes (n) 18,700
Inventory (34,000 + 30,000 – (m) 12,750) 51,250
Accounts receivable (17,500 + 10,200) 27,700
Cash (12,500 + 13,200) 25,700
Total assets $712,760

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62 Modern Advanced Accounting in Canada, Eighth Edition
Ordinary shares $100,000
Retained earnings 266,200
Non-controlling interests 56,733
422,933
Unfavourable lease agreement 8,400
Accounts payable (247,027 + 34,400) 281,427
Total shareholders’ equity & liabilities $712,760

(b)
Goodwill impairment loss – entity theory $1,350
Less: NCI’s share @ 30% 405
Goodwill impairment loss – parent company extension theory $945

NCI – entity theory $2,250


NCI’s share of goodwill impairment loss 405
NCI – parent company extension theory $2,655

(c)
Goodwill – entity theory $83,410
Less: NCI’s share @ 30% 25,023
Goodwill – parent company extension theory $58,387

NCI – entity theory $56,733


NCI’s share of goodwill impairment loss 25,023
NCI – parent company extension theory $31,710

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Solutions Manual, Chapter 8 63
CONSOLIDATED FINANCIAL STATEMENT WORKING PAPER
POST
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, YEAR 6
Eliminations
Post Sage Dr. Cr. Consolidated
Income Statements - Year 6

Sales $ 930,000 $ 259,000 11 232,000 $ 957,000


Management fee revenue 27,000 0 10 27,000 0
Interest revenue 0 7,100 12 3,240 3,860
Investment income from
Sage 2,100 0 1 2,100 0
Gain on sale of land 0 34,000 8 34,000 0
Total income 959,100 300,100 960,860

Cost of goods sold 570,000 182,000 7 12,750 11 232,000 528,500


6 4,250
Interest expense 20,300 0 12 3,240 17,060
Other expenses 183,000 75,100 10 27,000 226,900
5 4,200
Goodwill impairment loss 0 0 5 1,350 1,350
Income tax expense 83,000 16,000 6 1,700 7 5,100 82,000
8 13,600
Total expenses 856,300 273,100 855,810
Profit $ 102,800 $ 27,000 $ 105,050

Attributable to:
Shareholders of Peter $ 102,800
Non-controlling interest 13 2,250 2,250
Total $ 316,390 $ 289,390 $ 105,050

Year 6 retained earnings statements


Balance, January 1 $ 163,400 $ 62,000 3 62,000 1 0 $ 163,400
Profit 102,800 27,000 Above 316,390 289,390 102,800
266,200 89,000 266,200

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64 Modern Advanced Accounting in Canada, Eighth Edition
Dividends 0 0 0
Balance, December 31 $ 266,200 $ 89,000 Total $ 378,390 $ 289,390 $ 266,200

Statements of Financial Position - December 31, Year 6

Land $ 178,000 $ 22,000 8 34,000 $ 166,000


Plant and equipment 529,000 64,000 4 13,000 580,000
Accumulated depreciation (233,000) (20,000) 4 13,000 (240,000)
Investment in Sage 129,227 0 2 54,483 1 2,100 0
6 2,550 3 184,160
Goodwill 0 0 5 84,760 5 1,350 83,410
Deferred income taxes 7 5,100 18,700
8 13,600
Inventory 34,000 30,000 7 12,750 51,250
Notes receivable 0 54,000 9 54,000 0
Accounts receivable 17,500 10,200 27,700
Cash 12,500 13,200 25,700
Total assets $ 667,227 $ 173,400 $ 712,760

Ordinary shares $ 100,000 $ 50,000 3 50,000 $ 100,000


Retained earnings 266,200 89,000 Above 378,390 Above 289,390 266,200

Non-controlling interest 0 0 2 54,483 56,733


13 2,250
Notes payable 54,000 0 9 54,000 0
Unfavourable lease
agreement 0 0 5 4,200 5 12,600 8,400
Accounts payable 247,027 34,400 281,427
Total Shareholders'
equity & liabilities $ 667,227 $ 173,400 $ 712,760

$ 660,083 $ 660,083 0

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Solutions Manual, Chapter 8 65
JOURNAL ENTRIES

1 Investment income from Sage $ 2,100


Investment in Sage $ 2,100
To adjust investment account to beginning of year

2 Investment in Sage (note a) 54,483


Non-controlling interest 54,483
To establish non-controlling interest at beginning of year

3 Ordinary shares 50,000


Retained earnings 62,000
Goodwill 84,760
Lease agreement 12,600
Investment in Sage shares 184,160
To eliminate subsidiary's shareholders' equity and
establish acquisition differential at beginning of Year 6

4 Accumulated depreciation 13,000


Plant and equipment 13,000
To eliminate Sage's accumulated depreciation at date of acquisition

5 Goodwill impairment loss 1,350


Goodwill 1,350
Lease agreement 4,200
Other expenses 4,200
To amortize acquisition differential for the year

6 Investment in Sage 2,550


Cost of sales 4,250
Income tax expense 1,700
To eliminate unrealized after-tax profits in beginning inventory

7 Cost of sales 12,750


Inventory 12,750
Deferred income taxes 5,100
Income tax expense 5,100
To eliminate unrealized after-tax profits in ending inventory

8 Gain on land sale 34,000


Land 34,000
Deferred income taxes 13,600
Income tax expense 13,600
To eliminate unrealized after-tax profits in land

9 Notes payable 54,000


Notes receivable 54,000
To eliminate intercompany notes payable

10 Management fees revenue 27,000


Other expenses 27,000
To eliminate intercompany management fees
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66 Modern Advanced Accounting in Canada, Eighth Edition
11 Sales 232,000
Cost of sales 232,000
To eliminate intercompany sales

12 Interest revenue 3,240


Interest expense 3,240
To eliminate other intercompany items

13 Non-controlling interest-P&L 2,250


Non-controlling interest-SFP 2,250
To record NCI's share of income for the year

$ 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

Cost (60,000 x 80) $4,800,000


Implied value of 100% investment (80,000 shares x 80) $6,400,000
CA: Ordinary Shares $3,440,000
Retained Earnings 2,170,000 5,610,000
Acquisition differential $790,000
Allocation: Life
Inventory 30,000 Cr 1
Land 270,000 Dr
Equipment 270,000 Cr 10
Patents 470,000 Dr 5
L.T. Liability 170,000 Cr 4
Subtotal 270,000 Dr
Balance: Goodwill 520,000 Dr
790,000 Dr
Non-controlling interest (20,000 shares @ $80) $1,600,000
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Solutions Manual, Chapter 8 67
Amortization Table:

Allocation Life Amortization Balance


YR 7 – YR 10 YR 11 Dec. 3, YR 11

Inventory 30,000 Cr 1 30,000 Cr 0 0


Land 270,000 Dr 0 0 270,000 Dr
Equipment 270,000 Cr 10 108,000 Cr 27,000 Cr 135,000 Cr
Patents 470,000 Dr 5 376,000 Dr 94 000 Dr 0
L.T. Liability 170,000 Cr 4 170,000 Cr 0 0
Goodwill 520,000 Dr 0 0 520,000 Dr
790,000 Dr 68,000 Dr 67,000 Dr 655,000 Dr

Devine’s accumulated depreciation at date of acquisition 570,000

Intercompany Amounts:

Dividends: 500,000 x 75% 375,000


Sales: Vine (YR 11) 2,070,000 + Devine (YR 11) 1,270,000 3,340,000
Advances from Vine to Devine: 270,000

Intercompany profits BT Tax AT


Unrealized gain on land: Devine selling (upstream) 470,000 188,000 282,000
Opening inventory: Devine selling (upstream)
170,000 @ 40% 68,000 27,200 40,800
Opening inventory: Vine selling (downstream)
321,000 @ 33 1/3% 107,000 42,800 64,200
Ending inventory: Devine selling (upstream)
570,000 @ 40% 228,000 91,200 136,800
Ending inventory: Vine selling (downstream)
621,000 @ 33 1/3% 207,000 82,800 124,200

(b) Consolidated Income Statement for the year ending December 31, Year 11

Sales (13M + 4.4M – 3.34M) $14,060,000


Dividend, Investment Income, and Gains
(1.8M + 2.4M – 375K – 470K) 3,355,000

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68 Modern Advanced Accounting in Canada, Eighth Edition
17,415,000

Cost of Goods Sold


(10.1M + 2.9M – 3.34M - 68K – 107K + 228K + 207K) 9,920,000
Other Expenses (500K + 500K – 27K (Equip) + 94K (Patent) 1,067,000
Taxes (200K + 200K – 188K + 27.2K + 42.8K – 91.2K – 82.8K) 108,000
Total expenses 11,095,000
Profit $6,320,000
Attributable to:
Shareholders of Vine $5,631,250
Non-controlling interests (3.2M – 282K – 136.8K + 40.8K – 67K) x 0.25 688,750
$6,320,000

Reconciliation:

Vine Profit: $4,000,000


Dividends from Devine Included (375,000)
Equity in Earnings of Devine 2,006,250
Consolidated Profit Attributable to Vine’s Shareholders $5,631,250

(c) Consolidated Retained Earnings: Proof

Parent retained earnings at December 31, Year 11 $10,600,000


Sub retained earnings at December 31, Year 11 $5,600,000
Retained earnings at acquisition 2,170,000
Increase since acquisition 3,430,000
Less: unrealized after-tax profits in ending inventory
(upstream) (136,800)
Unrealized after-tax gain on land (upstream) (282,000)
Less: cumulative amortization of acquisition differential (135,000)
Realized retained earnings since acquisition 2,876,200 (a)
Parent % 75% 2,157,150
Less: unrealized after-tax profits in ending inventory (downstream) (124,200)
Consolidated retained earnings $12,632,950

(d)
Consolidated Statement of Financial Position
December 31, Year 11

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Solutions Manual, Chapter 8 69
Assets
Land (6M + 2.5 M + 270K – 470K) $8,300,000
Plant and Equipment (20.2M + 13.2M – 270K – 570K) 32,560,000
Accumulated depreciation (4.4M + 3.6M – 135K – 570K) (7,295,000)
Goodwill 520,000
Deferred Income Tax (188K + 91.2K + 82.8K) 362,000
Inventories (6M + 3.8M – 228K – 207K) 9,365,000
Cash and Current Receivables (2.36M + 1.7M) 4,060,000
$47,872,000

Equities and Liabilities


Ordinary shares $10,000,000
Retained Earnings (See part c) 12,632,950
Non-controlling interests (See Below) 2,319,050
Long Term Liabilities (8M + 2.5M) 10,500,000
Deferred Income Taxes (1.6M + 100K) 1,700,000
Current Liabilities (5.03M + 5.96M – 270K advances) 10,720,000
$47,872,000

Non-controlling Interests: (Method 1)

Devine – Carrying amount December 31, Year 11 $9,040,000


Unrealized after-tax profits – Upstream:
Land (282,000)
Inventory (136,800)
Unamortized acquisition differential 655,000
9,276,200
25%
Non-controlling interest $2,319,050

Calculation of non-controlling interests – December 31, Year 11 (Method 2)


Non-controlling interests at date of acquisition (25% x [4,800,000 / 0.75) $1,600,000
Devine’s adjusted increase in retained earnings (a) $2,876,200
NCI’s share @ 25% 719,050
Non-controlling interest, December 31, Year 11 $2,319,050
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70 Modern Advanced Accounting in Canada, Eighth Edition
(e)
Non-controlling interest – at date of acquisition
- under implied value approach (25% x 6,400,000) $1,600,000
- using market value of Devine’s shares (20,000 shares x 75) 1,500,000
Decrease in non-controlling interest 100,000
Non-controlling interest, December 31, Year 11
- as previously calculated 2,319,050
- as per new calculation $2,219,050

Goodwill at December 31, Year 11


- as previously calculated $520,000
- decrease due to change in non-controlling interest 100,000
- as per new calculation $420 000

(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

Cost of goods sold 10,100 2,900 9 435 7 3,340 9,920


0 8 175
Other expenses 500 500 6 67 0 1,067
Income taxes 200 200 8 70 9 174 108
10 188
Total expenses 10,800 3,600 11,095
Profit $ 4,000 $ 3,200 $ 6,320
Attributable to:
Shareholders of Peter 5,631
Non-controlling interest 12 689 689
Total $ 5,446 $ 3,877

Year 11 retained earnings statements


Balance, January 1 $ 6,600 $ 2,900 3 2,900 1 402 $ 7,002
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Solutions Manual, Chapter 8 71
Profit 4,000 3,200 Above 5,446 3,877 5,631
10,600 6,100 12,633
Dividends 0 500 5 375 0
13 125
Balance, December 31 $ 10,600 $ 5,600 Total $ 8,346 $ 4,779 $ 12,633

Statements of Financial Position - December 31, Year 11


Land $ 6,000 $ 2,500 3 270 10 470 $ 8,300
Plant and equipment 20,200 13,200 3 270 32,560
4 570
Accumulated depreciation -4,400 -3,600 3 108 -7,295
4 570
6 27
Patents 3 94 6 94 0
Goodwill 0 0 3 520 520
Investment in Devine, cost 5,070 0 1 402 3 7,062 0
2 1,755 11 270
8 105
Deferred income tax 0 0 9 174 362
10 188
Inventories 6,000 3,800 9 435 9,365
Cash and current receivables 2,360 1,700 4,060
Total assets $ 35,230 $ 17,600 $ 47,872

Ordinary shares $ 10,000 $ 3,440 3 3,440 $ 10,000


Retained earnings 10,600 5,600 Above 8,346 Above 4,779 12,633
Non-controlling interest 0 0 13 125 2 1,755 2,319
12 689
Long term liabilities 8,000 2,500 10,500
Deferred income taxes 1,600 100 1,700
Current liabilities 5,030 5,960 11 270 10,720
Total Shareholders' equity &
liabilities 35,230 17,600 47,872
$ 16,394 $ 16,394

JOURNAL ENTRIES

1 Investment in Devine shares $ 402


Retained earnings (note a) $ 402
To adjust retained earnings to equity method at beginning of year

2 Investment in Devine shares 1,755


Non-controlling interest (note b) 1,755
To establish non-controlling interest at beginning of
year

3 Ordinary shares 3,440


Retained earnings (see above) 2,900
Land 270
Patents 94
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72 Modern Advanced Accounting in Canada, Eighth Edition
Goodwill 520
Equipment 270
Accumulated depreciation 108
Investment in Devine shares 7,062
To offset investment account against subsidiary's shareholders' equity
& establish unamortized acquisition differential at beginning of Year 11

4 Accumulated depreciation 570


Plant and equipment 570
To eliminate Devine's accumulated depreciation at date of acquisition

5 Dividend revenue 375


Dividends paid 375
To eliminate dividend revenue from Devine

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

8 Investment in Devine 105


Cost of sales 175
Income tax expense 70
To eliminate unrealized profits in beginning inventory

9 Cost of sales 435


Inventory 435
Deferred income taxes 174
Income tax expense 174
To eliminate unrealized profits in ending inventory

10 Gain on land sale 470


Land 470
Deferred income taxes 188
Income tax expense 188
To eliminate unrealized profits in land

11 Current liabilities 270


Investment in Devine 270
To eliminate intercompany advances

12 Non-controlling interest-P&L 689


Non-controlling interest-SFP 689
To record NCI's share of income for the year

13 Non-controlling interest-SFP 125


Dividends paid (500 x 25%) 125
To record NCI's share of dividends paid
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Solutions Manual, Chapter 8 73
$ 16,394 $ 16,394

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

b NCI, end of Year 11 $2,319,050


Less: NCI's share of consolidated net income for Year 11 -688,750
Add: NCI's share of Devine's dividends for Year 11 (500,000 x 25%) 125,000
NCI, beginning of Year 11 $ 1,755,300

Problem 6-15
(a)

Cost of 70% investment, January 1, Year 2 $ 84,000


Implied value of 100% investment 120,000
Carrying amount of Sand’s net assets:
Common shares 50,000
Retained earnings 30,000
Total shareholders’ equity 80,000
Acquisition differential 40,000
Allocation: FV – CA
Inventory - 9,000
Equipment 24,000 15,000
Goodwill as at January 1, Year 2 $ 25,000

Balance Amortization/Impairment Balance


January 1, Year 2 Year 2-4 Year 5 Dec. 31, Year 5
Inventory $ (9,000) $ (9,000) — —
Equipment 24,000 12,000 $ 4,000 $ 8,000 (a)
Goodwill 25,000 — 21,500 3,500 (b)
$ 40,000 $ 3,000 $ 25,500 $ 11,500 (c)

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74 Modern Advanced Accounting in Canada, Eighth Edition
(b) PAPER CORP.
Consolidated Income Statement
for the year ended December 31, Year 5

Sales (798,000 + 300,000 – 100,0002) $ 998,000


Investment and interest income (1,050 + 3,600 – 1,0504 – 2,7003) 900
Total revenue 998,900

Cost of goods sold (480,000 + 200,000 – 100,0002 + 10,5006) 590,500


Interest expense (10,000 – 2,7003) 7,300
Research & development expenses (40,000 + 12,000 + (a) 4,000) 56,000
Miscellaneous expense (106,000 + 31,600 + (b) 21,500 – 24,0001) 135,100
Income taxes (80,000 + 34,000 – 4,200 – 10,000 )
6 5
99,800
Total expenses 888,700
Net income 110,200
Attributable to:
Shareholders of Paper 107,050
Non-controlling interest (51,000 – 15,0005 – (c) 25,500) (30%) 3,150
110,200

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)

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Solutions Manual, Chapter 8 75
i) Inventory (66,000 + 44,000 – 10,5006) $ 99,500
ii) Land (155,000 + 30,000 – 25,0005) $ 160,000
iii) Notes payable: The notes payable would not be shown on the consolidated balance sheet.
iv) Non-controlling interest (50,000+120,000–15,0005+(c)11,500) (30%) $ 49,950
v) Common shares $ 150,000

(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

Allocation of goodwill and goodwill impairment


Paper’s NCI’s
share share Total
Total value of subsidiary at date of acquisition 84,000 30,000 114,000
Fair value of identifiable net assets 66,500 28,500 95,000
Goodwill at date of acquisition 17,500 1,500 19,000
Goodwill impairment in Year 5 14,276 1,224 15,500
Goodwill at December 31, Year 5 3,224 276 3,500

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

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76 Modern Advanced Accounting in Canada, Eighth Edition