Professional Documents
Culture Documents
Chapter 5
Chapter 5
Consolidation Subsequent to
Acquisition Date
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Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
2 Modern Advanced Accounting in Canada, Seventh Edition
SOLUTIONS TO REVIEW QUESTIONS
1. There are two steps involved in testing the goodwill for impairment:
i) Compare the recoverable amount of each cash-generating unit with its carrying amount
(including goodwill). If the recoverable amount is the larger amount, there is no impairment
of goodwill. If the recoverable amount is the smaller amount the next step (ii) is performed.
ii) If the recoverable amount is less than the carrying amount, an impairment loss should be
recognized and should be allocated to reduce the carrying amount of the assets of the unit
(group of units) in the following order:
(a) first, to reduce the carrying amount of any goodwill allocated to the cash-generating
unit; and
(b) then, to the other assets of the unit pro rata on the basis of the carrying amount of
each asset in the unit. However, an entity shall not reduce the carrying amount of an
individual asset below the higher of its recoverable amount and zero. The amount of
the impairment loss that could not be allocated to an individual asset because of this
limitation shall be allocated pro rata to the other assets of the unit (group of units).
2. The process for testing for impairmentis essentially the same in that the assets are written
down to recoverable amount when they are less than the carrying amount. Recoverable
amount is defined as the higher of fair value less costs of disposal and value in use. The
write-down is called an impairment loss and is reported in net income unless the asset is
carried at revalued amount in accordance with another Standard (for example, in
accordance with the revaluation model in IAS 16). Any impairment loss of a revalued asset
should be treated as a revaluation decrease in accordance with that other Standard.
When the intangible assets must be tested for impairment is not the same for the different
types of intangible assets. Goodwill impairment tests must be conducted at least once a
year unless it is clear that there has been no impairment during the year and more often
than once a year when there is an indication that the cash-generating unit may be impaired.
For intangible assets with a definite useful live, the recoverable amount is only compared to
carrying amount if there is an indication that the asset may be impaired. Intangible assets
with indefinite useful lives must be checked for impairment on an annual basis and
whenever there is an indication that the intangible asset may be impaired.
3. The asset “Investment in subsidiary” on the balance sheet of the parent company is
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removed and replaced with the individual assets and liabilities from the balance sheet of the
subsidiary (which are remeasured by the unamortized acquisition differential), and by the
non-controlling interests in the net assets of the subsidiary (in cases of less than 100%
ownership). The item of income “Investment income” on the income statement of the parent
company is removed and replaced with the income and expenses from the income
statement of the subsidiary (adjusted for the amortization of the acquisition differential), and
by the non-controlling interests in the net income of the subsidiary (in cases of less than
100% ownership). As well, any intercompany transactions such as payables and receivables
would be eliminated upon consolidation, whereas under the equity method they remain.
5. IFRS does not require either method for internal record keeping purposes because the
parent is required to prepare consolidated statements for external financial reporting
purposes, and these statements are identical regardless of the method that has been used
by the parent to record the investment. However, if the parent wants to issue separate entity
financial statements in accordance with GAAP, IAS 27 requires that the investment in
subsidiary on the separate entity financial statements shall be reported at cost or in
accordance with IAS 39, Financial Instruments: Recognition and Measurement (or IFRS 9,
Financial Instruments: Classification and Measurement if it is adopted early).
6. The dividends that appear in the retained earnings column in the consolidated statement of
changes in equity are those of the parent company only. The subsidiary’s dividends that
were paid outside the entity to the non-controlling shareholders would appear on a
statement of changes in non-controlling interests (if such a statement was prepared). The
subsidiary’s dividends that were paid to the parent do not appear on any consolidated
statement because no cash left the combined economic entity.
7. This statement is partially true. As long as the parent continues to control the subsidiary and
as long as the subsidiary continues to hold the land, this part of the acquisition differential
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
4 Modern Advanced Accounting in Canada, Seventh Edition
will be used to remeasure the land on all subsequent consolidated balance sheets. If the
land is sold by the subsidiary, the acquisition differential will in part be used to determine the
loss or gain for consolidated purposes and will no longer appear on the consolidated
balance sheet. If consolidation of this subsidiary ceases (due to loss of control) the
acquisition differential would become redundant since the acquisition differential only
appears within the consolidated financial statements.
8. What this statement means is that in addition to recording the investor’s share of net income
earned by the investee since acquisition, entries must also be made for the amortization of
the acquisition differential, and for the holdback and realization of any unrealized profits
regardless of whether the profit was recorded by the investee or the investor. The
calculations for these entries are identical to those that would be made when consolidating.
(If equity method journal entries had been made to holdback unrealized profits, we would
not get this result.)
10. The elimination of intercompany receivables and payables has no effect on consolidated
shareholders’ equity or non-controlling interests.
11. Any fair value excess arising from the acquisition must be eliminated or amortized on
consolidation in the same way that a cost of an individual asset purchased directly by an
entity is eliminated or amortized. The matching principle states that the cost of an asset
should be expensed in the same period as the benefits received from using the asset. The
benefits are received over the useful life of an asset. Consequently, assets such as
property, plant and equipment should be amortized over their useful lives and assets such
as inventory should be expensed in the year they are sold.
12. The balance sheet accounts of the parent that have different balances are:
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Investment in subsidiary, and
Retained earnings.
In addition, the following two income statement accounts differ in amount and their description:
Dividend income (using the cost method)
Investment income (or equity earnings) (using the equity method)
13. This adjusts the parent's retained earnings under the cost method to what they would be
using the equity method. Under the equity method, the retained earnings of the parent
contain the parent's share of the subsidiary's net income since acquisition. Under the cost
method, the parent's retained earnings contain the parent's share of the subsidiary's
dividends since acquisition. Net income less dividends equals the change in retained
earnings. When we add the parent's share of the increase in the retained earnings of the
subsidiary to the retained earnings of the parent, the resultant amount now contains the
parent's share of the subsidiary's net income earned since acquisition.
14. The subsidiary’s revenue and expenses included in the consolidated income statement are
only those that have occurred since acquisition. Also, the non-controlling interest is based
on the subsidiary’s income earned subsequent to the date of acquisition.
*15.The initial entry adjusts the parent's investment account and retained earnings at the
beginning of the year to equity method balances. The investment account now reflects the
equity method balance at the beginning of the current year.
16. Under the cost method, the parent has recorded only its share of dividends received from
the subsidiary. It has not recorded its share of the subsidiary’s change in retained earnings
or its share of the amortization of the acquisition differential. Therefore, an entry or entries
must be made on the consolidation to record the parent’s share of the subsidiary’s change
in retained earnings and its share of the amortization of the acquisition differential. Since
the starting point for consolidation is the separate entity records of the parent and
subsidiary, a cumulative entry is required each year on consolidation to adjust the parent
company’s retained earnings to what it would be under the equity method. When the equity
method is used, the parent’s retained earnings already reflect its share of the subsidiary’s
retained earnings and its share of the amortization of the acquisition differential.
This case is concerned with the nature of the various intangible assets acquired in a business
combination, and their valuation in the consolidated financial statements pursuant to the
combination. The student is directed to devote attention to a variety of unrecorded intangible
assets, and should address their identification and then their valuation issues. Even though this
is an American Company, students are directed to basically treat it as a Canadian company as
far as financial reporting is concerned. Students need to recognize that IFRSs and US GAAP
are now almost identical in the accounting for business combinations.
The case mentions that the acquisition includes the extensive UDS refining, logistics, and retail
network operating under several brands, including Ultramar, Diamond Shamrock, Beacon, and
Total. The retail network is large, with 2,500 company-owned sites and supplying 2,500 further
sites. There are extensive brand support programs, and a large home heating oil business
(250,000 households).
IFRS 3 requires that the cost of the acquisition be allocated to identifiable assets acquired and
liabilities assumed in a business combination, whether or not recognized in the financial
statements of the acquired enterprise based on their fair values at the date of acquisition. An
intangible asset is identifiable and should be recognized apart from goodwill when:
• the asset results from contractual or other legal rights (regardless of whether those rights
are transferable or separable from the acquired enterprise or from other rights and
obligations); or
• the asset is capable of being separated or divided from the acquired enterprise and sold,
transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do
so).
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This acquisition includes a variety of intangible assets, some of which should be segregated
from goodwill under the provisions of IFRS 3.
The overall amount to be allocated to intangible assets is determined in two stages. First, fair
values of the various tangible assets and liabilities, and those intangible assets, which can be
ascertained separately from goodwill, should be determined. After these amounts have been
provided for, the remainder of the acquisition cost is recognized as goodwill.
It is necessary to carefully identify and determine the value of intangible assets, which can be
recognized apart from goodwill. Although no separate value can be assigned to the workforce or
management team, intangible assets that can be recognized include:
• Intangible assets that arise from contractual or other legal rights, regardless of whether
the asset is transferable or separable from the acquired enterprise or from other rights
and obligations. This category of asset would include the legal rights associated with
leases, licences, and other items of that nature, as well as legally protected trademarks
and brand names.
• Intangible assets that are not legal or contractual rights but which are capable of being
separated or divided from the acquired enterprise and sold, transferred, licensed, rented,
or exchanged, whether or not it was the intent of management to perform any of these
actions and even when these assets are linked to particular tangible assets. This
category would include the network of dealerships, where individual locations or
territories could be sold separately. It would also include the customer lists such as the
proprietary credit cards and the home heating business household addresses, as well as
the related customer contracts and service agreements.
Estimates of fair value for these items should be based on the best information available,
including prices for similar items, independent appraisals, and the results of other valuation
techniques. Valuation techniques used would be consistent with the objective of measuring fair
value, and may include such approaches as earnings or revenues multiples and present value
techniques. Individual values for many of these intangible assets (such as individual retail
locations) may be difficult to determine, and would not be necessary for financial reporting
purposes. However, if the disposition of any part of any assets were contemplated, an allocation
of cost to this level of detail would be required to determine the gain or loss on disposition.
Subsequent to the date of acquisition, the intangible assets should be accounted for as follows:
• An intangible asset is not written down or written off in the period of acquisition, unless it
becomes impaired during this period.
• A recognized intangible asset should be amortized over its useful life to an enterprise,
unless the life is determined to be indefinite. When an intangible asset is determined to
have an indefinite useful life, it should not be amortized until its life is determined to be
no longer indefinite.
• The amortization method and estimate of the useful life of an intangible asset should be
reviewed annually. An intangible asset that is subject to amortization should be tested
for impairment in accordance with IAS 36. (That is, when the carrying amount exceeds
its recoverable amount, the excess should be charged to income.)
• An intangible asset that is not subject to amortization should be tested for impairment
annually, or more frequently if events or changes in circumstances indicate that the
asset might be impaired. The impairment test should consist of a comparison of the
asset’s recoverable amount with its carrying amount. When the carrying amount of the
intangible asset exceeds its recoverable amount, an impairment loss should be
recognized in an amount equal to the excess.
Case 5-3
Memo to: Board of Directors of GIL
From: CA
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Subject: Financial Accounting & Reporting Policies
In determining appropriate accounting policies for GIL, I considered the users of GIL’s financial
statements and their information needs. There are many users, with varied and often conflicting
information needs. Accordingly, I have had to make assumptions when ranking the users in
order to determine the most appropriate policies.
• The bank will be concerned about liquidity and its security. Cash flow and current value
information would be useful for this purpose.
• Sam and Ida Growth will be concerned that the valuation of GIL’s net assets are
calculated fairly so that the redemption value of their preferred shares is fair. They will
also want information to evaluate the performance of GIL’s management since they still
have voting control.
• The common shareholders, the Growth children and Mario Thibeault, will be interested
in evaluating management’s performance and the performance of GIL’s investments.
Current value information is necessary for this purpose.
• The senior management of GIL will want to maximize income since it receives a bonus
based on net income.
• CRA requires historical cost information on realized gains and losses to assess income
taxes.
In my view, the most important users are Sam and Ida Growth, the preferred shareholders
because they have the most at stake in the company and could redeem their shares at any time
for fair value of GIL at November 30, Year 3. Thus, accounting policies have been chosen to
meet Sam and Ida’s objective of receiving a fair redemption value for their preferred shares and
of evaluating management. The valuation of the redemption creates a conflict. The common
shareholders will want the redemption value of the preferred shares to be as low as possible
To satisfy the information needs of Sam and Ida for a one-time revaluation of the net assets of
GIL at November 30, Year 3, a special purpose balance sheet should be prepared. The
balance sheet will report all assets and liabilities at fair value. This will determine the
redemption value of, and the value assigned to, the preferred shares. The old common shares
will be cancelled. The new common shares will be valued at $400, the cash received on
issuance of these new shares.
The special purpose balance sheet will not comply with generally accepted accounting policies
(GGAP) because GAAP only allows for a comprehensive revaluation of net assets when there
has been a change in control. Since Sam and Ida controlled GIL both before and after the
reorganization, there has not been a change in control.
To satisfy the information needs of the other users for Year 3 and subsequent years, general
purpose financial statements should be prepared in accordance with ASPE. The net assets of
GIL will be retained at their carrying value. Accordingly, the value assigned to the preferred
shares will be equal to the carrying value of the common shareholders’ equity prior to the
reorganization. The new common shares will be valued at $400, the cash received on issuance
of these new shares.
In the ensuing discussion, I will indicate the accounting and reporting requirements for both the
special purpose balance sheet and the general-purpose financial statements.
The special purpose balance sheet will show the fair value of Sam and Ida preferred shares at
the date of the reorganization. This value will be used as the base for future dividend
distribution. This balance sheet will not be updated on an annual basis.
Fair value is defined in IFRS 13: Fair Value Measurement as the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date (i.e. an exit price). It would reflect the highest and best use for the asset.
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The various properties should be valued at appraised value regardless of whether the appraised
value is higher or lower than carrying value. The non-interest bearing note receivable should be
discounted at current market rates to reflect the true value. Assuming an interest rate of 10%
(based on current five-year mortgage interest rates), the present value of the receivable is
$1,895,000 (500,000 x 3.79).
GIL’s outstanding debt bears varying interest rates. These liabilities should also be discounted
at current market rates to reflect their true value.
In revaluing the assets and liabilities of GIL, we must consider the tax effects of the revaluation.
Selling costs should be deducted in determining the fair value of these assets and liabilities.
Then, future income taxes should be set up to reflect the tax that would be payable or
receivable if these assets and liabilities were sold or paid off at their fair value.
There would be no benefit in capitalizing the real estate taxes and interest on the debt incurred
to finance the raw land purchases since the land is being revalued to its fair value. If these
costs were capitalized, the land would be reported at a value in excess of its fair value.
A professional appraiser should appraise the apartment building that is planned to be converted
to a condominium. The appraised value should reflect the likelihood of conversion and the
potential profits from the conversion.
GIL should record the benefits of the low lease payments ($100,000 versus $220,000 per year)
as an asset at the time of reorganization because the new shareholders will benefit from the
leasing decision made by the previous owners. Using a discount rate of 10% for 14 years, the
remaining term of the lease, the reduced payments have a value of $884,400 (120,000 x 7.37).
The investment in the joint venture should be valued at fair value by valuing the net assets
owned by the joint venture at fair value and multiplying by GIL’s 50% interest.
The likely amount of contingent consideration to be received from the sale of the office building
should be included in the redemption value of the shares since the decision to sell the building
was made by Sam and Ida.
The general-purpose financial statements will be prepared in accordance with ASPE and will be
prepared on an annual basis. Unless otherwise noted below, the assets and liabilities of GIL
will not be revalued to fair value on the date of the reorganization.
The non-interest bearing note receivable should be valued at $1,895,000, as calculated above,
on the date of the sale of the building. The difference between the face value and the present
value of the note, $605,000, represents deferred interest revenue. It should be reported as a
deferred credit on the balance sheet and amortized into income over the five-year term of the
receivable. The $605,000 of interest revenue will reduce the amount of gross profit recognized
on the sale. Only $500,000 of the note receivable should be reported as a current asset. The
remainder should be reported as a long-term asset.
The real estate taxes and interest on debt incurred to finance the raw land purchase should be
added to the cost of the land. These are costs of getting the land ready for sale or ready for
use. These costs will be recovered through future sales.
The increase in value of the building due to conversion to condominium status will not be
reflected in the financial statement on conversion. The gain will be reported if and when the
building is sold.
GIL should report a gain as a result of the sale to the joint venture partner of one-half of its
interest in the land on which the shopping center is being built as this portion was deemed to be
sold to an arm’s length party.
GIL has an accounting policy choice to report its investment in the joint venture using the cost
method, equity method or proportionate consolidation. The equity method or proportionate
consolidation both reflect GIL’s share of the income in the joint venture as the income is earned
by the joint venture. The cost method is easier to account for but doesn’t reflect income until it is
received as a dividend from the joint venture. The details of the joint venture arrangement
should be disclosed including its significant commitment to the construction company.
The sales agreement for the office building contains a contingent fee clause. Any additional
sums received are really a part of the selling price of the building. These additional amounts
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should be added to the selling price once they are measurable. Since new leases have already
been signed, no uncertainty exists regarding at least a portion of the contingent consideration.
GIL is currently using the same depreciation rates and methods for tax purposes and
accounting purposes. However, the rates used for tax purposes do not necessarily reflect the
true economic lives of the assets. GIL should review all its depreciation rates and ensure that
they properly represent the actual usage of the assets over time.
According to paragraph .23 of section 3856 of Part II in the CICA Handbook, an entity that
issues preferred shares in a tax planning arrangement should present the shares at par, stated
or assigned value as a separate line item in the equity section of the balance sheet, with a
suitable description indicating that they are redeemable at the option of the holder. When
redemption is demanded, the issuer shall reclassify the shares as liabilities and measure them
at the redemption amount. Any adjustment shall be recognized in retained earnings. Extensive
note disclosure will be required of the share exchange and the conditions of the preferred share
issue.
(CICA adapted)
Case 5-4
We have been engaged to provide you with recommendations that will assist you in managing
Total Protection Limited (TPL or the Company) profitably on a long-term basis. The key
decisions that TPL will be making concern pricing, cost control, and cash management and
investment. Our report offers advice intended to assist the Company with these decisions, as
they are the determinants of future profitability.
(Candidates were expected to identify the key decision needs facing this company. Few
candidates did this.)
Pricing
There appears to be no rationale for pricing other than charging what the market will bear. It is
important to set prices for each builder that will more than offset the costs of warranty repairs
and price guarantees if long-term profitability is to be achieved. The attached accounting
I have done an analysis of warranty revenues and costs by builder (see Appendix I). No undue
reliance should be placed on the data, given the condition of the Company's records. However,
some problems seem apparent:
1. The prices being charged for the warranties and repair costs incurred vary widely among
the builders.
2. Warranty revenues charged by Kings Road and Safe-Way Builders are low in
comparison to those of the other builders and are unlikely to cover future warranty costs.
3. Repair costs bear no relationship to the price of the warranties. Not surprisingly,
warranties for houses built by the companies using lower cost materials are experiencing
higher repair cost claims. These builders are also charging only the minimum amount for
the upfront fees.
4. Safe-Way has the highest repair cost per warranty sold of the shareholder participants
and is, therefore, probably the least qualified to do the warranty repairs.
5. Kings Road has the smallest margin between cost and revenues and given the length of
the warranty, its costs will soon exceed its revenues.
6. Repair costs based on experience to date are highest for the builders that are not
shareholders in the Company, and they may be using the warranties to increase their
own profits.
All these problems suggest that a major overhaul of the pricing structure is in order to allow
flexibility for homes of different quality. Although the current commission structure helps
maximize the price that is received for the warranties sold, it does not motivate the builders to
minimize the repair costs incurred as a result of using lower quality materials.
The minimum premiums for Kings Road, Safe-Way Builders, and the other builders will all have
to be increased substantially to cover repair costs adequately and ensure fairness to all
shareholder participants in the Company. At present, the better-quality builders are subsidizing
the lower-quality builders. Perhaps a large deductible should be imposed on each repair claim
to reduce the amount of this differential, or some other variation of pricing structure should be
considered that relates price to cost history.
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Larkview, Towne and Granite have sold warranties at reasonably high prices and have relatively
low repair costs, perhaps as a result of the higher-quality construction they undertake. Little
change in their pricing structure is needed at this time for these builders.
(Candidates were expected to identify the pricing problem and recognize that it was a critical
issue for long-term profitability. Marks were heavily awarded for interpretation of quantitative
analysis. No marks were awarded to candidates who performed the quantitative analysis but did
not use it in their responses.)
(Candidates recognized the need for a better internal control system but failed to identify the
pricing problem as the critical issue for long-term profitability. Failing to charge an adequate
amount for the warranties will lead to the ultimate failure of the business as warranty costs are
incurred.)
Safe-Way Builders are currently performing all the repair work on warranties. There is a problem
in having any shareholder solely responsible for the repair work. The motivation for any builder
will be to maximize the price of the repair work in order to increase its own profits. TPL should
therefore institute certain controls to ensure that all repair work performed is in fact required and
that it is performed at the best price to TPL.
Standards should be developed for hourly rates and the number of hours required for the
various types of repairs.
An approval process for repairs should be introduced whereby another shareholder must
approve the warranty work of a given builder. A system of reporting should also be
implemented, requiring TPL to report the various repair claims it undertakes to each of the
shareholders and to include an analysis of the variances from standard,
Hiring independent staff and increasing the segregation of duties in the Company may help
improve controls over warranty claims and will reduce the need for involvement by the
shareholders in the future.
(Candidates were expected to provide recommendations to resolve the cost control and conflict-
of-interest problems. Candidates could have considered other recommendations.)
(Candidates failed to recognize the need to control work performed by Safe-Way. Most
candidates did not identify the conflict-of-interest position that Safe-Way is in.)
As warranty costs are usually incurred in the future while the warranty revenue (initial fee) is
received currently, TPL will always have excess cash balances that must be invested.
Investments in low risk government/corporate bonds and other investments typically used for
trusts would be the most appropriate. A cash budget should be completed, and the terms to
maturity of such investments should coincide with the requirements identified in the cash
budgets. A large portion of the investments should be highly liquid because the future cash
flows cannot be estimated with a high degree of certainty.
Real estate investments can be illiquid and risky in cyclical markets and should be avoided. The
acquisition of the local construction company was probably not a good idea at this time because
you are likely going to need the cash for warranty work in the near future. You should seriously
consider divesting of this investment unless you need the construction company to carry out the
warranty work.
Dividends should not be declared and management fees should not be charged by the
participants until the Company has more experience with warranty repair claims.
(Candidates were expected to respond to the comments of the president of Safe-Way regarding
the disposition of excess cash balances. The recommendations given above are not exhaustive;
however, candidates should have addressed liquidity of the investments and timing of cash
flows.)
(Candidates generally recognized the need to maintain some amount of short-term investments
in order to meet repair costs as they become due.)
There are a number of users of the financial statements of TPL, each with different interests:
1. The shareholders/builders will use the financial statements to assess the profitability of
the Company and to determine what cash, if any, should be distributed.
2. Safe-Way will calculate its royalties on the basis of the revenue-recognition policies adopted
by the Company.
3. Customers may use the statements to determine the liquidity and viability of the Company
before purchasing a warranty.
4. Other builders may rely on the statements before participating in the warranty programs.
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Their reputations are at stake.
5. The government may use the statements as part of its review of the Company's operations
from time to time.
(The selection of accounting policies cannot be done in a vacuum. Candidates had to recognize
the different users of the financial statements and their information needs in determining the
usefulness of the accounting policies selected.)
Accordingly, policies for accruals of future warranty costs will be of great importance to all the
users and will affect the long-term viability of TPL. Given the number of users and high levels of
assurance each requires, statements should be prepared in accordance with generally accepted
accounting principles, with the appropriate disclosures.
Since TPL is a private company, it can choose to use IFRSs or ASPE. Assuming that the five
shareholders are also private companies and assuming that they all use ASPE, it would be
appropriate for TPL to also use ASPE.
The most significant accounting policies that must be developed are for warranty liabilities and
expenses, revenue recognition and business combinations.
Matching the revenues and expenses is the critical issue because the largest portion of cash
from warranty sales is received up front and expenditures will be made on warranty repairs
unevenly over the following ten years.
To the extent that cash reserves are in place to meet future contingencies, interest will be
earned on those funds. Policies should be re-evaluated from year to year according to repair
experience and potential increases in reserves from investment income.
Future warranty expenses are difficult to estimate because few warranties of 10 years have
been offered in the marketplace. Accordingly, data on repair history for warranties longer than
one year are not available in the industry. Further complicating estimations is the fact that new
builders do not use materials and construction techniques of identical quality, and there are no
controls over the builders participating in the plan.
Despite the problems with warranty cost estimation, an attempt must be made to quantify the
estimated future liability by reviewing the repair history of each builder participating in the plan
and the nature of the repairs incurred to date. Otherwise, revenue cannot be recognized until
the end of the warranty period.
Historical repair data from each builder should be reviewed to properly estimate the current
portion of the warranty liability at the balance-sheet date. This is particularly important in light of
the Company's liquidity objective.
(Candidates were expected to recognize that the uncertainty of the warranty liability was the
critical element affecting the choice of financial accounting policies.)
(Many candidates failed to recognize the necessity of estimating the warranty liability in order to
recognize any revenue.)
Revenue recognition
This method is appropriate if the total warranty costs can be estimated and if the collection of all
maintenance fees is assured. The method provides information to the shareholders and other
users on the expected profitability from yearly sales. It is unlikely that the estimations required
by this method can be made with sufficient certainty.
2. Defer all revenues until the end of the warranty period (year ten).
This method is the most conservative and implicitly recognizes that warranty cost estimation is
impossible and that income should, therefore, not be recognized until the critical event takes
place - that is, the expiration of the warranty period. Thus, revenues could be recognized only to
the extent that costs were incurred.
This method is of limited usefulness to the shareholders because profitability is not assessed
(although regulators would likely be most satisfied with this treatment because of its
conservative nature).
3. Recognize the initial warranty fee and annual maintenance fees on a cash basis.
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A percentage of total warranty costs is expensed in the same proportion as the income
recognized. The problems with estimating total warranty costs have been discussed previously.
Using the cash basis of revenue recognition avoids the problem of estimating the collection of
future maintenance fees.
This method provides the shareholders with information on cash flows and estimated future
liabilities that are required to determine dividend payments.
This is similar to the previous method except that warranty costs drive revenue recognition.
Warranty-cost estimation is still very subjective and is not an appropriate basis on which to
recognize revenue.
5. Amortize the initial payment received for the warranties equally over the ten-year life and
recognize maintenance fees as received.
This method assumes that the initial fee represents the present value of future cash flows.
Again, warranty expenses must still be estimated and are unlikely to be incurred equally
throughout the life of the warranty, resulting in a mismatch of revenues and expenses in most
years.
(Candidates were not expected to discuss all these methods but should nevertheless have
presented some alternative accounting treatments.)
I recommend recognizing revenues and expenses on a cash basis because this method
recognizes the reality of warranties for homes (i.e. that the majority of claims will occur in the
first two years). If there is a problem with construction, it is much more likely to become
apparent in the first year than in later years. The cash method recognizes more revenues and
expenses in the first year, and the maintenance payments should cover repairs that may be
made in subsequent periods.
(Some assumptions have been made here. Candidates could have made other
recommendations as long as they were supported by the analysis they presented.)
By purchasing 100% of the shares of Gainery Construction Ltd. (Gainery), TPL has obtained
control over Gainery. Under ASPE, TPL can report its investment in Gainery on a consolidated
basis or by using the cost method or equity method. The cost method is the simplest but only
reports income as dividends are received. Given that Gainery probably needs its cash for
operating purposes, it may be more meaningful to use the equity method or consolidation
method. Both methods will report the same amount of income. As indicated in Appendix II, the
amount paid by TPL for Gainery appears to be less than the fair value of the identifiable net
assets. You will need to verify that these fair values are realistic. If they are realistic, then TPL
could report a gain on purchase in the amount of $280,868 on the consolidated income
statement for Year 1. However, when the homes under construction and undeveloped land are
sold, the acquisition differential for these assets will have to be expensed. This will reduce the
gains reported on the consolidated income statement. The acquisition differential pertaining to
the equipment should be amortized over the life of the equipment. This will reduce depreciation
expense reported on the consolidated income statement.
The repairs and rent charged by Safe-Way to TPL and the royalties received by Safe-Way from
the Company are related party transactions. Details of these transactions must be fully
disclosed in the financial statements.
APPENDIX I
21
Per warranty 120 106 111 168 223 230 184
* Readers should be cautioned that these figures have not been independently verified.
APPENDIX II
Less: amount attributable to consulting services provided by Mr. Gainery (Note 2) (22,500)
Notes:
1. Assuming an incremental borrowing rate of 8%, annuity of $500,000 per year for 3
years.
2. Assuming that consulting services are worth $50 per hour: $50 x (300 + 150)
SOLUTIONS TO PROBLEMS
Problem 5-1
(a)
Net income Pill – Year 1 (cost method) 25,000
Less: Dividends from Sill (85% 9,000) 7,650
17,350
Net income of Sill – Year 1 40,000
Less: Goodwill impairment loss 1,500
38,500
85% 32,725
Consolidated net income attributable to Pill’s shareholders – Year 1 50,075
(b)
(c)
Investment in Sill – Dec. 31, Year 1 (cost method) 238,000
Income from Sill 32,725
270,725
Less: Dividends from Sill 7,650
Investment in Sill – Dec. 31, Year 1 - equity method 263,075
Problem 5-2
Cost of 75% investment 600,000
Implied cost of 100% investment 800,000
Carrying amount of Small’s net assets = Carrying amount of Small’s shareholders’ equity
Ordinary shares 400,000
Retained earnings 100,000
500,000
Acquisition differential – Jan. 1, Year 1 300,000
Allocated:
Inventory 40,000
Patents (70,000) (30,000)
Balance – goodwill 330,000
Balance Balance
Jan. 1 Amortization Dec. 31
Year 1 Yr 1 & 2 Year 3 Year 3
Inventory 40,000 40,000
Patents (70,000) (28,000) (14,000) (28,000)
Goodwill 330,000 0 19,300 310,700
300,000 12,000 5,300 282,700
PART A
Year 1 Year 2 Year 3
Investment in Small 600,000
Cash 600,000
23
Cash 18,750 7,500 30,000
Dividend income 18,750 7,500 30,000
PART B
(i) Goodwill 310,700
(ii) Small’s ordinary shares 400,000
Small’s retained earnings (100,000+80,000-25,000-35,000-10,000+90,000
-40,000) 160,000
560,000
Unamortized acquisition differential 282,700
842,700
NCI’s share (25%) 210,675
(iii) Large’s retained earnings 500,000
Small’s retained earnings (100,000+80,000-25,000-35,000
-10,000) 110,000
Small’s retained earnings, date of acquisition 100,000
Change since acquisition 10,000
Less: cumulative amortization of acquisition differential 12,000
Adjusted change since acquisition (2,000)
Large’s share (75%) (1,500)
Consolidated retained earnings 498,500
(iv) Large’s profit 200,000
Less: dividends from Small (40,000 x75%) (30,000)
170,000
Small’s profit 90,000
Less: amortization of acquisition differential 5,300
84,700
Large’s share (75%) 63,525
Consolidated profit attributable to Large’s shareholders 233,525
(v) NCI on income statement (84,700 x 25%) 21,175
PART C
(i) Year 1 Year 2 Year 3
Investment in Small 600,000
Cash 600,000
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
24 Modern Advanced Accounting in Canada, Seventh Edition
Investment in Small (75% x Small’s profit) 60,000 (26,250) 67,500
Investment income 60,000 (26,250) 67,500
Cash (75% x Small’s dividends) 18,750 7,500 30,000
Investment in Small 18,750 7,500 30,000
Investment income (75% x amortization of PD) 19,500 (10,500) 3,975
Investment in Small 19,500 (10,500) 3,975
Problem 5-7
Grant NCI
25
Inventory 5,000 5,000
Patent 10,000 4,000 2,000 4,000
Goodwill* 14,000 4,000 10,000
29,000 9,000 6,000 14,000
(a)
Acquisition 30,000
Increase 35,000
80% 28,000
315,200
18,400
12,800
242,800
Total 433,000
Attributable to:
247,500
Grant Corporation
Goodwill 10,000
1,121,000
27
Common shares 170,000
1,121,000
Note 1:
94,000
24,000
Problem 5-8
(a) Calculation of consolidated net income attributable to Paris’ shareholders
Paris Corporation
Consolidated Income Statement
for the Year Ended December 31
210,000
29
Consolidated retained earnings – Jan. 1 669,800
Paris Corporation
Consolidated Retained Earnings Statement
for the Year Ended December 31
Proof
Paris retained earnings 311,000
Retained earnings Slater 629,000
Retained earnings Slater – Acquisition date 53,000
Increase 576,000
Less: Acq. Diff. amort. to date (8 years x 10,000) 80,000
496,000
80% 396,800
707,800
Amortization Schedule
Balance Amortization Balance
July 1 year ending June 30
Year 5 June 30, Year 6 Year 6
Equipment (8 years) –21,600 –2,700 –18,900
Government contract (5 years)50,000 10,000 40,000
Goodwill 37,800 17,800 20,000
66,200 25,100 41,100
The government contract should be recognized as an identifiable asset because it can meet the
separability test. It can be sold separately and provides future economic benefits.
Big
Consolidated Income Statement
for the Year Ended June 30, Year 6
Big
Consolidated Retained Earnings Statement
for the Year Ended June 30, Year 6
Balance July 1, Year 5 459,000
Net income 110,276
569,276
Dividends 32,400
Balance June 30, 2006 536,876
Big
Consolidated Balance Sheet
June 30, Year 6
Problem 5-10
Cost of 80% of Storm 310,000
Implied value of 100% 387,500
Carrying amount of Storm’s net assets
= Carrying amount of Storm’s shareholders’ equity
Ordinary shares 200,000
Retained earnings 60,000
33
260,000
Acquisition differential 127,500
Allocated: FV – CA
Plant assets 40,000
Trademarks 24,000 64,000
Goodwill 63,500
Bal Amortization Loss Bal
Dec. 31/Yr2 to Dec.31/Yr5 Yr6 Yr6 Dec. 31/Yr6
Plant assets 40,000 15,000 5,000 20,000
Trademarks 24,000 6,000 2,000 2,250 13,750
Goodwill 63,500 ----- ------ 13,500 50,000
127,500 21,000 7,000 15,750 83,750
Palm’s shareholders
101,800
Palm Inc.
Consolidated Statement of Financial Position
December 31, Year 6
35
Notes payable (130,000 + 100,000) 230,000
Other current liabilities (10,000 + 50,000) 60,000
Accounts payable (80,000 + 62,000) 142,000
1,165,750
(b) If none of the acquisition differential had been allocated to trademarks, the schedule to amortize
the acquisition differential would have been as follows:
Bal Amortization Loss Bal
Dec. 31/Yr2 to Dec.31/Yr5 Yr6 Yr6 Dec. 31/Yr6
Plant assets 40,000 15,000 5,000 20,000
Goodwill 87,500 ----- ------ 37,500 50,000
127,500 15,000 5,000 37,500 70,000
(i) The return on equity would decrease because net income would decrease by $19,750 i.e.
the change in amortization and impairment of the acquisition differential for Year 6 and total
shareholders’ equity would only decrease by $13,750 i.e. the change in unamortized
acquisition differential at the end of the year.
(ii) The debt to equity ratio would increase because debt would not change but total
shareholders’ equity would decrease.
Problem 5-11
Cost of 80% investment – July 1, Year 4 543,840
Implied value of 100% investment 679,800
Carrying amount of Bondi’s net assets
Assets 936,000
Liabilities 307,200
628,800
Acquisition differential 51,000
Allocated: FV – CA
Accounts receivable 24,004
Inventory 48,000
Plant assets - 90,000
Bonds payable 13,466 - 4,530
Balance – goodwill 55,530
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
36 Modern Advanced Accounting in Canada, Seventh Edition
Bond Carrying
Cash Interest Premium Amount
Date Paid Expense Amortization of Bonds
July 1/ Year 4 $186,534
Dec 31/ Year 4 $6,0001 $7,4612 $1,4613 187,9954
June 30, Year 5 6,000 7,520 1,520 189,515
Dec 31/ Year 5 6,000 7,580 1,580 191,095
June 30, Year 6 6,000 7,644 1,644 192,739
Dec 31/ Year 6 6,000 7,710 1,710 194,449
37
650,399
20%
130,080
Calculation of non-controlling interest – Dec. 31, Year 6 (Method 2)
(a)
Aaron Co.
Consolidated Financial Statements
December 31, Year 6
Income Statement
(b)
(c)
39
NCI – entity theory 130,080
Problem 5-13
Amortization Schedule
Balance Amortization Balance
July 1 Dec. 31 Dec. 31 Dec. 31 Dec. 31
Year 2 Year 2 Years 3 to 5 Year 6 Year 6
Inventory 360,000 360,000
Equipment 480,000 30,000 180,000 60,000 210,000
Goodwill 360,000 70,000 20,000 270,000
1,200,000 390,000 250,000 80,000 480,000
41
Income tax (250,000 + 120,000) 370,000
3,830,000
Net income 1,170,000
Attributable to:
Pearl’s shareholders 1,090,000
Non-controlling interest [25% (400,000 – 80,000)] 80,000
1,170,000
Pearl Company
Consolidated Retained Earnings Statement
for the Year Ended December 31, Year 6
Pearl Company
Consolidated Balance Sheet
December 31, Year 6
(c)
Problem 5-15
43
Inventory 200,000
Patents 500,000
Bonds payable - 300,000 400,000
Balance – goodwill 250,000
Amortization Schedule
Balance Amortization Balance
Jan. 2 Dec. 31 Dec. 31 Dec. 31
Year 1 Years 1 & 2 Year 3 Year 3
Inventory 200,000 200,000
Patents 500,000 100,000 50,000 350,000
Bonds payable - 300,000 - 60,000 - 30,000 - 210,000
Goodwill 250,000 25,000 12,500 212,500
650,000 265,000 32,500 352,500
Brady Ltd.
Consolidated Income Statement
for the Year Ended December 31, Year 3
Sales (10,000,000 + 5,000,000) 15,000,000
Cost of goods purchased (6,930,000 + 2,890,000) 9,820,000
Change in inventory (70,000 + 110,000) 180,000
Depreciation expense (900,000 + 400,000) 1,300,000
Patent amortization (100,000 + 50,000) 150,000
Interest expense (480,000 + 300,000 – 30,000) 750,000
Other expense (680,000 + 850,000) 1,530,000
Goodwill impairment loss 12,500
Income tax (600,000 + 150,000) 750,000
14,492,500
Profit 507,500
Attributable to:
Brady’s shareholders = profit under equity method 474,000
Non-controlling interest [20% (200,000 – 32,500)] 33,500
507,500
45
Retained earnings under the cost method would also be decreased by $242,000. It would change
from $6,362,000 under the equity method to $6,120,000 (6,362,000 – 242,000) under the cost
method.
(in 000s) Equity Cost Consolidation
Current assets 6,000 6,000 9,800
Current liabilities 3,000 3,000 4,400
Current ratio 2.00 2.00 2.23